The path of output prior to the financial and economic crisis turned out to
be not sustainable and lower than previously estimated in some European crisis
countries. Specifically, the output gaps have been underestimated (and inversely
potential output overestimated) before the recent crisis. It is fair to say that the
employed estimation techniques failed to provide valid real-time assessments of the
state of the credit boom driven euro area economies. One reason for this may be
the breakdown of the Phillips curve relationship during the last years. Against
this backdrop, we comprehensively analyse the validity of the Phillips curve for
five European countries with a focus on the recent crisis. We find that a mostly
insignificant relation between in
ation and the output gap or unemployment gap,
which questions the adequacy of the Phillips curve to identify the sustainable level
of output in an economy. The credit-driven boom in crisis countries has made
clear that (disadvantageous) financial markets conditions may result in structural
and long-term real economic distortions that are not yet taken into account in
conventional methods for the estimation of potential output and the output gap.
Since both, potential output and output gaps, are a key notion in policymaking,
incorporating financial factors could improve the reliability of the estimates. Our
results point in this direction.
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