A wavelet filtering based estimation of output gap

Accurate estimation of output gap is an important and challenging problem for any economy. We consider here the problem of estimating the output gap for the Indian economy. The estimation of output gap involves a hypothetical variable, the potential output of the economy. In this paper, we propose a wavelet filtering based technique for estimation of output gap using monthly the Index of Industrial Production (IIP) series. We compare the results obtained using the proposed wavelet based technique with the widely used Hodrick-Prescott filtering and Seasonal ARIMA modeling based techniques. In order to compare the output gap estimated using the proposed technique with the other techniques, we explore the causal relationship between the estimates of output gap and the growth rate of an equity market indicator. It is observed that the wavelet filtering technique gives better results than the more popular econometric and standard time-series modeling techniques.