1. Estimating potential output growth in the euro area Alberto Musso Directorate General Economics European Central Bank Presentation for AIECE Workshop on Estimating potential output in the European Union 29 October 2004

2. Structure of presentation Framework, measurement and policy issues Main model and basic estimates Developments in factors of production Conclusions

3. Definition and policy relevance Definition: sustainable (i.e. non-inflationary) rate of growth of aggregate real output over the medium-term Monetary analysis: assumption for potential output growth is an input to the derivation of the reference value for monetary growth Economic analysis: measures of slack among indicators monitored to assess the risks to price stability in the short to medium run See ECB: The Monetary Policy of the ECB, 2004

4. Role in ECB monetary policy strategy potential output growth as input in the derivation of the reference value including slack indicators

5. ECB review of the reference value In 1998 medium-term trend real potential GDP growth estimated in the range 2-2.5% per annum Over 1999-2002 assumptions reviewed, but no new decisive evidence emerged pointing to a significant change in assumption In May 2003 Governing Council decided to no longer review assumptions on an annual basis but their validity still monitored regularly Any changes in assumptions will be communicated as soon as they become necessary See ECB Press Releases December 1998-2002 and May 2003

6. Issues in the estimation of PO growth Measurement inevitably surrounded by considerable uncertainty, especially in real time and looking ahead, stemming from various sources:  model uncertainty  parameter uncertainty  data uncertainty From ECB perspective:  Relevant time horizon is medium run  Euro area aggregate perspective See ECB Monthly Bulletin article entitled “Potential output and output gaps: concept, uses and estimates”, October 2001

7. The approach of the ECB Given the uncertainty characterising unobserved PO an encompassing approach is warranted:  assess estimates from alternative methods and institutions  assess developments in key factors of growth  define trend PO growth as the range that captures medium term developments

8. A basic analytical framework Economic structure provided by use of a Production Function Approach combined with a generalised Phillips-curve Statistical inference made possible by applying Unobserved Components estimation techniques Advantages:  consistent with the definition of PO  general and flexible  allows for contribution of inputs to be estimated  can get a well-specified statistical model  can estimate confidence bands See T. Proietti, A. Musso and T. Westermann (2002): “ Estimating potential output and the output gap for the euro area: a model-based production function approach”, EUI working paper ECO 2002/09, May 2002

9. The production function approach Cobb-Douglas production function with total factor productivity, capital and labour as inputs Labour decomposed into working age population, the participation rate and the contribution from the unemployment rate Capital stock and working age population assumed to have a permanent but no transitory component Thus, measurement model consists in decomposing TFP, labour force participation and the unemployment rate into respective permanent and transitory component For evidence supporting the Cobb-Douglas production function for the euro area see A. Willman "Euro area production function and potential output: a supply side system approach", ECB working paper 153, June 2002

10. The inflation equation The measurement model is augmented with a Phillips-type of relationship Inflation is modelled as a function of the output gap, lagged inflation, commodity prices and euro exchange rate Consistent with Gordon’s triangle model, where inflation has three main determinants: excess demand, inertia, and supply shocks See R. Gordon (1998): “ Foundations of the Goldilocks Economy: Supply Shocks and the time-varying NAIRU”, Brookings Papers on Economic Activity, 2: 1998

11. Statistical representation Trend and cycles modelled along the lines of the multivariate structural time series model of Harvey and Koopman (1997) Cyclical components are allowed to be correlated, while trends are assumed to be uncorrelated Trends modelled as local linear trends (stochastic trends) Cyclical components modelled as functions of AR(2) processes with complex roots See Harvey, A. and S. Koopman (1997): “ Multivariate structural time series models”, in C. Heij et al. (eds), Systematic dynamics in economic and financial models, Chichester: Wiley and Sons

12. Variants Multivariate variants considered: A) common cycle model all cyclical components driven by the cycle in the capacity utilisation rate B) pseudo-integrated cycles model cyclical components driven by a combination of common and specific cycles C) hysteresys model trends function also of cycles

13. Estimation and inference System approach for the five variables All components estimated simultaneously within a multivariate unobserved components model that incorporates the relationships specified (PFA and PC) Model cast in state space form, and Kalman filter and associated smoother algorithms enable maximum likelihood estimation and signal extraction Computations performed using Ox 3.0 and SsfPack 2.3

14. Work in progress Planned extensions: more general production function (CES, other inputs) more flexible specification of inflation equation

15. Table 1 - Alternative estimates of euro area average potential output growth (Annual percentage changes, average over period indicated) Sources: ECB computations and IMF: World Economic Outlook September 2004; OECD: Economic Outlook June 2004; European Commission: Autumn Economic Forecasts October 2004.

17. Comments on estimates Long run average of all estimates (1980-2004) tends to support the range of 2-2½% assumed by the ECB Potential output growth estimates tend to vary across method, although less so over longer periods Residual cyclicality from all methods Current and future estimates are more uncertain than historical estimates

18. Developments in factors of growth Growth accounting framework allows for alternative insightful decompositions: 1) Output as function of  TFP  Labour supply  Capital stock 2) Output as function of  Labour productivity, function of TFP and capital intensity  Labour utilisation, function of average hours worked, the unemployment rate and the participation rate  Demographic components: population and dependency ratio

21. See ECB Monthly Bulletin article entitled “Labour productivity in the euro area: aggregate trends and sectoral patterns”, July 2004. Table 2 – Developments in euro area labour productivity

22. Chart 4 – Contributions to growth from labour productivity per hour in the euro area See ECB Monthly Bulletin article July 2004.

23. Summary of main developments by factor Gradual decline in productivity growth, accounted for by lower contribution from both capital deepening and TFP Increasing contribution from labour supply growth, resulting mainly from a decrease in the unemployment rate and slower decline in hours worked

24. Looking ahead: short to medium run Projected decline in working age population growth is likely to have an adverse impact This may be counteracted by likely further increase in the participation rate (and possible further decline in the unemployment rate) Outlook for productivity growth more uncertain

25. Looking ahead: medium to long run Demographic developments, as projected by both Eurostat and the United Nations, are likely to have a significant adverse impact in the long run Developments in other factors more uncertain Only a combination of compensatory measures can counteract the adverse impact of demographic developments on growth Further structural reforms are needed to sustain and possibly expand potential growth in the medium to long run

26. Overall conclusion Revision of assumption for medium term potential output growth is warranted only in the presence of clear and compelling evidence that structural changes are actually leading to a change in potential output growth The ECB will continue to closely monitor future developments