Economists define the output gap as the deviation of actual GDP from potential GDP. Put simply, when an economy’s actual GDP is equal to its potential GDP, inflation in that economy is stable. For example, in the context of euro area member states, including Croatia, an annual inflation rate of 2% is considered desirable. If the actual level of economic activity in a country is high, meaning that its actual GDP is higher than its potential GDP, inflation exceeds 2%, and the economy is said to be overheating. Conversely, a low level of economic activity, meaning that actual GDP is below potential GDP, is associated with an inflation rate below 2%, and the economy is said to be operating below its capacity.

To calculate the output gap, potential GDP must be subtracted from actual GDP, which is data published by national statistical offices. There are numerous methods for calculating, or rather estimating, potential GDP, and there is no consensus among economists as to which method is the best. The lack of consensus on this issue and the wide range of methods used have led some economists to employ several methods instead of relying on a single method to estimate potential GDP, and hence the output gap, and then average the resulting estimates. The output gap obtained in this way is referred to as the model-averaged output gap.

In the paper entitled “Output Gap and Model Uncertainty,” authored by Josip Tica, Vladimir Arčabić, and Viktor Viljevac, the properties of the model-averaged output gap are examined across different phases of the business cycle. The authors estimate the output gap using 13 different methods based on data for 25 European Union countries and the United Kingdom. They then calculate the model-averaged output gap and the associated standard deviation around this average. The standard deviation of the model-averaged output gap serves as a measure of model uncertainty, that is, the extent to which different methods of estimating the output gap produce similar or different results.

The results of the paper show that the model uncertainty associated with output gap estimates is not the same across all phases of the business cycle. Specifically, during periods of a pronounced decline in GDP, model uncertainty increases, whereas this pattern does not emerge during expansions. In other words, periods characterized by larger negative GDP growth rates are associated with greater model uncertainty, meaning that output gap estimates are less reliable during such periods. The accompanying graph shows that, for negative GDP growth rates below a certain threshold, increasingly negative GDP growth rates are associated with greater model uncertainty. This result is important because it suggests that relying on output gap estimates—for example, when conducting economic policy—is not equally reliable in every phase of the business cycle.