Potential Output: Concepts and Measurement - Department of Labour

Darren Gibbs 97
force participation rates was replaced with a series in which all observations
were equal to the average rate of participation over the sample period; the actual
series of employment rates was replaced with the estimated ‘natural’ employment
rates derived earlier in this section; the actual series of hours worked per
employee was replaced with a series in which all observations were equal to the
average hours per employee over the sample period; and the actual series of
capacity utilisation was replaced by a series in which all observations were equal
to the average rate of capacity utilisation over the sample period. 14 The influence
of technology was proxied as is standard in these techniques by adding back the
residuals to the above predicted values.
Figure 5 illustrates the estimated potential output series and the estimated
output gaps obtained by following the above approach.
As Figure 5 illustrates, the output gap derived from the production function
based estimate of potential output is similar to the others derived so far. The mid
1980s is identified as a period in which output was above potential, while the
early 1990s is identified as a period during which output was well below potential.
Output is estimated to have moved above potential in late 1993/early 1994.
4.4 Stochastic filtering approaches
Four filtering approaches were applied following the methodology discussed in
section 3. The first relies on the conventional Hodrick-Prescott filter, while the
remaining three involve various forms of the multivariate filter which include
progressively greater degrees of ‘outside’ information.
Hodrick-Prescott filter
The first approach tried was a straightforward application of the Hodrick-
Prescott filter. As noted in section 3, the only parameter that must be chosen is
the smoothness constraint (λ). Three variations of the constraint were applied
yielding three different potential output series. The first variation involved
setting λ to equal 1600—the value recommended by Hodrick and Prescott. The
second variation involved setting λ to equal 200. This results in greater nonlinearity
of the potential output series so that supply shocks are assumed to be
more dominant than in the case when λ is equal to 1600. The third variation
involved setting λ to equal 100,000. This results in greater linearity of the
potential output series so that demand shocks are assumed to be more dominant
than in the case where λ is equal to 1600.
Figure 6 illustrates the three estimated potential output series (hp1600, hp200,
hp100,000) obtained by following the above approach, and the estimated output
gaps.
14
As noted earlier, these assumptions require that the period covered is cyclically neutral.
Moreover, these assumptions could be improved by modelling the trend of each of these
series individually.