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Filling the Gap-- Open Economy Considerations for More Reliable Potential Output Estimates

Author

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  • Zsolt Darvas
  • András Simon
Abstract
This paper argues that in open economies the Phillips-curve relationship is not sufficient to trace back the output gap, because the effect of excess demand is not symmetric across tradable and non-tradable sectors. In the non-tradable sector excess demand creates excess employment and inflation via the Phillips-curve, while in the tradable sector much of the excess demand is absorbed by the trade balance. We set up an unobserved-components model including both a Phillips-curve and a trade equation to trace back ‘sustainable’ output. We apply the model to a Greece, Ireland, Spain, Portugal, Argentina, Mexico, Korea and Hungary to test the importance of the two relationships. state-space models and Kalman-filter We find that the trade balance is more important than the Phillips-curve in identifying sustainable output. Our sustainable output estimates for euro-area periphery countries differ substantially from the potential output estimates of the European Commission and, in our view, our results can be better interpreted in light of economic developments. We also found that our model was able to correctly identify the sign of the output gap in real time, in contrast to the estimates of the European Commission. Furthermore, the revisions in our output gap estimates were smaller than the revisions of the European Commission’s estimates. NOTE: AN EARLIER VERSION OF THIS PAPER WAS ACCEPTED FOR PRESENTATION AT 2014 ECOMOD, BUT I COULD NOT OBTAIN FUNDING TO TRAVEL TO INDONESIA. THIS YEAR I WILL HAVE FUNDING TO TRAVEL TO BOSTON.

Suggested Citation

  • Zsolt Darvas & András Simon, 2015. "Filling the Gap-- Open Economy Considerations for More Reliable Potential Output Estimates," EcoMod2015 8650, EcoMod.
    • Handle: RePEc:ekd:008007:8650
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    Citations

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    Cited by:

    1. Peter D. Williams & Mr. Yasser Abdih & Emanuel Kopp, 2020. "Reading the Stars," IMF Working Papers 2020/136, International Monetary Fund.
    2. Zsolt Darvas, 2018. "Forecast errors and monetary policy normalisation in the euro area," Policy Contributions 28816, Bruegel.
    3. Roberta Santis & Piero Esposito & Elena Masi, 2019. "Structural determinants of potential output growth in Europe and the role of fiscal policy," International Economics and Economic Policy, Springer, vol. 16(4), pages 565-591, October.
    4. Roberta De Santis & Piero Esposito & Elena Masi, 2017. "Are there common structural determinants of potential output growth in Europe? An empirical exercise for 11 EMU countries," Working Papers 4, Department of the Treasury, Ministry of the Economy and of Finance.
    5. Pönkä, Harri & Sariola, Mikko, 2021. "Output gaps and cyclical indicators: Finnish evidence," BoF Economics Review 6/2021, Bank of Finland.
    6. Lorenzo Burlon & Paolo D'Imperio, 2019. "The euro-area output gap through the lens of a DSGE model," Questioni di Economia e Finanza (Occasional Papers) 477, Bank of Italy, Economic Research and International Relations Area.
    7. Burlon, Lorenzo & D’Imperio, Paolo, 2020. "Reliable real-time estimates of the euro-area output gap," Journal of Macroeconomics, Elsevier, vol. 64(C).
    8. Karsten Staehr, 2018. "Capital flows and growth dynamics in Central and Eastern Europe," Post-Communist Economies, Taylor & Francis Journals, vol. 30(1), pages 1-18, January.
    9. Marko Melolinna & Máté Tóth, 2019. "Output gaps, inflation and financial cycles in the UK," Empirical Economics, Springer, vol. 56(3), pages 1039-1070, March.
    10. European Fiscal Board (EFB), 2019. "Assessment of EU fiscal rules with a focus on the six and two-pack legislation," Reports 2019, European Fiscal Board.
    11. Larch, Martin & Orseau, Eloïse & van der Wielen, Wouter, 2021. "Do EU fiscal rules support or hinder counter-cyclical fiscal policy?," Journal of International Money and Finance, Elsevier, vol. 112(C).
    12. Josef Baumgartner & Serguei Kaniovski & Simon Loretz & Stefan Schiman-Vukan, 2018. "Wachstum schwächt sich ab. Mittelfristige Prognose der österreichischen Wirtschaft bis 2023," WIFO Monatsberichte (monthly reports), WIFO, vol. 91(10), pages 713-731, October.
    13. Jonas Dovern & Christopher Zuber, 2020. "Recessions and Potential Output: Disentangling Measurement Errors, Supply Shocks, and Hysteresis Effects," Scandinavian Journal of Economics, Wiley Blackwell, vol. 122(4), pages 1431-1466, October.
    14. Eddie Casey, 2019. "Inside the "Upside Down": Estimating Ireland's Output Gap," The Economic and Social Review, Economic and Social Studies, vol. 50(1), pages 5-34.
    15. Michael O’Grady, 2019. "Estimating the Output, Inflation and Unemployment Gaps in Ireland using Bayesian Model Averaging," The Economic and Social Review, Economic and Social Studies, vol. 50(1), pages 35-76.
    16. Sariola, Mikko, 2019. "An unobserved components model for Finland – Estimates of potential output and NAWRU," BoF Economics Review 2/2019, Bank of Finland.

    More about this item

    Keywords

    Greece; Ireland; Spain; Portugal; Argentina; Mexico; Korea and Hungary; Business cycles; Macroeconometric modeling;
    All these keywords.

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