Potential Output: Concepts and Measurement - Department of Labour

Darren Gibbs
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These measures are also relevant for labour market analysts and commentators.
In addition to their use in developing employment and wage projections,
which rely on forecasts of the overall level of activity, they also play a part in
informed decision-making regarding the feasibility of various labour market
policy settings. For instance, a knowledge of how close to capacity the economy
is can tell us about the extent to which efforts to reduce unemployment, or
trends in employment growth, are likely to result in upward pressure on wages
or prices.
The aim of this paper is to present a brief survey of the techniques that have
been used overseas to measure potential output, and to apply several of these
techniques in order to estimate preliminary potential output series for New
Zealand. Section 2 defines what is meant by the term ‘potential output’, and
outlines more fully why the concept is of interest to central banks, governments
and private sector businesses. The main techniques used by economists to
empirically measure potential output are then discussed in section 3. Section 4
presents the results obtained when applying a number of these techniques to
New Zealand data, and section 5 uses econometric techniques in an effort to
select which of the estimates is preferable. The paper ends with a brief
conclusion, which summarises the main ideas and results and suggests possible
directions for future research.
2 Economic growth and potential output
Following World War II, a stable economic environment saw standards of living
in most OECD countries grow rapidly. 4
For many years New Zealand also
enjoyed strong economic growth and almost everybody who wanted a job was
able to find work. However by the late 1960s economic performance had begun
to deteriorate in most OECD countries, and the extent of deterioration was
particularly marked in the case of New Zealand. Whereas New Zealand’s
standard of living was ranked third in the developed world in 1950 (behind the
United States and Canada), by 1975 it had dropped to fifteenth. During the
decade following the first oil shock in 1973, New Zealand’s economic
performance slumped significantly. Growth during 1975 to 1984 averaged little
more than 1.5 percent; and our relative standard of living dropped further to
twenty-first place on the OECD ladder.
The deterioration in economic performance prompted a serious rethink of
economic policy. As a consequence, since the mid 1980s, successive governments
have implemented a comprehensive programme of economic and financial
reform. These reforms have included: the deregulation of the banking industry;
the freeing of controls on international capital flows (including the floating of the
4
The term ‘standard of living’ as used here refers only to measured pecuniary benefits as
proxied by GDP.