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by Yvan Guillemette and Thomas Chalaux, OECD Economics Department
To assess the cyclical position of an economy, macroeconomists use a concept called potential output, which measures the economy’s production rate that is consistent with stable inflation at the target. When actual output is below potential, the ‘output gap’ is negative, the economy is depressed and, without prompt intervention by the central bank, inflation would tend to sag below target. Conversely, a positive output gap indicates an overheating economy and portends price and wage pressures, signalling the need for tighter monetary policy.
A country’s output gap is also a crucial ingredient in the estimation of the structural budget balance, which serves to assess the impulse that fiscal policy is imparting on the economy. Since the 2005 reform to the European Union’s fiscal framework, the Stability and Growth Pact, the structural budget balance has been at the centre of assessments by the European Commission of member countries’ adherence to the Union’s fiscal rules.
The difficulty is that potential output, and measures derived from it, such as the output gap and the structural budget balance, are not directly observable but must be estimated. The objective is for potential output to capture structural changes in the economy, such as a declining working-age population associated with ageing, while letting cyclical fluctuations, which are expected to be temporary, flow through to the output gap measure. Potential output estimation is therefore largely a matter of separating out cyclical fluctuations from structural changes. Three international organisations routinely produce such estimates for their member countries: the European Commission (EC), the International Monetary Fund (IMF) and the OECD. Despite using broadly similar methods, differences arise from a number of methodological and judgemental choices.
It is difficult to assess the quality of potential output estimates because there are no ‘true’ observed values to compare them to. Nevertheless, one criticism increasingly levelled against such estimates is that they treat too much of regular economic fluctuations as being structural. Estimated potential growth tends to be too weak when the economy is weak and vice-versa. In other words, potential output estimates are excessively ‘pro-cyclical’. One consequence is that governments will tend to have a pessimistic view of the structural budget balance in bad times and, conversely, an optimistic view in good times. Too much procyclicality in potential output therefore encourages procyclicality in fiscal policy, whereas economists generally agree that fiscal policy should be countercyclical.
For instance, the economists Antonio Fatás and Lawrence Summers have argued that the monetary and financial disaster of 2008 created an excessively pessimistic view of potential output amongst coverage makers, which led them to help contractionary fiscal coverage (i.e. cuts in spending or enhance in taxes). Fiscal austerity affected economies negatively by subtracting a significant supply of demand and, by way of hysteresis results, precipitated a discount in potential output that not solely validated the unique pessimistic evaluation, but in addition led to a second spherical of fiscal consolidation. As Fatás says, this succession of contractionary fiscal insurance policies was probably self-defeating for a lot of European nations within the sense that their public debt-to-GDP ratios are barely higher at this time than when austerity measures began.
A easy measure of the cyclicality of potential output sequence may be obtained by regressing the annual change in estimated potential development on a relentless and the annual change in precise development. The estimated coefficient on precise development then measures the sensitivity of potential development to precise development. Intuitively, this measure needs to be optimistic however small.
The chart beneath reviews the results of this train for potential output estimates revealed by the three aforementioned establishments as a part of their spring 2018 forecasting rounds, utilizing a standard panel of 24 nations over the 1980-to-2017 interval. Every regression makes use of 682 observations, so a median of 28 years per nation.
The outcomes present clearly that the spring 2018 European Fee potential output sequence had been essentially the most cyclical. On common within the Fee estimates, a one-percentage level change in precise actual GDP development is related to a 0.18 proportion level change in potential development. The coefficient on the IMF estimates is just barely smaller. Then again, the OECD coefficient is lower than half of the 2 others. One cause the OECD potential output measure could also be much less cyclical is that earlier than smoothing them with a filter, the part sequence used to assemble potential output are first cyclically adjusted by making use of different variables – equivalent to survey measures of capability utilisation or the funding charge – that are recognized to be correlated with the cycle (see Turner et al., 2016).
The above train doesn’t use ‘real-time’ estimates of potential output so, as an illustration, the 2010 potential development estimate for France is totally different now than it was again in 2010. The 2010 estimate was in fact the related one for the conduct of coverage on the time. Fairly, the check assesses the quantity of cyclicality inherent in present methodologies, which can even have advanced since 2010. And if present estimates for previous years are thought-about too delicate to precise development, then it’s probably that the real-time estimates being produced now with a given methodology are too delicate as nicely.
The sensitivity of adjustments to potential development to adjustments in precise development charges is neither an ideal nor a complete measure of the standard and reliability of potential output estimates. In any case, merely utilizing a hard and fast quantity for a rustic’s potential development would present a zero correlation however would clearly be problematic. Nonetheless, within the absence of different apparent flaws, the OECD potential output estimates seem much less uncovered to the procyclicality criticism than these of the EC or IMF.
References
Coibion, O., Y. Gorodnichenko and M. Ulate (2017), “The Cyclical Sensitivity in Estimates of Potential Output”, NBER Working Papers, No. 23580, Nationwide Bureau of Financial Analysis.
Fatás, A. (2018). “Fiscal Policy, Potential Output and the Shifting Goalposts”, CEPR Dialogue Papers, No. 13149, Centre for Financial Coverage Analysis.
Fatás, A. and L.H. Summers (2018), “The permanent effects of fiscal consolidations”, Journal of Worldwide Economics, Vol. 112, pp. 238–250.
Turner, D. et al. (2016), “An investigation into improving the real-time reliability of OECD output gap estimates”, OECD Economics Division Working Papers, No. 1294, OECD Publishing, Paris.
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