Potentially miscalculating potential

Torrens knows that Mrs Hume will read his blog today, so Happy Valentines Day Mrs Hume. She’s watching the tele thinking that Torrens should be too, so no proof reading today!!

There was an interesting post on Paul Krugman’s blog a couple of days ago. It was related to the observation in the literature that potential GDP (the value output that the economy is capable of producing when the economy is running at full capacity) often falls permanently after a recession. TH reckons that this observation may be a of an illusions because of the way that statisticians measure real GDP.

Here’s why. Suppose that a country produces two things cars and restaurant meals. The combination of goods that can possibly be produced in the economy is shown by the production possibilities frontier in the diagram below. Just touching the PPF (the bowed out bit) is a line that line shows the terms of trade (the price at which you can trade restaurant meals for cars) before the recession (it is tangent with the PPF at A showing that the economy is at potential – there is no unemployment).

Now imagine that there was a recession 3 years ago that happened to be associated with a permanent terms of trade shock (manufacturing prices fall due to competition from somewhere or another). Now the terms of trade have changed the relative price of restaurant meals has risen as the price of cars fell. The economy has responded to the terms of trade shock and now produces less cars and more meals. The new equilibrium is shown at the point B.

OK, since the recession was 3 years ago and we’re now back at full employment, everything is hunky dory, right? And clearly there has been no change in potential, because the PPF has not shifted in by the recession, right?

Well, yes except for one thing. The statistician says that the economy hasn’t returned to potential.

“Hang on,” I hear you say, of course it has, its right here at point B.
“Ah, yes, says the statistician. … The trouble is I measure real GDP — holding prices CONSTANT at their base year levels. I use the original terms of trade.”
So he draws on a line going through B, but parallel to the original line that went through A, and proudly pronounces that potential GDP has clearly fallen!!! (see the terms of trade line measures the value of GDP and it lies inside the original terms of trade line – it says the economy is producing less).

So some of what appears to be a fall in GDP might only be an aberration. Of course potential can fall for real reasons (people lose their skills during periods of unemployment, for example). But nevertheless, if the recession is associated with a permanent terms of trade shock and TH’s guess is that they often are, then part of the reduction in potential may just be a statistical error.

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