Abstract
This paper focuses on the estimation of the potential output of Ghana. Potential output or its derivative the output gap are not observable. However, “potential output” is a powerful conceptual tool that guides analysts and policymakers in gauging whether the current observed economic activity is sustainable and how much of it is greater than or less than potential. Based on Ghanaian GDP annual data from 1960 – 2017, the paper estimates potential output and output gaps using the following methodology: linear time trends, Hodrick-Prescott (HP) filter trends, multivariate HP filter trends, and a production function model. The results show that estimates of the potential output and output gaps are model-dependent as estimates vary from one methodology to the other. The paper recommends that policymakers should not mechanically choose a model to estimate output gap. For the avoidance of costly policy mistakes, the choice of the model should be complemented with sound judgement based on a set of pertinent economic information.
Highlights
Managers of a country’s economy, those in the central banks, pay significant attention to the movements of potential output
The output gap, which is the difference between actual output and potential output, is an important indicator for policymakers and it is key that the potential is estimated with minimum errors
Labour inputs are influenced by the average number of hours worked, labour force participation and changes in population. Given that these are not constant over time, as they change with structural shocks to the economy, potential output can only grow at a time-varying growth rate and not at a constant rate
Summary
Managers of a country’s economy, those in the central banks, pay significant attention to the movements of potential output. A good understanding of potential output is needed to guide policymakers on how to calibrate the effective size of the fiscal and monetary policies that the economy would need. Policy makers constantly estimate the output gap, or the difference between real output and potential output. The output gap, which is the difference between actual output and potential output, is an important indicator for policymakers and it is key that the potential is estimated with minimum errors. A wrong estimate of the potential output and the output gap will result in policy errors. Actions taken by policymakers will impact negatively as resources and capacity will be underutilized. This means that the estimation of the potential output is very critical to the conduct of effective macroeconomic policies.
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