The Inflation - Output Gap Dynamics in Ecuador: A Descriptive Analysis during Episodes of Positive and Negative Output Gaps. 1970 – 2014.

Abstract

This research paper is a descriptive, empirical analysis of inflation dynamics during past episodes of positive and negative output gaps. In so doing, this study pay attention to the new Keynesian Phillips Curve theory as guide to support the theoretical expectations between the mentioned variables, and it includes the analysis of historical events and key-macroeconomic variables in order to know other factors that could affect this relationship. This research includes four episodes of positive output gaps and four episodes of negative output gapes since 1970 to 2014. The analysis finds that episodes of positive output gaps generally generate an inflationary process, which can be mainly affected and distort by social events such as political instability and oil prices. On the other side, negative output gaps generally brought disinflation however, exceptions are limited to the effect of historical events, low initial inflation rates, the economy recovery from previous periods, and lower oil prices in several cases. Nevertheless, these findings are qualified only by the observation of inflationary and disinflationary pressures within episodes of positive and negative output gaps. Consequently, in this study, the failure of theoretical expectations in some cases is most likely related to external shocks, such as historical events, initial low or high inflation rates, oil prices and government inflation targets. Overall, the past- real evidence provides some assurance that output gaps matter in inflation dynamics, at least when the economy is not affected by the shocks mentioned before. Finally, the research suggests the periodic calculation of the output gap as a useful indicator for the economic authorities to strength the public policy process to monitor and control inflation in advance. Therefore, the estimation of the output gap should take into account a proper methodology, which fits, and reflect better the Ecuadors reality and social structure. Additionally, the ultimate goal of this research is to suggest government that science or theoretical expectations might not be always right or complete enough to explain social phenomena or changes in economy. Governments public policies should be based on four main aspects: science, past evidence, social context and political judgment.