Output Gaps and Potential Incomes

David Beckworth commented on my post about the Taylor rule, and suggested that I look at Laubach and Williams estimates of potential output. Here is the link to their data.

Laubach and Williams have two measures of the output gap, a one-way and a two-way. The following rather busy graph shows real GDP, the trend of real GDP, and the CBO, LW1, and LW2 measures of potential output.

In the second quarter of 2009, real GDP was 9.1 percent below its 3 percent trend growth path The output gap according to the CBO is -5.3 percent. And both of Laubach and Williams' measures show a -2.3 percent gap.

According to the CBO, the productive capacity of the economy is currently about 3.8% below trend. Laubach and Williams estimate that the productive capacity of the economy is about 6.8 percent below trend.

Perhaps more interestingly, the CBO's estimates shows potential output growing less than the trend growth rate of real GDP. Potential output never falls, it just grows more rapidly or more slowly. Laubach and Williams' estimates, on the other hand, show absolute drops in the productive capacity of the economy.

According to LW 1, productive capacity peaked in the second quarter of 2008 and had fallen 2.3 percent by the second quarter 2009. According to LW 2, productive capacity peaked in the third quarter of 2008 and hit a low in the first quarter of 2009, having fallen about .8 percent, and in the second quarter of 2009 had risen a bit, but remains just shy of 1/2 of one percent below its peak.

What are the implications of these different measures of the output gap for the Taylor rule? More importantly, what are the implications for inflation if the Fed had been able to keep nominal expenditure growing at a 5 percent or 3 percent rate?

More later...