To determine whether economic progress of a country presents a threat to its macroeconomic sustainability, the difference between actual and potential output is usually used in the formulation of the economic policy. A number of methodologies, including the time series method, HP filter approach and CD function, have been used in the estimation of potential GDP. Potential production factor values were calculated for the needs of the production function. The data used in the paper lead to an inference that the economic growth depends on increases in capital stock and technological progress, both contributing to labour productivity and offsetting workforce shrinkages. Focusing on the relationship between output gap and inflation, this paper concludes that in Latvia, in contrast to several developed countries, the correlation between output gap and inflation is extremely weak due to the size and openness of the national economy as well as labour market inelasticity. Surveys conducted to date do not produce adequate data for an accurate estimation of the impact the output gap may have on inflation. Inflation is affected by a number of factors, e.g. Latvia's openness to imports, a relatively unlimited external supply of goods for relatively fixed prices, and administratively regulated prices, but it does not depend on the output gap. Hence the excessive demand is to be associated with a rise in imports rather than an upswing in inflation. Therefore, instead of inflation rate, it is the current account that reflects the domestic demand and its development trends more accurately.
