Wednesday, June 18, 2014

Potential GDP Estimates In The US And The Output Gap

Growth in productivity plays a major role in Robert Solow's neo-classical growth theory.  This article reviews a study at the San Francisco Fed which concludes that a positive shock to the economy occurred between 1995 and the early 2000's.  The application of information technology during the dotcom boom produced a bump in productivity.  That, in turn, led to a bump in potential GDP.  If the productivity bump was temporary, the bump in potential GDP was also temporary.  That has important implications for the future growth rate in the US, and also for economic policies.

Potential GDP is measure of an economy's ability to produce output.  Actual GDP is a measure of the output that is produced.  The difference between potential GDP and actual GDP is called the output gap.  If we use the potential GDP trend line, that includes a  bump in productivity from IT between 1995 and the early 2000's, our estimate of the output gap would be higher than otherwise.  Therefore, more should be done to reduce the output gap.  On the other hand, if the increase in productivity was temporary, as the San Francisco Fed paper concludes, the output gap is much lower and we need to do less to lower the gap between potential GDP and actual GDP.  Moreover, we should expect that economy will grow more slowly in the future than it is commonly assumed.  The US economy will grow at 2% rather than 3%.  In a sense, this provides an explanation for secular stagnation that has been advanced by Larry Summers and other economists.  Of course, something unexpected could happen that would provide another bump to productivity and potential GDP.  There is no consensus, however, within economics about new technologies and their potential to increase productivity growth.

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