Potential insights

In a post titled Potential Misunderstandings, Paul Krugman makes a really good point about potential GDP… many people do not understand what it is. He is absolutely right to say that it is a supply-side concept. Yet, in order to know where your potential output is, one must consider demand potential. I use effective demand to determine that.

Menzie Chinn over at econbrowser.com had a post about potential output last week… and I made a comment under his post.

“I find it so interesting how potential GDP is determined upon supply potential without considering a demand potential. Because there looks to not be enough demand to reach potential output.
The theory says, more output means more income, which means “corresponding” demand. Yet, supply won’t surpass effective demand as Keynes said and even fall short of what is considered full-employment. Unless of course you follow Say’s law.

“Here is an excerpt from Chapter 3 of General Theory by Keynes…
“Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.”

So yes, Paul Krugman is right about potential GDP being a supply-side concept, but Keynes says that if you allow supply to create its own demand, you may be a fool. Did he say that? Not in those exact words, because he was a gentleman. Yet, if one does not have a proper measure of effective demand, your determination of potential output for full employment may be folly.

My research into effective demand makes me determine a lower potential GDP than Mr. Krugman. I see potential GDP as the center of a cycle between capacity utilization and labor share. The top limit of that cycle is determined by effective demand. Thus, my view corresponds to Keynes’ words about demand. I use the following graph of past data for my determination of potential GDP.

pot rgdp 2

Blue line is real GDP minus the official CBO potential GDP. When the blue line is above 0, there is an “inflationary” gap, below 0, there is a “recessionary” gap. The red line is the percentage difference between capacity utilization and effective labor times a business cycle amplitude constant (2005 $$ in this graph). You can see that the lines tracked very well from 1967 to 1991. Then they got off track, but came back together 5 years before the crisis. Now the CBO is projecting a large “recessionary” gap, whereas the relationship between capacity utilization and effective labor share (red line) shows an “inflationary” gap.

There is an obstacle to full employment. It’s called the top of the business cycle. Effective demand says we are closer to the top than economists like Mr. Krugman say.