Academic journal article Federal Reserve Bank of St. Louis Review

Parsing Shocks: Real-Time Revisions to Gap and Growth Projections for Canada

Academic journal article Federal Reserve Bank of St. Louis Review

Parsing Shocks: Real-Time Revisions to Gap and Growth Projections for Canada

Article excerpt

The output gap--the deviation of output from potential output--has played an important role in the conduct of monetary policy in Canada. This paper reviews the Bank of Canada's definition of potential output, as well as the use of the output gap in monetary policy. Using a real-time staff economic projection dataset from 1994 through 2005, a period during which the staff used the Quarterly Projection Model to construct economic projections, the authors investigate the relationship between shocks (data revisions or real-time projection errors) and revisions to projections of key macroeconomic variables. Of particular interest are the interactions between shocks to real gross domestic product (GDP) and inflation and revisions to the level of potential output, potential growth, the output gap, and real GDP growth. (JEL C53, E32, E37, E52, E58)

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Potential output is an important economic concept underlying the design of sustainable economic policies and decisionmaking in forward-looking environments. Stabilization policy is designed to minimize economic variation around potential output. Estimates of potential output may be used to obtain cyclically adjusted estimates of fiscal budget balances; projections of potential output may indicate trend demand for use in investment planning or trend tax revenues for use in fiscal planning; and potential output provides a measure of production capacity for assessing wage or inflation pressures.

Although potential output is an important economic concept, it is not observable. The Bank of Canada defines "potential output" as the sustainable level of goods and services that the economy can produce without adding to or subtracting from inflationary pressures. This definition is intrinsic to the methodology used by the Bank of Canada to construct historical estimates of potential output. In addition to using a production function to guide estimation of long-run trends influencing the supply side of the economy, the procedure incorporates information on the demand side that relates inflationary and disinflationary pressures to, respectively, situations where output exceeds and falls short of potential output.

Potential output and the "output gap," defined as the deviation of output from potential output, play central roles in monetary policy decisionmaking and communications at the Bank of Canada. Macklem (2002) describes the information and analysis presented to the Bank's Governing Council in the two to three weeks preceding a fixed announcement date. (1) As described in that document, the output gap--both its level and rate of change--is the central aggregate-demand link between the policy actions and inflation responses. (2)

In addition to being central to policy deliberations, the output gap has played a critical role in Bank of Canada communications. The concept of the output gap is simple to explain and understand. It has been used effectively to simultaneously provide a concise and intuitive view of the current state of the economy and inflationary pressures. It also provides a point of reference in relation to current policy actions and helps align the Bank's current thoughts on the economy with those held by the public.

Use of the output gap as a key communications device with the public is clearly seen in Monetary Policy Reports (MPRs) and speeches by governors and deputy governors of the Bank. The Bank of Canada began publishing MPRs semiannually in May 1995 (with two additional Monetary Policy Report Updates per year starting in 2000), and the output gap has been prominent in the reports from the beginning. (3) Indeed, a Technical Box appears in the first MPR regarding the strategy used by the Bank to estimate potential output. (4) Not only is the Bank's estimate of the output gap referenced in the text of the MPR as a source of inflationary (or disinflationary) pressure in the economy, but the estimates of recent history of the output gap up to the current quarter are also charted. …

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