02-mdsx_m02_slides.pptx

Macroeconomic Diagnostics (MDSx) Module 2 Potential Output and Output Gaps

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 1

Video #: 1 Video Title: About Module 2 Video Type: Presenter Only

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 2

Video #: 1 Video Title: Aggregate Supply in the Short Run Video Type: PPT

Short-Run Aggregate Supply

In the short run Aggregate supply is not fixed

Production inputs can vary

Some production inputs are fixed

Aggregate Supply in the Short Run

Remember: aggregate supply is typically expressed as:

𝑌 = 𝐹(𝑇𝐹𝑃, 𝐾, 𝐿) To alter aggregate supply in the short run: Increase/decrease labor (L) Increase/decrease capital (K) TFP typically cannot vary in the short run

Aggregate Supply in the Short Run – Changing Inputs

Higher capital and labor needed by firms:

Higher labor input…

Higher capital input…

Hiring unemployed workers

Using idle machines

Overtime of employed workers

Increasing capacity utilization

Increasing Inputs and Costs

To increase the inputs of production:

Need higher wages to attract workers/pay for overtime

Higher capacity utilization of capital (more depreciation) This leads to higher per unit costs of production: In the short run: more aggregate supply ⇒ higher costs

Short Run Aggregate Supply Curve AS

P2 P1

Y1

Y2

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 2

Video #: 2 Video Title: Aggregate Demand in the Short Run Video Type: PPT

Introducing Concept: Aggregate Demand

Defined as…

The total final demand for all goods and services in an economy, in a given period (quarter, year).

Aggregate Demand in the Short Run

Aggregate demand can vary in two ways:

It can vary with the aggregate price level

It can vary due to other factors (besides aggregate prices)

Aggregate Demand and Prices

If prices of all goods and services drop… Households feel richer (wealth effect) and demand more If prices of all goods and services increase… Households feel poorer (wealth effect) and demand less

Aggregate Demand Curve P

P1

P2 AD1 Y1

Y2

Real GDP

Aggregate Demand Curve Shift

Aggregate demand can increase at the same price level if:

Households change their preferences and demand more at any given price

Government economic policy changes (fiscal, monetary)

Aggregate Demand Curve Shift P

P1

AD1 Y1

AD2

Y2

Real GDP

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 2

Video #: 3 Video Title: Short Run Equilibrium, Shift in Aggregate Demand Curve Video Type: PPT

Building Blocks of Economic Equilibrium

Recall… Short-run aggregate supply curve

Short-run aggregate demand curve

Short Run Economic Equilibrium AS

P

P1

AD Y1

Real GDP

Characteristics of Economic Equilibrium

Short run economic equilibrium consists of Price level (the aggregate price level)

Quantity (aggregate output)

At the given price level, aggregate supply equals aggregate demand, corresponding to aggregate output

Change in Short Run Economic Equilibrium

In the short run economic equilibrium can change if… Aggregate supply curve shifts

Aggregate demand curve shifts

Aggregate Supply Curve Shift and Equilibrium P

AS1

AS2

P1

P2 AD Y1

Y2

Real GDP

Aggregate Demand Curve Shift and Equilibrium P

AS

P2

P1 AD2 AD1 Y1

Y2

Real GDP

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 3

Video #: 1 Video Title: Potential Output Video Type: PPT

Potential Output

Defined as…

The highest level of output that is consistent with nonaccelerating level of inflation (stable inflation).

Potential Output – Concept

It captures the notion that…

Short run aggregate supply varies with the price level

Above a certain level of output, the economy is running too “hot”, generating inflation

Potential Output

Some equivalent concepts: Full employment (employment at potential output)

Natural rate of unemployment (unemployment at potential output)

Full capacity utilization (capital utilization at potential output)

Potential Output

Some caveats of the concept of potential output: Not the maximum level of output

Full employment and full capacity utilization do not imply the maximum employment or capacity utilization possible

Higher output will lead to accelerating inflation

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 3

Video #: 2 Video Title: Output Gap Video Type: PPT

Output Gap

An economic measure of… …the difference between actual output and potential output

It is defined as…

...percentage deviation from potential output

Computing Output Gap

𝑂𝑢𝑡𝑝𝑢𝑡 𝐺𝑎𝑝𝑡 =

∗ (𝑌𝑡 −𝑌𝑡 ) ∗ 𝑌𝑡

Yt* – denotes real level of potential output at time t.

Potential Output

P

AS

P2 P1 AD2 AD1 Y1

Y* Y2

Real GDP

Positive and negative output gap and potential output

Output

Positive output gap

Negative output gap

Potential output Actual output

Time

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 3

Video #: 3 Video Title: Use and Interpretation of Output Gap Video Type: PPT

Use of Output Gap

Estimating Potential Output and Output Gap provides: Short Run: Guidance in calibration of macroeconomic policy

Medium and Long Run:

Guidance in formulating macroeconomic structural reforms

Interpretation of Output Gap

Output above potential level Strong growth in aggregate demand Employment above full employment

Capacity utilization above full level Accelerating inflation

The level of production is too high. Negative Gap

No Gap

Positive Gap

Interpretation of Output Gap

Output at potential level The level of output is consistent with:

full employment full capacity utilization stable inflation

The level of production is sustainable. Negative Gap

No Gap

Positive Gap

Interpretation of Output Gap

Output below potential level Implication of negative output gap High unemployment and low capacity utilization Weak demand Low and/or falling inflation

The level of production is too low. Negative Gap

No Gap

Positive Gap

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 3

Video #: 4 Video Title: Overview of measurement of output gap Video Type: PPT

Estimation of Potential Output

Measuring potential output is no easy task

We do not observe potential output directly from data

There is no indicator that tells us what the output gap is

Necessary to use statistics and economic theory for estimation

Estimating Potential Output

Univariate methods…

Multivariate methods…

Linear Trend

Production Function Approach

Hodrick-Prescott (HP) Filter

Multivariate Filters

Band-Pass Filter

DSGE Models

Tools for Estimation

Two steps in reaching an estimate:

Use diagnostic tools to estimate the output gap.

Compare across different methods to select the best estimate.

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 4

Video #: 1 Video Title: Linear Trend Method Video Type: PPT

Estimation Tool 1 – Linear Time Trend

Key aspects: Assumes that potential output grows at a constant rate.

Estimates the average growth rate over the sample period.

Estimation Tool 1 – Linear Time Trend Real GDP in logs

Constant

Trend

yt     t   t ˆ ˆ y    t * t

Estimated Potential Output

Estimated Constant

Estimated Trend

Diagnostic Tool 1 – Estimated Potential Output Country B: Real GDP and Potential GDP 351000 Real GDP 301000

251000

201000

151000

101000

51000

1000

Potential Output

Diagnostic Tool 1 – Shortcomings

Shortcomings of the deterministic trend: Assumes constant growth rate of potential output.

Growth of potential output varies over time.

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 4

Video #: 2 Video Title: Linear Trend in Excel Video Type: Excel

EXCEL

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 4

Video #: 3 Video Title: Hodrick-Prescott (HP) Filter Video Type: PPT

HP Filter Method

Key aspects of the Hodrick-Prescott (HP) Filter: Decomposes the time series into trend and cyclical component.

Allows for variation of growth rate of trend

HP Filter Mathematical Formula

∞

∞

∗ ∗ 𝑚𝑖𝑛𝑦𝑡∗ ෍ 𝑦𝑡 − 𝑦𝑡∗ + 𝜆 ෍ 𝑦𝑡+1 − 𝑦𝑡∗ − 𝑦𝑡∗ − 𝑦𝑡−1 𝑡=0

𝑡=2

2

Diagnostic Tool 2 – Potential Output with HP Filter Country B: Real Output and Potential Output 351000 Real GDP 301000

251000

201000

151000

101000

51000

1000

HP Filter (λ=1600)

Diagnostic Tool 2 – Varying Parameter λ Country B: Real GDP and Potential GDP 351000 Real GDP 301000

251000

201000

151000

101000

51000

1000

HP Filter (λ=infinity)

Diagnostic Tool 2 – Shortcomings

Shortcomings of the HP Filter:

HP filter decomposition does not have a theoretical foundation.

If growth rate of potential output exhibits cycles – our estimate may contain trend AND cycle

End-point problem

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 4

Video #: 4 Video Title: Hodrick-Prescott Filter in Excel Video Type: Excel

EXCEL

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 4

Video #: 5 Video Title: Production Function Approach Video Type: PPT

Production Function Approach

Main features: Uses Cobb-Douglas production function

Requires several economic data series as inputs

Production Function Approach – Inputs

To use this approach we need to compute An estimate of full employment

An estimate of capital at full capacity utilization

An estimate of trend TFP

Cobb-Douglas Production Function

∗ 𝑌𝑡

=

∗𝛼 ∗1−𝛼 𝐾𝑡 𝐿𝑡

Use potential output values of the inputs: L* – Labor at full employment K* – Capital at full utilization TFP* – TFP at potential output

Diagnostic Tool 3 – Production Function Approach

Main Steps: 1) Use series on output, capital and labor into production function to compute a series for TFP 2) Estimate capital at full utilization - K* 3) Estimate labor at full employment - L* 4) Estimate trend TFP – TFP*

5) Plug in TFP*, K*, L* into Cobb-Douglas function - Y*

Production Function Approach – Caveats

Some of the disadvantages of this approach

Requires multiple data series

Relies on estimates of the inputs at potential output

Requires us to make an assumption about the exact form of the aggregate production function.

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 4

Video #: 6 Video Title: Production Function Approach in Excel Video Type: Excel

EXCEL

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Course: Macroeconomic Diagnostics (MDSx) Module: 2 Section: 5

Video #: 1 Video Title: Selecting an Estimate and Interpreting Results Video Type: PPT

Selecting the Best Estimate to Use

There are two considerations:

Judging the characteristics and properties of each tool

Analyzing their estimates of potential output

Properties of Methods for Estimation

Variation in Trend of Potential Output

Endpoint Problem

Requires Capital and Labor Data

Linear Trend

No

No

No

Hodrick-Prescott Filter

Yes

Yes

No

Production Function Approach

Yes

Yes

Yes

Interpreting Results for Country X

GDP and Potential Output Growth Real GDP Growth (%Δ,)

Potential Growth (%Δ)

8.0 6.0 4.0 2.0 0.0 Q1-1981 Q1-1984 Q1-1987 Q1-1990 Q1-1993 Q1-1996 Q1-1999 Q1-2002 Q1-2005 Q1-2008 Q1-2011 Q1-2014 -2.0 -4.0 -6.0 -8.0

Interpreting Results for Country X

Output Gap (in percent) 6.0

4.0

2.0

0.0 Q1-1980 Q1-1983 Q1-1986 Q1-1989 Q1-1992 Q1-1995 Q1-1998 Q1-2001 Q1-2004 Q1-2007 Q1-2010 Q1-2013 Q1-2016 -2.0

-4.0

-6.0

-8.0

-10.0

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Course: Macroeconomics Diagnostics (MDSx) Module: 2 Section: 6

Video #: 1 Video Title: Summarizing What We Learned Video Type: PPT

Module Wrap-Up

Tools estimating potential output:

Deterministic Trend

Hodrick-Prescott (HP) filter

Production Function Approach

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Course: Macroeconomics Diagnostics (MDSx) Module: 2 Section: 7

Video #: 1 Video Title: Revelation Video Video Type: PPT