Finance, Potential Output and the Business Cycle: Empirical Evidence from Selected Advanced and CESEE Economies

Traditional approaches to separate the underlying trend of potential output from cyclical developments mostly rely on the concept of nonaccelerating inflation output and are thus unable to detect upswings caused by the financial cycle, which often appear to be unsustainable in the long run. In this study, we therefore propose to extend the structural unobserved components model developed by Harvey (1989) and Harvey and Jaeger (1993) by including information on the financial cycle, i.e. private credit and house price developments, to explain the cyclical deviations from potential GDP. Thus, we are able to calculate “finance-neutral” potential output and corresponding “finance-augmented” output gaps, which take the effect of financial variables into account. We apply this novel concept to four advanced economies (AT, IE, NL, US) and four economies in Central, Eastern and Southeastern Europe (BG, EE, PL, SK) in a comparative manner. Our results show a considerable impact of the financial cycle on business cycle developments in most of the economies under review, both advanced and emerging. Remarkably, our finance-augmented output gaps exhibit a considerably higher explanatory power for the variation of observed unemployment rates in corresponding economies than standard approaches (such as the HP filter). In other words, our results considerably strengthen the case for considering the financial sector in business cycle measurement.