Measuring potential output and output gap for Malta

Abstract

Despite being widely used in the policy arena, the concept of potential output remains to this day a rather elusive concept that is not easily measured. Literature proposes a number of methods for the estimation of this unobservable variable that can be classified in two broad categories, the statistical approaches based on a decomposition of time series into a trend and a cycle component by means of a filter, and the structural methods that use theoretical relations to provide a potential output figure. In light of the lack of consensus on the best method to be used, this study seeks to estimate potential output for Malta using two methods which lie on opposite sides of the spectrum of methods used in literature; an HP filter approach and a production function approach. These methods were applied on a long sample period ranging from 1970 to 2014 allowing the identification of a number of structural reforms that have transformed Malta’s economy. Also, this study seeks to provide a potential output figure that is consistent with national accounts figures updated with the latest ESA 2010 methodology. Results indicate a slowdown in potential output growth for Malta in the last 44 years, with falls in TFP and capital stock contributions outweighing increases in the contributions of potential labour supply. Although a slowdown in potential output growth is expected when a country reaches its maturity, this analysis uncovers some trends that might necessitate policy intervention especially when one factors in future developments in working age population. Indeed, it is important to keep investing in an educated workforce and attract new entrants in the labour supply as well as incentivise those who choose to stay longer in employment. Attracting new foreign direct investment as well as improving access to financing for SMEs that seek to invest in research and development would help improve capital and TFP contributions to potential output growth.