Comparing methods to determine the Output Gap

David Beckworth made a determination of nominal interest rates using the Output Gap from this paper…Measuring potential output: Eye on the financial cycle, by Claudio Borio, Piti Disyatat, Mikael Juselius. Determining the output gap correctly in real-time is very important for determining the nominal interest rate and many other factors. It is not good to get the output gap wrong.

In the paper they present this graph of output gaps determined by various methods, real-time and ex-post.

output gap 2

The red lines are what was given in real-time. The blue lines show what was determined later by looking backward (ex-post).

In the paper, they say…

“The HP filter gap and the full-fledged approaches of the OECD and IMF – a representative sample of current approaches – did not detect that output was above sustainable levels during the boom that preceded the financial crisis. In fact, the corresponding real-time estimates indicated that the economy was running below, or at most close to, potential. Only after the crisis did they recognise, albeit to varying degrees, that output had been above its potential, sustainable level. By contrast, the finance-neutral measure sees this all along (bottom right-hand panel). And it hardly gets revised as time unfolds.”

David Beckworth uses the Finance-neutral calculation for his determination of the output gap.

But now I want to show my determination which would have been real-time without being revised later. (quarterly data)

output gap 3

The paper criticizes the approaches of the IMF, OECD and HP filter for not seeing the economy was over potential before the crisis, but my real-time calculation would have seen that for 3 years.

Also, the Finance-neutral method did not see that the economy was running below potential after the 2001 recession. My method, along with the IMF and HP filter, did see that. Even their revisions kept showing the economy was below potential in 2003.

My method, along with all others, recognized the fall from potential in the crisis. However, my method is set up to see in real-time a fundamental shift in demand impacting potential if one occurs. My method and the HP filter show GDP returning to potential by 2011. A shift downward in potential is seen since the crisis.

The HP filter gives results that most resemble mine. HP stands for Hodrick-Prescott (HP) filter. A neighbor of mine works in the same office as Edward Prescott… Coincidence.

My method to determine potential GDP is a simple equation that does not require re-configuring ex-post…

Potential GDP = real GDP – a * (c/f – 1)

a = business cycle amplitude constant in real 2009 $$, $3.4 trillion… f = effective labor share (Labor share: Business sector * 0.762)… c = capacity utilization…