Closing the Output Gap in Advanced Economies

CEIC WorldTrend Data Talk - August 20, 2015 The output gap is one of the indicators that receives great attention from both analysts and academics due to its importance in estimating economic development and its complicated and unobservable nature. Calculated as the difference between actual and potential GDP, the output gap shows whether the economy is operating below or above its capacity and is also often a good predictor of inflationary pressure. The concept of potential GDP is one of the economic variables that is unobservable, and therefore challenging to estimate and frequently revised. For this reason, international institutions such as the European Commission, IMF, OECD and World Bank have extensively worked on developing a standardised approach in calculating it, thus allowing for a cross-country comparison. Output gaps for the advanced economies are provided by the IMF and the OECD and readily available in the WorldTrend Database. The data are disaggregated by regions and individual countries with forecasts until 2020. The IMF’s data follow the standardised approach of estimating potential growth using a production function taking into account the contributions of capital, labour and total factor productivity in measuring output. These estimates are nevertheless heavily influenced by the average level of economic activity over time while historical data revisions, forecast errors and changes of methodology can also affect estimates of potential output making these data prone to frequent revisions. In 2014, output gaps were still negative for the G7 countries, averaging -1.9% of GDP. Negative figures are projected to last until 2020 when gradually the output gap is expected to close. The output gap of the G7 countries is expected to reach -0.07% in 2020, thus closing by 1.8 percentage points (pp) compared to 2014, or by 0.2% on average per year. The forecast, however, is highly dependent on current production capacity levels and on the assumption that the present trends will continue. The European economy is therefore not expected to reach its potential level any time soon. The euro area was strongly hit by the sovereign debt crisis which substantially widened the output gap, causing deflation. While hovering around 0% currently, the euro area inflations rate is only expected to gradually reach 1.7% by 2020, as calculated by the IMF. In 2014 the output gap stood at -2.8% and is expected to narrow, but remain slightly negative at -0.2% by 2020. With unemployment rates close to 10% throughout Europe, and inability to reverse fiscal imbalances, the European economy faces a hard struggle to reach potential output. This implies that the output gap will not fully close in the next five years. However, the pace of closure is projected to be more pronounced than that for the G7 countries. There is some overlap as Germany, France and Italy are in both groups, but the closure of the output gap is expected to be around 0.4% per year, so stronger growth is projected for the much troubled euro area than for the G7. Of special interests to the global economy are the output gaps of the U.S. and Japan (the two largest G7 economies). These two countries, although starting with considerably low output gaps in 2014, are expected to reach their potential in the next couple of years. The U.S. output gap is expected to close in 2017, reaching 0.2% of GDP. On the other hand the Japanese economy is expected to surpass its potential output in 2019, reaching 0.05%. These developments may cause positive spillover effects for emerging market economies, as the strengthening of the U.S. and Japan suggests increased demand in these import-dependent countries. Even though output gaps in most advanced economies* are expected to be negative in 2015, some countries, such as Germany, New Zealand and Malta, are forecast to reach their potential GDP by the end of this year. Others, such as South Korea, Luxembourg, Estonia and Sweden are expected to reach it in 2016. Not surprisingly, the countries further away from their level of potential output are the ones that were hit hardest by the sovereign debt crisis, for example Greece, Italy and Spain. The effect of the projected closure of the output gaps in the advanced economies is difficult to estimate, but it can be broadly summarised by two transmission channels. Firstly, the increased output of the advanced economies may translate into surging imports from other countries, and therefore export levels of emerging markets and other major exporting economies would be expected to surge. IMF forecasts show imports of goods in the euro area, G7 and other advanced economies growing between 4% and 5% annually from 2016 to 2020, compared to average annual growth rates of less than 2% during the last four years. Hence the closure of output gaps in advanced economies will have positive spill-over effects in the rest of the world. The second channel through which increased economic activity may have an impact on emerging markets is related to international capital flows. Growing output in advanced economies is expected to be accompanied by an increase in interest rates and currency appreciation, as is the case with in the U.S. where in July 2015 the short-term interest rate jumped to 0.08% pa from 0.01% pa, and the real effective exchange rate marked an appreciation of 12% year-on-year. Such developments in turn may result in surging capital outflows from emerging markets, an event which has already gained pace. It is hard to judge which one of the two channels will prevail, but in general the projected increase in output in the developed countries is historically related to positive spill-over effects in the rest of the world. *The group of advanced economies according to the IMF is composed of 36 countries including the G7 countries, the euro area and Australia, Czech Republic, Denmark, Hong Kong, Iceland, Israel, South Korea, New Zealand, Norway, San Marino, Singapore, Sweden, Switzerland, and Taiwan. By Petar Chavdarov - CEIC Analyst Discuss this post and many other topics in our LinkedIn Group (you must be a LinkedIn member to participate). Request a Free Trial Subscription. Back to Blog
19th August 2015 Closing the Output Gap in Advanced Economies

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