1 Introduction

The global financial crisis (GFC) has cast a long shadow on many developed economies, particularly the US and the Euro area. Since the crisis, many countries have continued to revise down their growth outlook. Furthermore, many researchers and economic commentators have debated to what extent the crisis may have affected the supply side of the economy.

In 2009, the UK Treasury assumed that the GFC would reduce the level of potential output by 5% over three years, but that the long-term growth rate of potential GDP would remain unaffected at 2¾% (UK Treasury 2009). However, in the 2011 Budget, the judgement of the Office for Budget Responsibility (OBR) is that the long-term trend rate of growth is projected to be 2.35%, falling back to 2.10% from 2014 as demographic changes reduce the growth of potential labour supply. In the economic outlook released in November 2011, the OBR further reduced the estimate of the level of potential output in 2016 by about 3.5% but revised up the long-term growth rate to 2.3% (UK Treasury 2011).

In the US, the Congressional Budget Office (CBO) has not changed its estimate of potential output significantly since the GFC. In 2009, CBO's projection for the growth of potential was estimated to be 2.3% on average during the 2009-2019 period which is only one-tenth of a percentage point slower than what was estimated in the 2008 report (CBO 2009). This view reflects the CBO's assumption that potential output in the US has been largely unaffected by the crisis. As the CBO assumes that the recent slowdown in output growth is cyclical rather than structural, the CBO's estimates of the output gap are relatively large suggesting that there is significant spare capacity in the US economy.

However, some economists question the CBO assessment of the output gap because core inflation has fallen relatively little, hinting that there may be less slack in the US economy than suggested by the CBO estimates of the output gap (Weidner and Williams 2009).

In the 2009 quarterly report (EC 2009), the European Commission (EC) revised down not only future, but also historical, potential growth rates in the euro area owing to higher unemployment and plummeting investment. As a result, the EC predicted that the crisis will entail a permanent loss in the level of potential output. At that juncture, the EC forecast that the European economy will return to its pre-crisis long-term growth rate of 2% in the medium run.

Source: European Commission

Although New Zealand is far away from the epicentre of the crisis, we are not immune to the impact of the GFC on potential output growth. In the 2009 Budget Economic and Fiscal Update, the Treasury lowered the level of potential GDP in the 2013 March year by around 5% compared to the previous forecasts released in December 2008.

The New Zealand Treasury relies on a set of standard tools in estimating potential output. The methods include the Hodrick and Prescott filter (HP filter), the HP filter augmented with structural variables (MV filter), the unobservable components model (or Kalman filter) and the on-trend method. The methods have been described in detail by Downing et al (2003).

Apart from the on-trend method, all other methods are statistical tools that do not have much economic underpinning. Quah (1992) notes that focusing on the univariate time series properties of a variable means that it is not possible to identify what causes the fluctuations that occur in the variable. As a result, unless one imposes additional restrictions in an ad hoc manner, it is not possible to accurately assess the extent to which fluctuations in a variable are permanent or transitory.

The use of statistical filters may work well during a typical business cycle, where fluctuations are predominantly driven by demand shocks. However, in periods such as the GFC, the economy was hit by financial shocks, which could affect both the demand and supply sides of the economy. Reinhart and Rogoff (2009) also argue that recessions associated with a systemic banking crisis tend to be deep and protracted.

Therefore, the GFC has significantly increased the uncertainties surrounding the outlook for potential output and the estimates of potential growth rate are expected to be subject to large revisions. In this paper, we use a new technique for measuring and updating potential output, which incorporates a few key economic concepts such as Okun's law and the concept of equilibrium unemployment rate (NAIRU) within the framework of a small macroeconomic model. The model was first developed by IMF to understand past developments in the US economy (Carabenciov et al. 2009). The model was then extended further to cover a wide range of economies (Benes et al. 2010). In this paper, we modify the model slightly to better reflect some characteristics of the New Zealand economy.

The advantage of this approach is that it is designed to address the criticism of the atheoretical nature of statistical filters as it contains structural equations describing an economy. Like the unobservable components model, this new approach allows us to quantify the uncertainty of the estimates. The new approach will become part of a toolkit in the New Zealand Treasury for assessing potential output and the results of this new approach will complement insights from other approaches.

The paper is organised as follow. Section 2 presents the small macroeconomic model. Section 3 outlines the data and the initial parameters of the model. Section 4 assesses the model's empirical fit by comparing how well the model matches the second moments of the data. The results of the estimates and their confidence intervals are presented in Section 5. A sensitivity analysis is performed in Section 6, where we analyse whether the estimates of the output gap are robust to an alternative measure of core inflation, different periods of estimation, a different assumption for the steady-state growth rate and different assumptions on the priors used in the estimation. Finally, Section 7 concludes.