A Parsimonious Approach to Incorporating Economic Information in Measures of Potential Output

40 Pages Posted: 27 Feb 2014

See all articles by Claudio E. V. Borio

Claudio E. V. Borio

Bank for International Settlements (BIS) - Research and Policy Analysis

Piti Disyatat

International Monetary Fund (IMF) - Research Department

Mikael Juselius

Bank for International Settlements (BIS) - Monetary and Economic Department; Hanken School of Economics - Department of Economics; University of Helsinki - Department of Political and Economic Studies

Date Written: February 2014

Abstract

A popular strategy for estimating output gaps is to anchor them to structural economic relationships. The resulting output gaps, however, are often highly sensitive to numerous auxiliary assumptions inherent in the approach. This complicates their use in policymaking. We illustrate the point using the Phillips curve, arguably the most popular structural relationship in this context. Depending on the specification, we show that conditioning on this relationship either introduces a trend in the output gap - which is conceptually unappealing - or has little effect on it - which defeats the purpose of the exercise. Moreover, the estimated gaps perform poorly in real time, with large ex-post revisions. The opaqueness of the approach, which increases greatly with the dimension of the estimated system, can mask these problems. In order to address these limitations, we propose a more parsimonious and transparent approach to embedding economic information that is less vulnerable to misspecification. As an illustration, we apply the corresponding parsimonious multivariate filter to US data. We find that proxies for the financial cycle, notably credit growth, but also unemployment contain significant information and help generate robust real-time output gap estimates.

Keywords: Potential output, output gap, Phillips curve, financial cycle

JEL Classification: E10, E40, E44, E47, E52, E60

Suggested Citation

Borio, Claudio E.V. and Disyatat, Piti and Juselius, Mikael, A Parsimonious Approach to Incorporating Economic Information in Measures of Potential Output (February 2014). BIS Working Paper No. 442. Available at SSRN: https://ssrn.com/abstract=2397702

Claudio E.V. Borio (Contact Author)

Bank for International Settlements (BIS) - Research and Policy Analysis ( email )

CH-4002 Basel, Basel-Stadt
Switzerland

Piti Disyatat

International Monetary Fund (IMF) - Research Department ( email )

700 19th Street NW
Washington, DC 20431
United States

Mikael Juselius

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Hanken School of Economics - Department of Economics ( email )

PO Box 479
FI-00101 Helsinki
Finland

University of Helsinki - Department of Political and Economic Studies ( email )

P.O. Box 54
FIN-00014 Helsinki
Finland

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