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Estimating potential output growth in the euro area
Alberto MussoDirectorate General Economics
European Central Bank
Presentation for AIECE Workshop on Estimating potential output in the European Union
29 October 2004
Structure of presentation
• Framework, measurement and policy issues
• Main model and basic estimates
• Developments in factors of production
• Conclusions
Definition and policy relevance• Definition: sustainable (i.e. non-inflationary) rate
of growth of aggregate real output over the medium-term
• Monetary analysis: assumption for potential output growth is an input to the derivation of the reference value for monetary growth
• Economic analysis: measures of slack among indicators monitored to assess the risks to price stability in the short to medium run
See ECB: The Monetary Policy of the ECB, 2004
Role in ECB monetary policy strategy
potential output growth as input in
the derivation of the reference value
including slack indicators
ECB review of the reference value
• In 1998 medium-term trend real potential GDP growth estimated in the range 2-2.5% per annum
• Over 1999-2002 assumptions reviewed, but no new decisive evidence emerged pointing to a significant change in assumption
• In May 2003 Governing Council decided to no longer review assumptions on an annual basis but their validity still monitored regularly
• Any changes in assumptions will be communicated as soon as they become necessary
See ECB Press Releases December 1998-2002 and May 2003
Issues in the estimation of PO growth• Measurement inevitably surrounded by considerable
uncertainty, especially in real time and looking ahead, stemming from various sources:
model uncertainty parameter uncertainty data uncertainty
• From ECB perspective: Relevant time horizon is medium run Euro area aggregate perspective
See ECB Monthly Bulletin article entitled “Potential output and output gaps: concept, uses and estimates”, October 2001
The approach of the ECB
• Given the uncertainty characterising unobserved PO an encompassing approach is warranted:
assess estimates from alternative methods and institutions
assess developments in key factors of growth define trend PO growth as the range that
captures medium term developments
A basic analytical framework• Economic structure provided by use of a
Production Function Approach combined with a generalised Phillips-curve
• Statistical inference made possible by applying Unobserved Components estimation techniques
• Advantages: consistent with the definition of PO general and flexible allows for contribution of inputs to be estimated can get a well-specified statistical model can estimate confidence bands
See T. Proietti, A. Musso and T. Westermann (2002): “Estimating potential output and the output gap for the euro area: a model-based production function approach”, EUI working paper ECO 2002/09, May 2002
The production function approach
• Cobb-Douglas production function with total factor productivity, capital and labour as inputs
• Labour decomposed into working age population, the participation rate and the contribution from the unemployment rate
• Capital stock and working age population assumed to have a permanent but no transitory component
• Thus, measurement model consists in decomposing TFP, labour force participation and the unemployment rate into respective permanent and transitory component
For evidence supporting the Cobb-Douglas production function for the euro area see A. Willman "Euro area production function and potential output: a supply side system approach", ECB working paper 153, June 2002
The inflation equation
• The measurement model is augmented with a Phillips-type of relationship
• Inflation is modelled as a function of the output gap, lagged inflation, commodity prices and euro exchange rate
• Consistent with Gordon’s triangle model, where inflation has three main determinants: excess demand, inertia, and supply shocks
See R. Gordon (1998): “Foundations of the Goldilocks Economy: Supply Shocks and the time-varying NAIRU”, Brookings Papers on Economic Activity, 2: 1998
Statistical representation• Trend and cycles modelled along the lines of the
multivariate structural time series model of Harvey and Koopman (1997)
• Cyclical components are allowed to be correlated, while trends are assumed to be uncorrelated
• Trends modelled as local linear trends (stochastic trends)
• Cyclical components modelled as functions of AR(2) processes with complex roots
See Harvey, A. and S. Koopman (1997): “Multivariate structural time series models”, in C. Heij et al. (eds), Systematic dynamics in economic and financial models, Chichester: Wiley and Sons
VariantsMultivariate variants considered:
A) common cycle model
all cyclical components driven by the cycle in the capacity utilisation rate
B) pseudo-integrated cycles model
cyclical components driven by a combination of common and specific cycles
C) hysteresys model
trends function also of cycles
Estimation and inference• System approach for the five variables• All components estimated simultaneously within a
multivariate unobserved components model that incorporates the relationships specified (PFA and PC)
• Model cast in state space form, and Kalman filter and associated smoother algorithms enable maximum likelihood estimation and signal extraction
• Computations performed using Ox 3.0 and SsfPack 2.3
Work in progress
Planned extensions:• more general production function (CES, other
inputs)• more flexible specification of inflation equation
Table 1 - Alternative estimates of euro area average potential output growth
(Annual percentage changes, average over period indicated)
Sources: ECB computations and IMF: World Economic Outlook September 2004; OECD: Economic Outlook June 2004; European Commission: Autumn Economic Forecasts October 2004.
1980-2003 1983-1993 1993-2003 2004-2006
EC 2.2 2.3 2.0 2.0OECD 2.2 2.2 2.0 1.9IMF 2.3 2.4 2.1 2.0UC model (common cycles variant) 2.1 2.3 1.9 2.2UC model (pseudo-integrated cycles variant) 2.1 2.2 2.0 2.2UC model (hysteresis variant) 2.1 2.3 1.9 2.1
AVERAGE 2.2 2.3 2.0 2.1
Euro Area
Chart 1: Estimates of euro area potential output growth by international organisations
1.0
1.5
2.0
2.5
3.0
3.5
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
(annual percentage changes)
IMF
OECD
European Commission
Sources: IMF: World Economic Outlook September 2004; OECD: Economic Outlook June 2004; European Commission: Autumn Economic Forecasts October 2004. Results for 1991may be distorted due to the changeover to
Comments on estimates
• Long run average of all estimates (1980-2004) tends to support the range of 2-2½% assumed by the ECB
• Potential output growth estimates tend to vary across method, although less so over longer periods
• Residual cyclicality from all methods• Current and future estimates are more uncertain
than historical estimates
Developments in factors of growth• Growth accounting framework allows for alternative
insightful decompositions:
1) Output as function of TFPLabour supplyCapital stock
2) Output as function of Labour productivity, function of TFP and capital intensityLabour utilisation, function of average hours worked, the
unemployment rate and the participation rateDemographic components: population and dependency ratio
Chart 2 - Contributions to real GDP in the euro area(percentage points)
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
1981-1993 1993-2003
total factor productivity capital labour
Chart 3 - Contributions from labour components(percentage points)
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1981-1993 1993-2003
labour force unemp. rate hours worked
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1981-1993 1993-2003
part. rate population dep. ratio
See ECB Monthly Bulletin article entitled “Labour productivity in the euro area: aggregate trends and sectoral patterns”, July 2004.
Table 2 – Developments in euro area labour productivity
Chart 4 – Contributions to growth from labour productivity per hour in the euro area
See ECB Monthly Bulletin article July 2004.
Summary of main developments by factor
• Gradual decline in productivity growth, accounted for by lower contribution from both capital deepening and TFP
• Increasing contribution from labour supply growth, resulting mainly from a decrease in the unemployment rate and slower decline in hours worked
Looking ahead: short to medium run
• Projected decline in working age population growth is likely to have an adverse impact
• This may be counteracted by likely further increase in the participation rate (and possible further decline in the unemployment rate)
• Outlook for productivity growth more uncertain
Looking ahead: medium to long run
• Demographic developments, as projected by both Eurostat and the United Nations, are likely to have a significant adverse impact in the long run
• Developments in other factors more uncertain• Only a combination of compensatory measures can
counteract the adverse impact of demographic developments on growth
• Further structural reforms are needed to sustain and possibly expand potential growth in the medium to long run