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Mntr pl th nrtn tt f ptntl tpt

Knnth Kttnr

Ae yeas o egec oe- ase o e uemoyme ae Seco i ia ouu as aw eewe oies a way o cacuae e uceaiy aeio as a iu o moe- associae wi e esimae wic is aicu- ay oicy aeaig i a ay imoa o oicymakes cage wi oa age o ece eea keeig ouu a o ea oeia e ia esee sysem a acaemic eseac A secio o e aice igigs e acica oe ee i is e raison d' etre o a aciis imicaios o is uceaiy a eamies moeay oicy I oeia ouu measues is oe uig e ai easio o 19-9 e ecoomys caaciy o ouce goos a seices wiou aig o iaioay es- Wht ptntl tpt? sues e goa o a saiiaio oicy sou I oaes ems oeia ouu is a e o kee e ecoomy oeaig as cose o measue o e ecoomys oea oucie oeia as ossie caaciy o is equiiium ee o ouu I Wie is sigiicace is wiey ackow- oe wos oeia ouu is suose o ege ee is ie ageeme o e es summaie e sae o e suy sie o e measue o oeia ouu Ui i was is- ecoomy wose mai eemias ae ao coiue e yeas ago e seies maiaie caia a ouciiy ucuaios i ese y e Couci o Ecoomic Aisos (CEA a oe suy sie acos—oi ices o a uise i e Economic Report of the eame—a coiue o aiaio i e President was oay e mos omie; gow o oeia ouu oug ime sice e a ume o comeig measues I coas o suy socks wic aec ae aeae e is secio o is aice oeia as we as acua ouu ema iscusses i geae eai wa i is a oe- socks ae e ecoomys saus relative o ia ouu is suose o measue a eiews oeia Eames icue moeay a some o e esimaes i cue use isca oicy as we as eogeous cages i e e secio iscusses a ew ecique cosumio iesme o ema o US o esimaig oeia ouu is meo eos Isuicie aggegae ema may ies om eisig measues y eiciy esu i a ee o ouu a wic acos o moeig oeia ea G as a uose- oucio ae ess a uy emoye; simi- ae aiae usig aa o ouu gow a ay ecess aggegae ema may emoai- iaio o ie is ee I aso oes wo y i e ecoomy aoe is equiiium ee sigiica aaages oe eisig measues Knnth Kttnr nr nt t th dr is ecause i is eie i ems o iaio l rv n f Ch. h thr thn i is o ueae o e sucua cages i Stv Strnn nd Mr Wtn fr thr e ao make a ae isoe measues nt.

2 ( 1I; ESECIES o ouu is aoomy o socks i ems o suy socks Sice e muc o e e- suy o ema suggess eiig oeia seac o oeia ouu as ocuse o ca- ouu as u-emoyme oucio coe- uig e ime-aiaio iuce y aggegae soig o e ea G e ecoomy wou suy sis ouce i e asece o ema socks I An d n ll vr trdtnl oe wos wi e ecoomy oeaig ea prptv n ptntl tpt oeia ao a caia wi e uiie o a ecoomiss agee a i makes as uy as ossie gie ay suy sie sese o escie usiess cyces i ems o cosais eaues om oeia ouu a isagee- A aeaie u comemeay eii- me a suaces i we kow ece ie- io o oeia ouu eois e ik e- meiae ee macoecoomics eooks A wee ouu a iaio emoie i e iscussio o oeia G aeas omie- aggegae suy cue e aggegae suy y i e ioucio o ousc a isc- ucio escies a osiie eaiosi e- es (199 ook wose iew is cosise wi wee ees o ea ouu a e iaio e esciio o oeia ouu skece ae muc as e we kow iis Cue aoe y coas e suec eceies o escies e egaie coeaio ewee e meio a a i aos (199 e uemoyme ae a iaio owee i aos omissio o ay iscussio o as og ee ecogie a is ouu-ia- oeia G eecs e ew Cassica a- io aeo woks oy i e so u; a is oac o usiess cyces as emoie i e i e og u e aggegae suy cue is ea usiess Cyce (C eoy ioeee eica eeoe a sae iaio ae—oe y Kya a esco (19 C eoy a is eie iceasig o eceasig—is asses a ecoomic ucuaios ae e ou- ossie oy wi ouu equa o oeia come o comeiie equiiia i wic wages is coecio ewee oeia ouu a ices aus aiy o cea a makes a a sae iaio ae isie Au Accoig o is iew suy socks (usuay Okus (197 eiiio i wic oeia aee ecoogy socks ae e soe souce ouu is e "maimum oucio wiou o ucuaios i ea ecoomic aiaes suc iaioay essue o moe ecisey e as ouu a emoyme ema socks oi o aace ewee moe ouu a yicay aec oy omia aiaes—e geae saiiy" So og as ee is a sae aggegae ice ee o isace—wiou eaiosi ewee emoyme (o caaciy aecig eaie ices ea ouu o emoy- uiiaio a iaio is oiaioay me Accoig o e C iew eeoe caaceiaio o oeia ouu is comai- i makes o sese o isiguis ewee acua e wi is eiiio as u-emoyme ou- a u-emoyme ouu Wi ouu e- u Coceuay eiig oeia ouu i emie eiey y e suy sie o e ems o sae iaio simy sis e ocus ecoomy oeia ouu is simy equa o om is ueyig eemias o is ia- acua ouu ioay imicaios A a acica ee e e oicy imicaios o C eoy ae ik ewee oeia ouu a sae ia- a eacig I ese moes isceioay io oies e ouaio o e oeia moeay oicy ca ay o useu oe i ouu measue iscusse i is aice saiiig e ecoomy as e oy eec o Aoug oeia ouu is someimes moeay oicy is o e ice ee ue- associae wi a sime e ie ie o ea moe ecause e ecoomys ucuaios e- G oig i eie o ese aeaie su om comeiie equiiia ey ae eco- eiiios imies a e gow ae o o- omicay eicie° eeoe ee i ose eia ouu emais cosa oe ime e moes i wic moeay oicy ca aec souce o is eceio is a ougou ea aiaes oig so wi yicay euce muc o e 19s a og-iea e was wie- oea weae y use as a oy o oeia ouu As Ceay a ue C amewok as o escie eow ees o e 197s emo- ace eie o esimaig oeia ouu o sae a e saig-ie meo was sais- o usig i as a guie o macoecoomic oi- acoy oy i e asece o ay sigiica cy Isea iewig usiess cyces as ea-

FEDERAL RESERVE RANK OF CHICAGO ues om oeia ouu is muc moe co- aaysis o Okus aw O e ee e seg- sise wi e so-cae aiioa aoac o mee e ecique is perhaps the simes macoecoomic ucuaios skece eaie yicay is ioes awig saig ie Aoug e meooogica ieeces e- segmes oug a o o (og ea G wee e aiioa a e cassica iews ae Giig eac ie segme is ow soe is a ee C moes ae a a mao imac o sime way o caue oca aiaios i e eseac a oows e aiioa aoac e gow ae imaiy y emosaig e imoace o A key isicio amog segmee e suy socks as a souce o usiess cyce measues ies i e coice o e segmes ucuaios e ew measue o oeia eois Oe we kow eame is e ouu iscusse i is aice akes is oo- mi-easio G seies uise y e siio seiousy a seeks o quaiy e ea- ueau o Ecoomic Aaysis (EA oe ie imoace o suy a ema acos i e o ae o igue 1 (e seies is oe o a ogaimic scae As e ame Extn r f ptntl tpt imies e segmes eois ae e mi- Mos eisig measues o oeia G ois o usiess cyce easios wose ae eie o oe o moe o e oowig aes ae eemie ex post y e aioa eciques segmee es suy-sie ueau o Ecoomic eseac e owe

IGUE Mi-easio G

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4 ECONOMIC PERSPECTIVES ae o igue 1 os e auaie gow ow—coiue o e eakow o a ai- ae o mi-easio G wose saise ey o oeia ouu measues e isie- aeaace is ue o e segmee e co- gaio o measues ase o Okus aw wi a sucio o e seies ie aua ae o uemoyme was ese- e suy-sie aaysis a was e asis ciay cosicuous Wi uemoyme aes o e iscoiue CEA esimae is coceu- we aoe ece ese measues iicae ay muc moe soisicae a e mi- a ouu was a eow oeia ye iaio easio seies 9 is meo gauges oe- coiue o ise e usua measues o oe- ia ouu y way o a aggegae oucio ia ouu o oge seeme o coeso o ucio eaig aco ius—ao a cai- sae iaio eaig some oay Goo a—o ea ouu oeia ouu is e (1975 o use aeaie ime-ayig measues eemie y susiuig e u-emoyme o eai e eaio o iaio aues o ao a caia io e oucio e eeioaio o Okus aw ca e ucio e mai awack o is ecique ace o gow i e aks o e sucuay is is omiae aa equiemes ecause uemoye wokes wo ecause o sucu- quaey caia sock igues ae so ueiae a cage i e ecoomy a o eai o imemeaios o is meo usuay ocus eocae i oe o i ew emoyme I o ao ius Ee so i equies aa o esose o e ise i sucua uemoyme cycicay ause emoyme ous ao ecoomiss eise ei coceio o u em- oce aiciaio aes a ouciiy o oyme a e aguage use o escie i cosuc is esimae o u-emoyme ou- e awkwa ase "oacceeaig iaio u e osce a Mis (199 seies is a ae o uemoyme" eace "aua ae" eae measue wic aems o caue e aoiig e imicaio a sae iaio suy-sie eecs o oi ice socks a was ecessaiy associae wi a ow uem- cages i iiiuas magia a aes oyme ae ikewise e EA swice o e i commoy use ecique is wa i cae a "ig-emoyme ecmak" ase o Okus ceeae aw wic uses e ae o uemoyme equa o ece uemoyme ae as a oy o e ga e- is eeiece eose e Acies ee wee oeia a acua ouu Wi U o Okus aw as a ouaio o oeia eoig e uemoyme ae a eig ouu e uoseaiiy o e ime-ayig G a U eese oeia ea G a aua ae o uemoyme I U is eie e aua ae o uemoyme eseciey ie o oseae Okus aw meey e- Okus aw scies a eaiosi ewee wo uose- aes a cao e use y ise o comue (1 G = G • [1 + 3 (U – U] oeia G; oy i coucio wi some ieee measue o e aua ae o saes a e eceage eiaio o G uemoyme wi i yie a esimae o o- om oeia is ooioa o e ga e- eia ouu wee uemoyme a e aua ae e e oeia G seies oose y Cak coeicie o 3 meas a a 1 ece u- (193 a au (199 ae wo ece eam- emoyme ga coesos o a 3 ece ga es o measues ase o ieee esimaes ewee ea G a oeia I e aua o e aua ae o uemoyme aus ae is kow (Oku assume i was ece seies is acuay a yi measue comiig is equaio easiy eies a esimae o a Okus aw equaio wi a segmee e oeia G uig e ecoomicay quies- seciicaio o oeia ouu ike oe ce 195s a 19s a og-iea e o- segmee e measues i aso eies o some uce esimaes o oeia ouu eay ie- io eemiaio o e aoiae aes o ica o ose geeae y Okus aw wi U e eakois" equa o a cosa ece I ac ecause dd vr ndd tt i ouce a smooe seies Oku ecom- mee usig e e meo as a aea- Oe esseia isicio ewee ese ie o e aoe equaio aeaie eciques is e egee o wic e os iomaio a is wee e ees o e 197s—e oi sock e ey ey o 197-75 ecessio a e ouciiy sow- ey ae cosuce coemoaeousy o

EEA ESEE AK O CICAGO eoseciey A esimae o a gie qua- maes use oy cue a agge aa wie es ee o oeia G is one-sided i i wo-sie esimaes use o ags a eas uiies oy aa aaiae i a quae A e EAs mi-easio e G is a two-sided esimae o e oe a icoo- goo eame o a eiciy wo-sie mea- aes aa a ecome aaiae ae o sue ecause usiess cyce eaks ae ae isace a esimae o 199 oeia a we ae e ac e easios mioi use 19911 iaio wou e wo-sie; oe ca e eemie oy eoseciey—oi- a eie oy o aa oug 199 wou ousy oo ae o e o ay use o a oicy e oe-sie I oe wos oe-sie esi- esige o ae a ecessio o ouce a

An econometric model of potential output

The potential output measure proposed in Kuttner Having described the link between the unobserved (1991) builds on a statistical technique known as a level of potential output and observed realizations of dynamic factor or multiple-indicator model. The basic real output growth and , it remains only to idea behind these models is to describe the behavior of specify how potential output, x; evolves over time. The the observable data in terms of some underlying, unob- multiple indicator model replaces the traditional seg- served variable. In this application, potential output is mented trend with a more flexible stochastic trend the key latent variable; inflation and real growth data specification discussed in Stock and Watson (1988). are used as indicators of the unobserved level of poten- This specification says that over the long run, output tial output. will grow at some average rate, labelled g However, Let x, represent the natural logarithm of real GNP shocks to potential output, can cause potential output at time t, and let e,a denote a period t shock to real GNP growth to deviate from its mean. Moreover, these that does not affect potential output, denoted by x*,. shocks are persistent with respect to the level of poten- The Greek letter A is the first-difference operator, so tial output: once perturbed by an e shock, x*will show

that Ax, = The first component of the multiple- no tendency to return to its trendline. Plotting it along- indicator model is the error-correction equation for side a deterministic trend with slope equal to g the real output, stochastic trend will appear to wander. The mathematical expression of the stochastic

( A= a0 + a i ( + a2 _ i + a _ 2 + + a4ea trend specificaion is a random walk with drift:

where ao through a4 are coefficients to be estimated. If (3) = g + ey a i is positive, x,* in excess of x, implies higher than average future real growth rates (subject to the distribut- The intercept g is the "drift" term in the random walk, ed lag captured by the a 2Ax,_, and a A_2 terms, and the corresponding to the long run growth rate of output. current and lagged shocks e+ a4ei In this way, output The unit coefficient on lagged .x,* makes (log) potential tends towards potential over time, unless perturbed by output a random walk. By constraining the coefficient e shocks. c/o in Equation 1 to equal g(1 — a 2 — a real output is The model's second building block is the inflation forced to grow at the same rate as potential on average. equation, based on a simple dynamic aggregate supply The practical advantage of the stochastic trend relationship reflecting the link between potential output assumption is to allow smooth variations in the growth and stable inflation. The change in the inflation rate is rate of potential output unlike the segmented trend with proportional to the gap between actual and potential its discrete kinks. While some research has endowed the output; GNP in excess of potential implies rising infla- random walk specification with a deeper economic tion, while falling inflation is a symptom of GNP below interpretation, it was chosen for this application as a potential. The growth rate of M2 is allowed to exert an convenient way to pick up low-frequency time variation independent effect on the inflation rate. Using i to in the underlying trend. represent the current inflation rate, and letting m,_, and One attractive interpretation of the overall model represent the lagged logarithms of M2 and the price is in terms of shocks, along the lines level, the following equation embodies this output- sketched earlier. The notation used here is consistent inflation relationship: with this interpretation: the e,' in Equation 3 represent supply shocks, affecting the economy's underlying (2) Aic, = i („ — + 2(_2 + capacity to produce goods and services without addi-

A(m_ _+ tional inflationary pressure. Similarly, the shocks in Equation 1 are disturbances to ,

which includes a moving-average error term, e"+ 4e which can deflect the economy's convergence to poten- The — x,_, — I term, recognizable as the lagged tial output. logarithm of the inverse of M2 velocity, captures the Two specific features of this interpretation deserve direct effect of money stock changes on the price level. special note. First, the supply shocks are assumed to

6 ECOOMIC ESECIES

coemoaeous esimae wou ioe ea- sime oceue usig Okus aw wi a ig om e mi-easio eiiio i some cosa aua ae o uemoyme is oe- way suc as eaoaig e oca e om sie y coas e ecique escie i e eious eeece cyce Mos segmee Cak (193 is wo-sie uiiig eas as e esimaes sae is wo-sie oey as we as ags o e ga ewee uemoyme i usuay akes seea yeas o aa o isce a a a ime-ayig aua ae cage i e ecoomys ueyig gow ae equey e ecmak aua uem- Oe eciques ca yie eie oe- o oyme ae use as a iu o Okus aw is wo-sie esimaes As escie aoe e ise wo-sie Esimaes o oeia ouu

have permanent effects on the AE economy's productive capac- ity, while the demand shocks' Esimaes o e aamees o e impact is purely transitory. oeia ouu moe This distinction reflects the Output gow equaio (1 Saa eiaio o e°= 93 implications of the natural rate hypothesis introduced Ax = 3 + + 5 i + _ + - 17 earlier, in which changes in (5 (3 (15 (31 aggregate demand have no lasting effects on real vari- Iaio equaio ( Saa eiaio o e = 5 ables. Second, the combina- tion of the stochastic trend An = 1 (;_ 1 — _ 1 — 1 (x; - A(I _ i - - p_ i ) + — 7e; 1 and error-correction specifi- (3 (3 (3 (3 cations of Equations 1 and 3 allows supply shocks to oeia ouu equaio (3 Saa eiaio o es = 7 generate behavior. In other words, = 75 + + est demand shocks are not the (7 sole cause of output gaps; some fluctuations of output OES: e same is 60: oug : around potential are attribut- e aa ae eesse as quaey ece gow aes able to the dynamics of e umes i aeeses ae esimae saa eos adjusting to a new equilibri- um level of output. Equation 1, the coefficient of 0.11 on (: x,) means Ettn th dl that in the absence of any shocks, output will gradually If data on x:existed, one could easily estimate converge to potential at a rate of 11 percent per quarter. Equations 1 and 2 with the familiar linear regression However, this adjustment is interrupted by demand technique. What complicates matters here is the fact shocks with a standard deviation of 0.95 percent per that the key right-hand-side variable, (x:— x,), is unob- quarter, or almost four percent in annualized terms. In servable. One technique that makes it possible to Equation 2, the statistically significant coefficients on estimate models with unobserved independent variables the two lags of the are consistent with a is the recursive Kalman filter algorithm.' Essentially, strong relationship between aggregate demand and this algorithm uses the law of motion for potential inflation. Similarly, M2 growth (less nominal output output in Equation 3 to compute its optimal guess of the growth), appears as a significant additional determinant unobserved In the next step, it uses that guess in of inflation. The intercept in Equation 3, which repre- Equations 1 and 2 to generate one-quarter-ahead pre- sents the mean quarterly growth rate of potential out- dictions for Art and Ax. The equations' fit is gauged by put, is consistent with an average annual growth rate of comparing these predictions to the actual data. A roughly 3 percent. The magnitude of the persistent maximum-likelihood routine is then used to determine shock to potential output, as measured by its standard the coefficients that yield the best predictions. A by- deviation, is similar, endowing the potential output product of this process is an estimate of the unobserved series with a relatively large amount of time variation. x* series, based on the observable output growth and inflation data and the best-fit coefficients from Equa- 'The Kalman filter technique is discussed in many time-series tions 1 -3 texts, including Harvey (1981). Table 1 displays estimates of Equations 1-3, fitted to quarterly data from 1960:1 through 1991:3. In

EEA ESEE AK O CICAGO ase o suc measues sou eeoe e esimaes; comaig em igs e isic- cassiie as wo-sie ee we ey use io io sa ocus A eamiaio o e oy cue a agge aues o e uem- easioay 19-9 eio iusaes e oyme ga issmas (19 ime-ayig acica imoace o is isicio esimae o sucua uemoyme is a goo is measue eies oeia ouu i eame as i uses eas a ags o emoy- ems o wo key aiues is i coe- me gow isesio Simiay e com- sos o a susaiae ee o oucio; a mo suy-sie measues cou a io eie is a ee cosise wi sae uue ea o ese wo caegoies eeig o wee gow aes Oe way o caue is oey ey use oe- o wo-sie meos o cyci- is oug a error correction equaio o ea cay aus e aco iu aa a oeia G is equaio escies e Oe aea wee e wo- esus oe-sie ecoomys ea gow ae as a ucio o e isicio is key is i e omuaio o a isceacy (e "eo" ewee acua a oicy eeack ue Some ecoomiss ayo oeia G a ema socks I ouu (195 o eame ae oose esios o equas oeia e ecoomy wi gow a e moeay oicy ues i wic e eea same ae as oeia i e asece o e- esee wou age e ga ewee ea G ma socks We ouu ecees oeia a e o oeia G o aciee a e ecoomy es o gow moe sowy a aoiae aace ewee iaio a oeia esoig equiiium oe ime ouu goas e ouu ga age wou e Simiay we e ecoomys ea G is suec o eeack ause owwas we eow oeia ouu es o gow moe e ae o iaio eceee is age a aiy I is equaio ema socks ee- ice esa se ose acos a eu e ecoomys Ay sysemaic imemeaio o suc a ausme ocess ue wou ae o oeae i real time; a is e seco mai eaue o is measue is e age wou ae o e ause o e is coecio o e iaio ae As i e asis o cuey aaiae iomaio wi- usua aggegae suy eaio escie eai- ou e eei o susequey aaiae aa e oeia ouu is eie as a ee o I oe wos eeack ues cou ey oy ouu a wic iaio sows o eecy o o oe-sie esimaes o oeia ouu icease o ecease oig oe acos ecuig e use o some o e measues (moey gow o eame cosa We iscusse aoe is cosieaio is ese- ouu ecees oeia e iaio ae es ciay eea o segmee e measues o ise eecig e uwa soe o e agge- ike mi-easio G As oe eaie gae suy cue ecause ey o ee eaoaig ese seies o oie cue o e ga ewee acua ouu a uo- eio esimaes wou usuay ai o ack see oeia ouu ea gow a ia- coemoaeousy cages i e gow o io aa ca e use o esimae e sie o e oeia ouu ga ewee e wo igue os e ogaim o oeia A n, nfltnbd r f ptntl tpt G esimae usig is ecique aog wi a iea e a e ogaim o osee e aeaie measue o oeia ea ea G Comaig oeia ouu wi e G escie i Kue (1991 (see o e igigs e cosieae ime aiaio uses a ecique a ies sigiicay om i oeia ouu gow om a eaiey ose escie aoe eaig oeia ouu ai gow ae i e eay 19s oeia iecy o e osee eaio o iaio ouu sows ae i e ecae a io e is meo uses ea G gow a ia- 197s eecig e we kow ouciiy io as gauges o e ee o oeia ouu sowow o a eio oeia ouu wic ise is uosee Uike eisig gow icease oce agai i e eay 19s measues is ecique eiciy ecogies as oi ices saiie a e ecoomy eco- e uceaiy ioe i eacig a mea- ee om e 191- ecessio sue o oeia ouu om e aaiae aa Wie is meo oes a coeie a A aiioa aaage o is ecique is is aeaig way o esimae oeia ouu i aiiy o ouce eie oe- o wo-sie ike e aiioa measues iscusse eaie

8 ECOOMIC ESECIES IGUE 2 Actual GNP, potential GNP, and linear trend

ogaims o 82 oas 84 —

80

6

2 is a esimae o a somewa imecise eiy ig o e ikeioo o a suseque ow- As suc i is imoa o emasie a ig- wa eisio o e aa sou oicy ac ue os oy e oi esimae o oeia ow o euce e gow ae o omia ouu Uike e aiioa measues ow- G? Ceay e oe eacio ees ee is ew meo moes e eo associ- sigiicay o e amou o uceaiy e ae wi esimaig oeia ouu a o- ess ceai e esimae e smae e ao- ies a esimae o e magiue o a eo iae oicy esose e oowig secio eoes e coseque- I is eame e eea esees ces o is uceaiy o oicy ase o a age is kow wi ceaiy u e ue sae uceai esimae o oeia ouu o e ecoomy is o e oem is com- oue we e oicy age ise is uce- Unrtnt nd rn pl ai as i e case o a oeia ouu age Oe o e mos imoa acica o- ems acig oicymakes is e uceaiy On vr tdd nrtnt n associae wi coemoaeous measues o ptntl tpt macoecoomic eomace aa eisios Oe useu eaue o e muie-iica- ae eiece o e uceaiy a eaes o moe is a i ca yie eie oe- o wo- ee e mos asic macoecoomic aa e sie esimaes o uosee oeia ouu aace esimae o G o eame usuay As escie i e accomayig o e ies sigiicay om e eimiay a Kama ie ecique eies e oima ia esimaes eease oe a wo mos esimae o oeia ouu gie e aa ae Ee e ia esimaes ae eise au- aaiae a e ime A comimeay ago- ay as we as eey ie yeas uig e im—e Kama smooe—uses aa ecmak eisio ocess Moey sock oug e e o e same o eac a saisics uego simia eisios" esimae o oeia ouu gie o as a ow sou oicy eso we ecoom- uue aa A e same ime o e ie ic sigas ae uceai? o iusae is o- a e smooe aso ouce esimaes o e em wi a seciic eame cosie e e- saisica uceaiy associae wi e esi- ecs o aa uceaiy Suose e eea mae eee o as ie uceaiy A ai- esee wises o maiai omia G ioa souce o aiace e aamee uce- gow a a aua ae o 7 ece Suose aiy comes om e esimaio o e mo- aso a e aace aioa icome aa es aamees iicae omia G gow o ece I

EEA ESEE AK O CICAGO igue 3 isays e sie o is uceaiy y oig e wo-sie esimae o oeia ouu aog wi e 5 a 95 eceies o is isiuio wic eese e 9 ece coiece ous cacuae usig e ec- ique oose y amio (19 As eo- ie aiace 08 84 e o e as ie o ae 1 e aeage wo- sie saa eo is aoimaey 1 ece aamee aiace 0 08 (eaie o e ee o oeia ouu coe- Oea saa eo 6% 62% soig o a 9 ece coiece ou o oe ece e coiuios o e ie a aamee aiace o e wo-sie saa Wh hndht rd nrtnt eo sow o e is wo ies o e ae Suseque aa imoes e esimaes sow ow e ocess o siga eacio a ecisio o wo easos is ee is e e imecisio o e aamee esimaes co- ysica ag Ceai iicaos—oay ia- iue comaay o e uceaiy o e io—eac o G cages wi a ag e oeia ouu esimae iaio equaio o e oeia ouu moe owee ecause e wo-sie esimaes icooaes is eay y eaig e cue ey o aa uaaiae o oicymakes i ea cage i e iaio ae o agge aues o ime ey uesae e amou o uceaiy e ga ewee ouu a oeia us a ese i ose esimaes A ee measue o wieig o e ouu ga is quae oes o is uceaiy is a associae wi e oe- aea as a cage i e iaio ae ui e sie esimaes Comaig e wo coums o oowig quae ae 1 sows a wi a aeage saa A seco moe sue easo o a ag eo o 1 ece e oe-sie esimaes ae comes om e ocess o siga eacio ess ecise a e aaogous wo-sie seies ise i is case e ocess o eacig a Wie e wo-sie esimaes ae moe ecise esimae o e uosee ee o oeia o aeage a e oe-sie esimaes is is ouu is ag comes om e ac a e o ue o e as quae o e same ee iaio a ouu aa ae oisy iicaos o i e asece o aa o uue ouu gow e ouu ga suec o aom moemes a iaio e wo- a oe-sie esimaes wic may o eec a cage i e ee o a ei saa eos ae ieica oeia G

IGUE Actual and two-sided potential GNP

lrth f 82 dllr 8.4

8.0

.6

.2

0 A( I o isace suose we wee o see a rnn tpt p n rl t icease i e iaio ae om 5 ece o Ece o e ac a e aamees o ece oe e sa o oe quae is e moe ae esimae usig aa om e aiioa iaio cou e e sig o a eie same e oe-sie esimaes ougy oeeaig ecoomy as e ae ema coeso o e esimaes o oeia ouu essue e ims a wokes o ema wage a wou ae ee aaiae o oicymakes a ice iceases O e oe a e ise a e ime is aises e quesio o wee cou e a uke e esu o a saisica ae- ee ae isaces wee e coemoaeous aio o secia acos I is wee e case uceaiy suouig e oeia ouu ieeig e iaio as a symom o a goa is so age a aoiae oicy coec- wieig ouu ga wou e a misake ios ca e iscee oy i eosec ee ae wo ways o isiguis mee e 195-9 1973-7 a 197-79 ea- is om ea ema essue is oe sios a e 191- ecessio a eese mig ook a e co-moeme ewee ia- saisicay sigiica eiaios o ouu io a ouu I e iaio accomaie om oeia as measue y e 9 ece sackeig ouu gow e wo iicaos ous owee e 197-75 ecessio a ogee wou oi o ecess ema ike- e 19-9 oio o e mos ece ea- wise i e iaio coiue oe e couse sio ae amiguous eaie o e wo-sie o seea quaes i wou oie soge esimaes i igue 3 ese wo eisoes ae eiece o a ouu ga owee waiig sigiica eiaios om oeia ouu aou o moe aa o aie akes ime A owee eie o ese eiaios is sigii- e ess eiae e iicao—i ime-seies ca wi esec o e oe-sie 9 ece aace e age e aio o oise o sig- ous i igue suggesig a a e ime a—e soge e iciaio o wai o isiguisig e aoiae couse o moe- coooaig eiece o aea eoe akig ay oicy mig ae ee iicu e acio I oe wos siga eacio uce- moe ece eisoe is eamie i geae aiy ca e caaceie as aoe souce o eai eow wa Mio iema cae e ecogiio ag eeig o e eg o ime i akes o A lr l t th 888 b ecogie e aeaace o a siuaio equi- Oe eseciay goo iusaio o e ig a oicy acio uceaiy oem is e sma oom o 19- 9 Ae seea yeas uig wic ouu e

IGUE 4 Acua a esimae oe-sie G

lrth f 82 dllr 8.4 —

0% rrr bnd

8.0

.6 tntl G

.2 6 64 6 0 6 82 8 88

FEDERAL, RESERVE BANK OF CHICAGO

so o oeia e ecoomy IGUE gew aiy i 197 a eay 19 acieig auaie ea wo-sie esimaes as o 1991 Q3 gow as ig as 5 ece e- ece acig o e ecoomys uosee — seg eea esee oicy gauay igee ougou 19 esuig i a isig eea 2 us ae Usig e em sea (e ieece ewee e e yea easuy o yie a e eea us ae as a oug measue o moeay oicy as suggese y aue (19 a eake a 0 ie (199 is cage i oi- cy coesoe o a ecie i e I • em sea om + asis ois Q Q2 Q Q4 Q Q2 Q Q4 0 Q2 Q Q4 Q Q2 Q Q4 i 191 o —1 asis ois i 8 88 8 0 199 is secio eamies e quesio o wee oicymakes cou ae a oug e is quae o 199 a wic iscee is oom sooe a ace o ose oi e ga gauay egis o a Mea- i gie e aa aaiae a e ime wie aoug moeay oicy was sowy is quesio is eoe i igues 5-7 igeig oe is eio e em sea i e as i eac ga eese e ouu o ecome egaie—usuay a sig o moe- ga—measue ea G ess esimae oe- ay esicio—ui e is quae o 199 ia G—eesse i eceage ems A I eosec e i aeas a moeay osiie ouu ga escies a oeeae oicy sou ae igee moe aiy i ecoomy wi iceasig iaio essue eay 19 i e aaiae aa suo suc Simiay a egaie ouu ga coesos o a acio? susiig iaio essue owee ecause igue isays e aaogous oe-sie ey ee o e level o ouu eaie o o- esimaes o e ouu ga a e ue 9 eia egaie ouu gas o o ecessaiy ece coiece ou As oe-sie esi- coeso o ecessios wic ae yicay maes ey ae simia o ose wic wou eie i ems o e gow ae o ea ou- ae ee aaiae a e ime owee u e soi ie i eac ga eeses e ue 9 ece IGUE 6 coiece ou iscusse eaie A ouu ga i ecess o is Oe-sie esimaes as o 1991 Q3 ou says a e osee e- ece aio o ouu a iaio is saisicay quie uikey o ae 1111 come om a ecoomy i wic 2 e ouu ga is eo igue 5 sows e wo-sie esimae o e ouu ga a is ue eo ou om e a- age oi o 1991 i is aae 0 I I I a e ey ai ouu gow o 197- e ea G o ecee I I I oeia y e is quae o 19 wee e ga eaces 3 2 1 I I I I I ece Ouu coiues o e- Q Q2 0 Q4 0 02 Q Q4 C 02 0 04 0 Q2 Q Q4 cee e 9 ece coiece 8 88 8 0 ou ougou e es o 19

2 ECON01111. PERSPECTIVES ee is a imoa ieece wie ey o gow is omay associae wi ouu eig o eiciy use ay os-ae aa e esi- eow oeia e moe iees ase- maes ae ase o e revised G a M a-oma gow as oe sig o a egaie seies aaiae as o ae 1991 Usig ese ouu ga us e wo souces o uceai- igues e ouu ga ee ecees e ue y—a associae wi oeia ouu a eo ou e esimae ouu ga cages e eo i esimaig G ise—comie ie ewee igue 5 a e mai ie- o iso e ue sae o e ecoomy comi- ece ewee e wo is e sie o e eo caig e oicy ecisio ou e wo-sie ou is ess a e- ce wie e oe-sie ou is eay 3 Cnln ece is isceacy iecy eecs e o e ee a e eea esee eucio i siga-eacio uceaiy a akes esosiiiy o ameig ema- esus om aiioa aa e oicy imi- iuce ucuaios i e ecoomy i wi caio o is comaiso is sikig uge y eie eiciy o imiciy—ase is oicy e 9 ece eo ous e case o ase o some aaisa o e ecoomys ee o moeay oicy igeig was muc ess cea oeia ouu is aice as oose a i 19 a i is wi isig ew ecique o igoousy cosucig suc Usig e unrevised G aa—ose aa a measue usig iaio a ea gow aa acuay aaiae a e ime—e eiece o o eemie e ee o G cosise wi quicke oicy acio ecomes ee weake sae gow a cosa iaio is ew igue 7 sows e ouu ga ase o oe- oeia ouu seies successuy caues sie esimaes usig e aa aaiae i e gaua cages i e ecoomys ueyig ou quae o 199 wic icue e e- gow ae wiou ioucig e au imiay esimae o i quae G Moe kiks a caaceie seies ase o segme- imoay ese aa aso eae e 199 e es uemoe is ew seies is aua eisios Usig ese aa e oe- uique i e way i eies a measue o e sie eo ous ae comaae o ose i saisica uceaiy ioe i cosucig igue owee e ouu ga oe e e seies As ague aoe a measue o is eio is somewa smae eacig a eak o uceaiy is esseia o caiaig e e- oy 19 ece comae wi 3 ece sose o moeay oicy usig e 1991 esimaes ei is isce- e eici ecogiio o is uceaiy acy is e ac a e iiia igues om aso igigs is cosequeces o ea-ime 199 sowe cosieay soge gow a oicymakig ecause e siga-eacio e eise esimaes ecause ai ouu eo associae wi a gie quaes esimae o oeia ouu as as moe aa ecome aaiae siuaios IGUE equiig oicy acio may o Oe-sie esimaes as o 199 Q3 e ecogiae ui ae o

ece is eomeo imis e scoe o moeay saiiaio equey e es esose o uceaiy is o ao a wai a 2 see aiue ui moe ioma- io ecomes aaiae As em- osae y e 19-9 eam- e y a ime i may e oo ae o eso eeciey 1 1 1 1 1 1 1 1 is cocusio is o imi- I I e o e case o oeia ouu - So og as ee is ay uceai- y i oicymakes assessme 2 I I I I o ecoomic coiios moe- Q Q2 Q Q4 Q Q2 Q Q4 Q Q2 Q Q4 Q Q2 Q Q4 8 88 8 0 ay oicy wi ee e ae o

FEDERAL RESERVE RANK OF CHICAGO ose e uesiae eecs o ema socks Oe way o imoe e measueme o A ess essimisic esaeme o e same oeia ouu is o icooae oe iica- cocusio is a eucig e eo associae os o e ga ewee ouu a oeia wi measues o macoecoomic eomace suc as e uemoyme ae o e ae o ca imoe e eomace o oicy as moe caaciy uiiaio Aoe way is o augme ecise esimaes eae oicy o eso moe e moe wi measues o aco ius ao quicky o cagig ecoomic coiios oce a e caia sock o o ese ae omisig iecios o uue eseac

OOOES

'For example, see Boschen and Mills (1990), Braun (1990), To be precise, competitive equilibria are Pareto efficient, and Hallman, Porter, and Small (1989). Prominent in the meaning no individual in the economy could be made academic literature is Blanchard and Quah (1989), who better off without making someone else worse off. This is decompose output fluctuations into the distinct effects of a statement of the well known First Welfare Theorem of supply and demand shocks. See also the references in general equilibrium . Boschen and Mills (1990). 7A recent exposition of the traditional approach to macro- The use of the term "" in this context is economic fluctuations appears in Blanchard (1989). somewhat misleading. Because supply shocks also create short term economic dislocation, full-employment potential DeLeeuw and Holloway (1983) describe the construction need not correspond to a situation in which no resources go and use of the BEA's mid-expansion and high-employment unused. One definition of potential output that takes the measures. full-employment idea to an extreme is the Delong and Summers (1988) measure. They argue that potential output 9Papers discussing the CEA's methodology include Perry should represent the maimum feasible level of output (1977) and Clark (1979). attainable during peacetime. "This series gained prominence as the potential GNP series 3 Okun (1970), pp. 132-133. used in Hallman, Porter, and Small's (1989) definition of Aside from the choice of breakpoints, a ioi judge- Eichenbaum (1991) provides a useful appraisal of the ment is also implicit in the choice of the four 14, distributed current state of RBC research. Further discussion of the lag weights in Braun's Equation Cl.. implications for RBC theory for the measurement of poten- tial output appears in Boschen and Mills (1990). "See Strongin (1986).

5Some recent RBC models do allow demand shocks to affect real variables: Cooley and Hansen (1989) and Chris- tiano and Eichenbaum (1990) are examples.

EEECES Barro, Robert, , 3 eiio Boschen, John, and Leonard Mills, "Moe- o Wiey & Sos 199 ay oicy wi a ew iew o oeia G" eea esee ak o iaeia Business Bernanke, Benjamin, and Alan Blinder, "e Review, uy/Augus 199 3-1 eea us ae a e caes o moeay asmissio" Mausci iceo Uiesi- Braun, Steven, "Esimaio o cue-quae y 199 goss aioa ouc y ooig eimiay ao-make aa" Journal of Business and Blanchard, Olivier, "A aiioa ieea- uy 199 93-3 io o macoecoomic ucuaios" American Economic Review 79 eceme 199 Christiano, Lawrence, and Martin Eichen- 11-11 baum, "Cue ea usiess cyce eoies a aggegae ao make ucuaios" Isi- Blanchard, Olivier, and Danny Quah, "e ue o Emiica Macoecoomics iscussio yamic eecs o aggegae ema a su- ae 199 y isuaces" American Economic Review 79 Seeme 199 55-75

4 ECOOMIC ESECI EI■ Clark, Peter, "oeia G i e Uie Harvey, Andrew, Time Series Models, o Saes 19-" Review of Income and Wealth Wiey & Sos 191 5 ue 1979 11-1 Kuttner, Kenneth, "Usig oisy iicaos o Clark, Peter, "Okus aw a oeia G" measue oeia ouu" eea esee Mausci eea esee oa o Goe- ak o Cicago Working Paper #1991-14, os 193 1991

Cooley, Thomas, and Gary Hansen, "e Kydland, Finn, and Edward C. Prescott, iaio a i a ea usiess cyce moe" "ime o ui a aggegae ucuaios" American Economic Review 79 Seeme Econometrica 5 19 135-137 199 733-7 Laurent, Robert, "A iees ae-ase ii- DeLeeuw, Frank, and Thomas M. Holloway, cao o moeay oicy" eea esee "Cycica ausme o e eea uge a ak o Cicago Economic Perspectives 1 eea e" Survey of Current Business 3 auay/euay 19 3-1 eceme 193 5- Okun, Arthur, The of Pros- Delong, James Bradford, and Lawrence Sum- perity, e ookigs Isiuio 197 mers, "ow oes macoecoomic oicy aec ouu?" Brookings Papers on Economic Ac- Perry, G., "oeia ouu ece issues a tivity 1 19 33- ese es" i U.S. Productive Capacity: Estimating the Utilization Gap, Cee o e Dornbusch, Rudiger, and Stanley Fischer, Suy o Ameica usiess Working Paper Macroeconomics, 5 eiio McGaw-i 3 Wasigo Uiesiy 1977 199 Rissman, Ellen, "Wa is e aua ae o Eichenbaum, Martin, "ecoogy socks a uemoyme?" eea esee ak o e usiess cyce" eea esee ak o Cicago Economic Perspectives 10, Seem- Cicago Economic Perspectives 15 Mac/ e/Ocoe 19 3-17 Ai 1991 1-31 Stock, James, and Mark Watson, "aiae Gordon, Robert, "e imac o aggegae es i ecoomic ime seies" Journal of ema o ices" Brookings Papers on Eco- Economic Perspectives 19 17-17 nomic Activity 1 1975 33- Strongin, Steven H., "Ml: e ee-cagig Hallman, Jeffrey, Richard Porter, and David as" eea esee ak o Cicago Small, "M e ui o G as a aco o Econonomic Perspectives 10, Mac/Ai e ice ee" Board of Governors of the 19 3-1 Federal Reserve System Staff Study 157 199 Taylor, John, "Wa wou omia G Hamilton, James, "A saa eo o e ageig o o e usiess cyce?" Carnegie- esimae sae eco o a sae-sace moe" Rochester Conference Series on Public Policy Journal of Econometrics 33 eceme 19 Sig 195 1- 37-39

EEA ESEE AK O CICAGO