Measuring potential GDP in the United States, and the case for emphasizing demand in monetary policy
Just how concerning is the tepid growth of gross domestic product, or GDP, since the Great Recession? The growth we have seen may seem less concerning in the short run because many estimates of potential GDP—the estimate of economic output when all resources are being fully utilized—have declined, making the gap between reality and the possible seem smaller. Yet it’s not entirely clear that actual GDP growth is all that close to potential GDP growth. Policymakers may have more room to stimulate the economy, and such a move today might have long-term payoffs as well.
That’s the upshot of a recent study that casts some doubts about the decline in estimates of potential GDP in recent years. Research by economists Olivier Coibion at the University of Texas at Austin and Yuriy Gorodnichenko and Mauricio Ulate at the University of California, Berkeley, looks at the construction of different measures of potential GDP and finds that the estimates often used are not necessarily good measures of the actual productive capacity of the economy. The reason, they say, is that the estimates are overly influenced by short-term demand-side fluctuations in GDP.
A good, unbiased estimate of potential GDP would only be affected by shocks to the supply side of the economy, such as a change in the supply of oil or a shift in tax policy, but not by temporary shocks to demand, such as changes to monetary policy or government spending. What the three authors find is that estimates of potential GDP are indeed influenced by demand shocks such as contractionary monetary policy, which they shouldn’t be. They propose using another measure to estimate potential GDP—one that tries to remove from potential-GDP calculations any temporary demand shocks. Their resulting measure of potential GDP shows that GDP as of 2016 was 10 percentage points below its potential.
This “output gap” calculated by the three economists, notes City University of New York economist J.W. Mason, doesn’t look that different from an analysis that simply extrapolates potential GDP today from the 2008 estimates of potential GDP. A U.S. economy that is 10 percentage points below its potential should be an immediate and pressing concern for short-term, demand-side policy. If these estimates are correct, then monetary and fiscal policy can do more to boost GDP growth right now.
At the same time, this potentially significant amount of slack in the economy may also have implications for the long-term potential of GDP. Several economists and writers, including J.W. Mason, Ryan Avent, and Karl Smith, argue that the short-run condition of the economy can influence long-run potential. Strong GDP growth in the short run can boost investment growth and productivity, while tight labor markets raise wages and spur companies to invest in productivity-enhancing efforts.
In other words, the case for quickly and assuredly closing the output gap today means that the U.S. economy and society may be a richer place in the future. That means policymakers need to seriously consider moving monetary and fiscal policy in a direction where the bias is toward erring on the side of encouraging too much demand rather than too little of it. Current policymakers seem to be erring in the opposite direction. The potential consequence of such a decision may not be just a poorer United States today but also fewer economic possibilities for our children and grandchildren.