Compute output gap using Blanchard and Quah method

Thi Viet Giang DAO, MscE, HEC Lausanne, Spring 2017

Introduction: Output gap is one of the most important macroeconomic indicator that policymakers
would like to know. The estimation of output gap, however, is not easily acquired. In this project report, I
explain the theoretical framework of Blanchard and Quah method and the implementation in R, to
compute the output gap for an economy. In application, I implement the method in 6 developed
economies: the United States, the United Kingdom, Switzerland, Germany, France and Japan.

1. Theoretical framework of the methodology

Output gap is the difference between potential output and current outputs, or the
difference between what an economy can produce and what is is producing. Output gap is
therefore an important macroeconomic indicator because its ups and downs reflect the business
cycles of the economy and observing output gap will help policymakers balance the economy.
When there is a boom, output gap is usually positive, meaning that the economy is operating at
higher productivity than it really is. When there is a recession, conversely, output gap tend to
fall below zero and to produce at lower level than it could potentially achieve. An economy
with output gap stable around zero is deemed to be a good one, and policymakers also look for
this scenario.

Output in output gap could be understood as Gross Domestic Products or Gross

Nominal Product or Gross National Income in real value, with a given based year. These
measures could be obtained manually every month, quarter or year. The matter is left with
potential output which for long term does not fluctuate as much as the periodical one. How to
know the optimal quantity that an economy could produce with all of its resources at one
specific time is not an easy question when we could not observe this optimal quantity visibly.

Macroeconomics then has to build up some models from which we have a framework to
compute the potential output and output gap. Hodrick-Prescott filter is one of those methods. It
aims at minimizing the difference between actual output and potential output while imposing
constraints on the extent to which growth in potential output can vary, which means their
optimization problem is:
1

min

{( ) + [(+1 ) ( 1 )]2 }
2

=1 =2

The first term of this equation is the sum of squared differences between actual output
levels and potential output levels. The second term is the squared changes in potential output
growth. is a parameter with value between zero and infinity that determines the extent of
permissible variations in potential growth and is determined outside the model. If is zero, the

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difference between actual output and potential output is minimized. If increases to infinity,
the variations in potential output growth will be minimized. In either case, we could filter out
the trend, or the long term potential output and then directly get output gap. is widely set to
1600 for quarterly data, as proposed by Kydland and Prescott (1990).

Hodrick-Prescott (1997) filter is currently most commonly used in macroeconomics.

Apart from this method, Band-pass filter, univariate unobserved component method, or
production function method are also common among many countries. For Sweden, for
example, Production Function method was used by the Central Bank of Sweden for many years
(Hjelm, 2010).

In 1989, Blanchard and Quah suggested a new method to estimate output gap by using
Structural Vector Autogressive (SVAR) model and this method is considered to be better at
estimating output gap than the others. We could see this superiority by comparing the
estimated output gaps from different methods at their correlation with domestic inflation rate,
based on the Philips equation (Bjornland, 2005), or by looking at whether the turning points of
the gaps are associated with the ones in reality (Bjornland 2005), or by observing the two kinds
of outputgaps computed from one method and see whether they are the same (Bersch, 2013).

In fact, SVAR model is usually applied in order to measure the impact of some shock
(demand or supply) on economic performance. SVAR is basically VAR model with more than
one endogenous variable and therefore there are different shocks in the residuals which affect
the variables in long run or short run. To identify these structual shocks, some theoy-based-
restrictions need to be put. SVAR model is to deal with these restrictions and allow us to see the
impact of one specific shock on a specific endogenous variable.

The SVAR model has the following form:

= + + + + , ~(0, ).

where = [1, 2, , ]1 , and we could use maximum likelihood estimation to
obtain matrices as well as residuals . In order to test stationarity of this joint process { },
we could transform the equation above into:

[ ]=[ ]+[ ][
]+[ ]

+

Or simply: = + + ;

If the eigenvalues of matrix lie within the unit circle, then the process { } is
covariance stationary.

The residuals is actuatlly a linear combination of structual shocks s. That is,

2
 =

(2 ). To identify the structual shocks,

we must find out the B matrix, i.e., we must find all 2 elements in B. As a result, we need 2
restrictions.

(+1)
2
restrictions can be obtained from covariance matrix of residuals : = = .

(1)
The other 2
restrictions are unknown theoretically, which means we have to come up with
some ideas from reality.

Cholesky decomposition is one common method of setting restrictions with assumptions

being that B matrix is lower triangular. Normally there are two types of restrictions we could
implement based on empirical evidence: short run and long run restrictions. A short run
restriction prevents a structual shock from affecting an endogenous variable
contemporaneously. Based on which shock and which variable, we could set the relevant entry
of B matrix equal to 0. On the other hand, a long run restriction prevents a structual shock from
having a cumulative impact on one of the endogenous variables, and this cumulative impact of
the effect of that shock on the variable, which we want to find.

Blanchard and Quah (1989) suggest a SVAR model with 2 endogenous variables: real
GNP growth rate and unemployment rate, and 2 shocks: demand shock and supply shock. They
want to identify the effect of demand shock on real GNP growth rate, therefore they propose a
long run restriction on this effect and could then measure the cumulative values over time. In
details, they assume that neither supply shock nor demand shock has long run impact on real
unemployment but supply shock does on real GNP growth rate. Demand shock also only
affects real GNP growth rate in a short period of time and will vanish soon enough.

Identifying the impact of demand shock on real GNP growth rate is important because it
is also the impact of demand shock on output. Because demand shocks impact will soon die
out, it is believed to be the driver of output fluctuations around potential one, and therefore the
calculated accumulative effect is the output gap we want to achieve. With this approach, we do
not need to estimate the potential output when trying to compute the output gap.

Technically, Blanchard and Quah (1989) assume that the process { } is covariance
stationary. In fact this assumption could be satisfied easily because we could modify the data
with several common techniques such as time series decomposition, differencing with ,
etc. With stationary process, we could estimate a VAR(p) model as follows:

= + + + +

where = [ ] (with real GNP growth rate and unemployment being endogenous
variables), and = [ ] (with demand and supply shock). As soon as having estimated

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values of residuals (a matrix with 2 columns), we could continue with finding B matrix using
the property of variance mtrix of residuals and the restrictions aforementioned.

The output gap is finally achieved as follows:

= + + +

2. Data and Application

Data are acquired from 6 developed countries: the United States, the United Kingdom,
Switzerland, Germany, France and Japan, on real GDP growth rate and unemployment level,
quarterly from 1992Q1 to 2017Q1 (around 100 periods). I use normal time series decomposition
to detrend and seasonally adjust the data. If after this decomposition, the series are still
nonstationary, I utilize difference between the value of one time t and its lag value from the
previous time (t-1). To check stationarity of one time series, unit root test (Augmented Dickey
Fuller test), KwiatkowskiPhillipsSchmidtShin (KPSS) test, and LjungBox test. I also observe
the correlation among lagged values of data by using autocorrelation function and partial
autocorrelation function.

After getting stationary series, I can construct the VAR model. The number of lags is
acquired by using different suggestions from Akaike information criterion (AIC), Bayesian
information criterion (BIC), Schwarz Criterion (SC), and Akaikes Final Prediction
Error Criterion (FPE) which could obtained at one time by command VARselect. As proposed
by most criterion, the number of lags then help estimate residuals, matrix (of which
eigenvalues help confirm the stationarity of process), and B matrix. As stated above, I could use
B matrix and VAR residuals to acquire the output gap.

For comparison, I use Hodrick-Prescott filter and get another estimation of output gap.
Both of these estimates usually show the similar fluctuations, reflecting the same business
cycles. On the results shown in graphs below, the blue line represents output gap measured by
Blanchard and Quah method and the orange line by Hodrick-Prescott filter. The yellow line is
just an interest where I use command BQ from package VARS of R software, which could be
useful in terms of comparison.

Finally, extension on the Blanchard and Quah method is usually replacing

unemployment with inflation Bersch (2013), or adding inflation into the existing model to have
a new model and new restrictions Bjornland (2005). Despite being relatively more complex, the
Blanchard and Quah method is deemed to be a good way to estimate output gap when the
potential output is hard to see.

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Reference
Bersch, J., Sinclair, T. M., Statistical versus economic output gap measures: Evidence from Mongolia,
Institute for International Ecnomic Policy, IIEP-WP-2013-7 (2013).

Bjornland, H. C., Brubakk, L., Jore, A. S., The output gap in Norway a comparison of different
methods. Norges Bankss Economics Department, Economic Bulletin, p90-100 (2005).

Blanchard, Olivier J. and Danny Quah, 1989, The Dynamic Effects of Aggregate Demand and
Supply Disturbances, American Economic Review, Vol. 79, No. 4, pp. 655-673.

Hjelm, G., Jonsson, K., In search of a method for measuring the output gap of the Swedish economy.
National institute of economic research (NIER), working paper NR 115 (2010).

Hodrick, Robert J. and Edward C. Prescott, Postwar U.S. Business Cycles: An Empirical
Investigation, Journal of Money, Credit, and Banking, Vol. 29, No. 1, pp. 1-16 (1997).

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Appendix
Note that for the sake of stationarity, the number of periods in each model for each
country may be different. In the graphs below I do not display the real timing but the order of
periods instead.

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