Ireland: Background Papers

This paper considers elements of macroeconomic policy central to Ireland’s objective of being among the first countries to enter into European Economic and Monetary Union. The paper analyzes the main determinants of the Irish pound/sterling exchange rate, an issue brought to the fore by the currency turbulence of March 1995, which saw a sterling-inspired decline in the Irish pound against the deutsche mark. It also considers fiscal developments and prospects, highlighting tax reform measures undertaken to accelerate job creation, the growth of spending in recent years, and the medium-term fiscal outlook.

Abstract

This paper considers elements of macroeconomic policy central to Ireland’s objective of being among the first countries to enter into European Economic and Monetary Union. The paper analyzes the main determinants of the Irish pound/sterling exchange rate, an issue brought to the fore by the currency turbulence of March 1995, which saw a sterling-inspired decline in the Irish pound against the deutsche mark. It also considers fiscal developments and prospects, highlighting tax reform measures undertaken to accelerate job creation, the growth of spending in recent years, and the medium-term fiscal outlook.

IV. Estimates of Output Gap for Ireland 1/

1. Introduction

This chapter presents estimates of the output gap for Ireland during 1990–95. The main objective is to assess the current cyclical position of the economy, which constitutes important background information for evaluating the current stance of monetary and fiscal policies.

Two widely used approaches to computing output gaps are considered here—the HP filter and the segmented trend method. Given the lack of consensus about the superiority of any method, a comparison between these two approaches is important in that it provides a consistency check on the reliability of the respective estimates. 2/

In light of the potential distortions of Irish GDP figures due to transfer pricing, 3/ this chapter uses GNP as a measure of aggregate economic activity. In addition to GNP, however, an indicator of output in the non-tradable sector is also considered; 4/ the objective is to look more closely at incipient inflationary pressures arising from labor-intensive sectors of the Irish economy that are not subject to international price setting. 5/

The remainder of this chapter is divided into three sections. Section 2 briefly reviews the main features of the segmented trend method and presents the respective output gap estimates for real GNP and non-tradable output. Section 3 considers the HP filter approach and spells out its results. Section 4 summarizes the main findings.

2. Segmented trend estimates

The segmented trend approach constitutes an improvement on the traditional method of calculating potential output by fitting a linear or exponential trend to the data. As is well-known, the main shortcoming of fitting an unbroken trend to time-series data is the neglect of shocks which can shift the rate of growth of output or employment on a permanent basis (hysteresis effects). The segmented trend allows for this possibility by breaking the trend rate of growth at benchmark dates at which permanent shocks are supposed to have occurred. Such dates are chosen by the analyst on the basis of a priori information or through visual inspection of the data.

In practice, the segmented trend approach amounts to running a simple OLS regression of the level of the variable on a constant and a time trend with dummy variables to account for trend shifts around the pre-specified break points. Estimates yielded by this method are reported in Table 3 and Chart 6. 1/ In the case of the GNP indicator, the results indicate that aggregate output has moved from below potential in 1994, to being 0.9 percent above potential in 1995. Although such a positive gap could point to underlying inflationary pressures, Table 3 also shows that the magnitude of the current output gap is relatively small compared with that for the period 1990–91. 2/

Table 3.

Ireland: Segmented Trend Estimates of Output Gap 1/

(In percent)

article image
Source: Staff estimates.

Positive numbers indicate that output is above trend while negative numbers mean that output is below potential. Estimation sample period: 1979–97, annual data.

Staff projections.

As a percentage of potential output.

CHART 6
CHART 6

IRELAND OUTPUT GAP

(Segmented trend method, in billions of Irish pounds)

Citation: IMF Staff Country Reports 1995, 076; 10.5089/9781451818673.002.A004

Sources: Central Statistics Office; and staff calculations.

In contrast, the non-tradable output gap estimate points to larger variations. During the economic slowdown of 1991–93, non-tradable output appears to have been over 4 percentage points below potential. This situation, however, was sharply reversed during the 1994–95 recovery. At the projected production levels for 1995, non-tradable output is estimated at 1.5 percent above potential, higher than for the rest of the economy. 3/

3. HP filter estimates

The HP filter approach is motivated by two main limitations of the segmented trend approach. On the one hand, the segmented trend method assumes that breaks in the growth rate of potential output are infrequent and abrupt. On the other hand, it requires the analyst to choose—based on the data or other source of a priori knowledge—when such breaks take place. This may introduce subjective considerations in the analysis and thus undermine the objectivity of the output gap estimates.

The HP filter overcomes both problems by providing an algorithm which endogenously determine the growth path of potential output. 1/ As a consequence, the trend growth of output tends to be smoother and, in general, tracks actual output more closely than according to the segmented trend approach.

HP estimates of the output gap are provided in Table 4 and in Chart 7. The results are similar to those yielded by the segmented trend method. Estimates based on GNP show that the economy was well above potential in 1990 and 1991 but also that this gap has declined since. In 1995, the economy appears to be just over one percentage point above potential. This is more than half of the size of the output gap in 1990–91. Thus, these estimates suggest that inflationary pressures may be present at the current stage of the cycle, but to a much lesser extent than in the previous upswing.

Table 4.

Ireland: HP Filter Estimates of Output Gap 1/

(In percent)

article image
Source: Staff estimates.

Positive numbers indicate that output is above trend while negative numbers mean that output is below potential. Estimation sample period: 1979–97, annual data.

Staff projections.

As a percentage of potential output.

CHART 7
CHART 7

IRELAND OUTPUT GAP

(HPFilter method, in billions of Irish pounds)

Citation: IMF Staff Country Reports 1995, 076; 10.5089/9781451818673.002.A004

Sources: Central Statistics Office; and staff calculations.

As with the segmented trend method, HP filter estimates for non-tradable output point to more pronounced variations. The highly negative gap during 1991–93 has been entirely eroded during the current upswing; by 1995, output for these sectors is computed at 2.3 percent above trend. These figures therefore suggest that inflationary pressures in the non-tradable sector are considerably higher than for the aggregate economy at this stage of the cycle.

Over the medium-term, the staff’s projection of 4.5 percent real GNP growth implies that the economy should gradually return to potential. According to the HP filter method, the closing of the gap would take place in 1998. The segmented trend approach indicates that the closing of the gap would occur in early 1996. Both methods indicate that non-tradable output will remain slightly above potential for a longer period, a result compatible with the assumption of a relative expansion of the service sector in Ireland over the medium term.

4. Summary and conclusions

This chapter has presented estimates of the output gap in Ireland during 1990–95, using two distinct methods—the segmented trend and the HP filter approaches. Both indicate that real GNP is around 1 percentage point above its potential in 1995. Although this posits the existence of some inflationary pressure in the economy, a comparison with estimates for 1990–91 suggests that the current size of the GNP gap is relatively small.

In a small open economy such as Ireland, where domestic prices of tradable goods are determined abroad, domestic inflationary pressures are more prone to arise in the labor-intensive, non-tradable sector. As an attempt to gain some insight into this issue, this chapter also provided output gap estimates based on an index of non-tradable output. The results point to a similar cyclical pattern as that for GNP, but with larger variations. Estimates of the output gap for the non-tradable sector indicate that output is currently in the range of 1.5 to 2.5 percent above potential-i.e. about twice as high as for the aggregate economy.

1/

Prepared by Luis Catão.

2/

Ideally, it would also be useful to have estimates based on the production function; since the latter incorporates information on the growth of the capital stock and the labor force, it normally provides a further consistency check on the other two methods. In the case of Ireland, however, the lack of a comprehensive series on capital stock and the difficulties in projecting the growth of the labor force (due to the volatility of immigration and sharp changes in participation rates) prevent a meaningful use of the production function approach for the present purposes.

3/

See Chapter 5.

4/

Defined as GDP minus agriculture minus manufacturing output.

5/

There are two other reasons for considering this alternative indicator. First, increases in productive capacity in those services tend to respond to demand pressures in a much slower fashion than in other sectors. Second, service data are much less subject to possible distortions related to transfer pricing.

1/

The OLS regression is run from 1979, with a trend break in 1987. The choice of 1979 and 1987 as turning points is clear in the Irish case. The first marks the end of monetary union with the United Kingdom, Ireland’s ERM membership and the second oil shock. The period starting in 1987 is characterized by debt consolidation, greater macroeconomic discipline and rapid economic growth.

2/

Consumer price inflation during those years was slightly above 3 per-cent.

3/

The growth of the non-tradable index for 1995 was projected according to the elasticity of non-tradable output to GNP during 1979–94. Non-tradable output for 1995–97 was then extrapolated using the staff projections of real GNP for those years.

1/

The HP filter is based on the minimization of the following loss-function associated with deviations of log of a variable (y) from its trend (y*):

1TΣt=1T(ytyt*)2+λTΣt=2T1[(yt+1*yt*)(yt*yt1*)]2

where the parameter λ determines the degree of smoothness of the filter and is usually set to 1,600.

Ireland: Background Papers
Author: International Monetary Fund
  • View in gallery

    IRELAND OUTPUT GAP

    (Segmented trend method, in billions of Irish pounds)

  • View in gallery

    IRELAND OUTPUT GAP

    (HPFilter method, in billions of Irish pounds)