Potential Output in Theory and Practice: A Revision and Update of Okun's Original Method

Abstract

This paper challenges the mainstream view of potential output, and enquires into the supposed effects of Great Recession on potential growth. We identify in the demand-led growth perspective a more promising theoretical framework both to define the notion and to gauge the long-term effects of a demand slow down. Based on the poor reliability of standard estimates of potential output, we also propose an alternative calculation. This is based on an update of Arthur M. Okun's original method for estimating potential output, which, differently from the estimation methods currently in use, does not rely on the notion of NAIRU, thus being immune to its theoretical and empirical shortcomings. Our calculation, based on a re-estimation of Okun's Law on US quarterly data, shows both how far an economy generally operates from its production possibilities, and how much potential growth is affected by the actual growth of demand over time. These wide margins for expansion of actual and potential output growth imply that a determined policy of demand expansion would create, given time, the very capacity that justifies it.

Potential Output, EU Fiscal Surveillance and the COVID-19 Shock

“…There are numerous technical papers that work towards achieving better real-time estimates, which are less prone to suffer from systematic pro-cyclical revisions (e.g. Coibion et al, 2018;Jarocinsky and Lenza, 2018;Fontanari et al, 2019).…”

The Updated Okun Method for Estimation of Potential Output with Broad Measures of Labor Underutilization: An Empirical Analysis

“…The urgency of the pandemic and the long history of poor performance of potential GDP estimates reinforces the conviction that it is time to rethink profoundly both the definition and the measurement of potential output, as we advocated in Fontanari et al (2020). A better assessment of the gulf that has opened between actual and potential output may prove especially important during the phase of recovery.…”

“…The latter ends up being defined in practice as any level of unemployment that happens to persist on average for a sufficient length of time, based on the theoretical idea, built into the estimation methods, that deviations of actual from equilibrium unemployment only occur on a temporary basis. As we have shown in Fontanari et al (2020), this confers a tautological quality to estimates of both the NAIRU and potential output, which in the medium-long period tend to reflect actual trends of unemployment and output. This explains why recessions sediment into estimates of potential output, drag them down, leading to hasty judgements that output gaps have closed, when in fact they have not.…”

Secular stagnation and core-periphery uneven development in post-crisis eurozone

“…There are several critiques to the above definition of potential GDP and to the way it is estimated. Palumbo (2015) and Fontanari et al (2019) criticize the fact that the concept of potential output is theoretically biased, as it incorporates the mainstream theory of inflation and unemployment, i.e. the NAIRU, 6 and its computation is based on filtered macro data fitted onto a mainstream production function.…”