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

53 Pages Posted: 15 Jul 2019

See all articles by Claudia Fontanari

Claudia Fontanari

Roma Tre University

Antonella Palumbo

Universita di Roma Tre, Italy

Chiara Salvatori

University of Rome III

Date Written: March 31, 2019

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.

Keywords: potential output; Okun’s law; unemployment; demand-led growth

JEL Classification: E60; E23; E24; O40; E11; E12; C22

Suggested Citation

Fontanari, Claudia and Palumbo, Antonella and Salvatori, Chiara, Potential Output in Theory and Practice: A Revision and Update of Okun’s Original Method (March 31, 2019). Institute for New Economic Thinking Working Paper Series No. 93, Available at SSRN: https://ssrn.com/abstract=3419280 or http://dx.doi.org/10.2139/ssrn.3419280

Claudia Fontanari

Roma Tre University ( email )

Via Ostiense, 159
Rome, RM 00145
Italy

Antonella Palumbo (Contact Author)

Universita di Roma Tre, Italy

via Ostiense, 139
Rome, 00154
Italy

Chiara Salvatori

University of Rome III ( email )

Via Ostiense, 159
Rome, RM 00145
Italy

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