Estimating potential output growth
in the euro area
Alberto Musso
Directorate 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
including slack indicators
potential output growth
as input in the derivation
of the reference value
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
Variants
Multivariate 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)
1980-2003
1983-1993 1993-2003
2004-2006
Euro Area
EC
OECD
IMF
UC model (common cycles variant)
UC model (pseudo-integrated cycles variant)
UC model (hysteresis variant)
2.2
2.2
2.3
2.1
2.1
2.1
2.3
2.2
2.4
2.3
2.2
2.3
2.0
2.0
2.1
1.9
2.0
1.9
2.0
1.9
2.0
2.2
2.2
2.1
AVERAGE
2.2
2.3
2.0
2.1
Sources: ECB computations and IMF: World Economic Outlook September 2004;
OECD: Economic Outlook June 2004; European Commission: Autumn Economic
Forecasts October 2004.
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
TFP
Labour supply
Capital stock
2) Output as function of
Labour productivity, function of TFP and capital intensity
Labour utilisation, function of average hours worked, the
unemployment rate and the participation rate
Demographic components: population and dependency ratio
Chart 2 - Contributions to real GDP in the euro area
(percentage points)
total factor productivity
capital
labour
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
1981-1993
1993-2003
Chart 3 - Contributions from labour components
(percentage points)
labour force
unemp. rate
part. rate
hours worked
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
-0.2
-0.2
-0.4
-0.4
-0.6
-0.6
1981-1993
1993-2003
1981-1993
population
dep. ratio
1993-2003
Table 2 – Developments in euro area labour
productivity
See ECB Monthly Bulletin article entitled “Labour productivity in the euro area:
aggregate trends and sectoral patterns”, July 2004.
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
Overall conclusion
• Revision of assumption for medium term potential
output growth is warranted only in the presence of
clear and compelling evidence that structural
changes are actually leading to a change in
potential output growth
• The ECB will continue to closely monitor future
developments