The Output Gap and the Potential Growth Rate:Issues and Applications as an Indicator for the Pressure on Price Change*
May 9, 2003
Bank of Japan
Research and Statistics Department
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There are a number of factors driving price movements. It would be fair to say, however, that one of the fundamentally decisive factors is the extent to which aggregate supply capacity is actually met by aggregate demand. The difference between aggregate supply capacity and aggregate demand is generally known as the output gap, and it is widely used by international institutions and central banks in many countries all over the world when analyzing economic conditions, as one of the fundamental indicators for evaluating the pressure for price change. Indeed, the output gap underlies the description of future price movements in the Outlook and Risk Assessment of the Economy and Prices, published by the Bank of Japan biannually.
- In order to calculate the output gap, we need figures for both aggregate supply capacity and aggregate demand. We may think of actual GDP as representing aggregate demand. What we refer to here as aggregate supply capacity, on the other
hand, is the supply capacity premised upon the economic structure current at the time, and is more generally termed potential output. A problem is to provide a specific definition for potential output, and to select a means of its estimation. The Research and Statistics Department of the Bank of Japan defines potential output as the level of economic activity that would be reached assuming that labor and capital resources are used to their fullest potential within the existing economic structure. Estimation is carried out, based on what is known as the production function approach. In this approach, GDP is determined by a macro production function that includes three variables: (1) utilization of the capital stock; (2) labor input; and (3) the efficiency with which these factors are used, namely total factor productivity (TFP). We refer to the annual rate of change in potential output as the potential growth rate.
- Looking at the estimated potential growth rate in Japan, we see that the rate stood at around about 4 percent throughout the 1980s; it has been trending downward since the bursting of the asset bubble and has recently dropped to around the 1 percent level. During the same period, however, the trend growth rate of actual output has been still lower. The output gap expands when the actual growth rate falls below the potential growth rate. In fact, since the bursting of the asset bubble, the output gap has continued expanding with cyclical movements and is open very widely to date.
- Carrying out a simple comparison between the inflation rate and the output gap thus obtained for the period of, for example, the last 20 years, we may observe a correlation, though not very strong, between the expansion of the output gap and the drop in the inflation rate. After it hit a peak in the early 1990s, the inflation rate declined gradually, and has been slightly negative in recent years. When we think about this in the context of the above relationship, this price movement may reflect the underlying expansionary trend of the output gap during this period. It must be noted, however, that this relationship holds only on average for the last 20 years or so. When we include the period of high inflation in the 1970s, for example, the relationship breaks down. Accordingly, there is no guarantee that the current relationship will continue to be stable over the long term. Furthermore, looking at the short term (periods of 1-2 years), movements in the inflation rate regularly defy explanation in terms of the output gap. As explanations for this we may cite the facts that (1) the output gap is not only influenced by prices but also by a variety of factors, including exchange rates and competition from imports; and (2) there is considerable potential for error in the estimates of the output gap per se.
- Among various ways of measuring the output gap, the Research and Statistics Department of the Bank of Japan relies on the one explained above for the following practical reasons: (1) since the factors that make up the production function are aggregated in a simple way when carrying out the estimation, it is easy to demonstrate the basis for any hypothesis about the future direction of the output gap; and (2) we can discern the downwardsloping broad relationship with the inflation rate mentioned earlier. On the other hand, our measure of the output gap also has several drawbacks: (1) since the estimation is dependent upon past trends and maximum values of various pieces of data, the output gap tends to be rather slow in responding to changes in the economic structure; (2) with definitions of potential output differing among international institutions and other such bodies, care needs to be taken when reading the level of the output gap; and (3) the relationship with the inflation rate is not precisely in accordance with economic theory.
- To amend the above drawbacks, the Research and Statistics Department of the Bank also takes other approaches to measure the output gap. Notable examples are (1) the HP filter approach, in which a smooth trend curve is fitted to the actual GDP data; and (2) the time-varying nonaccelerating inflation rate of unemployment (NAIRU) approach, which is now an international standard and redefines potential output as that level of output consistent with an inflation rate that is neither accelerating nor decelerating. We also make use of (3) the Tankan diffusion indices as an indicator for the output gap. As mentioned above, the current measure of the output gap may be considered somewhat slow to respond to changes in the economic structure. Thus, when the pace of structural change accelerates as the result of structural reform in the future, the need to cross-check a variety of measures of the output gap and other comparable indicators becomes more pronounced.
- In implementing monetary policy to achieve price stability, a central bank is expected not only to make accurate forecasts of future prices, but also to provide an explanation for these. The output gap is a useful statistic for both of these purposes. However, inflation movements often cannot be explained just by looking at the output gap alone. For this reason, while we take the outlook for the output gap as a basis for forecasting prices, we should also balance the advantages and the disadvantages of this indicator, and judgments should be reached only after due consideration has been paid both to a broad range of indicators related to the supply and demand situation and to other determinants of price movements. At the same time, further research in this area should be vigilantly pursued, with the possibility kept in mind that the efficacy of the output gap hitherto employed deteriorates when there is an acceleration in the structural economic change.