Potential Output: Concepts and Measurement - Department of Labour

Darren Gibbs 81
Fourthly, Plosser and Schwert (1979) demonstrate both theoretically and
empirically that Okun’s procedure of inverting a regression of unemployment on
output is valid only if the correlation coefficient is equal to ±1.
Finally, a more significant problem with the technique is that it can result in
potential output series which display unreasonable volatility. Indeed, in a recent
study by the OECD (1994) using an Okun’s Law based technique, they found
that the potential output series derived for some countries was more volatile
than the actual output series on which they were based.
Because of these shortcomings, the reliability of potential output estimates
obtained using these techniques also suffered as output and inflation became
more variable in the 1970s. As noted by Adams et al (1987):
. . . because these approaches tend to deal somewhat mechanically with any change
in economic conditions, they are not well suited to separating permanent from
transitory influences. These approaches tend to extrapolate any change in growth
automatically, provided it is maintained long enough, and, even when they produce
correct judgments about historical developments in potential output, they do not
identify the underlying determinants. Such methods are, therefore, unreliable for
forecasting, particularly when the economic environment is undergoing substantial
change.
Adams’ last comment is particularly pertinent in the case of New Zealand.
The output-capital ratio approach
Whereas Okun’s measure relies solely on the labour market as an indicator of
the output gap, this approach hinges on the existence of a stable proportional
relation between the stock of capital and potential output. The method assumes
that fluctuations in the observed output/capital ratio are largely due to
deviations in output from its potential level.
An example of the use of this method is contained in Panic (1978). First he
constructs an output/capital ratio series ( Q t
K ), and then he fits a least squares
t
linear trend to the actual output/capital series, to yield a ‘capacity’ output/
capital series, as follows:
⎛ Qt
⎞
⎜ ⎟ = α0 + α1t+
e
⎝ K ⎠
t
t
where Q t
and K t
represent output and the capital stock at time t and e t
is a
random error. The capacity output/capital ratio is taken to be the points on a line
with the time derivative α 1
raised just enough so that it touches only one of the
observed Q t
Q
c
t
K data points. The adjusted trend ratio ( )
t
K is the assumed capacity
t
output/capital ratio. From here, a series measuring potential output is simply
Q
c
t
.
given by K t ( K )
t