Potential Output: Concepts and Measurement - Department of Labour

Darren Gibbs 93
FIGURE 3: Estimated potential output and output gap series—labour input
methods
20
15
10000
Output gap (%)
10
5
0
-5
-10
-15
-20
8000
6000
4000
2000
0
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
Output ($m 82/83)
June years
yl1: output gap (left axis)
gdp (right axis)
yl1: output gap (left axis)
yl2: output gap (left axis)
yl1: potential output (right axis)
rate; the real unemployment benefit; the minimum wage rate; and the volume of
world trade. The natural rate of unemployment is then obtained by solving out
the equation with the cyclical factors eliminated.
An alternative approach involves the estimation of a Phillips curve or twoequation
wage-price model. This model is subsequently solved for an
unemployment rate that is consistent with stable inflation.
It was decided to adopt the Phillips curve approach in this paper. However,
the estimated natural unemployment rate series also displayed unreasonable
volatility. This was removed by passing the series through the Hodrick-Prescott
filter, producing the natural unemployment rate series depicted in Figure 2.
Clearly this methodology is deficient. However, its use was necessitated by
the absence of better estimates of the natural rate of unemployment (which is a
major task in its own right). Although the true natural rate series is likely to be
less smooth, the estimated natural rate of 7.75 percent as of March 1994 seems
plausible; however recent falls in unemployment (to 6.3 percent in June 1995)
combined with only moderate wage growth suggest that it was likely to have
been lower than this by mid 1995.
The second labour input related potential output series estimate is based
directly on Okun’s model relating the levels of output and unemployment as