Potential Output: Concepts and Measurement - Department of Labour

Darren Gibbs 77
common procedure for estimating potential output is to fit a trend either to
actual output or through its peaks. The choice between these two methods
implies different views of the business cycle. The essential point is whether the
gap between potential output and actual output over some cyclically neutral
historical period is, on average, zero or positive. In the latter case there is
presumably scope for appropriate macroeconomic policies to increase the mean
level of output; but in the former case macroeconomic policies may be able to
decrease the variability of output, but not increase its mean (assuming that initial
macroeconomic policy settings are structurally optimal). 5
The most attractive feature of these essentially theory-free estimates is their
simplicity. The main univariate techniques are the trends through peaks
approach, the linear time trend approach, and the Hodrick-Prescott filter
approach. Discussion of the latter is reserved until later in this section where a
more general application of filtering techniques is outlined.
Trends through peaks approach
The trends through peaks approach is one of the most popular techniques
considered in the literature, and was the accepted methodology in the 1960s and
early 1970s. To apply this approach, seasonally adjusted output is first graphed.
It is then assumed that ‘major’ peaks in the series represent output where
resources in the economy are utilised at 100 percent of capacity. A straight line is
drawn between each of the major peaks, and is then extrapolated (using the
same slope as the line connecting the previous two peaks) beyond the last one.
This line is taken to be potential output. The output gap is represented by the
difference between the line representing potential output, and actual output.
Because the approach results in a succession of discrete changes in a linear time
trend, it is also sometimes referred to as the ‘split time trend’ method.
This approach reflected the prevailing economic thinking at that time. The
supply side of the economy was seen as deterministic, with changes in demand
seen as the prime factor underlying observed business cycles. By focusing on the
peaks of cycles, potential output was defined as the maximum possible output
in a physical capacity or engineering sense; and so the calculated output gaps
were almost always negative (ie actual output was below potential). As Laxton
and Tetlow (1992) note, this reflected a belief that the unbridled economy tends
towards inefficient outcomes, and that the goal of macroeconomic policy should
be to offset this tendency.
As growth through the 1960s was relatively constant, and inflation was low
and stable, the conceptual link between the output gap and inflation which had
5
As Laxton et al (1994) note, if the short-run Phillips curve is asymmetric, trend output
will lie below potential output. In this circumstance, a policy aimed at decreasing the
variability of output will also increase mean output.