| Summary: | Excess demand pressures play a fundamental role in macroeconomic policy and analysis. The output gap, as a proxy for excess demand, is widely used but is notoriously difficult to measure due to it being a latent variable. This thesis discusses the most prominent measures of the output gap, analysing their advantages and drawbacks. The use of arti…cially generated data enables explicit evaluation of the performance of univariate 'gap' measures, exposing the degree of disparity between measures. Analysis of the production function approach suggests modelling output in a dynamic setting in order to overcome the problems of systematic and substantial measurement errors in stock variables. The empirical application of the paper assesses the importance of excess demand in explaining inflation. Inflation is modelled in a dynamic single equation framework in which a general to speci…c modelling strategy is used, encompassing all relevant theories. The output gap, based on a composite measure using principal components analysis, is found to have a substantial impact upon inflation. Furthermore, the paper forecasts inflation over the 1 and 4 quarter horizon using a broad variety of forecasting models. The importance of an accurate, unbiased estimate of excess demand at the forecast origin is emphasized. Inference regarding the business cycle is integral to macroeconomics and this thesis aims to illustrate the importance of the output gap from a variety of angles.
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