Estimation And Evaluation Of China’s Potential Output

After the economic crisis of Europe and the United States, the process of theworld economy recovery was slow, and the unemployment rate of major economies inEurope and America remained high. China at present is also facing the downwardpressure on economic. Thus, it has increasingly become the topic of public concernwhether China’s economy can keep the high-speed growth as it has done in the past30years for some time to come. Estimates of potential output and analysis are veryimportant for a country to develop medium and long-term economic policy and tosuppress short-term economic fluctuations. Therefore, a number of institutions,including Congressional Budget Office, Organization for Economic Co-operation andDevelopment, international Monetary Fund, Federal Reserve System and World Bank,are carrying out research on potential output, and do their policy-making based on theresearch.Potential output and output gap are important concepts in macroeconomics, whichare closely related to what policy makers concern: the economic growth, the price level,the unemployment rate and short-term fluctuations. Therefore they have importanttheoretical and practical significance. Potential output was first proposed by theAmerican economist Okun. Based on the natural rate hypothesis, he originated thedefinition of potential output:"the most likely output when an economy makes full useof all the resources." Also, it is the first time to use the linear trend for regression toestimate potential output and output gap. Output gap is extended from the concept ofpotential output, which is expressed as balance between potential output and the actualoutput and indicated as a proportion of the balance in the actual output. It reflects thedifference between the aggregate demand and the aggregate supply.?Estimating potential output can accurately analyze and judge the influentialfactors and developing trends of the long-term economic growth of a country andregion, which can let the policy maker clearly know the maximum potential of theeconomic growth in order to provide the basis for government to formulate long-term economic development goals. The output gap is close relatived of the short-termeconomic fluctuations, and is closely relatived to inflation and unemployment rate. Ifthe output gap figure is negative, that is, actual output is below potential output and theentity economic operates below the potential level, it is evident that the economy haslow efficiency or elements are idle in the development process. When it’s transferred tothe labor market, involuntary unemployment shows up, namely the actualunemployment rate is higher than the natural rate of unemployment. To make mattersworse, the high unemployment rate can easily lead to a series of social problems,which is the most intolerable situation to the people and government; When the outputgap figure is positive, that is, the actual output is above potential output and the entityeconomic operates above the potential level, it means the factors have been overlyused in the development process, which will lead to prices rise of factors and otherproducts, but the short-term demand shocks will not increase the actual long-termoutput, just bring inflation consequences. Therefore, calculating the output gap canmake policy makers know the reasonable level to economic operation, and distinguishthe situation of economic fluctuations, providing the basis for the short-termmacroeconomic regulation and control of government.To avoid severe inflation and high unemployment rate, the government hopes touse various macro-control policies to ensure that economy runs smoothly nearbypotential output or slightly below. Thus, potential economic growth is an importantparameter to judge if an economy runs healthily. However, potential output and outputgap cannot be observed directly by the statistical office. Hence, the quantitativeestimation of potential output and output gap, which reflects both the direction ofeconomic macro-control and real economic operation level, has become an importantissue that many scholars and institutions would take huge efforts to study.The main part of the article can be divided into five chapters, starting with theconcept of potential output analysis, and using three kinds of mature method ofcalculation of potential output and the output gap. Then, combining the explanatorypower of inflation with the changes in the economic cycle, the article will establish thesystem of evaluation of the potential output to make appropriate policy conclusions.Chapter one is theoretical review of potential output, which is the basis of thisstudy. In this chapter, we classify and review the existing literature to sort out theresearch results and research progress of the potential output, and conduct a comprehensive comments including the definition of the basic connotation of potentialoutput and the output gap, the classification of estimation methods for potential outputand analysis of their strengths and weaknesses, and potential output research status athome and abroad. It will be apparent that how this article estimates the potential outputand the output gap from which several perspectives and applying which severalmethods.In chapter two, different production function methods are used to estimate thepotential output and the output gap based on the aggregate supply theory. Productionfunction method has been widely used by many foreign authorities including theInternational Monetary Fund (IMF), the Federal Reserve (Fed). This method isestablished theoretically on economic growth. From the supply point of view, it hastaken full account of the contribution of factor inputs for economic growth and it alsohas a clear economic theoretical basis and contains main factors to explain thepotential economic growth. China’s labor force and capital stock are modified andre-estimated. As to the selection of four key variables of the capital stock, detailedstudies and discusses have been done in this chapter. There exist different opinions onthe value of capital depreciation rate in China. In order to have a full study,6%and10.96%, which are more recognized, are selected as the final rate of depreciation. It isfound that working capital substitution elasticity of substitution (1996-2011) is variableand shows an overall downward trend. To solve the above problems, this chapterselects the transcendental production function to estimate China’s potential output forthe first time. The final evaluation results also verify the correctness of the modelselection, and the result of using the transcendental production function to calculatepotential output is the best among all the results in various evaluation criteria. Thedecline in the substitution elasticity of labor to capital means that the factor ofproduction of labor become increasingly scarce in economic activities, and anothermajor factor of production capital becomes relatively abundant. The result matches theempirical results and rising labor costs in China’s basic national conditions, whichmeans that China will be no longer rely on the original production to achieve rapideconomic growth in future. The Cobb-Douglas production function and thetranscendental production function are used to estimate the potential output and theoutput gap respectively using two sets of capital stock (different rate).Chapter three is based on the aggregate demand and aggregate supply equilibrium theory and is referred in the setting mode of long-term fluctuations of demanddisturbances to output level by Blanchard and Quah(1989). Assuming that if thedemand disturbances will only cause hort-term economic fluctuations do not causelong-term fluctuations to the trend of output. The trend of the economics’ long-termbalance comes from permanent disturbances(supply disturbances).The final empiricalresults show that demand disturbances on output level is really just temporary, whilethe impact of supply disturbances on output level is continued, which verify the SVARmodel assumptions about supply shocks and demand shocks is reasonable. Based onBernanke’s financial accelerator principle, the financial system contributessignificantly to the volatility of the economy. For this reason, the policy authoritiesshould take various effective measures to ensure the minimum of output volatility asfar as possible, and should not abuse demand management tools in order to pursueshort-term faster economic growth. Focus on short-term policy stability, otherwise itmay cause huge fluctuations in the level of output and appear the "ups and downs" onthe overall macroeconomic. Compared to short-term fluctuations in output, thegovernment should implement a long-term policy aimed at improving the outputsupply. The impact of these long-standing policy may not be as quick as the short-termdemand management policy tools do, but it is very critical for the economic growth ofoutput level in the long-term. Based on the long-term assumption constraints, thischapter estimates China’s potential output and the output gap using structural vectorauto-regression method, in accordance with the relationship of economic variableswhich the Phillips curve and Okun’s law curve response, taking the impact of supplydisturbances and demand disturbances into account at the same time.The international economy factors are considered in chapter four, especially themajor factors which influence output fluctuations (including internal factor andexternal factor). Domestic potential output and output gap will be evaluated in an openeconomy condition. In this chapter, we adopt the State Space Model, and use apowerful iterative algorithm-Kalman filter–to do the estimation. The key is thesetting of both measurement equation and state equation, because different settings canbring different results to the estimation. The setting of the State Space Model forpotential output is based on Expectations-Augmented Phillips Curves and the mainfactors that influence the output fluctuation in an open economy condition, in whichthe proportion of output gap represents the fluctuation of economic cycle. This fluctuation is mainly caused by internal and external impact. The former impart refersto the impact of interest rate gap, while the latter focus on net exports and overseas netinvestment. At the same time, the proportion of output gap can be also influenced byinflation and the record of last term. The final empirical results prove that both internaland external impacts that influence domestic economic cycle do exist, which indicatesthat the reason why our economy experiences a period of fluctuation is not only thoseinternal factors including inflation, interest rate gap, but also external factors includingnet exports gap and overseas net investment. And these are doubtlessly of vitalimportance for policy authority.Chapter five makes comprehensive comparison and evaluation on potential outputcalculation methods discussed in the second, third and fourth chapters. The fourevaluation criteria include: whether the proportion of the output gap is able to explainthe changes in the inflation rate; whether the proportion of the output gap is wellillustrated in the law of changes in China’s economic cycle; soundness test modelresults in different sample intervals; the ability of potential output growth rate of actualproduction to forecast the rate of growth of short-term. The final results of theevaluation show that calculating potential output resulting in the framework of theproduction function is the most credible. Using the SVAR model to calculate thegrowth rate of potential output and the effects of potential output is superior to theresults of the state space model to calculate potential output. It is not obvious that thereare some differences in the explanation of the inflation and the robustness test ofmodel results between Cobb-Douglas production function and the transcendentalproduction function. While in comparison with Cobb-Douglas production function,trans-production function has one more turning points that equal the benchmark yearof economic cycle valley value. Relatively, trans-production function for calculatingpotential output is slightly better than Cobb-Douglas production function. As toshort-term forecasting effect on real output growth rate, trans-production function inthe depreciation rate of10.96%results two test conclusions which are inconsistentwith the two models, but it is significant that the forecast effect of potential outputgrowth rate to the short-term of real output growth rate is under the depreciation rate of6%To sum up, under the selection of the sample interval, using trans-productionfunction (in the capital depreciation rate of6%) to calculate the potential output issuperior to other methods. Finally, according to these empirical results, we give the corresponding policy recommendations.The conclusion part is to summarize the full text and offer policy suggestions basedon the whole.