Working Paper

Filling the gap: open economy considerations for more reliable potential output estimates

This paper proposes a novel structural model to estimate the equilibrium level of output and reports results for 45 countries. The model is conceptually more appropriate than existing methods by incorporating open economy considerations, which are completely missing from the models of the European Commission, IMF and OECD.

By: Zsolt Darvas, András Simon and Bruegel Date: October 22, 2015 Topic: Macroeconomic policy

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Highlights

This paper argues that the Phillips curve relationship is not sufficient to trace back the output gap, because the effect of excess demand is not symmetric across tradeable and non-tradeable sectors. In the non-tradeable sector, excess demand creates excess employment and inflation via the Phillips curve, while in the tradeable sector much of the excess demand is absorbed by the trade balance.
We set up an unobserved-components model including both a Phillips curve and a current account equation to estimate ‘sustainable output’ for 45 countries. Our estimates for many countries differ substantially from the potential output estimates of the European Commission, IMF and OECD.
We assemble a comprehensive real-time dataset to estimate our model on data which was available in each year from 2004-15. Our model was able to identify correctly the sign of pre-crisis output gaps using real time data for countries such as the United States, Spain and Ireland, in contrast to the estimates of the three institutions, which estimated negative output gaps real-time, while their current estimates for the pre-crisis period suggest positive gaps.
In the past five years the annual output gap estimate revisions of our model, the European Commission, IMF, OECD and the Hodrick-Prescott filter were broadly similar in the range of 0.5-1.0 percent of GDP for advanced countries. Such large revisions are worrisome, because the European fiscal framework can translate the imprecision in output gap estimates into poorly grounded fiscal policymaking in the EU.

potential output

Mind the gap (and its revision)!

In this post Zsolt Darvas presents an analysis of the revisions made to output gap estimates between 2001 and 2015 by the European Commission and the IMF. The output gap shows the difference between actual output and potential output, where the latter should represent the output that could be produced if all resources were employed at their long-term sustainable rate.

By: Zsolt Darvas Topic: Macroeconomic policy Date: May 20, 2015

Mind the gap! And the way structural budget balances are calculated*

The so-called structural balance of the general government aims to measure the ‘underlying’ position of the budget by excluding the impact of the economic cycle and one-off measures, like bank recapitalisation costs. It has a crucial role in designing fiscal consolidation strategies in the EU (see the Annex at the end).

By: Zsolt Darvas Topic: Macroeconomic policy Date: October 18, 2013

Blogs review: output gaps and the behavior of inflation

What’s at stake: The big issue underlying most macroeconomic discussions these days is the extent to which the decline in GDP is temporary or permanent. To distinguish between these two alternative explanations, it is natural to look at the behavior of inflation. The argument is that if the economy is operating significantly below potential, inflation should be decreasing, while it should be increasing if the drop in output is permanent. As we point out in this issue, this exercise is, however, harder than it looks because of the presence of downward nominal wage rigidities, anchored inflation expectations and the possibility of temporary decline in potential output.

By: Jérémie Cohen-Setton Topic: Global economy and trade, Macroeconomic policy Date: April 6, 2012

Bubbles and potential output

What’s at stake: What started as a speech on inflation targeting by the President of a regional Fed has turned into a fierce economic debate on the impact of the collapse of a bubble on potential GDP. While it is natural for the current debate to focus on this phase of the problem, a growing literature has also explored the impact of bubbles on potential GDP during the boom phase. We start by reviewing the provocative body of work that studies bubbles in the presence of financial frictions, which often come to the conclusion that bubbles can increase potential output by reducing the inefficiency induced by financial market frictions. We then review the current debate on the econ blogosphere following the infamous Bullard speech. Although the arguments are somewhat decoupled from the ones we outline in the first part and focus on more familiar ideas, it is interesting to see that a Fed regional President played by the rules of the econ blogosphere and wrote his own “geeky” post as a response to the criticisms he had received.

By: Jérémie Cohen-Setton and Martin Kessler Topic: Global economy and trade Date: February 17, 2012