From Multiplicative to Additive Growth: Redefining TFP in the European Framework

In a recent paper, Thomas Philippon argues that total factor productivity (TFP) has historically followed an additive rather than an exponential growth path. Exponential TFP modelling is part of the fiscal and macroeconomic surveillance toolbox at the European level. The corresponding state-space model and its Bayesian estimation are part of the Commonly Agreed Method (CAM) for the estimation of potential output growth. Given the high relevance of the CAM for economic policy, we propose a model that introduces the idea of additive growth through a simple transformation of the data, while maintaining the structure of the state-space model and the estimation procedure. The adaptation of the current estimation methodology used by the European Commission and member states of the European Union (1) improves the forecast error in the long run and (2) obtains reliable estimates of the short-run gap. Using US data and data for the 6 largest European countries, we are able to reduce the RMSFE by 35 percent on average for various forecast horizons compared to the CAM.

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