Rethinking potential output: embedding information about the financial cycle

This paper argues that information about the financial cycle should be incorporated in measures of potential output. Identifying potential output with non-inflationary output is too restrictive given that growing financial imbalances can place output on an unsustainable path even if inflation is low...

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Bibliographic Details
Published in:Oxford economic papers 2017-07, Vol.69 (3), p.655-677
Main Authors: Borio, Claudio, Disyatat, Piti, Juselius, Mikael
Format: Article
Language:English
Subjects:
Economic forecasting
Federal Reserve monetary policy
Inflation
Simulation
Studies
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Summary:This paper argues that information about the financial cycle should be incorporated in measures of potential output. Identifying potential output with non-inflationary output is too restrictive given that growing financial imbalances can place output on an unsustainable path even if inflation is low and stable. We propose a simple and transparent framework to accommodate information about the financial cycle in constructing output gap estimates. Applied to US data, our approach yields measures of potential output that are not only estimated more precisely, but also much more robust in real time. Inflation, by comparison, carries very little information that can be exploited to infer potential output.
ISSN:0030-7653
1464-3812
DOI:10.1093/oep/gpw063