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Economic SYNOPSES short essays and reports on the economic issues of the day 2004 ■ Number 2 Mind the Gap: Measuring Actual vs. Potential Output Kevin L. Kliesen he Organization for Economic Cooperation and available to policymakers as of May 2001 (initial estimate of Development recently forecasted that real U.S. GDP first-quarter real GDP). The third measure uses the Hodrick(output) in 2004 will average 0.3 percent less than Prescott (HP) technique, which measures the gap with the potential output. In the third quarter of 2003, though, real GDP current vintage of NIPA data (in 2000 dollars). grew at a surprising 8.2 percent annual rate, the economy’s From the chart, it is apparent that estimates of the output fastest rate of growth in nearly 20 years. If real GDP has gap can differ significantly across both estimation techniques increased by 4 percent (annual rate) in the fourth quarter of and data vintages. For example, in the first quarter of 2000, 2003, which many economists expect, then the economy will the difference between the CBO estimate and the real-time have grown at a 6.1 percent annual rate over the second half BP estimate was 2 percent of potential GDP. of 2003. There are two key reasons why estimates of the gap should Although few economists expect this growth rate to persist be viewed cautiously. First, the output gap depends on a value into 2004, it seems apparent that recent economic growth has that can be measured with reasonable accuracy (real GDP) and been boosted by expansive monetary and fiscal policies. Hence, a value that cannot (potential output); moreover, there is no an important question for policymakers is when will the peragreed upon method for calculating potential output. Second, centage difference between the economy’s hypothesized level actual GDP is continually revised to incorporate improved of potential output and actual output—termed the output gap— data or new methodologies. Hence, the current estimated gap be closed? A highly expansionary monetary policy entails little may look much different after a future revision that incorporisk of an acceleration of inflation when there is considerable rates new information. ■ resource slack. But as the gap closes and the economy increases 1 Data are from the manuscript “The Reliability of Inflation Forecasts Based on its use of resources, continuing such a policy carries significant Output Gap Estimates in Real Time,” by Athanasios Orphanides and Simon van Norden (November 2003). risk of a rapid acceleration of inflation. Key to this framework, though, is a correct measurement of the gap. Thus, perhaps a more pertinent question is GDP Output Gaps: How Reliable? how accurate are measures of the output gap? The chart plots three different measures of the Percentage of Potential GDP output gap using three different vintages of data. 4.00 The first measure is derived from the Congressional 3.00 Budget Office’s (CBO) measure of potential real GDP, which is estimated from an econometric model. 2.00 This gap is measured in 1996 dollars, which are the 1.00 estimates prior to the Dec. 10, 2003, 12th comprehensive revision of the national income and product 0.00 accounts (NIPA). –1.00 The remaining two measures are derived from two different statistical filtering (detrending) tech–2.00 CBO ($1996) Band-Pass (Real Time) H-P ($2000) niques that extract the long-run component of real –3.00 GDP, which approximates potential output. The 1995 1996 1997 1998 1999 2000 2001 2002 2003 first, using the band-pass (BP) technique, measures NOTE: The H-P measure uses data after the Dec. 10, 2003, NIPA comprehensive revision. The other the gap in “real time.”1 For example, the output gap two measures use data prior to this revision. for the first quarter of 2001 is calculated from data T Views expressed do not necessarily reflect official positions of the Federal Reserve System. research.stlouisfed.org