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Financial Cycles and the Real Economy

Financial Cycles and the Real Economy

Lessons for CESEE Countries

Edited by Ewald Nowotny, Doris Ritzberger-Grünwald and Peter Backé

What is the link between the financial cycle - financial booms, followed by busts - and the real economy? What is the direction of this link and how salient is this connection? This unique book examines these fundamental questions and offers a paramount contribution to the debate surrounding the recent financial and economic crisis.

Chapter 14: Finance, potential output and the business cycle

Dominik Bernhofer, Octavio Fernández-Amador, Martin Gächter and Friedrich Sindermann

Subjects: economics and finance, financial economics and regulation, money and banking


The global financial crisis that started in 2007 challenged the conventional view on potential output and emphasized the important role of finance for understanding cyclical fluctuations. The concept of potential output typically refers to the maximum level of economic activity that can be sustained over the long term. It cannot be observed directly but has to be estimated by using a variety of approaches, from statistical filters to structural models. The estimates are crucial to the modern consensus on rule-based economic policy-making. Indeed, the difference between actual and potential output – the output gap – informs policy-makers about the current state of the business cycle, allowing them to intervene in a stabilizing manner. However, potential output estimates perform badly in real time. It is well documented that the major approaches overestimated potential output growth in the euro area prior to the crisis (ECB, 2011; Marcellino and Musso, 2011). As has been noted by Borio et al. (2013), a common thread tying together the various concepts of potential output is the idea of sustainability. This means that a certain level of output is possible without generating unwelcome side-effects which, sooner or later, will lead to some form of correction. The most common undesirable side-effect of economic booms or unsustainable output in mainstream economics is inflation. Therefore, the conventional structural approaches to estimate potential output all assume some form of Phillips curve, making sustainable output equal to non-accelerating inflation output.

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