Showing papers on "Potential output published in 2006"

Calculating potential growth rates and output gaps: A revised production function approach

Abstract: Any meaningful analysis of cyclical developments, of medium term growth prospects or of the stance of fiscal and monetary policies are all predicated on either an implicit or explicit assumption concerning the rate of potential output growth. Given the importance of the concept, the measurement of potential output is the subject of contentious and sustained research interest. All the available methods have "pros" and "cons" and none can unequivocally be declared better than the alternatives in all cases. Thus, what matters is to have a method adapted to the problem under analysis, with well defined limits and, in international comparisons, one that deals identically with all countries. This is the approach adopted in the present paper where it is stated clearly that the objective is to produce an economics based, production function, method which can be used for operational EU policy surveillance purposes.

Estimating Potential Output, Core Inflation, and the NAIRU as Latent Variables

Abstract: This article proposes a new method to obtain estimates of the NAIRU, the core inflation rate, and the trend investment rate for the United States using an unobserved components model that is compatible with the usual decomposition of real gross domestic product into trend and cycle. The model includes Okun's law, a forward-looking Phillips curve, and an accelerator-type investment equation and accounts for some volatility breaks in two components. The unknown parameters in the model are estimated by maximum likelihood using a Kalman filter initialized with a partially diffuse prior, and the unobserved components are estimated using a smoothing algorithm. Our results show that the output gap is positively correlated with the deviations of the investment rate from its trend and the inflation rate from core inflation, and negatively correlated with the deviations of the unemployment rate from the NAIRU.

Stabilization policy: a reconsideration

Abstract: I. INTRODUCTION In 1936 Keynes's General Theory explained how fiscal and monetary policy could be used to end depressions. Since that time no developed country has ever seen a downturn on the scale of the 1930s. The General Theory was not just a how-to book on the avoidance of depressions. It was an argument for stabilization policy itself. The years since The General Theory have seen a revolt against Keynesian economics. In a revisionist mode, Milton Friedman argued that countercyclical policy cannot affect the average level of unemployment and output. Robert Lucas and Thomas Sargent (1979) went further, contending that it is not only impossible to increase average output, it is also impossible to stabilize it. More recently, Lucas (1987, 2003) has argued that policies to stabilize output, even if effective, would yield negligible welfare gains. Thus, stabilization policy should not be a macroeconomic priority. Lucas's conclusion notwithstanding, stabilization policy has long been an explicit or implicit objective of monetary policy in most industrial countries, even including those countries with inflation targets. The volatility of output has, in fact, declined in most major industrial countries since the mid-1980s, and monetary policy arguably deserves at least partial credit (see Bernanke 2004). Mirroring practice, monetary policy research commonly takes it as "given" that, along with price stability, stabilization policy--the minimization of squared deviations of output around potential--is an appropriate policy objective (see, for example, Clarida et al. 1999). In this article we explore the economic rationale for stabilization as a policy goal, concluding that it does, in fact, deserve high policy priority. We survey a large body of literature that critiques the validity of key assumptions in Lucas's argument. We also offer suggestive evidence that stabilization policy can significantly reduce average levels of unemployment by providing stimulus to demand in circumstances where unemployment is high but underutilization of labor and capital does little to lower inflation. A monetary policy that vigorously fights high unemployment should, however, also be complemented by a policy that equally vigorously fights inflation when it rises above a modest target level. The Federal Reserve Act thus wisely enunciated price stability and maximum employment as twin goals for monetary policy. II. THE CASE AGAINST STABILIZATION POLICY Macroeconomic analysis typically assumes that social welfare depends negatively on both inflation (above a modest target level, here assumed zero) and unemployment (above some minimum, socially efficient level). For example, a standard social welfare function is the discounted sum of period losses ([L.sub.t]) of the form (see, among others, Barro and Gordon 1983, pp. 592-93): (1) [L.sub.t] = a([u.sub.t] - [1 - k][u.sup.*])2 + b[[pi].sup.2.sub.t], where [u.sub.t], and [[pi].sub.t] are the unemployment and inflation rates in period t, and [u.sup.*] is the natural rate of unemployment. The coefficient k is positive, reflecting the desirability of unemployment below the natural rate. Because real economies deviate in many respects from perfect competition, the natural rate of unemployment is likely to exceed the socially optimal unemployment rate. For example, with monopolistic competition, goods are underproduced because they are priced above marginal cost, so "potential output" is inefficiently low and "equilibrium unemployment" is too high. Standard macroeconomic analysis additionally assumes that inflation is determined by an expectations-augmented, accelerationist Phillips curve of the form (2) [[pi].sub.t] = [[pi].sup.e.sub.t] - f([u.sub.t] - [u.sup.*]) + [[epsilon].sub.t], where [[pi].sup.e.sub.t] is the expected inflation rate at time t (with expectations formed at t - 1), and [[epsilon].sub.t], captures supply shocks to the Phillips curve at t. …

New OECD Methods for Supply-side and Medium-term Assessments

Abstract: The OECD makes frequent use of the supply-side framework and associated measures of factor productivity, productive potential and associated output gaps in the assessment of the short-term conjunctural situation, comparative economic performance and longer-term growth determinants. This paper describes a number of recent changes and improvements in the methods used in estimating potential output for OECD countries and the systems in which they are used, notably for the production of mediumterm economic scenarios. By and large, these reflect important changes and improvements in available statistical data sets, notably for measuring productive capital, as well as the development of more efficient model-based methods for making medium-term projections on a consistent international basis.

Estimating Potential Output with a Production Function for France, Germany and Italy

Abstract: This paper discusses the supply conditions for economic growth in terms of potential GDP estimated by the production function approach for France, Germany and Italy. The aim of this study is twofold: first, we keep a consistent framework as regards national accounts institutional sectors. Second, after defining Total Factor Productivity (TFP) in the so-called productive sector from the Solow residual, we specify it in a general framework for the three countries as a function of a time trend corrected for the effects of the age of equipments and the capacity utilisation rate (CUR). This framework allows to distinguish temporal considerations: in the medium to long term, the variables that could generate short to medium term fluctuations in potential output growth are assumed to be stable at a structural level. This implies modifications of the functional specifications related to the time horizon.

The Utilization-Adjusted Output Gap: Is the Russian Economy Overheating?

Abstract: This paper estimates the output gap in Russia using a utilization-adjusted production function approach, which we argue is preferable to traditional output gap methods. The approach amounts to (1) using available surveys to estimate the 'natural rates' of capacity and labor utilization above which inflation begins to accelerate; (2) estimating a production function with utilization-adjusted capital and labor inputs; and (3) defining potential output as the level of output obtained when both capital and labor are at their estimated natural rates. The results suggest that the output gap in Russia was negative between 1999 and 2003, but may have recently become positive, thus contributing to inflationary pressures.

Measures of Potential Output from an Estimated DSGE Model of the United States

Abstract: This paper develops a DSGE model for the United States that features rational in‡aton inertia and persistence. The model is estimated with Bayesian-estimation techniques and time-varying in‡ation objectives to account for movements between regimes. After showing that the model produces forecasts that are quite competitive with other methods we use the forecasts of the model to generate more robust Hodrick-Prescott …lter end-of-sample estimates of the output gap.

The Utilization-Adjusted Output Gap : Is the Russian Economy Overheating?

Abstract: This paper estimates the output gap in Russia using a utilization-adjusted production function approach, which we argue is preferable to traditional output gap methods. The approach amounts to (1) using available surveys to estimate the "natural rates" of capacity and labor utilization above which inflation begins to accelerate; (2) estimating a production function with utilization-adjusted capital and labor inputs; and (3) defining potential output as the level of output obtained when both capital and labor are at their estimated natural rates. The results suggest that the output gap in Russia was negative between 1999 and 2003, but may have recently become positive, thus contributing to inflationary pressures.

Computing potential output and the output gap for the portuguese economy

Abstract: The computation of potential output and the output gap for the Portuguese economy enables not only an assessment of economic growth potential, but also the measurement of the cyclical position of the economy and the identification of changes in the pattern of business cycle evolution. These indicators usually play a relevant role in different domains of economic analysis, such as in the computation of structural indicators (for instance, the cyclically-adjusted budget balance) and in the appraisal of inflationary pressures in the economy stemming from the demand side. Additionally, these indicators are also used in the assessment of the overall consistency of the macroeconomic projections for the Portuguese economy. Potential output is not an observable variable and must therefore be computed using an information set that contains observable variables, using techniques that combine macroeconomic theory with statistics and econometrics. These techniques are usually classified into two broad categories: statistical methods, which decompose mechanically real GDP time series into its trend, cycle and irregular components; and structural methods, which use economic theory in the process of potential output computation. Since potential output resulting from the implementation of the previous methodologies is not an observable variable, it is not possible to evaluate the accuracy of the computed figure based on the usual goodness of fit measures, in contrast to what usually happens with observable variables. Thus,

Foreign Direct Investment: South Africa’s Elixir of Life?

Abstract: Foreign direct investment (FDI) has of late been revered as the solution to a great deal of the developing world’s problems. This paper seeks to examine the macroeconomic link between foreign direct investment in South Africa, and its resultant impact on potential output. Cointegration techniques and time-series data from 1970-2003 are utilized to construct a model suitable for policy analysis. Policy options, through which the level of foreign direct investment inflow can be raised, and its’ ultimate impact on output are investigated. Empirical results indicate that market size, openness, infrastructure and nominal exchange rate are factors on which South African policy makers should focus when seeking to attract foreign direct investment.

The sources of growth at different stages of development

Abstract: What separates wealthy nations from poor ones is one of the oldest and most fundamental questions in economics. But it has only been in recent years, with the development of powerful computational techniques and data sets, that empirical analysis of growth and why it happens (or, more revealingly, does not happen) has taken off. A common technique in this analysis has been cross-country regressions in which national economic performance, typically growth in per capita product, has been used as the dependent variable. Among the pioneering work in this regard is Barro (1991). The technique has also been applied to investigate derivative issues such as foreign aid (Burnside and Dollar 2000) and the effects of an open economy (Rodriguez and Rodrik 2001; Sachs and Warner 1995). Yusuf and Stiglitz (2000) lay out what we know about achieving modernization in light of this empirical revolution, which they refer to as the settled issues in development economics. Among them are the importance of physical and human capital accumulation (including not just education but knowledge available nonrivalrously to all and produced by activities such as scientific research), low inflation, open trade, clean governance, secure property rights, flexible labor markets and provision of social safety nets. Other issues, for example, the role of industrial policy, remain unsettled. But a tacit assumption of much of this empirical growth literature, as well as the aforementioned theoretical consensus, is catholicity--the notion that whatever the sources of growth, they operate identically in all countries, be they highly advanced or pre-industrialized. The growth process is assumed to be the same in Sweden as it is in Bangladesh, with only parameter values distinguishing the two. Typically this assumption plays out when data from all nations are thrown into a single cross-country growth regression covering all levels of per capita income. This article investigates whether the findings of the growth literature are common to countries at different levels of per capita income. The results provide some insight with respect to proper sequencing of reforms when political constraints exist, and explain some of the stylized facts of development and the politics of international trade. Section I describes the econometric problem and some of the theoretical controversies in the literature its resolution might address, sections II-IV contain the empirical results, and section V draws some implications. I. GROWTH NONLINEARITIES The approach bears some similarity to Barro (2000a). There is a production function that relates potential output to a vector of inputs. At the same time, societies face constraints, imposed by government or beyond their control, that limit the efficiency of input conversion, and hence cause output to fall short of the production frontier. To the extent that these constraints are the results of policy choices, such choices thus have costs that may or may not be worthwhile but must be accounted for in understanding growth. Actual output then depends on available resources and the choices that have been made or the constraints that are faced with respect to macroeconomic management, political stability, and so on. These serve to limit actual output below the potential derived from the production technology. An issue of interest is whether the resources available and the choices made have different effects at different levels of this function. Government spending, for example, is sometimes both in theory (Krichel and Levine 2001) and empirically (Barro 1991, 2000a; Tavares and Wacziarg 2001) shown to be negatively related to growth. Do advanced societies more frequently fall into factional warfare over government spoils to such an extent that they cripple the economy's productive capacity (Olson 1982)? Or is there a rent-seeking trap visible in government spending (or in economic distortions) that tends to affect the poorest countries most (Krueger 1974)? …

Structural change and nonlinearities in a phillips curve model for south africa

Abstract: I. INTRODUCTION A crucial precondition for a central bank to maintain price stability is a stable and predictable trade-off between inflation and real economic activity. As Mankiw (2001) succinctly put it: "The tradeoff is inexorable because it is impossible to make sense of the business cycle, and in particular the short-run effects of monetary policy, unless we admit the existence of a tradeoff between inflation and unemployment" (pp. 45-46). The relevance of the Phillips curve for monetary policy came under close scrutiny during the 1970s, following its empirical failure in the face of supply shocks and changing expectations. Unexpected supply shocks, the Lucas critique (1976), labor market reforms, regime changes and imprecise measures of potential output, and the nonaccelerating inflation rate of unemployment (NAIRU) are various factors that make it unlikely that the Phillips curve will ever provide a tight fit for forecasting and policy analysis (Mankiw 2001). Despite these modeling difficulties, empirical evidence for developed countries shows that the Phillips curve model augmented to include supply shocks, expectations, and a time-varying NAIRU remains useful to examine the short-run effects of monetary policy (Cunado and de Gracia 2003; Debelle and Laxton 1997; Gordon 1997; Gruen et al. 1999; Hassler and Neugart 2003; Rudebusch and Svensson 2002; Stock and Watson 1999). The adoption of inflation targeting strategies by many advanced economies, emerging markets, and transition economies since the 1990s, reflects the importance of the Phillips curve in modern-day monetary policy. The main transmission mechanism that underlies an inflation targeting strategy is based on a direct link between monetary policy, aggregate demand, and inflation (Svensson 1999, 2000; Rudebusch and Svensson 2002). In addition, almost all models used by policy makers worldwide include some version of the Phillips curve that serves as an essential mechanism to examine the short-run effects of monetary policy shocks (Gruen et al, 1999). In 2000, South Africa adopted an official monetary policy framework of inflation targeting. Based on the evidence of recent studies, however, there is some uncertainty about the relevance of the Phillips curve for policy purposes. Jonsson (2001) shows that a positive shock to real output exerts upward pressure on prices after about five quarters. The results in Nell (2004) suggest that although the origins of inflation have changed to structural forces since the mid-1980s, demand-pull inflation has played an important role in South Africa's historical inflationary process. Akinboade et al. (2002), on the other hand, claim that the monetary authorities in South Africa can do very little to stabilize prices around the level of its major trading partners, because the dominant sources of inflation are unit labor costs and exchange rate changes, which occur autonomously from the pressure of demand in the product market. (1) Similarly, Fedderke and Schaling (2005) advance the idea that inflation in South Africa is mainly a cost-push phenomenon. Aron et al. (2004) examine the various monetary transmission mechanisms in a four-equation macroeconomic system. The study shows that the output gap only affects consumer price inflation indirectly through producer price inflation. A direct channel is identified on the assumption that the current account ratio is a good proxy for demand pressure. The role of the conventional Phillips curve is further obscured by several complicated transmission mechanisms that appear to underlie the inflationary process. Finally, contrary to the theoretical prediction of the Phillips curve model, Hodge (2006, p. 175) finds a negative relationship between the level of the inflation rate and output growth. The main objective of this article is to reexamine the role of the Phillips curve model for monetary policy analysis in South Africa. Unlike previous studies, the analysis proceeds by augmenting the Phillips curve model for major structural changes in the balance-of-payments and labor market. …

An Eclectic Approach to Estimating U.S. Potential GDP

Abstract: Rennison (Comparing alternative output gap estimations: a Monte Carlo approach, 2003) has provided simulation-based evidence showing that the joint use of extended multivariate filters and structural vector autoregression models is optimal for estimating potential output. We use this approach to estimate the two components of potential GDP: the full-employment labour input and trend labour productivity. This decomposition is useful for identifying sources of fluctuations in potential output. It reveals, for example, that the vigorous growth rate of U.S. potential GDP recorded during the second half of the 1990s is attributable to a fall in the structural rate of unemployment and a marked upswing in trend productivity growth.

Measuring a roller coaster: evidence on the finnish output gap*

Abstract: The output gap – which measures the deviation of actual output from its potential – is frequently used as an indicator of slack in an economy. This article estimates the Finnish output gap using various empirical methods. It evaluates these methods against economic history and each other by a simulated out-of-sample forecasting exercise for Finnish CPI inflation. Only two gap measures, stemming from a frequency-domain approach and the Blanchard-Quah decomposition, perform better than the naive prediction of no change in inflation – but do not improve upon a simple autoregressive forecast. The pronounced volatility of output in Finland makes it particularly difficult to estimate potential output, producing considerable uncertainty about the size (and sign) of the gap. (JEL: E31, E32, E37)

Supply-Side Performance and Structure in the Czech Republic (1995-2005)

Abstract: In this paper, we apply the aggregate production function to approximate the path of potential output We use a time-varying NAIRU to derive the amount of potential labour and a newly developed measure of capital services to account for the productive impact of capital In addition, trend total factor productivity is estimated Production functions for the key sectors (Agriculture, Industry, etc) are also calculated, exploring the growth accounting approach and decomposition of total factor productivity growth During 1995--2005, the growth in potential output was constrained by a gradual increase in the NAIRU, a temporary drop in investment activity and, most importantly, by only a modest rise in total factor productivity In this period, the Czech economy also suffered from a structural burden, ie all growth in total factor productivity was exclusively due to better utilisation of resources, given their initial allocation, with an even negative contribution of resource reallocation Just from 2001 onwards, we observe substantial improvements in supply-side performance, except for the functioning of the labour market

Economic Reforms in the Euro Area: Is There a Common Agenda? Bruegel Policy Contribution/November 2006, Issue 5

Abstract: Despite the recent growth revival, the state of the euro area economy remains vexingly disappointing. What is taking place is too little, too late and the very fact that output growth only started to pick up in the fourth year of the global recovery suggests that something must be wrong. Against this background, the overriding priority remains to design and implement policy packages aiming at: (i) Increasing potential output through higher employment, higher labour participation, and higher productivity; (ii) Ensuring that actual output does not lag behind gains in potential output. While several items on the reform agenda remain a matter for discussion, the overall direction and a large part of the concrete prescriptions increasingly command consensus among euro-area policymakers2. It is also widely recognised that this agenda leaves room for social choices that may differ from one country to another or from one political camp to another — say, as regards the respective roles of public and private initiatives or the balance between individual and collective responsibility.

India's Public Finances: Excessive Budget Deficits, a Government-Abused Financial System and Fiscal Rules

Abstract: Capital formation is a key driver of the growth of potential output. With continuing widespread capital controls and persistently small inward FDI the volume of capital formation in India is constrained by domestic saving. The national saving rate in India (the sum of the saving rates of households, enterprises and the state) is depressed by the continuing large public sector deficits (and much below the near 40% of GDP saving rates achieved by China). Even this saving rate should be able to support a higher growth rate than has been achieved thus far. The reason it does not is that the intermediation of this saving into domestic capital formation is inefficient. Since the middle of the 1990s, India's public debt has risen steadily as a share of GDP, but remains below the levels achieved at the time of the 1991 currency crisis. The composition of this debt is, however, significantly different from that in 1991: external public debt is modest and international gold and foreign exchange reserves stand at historically high levels. The domestic debt is rupee-denominated. For all these reasons, government solvency may not be a pressing issue at this stage. Globally, risk-free rates at all maturities and all imaginable credit risk spreads are extraordinarily and unsustainably low. Continuation of the pattern of recent years - a steady increase in the debt-GDP ratio - will sooner or later raise the public debt to unsustainable levels. The fiscal rules adopted by the Indian Central Government under the Fiscal Responsibility and Budget Management Act do not address the key distortions imposed by the authorities on the private sector through financial repression, misguided regulations and inefficient ownership and incentive structures. Nor do they address the underlying fiscal sustainability problem faced by the Indian state. In addition, they create a mechanism for macroeconomic volatility-enhancing, pro-cyclical fiscal policy.

Convergence or divergence in Europe? : growth and business cycles in France, Germany and Italy

Abstract: General Conclusions.- Measuring Cyclical Comovements and Asymmetries in Growth and Business Cycles.- Supply-side Developments.- Cyclical Patterns in Main Components of Aggregate Demand.- Convergence and Divergence in External Trade.- Panel Discussion.- Measuring Cycles.- Tracking the Economy in the Largest Euro Area Countries: a Large Datasets Approach.- Assessing Aggregate Comovements in France, Germany and Italy Using a Non Stationary Factor Model of the Euro Area.- Supply Side.- Capital, Labour and Productivity: What Role Do They Play in the Potential GDP Weakness of France, Germany and Italy?.- Estimating Potential Output with a Production Function for France, Germany and Italy.- Demand Side.- Synchronisation of Cycles: a Demand Side Perspective.- Short-Run and Long-Run Comovement of GDP and Some Expenditure Aggregates in Germany, France and Italy.- Synchronization of Responses to Cyclical Demand Shocks in France, Germany and Italy: Evidence from Central Banks Macro-models.- External Side.- Market Shares and Trade Specialisation of France, Germany and Italy.- Modelling Imports and Exports of Goods in France, Distinguishing Between Intra and Extra Euro Area Trade.- Has the Impact of Key Determinants of German Exports Changed?.

Measuring the Natural Interest Rate for the Peruvian Economy

Abstract: Since the adoption of the fully-fledged inflation targeting (IT) regime by an important group of central banks, a measure of both the potential output and the natural interest rate have become one of the main concerns of the research agenda. Estimation of the natural interest rate (NIR) is crucial to capture the stance of the monetary policy. In particular, the gap between the instrument rate of the Central Bank and the NIR can be a useful guideline for the position of the monetary policy and can also help to rationalize policy decisions. In this paper we estimate the NIR for the Peruvian Economy. We do so by applying the Kalman Filter to a semi-structural small open economy model with Peruvian data during he sample 1994-2005. Overall, our findings show a persistent reduction on the Peruvian NIR since 1999, which is related to an improvement on the terms of trade and a reduction on the international interest rate. Moreover, the estimated gap shows a loose monetary impulse between 1994 and 1997, tight between 1998 and 2001, and slightly loose between 2002-2005. Finally, the variance decomposition shows that 25 percent of fluctuations in the gap are explained by fluctuations in the NIR. According to this, a time-fixed NIR would give a quite imprecise measure of monetary policy stance.

The Effect of Adverse Supply Shocks on Monetary Policy and Output

Abstract: The aim of the present research is to use a model economy built for Brazil, based on an optimizing dynamic general equilibrium model, in order to perform numerical simulations to derive the ability of the artificial economy to explain the impact of monetary policy interventions on short run economic performance in terms of the inflation rate, output gap, interest rate and level of economic activity in the face of an adverse supply shock Alternative specification of monetary reaction functions are introduced into the model economy in order to perform a sensitivity analysis of derived impulse responses to those interventions facing the negative productivity shock The preliminary results suggest that the introduction of habit persistence into the consumption hypothesis does not make much difference However the introduction of different monetary reaction functions does alter the impulse response of output, inflation rate, and nominal interest rate A common result is the decline in potential output for all models Additionally, the only case where a reduction in the output gap is observed is when using the Taylor rule that takes into consideration the output gap and past interest rates with high persistence

Should the bank of israel have a growth target? what are the issues?

Abstract: The main objective of this paper is to contribute to the public policy discussion regarding whether or not a growth target (or a flexible inflation target) should be assigned to the Bank of Israel by reformulating this question in a way that leads to verifiable and falsifiable propositions. It is shown that the answer to this question depends on the structure of the economy as summarized by the objective tradeoff between stabilization of inflation and stabilization of output. If a change in the interest rate has a strong impact on inflation and little impact on output, strict inflation targeting is indicated. Otherwise, some form of growth (or flexible inflation) targeting is desirable. The paper identifies some of the basic parameters that determine this crucial tradeoff coefficient and utilizes recent estimates to evaluate it. It is also argued that the desirability of growth targeting rises the more inflationary expectations are anchored in the economy. Finally, due to the unobservability of potential output and the output gap, even optimal monetary policy is subject to serially correlated forecast errors. Flexible inflation targeting that assigns a positive weight to stabilization of the output gap leads to larger discrepancies between the actual and the full- information interest rate than strict inflation targeting. The paper also briefly evaluates the case for nominal income targeting.

Measuring a Roller Coaster: Evidence on the Finnish Output Gap

Abstract: The output gap – which measures the deviation of actual output from its potential – is frequently used as an indicator of slack in an economy. This article estimates the Finnish output gap using various empirical methods. It evaluates these methods against economic history and each other by a simulated out-of-sample forecasting exercise for Finnish CPI inflation. Only two gap measures, stemming from a frequency-domain approach and the Blanchard-Quah decomposition, perform better than the naive prediction of no change in inflation – but do not improve upon a simple autoregressive forecast. The pronounced volatility of output in Finland makes it particularly difficult to estimate potential output, producing considerable uncertainty about the size (and sign) of the gap.

A measure of output gap for Italy through structural time series models

Abstract: The aim of this paper is to achieve a reliable estimate of the output gap for Italy through the development of several models within the class of the unobserved component time series models. These formulations imply the decomposition of output into a trend component (the ‘potential output’) and a cycle component (the ‘output gap’). Both univariate and multivariate methods will be explored. In the former, only one measure of aggregate activity, such as GDP, is considered; in the latter, unemployment and industrial production are introduced. A comparison with alternative measures of output gap, mainly those published by international organisations, will conclude.

Should the Bank of Israel have a growth target? What are the issues?

Abstract: The main objective of this paper is to contribute to the public policy discussion regarding whether or not a growth target (or a flexible inflation target) should be assigned to the Bank of Israel by reformulating this question in a way that leads to verifiable and falsifiable propositions. It is shown that the answer to this question depends on the structure of the economy as summarized by the objective tradeoff between stabilization of inflation and stabilization of output. If a change in the interest rate has a strong impact on inflation and little impact on output, strict inflation targeting is indicated. Otherwise, some form of growth (or flexible inflation) targeting is desirable. The paper identifies some of the basic parameters that determine this crucial tradeoff coefficient and utilizes recent estimates to evaluate it. It is also argued that the desirability of growth targeting rises the more inflationary expectations are anchored in the economy. Finally, due to the unobservability of potential output and the output gap, even optimal monetary policy is subject to serially correlated forecast errors. Flexible inflation targeting that assigns a positive weight to stabilization of the output gap leads to larger discrepancies between the actual and the full- information interest rate than strict inflation targeting. The paper also briefly evaluates the case for nominal income targeting

Estimating Potential Output for Jamaica: A Structural VAR Approach

Abstract: Potential output and the output gap play a critical role in macroeconomic policy formulation as it is an indicator of excess demand and consequently potential inflationary pressures. Against this background this paper reviewed four methods that are used to estimate potential output and hence the output gap, namely HP and Band-Pass filters, linear time trend and the SVAR model. The assumption that movements in output can arise from either demand-side or supply -side developments provide the set of identifying restrictions for the structural model. The results suggest that the measure of output gap from the SVAR model provides a more robust and reliable predictor for inflation. In that regard, the SVAR estimate can be used to compliment the Bank’s estimates of potential output derived from the Kalman filter. The trends in the potential output from the SVAR can be reasonably explained by movements in total factor productivity.

A Simultaneous Model of the Swedish Krona, the US Dollar and the Euro

Abstract: In this paper we simultaneously estimate the real exchange rates between the Swedish Krona, the US Dollar and the Euro. A prime candidate for explaining the exchange rate movements is relative potential output. Since this variable is unobservable, cyclical and potential output are estimated in an unobserved components framework together with a Phillips curve. Our empirical exchange rate results are in line with theory. Increases in relative potential output and the terms of trade strengthen the exchange rate, while a relative increase of the fraction of middle-aged people in the population and budget deficits depreciate the exchange rate. The estimates suggest that the recent deterioration of the relative budget situation for the US versus Europe is a prime candidate for explaining the USD/EUR exchange rate change lately.

Does South Africa have the potential and capacity to grow at 7 per cent? : a labour market perspective

Abstract: Facing the challenge to adjust, the question is to what extent South African markets, specifically labour and investment markets, are flexible enough to enhance its global competitiveness, without having to revert to inward domestic protectionism. In investigating the level of flexibility in this regard, we need to determine the adjustment potential or capacity of the South African economy. However, modelling potential output and/or capacity is problematic. Building on previous research, this paper’s estimation of potential output for South Africa is based on a structural production function relationship with the maximum level of output consistent with stable inflation, supported by a full-scale macro-econometric model which is primarily supply-side driven, with capacity utilisation (or the output gap) as one of the key drivers of economic activity. The extent to which capacity is utilised in the economy is determined (defined) by the actual output (gross domestic product) relative to the potential of the economy to generate gross domestic product. Following this approach, South Africa’s potential employment needs to be determined. Does the entire labour force of working age have the potential and necessary skills to fill the available vacancies in the job market? On the contrary, our belief is that there exist certain constraints/rigidities in the labour market, which reduce the ranks of the potentially employable. In order to capture this effect, we assume that some “equilibrium or natural rate of unemployment” exists. Therefore, we presuppose a NAWRU - a natural rate of unemployment consistent with stable wage inflation. Ideally speaking, the NAWRU of an economy should be stable and not trending. However, the estimate we obtain for the NAWRU of the South African economy is increasing at a steady rate, suggesting severe structural problems in the economy, in particular, the labour market. Using this calculated NAWRU, we obtain estimates for potential output based on the structural production function approach. Our results indicate that the capacity of the South African economy is lower than conventionally expected. This reveals the essence of the impediments on the South African economy, primarily due to the sizeable constraint posed by rising labour market disequilibrium.

Estimating Potential Output with a Production Function for France, Germany and Italy

Abstract: This paper discusses the supply conditions for economic growth in terms of potential GDP estimated by the production function approach for France, Germany and Italy for the 1986:2003 period. The aim of this study is twofold: first, we keep a consistent framework as regards national account institutional sectors. Second, after defining Total Factor Productivity (TFP) in the so-called productive sector from the Solow residual, we specify it in a general framework for the three countries as a function of a time trend corrected for the effects of the age of equipments and the capacity utilisation rate (CUR). This framework allows to distinguish temporal considerations: in the medium to long term, the variables that could generate short to medium term fluctuations in potential output growth are assumed to be stable at a structural level. This implies modifications of the functional specifications related to the time horizon.