||Downes, Darrin; Moore, Winston (2005)
Estimates of the output gap are useful for identifying the sustainable level of non-inflationary output growth in countries with a flexible exchange rate regime. For nations with a fixed exchange rate, however, domestic prices are inexorably linked to the prices of its main trading partners and are likely to bear little relation to the output gap. This paper shows that a positive output gap in a small open economy with a fixed exchange rate is more likely to be reflected in an imbalance on the external current account. Both theoretical and empirical evidence is presented to support this conclusion.