A Century of Gaps: Where TFP Goes, Potential Follows

We investigate the role of financial factors in the estimation and dynamics of the U.S. output gap over more than a century. We propose a highly parsimonious semi-structural model which produces qualitatively similar dynamics and quantitatively comparable levels and gaps to the U.S. Congressional Budget Office output gap model (Shackleton (2018)). Allowing for time-varying effects of financial factors significantly improves real-time estimates of the output gap. Three major insights follow. Credit dynamics are the primary drivers of the observed financial crisis albeit with different conduits over the century: the stock market in 1929 and the housing market in 2008. Accounting for credit growth, U.S. potential output has been steadily growing at roughly 2% since the beginning of 1980. Long-run TFP levels and dynamics are closely linked to observed variation in potential growth.