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short essays and reports on the economic issues of the day
2009 ■ Number 45

Has the Recent Real Estate Bubble
Biased the Output Gap?
Chanont Banternghansa, Research Associate
Adrian Peralta-Alva, Economist
he output gap is the difference between actual gross
domestic product (GDP) and the economy’s potential
output at a given moment in time. The Congressional
Budget Office (CBO) estimates a very large and negative
output gap for 2009’s second quarter: –6.7 percent. Because
this (predicted) output gap is so large, several analysts have
concluded that monetary policy can remain very accommodative without fear of inflationary repercussions. We
argue instead that standard output gap measures may be
severely biased by the bubble in real estate prices that,
according to many, started around 2002 and burst in 2007.
One difficulty in estimating output gaps is that a key
component—potential output—is defined as the GDP
attainable when the economy is operating at a high rate of
resource use. Because economies are subject to the effects
of recurrent external forces, actual GDP is typically not at
its full potential. This implies that we cannot really ever
observe potential output and, hence, it must be approximated. The first method to do this consists of identifying
potential output according to long-term
trends in GDP. The second method—
the production function approach—is
Output Gap
based on a relation between available
productive inputs (such as capital and
labor), their current utilization rates,
and aggregate production.
Components of existing statistical
methods to estimate potential output
are typically subject to inertia. Hence,
if the recent real estate bubble increased
GDP and productive inputs to levels
higher than what would
by economic fundamentals, then it is
likely that potential output estimates
will also be beyond what economic
fundamentals would imply. Thus,
these estimates would be biased. One
way to better understand how bubbles


affect key macroeconomic indicators is to consider that
high growth in real estate prices may affect GDP not only
through the increase in the value of residential services,
but also through its indirect impact on higher-than-usual
growth in (i) the finance and insurance sector and (ii) consumption—the latter caused by perceived increases in personal wealth.

We offer a word of caution to
policymakers: Policies based on
point estimates of the output gap
may not rest on solid ground.
Knowing the exact rate at which the economy would
have grown without a bubble might be impossible. Nevertheless, we construct two estimates of potential output that
we consider reasonable and “bubble-free.” These estimates

Based on Production Function
Based on GDP Trend





Economic SYNOPSES

Federal Reserve Bank of St. Louis

are based on the long-run trends1 of GDP and capital
stock up to 2002, before the bubble began. We call the difference between our artificial constructs and actual GDP
our “bubble-free” output gaps. Our results are summarized
in the chart.
Our output gap estimate based on GDP growth trends
during the 50 years preceding the real estate bubble yields
an output gap more negative than the CBO’s estimate. Why
the difference? Growth during 2002-09 was relatively weak
compared with the past 50 years. Notably, this estimate also
has the undesirable characteristic of being sensitive to the
period chosen to estimate GDP growth trends. In contrast,
the output gap based on the production function approach,


after adjusting the value of inputs for possible bubbles,
results in an output gap less negative (and positive through
2008) than the CBO’s estimate. Hence, two reasonable
methods yield opposite conclusions about the output gap.
At the very least, we can say that the confidence intervals
for the output gap seem to be wide.
Our results add to a long list of practical problems in
precisely measuring the output gap. We offer a word of
caution to policymakers: Policies based on point estimates
of the output gap may not rest on solid ground. ■

The long-run trends for both estimates were constructed using the HodrickPrescott filter; we use the average growth rate from 1950-99 as the long-run
growth rate.

Posted on December 16, 2009
Views expressed do not necessarily reflect official positions of the Federal Reserve System.