Tuesday, March 12, 2013

Imagine That!

Both potential output and the natural rate of unemployment are imaginary numbers. Estimates. But not like estimates of actual unemployment and actual output, which are based on actual conditions. As Arthur Okun wrote in 1962:

The quantification of potential output -- and the accompanying measure of the "gap" between actual and potential -- is at best an uncertain estimate...

According to an old FRBSF Economic Letter,

The natural rate is the unemployment rate that would be observed once short-run cyclical factors have played themselves out.

(Emphasis added.)

Of the NAIRU, Bill Mitchell says simply, "it is not observed."

The NAIRU. That's the number CBO uses to calculate the natural rate of unemployment:

For the natural rate of unemployment, CBO uses its estimate of the nonaccelerating inflation rate of unemployment (NAIRU).

We're dealing with hypothetical quantities here. The unobserved NAIRU is used to calculate the natural rate of unemployment. The natural rate of unemployment is used to calculate potential output.

Oh... and potential output? According to William Gavin, potential output is "a theoretical concept that means different things to different people."

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