The production function methodology for calculating potential growth rates and output gaps

The concepts of potential growth and the output gap form a crucial part of the toolkit for assessing the cyclical position of the economy and its productive capacity. These concepts have become an essential ingredient of the fiscal surveillance process emanating from the Stability and Growth Pact. Estimating the output gap is difficult since potential growth is not directly observable whilst actual GDP is subject to significant historical / forecast revisions. Given the large uncertainty surrounding output gap estimates, due care must be taken in interpreting their size and evolution. Whilst mindful of these uncertainties, the potential growth and output gap forecasts produced by the ECOFIN Council approved production function (PF) methodology have been providing essential information to policy makers since their initial release in 2002. This information has been used by policy makers for their ongoing discussions regarding the appropriate mix of macroeconomic and structural policies in the various EU economies, with the former geared to eliminating cyclical slack and the latter being used to raise the output potential of their respective economies. Given the importance of this work, the EU's Economic Policy Committee has a dedicated working group (i.e. the "Output Gap Working Group" - OGWG) which meets regularly to discuss the operational effectiveness & relevance of the existing PF methodology. Periodically, the Commission services produce a paper which tries to succinctly summarise the work of the OGWG over a specific period of time, with the present paper updating the last published paper on this topic which appeared in 2006JRC.G.3-Econometrics and applied statistic