Rethinking Potential Output: Embedding Information About the Financial Cycle

35 Pages Posted: 12 Apr 2013 Last revised: 10 May 2014

See all articles by Claudio E. V. Borio

Claudio E. V. Borio

Bank for International Settlements (BIS) - Research and Policy Analysis

Piti Disyatat

Bank for International Settlements (BIS)

Mikael Juselius

Bank for International Settlements (BIS) - Monetary and Economic Department; Hanken School of Economics - Department of Economics; University of Helsinki - Department of Political and Economic Studies

Date Written: February 1, 2013

Abstract

This paper argues that incorporating information about the financial cycle is important to improve measures of potential output and output gaps. Conceptually, identifying potential output with non-inflationary output is too restrictive. Potential output is seen as sustainable; yet experience indicates that output may be on an unsustainable path even if inflation is low and stable whenever financial imbalances are building up. More generally, as long as potential output is identified with the non-cyclical component of output fluctuations and financial factors play a key role in explaining the cyclical part, ignoring these factors leaves out valuable information. Within a simple and transparent framework, we show that including information about the financial cycle can yield measures of potential output and output gaps that are not only estimated more precisely, but also much more robust in real time. In the context of policy applications, such "finance-neutral" output gaps are shown to yield more reliable estimates of cyclically adjusted budget balances and to serve as complementary guides for monetary policy.

Keywords: Potential output, output gap, financial cycle, monetary policy, fiscal policy

JEL Classification: E10, E40, E44, E47, E52, E60

Suggested Citation

Borio, Claudio E.V. and Disyatat, Piti and Juselius, Mikael, Rethinking Potential Output: Embedding Information About the Financial Cycle (February 1, 2013). BIS Working Paper No. 404, Available at SSRN: https://ssrn.com/abstract=2247905

Claudio E.V. Borio (Contact Author)

Bank for International Settlements (BIS) - Research and Policy Analysis ( email )

CH-4002 Basel, Basel-Stadt
Switzerland

Piti Disyatat

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Mikael Juselius

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Hanken School of Economics - Department of Economics ( email )

PO Box 479
FI-00101 Helsinki
Finland

University of Helsinki - Department of Political and Economic Studies ( email )

P.O. Box 54
FIN-00014 Helsinki
Finland

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