WS 2006/ Measurement of Potential Output Alternative definitions of PO (vgl. SVR, JG 2007/08, TZ 693) real GDP at full use of capacities real GDP at normal use of capacities normal use of capacities => calculated from trend in recent cycles normal use of capacites => defined as non- inflationary U. van Suntum, KuB 1 U van Suntum, Vorlesung KuB 1

WS 2006/07 2 U. van Suntum, KuB 2 Capacity utilization (Auslastungsgrad) CU = GDP/PO Output-gap (Outputlücke): OG = (GDP – PO)/PO U van Suntum, Vorlesung KuB 2

WS 2006/07 3 Measurement of Potential Output U. van Suntum, KuB Short term: (at constant level and quality of factors of production)  statistical filter-approaches (Hodrick/Prescott 1997, Baxter/King 1999 u.a.) Long term: (allowing for investments in both human and real capital and for technical progress)  production function approaches (Okun, Bundesbank, OECD, SVR) 3 U van Suntum, Vorlesung KuB 3

WS 2006/07 4 U. van Suntum, KuB 4 U van Suntum, Vorlesung KuB 4

WS 2006/07 5 U. van Suntum, KuB 5 U van Suntum, Vorlesung KuB 5

WS 2006/ Potential Output by Okuns`s Law (A.M. Okun, 1962) U. van Suntum, KuB 6 Based on empirical observations in USA Decline in unemployment rate RU by 1% => increase of GDP by 3% Natural rate of unemployment (NRU) = 4% Critique (i): today capital is the more scarce factor Critique (ii): rule of thumb, dependent on time and region U van Suntum, Vorlesung KuB 6

WS 2006/07 7 U. van Suntum, KuB 2. Potential Output by Peak-to Peak (L. Klein 1964) GDP real Zeit „Peaks“ PO Critique (i): trend may not be stable Critique (ii): not every peak implies full capacity utilization Critique (iii): trend of GDP or trend of GDP-growth? 7 U van Suntum, Vorlesung KuB 7

WS 2006/07 8 U. van Suntum, KuB PO by peak to peak BIP real 8 U van Suntum, Vorlesung KuB 8

WS 2006/07 9 U. van Suntum, KuB 3. Potential Output by shifting the trend PO trend GDPreal Maximum tangent point 9 Critique (i): trend may be unstable Critique (ii): trend of GDP or trend of GDP growth? U van Suntum, Vorlesung KuB 9

WS 2006/07 10 U. van Suntum, KuB 4. Potential Output by production function (Bundesbank, OECD) Critique (i): capital stock and N pot must be estimated Critique (ii): Cobb-Douglas production function appropriate? 10 U van Suntum, Vorlesung KuB 10

WS 2006/07 11 U. van Suntum, KuB 5. Potential Output by non-parametric estimation (Bundesbank) Trend estimation wage share main advantage: absolute values of K und N pot need not be known Critique (i): absolute value of PO cannot be directly calculated 11 U van Suntum, Vorlesung KuB 11

WS 2006/07 12 U. van Suntum, KuB Exercise (I): Calculate PO by Okun´s law for quarter 7 U van Suntum, Vorlesung KuB 12

WS 2006/07 13 U. van Suntum, KuB Exercise (II): Calculate PO by peak to peak for quarter 14 U van Suntum, Vorlesung KuB 13

WS 2006/07 14 U. van Suntum, KuB Exercise (III): Calculate PO by trend shifting for quarter 14 U van Suntum, Vorlesung KuB 14

WS 2006/07 15 U. van Suntum, KuB Exercise (IV): Calculate PO by Cobb Douglas production function for quarter14 Assume: U van Suntum, Vorlesung KuB 15

WS 2006/07 16 Learning goals / Questions Which definitions of Potential Output do we know? How are potential output, capacity utilization, and output gap related to each other? How can we estimate/calculate Potential Output? What are the main strengths and weaknesses of the various approaches? U. van Suntum, KuB 16 U van Suntum, Vorlesung KuB 16