Bayesian estimation of the output gap for a small open economy

We introduce a novel approach for estimating output gaps for small open economies. Identification is based on a multivariate trend–cycle decomposition in which transitory exchange rate movements are linked to the output gap and inflation. The model is then applied to Canadian data. Highlights ► We estimate the output gap for Canada on the basis of a permanent–transitory decomposition of output and the exchange rate using an unobserved components model. ► Empirical identification is based on a simple structural model of a small open economy in which transitory exchange rate movements are used to identify the output gap. ► The unobserved components and the structural parameters are jointly estimated using the Kalman filter and Bayesian technique.