Estimates Of Potential Output Research Articles

AN EMPIRICAL TAKE ON THE “PLUCKING” MODEL

Traditional estimates of potential output based on the symmetric business cycle (boom–bust) view are prone to large retrospective revisions. The plucking view, which is supported by empirics, offers possible respite. Serious attempts to estimate the output ceiling in the plucking view, analogous to potential output in the traditional view, are scarce. This paper has three parts. The first estimates the output ceiling in a computationally simple approach. The second analyzes the relationship of the resultant output gap with inflation and with the unemployment rate. A comparison is made against output gap estimates based on prevailing methods. The third uses a vector autoregression (VAR) to analyze responses to supply and demand shocks. The paper finds that the plucking model offers three points of improvement over prevailing methods based on the boom–bust view. First, boom–bust estimates are prone to large retrospective revisions when two-sided filters are used, while the plucking estimates are not. Second, output gap estimates from both views do not correlate well with core inflation. This absence of evidence for a Phillips curve is problematic for the boom–bust view. The plucking estimates correlated well with the unemployment rate but the boom–bust estimates did not. Third, the output ceiling from the plucking model responded only to supply (oil price) shocks and not demand (interest rate) shocks, hence fits the description of a supply measure. This paper provides a template to estimate the output ceiling of the plucking model in other countries using publicly available macroeconomic data.

Potential Output and Cyclically Adjusted Balance: An Application of the Updated Okun Method to Spain (1987–2022)

ABSTRACT The estimation of potential output is at the heart of the ongoing debate on the reformulation of fiscal rules in the European Union as it is an essential variable for their application. Spain constitutes a striking case, with a small and even positive output gap along with one of the highest unemployment rates in the European Union. To resolve this contradiction, in this article we estimate the potential output of the Spanish economy for the period 1987Q2–2022Q4 by means of the Updated Okun Method. Our results indicate that both the output gap and the cyclically adjusted balance are much higher than what European institutions estimate. Consequently, Spain has much more fiscal space to implement expansionary fiscal policies.

Is there hysteresis in potential output estimates?

Using an error correction model, this paper studies the dynamics of GDP and potential GDP using OECD's Economic Outlook and IMF's World Economic Outlook estimates of the output gap. The findings suggest the presence of hysteresis, implying that short-run shocks to GDP have sizeable permanent effects on potential GDP.

Fed's monetary policy mistake and the US post-COVID economic recovery

This paper argues that the persistent inflation in the U.S. during the post-COVID economic recovery was mainly the result of the Fed’s policy mistake caused by an overestimation of the negative output gap. The paper shows that after a two-quarter contraction, the U.S. economy quickly rebounded and outpaced its potential output, thus remaining in overheating territory. However, policymakers prolonged the monetary expansion beyond the necessary, which contributed to fuel inflation for a more prolonged time. The policy mistake was the result of an inaccurate estimation of potential output. Based on an alternative estimation that uses full employment as a condition, this paper shows that the U.S. economy has been running with a positive output gap since mid-2021. The results illustrate that the Federal Reserve was well-behind the curve in an economy in overexpansion and with a galloping inflation escalating well-above the target.

Konjunkturbereinigung in der Schuldenbremse reformieren: Revisionen erst zeitverzögert einrechnen

AbstractIn this article, we point out requirements for potential output estimates used for cyclical adjustment in the German debt brake. Further, we propose supplementing the cyclical component in the debt break with an error term — regardless of the specific potential output estimation approach. The error term provides fiscal policy more time to adjust to potential output revisions and tax revenue forecast errors. Simulations based on past data show that the error term reduces erratic budgetary adjustments and strengthens automatic stabilisers.

Forschungs- und Entwicklungsaktivitäten in der Potenzialschätzung berücksichtigen

AbstractPotential output is a measure of the longer-term production possibilities of an economy. Since this quantity cannot be observed directly, it must be determined on the basis of assumptions from existing data. The use of a production function was established in the European Commission’s procedure for calculating potential output. However, it is important to capture all drivers of economic growth. In the current EU procedure, total factor productivity (TFP), which is interpreted as a measure of technological progress, is assumed to be exogenous. This means that key drivers of economic growth, in particular research and development (R&D) activities, are not explicitly taken into account. An extension of the production function approach can be derived from the theory of endogenous growth. This would improve the theoretical basis of the potential output estimates.

The updated Okun method for estimation of potential output with alternative measures of labor underutilization

This paper extends the Updated Okun Method (UOM) for estimation of potential output proposed in Fontanari et al. (2020), which, from a demand-led growth perspective, regards potential output as an empirical approximation to full-employment output, as in A.M. Okun's (1962) original method. Based on the apparent incapability of the official rate of unemployment to fully account for labor underutilization, we offer estimates of Okun's law both with alternative unemployment indicators and with an indicator of ‘standardized hours worked’ which we propose as a novel measure of the labor input. The paper reflects on the possible different empirical measures of full employment. The different estimates of potential output that we obtain show greater output gaps than those produced by standard methods, thus highlighting a systematic tendency of the latter to underestimate potential output. We define a ‘corridor’ of output gap estimates and propose a two-step procedure to identify the most relevant gap for policy purposes. JEL Codes: E60; E24; O40; E12; C30

Output gap in the WAEMU zone: Comparative analysis of estimate by production function, Kalman filter and Bayesian structural VAR

The potential output and output gap concepts are important tools for central banks, and in particular the Central Bank of West African States (BCEAO), to forecast inflation in pursuit of their priority objective of inflation control. The choice of a method for estimating inflation is a delicate one. This paper proposes an estimation of potential output by the unobservable component methods, Watson's (1986) and Kuttner's (1994) approach, and by an economic modelling method, namely the Bayesian structural VAR. It also proposes a comparison of these different methods with the production function, which is widely used in the literature and recognized as the best method for estimating potential output for WAEMU countries. The results indicate that the different approaches as well as the production function explain the different crisis periods identified within the union. The comparative analysis, against all expectations, reveals that only the output gap obtained by the production function does not explain inflation.

A Multivariate Unobserved Components Model to Estimate Potential Output in the Euro Area: A Production Function Based Approach

This paper builds an unobserved components model that combines a multivariate filter approach with a Cobb-Douglas production function. This combination allows potential output estimates to incorporate more economic structure than the traditional production function approach, while retaining the ability to conduct growth accounting exercises. The model is a backward-looking state space model estimated with Bayesian methods employing the Kalman filter to jointly decompose six key observable variables (real GDP, unemployment rate, labour force participation rate, hours worked per person, a measure of core inflation and wage inflation) into trend and cyclical components. To do so, it relies on several reduced form relationships across the cyclical components, such as a wage and a price Phillips curve and an Okun's law type relationship, while it also assumes common trends for a few variables and allows for hysteresis effects. The model is estimated on aggregate euro area data with Bayesian methods. The paper finds that the resulting output gap estimates have good revision properties and reasonable forecasting performance in particular in terms of GDP and core inflation vis-a-vis a set of benchmarks.

Potential Output, EU Fiscal Surveillance and the COVID-19 Shock

This paper discusses how the technical foundations of the EU’s fiscal rules constrain the fiscal space in EU countries in the context of the COVID-19 pandemic. We review the evidence on how estimates of potential output, which are at the heart of essential control indicators in EU fiscal surveillance, were revised in the ten years running up to the COVID-19 pandemic, and how these revisions affected the fiscal stance of EU countries. We provide first evidence for downward revisions in the European Commission’s potential output estimates against the background of the COVID-19 shock across the EU27 countries, and we assess the potential consequences in terms of fiscal space. According to our results, one additional percentage point in predicted losses of actual output is associated with a loss in potential output of about 0.6 percentage points. Given the importance of model-based estimates in the EU’s fiscal rules, avoiding pro-cyclical fiscal tightening will require that policymakers’ hands are not tied by overly pessimistic views on the development of potential output.

Climate Hysteresis and Monetary Policy

Since the birth of the natural rate hypothesis, the conventional notion that short-term output simply fluctuates around a relatively stable long-term trend became the norm in modern macroeconomics, including in the standard New Keynesian DSGE model. However, the global financial crisis (GFC) led to a serious rethinking of this norm, giving rise to the re-emergence of the Blanchard-Summers’ hysteresis debate and a new business cycle paradigm in which the short-term output effects of financial crises permanently feed into long-term growth trends. Using a Bayesian-estimated structural multivariate filtering model calibrated to data for Australia and the United States, the innovation of this paper is the incorporation of climate hysteresis into the estimation of potential output and the output and unemployment gaps. The results suggest non-trivia implications for monetary policy in a carbon-constrained world. Not only are the model-based estimates of potential output and NAIRU more volatile with climate shock persistence, the climate-neutral output and unemployment gap estimates are much smaller than conventional estimates, with different implications for inflation signals during the upturn or downturn of the business cycle. For economies that are more susceptible to disruptive climate shocks, especially in the developing world, an environment in which both demand conditions and the underlying supply potential are rapidly changing will severely complicate the conduct of forward-looking macroeconomic policy.

The Output Gap and Potential Output in Namibia

The study analysed the behaviour of potential output and output gap for the Namibian economyusing annual data from 1980 to 2016. The study employed the Hodrick-Prescott (HP) filter method and theproduction function approaches to estimate potential output before calculating the output gap. The resultssuggest an annual average growth rate of 3.6 percent in potential output. However, it has been noted that theaverage annual growth rate in potential output has been shifting during the period under review. In fact, theresults suggest an annual average growth rate of 1.6 percent between 1980 and 1985 and an increase to 2.5percent per year for the period 1986 to 1990. Potential output estimates obtained using the productionfunction approach was smooth and stable throughout the study period. The potential output estimatesobtained through the two methods follow the same cyclical movements. The output gap estimates from thetwo techniques are not different from each other, and they appear to move together.

Fiscal Policy, Potential Output, and the Shifting Goalposts

This paper studies the negative loop caused by the interaction between pessimistic estimates of potential output and the effects of fiscal policy in Europe during 2008–2014. We argue that policymakers’ reliance on overly pessimistic views of potential output led to a large adjustment in fiscal policy. Contractionary fiscal policy, via hysteresis effects, caused a reduction in potential output that in part validated the original pessimistic forecasts and led to a second round of fiscal consolidation. The paper concludes by discussing alternative frameworks for fiscal policy that could avoid this negative loop in future crises.

Revisions of Potential Output Estimates in the EU after the Great Recession

Using European Commission real-time data, we show that potential output (PO) estimates were substantially and persistently revised downwards after the Great Recession. We decompose PO revisions into revisions of the capital stock, trend labor, and trend total-factor productivity (TFP). Initially, trend TFP revisions contribute most to the overall PO revisions while all three components are almost equally important in the longer run. Revisions of the capital stock happen quickly while revisions of trend labor, mainly driven by revisions of the non-accelerating wage rate of unemployment (NAWRU), are made gradually. The relative contributions of the components to overall PO revisions differ systematically across countries. This suggests that heterogeneous policies are needed to push different countries back to their previous growth paths.

Potential Output in Theory and Practice: A Revision and Update of Okun’s Original Method

This paper challenges the mainstream view of potential output, and enquires into the supposed effects of Great Recession on potential growth. We identify in the demand-led growth perspective a more promising theoretical framework both to define the notion and to gauge the long-term effects of a demand slow down. Based on the poor reliability of standard estimates of potential output, we also propose an alternative calculation. This is based on an update of Arthur M. Okun’s original method for estimating potential output, which, differently from the estimation methods currently in use, does not rely on the notion of NAIRU, thus being immune to its theoretical and empirical shortcomings. Our calculation, based on a re-estimation of Okun’s Law on US quarterly data, shows both how far an economy generally operates from its production possibilities, and how much potential growth is affected by the actual growth of demand over time. These wide margins for expansion of actual and potential output growth imply that a determined policy of demand expansion would create, given time, the very capacity that justifies it.

Multivariate Filter Estimation of Potential Output for the United States: An Extension with Labor Market Hysteresis

This paper extends the multivariate filter approach of estimating potential output developed by Alichi and others (2018) to incorporate labor market hysteresis. This extension captures the idea that long and deep recessions (expansions) cause persistent damage (improvement) to the labor market, thereby reducing (increasing) potential output. Applying the model to U.S. data results in significantly smaller estimates of output gaps, and higher estimates of the NAIRU, after the global financial crisis, compared to estimates without hysteresis. The smaller output gaps partly explain the absence of persistent deflation despite the slow recovery during 2010-2017. Going forward, if strong growth performance continues well beyond 2018, hysteresis is expected to result in a structural improvement in growth and employment.

Multivariate Filter Estimation of Potential Output for the United States: An Extension with Labor Market Hysteresis

This paper extends the multivariate filter approach of estimating potential output developed by Alichi and others (2018) to incorporate labor market hysteresis. This extension captures the idea that long and deep recessions (expansions) cause persistent damage (improvement) to the labor market, thereby reducing (increasing) potential output. Applying the model to U.S. data results in significantly smaller estimates of output gaps, and higher estimates of the NAIRU, after the global financial crisis, compared to estimates without hysteresis. The smaller output gaps partly explain the absence of persistent deflation despite the slow recovery during 2010-2017. Going forward, if strong growth performance continues well beyond 2018, hysteresis is expected to result in a structural improvement in growth and employment.

Estimates of Potential Output and the Neutral Rate for the U.S. Economy

Estimates of potential output and the neutral short-term interest rate play important roles in policy making. However, such estimates are associated with significant uncertainty and subject to significant revisions. This paper extends the structural multivariate filter methodology by adding a monetary policy block, which allows estimating the neutral rate of interest for the U.S. economy. The addition of the monetary policy block further improves the reliability of the structural multivariate filter.

The Cyclical Sensitivity in Estimates of Potential Output

The fact that declines in output since the Great Recession have been parlayed into equivalent declines in measures of potential output is commonly interpreted as implying that output will not return to previous trends. We show that real-time estimates of potential output for the United States and other countries respond gradually and similarly to both transitory and permanent shocks to output. Observing revisions in measures of potential output therefore tells us little about whether changes in actual output will be permanent. Some alternative methodologies to estimate potential output can avoid these shortcomings. These approaches suggest a much more limited decline in potential output since the Great Recession.

Estimates of Potential Output and the Neutral Rate for the U.S. Economy

Estimates of Potential Output and the Neutral Rate for the U.S. Economy