Friday, March 15, 2013

CBO’s Method for Estimating Potential Output

From A Summary of Alternative Methods for Estimating Potential GDP (PDF):
CBO’s Method for Estimating Potential Output

CBO’s estimate of potential output is based on the framework of a textbook model of long-term economic growth, the Solow growth model... CBO estimates trends —that is, removes the cyclical changes—in the labor and productivity components by using a variant of a relationship known as Okun’s law.

Okun’s law postulates an inverse relationship between the size of the output gap (the percentage difference between GDP and potential GDP) and the size of the unemployment gap (the difference between the unemployment rate and the natural rate of unemployment). According to that relationship, actual output exceeds its potential level when the rate of unemployment is below the “natural” rate of unemployment; actual GDP falls short of potential when the unemployment rate is above its natural rate.

For the natural rate of unemployment, CBO uses its estimate of the nonaccelerating inflation rate of unemployment (NAIRU). That rate corresponds to a particular notion of full employment—the rate of unemployment that is consistent with a stable rate of inflation. The historical estimate of the NAIRU derives from an estimated relationship known as a Phillips curve...

CBO estimates an Okun’s Law relationship for hours worked and total factor productivity (TFP). It uses regression equations that link each variable to the same set of explanatory variables (including the unemployment gap) to capture the effects of fluctuations in the business cycle. It also uses several time trends, which constrain the growth of the potential variables to a constant rate over one or more specified historical periods. CBO then calculates the potential levels of hours worked and TFP from the predictions of the equations when the unemployment gap is set at zero. Those potential levels are combined with the capital input to compute potential GDP.

1. Start with the Phillips curve.
2. Observe the current relation between inflation and unemployment.
3. Use this relation to estimate the NAIRU.
4. Use the NAIRU as "the natural rate of unemployment".
5. Compare the natural and actual rates of unemployment.
6. Call the difference "the unemployment gap".
7. By Okun's law, the output gap is twice the size of the unemployment gap.
8. Calculate the output gap.
9. Add the output gap to actual output, to get potential output.

There's more to it. But this is where the Potential Output number comes from.

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