Demand-determined potential output: a revision and update of Okun’s original method

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Everyone is waking up to the fact that estimates of what is possible in the economy are way off: this paper explains why

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.