Measuring potential output for the South African economy: Embedding information about the financial cycle

Stellenbosch Working Paper Series No. WP03/2014
 
Publication date: 2014
 
Author(s):
[protected email address] (Bureau for Economic Research, university of Stellenbosch)
 
Abstract:

In a recent paper, Borio et al (2013a) show that information embedded in the financial cycle can serve to improve measures of potential output and output gaps. It is argued that output may be on an unsustainable path despite low and stable inflation if financial imbalances are accumulating. Borio et al (2013a) show that incorporating information on the financial cycle yields measures of potential output and output gaps for the US, UK and Spain that are estimated more precisely and are more robust in real time. With its well-developed financial markets and relatively open capital markets, the South African economy is potentially susceptible to the build-up of the sort of financial imbalances that characterised the recent financial crisis. However, existing measures of the output gap for South Africa do not generally incorporate information on the financial cycle. Using the framework developed in Borio et al (2013a), a finance-neutral measure of the output gap is estimated for South Africa. The traditional HP-filter is extended to incorporate information on credit and property prices. Including financial cycle proxies result in output gaps that are estimated more precisely and are more robust to data revisions and the arrival of new data points (i.e. estimated output gaps are more robust in real time), while also reflecting the impact of financial variables on economic activity. As such, the estimated finance-neutral output gap seems to represent a more appropriate measure on which to base monetary policy decisions than the traditional inflation-neutral measures prevalent in the literature.

 
JEL Classification:

E10, E40, E44, E47, E52

Keywords:

Potential output, output gap, financial cycle, monetary policy

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