Macroeconomic Diagnostics (MDSx)

Module 2

Potential Output and Output Gaps

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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 1

Video #: 1
Video Title: About Module 2
Video Type: Presenter Only
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 2

Video #: 1
Video Title: Aggregate Supply in the Short Run
Video Type: PPT
Short-Run Aggregate Supply

In the short run

Aggregate supply is not fixed

Production inputs can vary

Some production inputs are fixed

Aggregate Supply in the Short Run

Remember: aggregate supply is typically expressed as:

𝑌 = 𝐹(𝑇𝐹𝑃, 𝐾, 𝐿)
To alter aggregate supply in the short run:

Increase/decrease labor (L)

Increase/decrease capital (K)
TFP typically cannot vary in the short run
Aggregate Supply in the Short Run – Changing Inputs

Higher capital and labor needed by firms:

Higher labor input… Higher capital input…

Hiring unemployed workers Using idle machines

Overtime of employed workers Increasing capacity utilization

Increasing Inputs and Costs

To increase the inputs of production:

Need higher wages to attract workers/pay for overtime

Higher capacity utilization of capital (more depreciation)

This leads to higher per unit costs of production:

In the short run: more aggregate supply ⇒ higher costs

Short Run Aggregate Supply Curve

AS

P2

P1

Y1 Y2
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 2

Video #: 2
Video Title: Aggregate Demand in the Short Run
Video Type: PPT
Introducing Concept: Aggregate Demand

Defined as…

The total final demand for all goods and services in an

economy, in a given period (quarter, year).
Aggregate Demand in the Short Run

Aggregate demand can vary in two ways:

It can vary with the aggregate price level

It can vary due to other factors (besides aggregate prices)

Aggregate Demand and Prices

If prices of all goods and services drop…

Households feel richer (wealth effect) and demand more

If prices of all goods and services increase…

Households feel poorer (wealth effect) and demand less

Aggregate Demand Curve

P1

P2

AD1
Y1 Y2 Real GDP
Aggregate Demand Curve Shift

Aggregate demand can increase at the same price level if:

Households change their preferences and demand

more at any given price

Government economic policy changes (fiscal, monetary)

Aggregate Demand Curve Shift

P1

AD1 AD2
Y1 Y2 Real GDP
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 2

Video #: 3
Video Title: Short Run Equilibrium, Shift in Aggregate Demand Curve
Video Type: PPT
Building Blocks of Economic Equilibrium

Recall…

Short-run aggregate supply curve

Short-run aggregate demand curve

Short Run Economic Equilibrium

P AS

P1

AD
Y1
Real GDP
Characteristics of Economic Equilibrium

Short run economic equilibrium consists of

Price level (the aggregate price level)

Quantity (aggregate output)

At the given price level, aggregate supply equals

aggregate demand, corresponding to aggregate output
Change in Short Run Economic Equilibrium

In the short run economic equilibrium can change if…

Aggregate supply curve shifts

Aggregate demand curve shifts

Aggregate Supply Curve Shift and Equilibrium

P AS1

AS2

P1

P2
AD

Y1 Y2 Real GDP
Aggregate Demand Curve Shift and Equilibrium

P AS

P2

P1
AD2
AD1
Y1 Y2 Real GDP
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 3

Video #: 1
Video Title: Potential Output
Video Type: PPT
Potential Output

Defined as…

The highest level of output that is consistent with non-

accelerating level of inflation (stable inflation).
Potential Output – Concept

It captures the notion that…

Short run aggregate supply varies with the price level

Above a certain level of output, the economy is running

too “hot”, generating inflation
Potential Output

Some equivalent concepts:

Full employment
(employment at potential output)

Natural rate of unemployment

(unemployment at potential output)

Full capacity utilization

(capital utilization at potential output)
Potential Output

Some caveats of the concept of potential output:

Not the maximum level of output

Full employment and full capacity utilization do not imply the

maximum employment or capacity utilization possible

Higher output will lead to accelerating inflation

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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 3

Video #: 2
Video Title: Output Gap
Video Type: PPT
Output Gap

An economic measure of…

…the difference between actual output and potential output

It is defined as…

...percentage deviation from potential output

Computing Output Gap

∗
(𝑌𝑡 −𝑌𝑡 )
𝑂𝑢𝑡𝑝𝑢𝑡 𝐺𝑎𝑝𝑡 = ∗
𝑌𝑡

Yt* – denotes real level of potential output at time t.

Potential Output

P AS

P2

P1
AD2
AD1

Y1 Y* Y2 Real GDP
Positive and negative output gap and potential output

Output

Positive Negative
Potential
output gap output gap
output

Actual
output

Time
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 3

Video #: 3
Video Title: Use and Interpretation of Output Gap
Video Type: PPT
Use of Output Gap

Estimating Potential Output and Output Gap provides:

Short Run:
Guidance in calibration of macroeconomic policy

Medium and Long Run:

Guidance in formulating macroeconomic structural reforms
Interpretation of Output Gap

Output above potential level

Strong growth in aggregate demand
Employment above full employment
Capacity utilization above full level
Accelerating inflation

The level of production is too high.

Negative Gap No Gap Positive Gap

Interpretation of Output Gap

Output at potential level

The level of output is consistent with:
full employment
full capacity utilization
stable inflation

The level of production is sustainable.

Negative Gap No Gap Positive Gap

Interpretation of Output Gap

Output below potential level

Implication of negative output gap
High unemployment and low capacity utilization
Weak demand
Low and/or falling inflation

The level of production is too low.

Negative Gap No Gap Positive Gap

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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 3

Video #: 4
Video Title: Overview of measurement of output gap
Video Type: PPT
Estimation of Potential Output

Measuring potential output is no easy task

We do not observe potential output directly from data

There is no indicator that tells us what the output gap is

Necessary to use statistics and economic theory for estimation

Estimating Potential Output

Univariate methods… Multivariate methods…

Linear Trend Production Function Approach

Hodrick-Prescott (HP) Filter Multivariate Filters

Band-Pass Filter DSGE Models

Tools for Estimation

Two steps in reaching an estimate:

Use diagnostic tools to estimate the output gap.

Compare across different methods to select the best estimate.

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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 4

Video #: 1
Video Title: Linear Trend Method
Video Type: PPT
Estimation Tool 1 – Linear Time Trend

Key aspects:

Assumes that potential output grows at a constant rate.

Estimates the average growth rate over the sample period.

Estimation Tool 1 – Linear Time Trend

Real GDP in
Constant Trend
logs

yt     t   t

ˆ * ˆ
y    t
t
Estimated Estimated Estimated
Potential Output Constant Trend
Diagnostic Tool 1 – Estimated Potential Output

Country B: Real GDP and Potential GDP

351000
Real GDP Potential Output
301000

251000

201000

151000

101000

51000

1000
Diagnostic Tool 1 – Shortcomings

Shortcomings of the deterministic trend:

Assumes constant growth rate of potential output.

Growth of potential output varies over time.

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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 4

Video #: 2
Video Title: Linear Trend in Excel
Video Type: Excel
 EXCEL
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(Draft in PowerPoint and within the guides.)
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 4

Video #: 3
Video Title: Hodrick-Prescott (HP) Filter
Video Type: PPT
HP Filter Method

Key aspects of the Hodrick-Prescott (HP) Filter:

Decomposes the time series into trend and cyclical component.

Allows for variation of growth rate of trend

HP Filter Mathematical Formula

∞ ∞
∗ ∗
𝑚𝑖𝑛𝑦𝑡∗ ෍ 𝑦𝑡 − 𝑦𝑡∗ + 𝜆 ෍ 𝑦𝑡+1 − 𝑦𝑡∗ − 𝑦𝑡∗ − 𝑦𝑡−1 2

𝑡=0 𝑡=2
Diagnostic Tool 2 – Potential Output with HP Filter

Country B: Real Output and Potential Output

351000
Real GDP HP Filter (λ=1600)
301000

251000

201000

151000

101000

51000

1000
Diagnostic Tool 2 – Varying Parameter λ

Country B: Real GDP and Potential GDP

351000
Real GDP HP Filter (λ=infinity)
301000

251000

201000

151000

101000

51000

1000
Diagnostic Tool 2 – Shortcomings

Shortcomings of the HP Filter:

HP filter decomposition does not have a theoretical

foundation.

If growth rate of potential output exhibits cycles – our

estimate may contain trend AND cycle

End-point problem
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 4

Video #: 4
Video Title: Hodrick-Prescott Filter in Excel
Video Type: Excel
 EXCEL
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(Draft in PowerPoint and within the guides.)
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 4

Video #: 5
Video Title: Production Function Approach
Video Type: PPT
Production Function Approach

Main features:

Uses Cobb-Douglas production function

Requires several economic data series as inputs

Production Function Approach – Inputs

To use this approach we need to compute

An estimate of full employment

An estimate of capital at full capacity utilization

An estimate of trend TFP

Cobb-Douglas Production Function

∗ ∗𝛼 ∗1−𝛼
𝑌𝑡 = 𝐾𝑡 𝐿𝑡

Use potential output values of the inputs:

L* – Labor at full employment
K* – Capital at full utilization
TFP* – TFP at potential output
Diagnostic Tool 3 – Production Function Approach

Main Steps:

1) Use series on output, capital and labor into production

function to compute a series for TFP
2) Estimate capital at full utilization - K*
3) Estimate labor at full employment - L*
4) Estimate trend TFP – TFP*
5) Plug in TFP*, K*, L* into Cobb-Douglas function - Y*
Production Function Approach – Caveats

Some of the disadvantages of this approach

Requires multiple data series

Relies on estimates of the inputs at potential output

Requires us to make an assumption about the exact form

of the aggregate production function.
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Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 4

Video #: 6
Video Title: Production Function Approach in Excel
Video Type: Excel
 EXCEL
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(Draft in PowerPoint and within the guides.)
 Required to effectively communicate video segments.

Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 5

Video #: 1
Video Title: Selecting an Estimate and Interpreting Results
Video Type: PPT
Selecting the Best Estimate to Use

There are two considerations:

Judging the characteristics and properties of each tool

Analyzing their estimates of potential output

Properties of Methods for Estimation

Variation in Trend of Requires Capital

Endpoint Problem
Potential Output and Labor Data

Linear
Trend
No No No

Hodrick-Prescott
Filter
Yes Yes No

Production Function
Approach
Yes Yes Yes
Interpreting Results for Country X

GDP and Potential Output Growth

Real GDP Growth (%Δ,) Potential Growth (%Δ)

8.0

6.0

4.0

2.0

0.0
Q1-1981 Q1-1984 Q1-1987 Q1-1990 Q1-1993 Q1-1996 Q1-1999 Q1-2002 Q1-2005 Q1-2008 Q1-2011 Q1-2014

-2.0

-4.0

-6.0

-8.0
Interpreting Results for Country X

Output Gap
(in percent)
6.0

4.0

2.0

0.0
Q1-1980 Q1-1983 Q1-1986 Q1-1989 Q1-1992 Q1-1995 Q1-1998 Q1-2001 Q1-2004 Q1-2007 Q1-2010 Q1-2013 Q1-2016

-2.0

-4.0

-6.0

-8.0

-10.0
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Course: Macroeconomics Diagnostics (MDSx)

Module: 2
Section: 6

Video #: 1
Video Title: Summarizing What We Learned
Video Type: PPT
Module Wrap-Up

Tools estimating potential output:

Deterministic Trend

Hodrick-Prescott (HP) filter

Production Function Approach

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Course: Macroeconomics Diagnostics (MDSx)

Module: 2
Section: 7

Video #: 1
Video Title: Revelation Video
Video Type: PPT