Thursday, February 16, 2012

Potential Output & The Gap

I know that it gets much more complex, but economic history seems to be pretty clear to me:

Below "potential" output -> low inflation to deflation
Above "potential" output -> price-wage inflation spiral

Potential is in quotes because it really should be ideal or peak efficiency or something else (in some ways it shouldn't be possible to be above potential output). "Potential" output is pretty much "what we could make with full employment" though "full" employment in the US generally means ~4.5% unemployment, and maybe workforce participation is an even better gauge.

Anyway, there is an argument at exactly where that "potential" output should be, but the historic trend should give us a pretty clear indicator of whether we are above or below, and even by how much. Right now it would indicate that we are well below.

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