Potential output-in the sense of the GDP level or path an economy can sustain over the medium term-is a crucial benchmark for policymakers. However, it is difficult to estimate when financial "booms and busts" are driving the real economy. This paper uses a simple multivariate filtering approach to illustrate the role financial variables play in driving potential or sustainable output. The results suggest that it moves more steadily during financial "boom and bust" periods than implied by conventional HP filter estimates, which tend to more closely follow actual GDP. A two-region, multisector New Keynesian DSGE model with financial frictions sheds light on the economic forces that could be behind the results obtained from the filter. This has important implications for policymakers. JEL Classification Numbers: E32, E44, C51, C13.

This paper investigates how the presence of …nancial frictions and …nancial shocks changes the de…nition and the estimated dynamics of the output gap in a New Keynesian model. Financial shocks absorb explanatory power from e¢ cient labor supply shocks, thus changing radically the dynamics of the economy's e¢ cient frontier. Despite their large impact on the output gap, …nancial factors a¤ect the monetary policy trade-o¤s only to some extent. Nominal stabilization can be achieved at the cost of limited (but non-negligible) ‡uctuations in real economic activity. Finally, we discuss an alternative measure of the output gap (in deviation from the optimal equilibrium) that is a better measure of imbalances in the economy than the conventional output gap.

We suggest a new approach for analyzing the role of financial variables and shocks in computing the output gap. We estimate a two-region DSGE model for the euro area, with financial frictions at the household level, between 2000-2013. After joining the monetary union, a decline in some countries' borrowing costs contributed to a credit, housing and real boom and bust cycle. We show that financial frictions amplified economic fluctuations and the measure of the output gap in those countries. On the contrary, in countries such as France and Germany, financial frictions played a minor role in output gap measures. We also present evidence of the trade-offs faced by the European Central Bank when trying to stabilize two regions in a currency union with unsynchronized economic cycles.

The recent global financial crisis illustrates that financial frictions are a significant source of volatility in the economy. This paper investigates monetary policy stabilization in an environment where financial frictions are a relevant source of macroeconomic fluctuation. We derive a measure of output gap that accounts for frictions in financial market. Furthermore we illustrate that, in the presence of financial frictions, a benevolent central bank faces a substantial trade-off between nominal and real stabilization; optimal monetary policy significantly reduces fluctuations in price and wage inflations but fails to alleviate the output gap volatility. This suggests a role for macroprudential policies.

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