Full text of U.S. Productive Capacity: Estimating the Utilization Gap : Proceedings of a Conference Cosponsored by Center for the Study of American Business and Federal Reserve Bank of St. Louis, October 7, 1977

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Foreword
This
This volume contains the papers presented at the October 7,
1977
Productive Capacity: Estimating the
1977 conference on "U.
“U. S. Productive
Utilization Gap,"
Utilization
Gap,” held in St. Louis, Missouri. The conference,
cosponsored by the Center for the Study of American Business
the Federal Reserve Bank of St. Louis, examined the current
and the
current
and projected estimates of U.S. productive capacity and utilization.
Appropriate measures of
of the gap between productive
productive capacity
utilized and full productive capacity are important to the
development of appropriate
appropriate economic policy.

The three basic papers were presented by George Perry of the
Brookings Institution, Peter Clark of the staff of the Council of
Economic Advisers, and by Robert Rasche and Jack Tatom of
Reserve Bank of St.
Michigan State University and the Federal Reserve
Louis.
An economic policy address was given by William
William Nordhaus, aa
member of the Council of Economic Advisers. A paper by James
Ragan of Kansas State University on projections of capacity
utilization is also included in the Supplemental
Supplemental Papers section of
this volume. Discussion papers were presented by Pham Chi
Chi Thanh
of American University, Laurence Meyer of Washington University,
and Frank deLeeuw
deleeuw of
of the Congressional Budget Office.

•
I

POTENTIAL OUTPUT:

RECENT ISSUES AND PRESENT TRENDS
George L. Perry
would be associated
associated
Potential output measures the real GNP that would
with operating the economy at some specified level of labor utilization.
The concept offers answers to two basic types of questions:

be the level of GNP if unemployment was at a specified level?

what would
(Or what

would unemployment be if GNP were at some specified level?) And what
will unemployment be at some point in the future if GNP grows at some
specified rate?

(Or what will GNP be if some specified unemployment

target is achieved at some point in the future?)

In the process of

developing the concept of potential and providing
providing the needed estimates
for answering these questions, we have gained aa number of insights into

the cyclical characteristics of the economy.

Okun's law, which summaOkun’s
summa-

rizes many of these characteristics in linking marginal output to marmarginal changes in unemployment rates, is probably the most robust macromacroeconomic relationship yet developed.
Despite the general success of the original potential concept and
related relationships such as Okun’s
Okun's law, several developments of the
l97Os have cast doubt on traditional methods of measuring the nation’s
197Os
nation's

Dr. Perry is Senior Fellow at the Brookings Institution. The author is
grateful to Jesse Abraham for his research assistance and to Evelyn
Taylor for her typing. The views expressed in this paper are the
author’s and not necessarily those of the officers or trustees of the
author's
Brookings Institution,
Institution.

•

economic potential. First, the changing composition of the labor force,
and more dramatically, of the unemployed impinge on potential output

measures in two distinct ways: Labor input measured in efficiency
units has been diverging from labor measured by a head count; and aa
tradiona11y used as a benchmark for
for measurmeasurconstant unemployment rate, tradionally
coning potnetial output, has moved noticeably away from measuring a con-

stant degree of labor utilization measured in efficiency units. In the
unemploypast, I have addressed both these issues of labor force and unemployment composition, and they are both incorporated in recent official

analyses of potential by the Council of Economic Advisers. Second, the
slowdown in the growth of the capital stock -- which has been particpartic--

ularly marked since 1973
1973 once an allowance is made for investment that
is going to meet environmental requirements -- has raised anew the
--

question of whether explicit attention to the size and growth rate of
in estimating potential output. The most recent
capital is needed In
official CEA estimates are based on analysis by Peter Clark~that
Clarklf that

takes account of variations such as these in capital stock growth. And
the recent slowdown in the growth of the capital stock, measured after
deducting an estimate of investments going to pollution abatement, is
an important source of the slowdown in potential output growth estiesti-

mated by CEA. Third, the dramatic rise in energy prices has caused
some analysts to make estimates of potential that are seriously afaffected by this
this energy price explosion.

The most notable examples of

this
Rasche and John Tatom that
this new wrinkle are the papers by Robert Rasche
have been published in theFederal
the Federal Reserve Bank of St. Louis Review.~
Review ..?!

Finally, my colleague, Edward Denison has called my attention to the

importance for potential output measures of changes in the environment
businesses operate -- including the rise in crime, pollution
in which businesses
——

abatement regulations, and regulations covering safety and health
practices.

His research in this area is still underway.

In this paper, II will report on some work that deals explicitly
with the first of these departures from tradition and that indirectly
supports the last of these as well -- that is, the demographic issues
—-

and the Denison issues.

But before getting into this analysis, I want
But

to turn to why I am ignoring explicit attention to the capital stock,
although ideally II would like to integrate it into the analysis.

And

why I am ignoring the impact of energy prices, and think that giving
that development aa prominent role in modifying potential output meameasurements is mistaken.
The Case Against Using Capital
It is hard to argue that capital should not be included in

estimating potential output because everyone knows it belongs in the
calculation.

l96Os, the same CEA that introduced
Back in the 1960s,
introduced potential

introduced
output into the mainstream of policymaking and debate also introduced
the investment credit in order to stimulate capital formation.
capital is ignored, it is for a simple pragmatic reason:

one cannot

fpr capital in a
find an important or statistically significant role 15cr
freely estimated aggregate production
production function or any equivalent
relation that one might use in estimating potential output.

Although

this negative result is well known, II thought II would
would try again using

the newly—developed
newly-developed data on the capital stock from the Bureau of
Economic
Economic Analysis.

I tried, in turn, several versions of the capital

stock including the total stock, equipment separately, the stock with
estimated expenditures for pollution abatement subtracted, and the
nonfarm business
stock for manufacturing alone and for the total nonfann
sector. None of these worked.

This left me with a choice of research strategies. Constrain
the capital stock to play some specified role in determining potential
exoutput. Or see how well the trend in labor productivity can be ex-

plained by taking account of cyclical factors and changes in labor
force composition. Several considerations led me to opt for the latter
approach.

reAny capital stock series must rest on assumptions about re-

tirements of physical capital from the stock. We probably do not know
enough about these retirements and about whether they proceed smoothly
or whether they, in turn, depend on current rates of investment. The
degree to which the capital stock is utilized at any point in time is
not only hard to measure but is a very uncertain concept at bottom.
proNobody can ever explain how we had enough of a capital stock to pro-

duce the output we did during World War II.

generally, since it
More generally,

is the flow of productive services from
from the capital stock that we prepresumably want to measure, we have to deal with the fact that the flow
of services from aa given stock can be expanded simply by expanding the
double-shift operations
operations
hours over which we utilize it. Thus moving to double—shift

doubles the effective capital stock without any new investment taking
place. AA department store that starts staying open from 66 to 9 in the

evening adds a third to the effective capital stock of that operation.
ooeration.
This consideration is particularly troublesome when we try to measure
potential output since we are then interested in the effect of the

capital stock at some relatively high rate of production -- precisely
--

the situation in which a more intense utilization of the existing stock
might be expected. When the economy reached aa 4 percent unemployment
rate during 1966, the level then defining its potential, available
measures of capacity utilization in manufacturing reached levels subsubstantially higher than we have observed since then, despite achieving

even lower unemployment rates.

meanIf these utilization figures are mean-

from the capital
ingful, they indicate that the available services from
stock are quite expandable and are not closely linked to the level of
the unemployment rate.
Finally, even if we were ingenious enough to integrate these comcomcapital and Its
its relation to potential
plexities into our concept of
of.capital

output, we would still have to deal with the fact that the capital
today's, but the stock that will exist
stock that interests us is not today’s,
systemat the time potential is achieved. The measured capital stock system-

atically grows faster as the economy expands toward potential and more
when actual output recedes from potential.
slowly during recessions when
To decide what potential output will be in 1981, we would have to forefore-

cast the levels of investment that would take place each year in a move
analysis. After recession,
to potential and integrate these into the analysii.
when the economy is well below
beiow its potential, the capital stock always

looks low relative to aa trend line estimate of potential output.
5

Of course, against these complications that arise from trying to
utilize the capital stock in potential calculations, we have to weigh
the possible improvement we could get if we correctly measured the
relevant stock and its effect on labor productivity at potential.
Clark has made a careful attempt at doing this and we may have to
wait until
until potential is approached to know which research strategy
gives more accurate answers.
~seAainst
acts
The Case Against Hih
High Estimates of Ener
Energy Price Im
Impacts
The sharp increases in energy prices of recent years led to

assumplarge reductions in potential output under certain restrictive assumptions about how energy and output are related.

The simplest of these

assumptions, and the one utilized by Rasche and Tatom, is that output

in the business sector is governed by a Cobb-Douglas production funcfunction with capital (K), energy (E), and labor (L) as inputs and a disdisembodied productivity trend growing at the rate
rater:
r:
(1)

Aert La Kb Ec,

a+b+c

In this assumed production relationship, the output elasticity of
energy is one and its price elasticity is minus one,
one.

That is, doubling

output will double energy demand while doubling the relative price of

energy will cut the amount demanded in half.
plausible.
propositions seerrsentirely
see~sentirelyplausible.

The first of these
these

The second very unlikely.

it lies behind the proposition
proposi on that the rise in energy prices has

substantially
substantially reduced potential output.

Yet

Measured by the wholesale price of energy to users, the relative
price of energy rose 57 percent between 1973 and 1976.

If we believe

in the country,
the elasticity of -1.0, and apply it to all energy used In

our energy use should be only 64 percent of its former level (relative
to trend and adjusting for output effects, both of which are relatively
small by comparison).

oil-import problem and should
should have no oil—import

probably be exporting oil to the rest of the world -- unless they too
--

-1.0 for their demands.
had price elasticities of —1.0

Statistics on energy used in production, as opposed to use by
government consumers, are hard to get and Rasche and Tatom resorted
to using price data rather than quantity data in their production
function.

Cobb-Douglas assumptions, energy use is
Since, under the Cobb—Douglas

given by
(2)

EcVP~

where PE is the relative price of energy, their price series proxied
for the unobserved quantities of fuel use.

Up to 1973, there was not

much variation in the relative price of fuel, so it was probably hard
to view the resulting estimates very critically.

But what has happened

to energy use since 1973 shows the model is wildly unrealistic. And
therefore so are its implications for potential output.

I have made some estimates of how much business has curtailed

energy use in response to the increase in fuel prices since 1973. An
accurate total of business fuel consumption is hard to get, but I was
able to assemble time series covering about 60 percent of the total.

The main omissions were coninercial
commercial uses of petroleum for heating and
transportation.

I estimated the following
follo\11ing relationship over the

period 1949—1973,
1949-1973,

(3)

lnft

A+p1t+bflnU

where EE Is
is my series on BTUs used by business, QQ is gross business
potenti a1
product, u
U is utilization measured as the ratio of QQ to potential

o,V

is an estimate of the annual trend in IQ
This equation says
Is
that, through time, energy per unit of output has displayed a trend of
and

p
r1

While at a point in time, energy use will be (l+b11)) perpercent greater for every one percent additional output that is produced.
1

per year.

equaTable 11 shows three sets of coefficient estimates for this equa-

tion, the estimates differing according to whether the utilization term
is included and whether the equation is adjusted for serial correlation.
time period used for estimating since data on
They also differ in the time.

UU were not available before 1954. The estimates indicate aa trend
dee] ine of 1.
decline
1.33 to 1.
1.66 percent per year in energy per unit of output.

In the t,10
two equations that have it, the coefficient on the utilization
term indicates aa cyclical elasticity of energy use with respect to
Hov1ever, the estimate of bb11 has aa low t—statis—
t-statisoutput of 1.3 to 1.4. However,
tic in both equations 4a and 4b and equation 4c may be more reliable.
The relative price of energy trended down through most of the

estimation period and its effect cannot be separated from the trend in
energy per unit
unit of output.

But the post-sample prediction errors from

the Table 11 equations provide estimates of how much energy use has been

Table 1.

Estimated Equations for Energy Per Unit of Ouput,
0uput, Private Business Sector~/
Sectors”
Coefficients

Equation
number Constant
AA

Time
p1

Percent errors

Data
Utilization Period
b1
bl

1973

1976
forecast

-3.0%
-3,0%

-5.9%

-3.8%
—3.8%

—7.0%
-7.0%

—2.1%
-2. 1%

-7. O;i,
—7.0%

D.W. S.E.
S.E. rho prediction

‘C

(4a)

2~9l
2. 91
(9.82)

—0,01278
-0.01278
(—8.6)
(-8.6)

0,4413
0.4413
((1.43)
l . 43)

1954-73 0.805 0.9 0.034

(4b)

3.04
(9.
4)
(9.4)

-0.01266
—0.01266

0.
3111
0.3111
(0.93)

1954-73 0.877
1954—73

(-5.9)

(4c)

3.46
(115.8)

—0.01557
-0.01557
(—8.0)
(-8.0)

—

1.3

0.027 0.561
o. 561

929 1.9 0.031
1949—73 0,
0.929
1949-73

0.641
o. 641

reduced as a result of the post-1973 price changes. The ratio of
energy to output in the business sector declined by 10.2 percent
between 1973 and 1976.

Equations 4a, 4b, and 4c in Table 11 predicted

declines of 7.3, 7.0, and 5.3 percent respectively. Thus my measure

declined by 2.9 to 4.9 percent more than predicted,
of energy use decli
given the behavior of output over this period. Thissis
is the response
facone can attribute to higher energy prices or other, unspecified fac-

tors, using the equations of Table 1.

Since the relative price of

energy rose by 57 percent over this period, the indicated price
elasticity for business use of energy is betwqen
betw~en 0.05 and 0.085.
Low as these estimates are, they probably still overstate the

true amount of energy saving that has occurred thus far. The Table 1l
equations assume a constant trend through 1973 in energy per unit of
business output.

In fact, the nearer to 1973 one starts to estimate

the trend, the steeper the estimated decline rate is.

If the decline

that would have occurred without the price explosion was greater than
attrithe Table 1l equations indicate, the extra decline that can be attri-

buted to the price explosion is correspondingly smaller.
Other studies, based on long time series and on cross-sections,
have estimated higher price elasticities than these.

The absence of

any spectacular change in the relative
ative price of energy before 1973
would make any statistical estimates from time series up to that time
uncertain; while cross-sections may reflect differences other than just
the price of energy, and may not be useful for predicting the response
to a change in price in the U.S. The present estimates come from the

first opportunity to observe the response of use to aa large change in
It may be that three years is much too short a period to

price.

observe long-term effects; with more time, energy use may respond
further.

And it is probably true that total use of energy, as opposed

to business use, is more price elastic.

But it is business use that is

relevant for potential output calculations.

And it is the response to

stabidate and over the next few years that is relevant, at least for stabilization problems, not the response that may eventually occur
occur over a
period of many years when the capital stock -- and eventually the
—-

geographical distribution of the population and life styles -- have all
——

had a chance to evolve.
Effects on Potential Output
Knowledge of the quantity of energy conserved permits some
guess at the decline in labor productivity and potential output that
resulted from higher energy prices without making restrictive assumpassumptions about the form of an aggregate production function.

Valued at

1976 prices, the estimated energy saving of 2.9 to 4.9 percent was
worth $2.8 billion to $4.8 billion.

Reducing this to 1973 relative

prices, the range is $2.0 to $3.4 billion.

Since the most profitable

at the old price and the
substitution of other factors are marginal at
substitution
least profitable
profitable are marginal at the new, the midpoint is appropriate,
providing aa range of $2.4 billion to $4.1 billion for the value of

other inputs substituted
substituted for energy,
energy.

Even if business is assumed to

substituting labor for energy,
have accomplished all this saving by substituting
not much extra labor could have been used in this process.

11
11

$4.1 billion

sector.
is 0.5 percent of employee compensation in the business sector,
billion is 0.3 percent.

$2.4

substitution
Since an unknown amount of the substitution

must involve capital as well as labor, the added labor input would be

smaller still.
still.

If we assume the substitution
proportional to the
substitution is proportional

two-thirds, one—third
one-third split
usual two—thirds,
split of shares between capital and labor,
substituted falls to 0.2 percent to 0.33 percent.
the estimate of labor substituted
Finally, some part of the energy saving must have involved no substituFinally,
tion of other inputs at all:

lowering thermostats to 68 degrees in

winter and raising them to 75 degrees in summer or turning out every
other light in hallways are obvious examples, but there must have been
many less obvious examples of "waste"
waste that were eliminated only after

the OPEC crisis made firms more energy conscious,
conscious. The
The amount of
energy saving that involved labor substitution must be smaller than
all this "costless"
conservathe total energy saving by the amount of all
‘costless conservaI know of no way to pin down the answer more accurately; but on

tion.

the basis of the evidence here, it seems unlikely that higher energy
prices have caused more than aa 0.2 percent loss of labor productivity

and potential output between 1973 and 1976.
It seems likely that there will be more energy saved in the
longer run.

But it also seems plausible that any growing conservation

11 come disproportionately from substituting capital rather
of energy wi
will
than labor for energy.

If the price elasticity of energy use after ten

years is substantially greater than after three years, it is presumably
because the capital stock will be changed much more over the longer
period.

Thus, in response to higher energy prices, we would predict an

unusually large amount of investment with greater confidence than we
would predict an unusually slow growth in labor productivity.
productivity.
Don't Higher
Hurt?
her Prices Hurt
The apparent paradox in all this is that the inability to
substitute labor for energy has kept potenti
potential output from being
being
prices.
affected by the increase in energy prices,

If the substitutability

assumed by Rasche and Tatom were in fact available, our potential
potential

output would have fallen just as they described.
our economic welfare has been reduced by OPEC.

The answer is that
Our consumption possipossi-

bilities for other goods and services are smaller by the amount that
our fuel bills are larger.

Substitution would help us reduce the size

of this fuel bill, but the possibilities for substitution are slight,
at least in the short—run,
short-run, as the low response of energy use to date
has shown.
shown,
Since much of the added revenue from higher energy prices has
gone to U.S. producers, it gets complicated to figure out exactly who
is worse off and by how much.

Furthermore, our exchange rate may have

been affected by OPEC's
OPEC’s price increase and the subsequent spending and
trade
investment decisions of oil producers, thus altering our terms of trade
with the rest of the world and further muddying the full calculation of

us.
what it has cost us,
such a measure.
measure,

But for the present purpose, we are not after

For calculating potential output effects, we need to

know how much labor productivity has been affected.

the effect, thus far at least, is negligible.

And the answer is

Potential GNP Estimated

For the reasons I have just described, my own recent estimates of
attentionto
potential output are made without explicit attention
to the capital
stock or energy prices.W
prices ..Y An examination of the residuals from my

estimating equations should indicate whether these, or other, omissions
are inappropriate.
II define the potential path of the economy as the trend line of
GNP passing through actual real GNP in mid-1955
real GHP
mid—1955 and growing at aa
rate that would hold the weighted unemployment rate at its mid—1955
mid-1955
level.

This is similar to the long—established
long-established benchmark for potential

originally presented by Okun, except that the path is defined by concon-

stant weighted unemployment rather than the conventional aggregate
unemployment rate. Weighted unemployment measures underutilized labor
in efficiency units rather than bodies.

As such it is a better sunnary
summary

measure of labor market tightness than conventional unemployment. But
it is not intended to define a "noninflationary"
utili“noninflationary” level of labor utili-

zation. That is another, and more complicated, matter.
Over the past 15 years, the conventional unemployment rate along
the potential path has drifted upward, from 4.1 percent to 4.9 percent

in 1976. The main reasons for this are the declining proportion of
high-weight adult males in the work force and the rising relative
unemployment rates of low-weight young workers of both sexes. The
drift in conventional unemployment rates along the potential path is
very close to the drift along the CEA’s
CEA's path, which is based on a

similar treatment of the labor force.
14

The economy's
economy’s potential labor force is calculated using participation rate equations for each of 14
total
l4 demographic groups in the total
labor force.

These equations account for cyclical variability in the

labor force of women and younger men.

They also provide estimates of

participation rates along
c:1ong the potential path.
the trends in participation

Labor input

is measured by weighting
,veighting the employment and labor force in each of the
14 age-sex
age—sex categories by relative wages and summing them.

Potential

weighted labor force and weighted employment are obtained by adjusting
particithe actuals to potential using the cyclical components of the participation rate equations.

An equation estimating average hours worked per

year, again with a cyclical and trend component, provides estimates of
potential average hours.

Multiplying this by potential weighted

employment each year gives potential weighted total hours, the basic
measure of potential labor input in the analysis.
analysis.
Weighted labor productivity is defined as labor input divided by
output.

Since the labor input measure is already weighted to take

account of average productivity
productivity differences among workers in different
different
demographic groups, weighted productivity is already cleansed of this
productivity
source of cyclical variaticn
variation and trend in conventional productivity
measures.

business
The relationship between labor input and output in the business
sector provides the basis for examining the behavior of weighted proproeconomy,
ductivity and estimating aa potential output path for the economy.

The

productbasic model starts out with the proposition that weighted labor product-

ivity grows exponentially along the potential path:

-9-

(5)
C)

where Q
where
Q is output in the business sector, r is the annual growth rate,
tis
indicate potential
t is aa time index, and the bars over variables indicate
values. This can be modified to allow for aa break in the growth trend:
(6)

Be (r1t1+r2t2)

Cyclical deviations of productivity from its trend are expressed
by
(7)
(7)

__~i_
Q

_[_

where sS

>
>

=
=

iTh13
~H’

11 if, as expected, productivity is higher the higher the

potential.
level of actual hours or actual output relative to potential.

work has shown that some lags exist in this cyclical relation, and they
are allowed for by modifying 7
7 to
(8)

H
H
H
H

(Q)6IQ/Q

Combining equations
equations 66 and 8 to eliminate ~
Q leads to the basic equation
Combining
used for statistical
statistical estimation.
estimation,
In the original analysis,
analysis, some alternative
alternative specifications
specifications were
tried and residuals were examined to determine whether a break in the
time trend was important in modelling potential.
potential.

The evidence only

slightly favored the hypothesis of a trend break and two alternative
slightly
alternative

16
16

estimates of potential output were made, one based on a constant trend
1954-1976 interval, the other with aa
in weighted productivity over the 1954—1976

break in that trend in 1969.
Now, however, on the basis of the analysis that Edward Denison
compelis currently conducting, the case for a break in the trend seems compelling.

Denison is measuring the effect on productivity of business

costs or expenditures -- those associated with dishonesty and crime,
——

with compliance with health and safety requirements, and with pollution
control -- he finds productivity growth has been eroded since the late
--

1960s. When Denison’s
Denison's final estimates are available, it will be possipossil960s.

ble to integrate them carefully into an analysis such as the present
one.&/
nmv, they lend
1end independent support to the estimates that
one.~I But for now,
allow for a break in the weighted productivity trend.
The equation estimated with a break in the productivity trend
in 1969 is
(9)

log

(~)
t

-5.28 + O.0179T54
0.0179T54 + 0.651 log
—5.28
(13.5)
(16.5)
Q

l,og

(li)t 1-0.0237074
7-0.0237074 -- 0.0019169,
o.0019T69,
-0.093 ~og (E) - log (~)
1 (-3.3)
(-2.3) '-j
(-1.5)
Q t
QQ tlJ(,33)

SEE=
SEE = 0.0062, D.W.

=
=

1.77, estimation period is 1954-1976.
1954-1916.

T54 and T69 are the annual tim!
time trend duninies
dummies startstartIn this equation, 154
ing in 1954 and 1969 respectively. They indicate an annual trend in
weighted productivity of 2.75 percent through 1968 and 2.46 percent
thereafter. D74 is a duniny
dummy for the year 1974 when productivity

experienced its largest residual. While a variety of observations
about business behavior that year led me to use the duuaBy,
dummy, its only
noticeable effect is to reduce the size and importance of the lagged
adjustment term.

The residuals from the equation
equa.tion for 1973, 1975, and

1976 are only 0.2, 0.3, and 0.3 respectively, indicating only a slight

underprediction of productivity and no trend toward a growing error.
The final estimate of potential output that arises from combining
my potential labor input estimates with the trendin
trend in potential weighted

productivity are sumarized
summarized in Table 2.

In calculating these estimates,

labor input and output outside the business sector are assumed the same
at actual and potential.

Actual GNP in 1976 was estimated to be 8.3 percent below potential.
1976-81 period, potential is projected to increase at an average
In the 1976—81

rate of 3.88 percent, just slightly slower than in the 1970-76
1970—76 period
and noticeably faster than in the previous intervals covered by this
in the labor force is
The projected 2.1 percent annual growth In

study.

noticeably slower than the 1970-76
1970—76 average and slightly slower than in
the 1955-70
period.
1965—70 perIod.

However, as a comparison of the last two lines in

producthe table show, the difference between conventionally measured productivity and weighted
v1eighted productivity narrows sharply in the projection
projection
period.

v/here potential output growth was slowed
slov1ed over the past decade
Where

by the changing demographic composition of the work force, in the
period ahead, as a result of the maturing of the baby boom, it is not.
vJhile the impact of energy prices on potential has been shown to
While

be slight, a very modest adjustment to the point estimates presented

Table 2.

Profile of Changes in the Economy at Potential, Selected
Intervals,
Intervals, 1955-81 (annual rate of growth in percent)

Sector and
economic measure

1955-60 1960-65 1965-70 1970-76

Projected
1976-81

Total economy
Labor force

l.
01
1.01

1.29

2. 17
2.17

2.39

2.08
2.08

Employment

0.97

1. 23
1.23

2. 14
2.14

2.31

2.07

Real GNP

3.49
3,49

3.49

3.53

91
3.
3.91

3.88
3.88

Employment

1.21

1.11

2.30

2.87

2.07

Total hours

0.95

0.84

1.41
1.41

2.41
2,41

1.53
1.53

Output

3.62

3.42

3.64

4.34

3.92

Output per hour

2.65

2.56

2.19
2.
19

1,96
1 . 96

2.35

Output per weighted hour 2.79

2.79

2.67

2.48

2.49

Business Sector

here can be made to allow for it.

Reducing the estimate of the 1976
1976

output gap by 0.2 percent and the annual growth rate of potential
potential in
the 1976-1981
1976—1981 interval by 0.1 percentage point is about all the
adjustment that seems appropriate.

This brings the current annual

growth rate of potential to 3-3/4
3—3/4 percent.

The main implication of

this analysis for the capital stock is not that its present size
calls for aa downward adjustment of potential estimates,
estimates, but that we
should expect strong business investment demand and a rapid expansion
of the stock if the economy grows enough to approach its
its potential
level over the next few years.

Footnotes
1’ Peter K. Clark, “A New Estimate of Potential GNP (Council
1/
(Council of
Economic Advisers, 1977; processed).
Economic
2/ Robert H. Rasche and John A. Tatom, “The
"The Effects of the New
tnergy Regime 011
on Economic Capacity, Production, and Prices,’
Energy
Prices,"
2—12 and
Federal Reserve Bank of St. Louis Review, May 1977, pp. 2-12
GNP,”
Robert H. Rasche and John A. Tatom, “Energy
"Energy Resources and Potential
Potential GNP,"
Federal Reserve Bank of St. Louis Review, June 1977, pp. 10-23.
10—23.
3/ Potential QQ is taken from the analysis presented later in this
1/

paper. It could just as well
v1ell be taken from the CEA estimates as there
is 1little
ittl e difference between the two
tv10 over the relevant
re 1evant period.

4/ The estimated coefficients correspond to Equation (3) in the text.
text.
t—statistics are given in parentheses.
I-statistics

5/ The analysis is presented in greater detail in George L. Perry,
“Potential Output and Productivity,"
Productivity,” ~Brookings Pa
ers on Economic
"Potential
Papers
~~vit,
Activity, 1:1977.
i:1977.
6/ The analysis
anal is will be presented in a forthcoming issue of the
~eof0urrentBusiness.
Survey of Current Business.

POTENTIAL GNP IN THE
UNITED STATES, 1948-1980
Peter K. Clark
Introduction
Introduction
The concept of the output attainable
attainable by the economy if resources
were fully utilized
utilized has interested
interested economists for many years.

This

measure of maximum sustainable output, usually called ''potential
“potential GNP,''
GNP,”

has been aa useful tool for analyzing policies designed to bring about
utilization of labor and capital resources.
the full utilization

The potential GNP measure that gained the widest recognition was
first proposed by the Council of Economic Advisers in 1962
..!J After
first
1962.1/
making a number of calculations
unemploycalculations relating the overall rate of unemployment to constant-dollar
constant-dollar GNP, it
it was determined that a reasonable estimate of the GNP attainable at 4% unemployment equaled actual GNP in
thereafter.
mid-1955 and grew at aa 3.5% annual rate thereafter.

Between 1962 and

1976, CEA revised its potential GNP estimates aa number of times; the
annual growth rate for potential output was finally pegged at 4.0% for
the period 1968-1975 when trend output was thought to be rising rapidly
relative to the unemployment rate.

Still,
Still, in 1976, a judgmental variant

of CEA’s
CEA's original procedure?!
procedureY was still
still being used to determine potential
President's Council of Economic
Dr. Clark is aa staff member of the President’s
Advisers. However, the views expressed are solely the author's
author’s and are
not necessarily those of either the current or past Council of Economic
Advisers.

output.

Potential and actual GNP were still defined to be equal in

mid-1955, and the benchmark unemployment rate was still 4.0%.
Research on potential GNP from 1964 to 1974 produced a number
of different views on the best estimation technique, but very little
1” All of the results were
themselves)/
disagreement about the estimates themselves.
similar to the CEA estimates or even somewhat higher.

Perry [12],
(12], for

compensate for the
example, used a weighted labor input measure to compensate
outchanging composition of the labor force, and found that potential out1970's, or 0.3% higher
put was growing at 4.3% per year in the early 1970’s,
than the CEA estimate of 4.0%.
economy's performance between
However, several aspects of the economy’s
1973 and 1976 indicated that the maximum sustainable output might be
significantly lower than the CEA estimates.

First, in 1973 a number of

bottlenecks occurred both in primary materials industries and in labor

markets which indicated that the economy might have even exceeded the
non-inflationary leveL
level, rather than being below potential by 2.4% as
CEA estimated.

Second, shifts in the composition of the labor force

toward demographic groups (particularly those aged 16-24) with relatively
high unemployment rates indicated that the labor market in 1976 would be
much tighter with a 4.0% unemployment rate than it was In
in 1955. In other
words, if a 4.0% unemployment rate was consistent with a stable inflainflation rate in 1955,
1955, it would produce accelerating inflation in 1976.
1976.
Third, the productivity slowdown
slo,1down evident in the BLS statistics
since the mid-1960’s
mid-l960's did not seem to be adequately included In
in the CEA
estimate of 4.0% potential growth from 1968 to 1975. Although higher

labor force growth offset the poor productivity performance to some
extent it
it was not clear that the sum of these two effects should result
CEA's origorigin growth of potential a full one-half percent higher than CEA’s

inal estimate
estimate for the 1950s.
l950s,

The productivity decline in 1974
1974 was so

extraordinary compared with declines observed in earlier
earlier recessions
that it demanded special attention.
attention.

The persistence of the low level
The

of productivity in 1975 and 1976 indicated that a permanent setback may
have taken place.

Such an occurrence
occurrence would have lowered maximum sussus-

tainable output still further.
And finally, the Commerce Department revised its real output

series in 1976, shifting from 1958 to 1972 prices.

Such a shift
shift could

patterns of growth and to
normally be expected to change the observed patterns

lower measured growth rates.

The new data needed to be incorporated

into the potential output measure.

For these reasons, in 1976 the Council of Economic Advisers
decided to undertake aa comprehensive review of the official
official potential
GNP series and the methodology used to derive it.~’
it.:!! Using aa technique

that incorporated the contribution of capital formation to output growth,
together with a variable unemployment benchmark rising from 4.0% in 1955
calculated.!?./ This
to 4.9% in 1976, aa new estimate of potential was calculated.~!
paper refines the statistical
statistical methodology used to determine CEA’s
CEA's new
potential UMP
GNP series and updates the estimates with data through the
second quarter of 1977.

The new CEA
CEA estimate of potential GNP grows 3.5% per year between
between
1968 and 1976, significantly
significantly lower than previous estimates.

result
This result

makes the formulation of economic policy harder in one sense, but
easier in another.

The problem is that lower potential output implies

that high employment will generate
generate less output than previously estimated.
For the government, this means lower revenues and a smaller budget marmar-

reductions,
gin for new programs or tax reductions.

On the other hand, lower propro-

ductivity implies that a smaller increase in output will achieve the
same unemployment and capacity utilization
utilization targets.

If increases in

aggregate demand are constrained by low investment or a climate of
fiscal conservatism, poor productivity performance is not unambiguously
bad.

Disaggregation of GNP
hisThe crucial determinant of the difference between any two his-

torical potential
torical
potential GNP estimates is the rate of growth of productivity.
The main question is then:

productivity
How much has the rate of productivj~y

growth slowed down? The
The answer
answer is
not easy
to obtain
obtain because
because producproduc9r2~sloweddo~p?
is not
easy to
tivity varies widely with the business cycle, growing rapidly in expanexpansions in economic activity, and growing more slowly or even falling

during recessions.

Most of the research reported in this paper was

productivity growth
devoted to obtaining good estimates of the trend in productivity
by careful adjustment for cyclical factors,
factors.

These cyclically adjusted

productivity growth figures are then combined with estimates of factor
input to obtain potential output.
The first step in estimating the trend in productivity growth
was the division of GNP into four components:
1.

Gross Output Originating in the Rest of the World

Compensation of Government Employees

Gross Housing Output

Private Nonresidential
Nonresidential Output

GOP,
Gross output originating
originating in the rest of the world, or GNP minus GDP,

was an obvious candidate for exclusion from the productivity estimates
because this contribution
contribution to GNP is generated by
by investments outside
the U.S., and should not respond to domestic inputs of labor or capital.
Compensation of government employees is the only measure of
Compensation
government output in the national income and product accounts.

This

component is deflated by an index of salaries of government workers,
which implies that real output of the government sector is a weighted
average of government employment.

Therefore, productivity
productivity for the

weiqhted employment divided by employment, and
government sector is weighted
productivity growth is defined as zero in the National Income and

Product Accounts.

When measuring productivity growth, it
it is reasonable

to exclude government output so that variations
variations in the ratio of governgovernment to total employment do not affect the productivity calculations.

Segregation of housing output into a separate category was based
on the possibility
possibility that the real return from residential
residential capital and
nonresidential capital might be different.
different.

In theory, such aa disparity
disparity

should be only temporary, but in the actual
actual analysis,
analysis, it
it was thought
that the fixed nonresidential capital stock measured by the Commerce
Department was only a proxy for non—labor
non-labor inputs to private
private production.

Since housing was easy to exclude, it seemed worthwhile to do so.

Another important reason for excluding these three sectors is
that their output is not related to the domestic business cycle.

unemployment is high and capacity utilization low, government output,
the imputation to the residential capital stock, and gross product
originating in the rest of the world are not necessarily low.

ThereThere-

in these sectors.
fore, potential and actual output can be assumed equal In

Private nonresidential output, the residual in GNP after
(GNP-GDP), compensation of government employees, and output attributable

to the residential capital stock have been subtracted, corresponds
economists' preconception of private sector output,
closely to many economists’

produced by capital and labor.

It is this output which Is
is most closely

made.§!
studied, and for which productivity estimates will be made.~

Potential and Actual Capital Input to the Private Nonresidential Sector

Productivity is a ratio of output to input; real output for the
private nonresidential sector may be derived by subtraction, as
described in the last section, but the corresponding capital and labor
inputs must be estimated. Capital input was taken to be an estimate of
Inputs

the effective private
private fixed nonresidential capital stock multiplied by
an estimate of capacity utilization. The effective capital stock meameasure used was the B.E.A. gross stock of private nonresidential capital,
adjusted for investment in pollution abatement equipment.ZI
equipment.1” Quarterly
data were linearly interpolated from annual data; projections of
capital stock were derived from an investment forecast in which the
ratio of nonresidential fixed investment to real GNP rises to ten

percent by 1980.

Six percent of fixed investment was assumed to be

for pollution abatement throughout the forecast period.

Annual averages

of the capital stock series are given in Table A-1.
A—l
The newly—revised
newly-revised Federal Reserve Board manufacturing capacity
utilization rate-W
utilization
rate~ was taken as the starting point for estimating the
degree of capacity utilization
private nonresidential sector.
utilization for the private
However, since output in manufacturing is much more cyclical
cyclical than

private sector output as a whole, the cyclical variation in the FRB
manufacturing index must be reduced.

This was accomplished by multimulti-

plying the difference between 87.5 and the Fed index by 0.5, the
approximate ratio of the percentage standard deviation around trend
for private nonresidential output to the percentage standard deviation
around trend for manufacturing output.

If the ratio of utilized
utilized

capital to output is fixed in the short run, such an approximation
is reasonable.
reasonab 1e.
The potential capacity utilization
utilization rate of 87.5% was chosen
because it
it was this rate that was reached in mid-1955,
mid—1955, early 1968, and
all
all of 1973, all periods when it
it is generally considered that output
was near its potential level.

If there were a close relationship

between changes in the rate of inflation
inflation for private nonresidential
output (or the profit rate) and measured capacity utilization,
utilization, it
it
would be appropriate to estimate the relationship,
relationship, and define ''potential''
“potential”
capacity utilization
utilization as that rate which resulted in non-accelerating
prices.

However, in the absence of such a ''Phillips
“Phillips curve''
curve” for

capital, 87.5% is a reasonable benchmark.

Potential and Actual Labor Input to the Private Nonresidential Sector
emoloyment and labor force require a much
Extensive data on employment
more elaborate set of calculations for the estimation of private labor
input. The labor input measure that was constructed tried to adjust
for the productivity of different groups of workers by dividing
di vi ding the
(16-19, 20-24, 25—64,
25-64, 65+) and
labor force into four age categories (16—19,
also disaggregating by sex.

in each of these 88
Private employment In

governcategories was obtained by subtracting an estimate of civilian govern-

ment employment from total civilian employment. Private employment for
each group was then weighted by mean weekly earnings for that group In
in
May 1973)1
1973.2/ Use of the weekly earnings weights approximates the contricontriincluding
bution to production of an employee in each demographic group, Including

both average hourly earnings and average weekly hours.

It would be

better to have weights that vary over time rather than one fixed set of

weights, but data are not available to construct variable weights.
Therefore, the effect of changes in the age-sex weights representing

changes in average weekly hours and average hourly earnings is included
in
In the estimated trend terms described later.

Rates of growth of

l. Although the
weighted and unweighted labor input are shown in Table 1.

growth rate of weighted employment is less than the rate of unweighted
employment, it is only the change in this difference that explains part
of the productivity slowdown since 1966.
Determination of the potential level of labor input requires two
extensive
extensIve calculations.
determined.

First, the potential labor force must be

Then a benchmark unemployment rate is calculated, and used

Table 11
Rates of Growth of Weighted and Unweighted
Private Employment, 1948-1976
Private Employment, 1948-1976
Time
Time
Period

Private
Private
Emp
l oymenta
Employmenta

Private Employment
b
Private Employment
b
(weighted by 1973 earnings)

1948-1955
1948—1955

.58

.61

1955-1966

1.13
l.
13

.75

1966-1973

l. 78
1.78

1.38

aa
b
b

Civilian employment
employment minus
government employment
Civilian
minus civilian
civilian government
employment from
from
the Current Population Survey.
Civilian
employment minus
civilian government
government employment
by
Civilian employment
minus civilian
employment by
eight age-sex
(16-19, 20-24, 25—64,
25-64, 65+; M, F) weighted by
age—sex groups (16—19,
May
1973
mean
weekly
earnings,
all
from
Population Survey.
May 1973 mean weekly earnings, all from Current
Current Population
Survey.

to translate potential labor force into potential employment.

Since

labor input is a weighted sum of employment from eight age-sex groups,
levels for potential labor force and the full employment unemployment
rate must be determined for each group.

Full-employment labor input

governis then potential employment for each age-sex group reduced by govern-

ment employment,
employment, and then weighted by mean average weekly earnings
in 1973.
Potential Labor Force
Potential labor force for each age—sex
age-sex group Is
is calculated by
estimating a cyclical adjustment to labor force participation for that

group, and then adjusting actual labor force to full employment labor
force using the adjustment.

The general form of the labor force

participation equation is:
(4)
(4)

L~t
it

aa.

+b.~U

+c1

t+d1 Tlt+e1 ~MILt+f.
•5(~

+ g. · AGt+
AG + tit
1

Where
L.
Li
l

=
=

civilian labor force in group i

POP.1
POP
1

=
=

in group Ii
civilian noninstitutional population In

=
=

unemployment rate of men 25-54

=
=

ti
me
time

=
=

dur.llTiy which
vihi ch equals
equa 1s 0O until 1966:4,
1966; 4, and then
trend duniny

increases 1, 2, 3, 4...
4...
MIL

=
=

military employment divided by the civilian
16-24
noninstitutional population of men aged 16—24

SCC

=
=

degree credit enrollment in higher education as a
percent of population aged 16-24

=
=

civilian employment in agriculture.
proportion of civilian

Estimation results for equation (4)
(4) are given in Table 2.

Using

the lagged unemployment rate gives the largest
largest estimate of cyclical
variation in the labor force, even though the estimates are smaller

than might have been expected.

unemployment
Use of a contemporaneous unemployment

rate or a distributed lag on the adult
adult unemployment rate generates
lower estimates of cyclical variation.

By using the unemployment rate

of men 25-54 as aa cyclical variable for all groups, the problem of
upward simultaneous equation bias is avoided for all groups except men

25-64, where cyclical variation in labor force participation is
very small.

The cyclical adjustment for each group was the estimate in
coefficient was
insignificant coefficient
Table 2, except for men 25-64, where an insignificant

estimated even though substantial upward bias due to simultaneity
simultaneity was
suspected, and for women 65+, where the cyclical coefficient
coefficient was insiginsignificant and the wrong sign.

literature on pretest estimators
The literature

suggests that some of the other cyclical coefficients
coefficients should be set to
zero,J..Q/
but this was not done.
zero)-~’but
bit high.

be a
Thus, potential labor force may be

Of course, if the reaction of labor force participation
participation to

long periods of low unemployment is much stronger than its
its average
reaction over the cycle, potential labor force could be underestimated.
civilian
In 1976, the estimates in Table 22 imply a potential civilian
labor force 1.1 million workers larger than the actual labor force.

Table
Table 22
Cyclical Variation
Variation in Labor Force Participation
Estimates of Cyclical
Rates by Age and Sex
Rates by Age and Sex
Estimation
1953:1 to 1976:4
Estimation interval 1953:l
(standard errors
in parentheses)
(standard
errors in
parentheses)

(.00043)
( .00043)

.00277

1.95
l.95
((.52)
.52)

.60

.897

1.81

.00270
(.0005)

1.27
1.27
(.59)
(.
59)

.57
.57

.934
. 934

1.97
1.97

1.11
(.35)
(.
35)

.45
.45

.810

1.89

.00237
(.00026)

.57

.988
.988

1.87

—.00024
-.00024
(.00005)

—.00066
-.00066
((.0001)
.0001)

.64

.979
.979

1.86

—.00025
- .00025
( .00074)
(.00074)

.00151
((.00013)
.00013)

.00043
( .00022)
(.00022)

.78

.995

1.91

.481
(.015)
(.
015)

-.00183
—.00183
((.0013)
.0013)

-.00267
—.00267
(.00024)
(.00024)

.00138
(.00042)
(,00042)

.80

991
..991

l.68
1.68

.108
((.006)
.006)

.0003
(.0008)

-.00007
-.00007
( .00009)
(.00009)

-.00045
( .00017)
(.00017)

.61
.61

.817
.817

2.15
2,15

Group

Men 16-19
16—19

.411
((.072)
.072)

-.0096
—.0096
(.0016)
( .0016)

.00040
(.00058)
(.00058)

16—19
Women 16-19

.260
(.080)
(. 080)

-.0059
(.0018)

.00091
(.0005)
(.0006)

Men 20-24
20—24

.877
(.059)

-.0009
—.0009
(.0013)

.00080
((.00036)
.00036)

Women 20—24
20-24
Women

.427
(.001)
(.001)

-.0019
—.0019
( .0012)
(.0012)

.00111
(.00013)

Men 25.64
25-64

..963
963
( . 004)
(.004)

—.00017
-.00017
(.0004)

Women
Women 25—64
25-64

.333
((.008)
.008)

Men 65+
Women 65+

-196.3
—196.3
(44.1)
(44.l)

—.0039
- . 0039
(.0016)

d.w

w
w
N

This figure is only slightly
slightly higher than the approximately .9 million
“discouraged
workers” estimated by BLS for 1976.ll/
1976.]-]-!
"discouraged workers"

Projections of labor force by
by group were made with the estimated
labor force participation equations.

Since they include aa cyclical

adjustment, the projections are slightly higher than those made recently
by BLS.

Annual totals for potential labor force are given in Table A—2.
A-2.

Full Employment Unemployment Rates
The establishment of a benchmark unemployment rate for use in

estimating potential output is aa difficult problem.

If there were aa

good statistical relationship between unemployment rates and the ininflation rate, the vector of unemployment rates by age and sex that
yields aa constant rate of inflation could
could be determined directly.
Unfortunately, there seems to be no unique relationship between
“Phillips curve"
curve” method of
unemployment and inflation, so this simple "Phillips

estimating an appropriate unemployment benchmark is not available.
The picture is further complicated by increases in the proportion of
the labor force comprised of young people (aged 16-24) and of adult
(aged 25-64)
25-64) women, which seems
seems to have changed the relationship between
the unemployment rates of different age-sex groups.

The significant
significant

change in the unemployment survey in 1967 also tends
tends to make the
determination of an unemployment benchmark which is consistent over
time somewhat arbitrary.

The procedure actually used makes the assumption that aa 4.0%
overall unemployment rate represented full employment in 1955.

looking at the relationship of unemployment rates between age and sex

groups in 1955, the eight age-sex unemployment rates that would have
yielded aa 4.0% overall unemployment rate in 1955 may be determined.

It is further assumed that the unemployment rate for men aged 25-54 has
remained aa stationary indicator of the state of the labor
labor market.

The

increase or decrease in each group’s
increa•;e
group's unemployment rate is estimated
using an equation of the form
(5)

u.l
U.

=
=

Cl
~. •

Lp.
*
(
L~ i )
+
*
u
+
y.
+ ~
Si * U + y.l1 *(~LP
I LP 1 I

±)

where

of age-sex
age-sex group
group ii
unemployment rate
=
=
unemployment
rate of

U
u

of men 25-54 as before,
= unemployment rate of

LP.

Cp
LP

=
=

(I~ LiL·

equation (4) times
times Pop.
from equation
Popi

·.. Po~.1

~ (Li
=L.
l1

0P~i (Pop~)

The inclusion of the
the/ L:i) term, the relative proportion of group ii in
Iftp
LP ~
the labor force (purged of short-term
short—term variations) was based on the idea

of partial segregation of labor markets.

A
A relatively high proportion

of the labor force in aa particular group may make it difficult for
members of that group to find satisfactory employment.

The coefficient

yi estimates the change in relationship between the unemployment rate
of group i and the unemployment rate of men 25-64.
25-64.

The data used in

estimation of equation (5) (and equation (4)) have been adjusted for
by multiplying
the change in sampling procedure starting in 1967 by
by BLS using
employment and labor force by ratios obtained in 1966 by

both sampling techniques.1Y
techniques.i?!

While this adjustment is reasonable for

there is no evidence on its accuracy during
high-employment years, there
periods of low economic activity.
Estimation results for equation (5) are given
given in Table 33 for all
eight demographic groups.

The unemployment rates for women 25-64,
25—64,

women 65+, and men 25-64
25—64 did not exhibit significant change relative to

..Jl/ The sign of
the rate for men 25-54
25_54.i~!

was negative for men 65+

indicating
indicating the operation of other forces such as Social Security in the

labor market for these workers.

However, aa downward trend was evident,

so the equation was re-estimated with aa time trend, as shown.
The changes in benchmark unemployment rates
rates by demographic
group are illustrated by the results in Table 4.

The relative labor

force proportion of younger workers (ages 16-24)
16—24) has risen sharply;
equation (5) hypothesizes that this shift in proportions was responsible
for the observed change in relative unemployment rates.

When combined

with
the high
high employment
labor force,
these benchmark
benchmark
with estimates
estimates of
of the
employment labor
force, these
unemployment rates
rates yeld aa benchmark for the overall unemployment rate,
also shown in Table 4.

The overall benchmark unemployment rate equivequiv-

1977.
alent to 4,0%
4.0% in 1955 is 5.1% in 1977.

It would be an abuse of the

term "full
employment" to call 5.1:s
full employment”
5.1% the full employment unemployment
rate in 1977, given the high benchmark rates for teenagers, and the
fact that the burden of this joblessness is distributed unequally across
races and demographic groups.

Rather, the estimates in Table 33 are a

strong reminder an overall unemployment rate of 33 or 4% would be
be
characterized by
by aa very
tight labor
labor market
market for
for adults.
characterized
very tight
adults.

Tab
1e 33
Table
Estimates of the Relationship of Age-Sex
Unemployment Rates to the Unemployment Rate
of Men 25-54 (Equation 5)
of
Estimation
(standard
Group

IInterval
nterva 1 1948:2-1977:2
1948:2—1977:2
errors
errors in parentheses)a
Time
Trend

ii:-2

Si
S;

Men 16-19

.103
-1.
03
(2,33)
2.33)

1.87
1.87
(.152)
. 152)

208.7
208. 7
(51.5)
(51.
5

.77
. 77

.939

Women 16-19

-7.
99
—7.99

1. 31
1.31
(.189)
(.
189)

493.8
(60.2)

.76

.936

1.92
l.
92
(.116)
(.l1~J

36.5
19. 1
(19.1)

.70

.947

(1.23)
.42
( . 97)

1.08
. 106)

87
.4
87.4
18.9

.73

.919

.95

2.7
( .49

.46

.990

.60

.925

.49

.786

.42

.559

(2.15)
Men 20-24
Women 20-24
20—24
~106~_

- .63
-

Men 25-64
25-64

- l. 15
-1.15
( .26)
~(.02)(,49

Women 25-64
25-64
Men 65+
Women 65+
~0.5

2.33
2,33

(.02)

.77

.93)

.05)

2.37
~07~
( .29)

.70
(. 07)

—1.59
-1.
59
.82)

.09)

..36
36

.11
3.7

-.0072
((.0028)
.0028)
227,4
227.4
60.5

Data adjusted for 1967 CPS survey change.

Table 4
High Employment Benchmark Unemployment
Rates 1955
1955 and
and 1977
Rates
1977
(percent)
(percent)

Demographic
Group

1955

1977

Women
Women
Women
Women

10.8
6.2
3.8
2.7

17.7
9. l
9.1
4.3
l.8
1.8

l l. 7
11.7
6.5
3.0
3.6

14.8
7. l
7.1
2.4
3.2

4.0

5. l
5.1

Men
Men
Men
Men

16-19
16-19
20-24
25-64
25—64
65+

16-19
20-24
25—64
25-64
65+

Total
16+)
(Both Sexes, 16+}

Note:

Unemployment rates assume the survey technique actually used
in that year.

5.1%
4.0% in 1955 and 5.
1% in 1977 are in no sense estimates of the

lowest overall unemployment rate that does not cause inflation to
accelerate.

Rather, the time series of unemployment rates generated

by the equations in
in Table 33 is aa consistent set of unemployment rates
over time generated by the assumption that the unemployment rate of
men aged 25-54 is aa stationary measure of labor
labor market tightness.

The

non-accelerating inflation rate of unemployment, or NAIRU, was probably
about 0.4 percentage points higher in 1955, and 0.6 to 0.9 percentage
points higher today.

The high employment level of labor input is calculated in three
steps.

First, employment in each age-sex group
group is estimated by multimulti-

plying the
the potential
potential labor
labor force
force by
by one
one minus
minus the benchmark unemployment
unemployment
rate.

Second, civilian government employment is subtracted from these

potential employment estimates to obtain potential employment in the
private nonresidential sector.

Third, potential private nonresidential

employment in each age-sex group is weighted by mean average earnings
in May 1973 and aggregated to obtain weighted potential labor input.
input.

Cyclical Adjustment of Productivity and the Calculation of Potential GNP
The crucial step in the estimation of potential GNP is the
determination of good estimates of productivity at benchmark input
levels.

If an equation explaining the variation of productivity with

the rate of input utilization can be obtained, then aa benchmark
benchmark level
proof input can be entered into the equation to obtain the level of pro-

ductivity associated with that benchmark over time.

The basic specification of the variation of productivity with
utilization rates used in this study is:
(6)

yt
~t

7~/P
‘tt

=
=

(

It’\~

‘~

I
/

(It~i

I p
\I t—l

where
yt

=
=

real output of the private nonresidential sector
real output of the private nonresidential sector
in
in quarter
quarter tt

potential value of Yt in quarter t.

weighted combination of labor and capital input in the

weighted combination of labor and capital input in the
t.
private nonresidential sector in quarter t.

2
= (K * CU )l/3 · (Lt) 2 /3.
t
t
t
(Kt * CU~)”3 (Lt) /3.
=
of It in quarter t.
=
potential value of
I

=
=

nonresidential
adjusted for
for
nonresidential fixed
fixed capital
capital stock
stock adjusted
po 11 ut·i on abatement investment.
investment.
pollution

CUt
cut

=
=

Adjusted Federal Reserve Board manufacturing
index.
capacity utilization index.

Earnings-weighted private employment.
141
6) ‘t
Js~J holds,
holds,1~’ ((6)
If the invertibility condition ~sot
lsol >> ls1I
=
=

can be
be
can

‘Pt
past yt
expressed as aa convergent series of past

((7)
7)

- II
f

{Yt-s)
(Vt_s\ '\
~

s=
\ YPt-s
s-Uo \y~t-sJ

Equation (7) may be familiar to many readers as aa specification of the

lagged response of
of inputs to output that has been discussed extensively
extensively

in the literature
iiteraturei-~i
.0 Equations (6) and (7)
( 7) say that in the long run,
the percentage gap between potential and actual input is aa constant

fraction i/(s~+~~)
1/( Bo +si) oof
f the percentage gap between potential and actual
In the short run, this fraction is smaller, due to the lagged

output.

response of input to outputJ~’
output.ill
An alternative specification for the cyclical relationship
between output and input is equation (7) with aa one-period lag:
( 8)
(8)

It
I~

(Vt\ao

\V~)

y t-l)cq
(_V~~\ai
(

\V~-11
Yt-1

Equation
is aa variant
variant of
is sometimes
called "Okun's
Law."
Equation (8) is
of what
what is
sometimes called
‘Okun’s Law.”
If we let
JG
t

and

yG
VG
t

=
=

p
p ~t
It
It -It
p
It
I~
p
p
yt
_yt
VtJt

percentage input
input gap
gap
= percentage

= percentage output gap
=

then (8) becomes:
log (1

ItG)

~ log (1

V~) + ~1log (1

V~1)

The approximation log (1 ++ x) ~ xx for small
small x implies:
G
G
G
G
GG
~o Vt
It
= ao
Yt ++ a~
a1 Vt_i
Yt-l
=

which gives a percentage input gap as a function of current and lagged
output gaps, in much the same way Okun’s
Okun's Law relates an unemployment
gap to current and lagged output gaps.

One further assumption besides either (6) or (8) is needed: aa
specification for the growth in cyclically adjusted total factor
productivity:
(9)
(9)

1_V~
log
log ( y~
)
IP
It
t

)

f(t)+u
f(t)
+ ut ,

where f(t) describes how productivity
productivity has grown over time.

The

specification of f(t) was made on an ad hoc basis;
basis; namely, total factor
productivity was assumed to grow at aa constant rate from 1948 to 1966,
1966,
and at a different rate from 1967 to the present, to correspond with
the productivity slowdown that has been widely observed.

Additional

"kinks"
“kinks” in f(t) are necessary to help explain the extraordinarily bad
productivity performance observed in late 1973 and all of 1974.

Three

variants of f(t) were used:
(lOA)
(bA)

f(t)

aa+bt+cTi
+ bt + cTl

(108)
(lOB)

f(t)

=
=

a ++ bt ++ c(Tl)
c(T1) ++ d(T2)

(lOC)
(bC)

f(t)

=
=

c(Tl) ++ d(T3)
aa++ bt ++ c(Ti)

where

·=

Ti
Tl

T2
TZ

time trend

1,2,3,4 ....thereafter
thereafter
4, then 1,2,3,4..
1966:4,
o.....Oo until 1966:
= 0.
l.O thereafter
. 75 and 1.0
. 5, .75
....0o until 1973:4, then .25, .5,
= 00..

o....00 until 1973:3, then 1,2,3,4,5,4,3,2,1, and 0O thereafter.
= 0..

IIA'l variant gives
additi ona 1 consideration to plummeting
The “A”
gives no additional

productivity in 1974, and just treats it as another set of observations
on the cyclical variability of productivity.

"B" variant implies a
The “B”

once-and-for-all downward shift in the trend level of productivity in
once—and-for-all
1974,
due to
shift in
in the
relative price
of energy
1974, possibly
possibly due
to the
the shift
the relative
price of
energy or
or

underestimation of real output in an inflationary environment.

The

"C"
“C” variant explains the lower productivity in 1974 as an extraordinary
cyclical movement that disappears by the end of 1975.
1975.
Equations (6), (9), and (10 A-C) can be combined to yield aa
regression equation for total factor productivity in the private nonnonresidential sector which can then be used for estimating potential GNP.

Equation (6) implies:

log

bo~(~

(~-1)bog

Sibo~(~i)

Substituting in (9) and (10 A—C)
A-C) yields:
a ++ bt ++ cTl

Nt\ +
k’t /

( llA)
(hA)

log (Vt~

((11B)
llB)

bog(Vt\ ==a+
a + bt ++ cTl ++ dT2 +
+ (s
(so-h)
bog(It ~+ B1log
sflog
0 -l) log(:.!_)+
~I ,/
:. Ip

(se-i) bog

sibog(’t-l

' t

1
‘~ t—i \+ u
I~ /

\
(11C)
(llC)

log
=
a + bt
(se-i)
0 -l)
log ( :; ) =a+
bt ++ cTl
cTl ++ eT3
eT3 ++ (s
It’

bog(~t\+s
bog
log(:!)
+s11log

(‘ti
I t-1 \ ++ uut .
(

rL1 /
\‘tiJ

The regression equations derived from the alternative specification (8)

A-C) are:
along with equations (9) and (10 A—C)
(i2A)
(12A)

bog(Vt
log~::):
“ It

~
(ao
-

+a1)a
+a1)a

+
+

~
(a 0

(a~-1) bogflt\

ki~1
42

+a
+a11))

bt
bt

cL~
al

+ (cto
~1)
cTl
+
(ao +
+a1)
cTl

bog
log ( Vti\
yt-1 .) ++ u~
I~-1)
It-1

( 12B)
(128)

(a0+aj) a + (ao+ai ) bt
+ (cto+czz) cli + (a +a~ ) d12
0

lo~(”t):
‘ t

—

(a0—l) 1o9(t) —a~ 109( t_i

+
+ Ut
u

\ t—iI
(12C)

iog(~t~:
(a0+a1) a
I’

+
-

(aO

(a0 +a1) cli
(czo-1) log

(a0 +~2)c13

(v~\-aj
‘

logP’t-l\+

It should be noted that the algebraic manipulations required to derive
(12) from (8) and (10) imply that the disturbances In
in (12) will exhibit

second-order serial correlation. Thus it was not surprising when secondsecond—
order serial correlation was found in the estimation of (12) (and
Cochrane-Orcutt two
handled by
by a second-order
second—order generalization of the Cochrane-Orcutt

stage procedure).
Estimates of the parameters In
A-C) and (12 A—c)
A-C)
in equations (11 A-c)
Cochrane-Orcutt two-stage procedure are given in Table
obtained by the cochrane-Orcutt
5 below.

Standard errors are not given for the parameters of f(t) In
in

the estimates of equation(12), since these are obtained by dividing
least squares coefficients, implying that they have infinite variance.
It is reasonable to assume that equations hA-c
llA-C give more reliable
estimates, for two reasons.

mation errors for

estiFirst, the division problem allows esti-

and a11 in equation (1.2)
(12) to contaminate the growth
parameters a, b, and c. Second, the longer lag specification (equation
a

(7)) seems more appropriate than the short 1-period lag in equation (8).

Table 55
Parameter Estimates
Estimates and Implied
Implied Potential GNP for Equations (llA—C)and
(llA-C)and (l2A—C):
(l2A-C):
Cyclical Variation in Total Factor Productivity
Long-Run Growth
Growth and Cyclical
1977:2)
(quarterly data; estimation
estimation interval 1948:3
1948:3 or 44 to 1977:2)

Equation

+>
+>

llA

-3.70
—3.70
(.0095)

.00456
(.00017)

—.00155
-.00155
((.00038)
.00038)

11B
118

-3.70
—3.70
((.0083)
.0083)

.00443
(.00016)

-.00058
—.00058
(.00042)

.00455
(.00018)

-.00139
—.00139
(.00039)

C
C

llC
11C

-3.70
—3.70
(.0096)

12A

—3.69
-3.69

..00442
00442

—.00099
-.00099

12B
128

-3.69
—3.69

.00436

-.00044

l12C
2C

—3.69
-3.69

.00441

--.00084
.00084

in parentheses.)
parentheses.)
(Standard errors in

(so—l)
(So··l)
.878
(.114)

-.042
—.042
( .011)
(.011)

-.00523

(1—m0)
(1-ao)

p;
Pl

p
P2
2

d—w
d-w

_ 1955
1955 Potential GNP 1977
1977 Potential GNP
GNP
~2
R2
(billions of 1972
1972 dollars)

—.422
-.422
(.115)
(.
115)

.78

1,70
1. 70

.997

656.1
656. l

1392.4

-.414
.822
—.414
(.111) (.110)
( .110)

.76
.76

1,80
1.80

.997

653.7

1378.1
1378. l

.79
.79

1.86

.997

655.9

1399.4
1399
.4

-.00659
—.00659 .806
(.0022) (.112)
(.112)

-.028

Si
B1

-.352
—.352
(.113)
(.
113)
.656
( .022)
(.022)

—.148
-.148
(.022)

1.02
l.02

—.34
-.34

1,62
1.62

.9998

658.8
658. 8

1413.8

.644
(.023)

-.163
(.022)
( .022)

.97

-.'32
-:32

1.59
1,59

.9998

657 .7
657.7

1402.6

.649
(.022)

-.144
(.021)
( .021)

1.08

-.39
-.39

1.80

.9998

658.6

1420.4
1420.4

It is difficult to discriminate between the two hypotheses about
about
the 1973-74
1973—74 "productivity
“productivity disaster"
disaster” implicit in the BBand
and CC variants of
the equations.

If the B
B variant is the correct specification, and the

level of productivity shifted downwards in 1974, high inflation
infbation rates

could be the cause.

If such high inflation rates caused price increases

proto be overestimated, real output has been underestimated, and the productivity loss exaggerated.

de nee for this view
vi ev1 can be found
Some evi
evidence

in the Federal Reserve Board
Board Industrial Production
Production index,
Index, which fell
less than real GNP over the 1973-75 period.

One also suspects the

rapid rise in the relative price of energy, although the mechanism for
loss in productivity due to the high price of oil is not obvious.

In a

theoretical model with homogeneous capital, even if the elasticity of
substitution were zero, potential GNP measured in 1972 dollars would
not fall at all.

Cobb-Douglas formulation generates implausible
AA Cobb—Douglas

reductions in energy usage of 40 to 50%.

AA vintage model for capital

could explain the drop only if U.S. capital is more energy intensive
than foreign capital.

In this case, production using the most energy—
energy-

intensive capital in the U.S. might not cover
cover variable costs at world
output prices.

The
with the
the "C"
specification, is
is that
that
The other
other view,
view, consistent
consistent with
“C” specification,
the cyclical
movement in
in productivity
productivity was
was just
just much
much stronger
stronger in
the
the
cyclical movement
in the
1973-75 recession than in previous downturns.

Probably the truth lies

once-and-for-a 11 drop in tota
producsomewhere in between; aa once-and-for-all
total1 factor productivity of about 2% combined with some extra cyclical loss may be close
to correct.

The estimates of potential GNP shown in Table 5
5 are derived by

eliminating the cyclical components in each equation and setting labor
and capital inputs to their potential values.

This yields aa potential

for private nonresidential GNP, which then is added to the non-cyclical
components (compensation of government employees, imputation to the
residential capital stock, and income from investment abroad) to obtain

potential GNP.
61W,

The BB variant shows the lowest potential for 1977,

productiviey in
reflecting the pessimistic assumption that the drop in productivity
1974 not explainable by
by normal cyclical factors was permanent.

The

equation (12) estimates are higher than those from equation (11); this
difference may be caused by incorrect specification of
of the lag between
changes in output and input gaps in equation (12).

For example, the

long-run elasticiey
elasticity of the input gap with respect to the output gap is

1/(Go
equation (11B),
(118), while the same elasticity
elasticity is
1/(13o + 0~)
= .716 in equation
1) =
(a 0 ++

a 1 ) ==
a~)

.562
in equation
.562 in
equation (128).
(12B).

By allowing
the lag
lag to
to be
be longer
By
allowing the
longer

in (11), the sum of the coefficients
coefficients is larger; the larger long-run

elasticity implies aa smaller output gap for aa given input differential.
Estimates Using Only Labor Input
~atesUsin0n1LaborInut
Discussions of potential output are usually based on labor input

only, largely because the measurement of the capital stock is based
based on
a number of arbitrary (but necessary) assumptions, and because the
weight of capital in total input is the subject of some controversy.
controversy.
It is instructive, then, to investigate the effect of the capital stock
estimates on the calculation of potential output by performing the
analysis using labor input
input only.

All the same equations ((llA-C)
((hA-C) and
and

(12A-C)) may be estimated by replacing I~,the
It, the combination labor and

capital input, with Lt~the
Lt, the labor input component only. The basic
equations are then

(6’)

-w‘tt

(8’) Lt
t

and

1L ~o1
=it t ~t P-t—i~
plLp
\L,~ j \Lt_l

=I~t\ct’o (
t~ni
~\
\ti

(9’) logl/YPt \I
(PA
\t /

____

f(t)

t-11

u
t

The analysis is exactly the same, but the basic productivity concept is
1abor productivity instead of total factor productivity.
labor

capita 1
If the capital

input measure is sufficiently poor, ignoring capital will produce better
estimates.

The results of the “labor
"labor input only”
only" regressions are given

in Table 6.
The results are virtually identical; estimated potential GNP is
about 1% lower in 1955 and about 1% higher in 1977.

The difference is

primarily due to somewhat higher capital utilization rate relative to
in the mid-1970s, compared to 20 years earlier.
the unemployment rate In

The elasticity of the output gap with respect to the labor input
gap is higher than the elasticity of the output gap with respect to the
weighted gap for labor and capital. 1/(s~
l/(s 0 +s~
+s 1 ))

=
=

(llB') while (a 0 +
'"i) == .400 for equation (12B’).
(12B').
(lhB’)
+ ‘~)

.569 for equation
This is not sursur-

prising, for capital utilization
utiiization should adjust more rapidly to output

Table 6

Parameter Estimates and Implied Potential GNP for Equations (11*-C’)
(llA .. C 1 ) and (12A-C’):
(12A-»C: '):
Long-Run Growth and cyclical
Cycl ica1 Variation
Variation in Labor Productivity
(quarterly data: estimation interval 1948:3 to 1977:2)
(quarterly

Equation
‘HA’
l lA'

—3.11
-3. 11
( .011)

.00683

—.00179
-.00179

( .00020)
(.00020)

(.00044)

-3.11
—3.11
( .010)

..00671
00671
(.00020)

-.00081
—.00081

1K’
!lC'

-3.11
—3.11

. 00682
.00682
(.00020)
( .00020)

-.00162
—.00162
(.00045)

12A’
12A'

-3.10
—3.10

.00663

-.00117

128
12B'

—3.10
-3.10

.00654

-.00053
—.00053

12C’
!2C'

—3.10
-3.10

..00663
00663

.•. 00109
—.00109

llB'
118’

a
‘

( .011)

(Standard errors in parentheses)

(.00052)

-.045
—.045
(.014)

—.00690
-.00690
((.00265)
.00265)

—.029
-.029
—.00679
-.00679

(Go—i)
(Bo-!)

Gx
S,1

(i—ao)
( 1-ao)

aj
01

P1
Pl

d—w
d-w

1955 Potential
1955

1977 Potential

(billions of 1972 dollars)

1.79
1. 79
( .20)
(.20)

—.98
-.98
(.
20)
(.20)

.77
. 77

1.75
1. 75

.998

650.2

1405.5

1.67
(.20)

-.99
—.99
(.20)
(. 20)

.77
. 77

1.86

.998

648.0
648,0

1389.6

1.67
(.20)
( .20)

—.86
- .86

.78

1.87

.998

650.0
650.0

1413.1
1413.l

(.20)
.784
.784
( .022)
(.022)

—.190
- . l 90
(. 021)
(.021)

.85

1.15

.9998
.9998

651.8

1421.9

.773
. 773
( .022)
(.022)

—.197
- . 197
( .020)
(.020)

:86
:s6

1.19
1. 19

.9998

650.2

1410.1

.771
. 771
( . 021 )
(.021)

—.188
-.188
(. 020)
(.020)

.86

1.27

.9998

651.8
651.8

1426.2

than labor utilization.

It is also not surprising that the sum of the

coefficients ~o
a0 + a
ct~
“Okun’s
1 is very close to the sum reported in "Okun's
Law''
(12') is essentially Okun's
Law” equations, given that (12’)
Okun’s Law, as explained
earlier.

Unlike the total factor productivity estimates, second order

serial correlation was not significant
significant in (12A’
(12A' - 12C’),
12C'), implying that
-

some other form of specification error is responsible for the low
Durbi n—Watson statistic
statistic after the first-order
first-order serial correl
ati on
Durbin-Watson
correlation

correction.
The range of the 12 estimates of potential GNP derived from the

regression equations are given
qiven in Table 77 and shown pictorially in
Figure 1.

Projections of the labor force, capital stock and the comcom-

ponents of noncyclical output given in Tables A-1,
A-6 were
A-h, A-2, and A—6
used to obtain potential GNP projections to 1980.

The large increase

in the range of potential since 1973 reflects the uncertainty generated

by the precipitous productivity decline in 1974.

By 1980, the range of

estimates is almost 4% of potential GNP, aa figure that does not overoverunemployestimate our ignorance about the level of output in 1980, when unemployment and capacity utilization may be nearer their benchmark levels,
levels.

Most of the productivity decline since
s i nee the late
1ate 1960s
1960s cannot
cannot be
explained by
by the changing age-sex
age-sex composition of the labor
labor force, the
the
changing industrial composition of labor-hours, or changes in the rate
of qrowth
of the capital/labor ratio.ill
growth of
ratio.2~’ Instead, the slowdown must be
allocated to aa residual
residual category, or ‘technical
"technical progress.”
progress."

Since reareaSince

sons for
apparent changes
changes in
in the
of productivity
growth are
sons
for apparent
the trend
trend rate
rate of
productivity growth
are
not well
well understood,
understood, it may
may be
be the
the case
case that
that the
the trenc'
trend productivity

49
49

Table 7

Estimates of Potential GNP

(billions of 1972 dollars)

Year
1948
1950

1955

1960

1965

1970

1975

1980

Minimum
Estimate

Maximum
MaxImum
Estimate

494.5
517. 1
517.1
535. 7
535.7
560.0
580.8
604.0
625.
625.11
648.0
676.0

501. 8
501.8
524.6
543.6
571.0
593.7
615.9
636.5
658.8
685.7

696.0

708.1

721.9
743.5
772.0
801.0
819.9
848.
848.66
880.8
913.9
944.6
981.9
1017.
1017.44
1053.8
l 090. 8
1090.8
1124.
1124.99
1165.
1165.33
1208.
1208.88
1249.
1249.22
1278.
1278.66
1331
.7
1331.7
1378.
1378.11
1426.0
1477.l
1477.1
1531
.6
1531.6

732.0
752.9
779.6
807. 1
807.1
828.5
856.5
888.3
923.3
957.7
997.2
1034.
1034.11
1074. l
1074.1
1114.4
1152. 2
1152.2
1194.
1194.22
1240.2
1240.2
1282. 0
1282.0
1324.
1324.99
1373.7
1426.2
1477.7
1530.
1530.99
1587.
1587.55

Unofficial
** Unofficial

1977 CEA

Estimate
492.8*
514.4*
537.0*
560. 5*
560.5*
584.9

608.2
627.7
651 .4
651.4
673.9
697.2

721.
721.33

746.2

771 • 9
771.9

798.6
826.4
857. i
857.1
890.3
925.0
925.0
960.8
996.3
1031.
1031.77
l 068. 3
1068.3
1106. 2
1106.2
1145.
1145.55
1186.
1186.1l
1228.
1228.22
1271 . 7
1271.7
1316.
1316.99
1363.6
1412.0*
1462.1*
1513.9*
1567.7*

Figure 1
·Jange 1968-1~8
and ~iange
Es~irnate and
CEA Estimate
c;·1\JP: CEA
Potential
1963—19800
Potentia l CNP:
dollurs )~----- ---of -197F
liori~ of
------- -~--('lifl
fbiUion>~
1972 dollars)

-—

1600

1690

Maximum
Esti1nate
Maximum Estimate

Estimate
CEA Estimate
CEA
Estimate
Minimum
~inimum
Estimate

1500

- --,

1400
01

1300

1200

- -

1100
1100

1000

—

____

63
68

713

76
76

77
7?

78
?8

79
79

89
80

growth rate will be higher from 1977 to 1980 than it was from 1966 to
to
1973.

1974,
Even if there was a permanent 2% loss in productivitv
productivity in 1974,

altered relative prices may
nay generate the incentive for productivity
at low energy
energy prices.
increases that were not particularly profitable at
Therefore.
Therefore, cautious optimism either in the form of assuming that the
1974 productivity decline was temporary, or in the assumption that

the productivity growth trend will be higher from 1977 to 1980 than it
GlIP in 1980 of about $1560 billion
was in 1966-73, generates potential GNP

1972 dollars.
The estimates for the years 1952-1968
1952—1968 conform very closely to

previous estimates of potential output for the U.S. economy.

Potential

GNP is calculated to be very close to actual GNP ($654.8 billion 1972
rate of potential
potential is
is very
very close
close to
to
dollars) in 1955, and the growth rate
18/
l 952-1962 . - The
Okun's
Okun’s original estimate of 3.5% per year for 1952-l962.~
growth of potential in 1962-68 is also very close to the 3.75% per year
that had previously been estimated by the Council of Economic
Advisers.W
Advisers.-~” Since 1968, however, the growth in potential output has
estimated.
been much lower than was previously estimated.

Potential output growth

3,5% per year instead of 4.0%
for 1968-75 is estimated here at about 3.5%
for that period estimated by the Council in 1976. 201
for that period estimated by the Council in l976.~’

Although part of the difference between the previous 4% growth
rate and the new CEA 3.5% rate can be explained by the
t.he increase in the
unemployment benchmark from 44 percent to 4.9% in 1976, by far the
largest
of the
decrease is
is due
to slow
slow productivity
growth.
largest part
part of
the decrease
due to
productivity growth.

CalCal-

culations of the trend in total factor productivity using 4% unemployunemploy-

52
52

estimated potential GNP would be
ment as a benchmark indicate that estimated
.3 to 1.1 percent higher with this standard, depending on how the
reduced unemployment is distributed among demographic groups.

Unemp1o~entand
Unemployment and Real GNP Change:

Checking the Results

As a rough check on the potential GNP estimate of 1332-1374

billion 1972 dollars for 1976, the relationship between changes in the
overall unemployment rate and changes in real GNP was estimated using

equations 13A and 13B.
h3B.
(13A)
{13A)

AU
LIUt

~
(13B)
(h3B)

LIU
AU

.38
.24*
= .38 - .24*
(.04)
( .04) ((.02)
.02)

—

%GNP
.h8* A %GNP
%GNP - .18* LI %GNP
~
t1
t (.02)
(.02)
t-1
-

= .77 d-w == 1.89 data:

quarterly 1953:2-1976:4

.45 - .25k
%GNP - .10* ALI %GNPt
%GNP l
.25* LIA %GNPt
(.04)
(.02)
(.01)
(.04) (.02)
~ (ofl
Q3* ALI IGNPt_
%GNP 4
- .03*
- .08* LIA %GNPt 2 - .05* LIA %GNP
(.01)
(.005)
t-3
(.003)
(.01)
-2 (.005)
t-3
(.003)
(last four regression coefficients constrained to lie on a
straight
ine)
straight 1line)
R2
=
d-w=l.89
=
.75
d-w=h.89 data: quarterly 1953:2-1976:4
1953:2-1976:4
t

=
=

—

=
Ut_U
=
Ut-Ut == percentage point
point change in the overall
1 unemployment rate U.
tl unemployment rate U.
A%GNPtt =
=
100*(GNPt_GNPt
ll%GNP
l00*(GNPt-GNPt-l)/GNPt-l
1)/GNPt1 , == percentage change in
Gross National Product measured at 1972 prices.

AUt

Equation 13A implies that aa one percentage
percentage point reduction
reduction in the overoverall unemployment rate will be associated with a 2.4 percent increase
in real GNP in the long run, while equation 13B
l3B implies an eventual

2.0 percent increase.

A
unemployA 2.8 percentage point decrease in the unemploy—

ment rate in 1976 from
from the realized 7,7%
7. 7% to the 4.
9% CEA benchmark,
benchmark,
ment
4.9%
rea 1 GtJP
5. 6 to 6.
7%. Since
Si nee GNP at 1972 prices
would therefore increase real
GUP 5.6
6.7%.
was $1264.7 billion in 1976, these increases imply

of 1336 to 1350 billion 1972 dollars.

aa potential output

These figures are below the

middle of the potential GNP range for 1976.

It should be noted that the result of 2.5 or less for an estimate
of%
of % 6
A GNP/6
GNP/A U
U is lower than the 3.0 or greater used by some economists.
The confusion here probably lies in the distinction between the shortrun and long-run responses of unemployment to output.

In the short
short

run (one quarter), it takes an additional
additional increase of 4%
4% in real output

to reduce unemployment by an additional one percentage point.

However,

additional unemployment reductions are forthcoming in future quarters,
even if there are no additional marginal increases in real output.
Since attention is focused on real growth and unemployment during

economic activity,
activity, it
is natural
to estimate
the growth
periods of
periods
of slack
slack economic
it is
natural to
estimate the
growth
in output that would give an acceptable decline in the unemployment rate.
At the beginning of aa recovery, this “required
"required real growth”
growth" may be very
high.
high.

Conclusion
Concl us ion
The new CEA estimates of potential output are confirmed by the
updated results presented in this paper.

The changes generated by an

additional
year's data
very small,
small, with
with the
the biggest
adjustment
additional year’s
data are
are very
biggest adjustment
being the
the increase
increase in
in the
the unemployment
unemployment benchmark
4.9% to
being
benchmark from
from 4.9%
to 5.1%.
5.1%.
The atypical productivity decline experienced in 1974 has not been

reduced in the past
past year, adding more weight to the argument that
that

22 to 33 percent was permanently lost from the trend level of productivity.
The CEA potential
potential GNP estimates in the 1977 Economic Rqpprtof
Report of
the President are, if anything, optimistic about the gains in output

resulting from a reduced level of unemployment.

In the second quarter

of 1977, CEA estimated that a reduction in the unemployment rate from
the observed 7.0% to 4.9% would have increased real GNP from $1330.7
to $1405.8 billion, or 5.6%.

The 1977:2 potential estimates range from

1372.3 to 1419.6 billion, using aa slightly
slightly higher 5.1% unemployment
benchmark.

"Okun's Law,”
Law," with aa multiplier of 2.0 to 2.5, yields a
“Okun’s

range of $1386.6 to $1400.6 billion, using the 4.9% unemployment
benchmark.

Thus, the results reported here indicate an "output
“output gap”
gap"

which is generally smaller than the official CEA gap of 5.6%.

Estimates

of the current output gap which are significantly
significantly larger than 5.6% must

be based on assumptions about large cyclical variations in the labor
force and productivity which are unsupported by the data.

a1 growth rate"
Results on the "potenti
“potential
rate” for the economy over the
next five years are much less precise.

Structural models (as opposed

to the empirical trend-fitting equations used in this study) of growth

in labor force participation
participation and productivity have not been developed
to the point that they can be used to make good conditional predictions.

Therefore, any projection of potential output must be an extrapolation
of past trends.

A growth rate in potential output of 3.5% per year is
A

consistent with the growth rates of the labor force and output per
worker which have been observed since the late 1960s.

However, high

labor force growth, coupled with aa return to the pre-1966 trend in
tctal
total factor productivity, strong capital stock growth and lower
relative youth unemployment rates could generate spectacular economic

growth over the next five years.

Alternatively, sluggish performance

in all these areas could result in aa very low
101-1 real growth
growth rate. Erratic
behavior of
of productivity, coupled with recent changes in labor force
parti
ci pa ti on trends and unstable
unstable prices
prices make
make any
any projection
projection of future
future
participation
growth
grov1th rates subject to wide variability.

Footnotes
‘I! AJ2p
ort of the Council of Economic Advisers, January 1962,
1962,
l/
AnnualjRe
Report

p.
p.

y2/

49ff.

See Okun (11) for an explanation of the various methodologies used
to relate unemployment and real output.

Black and Russell (1)
3/ For example: Kuh (8), Thurow and Taylor (20), Black
l!
and Perry (12),
{12).

CEA was not alone in its concern about its "old"
“old’ estimates of
potential output. Data Resources voiced its concern over the
potential output
output estimates in early 1976 (Brinner (3)).
(3)). Publication
Economic Re
Report
of the 1977 ~g~pmic
ort, generated additional studies, including
Perry (13), and Rasche and Tatom (15).
(15).

5/
'ii

See the 1977 Economic Report of the President for aa non—technical
non-technical
discussion of the issues involved, and Clark (4) for some of the
statistical results
results used
used in
in the
the re-estimation
re-estimation process.

§j
6/

This concept of the private sector
sector is
is close to what Denison calls
"nonresidential business sector."
the “nonresidential
sector.” See Denison, (6), p. 2lff.
21ff.
It is
is also very
very close to
to the
the Bureau of Labor
Labor Statistics'
"private
Statistics’ “private
sector."
business sector.”

(17).
7/ See Musgrave, (9), and Segel and Rutledge, (17),
?J
8/
§j

See Raddock and Forest, (14).

9/
'}j

1973-1976.
Data are available by age and sex for May of the years 1973—1976.
1973 was chosen because it is closest to aa cyclical peak. Such an
adjustment is sometimes called “Perry-weighting”
"Perry-weighting" since aa similar
weighting
scheme
was
used
by
George
Perry in
in adjusting
adjusting the
weighting scheme was used by George Perry
the
unemployment rate: (12).

10/ See, for example, Sclove,
Sciove, (16).
lQ/

and Earnings, various issues.
11/ Bureau of Labor Statistics, Employment
ipjp~ep~,~ndE~nins,
ll/
12/
.!Y

See Stein,
adjustment
subject to

(19). Since
Since the parallel surveys in 1966 used for this
are only half the size of the CPS, these ratios are
considerable sampling variability.

13/ As mentioned earlier, this result indicates that the unemployment
DI
—

rate for all persons 25-64 could be used as aa cyclical indicator
in place of the unemployment
unemployment rate for men 25-64. Observations of
the adult womens’
womens' unemployment rate relative to that of adult men
57

point increase in the differential between them from
shows a .5 point
1962-1966,
1967 (as predicted by the BLS
1962—1966, a .7 point increase in 1967
1967 to 1968.
partial samples) and then aa .6 point decrease from 1967
This strange behavior of the women's
women’s unemployment rate influenced
the decision to use the rate for adult men, although results using
either rate are virtually identical.
14/ See G.E.P. Box and G.M. Jenkins, (2), p. 67ff, for aa discussion of
l'±I

the conditions under which aa moving average process such as (6) can
be converted to aa one-sided autoregressive scheme.

called “short-term
''short-term increasing
15/ This lagged response is sometimes called
Ji!
returns to labor.”
labor."

See Sims, (18).

16/

One possibility
possibility is that capital input response is instantaneous,
while labor input response is lagged. This implies aa cyclical
adjustment that treats labor and capital inputs differently.
Experiments with such a specification yielded results insignificantly
different than those reported below.

17/

See Norsworthy and Fulco (7) for aa discussion of the reasons for
the productivity slowdown. Embodied technical progress and investinvestment in research and development may have contributed to the
slowdovm, but these factors were not analyzed.
slowdown,

}W
18/

Okun, (8).

]2/
19/

Business Conditions Digest, August 1976, p.
p. 95.

20/

Ibid.

References

1/
]j

Black, S.W. and R.R. Russell, “An
"An Alternative Estimate of Potential
GNP,” Review of Economics and Statistics, February 1969,
70—76.
GNP,"
1969, p. 70-76.

Y
Time Series Analysis, Holden-Day,
2/ Box, G.E.P., and G.M. Jenkins, Lime
San Francisco, 1970.

]/
3/

Brinner, R.E., “The
"The Growth of Potential GNP,"
Resources
GNP,’ The Data Resources
U.S.~~-TermBul1eti,~,,
U.S.
Long-Term Bulletin, Winter
\~inter 1976, p. 91-110.

4/
1lf

Clark, P.K., "A
“A New Estimate of Potential GNP,"
GNP,” in ~~Conrefl,
U.S. Congress,
Joint Economic Committee, Hearings on the Economic Report of the
President, January 19, 1977.
1977.

5/
!if

Council of Economic Advisers, "The
“The Annual Report of the Council of
Economic Advisers,”
Advisers," in The Economic Report of the President,
various annual issues.

§!
6/ Denison, E.F., Accounting for United States Economic Growth,
Growth,
1929-1969, Brookings Institution, Hashington,
Washington, D.C., 1974.
1974.
Po ten ti a 1 Output in the U.S. Economy, Joint
7/ Knowles, J.K., Potential
?J
Economic Committee, 1959.

8/
§.I

Kuh, E.
"Measurement of Potential Output,"
E.,, “Measurement
Output,” American Economic
Review, September 1966, p. 758-76.
758—76.

2J
Residential
9/ Musgrave, J.A., "Fixed
“Fixed Nonresidential Business and Residential
1925-1975," Survey of Current
Capital in the United States, 1925-1975,”
Business, April 1976.
10/

Norsworthy, J.R.,
J.R., and L. Fuico,
Fulco, "Productivity
Costs in the
“Productivity and Costs
Private Economy, 1973,"
Monthly Labor Review, June 1974.
1973,” ~p,~hl

11/
ill

Okun,
A.M,, “Potential
Okun, A.M.,
"Potential GNP: Its Measurement and Significance,”
Significance,"
in American Statistical Association, Proceedings of the Business
and Economics Section (1962).

12/

Perry, G.L., “Labor
"Labor Force Structure,
Structure, Potential Output, and
Productivity,"
Papers on Economic Activity, (1:1971),
(1 :1971),
Productivity,” Brookings Papers
p. 11-47.

—

ill
13/

Perry, G.L.,
G. L., "Potential
Productivity," Brookings
Papers
“Potential Output and Productivity,”
g~i~jP~2!~
gn Economic Activity,
Actiyjj~y, (1977:1), p. 11-47.
on

14/

Raddock, R.D.,
R.D., and L.R. Forest, "New
“New Estimates of Capacity
Utilization: Manufacturing and Materials,"
Materials,” Federal Reserve
1976, p. 892-905.
Bulletin, November 1976,

15/

Rasche, R.H., and J.A. Tatom, “Energy
"Energy Resources and Potential GNP,”
GNP,"
Federal Reserve Bank of St. Louis Review, June 1977, p. 10-24.

16/

Sclove, S.L., “Improved
"Improved Estimators for Coefficients in Linear
Regression," Journal of the American Statistical
Regression,”
Stati sti cal Association,
June 1968.

]]j
17/

Segel, F.W.,
F.l✓., and G.L. Rutledge, “Capital
"Capital Expenditures by Business
for Air, Water,
l✓ ater, and Sol
id ,Jaste
and
Solid
Waste Pollution Abatement, 1975 and
Planned 1976,"
Survey
of
Current
Business,
July
1976.
1976,” ~
1976.

18/

Sims, C.A., “Output
"Output and Labor Input in
in Manufacturing,”
Manufacturing," ~r~~ins
Brookings
Papers on Economic Activity, (3:1974).
~

19/
ill

Stein, R.L., “New
"New Definitions for Employment and Unemployment,”
Unemployment,"
Monthly
Labor
Review,
February
1967.
~

20/

Thurow, L.C., and L.D. Taylor, "The
Interaction Between Actual and
and
“The Interaction
Potential Rates of Growth,”
Growth," Review of Economics and Statistics,
Statistics,
November 1966, p. 351-60.

~1/
21/

U.S. Department of
of Commerce, ~
Business
Conditions Digest, August 1976.
1976.
inessCopciItionsDiest,,

Table A-i
A-1

Fixed Nonresidential Capital Stock at 1972
i972 Prices
Excluding Pollution Abatement Capital
(billions of 1972 dollars)

1948
1950

1955

1960

1965

Note:

632.8
632.8
658.0
681 . l
681.1
707.5
734.2
761
.l
761.1
787.9
815.4
845. 7
845.7
876.3
902.2
925.0
950.5
976.4
1003.6
1033.5
1067.2
1110.4

1966

1970

1975

1980

1164.
1164.22
1219. 3
1219.3
1273.3
1331.1
1387
.6
1387.6
1437.2
1437.2
1486. 1
1486.1
541 . 7
1
1541.1
1600.6
1649.0
1687.1
1729. 9
1729.9
1783.5
1845. 6
1845.6
1913. 2
1913.2

Figures are average values of capital stock during the
given year.

Table A—2
A-2
Table
Potential Civilian
Force 1948-1980
Potential
Civilian Labor
Labor Force
1948-1980
(millions of persons)
(millions of persons)

1948
1950

1955

1960

1965

60.6
61.5
61.5
62.4
62.0
62. l
62,1
62.9
62.9
63.8
65.0
65.0
66 .5
66.5
67.0
67.0
68.0
68.0
68.6
68.6
69.8
69.8
70.8
70.8
70.8
72.0
72.0
73.2
74.4

1966
1966

1970
1970

1975
1975

1980
1980

62
62

75.6
75.6
77
.2
77.2
78.6
78.6
80.5
80.5
82.
82.77
84.
84.33
86.7
86,7
88.7
88.7
91.
91.1l
93.3
93.3
95.9
95.9
98.0
98.0
99. 7
99.7
l101.4
01 . 4
103.3
103.3

A-3
Table A-3
Table
75
Employment, 1948-19
Private Employment,
Private
1948—1975
)
persons
of
(millio ns
(millions of persons)

1948
1950

1955

53. 1
53.1
52.3
52.3
53.
53.1l
53.9
53.9
53.8
54.7
53.5
53.5
55.3
55.3
56.9
56.9
56.9
56.9
55.6
55.6
56.9
56.9

1960
1960

1965
1965

1970
1970

1975
1975
1976
1976

63
63

57.8
57.8
57.6
57.6
58.0
58.0
58.7
58.7
60.0
60.0
61. 5
61.5
62.6
62.6
63.2
63.2
64.3
64.3
65.9
65.9
66. 2
66.2
66.3
66.3
68.4
68.4
70.8
70.8
71. 9
71.9
70.3
70.3
72.5
72.5

Table A-4
Table
A-4
Estimated Capacity Utilization Rate
for the Private Sector,
l948~lg76~
Sector, l948-1976a
(percent)

1948
1950

1955

1960

85.0
80.8
85.2
86.7
86.4
88.4
83.8
87. 3
87.3
86.8
85.6
81. 3
81.3
84.6
83.8

1961

1965

1970

1975
1976

82.4
84.5
85.5
86.6
88.5
89.3
87,2
87.2
87.3
86.9
83.4
82.8
85.3
87.5
85.8
80.5
83.8

Annual
average rate.
rate, Quarterly
Quarterly series
from the
Annu~l average
series (Rt)
(Rt) is
is derived
derived from
the
FRB manufacturing utilization rate (Ft)
(see Raddock and
and
Forest (10)) according to the following
following formula:
Rt = 1/2 (87.5 + Ft)
Rt=

Table A-S
A-5

Full Employment Unemployment Benchmark
Equivalent to 4.0 Percent Unemployment in 1955
( percent l
(percent)

1948
1950

1955

1960

1965

4.4
4.3
4.3
4.2
4. l
4.1
4.0
4.0
4.0
4. l
4.1
4. 1
4.1
4.1
4. 1
4.1
4.2
4.2
4.2
4.3
4.3
4.5

1966

1970

1975

1980

4.6
4.5
4.5
4.6
4.7
4.7
4.9
5.0
5.0
5. l
5.1
5. l
5.1
5.
5.1l
5.2
5.2

5.2

Note: Unemployment rates are computed relative to the sampling

procedure actually used in
In a given time period. The CPS
in the benchmark
survey change in 1967 causes the shift In
unemployment rate from 1966 to 1967.

Table A-6
Projections of Noncyclical GNP Components 1976-1980
(billions of 1972 dollars)
(billions of 1972 dollars)

Compensation of
Federal Employees

Year

1976a
1977
1978
1979
1980

Compensation of
State and Local Government Employees

48.4

97.3
98.7
l 01 . 9
101.9
l 05. 2
105.2
108.7
108.7

48.6
48.6
48.7
48.7

Gross Ouput Attributed
to Residential Housing Stock

Originating
Gross Ouput Originating
in Rest of World
(GNP-GDP)
(G NP GD P)
-

1976a
1977
1978
1979
1980

6.7
8.0
9.2
9.2
10.3
11.
11.33

111.
111.66
114.88
114.
118.4
118.4
122.2
126.
126.22

1976 figures are actual, included for comparison.

POTE/lTIAL
GROi/T!{ RATE POTENTIAL OUTPUT NHJ
AND ITS GROWTH

—

THE OOfclI!!ANCE
DOMINANCE OF HIGiiEf;
HIGHER rnrnGY
ENERGY COSTS IN
I:i THE
TliE 1970’S
l970'S
Robert H.
1-!, Rnsche
John A,
Tatori
R11sche and ,John
A. Tator,1

l96Os, the level
Since the early
early 1960s,
]eve l and the rate of growth
grm'lth of
potential
output have become
subjects,
potenti a 1 outrut
becor,1e increasingly
i ncreas i n!J1Y important
ir1rortant subjects.

While
\/hi 1e

policymaker’s
concepts has become
po 1i cymaker' s and the public’s
rub l i c' s acceptance of these concerts
becorie
widespread, since the early
1videsrrend,
e11rly 1970s there
t!:enc has been
heen considerable

controversy concerning
measurement of potential
concernina the rneasurer,1ent
rotential output and its
its
growth.

By
fly 1973
lS173 it
it had become
hecorce clear to many
nany observers that the Council

of Economic Advisers (CEA) measure of potential output was too high.
That measure shov1ed
showed slack in the economy e~ual
equal to $30 billion (1972
dollars) while many
mc1ny observers thought
thou9ht the economy was
1,1as operating at or
above its potential, at least in the early part of the year.
In irid-1973,
mid—1973, Business Week
Heek summarized the “Debate
"Debate Over Gauging
the GilP
GHP Gap,"
Gap, pointing out the ir1portance
importance of the issue for assessing

stabilization policy, particularly
prospects. ]J
recession prospects,

for near term inflation and

La1·irence Klein, iiAlan
1an Greenspan, Geoffrey Moore
Lawrence

economy was much closer to full utilization
and others argued that the econoriy
potential
of resources than the CEA
CEf1 rotenti
al output measures then revealed.
Nevertheless,
llevertheless, Arthur Okun and George
Georqe Perry were said to remain
renain
defenders of the slack economy
view,
econol"y vie1•1.

sayino: "I
“I am
Perry is quoted as saying:

Ors. Rasche and latom
Tatom co—authored
co~authored this paper while
\lhiie both were employed
enployed
Drs,
by the Federal Reserve Hank
Bank of St. Louis.

that we
have the
the industrial
to bring
bring the
the
not persuaded that
we do
do not
not have
industrial capacity
capacity to
unemployment rate do1~n
down to 44 percent.

1looks
ooks 1like
i ke a firm number,”
number."

bi 11 ion gap still
sti 11
To me, the $20 billion

Y
V

Since 1973, energy price developments, the inflation experience,
1abor
s 1uggi sh capital growth in the recovery, and unusual labor
a recession, sluggish

productivity changes have brought the potential debate to a turning
point. Within the past year, Business Conditions
Conditions Digest ceased
publication of the CEA series.

Peter K. Clark’s
Clark's study, “A
"A New Estimate

of Potential
Potenti a1 GNP,"
GNP,” circulated, and the CEA reported a new series for
potential output in the 1977 Economic Report of the President,
President.

While

the revised estimates reduce the previous measures of potential output,
the ~
Report points to evidence of the need for further revisions due to
a productivity loss since 1974.

The ~Repo1't also suggests that the

growth rate of potential is about 3,5
prior
3.5 percent -- lower than the prior
—-

official view.

Early this year a study by Data Resources, Inc.,

reached a similar conclusion.

May of this year, the theoretical
In our Review article in i1ay
<lue to
foundations for aa loss in economic capacity and potential output due
the 1974 energy price change are derived.

Our results support the

capacity loss hypothesis which has been discussed in numerous Review
capacity
v1hich receives indirect support
articles in the past, an hypothesis which
monetarist price
price equation. 1/ Our Review
from an investigation of a monetarist
article in June provides further empirical support for the loss in

economic capacity
capacity due to the change in the relative price
price of energy
using aa production function approach to measure potential output.
contention that downward revisions are
results support the CEA contention
68

The

necessary in their revised potential output series for recent years.

Nevertheless, our potential output measure appears consistent with the
lfovertheless,
old CEA series until the early seventies, especially in 1955
1955 and

1969-70.
1969—70. §I
Perry's, “Potential
"Potential Output and Productivity,”
Productivity," appeared in
George Perry’s,
the July Brookings
Papers. §j
Brog jns Paers.

His potential output measures also

dmvnv1ard revisions from the old official series, especially
indicate downward
for the late l9GOs
1960s and early seventies
seven ti es when his potential
potenti a 1 output

measures are actually below the new CEA measures.
measures,

Perry's
Perry’s measure for

1973 shows the economy operating slightly
potential, a point of
slightly above potential,
agreement with
vtith Clark.
Perry's measure of potential output
Clark, 7J
Li’ Ho~1ever,
However, Perry’s
begins
begins to grow more rapidly in about 1970, and it
it grows more rapidly
than our measure or the new CEA measure of potential output.

In fact,

Perry's
o 1d CEA
Perry’s growth rate for 1970-76
1970—76 is about as fast as that of the old
period.
measure which he has repudiated for the earlier period,
The three studies share a general conclusion that, at least
through 1973,
1 d CE/1
potenti a 1 output of the
1973, the oold
CEA series overstated the potential

U.S. econo111)1,
economy.

There is some difference in the pattern of the downward

case,
revisions in each case.

Interestingly, both Clark and Perry reduce

while our measure is only $15
1973 potential output by over $30 billion 1°1hile

billion belm1
below that in the old CEA series.
differences,
serious differences.

After
After 1973, there are more

Our measure shovis
shows a substantial
substantial effect
effect of energy

developments, the others do not,
not.

Also, Perry's
Perry’s measures indicate a

sharp acceleration in the rate of potential output growth in the l970s
1970s

the nevi
new CEA estir.1ate.
estimate.
with potential growing much faster than tile
In this paper we review briefly the theoretical and empirical

basis of our earlier potential output results.

To provide a context

for this review,
quarterly potential output
reviews the discussion focuses upon quarterly
measures
nEasures instead of the annual measures presented in the June article.
article,
Our measures of potential output in the June Review and below rely
Clark's vmrk
rates.
heavily upon Clark’s
work on the labor force and participation rates,

developments
Ignoring energy deve
1
or errors due to assumptions concerning
capi ta1 growth or growth of non-private
non-pr'ivate business sector output
output and
capital
production
employment, the growth rate of potential output from our production
function analysis should be
his.
he about equal to his,

The only remaining

difference would be that our estimated labor, capital, and trend

coefficients deviate very slightly from his assumed labor coefficient
of two-thirds, and estimated trend term of about 1.55 percent.

Thus,

in our earlier work we found it convenient to follow Clark's
Clark’s analysis

1976.
and assume a 3.5 percent rate of growth of potential output after 1976,
Since there is a 1
arge gap between the CEA and Perry estimates of the
large
outlook for potential output growth, we examine the growth issue as
well.
During the recovery (since 1/1976),
I/1975), investment in plant and
equipment has been a continuing concern to economic analysts, not only
because it reflects the business outlook of investors and affects

current employment,
emp 1oyment, but also
a 1so because it affects the future growth of
actual output (or, implicitly,
impli t]y, the growth rate of potential output).

Our research offers an explanation
exp 1anati on of both the ssluggish
1 uggi sh growth of
investment and slower
slower than expected growth in potential output since
the recession,

Finally, we offer some comments on the prospects for

decade,
potential output growth for the remainder of the decade.
70
70

Quarterly Potential Output: 1949-1977
1949—1977
Until recently, the conventional method for measuring potential

output focused upon the relationship between output and labor force
growth.

The growth rate of potential output depended upon the growth

rate of the labor force, secular changes in hours per worker, and
and labor
productivity trends.
trends. In several papers, dating back to the original
potential output studies, the importance ,of
of accounting
accountin<J explicitly for
for
growth in the capital stock is emphasized.

The use of an aggregate

production function relating potential resource employment to potential

output is the obvious
obvious solution and one which has been followed most
recently by Clark and Brinner. However, they simply employ conventional
assumptions: a labor share of income of two—thirds
two-thirds and a residual or
one-third.
capital share of one—third.

Our theoretical work on capacity output suggests that energy price
rroductivity of domestic labor and capital
carita1
changes have an effect on productivity

resources. Moreover, we are not content to fix factor share
coefficients, especially since data on energy use is not collected in a
a11ows ready computation of its factor
factor share in cost.
form which allows

Thus,

our work
v/Ork begins with a production function, but the coefficients of the
three resources —- labor, capital, and energy —- are estimated.

From this
Froni

production function, potential output is measurable given assumptions
concerning potential resource employment.

AA Quarterly Aggreqate
Aggregate Production Function
measurina potential output
The fundamental relationship used for
for measuring

is a production function for private business sector output.
71

Output

(L),
(Y) is hypothesized to be a function of hours of all persons (1),

capital (K), energy (E), and disembodied technological progress.

The

Cobb—Douglas and r is the constant trend rate of
production function is Cobb-Douglas
growth,
growth.
( 1)
(1)

y_MrtLaKsEY

The demand for energy may be derived from the production function and
eneruy usage found by equating the supply of energy to the
the rate of energy
econorr,y is a price
price taker in the energy
demand for energy, assuming the economy
market.
market,

Substituting the equilibrium quantity of energy in the

yie 1ds
production function
functi 011 yields
(2)
(A* elt
ert ~
L a(j, KKfl8 PP -y)l/1-y
(2)
Vy =~ (A*
·js the relative price of energy, measured by deflating the
where PP is

wholesale price index for fuel, related products, and power by the
implicit price deflator for
for private business sector output.

81 Hours of

for the private business sector are
all persons data and output for

prepared by the Bureau of Labor Statistics of the U.S. Department of
Labor.

The capital stock data is based upon interpolation of the
structures
end-of-year net stock of fixed nonresidential equipment and structures.
91 The interpolation uses
prepared by the U.S. Department of Coimnerce.
Commerce. 2,’
fixed investment in
quarterly rates of constant dollar nonresidential fixed
GNP accounts as weights in finding
end-of-quar,ter net capital
capi ta1
the SIP
finding end—of-quarter
stocks. The flow of capital services is computed by multiplying the

previous end-of-quarter capital stock by its utilization rate as
measured by the Federal Reserve Board index of capacity utilization.

end-of-year capital stock is
Since a consistent measure of the end—of-year

only available with
~1ith a lag,
laf), estimates of the quarterly capital stock
from the prior
rrior (II/19481V/1975)
(II/l948IV/1975) relationship
after 1975 had to be found from

of quarterly changes in the net stock to the quarterly rate of
investr:ient and, to account for depreciation, the
nonresidential fixed investment

lagged net capital stock. The equation is:
(3)

—

~t—l= 1.012
(4.5)
(4.5)

.2457 It

—

(29.2)

= .98

.0252 Kt1
(-21.Cf)
(—21.4)

thU. == 2.10
2. 10

S.E. == .37
,37

.49

v1here Kt is the constant dollar net stock of equipment
equipr.1ent and structures
where

at the end of quarter tt and It is constant dollar nonresidential fixed
fixed
investment in quarter t.
The quarterly production
production function, estimated for the period
Il/1948
hor10geneity constraint, is:
11/1948 —- IV/1975 1•:ith
with a linear homogeneity
Y = 1.5380
L + .2774 ln
1n
• 7226 ln
ln Vt
1.5380++ .7226
In L+
in Kr,,

( 4)
(4)

(13. 77) (21.24)
(13.77)

—

(8. 15)
(8.15)

.HJ401n
.1040
in pp ++ .0046 tt
(-5.05)
(—5.05)

( 15. 35)
(15.35)

R2 = .98

D.td.
D. ~!" == 1.93

.0076
S.E. == ,0076

.80

The indirect es
estimates
ti mates of the production function parameters are
(standard errors in parentheses)
25. ]5; (3.09%), ~
y = 9.4% {1.86%),
a = 65.5% (3.09%), 8B == 25.1%
(1.86%),
'

r —= .4%
. 4"'
, J oI(.03%)
, . 03'L)
,,~

outrut elasticities are not
The estimated equation and the output
significantly different from the annual estimates or the quarterly
estimates reported in the June article.
article . 1.2/
.lQ/ As earlier, the estimated
elasticity of energy
eneroy is lower
lov1er than that found using annual data.
Therefore, the energy price effect will appear smaller in the potential
output series. The quarterly production function above was also
estimated with the output elasticity
elasticity of energy constrained to be 12
percent, the estimate found using annual
annual data.

An F test of the

constraint indicated that (y
(; =~ 12%)
12;;) could not be rejected (F ,,
1 106
106
Nontheless, the more conservative estimate of y is used below.

.66) •.!1!
== .66).!!!

Some statistical
statis
1•1e reported in the June
properties which we
repentinr;.
article bear repeatinq.

First, the production function is stable when

1 l or 197S.
\Jhen energy is omitted
01,1itted from the
estimated through 1973
1975. t4hen
aldin<J the observations
o:Jservatfons for 1974-75 results in a
production function, a4ding
th,, estimate
e,;tinat.:? of the output elasticity
'=lasticity of labor and a
sharp decline in the

significant rise in the standard error of the equation. AA Chow test on
s tructura 1 change when energy is
the additional observations indicates structural
whe:1 it is included.
omitted from
from the equation,
equation, but not when

Second, in our

discussion (Appendix
(Appenrlix II) of potential biases in the estimation
estimation due to
Cobb-D011'.)1 as production function, we
vie noted that if the
the assumed Cobb—Douglas

own—price
own-price elasticity of demand
demund for
for energy is not unity, our assumption
imparts a downward bias
b-ia,; to the estimate of the output elasticity of
energy (y) and an upward
up,nrd bias to the output elasticity of labor (a).

The consistency of th2
the estimate of

with the labor
labor share data

indicates that
that this bias, if present, is not substantial.

In any

bfos were
v1ere present, it would not bias the estimated
event, even if this bias

regression coefficients upon which
viiiich the potential
potent-ial output measures
neasures are
regression

based.
In estimating
estinating the annual production function for the June

article we
account for other
other factors
article
vie attempted
attempted to account
factors which have been cited
as Influencing
inf1uencin9 productivity in the last decade and which
11hich are believed
by many to have lowered
loviered potential output in recent years. Such
adjustments involve the labor force, capital and trend measures.
rneasures. An
attempt to adjust for the quality of hours in the
tile production function
by accounting for the labor force share of young
youno people proved to be
statistically insiunificant.
insignificant.

i\11 adjusticnt
adjustr:ent to the gross
9ross capital stock
An

rer,iove pollution abatement
abaterilent capital does not affect the coefficients
to reuove

or improve the standard error of the production function and does not
appreciably affoct
neasure of potential output either.
affect the measure

AA break in

the trend rate of gro\'lth
growth was also allowed because of an observed
slowdown in productivity growth
1967.
slov1dmm
orov1th since 1967.

The slowing
slo11inr1 of the trend

was statistically
statisticolly significant, but, lacking
lackinu a explanation for it, we
vie

have chosen to ignore
i rJnore it.
i::1portant
It may appear that the break in the trend has important

implications
i1;1plications for the prospective growth
9rov1th rate of potential output.
thc major effect is to raise potential output measures
rieasures in the
Instead, the
mid- l 960s. Trend terms
terr.is with
1/i th a break in 1967
1%7 show
silo\'/ trend growth
9rov1th to be at
mid—l960s.

a 2.02 percent rate prior to 1967 and 1.55 percent since then.

The

trend growth
~rowth in the production function above
ilbove of 1.6
l .G percent
riercent is not
markedly greater than the current trend rate where a trend growth
9ro11th

s 1ov1dovm is allowed.
a1101·1ed.
slowdown

Hours Per Worker
Potential hours per 1:orker
worker in the private business sector in the
vJOrker to a
June paper is ·'ound
?ound from an equation relating hours per worker
trend and a cyclical '!ariable
the civilian
variable ~~ the unemployment rate of the

labor force

estir;1ated for the period from the second quarter of 1948
estimated

through 1975.
·,\'io changes have been made to measure potential hours
l975~ Iwo
per worker.

First, for consistency the
tile cyclical variable has been

changed to the difference
difterence between the actual unemployment rate and the

fuli~employm2ntunempioyr;ient
fu11·•emp1oyment
une";ployr.1ent rate.
the regression equation, ·121

This change has little
little effect on

The second change
cnange is to allow for the unusual behavior of hours
1961-67 period by using a dummy variable.
per worker in the l96l~67period

Inspection
Inspection

of the earlier results reveals that the equation has systematically
large errors (more than one standard deviation) for every quarter from
mid-1961
mid~l96l through the first quarter of 1967.

More importantly, the

actual hours per 11arker
worker exceed the estimated potential levels

throughout the period by relatively large amounts.

Various

specifications
specifications were tested, including alternative time intervals for a
temporary or permanent shift and changes in the trend rate of decline
of hours per worker.
worker,

The time interval chosen and a temporary (versus

up1,ard in hours per worker fit the observed error
permanent) shift upward

pattern most closely and yielded the lowest standard error.

Tests for

a break in the trend rate of decline in hours per worker failed to
support such an hypothesis once the temporary shift upward was taken
into account,

Also a comparison of equations allowing only a break in

the trend or only the temporary shift in the level of hours per worker
76

revealed the te"1porary
temporary shift yielded the lowest standard error.
error,

121

The equation for hours per 1'/orker
worker is:
+ ,0136
ln !!Pk/
• 7983 - •.3229
3229 u:1
IIPW == .7983
UN - ,0010
.0010 t ±
.0136 D
D
(1004.6)
(-36. l)
(13.1}
(1004,6) (-10.7)
(—10,7)
(—86.1)
(13,1)
—

R2 =
99
= •
.99

ll.ll. == .74
• 74
[LW,

Sample: II/1948-IV/1975
iI/l948—IV/1975
Saraple:

S,E,
= •
.004
S.
E. =
004

v1here HP\'/
where
HPW is hours per worker, llll
UN is the excess of the unemployment
rate over its ful1-employ1,1ent
full—employment rate, tt is time, and UD is a dummy
v1hich rises
rises to one in steps
steps of one-fourth
variable which
one—fourth beginning in the

third quarter of 1961,
1961, and phases out in the same way reaching zero in
the second quarter of 1967.

ill
B’

Potenti
a1 hours per worker are found by setting UI,
equa 1 to
Potential
UN equal

zero.

It should be noted that potential hours per worker in the

mid-1960s are higher
hi1her than our previous esti111ates
mid—1960s
estimates so that the difference
betv1een our measure of potential output and the old CEA measures appear
between

smaller than in Chart IV of the June
dune paper.

~erl’Potentia10utut
Quarterly Potential Output
To measure potential output, potential resource er;1ployment
employment in
the private business sector and the
tl1e potenti
a 1 output in the remainder
rernai nder
potential

of the economy must be
he measured.
measured,

Actual output is assumed to be

econor;iy which are not included
included in
potential output for sectors of the economy
the private business sector (general
( genera 1 government,
governrnent, rest of world,
vmrl d, imputed
output of housing, and output of households and nonprofit
institutions).
institutions).

C<1pital
Capital ernploynent
employment is assumed to be the services of the

capital stock at an 87.5 percent

FRB
ms capital utilization rate. This

ut i1 i zat ion rate was chosen as a full—employment
fu 11-e1;1p 1oy,nent measure
r,1easure because It
it was
utilization
preva"ilino rate during the
tile benchmark
bench11:ark year of 1955 and in other
the prevailing
fol"l-employment periods.
peacetime full—employment

Energy employment
ernployment is asswned
assumed to be

that demanded at potential output, given the actual relative price of
energy in each quarter.
Potential hours of all persons are measured by combining
emp 1oyment and potential
measures of potential private business sector employment

,/Orker. Potential private business sector employment Is
is
hours per worker.
found by subtracting the 11rn,1ber
unemr,loy2d at full—employment
fo11-emp1oyrnent from
number of unemployed

Clark's
Clark’s measure
measure of the potential civilian labor force to obtain
emp 1oyr1ent and then subtracting
subtracti n9 actual
actua 1 employment
ernp l oyment
potential civilian employment
151
. ~ business
tJ11s1ness
.
t . ' t'
ou_s,ae
rie private
pr1vaLe
sec t or. -El
outside
the
sector.
11hich the potential output 1.1easures
The assumptions upon which
measures are

optil.listic and
und may
11ay result in overestimates
based are, if anything, very optimistic

of potential output, especially in recent years. First, by using the
estimate of the output elasticity of energy employment of 9.4 percent

instead of the 12 percent estimate
estitnate from
fror: the annual regressions, the
the
impact of energy price increases is
Is lowered.

Second, Clark’s
Clark's series

for the full-employment
ful1-e,1ployi;1ent unernployr:ent
rat1, may
may lead to a significant
unemployment rate

overstatement of potential employment.
er,1ployr,1ent.

,!achter
(DPEA, 1:1976
1 :1976 and BPEA,
Wachter (SPEA,

l :1977, pp. 4851) has made a strong
stron9 case for the
th1c full—employr;ent
ful1-employr.1ent
1:1977,
uner.1ployment rate being higher in recent years than
thnn the Clark and Perry
unemployment

estimate.

{His work also implies
ir:1plies a s1oHer
(His
slower rate of growth of the

force)$
potential labor force).

paper by Ronald Talley.

Sir.:ilar measures have been derived in a recent
Similar
161

Finally, the measures may
nay be overly
78

optimistic because they do not adjust for the
tr,e factors discussed earlier
which would
,iou1 d all
a l1 tend
tend to reduce potential
notenti a 1 output In
in recent years such as

pollution abatement investment,
investr.;ent, the changing
chan~ing composition of the labor
force and slowdown
slowdovm in the trend growth
9rowth of factor
fac:or productivity.
!leasures
(]Uarter1y potential output
ou-:µ:;t from 11/1948
!I/1948 through
Measures of quarterly

II/1977 are presented in Table 1.
1~
11/1977

These measures are compared to

others for selected years in Table 2 where
v1here annual averages of quarterly
measures are shown for selected years.
years~ The other measures are those
those of

t:1e CEA until January 1977, called “old
"old CEA,”
CEi\,'' the
tr1e CEA
CE/\ measures reported
the
in January 1977, called “new
nnew CEA,”
CEJ\,n and Perry’s
Perry's second series which does

not have a break in trend growth.
grm,1th. Using the
the old CEA
CE/\ series as a
standard, it nay
ueasure is fairly close in 1955 and
may be seen that our measure

1:170 (closer than either
eiV1er the new CEA
CE/\ measure
masJre or Perry II).
II), Comparison
1970
to measures
i;ieasures In
in 1960 and 196S
indicates that our estimate of the growth
1965 indIcates

rate of potential
potentic1l In
in the late 1960s is higher
hir;,-,er than the others 1·1hi1e
while our
9rov;th Is
is slower than the others
othc:rs during the
estimate of potential growth

earlier period, especially from
fron 1955—60.
1955-60,

Fron 1970 until 1973, our
From

CEf\ series, liut
measure is iJe1m1
below that in the old CEA
but it is closer than the

measures,,
other two measures.

Gy 1973, both the
t(w CEA and
anJ Perry reduce the old CEA
CEJ\
By

respectively)~
measure hy
by sizable amounts
amounts ($37 and $32 billion, respectively).

ccntrast,
rieasure is only
or,y about $16 billion below
belovi the old CEA
CE,q
contrast, our measure
i;;casure,, Figure 1
shm-;s the
tile: differences betv-,een
measure.
1 shows
between three of the measures

actua 1 output through
throu~1h mid—1977.
c,i d-1 ~J77 ~
from 1972-HO
1972—80 and actual
fdter 11973,
::J73, our measure
J.i1easure shows
sh0;1s the impact
ir.:pact
After

of the
tne loss
1 oss of
of

potential output due to the large increase
increa~:;c in the relative
re·iative price of

energy. By 1976, our measure is over $30 billion below the old ~EA
79

TABLE 11
QUARTERLY
~UARTERLY POTENTIAL GNP
(Bi 11 •ions of 1972 Dollars at Annual
Annua 1 Rates)
(Billions
I

1948
49
50
r•~

51
52
53
54

;)j

fi 13 ~ 'I
513.1
~)33,,0
533.0
562,,9
562.9
592.1
615. 2
615.2
629.2

6Ll6,. 7
646.7
669.7

h8G,,8
686.8

58
59
60

70B.3
708.3

S5
55

6'i
61

r~
62
Of-

63
64

,... ·-7
o,
67
68
69
70

71
70
,
72
~

73
74
75
765
77l

III

II
486,
486.11
520.7

537.7
572. 4
572.4
593.2
593"2
616,4
616.4
632.6

651. 6
651.6
676.3
676.8
692.3
720.5
740.1

731,,4
731.4
757 ,,6
757.6
IQ? ?:
U,-1,,,'
783.6
8HL6
810.6

764,,0
764.0
739~0
789.0
819,5
819.5

500.4
526. 1
526.1
543,6
543.6
578.9
601.9
618.0
639,3
639.3

1307.
1307.77
134 7. 9
1347.9

1353.8

798, l
798.1
824.0

829&9
829.9

335,,9
835.9

348.5
848.5

873,,8
873.8
902,9
902.9
950. 0
950.0
9"" ')
982.2
1027.0
1027"0

879.3
912.7
959.3
996,1
996.1
1035. 2
1035.2

1056,,9
1056.9

1071,3
1071.3
111 L9
1111.9
1151. 0
1151.0

1084.8

1100.9
1100" 9
1137, 4
1137.4
1178. 0
1178.0
1,-....J
?....,"!1,,u
C:
1231.6

1259?6
1259.6
1283.0
1324. B
1324.8
1361.0
l 361 "0

L,.

1194, 8
1194.8
1244.4

1259,'.)
1259.0

1294, 1
1294.1
"1335,,9
1335.9
1366,9
1366.9

501.8
526.8
552.2
584.0
611.2
621.2
641.5

669.7
683.9
704.8
732.9
754.2
775.2
803,2
822.3
856.7
880.5
921.6
967.7
1006,9
1006.9
1045. 3
1045.3
1092.4
1125. 3
1125.3
1167 .o
1167.0
1222.5
1265,4
1265.4
1279.7
1315. 9
1315.9

661.3
661.8
680.5
702.9
730,7
730.7
743,7
743.7
767. 1
767.1

866,,2
866.2
890,,6
890.6
935,,0
935.0
978.0
1012,,4
1012.4

Qt:.,"

1121.3

1155.7
1209.4
1257. 0
1257.0

1255.9
1265.9

TABLE
TM:LE 2'~

r iras urf's of Potential
Pot2ntiill Output
Alternative Ileasures
(Sill ions of 1972 Dollars)
rlol lars)
(Billions

Oldd CEA
C[/\
01

:~e\'l CEA
CEA
!levi

Perry II
Perry

657.5
756.0
766.0
9n7 .. o
907.0
1114. 9
1114.9

65G.6
656.6
779.9
932. 1
932.1
1124.4

651.4
771.
771.99
92 E-i., 0
925.0
1106.
1106.22

657.8
775.l
775.1
918.0
1091. 7
1091.7

1971

1152,3
1152.8

1972
1973

1201.
1201.33

11 fi(). 9
1169.9
i21G.7
1216.7
12f)S,,4
1265.4
131,i.tJ
1315.9
1368.6
1421.2

1145.5
ll 8fi. 1
1186.1
1228 .. 2
1228.2
1271.
1271.77
1316.9
13fi3. 6
1363.6

1136.
1136.00
1184.
1184.88
1233.
1233.1l
1283.6

Rr1schr.-Taton1
Rasche—Tatom

1955
1960
1965
1970

1974

1249.77
1240.
l 2GG,) l
1266.1

1975
1976

1300 .. 2
1300.2
134n,5
1340.5

8l
81

1334.9
1388. 1
1388.1

FIGURE 11

Actual Output and Ahernative
Alternative
Actua~Output
Potentia~Output
Potential Output Measures
Ratio Stole
Scale
Scale
Ratio Scale
Trillions of Dollars
Trillions of Dollars
Quorterty Doto
Dollars
7
1.7 , - - - - , - - - - - - , - - - - , - - - - - - - , - ~ - - - , - - - - , - - - - - , - - - - - - , - - - - - , 1 .Li

1.6
1.6

1.5

c:x~
00
ro
N

1.4

1.3

1.2

- - - - t - - - - t 1.2

Actual Output
1.1

1972

1973

1914

1975

1976
1976

1917

1918

1979

1980

Sources, U.S.
tJ.S. Deportment
~
Economic
Department of Commerce, Council of Economic
Economic Advisers, and George
George Perry
Perry, Brookings
Papers on Economic
3
~Activity \!:1977\.
1d9771.
L!.. George
George Perry’s
Perry's series
on annual
annual measure.
measure.
U.
series is
is on
[1
Potential output grows at 3.5"1;ofter 2nd quarter
quarter 1977.
~,Potential
3.5% after
plotted for Actual Output:
OutpuE 2nd Quarter 1977
Latest data plotted
Prepared
Prepared by Federal
Federal Reserve Bank of St. Louis

bfi1icn below
Df!lov1 Perry's
tJl11ion below
belo,1 the
measure, S43
$48 billion
Perry’s measure and S23
$23 billion
Comparina real OIIP
a::P to potential output yields
Comparing

new CE!\
tii:wsure,
CEA measure.

differe 1t measures
Measures of the C44P
Gr!P gap
!'JIIP in 1976. The new CEA gap
oap of
markedly different
1

G,5
parcent, Perry’s
Perry's gap of 8.2 percent
percont and the
t,;e old CEA
CE/\ gap of 10.3
6.5 percent,

percont
outr,ut i11ply
tl1at economic performance
perfonnance was worse
percent of potential output
imply that
pnivi ous pas
tv;a r year except 1975.
during 1976 than in any previous
postwar

contrast, our measure
rooa,ure of the
thn gap
(lap is below
he1(M all
~11 postwar
postwar recession years

except

197041.

Tt1us,
ile11cr' s recent claims
claius that the
tho difference between
Thus, Holler’s
alternative measures
nili!asures of potential
rotentfa1 output is sr~ialland
s,,.all and that there is
con:.iderilble
$1ack in the
t:w econony seriously misstate
r.Jisstate the case. )1j
considerable slack

Ile
He

apparently converts the revised CEA
CEi\ measure
mensure of 1412,0 and Perry’s
Perry's
Potential I measure
r,e11sure of 1436.7
1436, 7 for
for 1977
F.!77 to current dollars and concludes
conc1 udes

that in current dollars the gap is $116 btllion
billion to $148 billion. The
highest potential
rotential measure,
11(,asm·e, the o1d
CC/\ estimate
estirmte would, if allowed
a11m1ed to
old CEA
aro.;
3,75 percent
percent-~
rate~irip1y ari gap
gup of $200 billion.
bi11ion,
grow at 3.75
—e its 1976 rate
—- imply
esti~ate yields a gap of $165
~165 billion. At the
Perry’s Potential II estimate

otiler extrct1e,
I,1easure
other
extreme, the rm1,1
new CEA measure

~~
——

adjusted using their conservative

productiv1ty decline
dec1ino due to energy developments
developments-·
measure of the productivity
—. would
do11ur gap of
0f abo:rc
~69 billion.
i;i1lio11. Our second quarter
imply a current dollar
about $69

potential measure, on the same basis, implies an even smaller gap of
about $57 billion. One ~ayquestion whether the $200 billion measure
tOk!'n seriously since the
t!le CEA
CEi1 apparently does not.
not, However,
should be taken
s cudy for the
tne Joint
,Joint Economic
[conoP1ic Comittee
Co1 irn ttr.e suggests
sugoes ts the gap is
a recent study

even larger than the old CEA measure implies.

‘1W

~onetheless, 1a range
Nonetheless,

of !57
""mn $165 billion
biliion in alternative
a1tr!rnntive measures of the
$57 to $200 or even

current dollar GflP
GIIP gap does not seem very close and the difference in
gaps of 3 percent of potential output versus 10 percent is staggering
in iitself
tse 1f as we
11 as for what it might suggest to activist
well
policy-makers.
policy—makers.
Table 22 also indicates that in recent years our measure of
potential output has been growing more
mare slowly,
slowly.

This must be the case

when 1974 is in the interval over which the growth rate is computed
since our measure includes the potential output loss due to the energy

not,
price change while others do not.

But, even for 1975 to 1976 our

growth rate of 3 percent is markedly below
belov1 the new
nevi CEA's
CEA’s 3.5 percent,
the old CEA's
Perry's 3.9 percent.
CEA’s 3.75 percent or Perry’s
important for
While an assessment of the size of the GNP gap is important
understanding the recent performance
perforr.1ance of the economy, a measure of the
prospective growth rate of potential output, while more difficult to
pin down, is equally important for policy—making
policy-making purposes.

The Growth Rate of Potential Output: 1975 - 80
—

ti a 1 output from 1975 to 1977 has been
The growth rate of paten
potential

below both the CEA and Perry estimates.
estinates.

It is easy to understand why

this is the case for Perry’s
Perry's estimate since it follows so closely the
old method of estimating
estimating potential growth which concentrated on
potential growth in labor employment and trends in labor productivity.

As Otto Eckstein has noted, this method may have yielded plausible
results in the past, but tao
too many studies show that its results are
implausible in the seventies
seventies because it does not examine the changing
factors determining labor productivity.

W
12/

The rise in energy costs
costs can explain the slow growth of
potential output over the last two years,
years.

Hhile
While the increase in the

relative price of energy has been less dramatic over the last two
years, from the fourth quarter of 1974 through the first quarter of
this year the relative price has increased 10 percent.

Our earlier

1"1ork,
work, it will be recalled, concerned the effect of a 35 percent
increase in the prior year.
year.

The energy and energy price coefficient

esti"iates
estimates in the production function above indicate that, spread over

two years, a 10 percent increase in the relative price of energy
reduces the growth rate of private business sector potential output by

half a percent: the difference between Clark's
Clark’s estimate of potential
output growth (3.5%) and our measure of the gro1"1th
growth of potential (3.0%).
Moreover, economic
economic theory suggests a short-term
short-term effect on the
future gro11th
growth rate of potential output due to the large 1974 increase
in the relative price of energy.

In particular, a rise in the relative

price of energy depresses the demand for existing supplies of capital
capita 1
resources and, if new capital is energy intensive relative to the

remainder of the economy, raises the relative supply price of those
goods,

Thus, investment
investr,rent falls below
belol'I v1hat
othervtise would have
have been
what it otherwise

for some period until a desired capital output ratio is restored.

Such

"sluggish"
grol'lth has been observed over the last two years and
“sluggish” capital growth
has had a retarding effect on the 9r0v1th
growth rate of potential.

The effect of a higher relative price of energy on the growth of
potential resources is more fully discussed in the next section.

Then

we turn to the outlook for potential output grov1th
growth in the remainder of
the decade.

Since
Since this outlook depends on prospective energy price
85

well,
developments, some
sor,ie attention is devoted to this issue as well.

non-observable economic variable such as
Speculation on how fast aa non—observable
po
ten ti a1 GNP will
wi 11 grow should be considered "second
order
potential
“second order
rretaphysics",
practitioners of the subject.
metaphysics”, with apologies to practitioners
Nonetheless, it is useful for understanding the near-term growth,

employrrent
possibilities of the economy
econofl\Y and for policy
employment and inflation possibilities
formulation purposes to examine the question.
The Implications
implications of the 1974 Capacity
LossflGro!hRateofPot!QtialOa~ut
Los
2 for the Growth Rate of Potential Output
Our analysis of the 1974 rise in the relative price of energy
shows that the productivity of existing labor and capital resources
fell.
fell.

The production function estimates bear out the direction and

magnitude of the productivity loss.

We did not explore the impact of

the loss in potential output on the future rate of growth of potential
output.

However, the analysis which yields the loss in potential

output also suggests aa decline in the rate of growth of potential for
some period in the future.

In particular, the supply of plant,

equipment and labor resources can be affected due to a rise in the cost

of energy. With
Hi th given supplies of potential capital
capita 1 and 1labor,
abor, the
demand for each falls when the relative price
price of energy rises,
rises. These
shifts in the demand for resources measured in terms of decreases in
their rental prices may lower the growth of labor and capital resources
and reduce the future
future potential output rate.

The conventional analysis of the labor supply decision suggests
that there are two major impacts of the energy price increase.

The

shift in demand for labor services tends to reduce real wages.

Such aa

reduction in real 1;ages
wages induces both a substitution effect and an

full—employment supply of labor
income effect which
v1hich tend to reduce the full-employment
soi;1ev1hat.
somewhat.

'?:!JI The second impact
i111pact arises from a change in the value of

non-human wealth.
non—human

The price level impact
i~1pact of the higher relative price

of energy reduces the real
rea 1 va
1 ue of net monetary
rionetary wealth.
Hea 1th.
value

l\t
At the same

tirne,
time, the lower productivity of existing capital assets reduces the

present value of those assets.

Given that leisure is a normal good,

suc,1 a11 reduction in real 1·1eilltil
tile full—employment
full-er,1ployment
such
wealth tends to increase the

supply of hours of all persons.

possible,!a priori, to sign
It is not possible,

the effect of the energy price
rri ce increase; the wealth
,1ea 1th and
c1.nd labor
1abor iincome
ncorne
effects tend to increase the labor supply while a substitution effect
tends to reduce it.

We know of no evi
de nee that there is a net effect
evidence

on the fu11-emr1oyment
full-er.iployment supply of labor in either direction.

W
ZJJ

In
cari ta 1 resources, tile
result is much clearer.
In the case of capital
the resUlt
carital due to a left11ard
The reduction in the rental price of existing capital
leftward

demand for the stock or flow of services of capital also
shift in the dernand
shifts the demand for ne11
new capital goods.

Other thinrJS
Other
things equal,

investment
steady—state stock of capitai,~Y
investr.,ent tends to fall, as does the steady-state
capital.W
Oti1er things are, of course, not equal.
Other

In particular, the replacement
replacerr.ent

cost of capital, or the supply price of flew
ncM capital goods, may be
expected to change as v1el1.
well,

If capital goods are more energy intensive

than aggregate output, as one vJOul
re 1ati ve supply price
wouldd expect, the relative
93/
of capital goods
0oods v1ould
rise. 231
would tend to rise,
~—

Since
Since both the demand and

capitill
investrient falls a forti
fortiori
supply of nevi
new capi
tal goods tend to fall, investment
on

capi tal stock,
as does the long—run
lona-run equilibrium carital
stock.

ce
AA simple model relating the rental price of capital, the price

of new capital goods, the stock of capital, and
and the investment
Investnent rate
24 / Figure
illustrates these points. &5.~/
Fiaure 22 illustrates the steady state

relationship between the variables.

In Quadrant I the flow demand for

the services of capital, Q, is
Is shown as a function of its rental price,

R, and parameter a. The services of capital are assumed to be
proportional to the stock of capital, K.

In Quadrant II,
Il, the price of

a unit of the stock of capital is related to the rental price as a
discounted perpetual gross Income
income stream where r is the real rate of
interest and w
w is the depreciation rate. Quadrant
quadrant III shows the supply
Interest

of new capital goods, I, in terms of the price of a unit of capital and

s. Finally, Quadrant IV shows the steady state
the shift parameter, ~.
relationship between gross investment, I, and the stock of capital, K,
which is proportional to Q.

0
0
,
At Q
I0 , P
R0 and the Implied
implied K’
K0
Q°,i°,
pa,, and R°

is in an initial steady state equilibrium.
the economy Is

An increase in the relative price of energy shifts the demand
for the services of capital downward and to the left. Given the
K and services
existing capital stock K’,
0

Q , the
(~°,
0

ne~, capital goods.
does the demand price of new
replacement
replacement so the capital stock declines.

rental price falls as

is less than
Investment Is
The new steady state

ution occurs at a lower rental price, price of new capital, and with
th
solution

a smaller capital stock and flow of capital services.
An increase in the supply price of new capital shifts the supply
curve In
in Quadrant III upward and to the left.

The process of returning

to the steady state through temporary negative net investment is easily
is a higher steady state price of
traced through
through the graph. The result Is

FIGURE 2
2

., R
R

u.S

It
I
I

I
I

'o
~pO

F’

q
ID

fl
I
8~

capital, a lower
lo,ier stock and rate of replacevaent
replacer.1ent of capital and a higher
higner
rental price.

Finaliy,
combining both shifts yields a smaller capital
Finally, contining

stock in
-- achieved through a temporary declIne
decln1e in
In the steady state ——
tile net investment
fovestrnent rate.
rate,
the

\.Jhether the steady state price of capital and
and
Uhether

rental price
µrice of its services is higher depends on the dominance of the

init·ial reduction in the supply of capital goods over the reduction in
initial
der:ar.d for the services of capita
1. 25 /
demand
capital.
F1Dure
sl10,15 the
ti1e GUP
G,lP price deflator for plant and
FIgure 3 shows
and equipment
rel0tive to the PBS
Pii5 deflator.
cteflator. Table 3 shows the slow
slm1 rate of growth of
relative
capital in the last two years cor1pared
investment since
compared to the rate of lnvestment

t:,is measure of the
1949, and to subperiods since then. The rise in this
wen as recent Investment
investment
relative pr1ce
price of capital goods in 1974, as well

behavio,·, are consistent with this theoretical analysIs
analysis and the
behavior,
26
increased replacement cost hypothesis.
hypothesIs. /
grm1th of capital in the recent past
;:,ast is
is
summary, the
tile sluggish growth
In suninary,

consistent with the lower productivity of existing capital resources as
11el
welll as the increased relative price of capital goods, both of which
arc consequent to the
ttie large Increase.’in
increase in the relative price of energy.
are

S,.c:1 a sfo,:~ng
Such
slowing in capital growth is merely transitional so that, in a
srn1; in~ economy
econo,;1y with
,1i th the absence of further resource supply shocks,
growing
9ro,'ltn of
;:;f capita
its normal
norma ·1
growth
capital1 resources eventually approaches Its

ni ·i ;.1 t :On shh to the growth
grm-1th of 1
abor resources and
anu potential
potenti a 1 output.
relationship
labor
Ti112 energy
12ner-gy price change not only reduces the potential
poter:tial output yielded
The
by a particular
;;articu1J.r rate of use of services of labor and capital, it may
by

also leave
ieai,,: the economy
econociy with
v1ith fewer capital
carital services than
,vould have
nave
than would

othen--d se been the
tho case, after son1e
adjustment,,
otherwise
some period of adjustment.

FIGURE 33
FIGURE

Relative Price of Capitcil
Capital Good?
Goods*
1947=100
120

•~0

1947~100
1947=100

Quarterly Doto

----,120
120

118

116

114

112

110

110
110

108 ·

108

106

106
106

-S

104
102

100

--'--'--'--'----'--"---'-.J.--'---'---"'"""-.J.--'--..__. 98
98
ss st s1 ss 59 60 61 62 63 64 65 ~6 i1 is M 10 n 12
Mn 1,
111s

'--'---'-..J-JJ -'---'--'-

1947

~e 49 so s1 s2 53 s~

Sources: U.S. Deportment of Commerce and U.S. Department of labor
Shaded oreos represent periods of business recessions.
Note, First quarter 1947=100
*Ratio of pri-.:c indo -::,f ncn residential fi~ed iflvestment to price in.:lo: ·of v;;tp.;: :11 th0 p;:C, ::.:.:: ~usin,ess
sector.
Latest doto plotted: 2nd quarter
Prepared
Bank of
at St. Louis
Prep
a red by Federal
federal Reserve Bonk

TACLE 33
TABLE
The Rate of Grov1th
Equipnent
Growth of Plant and Equipment
(Constant Dollar 1!8t Capital Stock)

(Constant Dollar Net Capital Stock)
Period

I/1950
1/1950
I/1955
1/1955
I/1960
1/1960
I/1965
1/1965
I/1970
1/1970

(Growth Rate)

I/1955
1/1955
I/1960
1/1960
I/1965
1/1965
-— 1/1970
I/1970
- 1/1975
I/1975
—

1i.2%
4.2%
3,6
3.6
3.3
5.5
3.7

-—
—
—

I/1975 —- 1/1977
I/1977
1/1975

1. 8
1.8

I/1950 —- 1/1977
I/1977
1/1950

3,9
3.9

The Prospects
Prospr"cts for the Relative
r:el~tive Cost of Energy
[ner9y
Ener0y
huve been
heen heavily influenced by Federal
Energy prices have

:1ror;ra;1 announced in August,
Auoust, 197i.
1971.
regulations since the price control progran
This has been especially true for 11etroleur:1
petroktsn markets since 1973 1·1hen
when

rui sed the 11orl
prier> of crude oil
oi 1 above the protected
protected
OPEC actions raised
worldd price
market price in the United States.
'.>tates.

In order to insulate the U.S.

econo111y fro:1
ver/ large
larse increases
increu,;es In
in the world
V1orld price of oil,
economy
from the very

regul
dor:estic crude oil owners
mmers from
regulations
were putt in place to prevent domestic
receivinJ "vriHlfol1
ant: to avoid
uvoid the
tho recessionary impact
ir,1pact of
receiving
“windfall profits”
1Jrofits" and
') 7 /

• ncrct1se d petro
l cuL1 prices.
1increased
rr1• ces ~ -t.
petroleum

1 /

Tl10
oxistinq regulation
ro~ulation is the
tl1e crude oil
oil
The centerpioco
centerpiece of existing
entit·iemcmts
pro,irar.:, a method
nethod for allocating
allocatin9 controlled domestic crude
entitlements prograra,
oi
arnmq competing
competi n~ refiners.
re nors.
oil1 among

The essence
ossonce of the program is to provide

an "equal"
c1ail7 on controlled oil to all refiners based on their total
“equal” claim

inp11ts. The
T,10 effect
c
ct of the progran
pro0r<1r1 is to equalize
equa 1 i ze the price of
oil inputs.
,1hici1 is a 11eighted
avera~e of the
crude oil to all refiners at a level which
weighted average

controlied price and the world
v1orld price, set by OPEC,
DPEC, 1·1here
,1ei~hts
controlled
where the weights

are based
on the
basod on
thr, share of iuports
iqiorts and doriestic oil in total oil inputs.
inputs.
Tiius, the entitlement
en tlen;ent progran
progrilu provides a means
noans for holding
holdin9 the domestic
Thus,

price of energy
~rice
r:nol"'.7Y below
bolm·1 the world price and
ilnd a means
mr:,ms for distributing the
rents which
i'Jhi ci1 would
,-:nu1 d otherwise
otherv,i se accrue
accru2 to domestic crude producers,
producers.
“rents”
1

[xistin<J regulation
rcqulation hRs
1mrkr1J to hold the price of crude oil to
Existing
has worked
domestic buyers

L,e]m1 the
tire world
1•1orld price, but to allow
al1rn·1 it to gradually
f)raJually
below

rise toward the world price.
ir;1p1icitly
implicitly subsidized

oil owners.
m·mers~

riroc2ss, of course, imports
ir,1ports are
In the process,

with the rents expropriated
cxpropri ated from
frou domestic crude

Not only are
cheaper than they would
dot
arc refined
rcf·ined products dieurer
vrnuld be
he
93

TAGLE 4
TABLE

The Composite and Irirorted
Imported Refiner
Acquisition Cost of Crude Oil
Oi 1
Import
Imrort Cost
(Dollars/Barrel)
(Donars/flarrel)
1974
1974

I
II
II
III

IV
IV

1975
1975

II .
II
III
IV

1976

I
II
IIII
II

11.59
11.
59
12.93
12.
65
12,65
12.
6:1
12,60

Composite
Comrosite Cost
(Dollar/Barrel)
(Do11ar/8Rrre1)
8,24
fl.24
9,34
9.34

9.20
9,20
9.30

13.03
13.03
13.56
13.
56
14.
11
14.11
14.84
14,84

10.96
10,96

13.35
13.43
13,43

10,58
1o. 58
10.
72
10.72

9,83
9,98
9.98
10.
72
10,72

110,94
o. 94
11,26
11
.26

13,52
13.
52
13,59
13.
59

Percent Difference
Difference
34,1%
34.
1%
32.5
31.8
31,8
30.4
28,2
28.2
30.7
27.5
30.3
30,3
23,3
23.3
22.5
21,2
21.2
18,8
18.8

Uational Energy Infomation
Information Center
Source: Based on data from the ilational
ifonthly Energy
~~thiv
Ener Reviev1
Review (April, 1977), p. 73.

in
reoulations because of the incentive to produce
In the absence of the regulations
competinq energy sources tend to have lower prices as well,
more, but competing
due to their smaller demand.
de11iand.
Table 4 shows the “Refiner
"Refiner Acquisition Cost”
Cost" of Imported
imported oil and

the composite cost which
11h i
is the weighted average of the price of

frorn 1974 through 1976.
domestic and imported oil from

in
These costs are,
are, In

ces, but they reflect the impact
imp act of the control
contro 1
effect, delivered prices,
v1ilich the world
program. The last column shows the percentage by which
acquisition cost of imports, exceeds the
price, measured by the refiner aèquisition
composite, or domestic price.
ce.

Over time, this excess has fallen due to

both the actions of the Federal Energy Administration
Adr,1inistration (FEA)
(FE/\) In
in Its
its
attenpt to gradually remove
rermve the difference, and due to the increasing
attempt
share of high cost iniports
ir1ports in total crude usage and the falling share

and rate of production of “cheap”
"cheap" domestic
donesti c crude oil due to the
dm,1estic price controls.
doraestic

Ex·isting
ne1·1 energy policy
Existing regulations and major proposals for a new
11

en s ion the “rationalization”
ionalization" of the domestic
donestic petroleum
petroleurn market so that
envision
dor,estic prices and enorjy
usage are based upon social
socia1 costs or reflect
domestic
enet~yusage
j ,\ • This Is
.
economic
imposed).
econor:lic scarcity (even if artificially
artifi a l '1y 1r1pose,
is evident, for

example,
examplu, in the Energy
Ener0y Conservation and Production Act of 1915
1975 (ECPA)
al1ov1s controlled domestic prices to rise over tine and
which allows
termi nutes do;estic
dor,1es tic price control in 1979.
1979. The crude oil tax of the
tl1e
terminates

Administration's cne
icy proposal as well
1-1el 1 as crude oil decontrol
Administration’s
energy policy
sililre this
titis desired
proposals share
desired result,

Thus, it is very likely that the

dispa ty in
retroleur:1 prices, shown
shmm In
in Table IV, of about 20 percent
disparity
In petroleum
1930.
at the end of 1976 1ii1l
will be eliminated before the end of 1980.

AA 20 percent rise in the cost of crude oil to domestic refiners
will not only raise the price of refined products, but also, through
substitution effects on energy users and direct and Indirect
indirect cost
effects an competing energy producers, raise the price of other energy
resources.

To assess the impact of raising domestic crude oil costs to

the 1/1orld
world price on the relative price of energy resources and
and on
potential output, we have examined the relationship between the
relative price of crude oil and of energy prior to the deluge of
controls on primary, intermediate, and retail markets which began In
in
August, 1911.
1971 •
The relative price of energy is that used In
in our aggregate

production analysis and the wholesale price of crude oil Is
is used as a
measure of the domestic cost
cost of crude oil prior to August, 1971.

The

relative cost of crude oil is found by deflating by the implicit price

deflator for the private business sector. The simple linear regression
of first differences in the logs of the relative price of energy (P) on

the relative price of
(P) from 11/1948
Il/1948 through
of domestic crude oil D’c)
C
II/1971
11/1971 is:

(6)

2l+.4
3S4AlnPc
c~lnP=e.OO
ln P = - .0021
+ .4354
c ln Pc
(—1.68)
(-1.68)

(5.18)

R2s.23

D.\J. = 1. 77
D.W.=L77

S.E. —= .010
,010

This simple regression may be used to obtain information on the

increase in the relative price of energy resources occasioned by the
expected rise In
in domestic
dor;1estic crude prices and the average
avera9e cost of crude
in
oil to domestic consumers. 281 Given the 18.8 percent disparity In

prices at the end of 1976, the equation Indicates
indicates an 8.2 percent rise

in the relative price of energy as the disparity is removed sometime
over the next three years.
The 8.2 percent rise in the relative price
~rice of energy in the
United States assumes no change
d1ange In
in the relative price of energy or
crude oil in the world market. To the extent that our imports of

is some possibility that the
energy resources would
1✓ould be reduced, there is
11ea1th
"dominant firm”,
firm", the OPEC producers,
wealth maximizing price of the “dominant

might change.

The fundamental question is the effect of such a U.S.

elasticity of world
v10rld demand for OPEC oil.
policy change on the elasticity

AA simple

reduction in demand is not likely to lower the relative price of OPEC
oiL
oil.

The relative price of oil and other energy resources would tend

1•mrld market only If
if demand
del1and became more elastic and
to decline in
In the world

this would not necessarily occur simply because of a reduction in U.S.
imports.

An increased responsiveness of domestic supplies to the world

tile elasticity of demand for OPEC oil and
price would tend to reduce the

other energy Imports
and, thus, tend to reduce the cartelized ;vorld
world
other
irnports and,
oi L However, only decontrol
decontrol of domestic energy markets would
price of oil.

ensure such responsiveness of domestic suppliers and such a policy does
does
not appear likely over the next three years. Taxing existing supplies
to
iriplies little or no
to raise their cost to the world level implies
responsiveness of domestic supplies to world
,1orld prices and, to the extent
such
actua1ly reduces that responsiveness, provides a
suth a policy change actually

case for an even higher
higher domestic and world
1-1orld price of energy resources.

Thus, an 8.2 percent rise in the relative price of energy resources
sometime over the next three years
yenrs appears
arrears to be a reasonable prospect.

~ntial0utut
The Future Gro11th Rate of Potential Output
In order to find the growth rate of potential output,
assumptions concerning the gro11th
growth of potential resources are necessary.
He briefly describe the assumptions
assur,1ptions which 11e
We
we use below,

In each case

11e
nost optimistic ai;mng
we have tried to choose the most
among alternative
assumptions.
assumptions~
The ilon-Private-Business
Non-Pri vate-Business Sector and Employment
Em yment Growth -- Hhile
While
- -

output outside the private business sector {PBS)
(PBS) has grown with time,
it is not significantly affected by
hy employment.
employrnent.

AA quarterly regression

of non-PBS
1oy1"ent, the unemployment
uner.1p 1oyment rate of the civilian
non—PBS output on emp
employment,

II/1977 indicates that
labor force,
force, and time for the period II/1948
11/1948 - 11/1977
—

only the time trend of

3.24 percent per year is significant (t=12,2).
(t=12.2).

,25.
The t-statistics
t—statistics of the insignificant variables are less than .25,
equation is adjusted for autore~ression
autoregression and has an R
R22 of .997 and
rercent.
standard error of 1.6 percent.

The

<Jrov1th rate of non—PBS
non-PBS output
The growth

during the past tvm
ii.c1s also been 3.24 percent, uhile
vias
two years has
while it was
lower (2,7%)
(2.7%) in the prior five years (11/1970
(II/1970 - 1/1975),
I/1975).
—

Thus, it

appears
arpears reasonable or perhaps
rerhilrs slightly optimistic
optfoi sti c to assume the trend
rate will continue.
Employrnmt
important because it
Employment growth in the non-PCS
non—PBS sector is important
grov1th of PBS potential e1:1ploy1.1ent
limits the growth
employment and output.

Er,1ployment
Employment

growth in the private
rrivate business sector contributes more to total output
er.,ploy,.1ent in the non—PBS
non-P1lS sector.
than an equivalent increase in employment

the post—war
post-war period, non-PBS
en;p 1oy1:1ent has grown
0rown more
r,ore rapidly than
non—PBS employment
potentiill or actual PBS
PCS employnent.
potential
employment.

tionethelcss,
riaintain an
Nonetheless, to maintain

growth rate of potential
optimistic bias in the 9ro11th
potential output, it
it is assumed
98

t~at the future growth
groc,c:h rate of potential enployr:1ent
that
employment in
In the private
DJ5iness sector
s,,ctor is the
ti1e same
sarae as the growth rate
,·ate of potential
potentia1 employnent.~
employment. 292/ f
business
1

us,i·no Clark’s
Clurk s estimates
csti01ates of
Potential employment growth is found using
civi-!ian labor force and full—employment
ful1-emp1oyr:;ent unemployment
unemp1oyt1ent
the potential civilian

9rm1th of
pi,tccnti a 1 employment
er•p i:,yment is 1.65 percent per
rate. The rate of growth
of potential

yeLJ.r while
tJhi le hours growth
9ro~-1ti'! is
"is 1.25
1 ~25 percent per year In
in the private
year

business sector from 11/1977 through 1980.
Hat1;; of the Net
i{et Stock of Plant
Pl ant and Equipment
The Growth Rate

-- The

——

.,·:.st difficult Groblera
•n assessing future potential output growth Is
1s
most
problem in
n,:,ng the growth rate o•
ti1e capital stock.
finding
of the

As Table 3 indicates,

ti:e growth of capital has
nas been
Deen relatively slow in recent years, but
the
sin
over
fow five year
yer.r intervals
i
over a few
In the past, has been at relatively

;'ap1d rates.
rates,
rapid

detemine whether
1·1i1ether the
Since it is difficult to determine

trac1sitional adjustment
adjust;;ient of the
tt~,e capital stock to a higher relative price
transitional
of energy is complete,
complete: 11 and also since future increases are likely whIch
which

rnay not
may
not have been anticipated by investors, a continued 1ow
low rate of
investment should be allowed
allm,,,ed for as aa possible outcome.
outcome" To do this,
this, we

include 2a low
10,1 esti1,1ate
9rov1th based on capital
Include
estimate of potential output growth
gcov:th of 11 .8
~3 percent per year, the rate of increase of the past two
growth

_years~
years.
optir,1istic measure of capital growth may be found from
AA r10re
more optimistic
9rov1th to potential output growth
grovJth before
the relationship of capital growth

1973.

(a1.nuu1 rate) of capital exceeds that of
The mean rate of growth (annual

Il/194S
potential output for the period 11/1948

~ IV/l973hy
L'/1'-173 by .55 percent.
percent,

—

rna.y be used to estimate
estir:1utc a rate of capital growth .55
"55
relationship may

uercent faster than the growth
orm,, th rate of potential output.
output.,
percent
1

This

Gro,1th ——
-- Trend growth Is
is allowed to remain at
Energy and Trend Growth
tile private business sector. The impact of
1.6 percent per year in the
energy developments may be seen more clearly by measuring the growth
rate of potential output assuming no change In
in the relative price of
betvieen now and the end of 1980. Coithlnlng
Combining the asstanptions
assumptions
energy between

above concerning potential resource employment with the production
function (4) yIelds
yields an annual rate of growth of potential output of 3.8
functIon
percent.

if Investment
investment continues to yield the low rates of increase In
in
If

pl ant and equi
pr,1ent of the last
1ast two years, the growth rate of potential
potenti a1
plant
equipment
would be reduced to 3.2 percent. The higher rate Is
is predicated upon a
much larger
larger rate of growth
grov1th of the capital stock (4.4 percent per year).
such
Only one of the five year intervals shown
shm·m in Table 3 shows growth of
the capital stock of 4.~,
reriod 1965 to
4.4 percent per year or above, the period
1970.

However, capital stock growth
arowth has attained this rate during
durina

perfon1ance, such as the mld—1950s
riid-1950s and
durina
other periods of peak performance,
and during

1973.
The
assur.1e no
The potential output growth rates of 3.2 —- 3.8 percent assume
in the relative price of energy.
eneruy.
change In

Accountin<J for an increase In
in
Accounting

tfoc over the next
the relative price of energy of 3.2
8.2 percent some time
grov1th from
frrn,i the present to
three years noticeably reduces the rate of growth
1930. The
the end of 1980.
The additional energy price change will very likely
ter,1porary shock with
v1ith i;1uch
its effect occurring over a
tend to be a teMporary
much of Its

short period of tir.1e.
time. nonetheless,
lionetheless, since the tinlng
ti11ing of the change is
inpact on
currently unknmm,
unknown, the best that can be done is to show its Impact
the gro1-1th
in the
tl1e
growth rate over the longer period. Such an increase In
relative price of energy
eneray reduces the naxiinum
uaxi1,1urn expected growth
grm-1th rate of

100

3.
3.88 percent to 3.
3.55 percent.

The i1,1p
1i cit rate of growth
grov1th of the capita
inplicit
capital1

stock to achieve this result is 4,1
4.1 percent, essentially the mean
annual rate of growth of capital fror.1
fron II/191\8
11/1948 through 1973.

If capital

grows at the rate of the last two years, 1.8 percent, the rate of
growth of potential
potentiul output will he
be only 3.0
3,9 percent per year, the rate
achieved so far since 1974.
1974,
The results frame the alternatives quite well.

Perry's
Perry’s

estimated grm1th
growth rate of potential output for the next few years is
rougilly equal to our highest estimate.
roughly

Cut that estimate
estimate requires
But

unusually rapid capital accur:iulation,
accumulation, consistent v1ith
with our estir.1ates
estimates of

hut probably not his -- and, more importantly it
the recent gap -- but
—

——

changes and their effect.
ignores the prospects of further energy cost chanaes
Accounting for energy price developrients
developments and assuming capital growth to
remain the same as the last two years results in a grov,th
growth rate of

potential output 1,1hich
which is the sane as that we have observed for the
last two years, 3,0 percent.

Finally, allowing
allol'ling for energy price

developments and a more historically normal
nomal pace of capital growth of
estimate equal to Clark's
4.1 percent under peak conditions yields an estimate
Clark’s

of 3.5 percent per year.
year.

Ue
regard a 3.5
,Je re9ard
3. 5 percent growth rate of

output to be a reasonably optimistic estimate
potential outrut
estimate of the
potential growth rate when the recent response of investment to energy
cost changes is considered.

Since the current G:IP
GNP gap is quite small
srnll compared to alternative
esti1nates, and since our investigation of the growth rate of potential
estimates,
suggests it will grow at a niaxir:ium
about 3,5
3.5 percent, we
vie conclude
maximum of about
that the econorny
vlill achieve full—employment
fu1l-ernploy1,1ent and peak operating
economy will

101

performance
perfonnance within a year if the actual growth rate of real output
since 1974 continues.

Unlike other studies of potential output,
output. we

conclude that more stimulative monetary or fiscal policies
policies are neither
necessary or desirable.

Canel us ion
Concl
Our n~asures
measures show the econor.iy
rercent of
economy to be producing over 97 percent
1977.
its potential at mid-year
mid~year1977.

In addition, our measures show

potential output to have grown
grmm at about aa three percent rate during the
recovery,
recovery.

The rate of growth of potential GNP for the remainder of the

most,
decade is about 3.5 percent, at most.
contrast to the mainstream view.

These findings stand in stark

Several recent studies have shown the

be seriously flawed,
basis of this conventional view to he

Nonetheless,

most observers are reluctant to alter their views
viel'ls on U.S. economic
perfonnance or the potential output growth
grov1th rate after 1973, apparently
apparently
performance
due to the power of historical extrapolation,
extrapolation.
Our conclusions follow from a theoretical analysis of the role

of energy resources and the relative
re 1ati ve price of energy in the production

process of the U.S.
tJ,S, economy,
economy. The empirical analysis of the
er,1ploy1,1ent supports
relationship of aggregate production to resource employment
the theoretical conclusions.
conclusions,

The anaiysis
analysis provides empirical estimates

production function parameters which allow
allo\'/ the quantification of
of production
effects of changes in the supply of potential resources on output

possibilities.

These estimates go well
v1e1l beyond the
tile specificity allowed

by other studies, which either fail to take resources such as capital

or energy into account, or 1·1hich
which fall back on standard assumptions
102

about some of the relevant coefficients.
Our potential output series reflects our earlier conclusions and

those added here.

In particular, the large increase in the relative

price of energy led to a change in the pattern of resource use which
constitutes efficient production, changing the demand for aall
11

resources, but, most importantly, permanently reducing the productivity
abor and capita
cost of
of existing 1labor
capital1 resources. Increases in the cost

energy over the last two yenrs,
years, and further increases yet to come
during the remainder of the decade, continue the negative
neg11tive energy cost
effect on potential output but to a lesser extent,
extent.

The direct

productivity effect of the higher cost of energy is compounded by an
indirect effect temporarily reducing the rate of capital accumulation.
accur,1ulation,
The reduced incentive to invest was shovm
shown to be due to both the reduced
productivity of the services of existing capital and its increased

replacement cost,
cost.

These conclusions are supported by the unusually

sluggish growth of capital since 1974.
,fo
stinulative denand
r1anagement policies are
We have argued that stimulative
demand management

both unnecessary and inflationary,
inf111tionary, and that at potential output the
federal budget shows a very large deficit.

The economy will
will very

likely achieve its potential output rate within a year with only

moderate grm1th.
growth.

Carlson
1977, Review) has verified that,
that,
Garison (August 1977,

rather than aa high employment bnlanced
be the
balanced budget in 1977, as would he

1d CEA measures
neasures were correct, the high—employment
hi gh-erir 1oyrnent deficit
case if
if the oold
is currently about $20 billion.

Thus, within a year
it will
11ill become
3iear it

virtually impossible to postpone critical fiscal decisions concerning
permanent financing
financinCJ of the existina
the means of permanent
existing and/or desired role of
the federal government in a markedly changed American economy.

103

Footnotes

1J See Business Heek,
]J
Week,
y2/ Ibid., p. 77.
'}I
~f See Roger Brinner,

(June 9, 1973), pp. 76 - 77.
—

"Potential
‘Potential Grov1th
Growth to 1980,"
1980,” Otto Eckstein et.
al., Economic Issues and Parameters of the flext
Next 4 Years,
Lexington, nassachusetts:
Data Resources, Inc.,
Inc., Economic Study
t~’xington,
NassacThii~’E~:Data
Series, 1977, pp,
17.
pp. 99 - 17.
—

especi a 11y Denis S.
s. Karnosky, "The
4/ See especially
“The Link Between Money and Prices
- 1971—76,”
1971-76," Federal Reserve Bank of St. Louis, Review June
1976, pp. 17 - 23.
—

—

§j
~ References to our May and June papers throughout are: Robert H.
Rasche and John A.
/\, Tatom, "The
Regir.ie
“The Effects of the flew
New Energy Regime
on Economic Capacity, Production, and Prices,"
Prices,” and "Energy
“Energy
Resources and Potenti
a 1 GNP,”
GllP," Feder
a 1 Reserve Bank of St. Louis
Potential
Federal
Review ilay
[lay and June, 1977, pp. 2 - 12, and pp. 10 - 23,
respectively.
respecti vely.
—

§/
y

—

Brookings
Papers on Economic Activity, 1:1977,
:1977, pp. 11 —47.
- 47.
Brg9ki!
?.~zem,~!LEconomis.Activit,

ZJ This
2/
This contrasts
contrasts
§/ The derivation
~/

with his
his opinion
cited above.
above.
with
opinion in
in 1973
1973 as
as cited

of this specification is indicated in our June Review
paper. Note in particular that it assumes that the aggregate
demand for energy is on a de1nand
demand curve 1-1ith
with unitary elasticity
with respect to both output and relative price. This is aa
relatively comon
common assumption
assu~1ption when working with time series data
generated over annual intervals.
intervals, On the other hand, this
condition is less likely to be satisfied over shorter time
quarter. Under such circumstances, it is
intervals such as a quarter,
more conrion
corrmon to specify partial adjustment models 1·1hich
which have
smaller impact elasticities. For a discussion of the biases in
our estimates of the output elasticities which
which result from
impact elasticities which
,1hich are smaller than unity, see Appendix
II of our June paper. In addition, partial adjustment
mechanisms for factor demands, such as that specified by 11.
it I.
I.
Nadiri and S. Rosen, “Interrelated
''Interrelated Factor Demand Functions,”
Functions,''
457-71, would
American Economic Review, September 1969, pp. 457—71,
suggest that the above equation may he
be misspecified by the
omission of lagged values of all factors. It is not clear that
such a source of potential specification error
error would
systematically bias our regression coefficients in one
direction.

y9/

See John C. i·lusgrave,
"Fixed Nonresidential Business and
Musgrave, “Fixed
Residential Capital in the United States, 1925-75,"
1925—75,” ~Survey
of Current Business April 1976, pp. 46 - 52.
—

104

10/ The minor
lQ/
minor differences from the results in Appendix III of our June
article arise due to BLS data revisions and revisions in the GIIP
GNP
accounts.

jjJ
111

The constrained estimate yields a measure
rr.easure of the output elasticity
elasticity
of labor equal to 64.3 percent and quarterly trend growth rate
of .41
,41 percent. The Durbin-Hatson
Durbin—Watson statistic for the equation is
1.91, the estimate of rho is .78,
,78, and the standard error of the
regression is ,0077.
.0077,

lY
j~/The

standard error
error of the equation below is identical to that using
the unemployment rate to four decimal places.
places,

13/ The error pattern without any adjustment indicated a smooth phasing
in and out of the shift
shift over a four quarter period, thus, the
dummy variable was allowed to increase from zero to one in steps
of one—fourth
one-fourth and conversely to decrease at the end of the
period in the same v1ay.
way, Of course, this phasing in and out led
to a reduction in the standard error of the hours per worker
equation.
with such an hours per
14/ The weakness associated ,lith
especially with the adjustment
adjustment for the unusual
the 1960s,
a 1so been noted by Perry (1977,
( 1977,
l960s, has also
a similar equation for hours per worker in the
sector.
sector,

worker equation,
developments in
p. 31).
31), He used
nonfarm business

A
Clark's method for deriving the full-employment
A description of Clark’s
full—employment
unemployment rate and the potential labor force may be found in
GNP," Council
Council of
Peter K. Clark, "A
“A Nevi
New Estimate of Potential GNP,”
Economic Advisers, 1977; processed.
Output,"
16/ See Ronald J. Talley,
Tailey, "Some
“Some flew
New Estimates of Potential Output,”
]!I
forthcoming in American Statistical Association, 1977 Proceedings
of the Business and Economic Statistics
Statistics Section,
·

ia~

]lJ See \·Jalter
U. Heller, "Productivity
fl/
Walter W.
‘Productivity and GNP Potential,"
Potential
,“

Wall Street Journal, June 29, 1977.
l1. Heien,
18/ See Albert J. Eckstein and Dale ii.
Fleien, "Estimating
“Estimating Potential
.1§./
in a Model Framework,”
Framework," Achieving
Output for the U.S. Economy in
Achievin the
Goals of the Employment
Anniversary Review,
Em lo ment Act of 1946-Thirtieth
1946—Thirtieth Anniversar
eview,
U.S. Congress, Joint Economic Committee, 94th
9 t Cong., 2ncfsess.,
2n sess,,
25.
December 3, 1976, pp. 11 - 25,
—

Y1J
12/

See the
the comment
Otto Eckstein,
Eeks tei n, ~Brookings Papers on
Economic
See
comment by
by Otto
on Economic
Activity,(I:1977, p. 53.
~jvit,(I:1977,

20/ G. Cain &
eds., "Income
& H. Watts, eds,,
“Income Maintenance and Labor Supply,"
Supply,”
(Nevi
(New York: Academic Press, 1973).

105

21/ The model by Eckstein and Heien (1976) suggests a slight positive
increased energy cost.
cost.
effect on the labor supply due to the increased
However, it is not clear
clear whether they estimate the relevant net
effect or one of the components.

W
ggj/ Capital embodying different technologies is not differentiated

here. Presumably some substitution toward less energy intensive
processes would stimulate demand for certain kinds of capital
goods while reducing that of other capital and the total demand.

Also, the analysis follows the usual convention in assuming the
•

real rate of return demanded by lenders and equity owners and
that used by investors in discounting income streams is
unchanged.
unchanged,

23/ This result is demonstrated in our 11ay
article.
lay (1977) Review article,

24/ The graphical analysis is adopted from
fror1 Leonardo Auernheimer,
"Rentals,
“Rentals, Prices, Stocks and Flows: AA Simple 11odel,"
Model,” Southern
Economic Journal, July 1976, pp. 956-59.
956—59.
—

g~/If

price of new capital goods is independent of
the long-run
long—run supply price
price and
the output rate, the result is unambiguous as both the price
rental price of capital goods are higher in the new steady-state
solution.

26/ AA discussion of the unusual behavior of non-residential
non—residential fixed
investment in tile
the recent past may he found in Jal—Hoon
investnient
Jai-Hoon Yang’s,
Yang's,
"A
Recovery," Federal
“A G1lide
Guide to Capital Outlays in the Current Recovery,”
Reserve Bank of St. Louis, Review, February 1977, pp. 22 - 7.
—

evaluation of recent energy regulation
regulation in the United
27/ AA review and evaluation
States may he found in Paul W.
\/, flacAvoy,
rlacAvoy, ed., Federal
American
Energy Administration Regulation, Washington,
llashington, D.C.: Arierican
Enterprise Institute for Public Policy Research, 1977.
1977.
Enterprise
28/ In the levels form, the equation has a RR2 of ,93
.98 and standard error
,012. The price of crude
crude oil coefficient, .45
,45 (t == 5.65), is
of .012.
Is
in agreement
agreement with that reported above. The rho statistic has a
value of .97.
• 97. Thus, the first difference form is cited in the
below.
text and used be
lov1.
assumrtion is also made by PP.rry
29/ This assumption
Perry (T11ble
(Table 14, p. 45) and may
unusually r11pid
contribute to his unusually
rapid rate of growth conclusion.

106

WILL BOTTLENECKS SLOW THE EXPANSION?
William D. Nordhaus
The topic of this conference is indeed an ii1portant
important one,
one. Although
currently the United States economy suffers from considerable excess caca—

pacity, both in labor and in product markets, we hope that this condition
forever.
will not last forever,

What II would like to discuss this afternoon is

marthe state of utilization and the extent of imbalance
imbalance in different markets, and possible strategics
strategies for avoiding bottlenecks during this
rec ov cry.
recovery.

of the Recession
The Legacy
L sLfthef~s~ssiofl
Starting
Starting roughly five years ago the world economy was struck by a
cu1m 1nated in the worst inflation, and thereafter
series of shocks which culm~nated

the worst recession, of the post—war
post-war era,
era.

A
A simultaneous boom in all

the industrial countries led
le,1 to severe capacity shortages in major ininindustries,
dustries, especially materials
materials industries.

Following the 1973 boom, and

the food and oil inflation that succeeded
succeeded it, virtually every major inindustrial country suffered aa severe recession,
recession.
1972—73, together
The imbalances that developed in the boom of 1972-73,
with the devastating effects of the oil and grain shocks were enough to
downturn,
cause a downturn.

But the fiscal and monetary authorities added their

influences,
own restrictive influences.

Thus, examining
examining the OECD area:
area:

DFN~flEiusiTTmeThBeroTf1irPresident’sCouncil
Dr. Nordhaus is a member of the President's Council of Economic Advisers.
107

The narrowly defined money supply (M-1)
(N-i) decelerated
frOm an annual growth rate of over 12 percent at
from
the beginning of 1973 to below 77 percent at the end
of 1974.

OECD were rising at approxiapproxiSince prices in the OECO
mately 13 percent annually, this means that the real
money supply was falling
f~]jjn at almost 6 percent per anannum by the end of 1974.

short-term
As a result of the monetary stringency, short—term
rates rose from around 66 percent at the beginning of
1973 to 11 percent in the second half of 1974
1974 and
long-term rates rose about a point and aa half,
half.

afFiscal policy turned sharply toward contraction after the 1973 boom. Real government expenditures
from 1973 to 1974 rose only 11 percent in the United
States and United Kingdom, 44 percent in Germany, and
fell in Japan,
Japan.

The effect of these forces is by now well known.

One particularly

disturbing legacy of the recession has been its effect on investment and
thereby the level of capacity in the United States and abroad.
abroad,

Although

measurement of capacity is quite difficult, the estimates show a signisignificant decline in the growth of capacity in manufacturing industries
industries
over the last ten years.

From 1948 to 1968,
1968, growth of capacity in manumanu-

facturing averaged 4.5 percent per year,
year.
rate dropped to 4 percent per year.
year.

From 1968 to 1973, the growth

But in the period from 1973
1973 to 1976,
1976,

capacity grew at only 33 percent per annum.
annum, This means that over the
last three years, the growth of capacity has not matched what we would
would
need to keep up with potential output -- even with the most pessimistic
--

of the estimates of potential that we have heard today.
capacity
Examining the latest data, we see that the growth in capacity
leaves much to be desired, as is shown in Table 1.
1,

108
108

1.
TABLE 1.
Rate of Growth in Capacity 1976:2 to 1977:2
Manufacturing
Manufccturing

2.8%

Primary processing 3.2%
Advanced processing 2.5%
Materials
Basic
Basic metal
Textile
Paper
Chemical
Energy

•

1.4%
2.1%
3,0%
3.0%
4.8%
2.3%

For all of manufacturing the growth rate of the last year has been less
less
than 3 percent, with basic metal materials showing the smallest increase
and chemicals showing the most rapid.
It is clear that the recent slowdown in the growth of capacity
must be reversed.

noninflationary expanexpanWe cannot hope to sustain a noninflationary

withsion over the next three or four years, reaching high employment, without a major acceleration in the growth of capacity.

The Current Imbalance in Labor and Product Markets
Given the slow growth of capacity during the current recession, it
is inevitable that an imbalance between labor markets and capital or
product markets arises.

clear what the nature of this imTo make more clear
im-

balance is, let us consider capacity output as it is distinguished from
potential output:
o

~Potential output is conventionally defined as the
would be produced at a reference
level of output that would
unemployment rate, or weighted unemployment
109

rate,
conrate. In computing potential
potential output, it has been conventional (up until recently) to assume that there are
no capacity constraints. This can be rationalized by
assuming that,
that, through the accelerator principle on
investment, the level of capacity adjusts with a disdisdemand,
If this is the
tributed lag to the level of demand.
case, and if labor is inelastically
ultinelastically supplied, the ultimate constraint on output is labor input rather than
capital.
oo ~
Capacity output can be viewed as the level of output
which can be produced with the current capital stock.
Clearly, the definition of capacity differs across inindustries, both because of flexibility of productive
techniques in some industries and the possibility of
others, Nevertheless, expecially in
shift work in others.
continuous
continuous processing industries, capacity has a defdefinite meaning.
It is useful to compare the state of utilization of labor and
product markets by looking at what will be called the full employment
~
capacity utilization.

To calculate the full employment capacity utiliutili-

zation index, we need to know the relation between capacity utilization
and the level of unemployment.

capacity,”
Then, using an “Okun’s
"0kun's law for capacity,"

we can estimate what the level of capacity utilization would be if the
1’ We have taken the "full
unemployment rate were at “full
"full employment.
employment.”,,y
“full

employment"
weighted-average unemployment rate used
employment’ definition to be the weighted—average
in the CEA potential output series, this corresponding approximately to

a 55 percent rate today.
We have investigated the relationship between these two series
over the last twenty years, using a number of alternative techniques.

Figure 11 shows the result of one of these experiments.

According to

this graph the period from the mid-1950s
mid-l950s until the mid-l960s
mid-1960s showed aa
gradual upward creep in the full employment capacity utilization index.
Then starting in 1965 and lasting until approximately 1970, there was a
110

capacity Utilization
Utilization (Percent)
(Percent)
Capacity
iL
92

—

I
/I
I/
I/
I/

/\
1\

‘I

Full-Employment
Full—Employment

\
\

'--,

I/
/I

I
—

-J
~

80
80

—

I
I

—

I\
I '
I \\ \

/
78
78

I
I
\

\‘I I
\I

I
I
II
I
I/
I
I
I

I
I
\
\

/I
84

I
Actual
Actual

—>

I
I

I
\N

I
I

\
\

\
I

I
\
\
I

\
\ I1~
It I/
\I!
I, I
—

\ I
\I

I
74

\
~

—

I
I
I
I
72 '--...l...-1---l..-.L.-...L.-1--...L.-.L--1--'---1--'----'--'---'--'----'--'---'
I
I
I
1
.1
I
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1964
1966
1968
1972
1974
1976

Figure 1.
Figure

Actual
Capacity Utilization
Actual and Full—Employment
Full-Employment Capacity
Utilization
(Federal
Index)
(Federal Reserve
Reserve Index)

dramatic decrease in this, reflecting the potency of the investment
boom of the 1960s.

Starting in 1970, however, there was a definite

and sharp upward rise in the full employment capacity utilization

index.

Over the last six years full employment capacity utilization

has risen from approximately 81 percent to the current level of 91

percent.
percent.
indication
The full employment capacity utilization index is an indication
of how tight product markets in manufacturing would be, today, if we
were at full employment (and potential output as defined above).
can be compared with historical experience.

These

The capacity utilization

rates of the Federal Reserve Board, which we are using here, averaged
about 83 percent for manufacturing for the period 1955 through 1975,
and about 86 percent for industrial materials from 1967 through 1975.
1975.
The highest level of the capacity utilization index for manufacturing
perwhich has been experienced for an entire year since 1948 was 91 per1966. The most recent period of high utilization was in 1973.
1973.
cent in 1966.
In that year capacity utilization in manufacturing averaged 88 percent,
while primary processing industries had aa utilization rate of 92
percent.

What are the implications of this apparent rise in the full
employment capacity
capacity utilization
utilization index?
index? The
obvious point
point is
is that
that we
employment
The obvious
we
cannot expect to have high levels of employment without one of the
three following possibilities:

1) a significant investment boom;

2)
change in
in the
from manufac2) aa major
major change
the composition
composition of
of our
our output
output away
away from
manufacturing and materials; or 3) operating rates in manufacturing and

materials which are well above those which are normally experienced.
materials
112

Or put differently, it is clear that if the capacity and utiliutilization data of the Federal Reserve Board are relatively accurate, then
zation,data
there is currently insufficient capacity to sustain an inmediate
imediate

gallop to full employment.
Returning to our earlier discussion, we noted that one of the
most significant bequests of the recent recession was insufficient
investment.

Before the recession got underway, our index
index was considerconsider-

ably lower: thus in 1973 the full employment capacity utilization
index was 88 percent, 33 percent lower than it stands today.

The inin-

vestment slump and associated problems of the last three years have
apparently raised our full employment capacity utilization index three
full points.

The Break-even Capacity Utilization
Why has the growth of capacity not kept up with the growth of
potential output? This is the other side of the question, "why
“why has
badly during the current recession and recovery."
investment lagged so badly
recovery.”
CEA has studied the reasons behind the investment lag, using aa
number of economic theories of investment.

Although different models

give different
different answers, the basic reason -- and one that can hardly be
-—

surprising -- is that the demand for future capacity is performing
——

today’s capacity has been
been
poorly because the level of utilization of today's

so low.

There are other factors as well -- environmental regulations
--

certainly have raised the cost of additional capacity in many heavy
industries (steel, utilities, and chemicals being among the most

113

heavily affected).
affected).

In addition, the depressed state of the stock

market hardly is conducive to new ventures, although -- to be sure ---

stock market prices (and in particular the ratio of market value to
Q) have reflected quite closely levels of utilizautilizareplacement costs, Q)

tion of capacity
capacity over recent years.

Finally, there has been aa clear

shift in the composition of investment away from long-lived investinvestmen
ts
ments

especially structures -- and toward equipment.
--

Nonwithstanding the caveats, however, it is probably the case
that the major reason for the depressed state of investment is the low
levels of capacity utilization the economy has experienced over the
last three years.

We know that very low levels of utilization -—-

operating through the accelerator mechanism -- lead to aa slowdown in
--

investment and in the growth of capacity.

If capacity is below
below some

"break-even"
“break—even” point, and investment therefore insufficient to keep
capacity growing rapidly enough, we may actually be in the situation
where capacity is growing
gro~iing less rapidly than potential output.

The full

employment capacity utilization rate would therefore rise and the imimbalance between labor and product market would widen.

It is ironic

that in pursuing an anti-inflation policy which keeps the level of

slack in the econoroy
economy very high, we have created a situation in which
future bottlenecks become more likely.
As aa way
way of
of illustrating
illustrating the
the relation
the growth
of
As
relation between
between the
growth of
capacity and capacity utilization, we have run aa standard investment
investment to the rental
equation. The equation relates the level of investment
cost of capital and non-linearly to the level of capacity utilization.

114

Then by taking into account the historical relation between investinvest-

ment and capacity growth, we can ask whether the level of capacity
h·igh to assure that capacity growth
utilization has been sufficiently high
is as rapid as potential output.
relation between
Figure 22 shows a graphic representation of the relation
difference,
capacity utilization and capacity-potential difference.

In making

this relationship, we have assumed that the real cost of capital (in
terms of percent per annum) was at its post—war
post-war average, so that there
tenns
was no extraordinary push or pull from monetary or fiscal incentives.

difference between the growth
The figure
figure shows quite clearly that the difference
of measured capacity and potential output is positively and nonnonlinearly related to the appropriately lagged rate of capacity utilizautilization.
One can calculate from such aa relationship, assuming no change
in the historical level of capacity utilization at which the capital
break-even
stock has grown at the same rate as potential output, the break—even
utilization rate.

This presumes, as has been the case recently, that

-- if imbalances are not to appear -- potential output will grow
--

approximately 1.2 percent per annum faster than the capital stock.
According
relationships, the
the break-even
break-even capacity
capacity utilutilAccording to
to these
these relationships,
ization point is around 84 percent. That is to say, when capacity
utilization is 84 percent, and assuming the relationship is the same
as in the historical period, capacity output will be growing as
rapidly as potential output.
output,

On the other hand, if utilization is

lower than this -- say the 74 percent in 1975 or 80 percent in 1976

115

——

• 08

Difference
Difference
between growth
of capacity
capacity
and growth of
potential outoutput (per annum)

·~-..,., ~---

I
I

•

I
.06

I
I

•
•

.04
. 04

l
I

.02
.02

-1

-a

•

-S

"
------=-•..,_,-------=+1~.,----''0

•

S
0~

•

-.02
—.02

•a
.04
-.04

• S

~a
S

—

•

eec

a.,,

•1

•
a

••

S
*

•

a
a

.•.
S

C—
40
0
C

.
•

a
C

.. I --

•

.ISI ..

.4.. .

...•• ••
5,

0~’

•

•
Break—even
Break-even
capacity
capacity
utilization
utilization

a0
‘a.
•••

•

_.0670

.75

.90

.95
.95
Average capacity
capacity utilization

Figure 2. Relationship between lagged
lagged average capacity utilization
utilization and
and the
growth
of
capacity
relative
to
potential
output,
1955-76.
The
level
of
growth of capacity relative to potential output, 1955—76. The level of
capacity
at
which
capacity
and
potential
output
grow
at
the
same
rate
capacity at which capacity and potential output grow at the same rate
("break-even
utilization") is
is estimated
to be
be 84
84 percent.
percent.
(“break—even capacity
capacity utilization”)
estimated to

incentives to invest are insufficient to keep the capital stock growing
as rapidly as potential output.
It appears that even today we are below the break-even
break-even point, for
over the,last
thelast few months capacity utilization in manufacturing has been
averaging only 83 percent.
To summarize the evidence up to date:
doxical situation.

we are faced with a parapara-

Capacity output has been growing more slowly than

potential output for some time now.

Yet, we are constrained from having

a rapid growth in actual output because of the fears in many quarters
other hand,
of getting too close to the inflationary shoals. On the other
if we stay too far away from our objective
objective of high levels of employment
and utilization, we see that capacity will grow too slowly for us to

reach our ultimate target.

Thus,
historical
Thus, again according to historical

relationships, if we were to stay at a utilization rate of 83 percent
for an extended period of time, our full employment capacity utilizautilization index would continue to rise.

Speed Limits to Growth?

We have seen that there is aa fundamental dilemma which the econeconomy faces over the next four years.

A
wfll
A path of immediate recovery will

clearly lead the economy onto the shoals of capacity bottlenecks.

the other hand, a path of very slow growth, with capacity utilization
break—even point, will lead to an increasing
below the break-even
increasing secular diverdivergence between potential output and capacity output.
optimum lies somewhere in between.

117

Clearly the

The fly wishes to get as much of his tasty dinner as he

can, but in doing so he risks the danger of overshooting his dinner
and getting stuck on the flypaper.
Of course the flypaper problem is exactly the problem we have
been discussing up to now.

If we stay too far away from potential outout-

put and capacity in the hopes of avoiding the inflationary shoals, we
inflation, but we are risking future ininwill indeed not risk present inflation,
flation by building insufficient capacity to prevent future bottlebottle-

necks.

On the other hand, if w,,
immediate
we pursue the strategy of irrniediate

recovery,
we risk encountering inflationary bottlenecks immediately.
immediately, if
recovery,-we
we encounter exogenous disturbances which lead us to overshoot capacity

and trigger inflation.

Ther,.,fore, like our friendly fly, we must get
Therefore,

employment
close enough to capacity t)
to get investment, output, and employment
high, but at the same time not overshoot our target.

ies for The Recovery
Recover
Strategies
Given our current economic situation -- high levels of unemployunemploy—-

ment and the high level of the full employment capacity utilization

rate -- this suggests aa strategy for the recovery must take into
-—

account both factors.
oo We must assure producers that they will have
adequate markets to sell their output. This imimplies
that
the
levels
of
capacity
utilization
must
plies that the levels of capacity utilization must
be
above
the
break-even
point
-and
soon.
be above the break-even point
and soon.
--

118

The problem is what I will somewhat whimsically call the flyflypaper problem. A
A hungry fly sees a delicious morsel of fly food across
the room, but unfortunately the morsel is very close to a sticky piece
much of his tasty dinner as he
of flypaper. The fly wishes to get as nijch
can, but In
in doing so he risks the danger of overshooting his dinner
and getting stuck on the flypaper.

Of course the flypaper problem is exactly the problem we have
been discussing up to now.

If we stay too far away from potential out
out-

put and capacity in the hopes of avoiding the inflationary shoals, we

will indeed not risk present inflation, but we are risking future inin-

flation by building insufficient capacity to prevent future bottlebottlenecks. On the other hand, if we pursue the strategy of inrediate
immediate
necks..
immediately,
recovery, we risk encountering inflationary bottlenecks inrediately,
if we encounter exogenous disturbances which
1-1hich lead us to overshoot caca-

pacity and trigger inflation.

Therefore, like our friendly fly, we

must get close enough to capacity to get investment, output, and enploy—
employment high, but at the same time not overshoot our target.

Strategies for The Recovery
Given our current economic situation -unemploy-— high levels of unenploy—
ment and the high level of the full en~loymentcapacity
employment capacity utilization
must take into
rate -—— this suggests a strategy for the recovery iwst

account both factors.
o We must assure producers that they will have adequate marmarimplies that the levels of
kets to sell their output. This iwlies
-capacity utilization must be above the break-even point ——
and soon.
prooo At the same time we must recognize that our labor and pro—

119

means that
o duct markets are badly out of balance. This means
our recovery must proceed in an orderly fashion as
investment accelerates and capacity output recovers its
growth.
imbalance between capacity and potential output
oo The inthalance
must be taken into account in our overall fiscal and

monetary policy. It would be extremely untimely for the
monetary authorities to slam on the brakes at that point
investment. And our fiscal and
when we so badly need Investment.
tax policy oust
must recognize the central importance of spespecial incentives to invest during the next few years.

is the one on which I would like to close.
This last consideration Is

As I have indicated today, our capacity output does not dovetail with
the social and economic needs of today.

In designing the major fiscal

pol icy actions over the next two years, we must taken into account the
policy

needs for capacity expansion.

careThe Administration is considering care-

fully the possibility of giving special incentives for investment in
short-run to aid the growth of capacity.
the short—run

It should be emphasized that -- while it is always nice to have
-—

-- the needs over the next few years are particuparticuadditional capacity —-

larly critical.

If we are to succeed in reaching a noninflationary

profull employment economy, we must assure that capacity expansion pro-

ceeds at a sufficient pace.

I expect that the Administration will

propose tax measures especially designed to encourage the growth of
ity over the next few years.
capacity

We hope that a climate of cooperacoopera-

on from the monetary authorities and the business coni,unity
community will
tion

make sure that, in fact, capacity bottlenecks do not slow the current
recovery.
Footnote

l/
jJ

"straight up”
up" increase in outoutNote that the calculation is a “straight
calput and utilization, like that customarily employed in cal''gap.''
culating the “gap.”
120

SHORT TERM PROJECTIONS OF MANUFACTURING CAPACITY UTILIZATION
James F.
F, Ragan, Jr.

As the papers presented
presented at this conference demonstrate, there
there is
a divergence of views as to whether current measures of capacity utiliutilization overstate or understate the amount of untapped capacity remainremaining in the economy.

I want to sidestep
sidestep this issue, concentrating
concentrating

instead on one widely used measure of capacity utilization:

Fedthe Fed-

eral Reserve Board’s
Board's capacity utilization rate for manufacturing,
manufacturing.

rn
In

particular, II want to discuss aa simple model which can be used to

project manufacturing capacity utilization, as published by the Board,
over the next couple of years.

Those, including certain members of the

Board’s measure of
Federal Reserve Bank of St. Louis, who feel the Board's

probcapacity utilization is biased downward may argue that capacity problems will develop sooner than our model predicts; those who feel
current measures of capacity utilization are biased upward may take the
opposite view, arguing that capacity problems will not emerge until
later.

Nonetheless, examining when capacity is likely to become

strained--at
Board's capacity utilization
strained——at least on the basis of the Board’s
statistic--is
statistic—-is an interesting experiment and provides a useful benchmark
for discussions about prospective capacity problems.

Indeed, to leak

Or.
professor of Economics
Economics at Kansas State UniUniDr. Ragan is an assistant professor
versity. The author thanks Robert Falconer and An-loh Lin for comments
on an earlier version of this paper and Debbie Jamroz for research
assistance.

121

one of our findings, it is not necessary to take the "St.
Fed's"
“St. Louis Fed’s”
position that currently published measures of capacity utilization are
artificially low to show their concern about
about potential capacity probproblems within the next couple of years.
The model presented in this paper is for the key sector of manumanufacturing, although the technique can be applied to other sectors of
the economy as well,
well.

First, an equation
equation is estimated linking growth

in manufacturing output to growth in GNP.

Next, additions to manumanu-

facturing capacity are estimated, based on projections of investment.
The forecast of output is then divided by the forecast of capacity to
yield projections of capacity utilization.
utilization,

The model is first used to

project capacity utilization from 1977 III - 1978 IV, based on aa
—

"consensus" forecast of GNP growth.
“consensus”

Next, implications are drawn concon-

cerning the impact on capacity utilization of strong protracted econeconomic growth, the Administration’s
Administration's assumption.

Specifying the Model
Manufacturing output and GNP tend to move together.

In growth

terms, the relationship between
these two variables can be specified
betweenthese

as)/
as:1’
p

I°P
t

a 1 GNP t

(1
1)

0
Percentage change in the manufacturing index of indus—
indusII°P
Pt == trial
production,
i.e.,
100
/
trial production, i.e., 100 (IPt - IPt_ 1) / IPt-l.
-

0
0

GNP
GNPt
t

=
=

Percentage change in constant-dollar
constant—dollar gross national
product.
product.

122

"t =
Error term.
= Error term.
The change in capacity from one period to the next depqnds
dep~nds
positively on the volume of investment and negatively on the extent of
depreciation, which in turn depends on the level of capacity last

period.

(See Appendix l1 for greater elaboration.) The change-inchange—in-

depicted as follows:
capacity equation can therefore be depicted

C~ Ct1

= biCt1

b2It

(2)

Ct== Capacity index for manufacturing.
It== Real
Real manufacturing
manufacturing investment
net of
of pollution
pollution
investment net
control
expenditures.

= Error
=
Error term.

As many economists have observed, investment accelerates as
utilizathe volume of unused capacity shrinks, i.e., as the capacity utilization rate (CU) rises.

Changes in investment
investment are therefore specified to

be a function of past changes in capacity utilization:
00

= c c C°U~ +e~
I =c
1
1
t
00

(3)

It== Percentage change in investment
investment (I) from the
previous calendar year.

C°Ut1= Percentage change in capacity utilization (CU)
over the previous year (fourth quarter to
fourth quarter).

Et=
=

Error
Error term.

Although this equation greatly abstracts from the underlying determindeterminants of investment, it performs well empirically.

Another advantage of

this specification is that
that the capacity utilization rates generated by

123

our model can be used to project investment in subsequent years. That

is, when combined with GNP projections, equations (1), (2), and (3)
constitute a closed system capable of projecting capacity utilization
rates indefinitely into the future.

Empirical Results
Equations
were estimated
estimated over
over the
the perio4
periorl 1954-1976.
1954-1976.
Equations (1)
(1) -- (3)
(3) were
apparResults are reported in Table 1. From the first equation, it is apparis more volatile than GNP; the large
ent that manufacturing output Is
0
0

coefficient for GNP indicates that rapid GNP growth is on average
accompanied by even more rapid growth in manufacturing output. The
Ct-l in equation (2) indicates that, in the absence of
coefficient of ~

investment, capacity declines 3.35 percent per year, the result of
It indicates that
depreciation and obsolescence. The coefficient of I~indicates
each one billion dollars of non-pollution-control investment
investment expendexpenditures, measured in 1972 dollars, increases the capacity index
(1976 IV
IV= 163.2) by 0.29 percentage point.

Converting the investment

coefficient to an elasticity, each 1.0 percent change in real investinvestment net of pollution control is on average associated with aa 1.0
per1.0 percent change in gross additions to capacity (as opposed to net additions,
i.e., additions net of depreciation4~
depreciation.)Y Finally, as expected, equation
(3) indicates that investment accelerates as capacity utilization
rises.
The fit
fit of all three equations is quite good, as judged by the

R2
from zero.
R2 values, and all coefficients are statistically different from

124

Table 11
Regression Results*
(t-statistics in parentheses)

(t—statistics in parentheses)
0

I°Pt
1°pt S= —.756
-.756 + 2.203 GNP
GNPt
( 4.22) (16.46)
( 4.22) (16.46) ~
2
SE=
RR2 = .751
SE = 1.37
DW == 1.85
Sample
Period:
1954
I
1976
IV
Sample Period: 1954 I
1976 IV

(1)

C—C
Ct-Ct-l = —.0335C
-.0335 Ct-l +.29231
+ .2923 It
(3.23)
(7. 10)
t t—l (3.23) t—l (7.10) ~
R2 == .935
SE=
p = .578
SE = .576
Sample Period: 1954 - 1976
Sample Period: 1954 1976

(2)

DW == 1.70

It=
C Ut l
I = 4.196 + 1.754 c°u
(2.97)
(2.97) (6.55)
~0

(3)

2
R == .671

SE=
SE = 6.74
Sample Period: 1954 - 1976

DW == 1.71

r00 p =
Note: I°P
GNP=
GNP
CC =
I =
I=

Quarterly growth of manufacturing output
Quarterly growth of real gross national product
Index of manufacturing capacity
Real manufacturing investment net of pollution control
expenditures
0
cC°U
u == Growth
Growth of
of capacity
capacity utilization
utilization in
in manufacturing
manufacturing

The Cochrane-Orcutt
Cochrane-Orcutt iterative
iterative technique
technique was
was used
used to
to adjust
adjust
* The
first—order autocorrelation in equation (2).
for first-order

125

Even more important, simulation results (presented in Appendix 2)

indicate that the model
model does aa good job of tracking capacity utilizautilization during the current recovery,
recovery.

Having passed this test, the model
model

was then used to run two experiments, described in the following
sections.
sections.

~ec~nCaacitUtilization,
Projecting
Capacity Utilization, 1977 III - 1978 IV
-

Based on the increase in investment projected for 1977
0
3/ -- capacity is projected to increase by 3.2
= 12.9
12.9
percent~/
r177
percent77
percent between 1976 IV and 1977
IV, The increase is assumed to be
1977 IV.
--

distributed equally throughout the year, implying a quarterly growth

percent.11 Output growth is projected using the
in capacity of 9.791 percent.~”
median of eight prominent forecasts of real GNP growth, as published
1s Statistical
in
Board's
In the September 1977 issue of the Conference Board
Bulletin (see Table 2).

The output growth and capacity expansion propro-

jections are brought together in Table

3.Y
3,~.1

Based on the Conference

Board median GNP forecasts, our model projects that capacity utilizautilization in manufacturing will increase steadily to 85.8 percent in 1978 IV.

Capacity will expand at aa 3.2 percent annual rate in 1977 and at a 3.9

manupercent rate in 1978, compared to the 2.3 percent rate of 1976; manufacturing output will increase over the forecast period at an average
annual rate of 6.3 percent.

The 85.8 percent rate projected for 1978 IV is but 22 percentage
points below the 1973 quarterly peak and 2.8 percentage points below
the highest peacetime peak
recorded,
peak recorded.

126

Hence, based upon the median

Table 22
Real GNP
GNP Growth,
Real
Growth,
Median Conference Board Forecast
Compound Annual
Growth Rate
1977 III

4.4 percent
4,6
4.6

1978

1.082
l.
082 percent
1.131
1.
131

4,45
4.45

1.094
1.
094
1.082
1.034
1.034
.839
.839

4.4
4.2
4,2
3.4

III

Source:

Quarterly
Growth Rate

The Conference Board, Statistical Bulletin,
September 1977.

Table 33
Capacity Utilization Projections
Based on Median Conference Board Forecast

1977

GNP

IIPp

CU
cu

..791
791
..791
791

1.
082
1.082
1.131
1
. 131

1.628
1.628
1.736
1.
736

1.
008
1.008
1.009
1. 009

82.6
82.6
83.3
84.0

•.961
961
.961
.961
.961

1.094
1.082
1.082
1.034
.839

1.
654
1.654
1.628
1.522
522
1.
1.092
1.092

l. 007
1.007
1.007
1.006
l. 006
1.001
1. 001

II
III

1978

0
0

II
II
IIII
II

84.6
85.2

85.7
85.8

Note:

C == Percentage change in capacity
capacity (from previous quarter)
0
GNP == Percentage change in real GNP
0
II°P
P == Percentage
Percentage change in manufacturing output
pp =
= (IP~
(C~/ Cti)
(IPt / !Pt-l) / (Ct/
Ct-l)
CU
CU== Capacity utilization (percent)

127

forecast
fQrecast of GNP growth, as published by the Conference Board, our
model indicates that the manufacturing sector is likely to contain

some modest amount of untapped capacity at the end of 1978, yet
little enough so that concern over bottlenecks in 1979 seems
warranted.
Utilizati on as Im liedb

the Administration’s

Capacity Utilization as Implied by the Administration's
Projections of GNP Growth
The Administration recently set aa goal of reducing the aggreaggre4.6 percent by the end of 1981.
gate unemployment rate to 4,6

To achieve

this goal, they estimate that real GNP must grow from 1977
1977 through 1981
5,1 percent per year,~
by an average of 5.1
year.§! The implications for capacity
utilization can be examined by plugging the 5,1
5.1 percent growth rate
Into our model -- an experiment which indicates the Administration’s
Administration's
into
.~—

goal is apparently overly optimistic.

Based on the Administration’s
Administration's

GNP figures, our model
model projects that capacity utilization would reach
its 1973 peak in 1978 IV, its peacetime peak in 1979
1979 I, and its all—
all-

time peak in 1980 II {see
(see Table 4). Assuming 5.1 percent GNP growth
could be sustained, capacity utilization would rise to 96 percent in

1981 IV.

Historical experience, however, indicates that a utilization

rate
high is
unattainable for
manufacturing; widespread
shortages
rate this
this high
is unattainable
for manufacturing;
widespread shortages
aod bottlenecks would emerge well before such a rate could be achieved.
and
Of course, investment is not actually predetermined through 1981.

based on the historhistorThe investment values forecast by the model were based
ical relationship between changes in capacity utilization and changes

in investment growth.
growth,

But investment
investment growth can
can be influenced by other
other
But
128

factors as well; e.g., by changes in tax policy or in the degree of
factors

uncertainty facing businessmen.

Therefore, if the Administration wants

to foster prolonged economic growth it must attach increased importimportance to stimulating investment, thereby slowing the rise in capacity
strained,
utilization and postponing the time when capacity will become strained.

Administration's goal may still
Yet, even if investment is spurred the Administration’s
prove elusive.

Our model suggests that, on the basis of continued

strong GNP growth, capacity problems are likely to appear within the
next two years.

129

Tab 1e 4
Table

Capacity Utilization Projections
Based on the Administration's GNP Scenario
Based on the Administration’s GNP Scenario

1977

1979

1980

1981

0
0

GNP

I p
IP

cu
Cu

1.
012
1.012

82.6
83.6
84.6

II
IV

• 791
.791
.791
• 791

1.
251
1.251
1.251
1 • 251

2.000
~.00Q
2.000

1.012
1.
012

I
II
III
IV

.985
.985
.985
.985

1.
251
1.251
1.
251
1.251
1.
251
1.251
1.
251
1.251

2.000
2.000
2.000
2.000

1.010
1.010
1.010
l. 010
1.010

85.4
86.3
87.2

I
II
III
IV

11.131
• 131
1. 131
1.131
1. 131
1.131
l. 131
1.131

1. 251
1.251
1.
251
1.251
l. 251
1.251
1.
251
1.251

2.000
2. 00')
2.000
2.00,J
2.000
2. oo,J
2.000

1.009
1.009
1.009
1.009

88.8
89.6

I
II
III
III
IV

l. 251
1.251

1.251
1.251

l. 251
1.251
l. 251
1.251
i. 251
1.251
1.
251
1.251

2.000
2.000
2.000
2.000

1.007
1.007
1.007
1.007

91.8
92.5
93. 1
93.1
93.8

l. 251
1.251
1.
251
1.251
1.
251
1.251

2.000
2,000
2.000
2.000
2.000

1. 006
1.006
1. 006
1.006
1.
006
1.006
1.
006
1.006

94.4
94.9
95.5
96.1

IIII
II

1978

0
0

II
III

l. 251
1.251
l. 348
1.348
1.
348
1.348
1.
348
1.348
1.348

l. 251
1.251

130
130

88.0

90.4
91.2

Appendix 1:

Projecti
Capacity Growth
Projecting

Additions to manufacturing capacity are estimated from investment
data. Investment is measured in real or constant-do11ar
constant—dollar terms, since
addicapacity is related to real rather than nominal investment. In addition, pollution control expenditures are netted out, since these
expenditures do not augment productive capacity. Yet, even with these
adjustments, translating investment data into capacity growth can be
tricky
tricky..
composition as well as volume of
One difficulty
difficulty is that the ~p2~jtion
investment is important. Investment which eliminates aa production
bottleneck may have a tremendous impact on capacity. On the other
bottleneck
hand, investment which expands plant size may, while providing addiadditional office space, leave plant
ant capacity unchanged. A
machine,
A new riachine,
if added to the existing
existing sstock of equipment increases capacity, but
but if
if
some existing equipment is retired
red when the new machine is put in
place capacity
capacity need not be increased. Furthermore, expenditures on
modernization generally provide for smaller capacity growth than outoutnally, the impact of an investment
lays on new plant and equipment. Finally,
dollar is likely to vary from industry to industry.
industry, AA dollar spent in
an industry approaching capacity will have a more pronounced impact on
on
aggregate capacity than aa dollar spent in an industry possessing abundabundant unused capacity.
/i.lso
Also complicating the investment-capacity relationship is the
fact that investment frequently increases capacity with a lag.
1ag. ProProjects requiring years to finish are likely to add to capacity only when
completed or nearly so. AA plant half-completed may not augment a firm’s
firm's
capacity at aall,
11. Moreover, the lags
1ags invo
1
ved
may
vary
both
over
time
involved
and by type of investment.
The severity of these problems is difficult
difficult to assess a priori.
While the composition of investment may vary substantially
substantially over time
tithe
for a particular company or industry, in
in the aggregate the composition
of investment
investment may remain relatively
relatively stable. Therefore, how well aggreaggregate investment
investment explains capacity growth is ultimately an empirical
question. So is the question of whether capacity growth this period
is significantly related to previous investment. Each period, invest—
invest~nt
dollars
are
spent
which
increase
capacity
only
in
the
future.
At
rn~ntdollars
capacity
the same time, however, certain projects started in the past are
finished, adding to capacity in the current period,
period. If
If these two lag
effects wash out sufficiently,
empirically
capaci
sufficiently~ then
capacity growth may
not be related to previous investment, but only to current investment.
To investigate the relationship
relationsraip between investment
investment and capac~ty,
capacity, the
following model was developed.
ven period (C ) is identically
Capacity in a given
identically equal to capacity
last period minus the loss in capactty
capaccty due to depreciation and

131
13l

obsolescence (Dt) plus the gross additions to capacity (CADDt)t
(CADDt)' i.e.,
i.e.,
Dt
ct~ Ct_i
ct-1 —- Dt

+
+

CADDt.
CADDt.

(4)
(4)

It is assumed that capacity depreciates at a constant rate each period:

= a

C~_1.

(5)

In addition, it is assumed that gross additions to capacity are related
to
current and
and possib.ly previous investment:
to current
possibly previous investment:

CADOt = Bilt + ~21t—l
+ ...
(6)
(6)
where It refers to real investment net of pollution control expendiwhere It refers to real investment net of pollution control expenditures.
Combining the above equations, capacity can be rewritten as:

C,~—(l-.a)Ct_1

B1I~+ B2It..i + ... Ct.
(7)
where
In cawheres represents the error term. Alternatively, the change in
capacity
can
be
expressed
as:
pacity can be expressed as:
(7
Ct_1 = ..aC~_1 + ~l1t+ 821t—1 + ... e~.
(7’)
+

I )

—

cf a and ~
s are
arc the same whether
v:hcther obtained by estimating
Estimates of
equation (7) or
equation (7').
(7’).
or.equation

caThe capacity variable of this study refers to manufacturing capacity
as measured by the Board of Governors of the Federal Reserve
paci
System.y
System.7/ Capacity values were obtained for the fourth quarter of each
Fourth-quarter values were chosen because both
year (see Table 5). Fourth—quarter
the Board of Governors and McGraw-Hi
McGraw-Hill
11 estimate capacity growth on an
end-of-year
basis.
end—of—year

The
equipment
spending.

investment variable (I) is an estimate of real plant and
expenditures over the calendar year net of pollution control
The variable is defined as follows:

POL)/P
II== PE (100 - P01)/P
—

where PE

p1ant and equipment, in
== Expenditures for new manufacturing plant

bi 11ions of (current) dollars;
billions
of (current) dollars;
POL== Percent of plant and equipment expenditures for air and
P01
water pollution control;
water
pollution control;
Implicit ClIP
GNP price deflator
deflater for business fixed investment.
PP;= Inplicit
The
PE
data
are
published
by
the
Bureau of
of Economic
Economic Analysis,
Analysis, the
the P01
POL
The PE data are published by the Bureau

132

data by McGraw-Hi1l.~
McGraw-Hill.!!/
Equation (7’)
(7') was estimated over the period l954_76.2/
1954-76.Y Lagged
investment terms did not contribute to the explanatory power of the
equation, nor were their coefficients statistically significant. Only
current investment proved to be statistically important. Therefore,
the lagged investment terms were dropped. (Regression results are
reported
reported in Table 1, equation (2).

Table 5
Values
Values of
of the
the Investment
Investment and
and
Capacity Variables
Investment (I)

33. 1
33.!
28.9
28.7
33.
33.2:'.
36.2
33.0

62.7
65. 1
65.1
67.9
71.4
74.2
76.6
79.3
83.0
85.9
88.8
92.
92.11
96. 1
96.1
102.7
102.1
110. 2
110.2
117. 9
117.9
124.7
124.7
131 . 1
131.1
136. 1
136.1
140.0
140.0
144.7
150.3
155.7
159.5

34.2

163.2

18.9

1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
J965
1966
1967
1968
1969
1970
1910
1971
1972
1973
1974
1975

17.
17.88

18.3
22.2
22.7
17. 2
17.2
17. 2
17.2
20.3
19.4
20.2
21.6
25.4

30.4
35.6

35.0
33.3
35.1

1916
1976

133

Capacity (C)
( C)

Appendix 2: Simulating the Model
To test its predictive ability, the model was simulated over the
first nine
nine quarters of the current recovery. The equations, estimated
over the period 1954 I to 1974 IV, were used to generate forecasts for
1975 II - IV. After updating the equations through 1975 IV, forecasts
for 1976 were made. Finally, after extending the sample period through
1976 IV, capacity utilization was forecast for the first two quarters
~uarters
of 1977.
-

Althougn
Simulation results uncovered no apparent bias. Al
thougA capacity
utilization was somewhat underpredicted during 1976, the
t~e model did get
back on track. Capacity utilization was recorded to be 82.6 percent
in 1977 II, compared to a projected rate of 82.7 percent (see Table 6).
Thus, capacity utilization rose 11.7 percentage points during the first
11. 8 percentage
pe,·centag" points
nine quarters of the recovery, compared to the 11.8
projected by our model.
zation and the
mode1. Moreover,
Moreover, actual capacity uti ciizatio1
1. 3 percentage
p':rcentage
rate predicted by our model never di verged by more than 1.3
capacii;y utilization
uti1 iwtion
point. Our model even picked up the decline in capacity
registered
in 1976
IV.
registered in
1916 IV.
Table 66
Simulations of Capacity Utilization

1975

1976

1977

Note:

0
0

GNP

IPP

cu
CU

CtMCU
CU-CU

1I
II
II I
III
IV

.668
.668
.668

1. 573
1.573
2. 735
2.735
.745

2.627
2.621
5.008
1.930
l. 930

1.019
1. 019
1.043
1. 043
1.003

72.2
75.4
7!i. 4
75.6
7S.6

70.9
71.33
71.
75.3
75.8

.9
•9
.1
.1
—1.2
- 1.2

I
II
II
IIII
IV

.595
.595
.595
.595

2.130
1.234
.959
.288

3.946
1.
965
1.965
1.
357
1.357

1.033
1.
033
1.014
1. 014
1.008
.993

78.1
78. 1
79.2
79.8
79.3

79.0
80.2
8D.2
80.8
80.6

—.9
-.9
—1.0
-1.0
—1.0
-1.0
—1.3
-1. 3

II
II

• 791
.791
. 791
.791

l.
503
1.503

1. 025
1.025
1.
018
1.018

s:. 3
8..3
82.7

81.2
82.6

.l
.1
.l
.1

1.
833
1.833

—.126
- . 126
3. 282
3.282

2.555

cu = Capacity utilization
uti ization as simulated by the riodel
nodel
CU
CU
cu== Actual capacity
capac ty utilization

134

Footnotes

jJ
11

reNonlinear versions of equation (1) were also tried, but their tee
sults were empirically inferior.

y
~

The te~
term Gt= C~.
Ct —- (l—u)Ct_i
(1-a)Ct-l == C~
Ct - .9665 C~_
Ct-l 1measures the gross
change in capacity, i.e., the difference between actual capacity
and the level which would have prevailed in the absence of any
I, the elasticity of G
res.e_ect
investment. Since CG = .2923 I,
C with resp~ct
to I, evaluated at the mean, is n~== .2923 T/
T / ~whereTand
G where T and GG
refer to the mean values of I and CGover
over the estimation period
(1954-76). T = 26.92 and CG and 7.89.
7.89, Hence, t~
n = .2923 (26.92 /
invest7.89) = 1.0. In other words, each 1l percent change in our investment variable is associated with
withal
percent
change
in
gross
a 1
capacity growth. Therefore, if in a certain year $25 billion in
investment would increase capacity by 5 percent in gross terms,
then raising investment to $30 billion (an increase of 20 percent)
can be expected to raise gross capacity growth to 66 percent (also
cap
an increase of 20 percent). The finding that investment changes
and changes in capacity growth are linked in such a manner is
appealing on theoretical grounds, and suggests that our investinvestment variable does a good job of capturing gross additions to
capacity.

p
11

Interestingly, the 1977 projection of investment derived from
equation (3) fa11s
in between the investment plans reported by
falls in
the BEA and by McGraw—Hill
McGraw-Hill in late spring. Based on the growth
in capacity utilization between 1975 IV and 1976 IV, equation
(3) projects that manufacturing investment in 1917,
1977, as measured
by our investment variable (I), will exceed investment in 1976
by about 12.9 percent. The BEA investment survey figures transtranslate into a 9.3 percent increase in
in!;
the
McGraw-Hill
figures,
I;
McGr~w—HiIlfigures,
inGrease in
into a 14.3 percent increase (assuming aa 66 percent increase
the price of investment goods (P) and using the 1977 estimate
of pollution control expenditures reported by McGraw-Hill).
(l .00791 )4 =s 1.032.
That is, (l.0079l)~

—

Capacity utilization in time period ttis
Is defined as the ratio
of actual output to capacity output, i.e.,

Cut
cut== IPt/Ct.
it can easily be shown
By lagging this relationship one period, it.
that the utilization rates in successive periods are related as
follows:

135
135

Cut
cut
wherep=
where
p =

= P
P
=

cut_ 1

!Pt/
IPt-1
‘Pt / iPt_i
—----

Ct_i

This is
Is the formula used to project capacity utilization.
6/
§j

ZJ
LI

See Office of Management and Budget, Midsession Review of Fiscal
1978 Budget, Special Supplement, July 1, 1977.
j9~judet, ~Q~al Su lement, Jul yT~fl77~~
A.'llong other
other advantages,
the Board
Board of
of Governors
Governors series
is readily
readily
Among
advantages, the
series is
available to the general public, has a long track record, and
lacks any apparent cyclical bias. For a discussion of the major
series of capacity uti
utilization,
“Measuring
1i zat ion, see James Ragan, "Measuring
Capacity Utilization
Federal1 Reserve Bank of
Uti 1i zati on in Manufacturing,”
Manufacturing," Federa
New
New York 9~r~rlReview,
Quarterly Review, Winter 1976, pp.
pp. 13-20.

8/
'§I

The pollution control data are actually available only since 1967;
1967;
but, because pollution control expenditures did not begin their
rapid ascent until
untfl the late sixties, the fraction of investment
probexpenditures devoted to pollution control prior to 1967 was probably close to the fraction spent in 1967. This was the assumpassurnption made. Thus, the pre-1967 values of POL were set equal to the
1967 value (2.8 percent). The BEA also publishes
publishes a series on
pollution control expenditures, but it does not begin until six
years after the McGraw-Hill
McGraw~Hili series.

The estimation
estimation period was annual, rather than quarterly, because
truly independent capacity values were available only once per
year. Both the Federal Reserve Board (whose series is used in
this study) and McGraw-Hill
year-end.
McGraw—Hill obtain capacity values at year—end.
these are simply
Although quarterly estimates are available, these
interpolations
between annual
annual observations.
observations.
interpolations between

1 36
136

COMMENTS ON RASCHE ANO
AND TATOM,
"THE EFFECTS OF THE NEW ENERGY REGIME
.... "
“THE
REGIME.,
AND
“ENERGY RESOURCES AND POTENTIAL GNP"
GNP”
"ENERGY

Frank de Leeuw
These two studies have performed aa timely service in reminding us
that aa major rise i.n natural resource costs can have a sizable negative

impact on potential GNP.

The purpose of this note is not to question

that central proposition.

Rather, it is to argue that (1) the impact

on potential GNP takes place only gradually as production techniques

and consumption patterns change, not all at once as these studies imimply, and (a)
(2) that the ultimate
ultimate impact may not be as large as the 4 or

55 percent estimated in these studies.
studies.
At the present time, the note will conclude, production techtech-

substantiniques and consumption patterns do not seem to have altered substantially in response to higher energy prices.

Potential GNP has therefore

not yet declined appreciably; rather, what has happened is that aa larlar-

ger fraction of GNP (or claims against GNP reflected in balance-oftrade deficits) must be paid to the owners of energy resources.

PoPo-

tential ~consumption after subtracting out this fraction has been rereduced, but potential production has not.

It is, however, important to

Fiscal Analysis inte
in the
~r. deLeeuw is the Assistant Director for Fisca
~euw
Office. Views expressed in this note are those
Congressional Budget Office,
those of his employers.
of the author and not necessarily those
137

watch for signs that production techniques are beginning to respond to

high energy prices and to take any such response into account in formuformulating economic policy.

The Rasche-Tatom Assumptions and Their Implications
~sche-TatomAssumtionsandTheirImlicatiOns
The reasoning used in these studies to translate higher energy

prices into reduced potential GNP can be explained in aa few sentences.
potential output deSince output requires lator,
labor, capital, and energy, potential
depends on available supplies of these three inputs.

For labor and for

capital, it is possible to measure at least approximately maximum availavail-

particiable inputs, determined by population and expected labor force participation rates in the case of labor and by the initial capital stock, its

rate of depreciation, and the expected fraction of new output devoted
to fixed investment
investment in the case of capital.
Since energy is traded internationally in huge amounts, it does
not make sense to think of a fixed quantity of potential energy consumpconsumption by any one country, analogous to potential labor and potential capcap-

ital.

Rather, it makes sense to think of producers and consumers
consumers chooschoos-

ing aa ratio of energy to output on the basis of relative prices, technotechnoinfluences. The higher this
logical developments, and perhaps other influences,
ratio is —-the
--the more energy-intensive production is-—the
is--the more output can
be produced with given amounts of labor and capital.

A sizable increase
A

in the relative price of energy should lead producers to conserve energy
and consumers to shift
shift purchases away from energy-intensive goods and
services--should,
services—-should, in other words, reduce the ratio of energy to output.
supplies of
High energy prices should therefore mean that available supplies

138

labor and capital will not yield as much output as they would have if
the cheap-energy years of the past
past had continued.
A major increase in energy prices should, in this view, cause
cause
A

(1) energy conservation, or a fall in energy consumption per unit of outout(2} a rise in both labor consumption per unit of output {equivalent
put; (2)
(equivalent
to aa fall in productivity as usually measured) and capital consumption per
unit of output; and (3) a reduction in productive capacity or potential
output, properly measured.

The specific relationships used by Rasche and

relaTatom, furthermore, imply
imply that these reactions occur
occur at once when relative energy prices go up.

The Evidence Since 1973

Have these consequences actually taken place since the OPEC price
price
rise of 1973-1974?
1973-1974? The evidence is, at best, mixed.

The first conseconse-

quence, a fall in the energy-output ratio, is a central one.

Only as

this ratio falls do producers need to use more capital and/or labor per
unit of output and hence reduce potential GNP.

But there is no evidence

of a drop below trend in the energy-output ratio since 1973. Table 11
shows two measures of energy per unit of output from 1970 through 1976.
1976.
They both display a trend toward conservation over these years amounting
to a reduction of 11 to 33 percent in energy per unit of output each year.
But they show this trend before the dramatic increase in energy prices as
well as afterwards and there is no sign of any acceleration after the
energy price increase took place.

Examination of a longer period than

1970-1976 suggests that some movement toward conservation may have taken
1970-1976
place in recent years, but nothing like the 33 percent drop in the ratio
139

TABLE ‘I1
ENERGY CONSUMPTION AND GNP

(CONSTANT DOLLARS)
Energy Consumption
(thousand
trillion
BTIJs)
tri
11 ion BTUs)

Total
Total

Industrial

GNP, 1972 Prices
(billions of dollars)
Total "Industri
a1"l/
“Industrial”~-”

Ratio of Energy
to Output
(indexes, 1973
1973 == 100)

Total

Industrial

1
1970

68.3

23.3

1075.
1075.33

370.2

104.5

107 .8
107.8

1971

69.5

23.0

1107. 5
1107.5

374.9
374,9

103.2
103,2

105.1
105.1

1972

73.3

23.8

1171.
1171.1l

399.7
399,7

102.9
102,9

102.0
102.0

1973

75.1
75. 1

24.9

1235.0

426.4

100,0
100.0

100.0

1974

73.2

24.2

1217. 8
1217.8

402.6

98.8

102.9

1975

71.5

21.6
21,6

1202.1

379.9

97.8

97.4

1976

75.0
75.0

22,9
22.9

1274,7
1274.7

416.2
416.2

96.8
96.8

94.2
94.2

rce:
Source:

Energy Consumption--FEA,
Consumption——FEA, by telephone, through 1975-1976,
1975—1976,
CBO estimates based on data in
FEA'ss ~
Monthly Energy Review
FEA’
GNP--Commerce Department

140

roughly 50 percent IninRasche and Tatom would expect in response to the rpughly
crease in the relative price of energy in 1973-1974.

With respect to labor and capital, the evidence is not quite so
negative. Output per unit of labor did fall in 1974 and has not yet
caught up to its earlier trend, even after correction for cyclical inin-

fluences. After cyclical correction, however, output per unit of capicapital does not appear to have fallen. Output per unit of combined labor—
labor-

capital did fall, and the Rasche-Tatom regression results reflect the
fact that this shift in the relation of output to labor and capital inin-

puts occurred at the same time as the rise in oil prices.

But it is

hard to interpret these labor and capital changes as responses to energy
developments when there is no evidence of a shift in the energy-output
ratio.

Preferred Rates of Capacity Utilization
The third implication of aa rise in relative energy prices is a

decline in capacity and potential GNP. As Rasche and Tatom point out,
manufacturing capacity as measured by the Federal Reserve Board did not
fall when energy prices went up. Capacity, as Rasche and Tatom define
output-it--namely, the cost-minimizing or profit-maximizing level of output-—
should have fallen by 44 or 55 percent, according to their calculations.
They interpret the failure of the actual indexes to fall as due to a
difference in definition.

Published capacity statistics, they believe,

refer to maximum output feasible under customary operating conditions,
not to the concept of cost-minimizing output which they prefer.

141

I believe they are probably
probably right in their interpretation of pubpublished capacity statistics.
statistics,

In the short run at least, the failure of

published capacity indexes to fall is not a serious argument against
their view of the impact of energy prices.
confirmation of their view.

Neither, however, is it aa

It is simply not relevant to evaluating

their hypotheses.
The Bureau of Economic Analysis does, however, collect another set
set

of statistics in its capacity survey which are more relevant to testing
the Rasche-Tatom
Rasche—Tatom views.

These are manufacturers'
manufacturers’ views of the percent

of capacity at which they would prefer·
~f~r to operate.
is:

The exact question

"At
manufacturing capacity would
would your company
“At what percentage of manufacturing

have preferred to operate in order to achieve maximum profits or other

objectives?"Y
objectives?”~’

Now if high energy prices do not change rated capacity

but do have an immediate impact on production techniques and input propro-

portions as Rasche and Tatom
Tatom maintain,
maintain, then the minimum—average—cost
minimum-average-cost
rate of operation
operation should decline when energy becomes much more expen—
expensive.~
sive.Y1 AA reduction
reduction in preferred operating
operating rates looks like a promising
candidate for an empirical counterpart to this theoretical concept.

ManMan-

ufacturers might be expected to prefer not to operate equipment which
was extremely energy-intensive, and to prefer to operate other equipment
in ways which conserve energy and hence sacrifice some output.
manufacturers’ view
In fact, however, nothing much has happened to manufacturers'

of their preferred rate of operation.

For all manufacturers taken togetoge-

ther, preferred utilization was 95 percent of rated capacity from 1970

through 1974 and 94 percent in 1975 and 1976.

There is no sign of a 44

to 55 percent drop after the run-up of energy prices in 1973-1974.
142

Unpublished detail supplied by the Bureau of Economic Analysis, furtherfurthermore, does not suggest that the aggregate conceals any shifts
fts at indusindustry levels that would bear out the Rasche-Tatom view.
ew.

For example,

energy—
there does not appear to have been aa drop in preferred rates in energy-

intensive industries offset by a rise elsewhere. Thus, statistics on
preferred operating rates, like statistics on energy per unit of output,
suggest that so far there has not yet been a significant restructuring
of production techniques in response to higher energy prices,

flBeenHaenin?
What Has Been Happenin2?

There is no doubt that higher energy prices have created incenincentives to change production processes.

So far, however, the evidence

significant energy
indicates that these incentives have not yet led to significant
conservation and substitution of labor and/or capital for energy.

ProbProb-

ably one reason for the delay is that many of the possibilities
possibilities for enenergy conservation require new plant and equipment.

Frequently it will

pay to continue to operate existing capital goods for a time even if
they utilize uneconomic
uneconomic processes because they have already been paid
exfor and because conversion to a more energy-conserving process is ex-

tremely costly.

Another possibility is that large-scale energy conserconser-

vation is awaiting more certainty about future technological change.
and about government actions affecting
affecting energy costs.
While it is tempting to associate the recent productivity slowslowdown with the rise in energy prices, the facts about energy per unit of

output do not bear out this connection. The most likely explanation
for the productivity slowdown appears to lie elsewhere--lower
e1sewhere--1ower rates of
143

capital investment in relation to GNP, shifts in the experience—mix
experience-mix of
the labor force and the industry-mix of output, lower grcv1th
growth in research
and development spending, and the severity of the 1974-1975
1974—1975 recession.
With respect to potential GHP,
GNP, the short run conclusion is that
until production techniques begin to react significantly to the change
in energy prices, it would be aa mistake to translate higher energy
prices into reduced potential and lower output targets. So far, high
energy prices have not altered production techniques but have caused
this
prothis country to pay sizable amounts to oil producers in order to produce GNP by old production techniques.

In paying for oil,
1, we have

incurred large balance—of—trade
balance-of-trade deficits which represent growing foreign
claims against domestic output.

While potential output has not yet been

reduced substantially, these foreign claims mean that potential conconsumption by U.S. citizens has been reduced by high energy prices.
The conclusion about potential GNP in the long-run
conlong—run is more con-

jectural.

conserEventually high energy prices should lead to energy conser-

vation, substitution of other inputs for energy, and hence less potenpotential 61W
GNP from given supplies of labor and capital. Qualitatively, the

Rasche—Tatom results siem
Rasche-Tatom
seem quite plausible as a long—run
long-run proposition.
long-run effect may
I suspect, however, that quantitatively the long—run
not be as large as 4 or 55 percent. The 4 to 55 percent estimate assumes

no response of labor or technology to changing productivity and real inincome.

In actuality, low real wages due to high fuel costs could cause

the supply of secondary workers or other dimensions of labor supply to
increase.

conRecent labor market statistics and analyses seem to be con-

sistent with behavior of this kind, in which lower productivity is
144

partipartly offset (as it affects potential GNP) by higher labor force participation.

Furthermore, future technological advances could on balance

be energy-saving
energy—saving rather than neutral (as Rasche and Tatom assume) with

respect to input proportions.
These offsets are no more than possibilities,
possibilities, however.

It
It would

be a mistake to ignore the danger of a substantial eventual impact of

high energy prices on potential GNP.
GNP,

The Rasche and Tatom studies will

have served a highly useful purpose if they remind us to monitor

closely trends in energy conservation and productivity and be prepared
estimates of potential GNP when U.S. production techto adjust our estimates
techniques show signs of significant reaction to the new energy regime.

Footnotes
1/
11

"Industrial" sector covers manufacturing, mining, agriculture, and
“Industrial”
construction for comparability with energy consumption data.

y2/

See Marie P. Hertzberg, Alfred I. Jacobs, and Jon E. Trerathan,
“The
1965—73,” Survey of
"The Utilization of Manufacturing Capacity, 1965-73,"
Current Business, July 1974, p. 49.

Rasche and Tatom, “The
"The Effects of the New Energy Regime,”
Regime," pp. 3—4.
3-4.

145

ISSUES CONCERNING THE DEFINITION,
MEASUREMENT AND FORECASTING OF
PRODUCTIVE CAPACITY
Laurence H. Meyer
It would be difficult to identify a more important macroeconomic
issue (and one about which there was more disagreement) than recent
developments affecting the level and rate of growth in the nation’s
nation's
productive capacity.

Knowledge of the gap between actual and potential

immediate relevance to the design of short-run stabilizastabilizaoutput is of ininediate

tion policy and recent projections of slower growth in productive
capacity and the possible relation to slower growth in capital stock
appear to have heightened the interest of both the Administration
and Congress in tax reform keyed to expanding Incentives
incentives for capital
spending.

The Perry, Clark, Sd
and Rasche—Tatom
Rasche-Tatom papers are attempts to

provide the empirical evidence on the level and anticipated rate of
growth of potential output that is essential to designing such policies.

However, their approaches leave the question of the level of potential
output quite unsettled and their projections of future growth rates are
mostly conjectural.

Dr. Meyer is Associate Professor of Economics at Washington University.

147

Three issues
Issues Concerninq the
t~e Definition,
Definition,
Measurement, and Forecasting
of Potential Output
Forecastinq_pjJ’otential
It is useful to identify at the outset
Putset three separate issues concernconcern-

ing the definition, measurement, and forecasting
fore,:asting of productive capacity.
Each of the three papers deals at leas:
leas·. to
t,) some extent with each of the
three issues:

The determinants of the _leve,.
leve of potential output;
output.

2.
2,

The cyclical behavior of actual relative to potential output--

i.e.
Le. the analysis of the cyclical pattern
patt1ern of participation rates, hours
per worker, and productivity which along with
,1Lh cyclical pattern in employemploy-

ment explain the cyclical pattern in prod;ction.
prodiction.
The determination of the rate of growth of potential output In
in

g ov1th over the next five years.
the past and the projection of rates o · growth
0

thP level and rate of growth iss~Jes.
i SS\Jes.
The papers are most concerned wLh
wi::h Lhe

The Level of Potential ~
Output
There are three problems relatinç
relatinc to
t,J the determination of the level
of potential output th.at
thLtt arise in conmctior
connEct~orwith
with the three papers.
a.

inputs.
rates.

identif~inj
The first problem is idem:ifJ
in•J ‘potential”
'potential" levels of factor
Employment, hours, and partic~pa’:icn
partic,pa·:irn rates vary
vary with unemployment

To define the potential
potential level cf ~aLor
ator input, we need to know
know the

“full employment"
employment” level
unemp1o~rne:~trate.
"full
leve1 of the unemplo}me,1t

If capital is explicitly

cefne
treated in the analysis, we must also cef
ne a potential level of capital
input.
b.

The second problem i:
is the

r,os
;ibility of a once and for all shift
~os;ihi1ity

19’3-5 due, for example, to a once
in the level of productive capacity in
fo 19'3-5
and for all change in the relative price of
qf energy.

This must be picked up

by dummy variables unless energy develcpments
develcpm,!nts are explicitly integrated into
the model.
148
148

c, The third problem is the possibility of incompatibility between
i.e.,
potential levels of labor and capital inputs; i.e
4 the possibility that
ful1 utilization of the capital stock may occur prior to full utilization
full
of the labor force and that the capital stock, not the labor force,
force, is
the real binding constraint
constraint that determines potential output.

This

in much of the recent discussions
d·iscussions of
view seemed to be prevalent In

capital shortage.

It seems to me that such an incompatibility can

arise only under the assumptfon
putty-clay technology, but the
assumption of a putty—clay
Cl ark and Rasche-Tatom
Rasche- Tatom papers identify separate and conceivably conflictconflictClark
ing measures of potential
pot2ntial labor and capital inputs in a putty—putty
putty-putty model.
of_.E_o_tenti
a 1 Output
Projecting Rates of Growth of
Potential
The second issue-—the
issue--the cyclical
cyclic,il behavior of actual relative to potenpotential output, while interesting in its
;ts own right and the issue that motivamotiva•
ted early research in this area, Is
i,; most important in the three
three papers as
part of the methodology for providing
provid·ing evidence onthe
on the third issue, the
output.
trend rate of growth in potential oytput.

The basic approach used to

isolate the secular trend in the rate of growth of potential output is to
time trend
purge the actual data of cyclical influences and then to fit a time
dummies) to determine ex post rates of growth. When
(with appropriate duninies)
crLical role, projections of future growth
growtti
time trend dummies
duimiies play such a critical

rates become treacherous.

Should we
vie assume the time
tim<, trend relevant to

wi 11 be the sane
sar1e as that over the most recent homogenhomogenthe next five years will
1il1 earlier period, or be different from
st··
ous period, revert to that of a st

either? Plausible stories can be told to rationalize each possible choice
evi de nee in the
th 1: papers often doesn’t
dm,sn' t help in making
but the econometric evidence

the choice.
149

~p~flc
Specific Comments on the Three Papers
Perry papers
The Clark, Rasche-Tatom and Perry
papers are closely interrelated.
The Clark paper, for example, follows the approach Perry employed in
excep: that Clark
Clark introduces
earlier papers to measure potential output, except

capital explicitly and therefore
therc,fore investigates
investigatE,s weighted
weightr,d factor input
productivity rather than lator
l ator procuctivity.
proc:uctivity.

Rasche—Tatom
And the Rasche-Tatom

capita: as
2,5 an explicit
exp"!icit factor input
paper introduces energy as vell
yell as capital
in the analysis.

discu,,ses t~erole
tre role o''
Finally Perry discusses
o~capital and energy

in the measurement of potential output and concludes his simpler method
remains capable of a more reliable
r1oliable estimate of po:ential
potentia1 output.

The Clark
Cl ark and Perry Papers
The Clark paper provides evidence thaI:
tha1: the level of potential output,
if appropriately set in relation to
t(J a 4% agqregate
aggregate unemployment rate in
1955, now should be defined in relation
rel,tion to a,, 4~9%unemployment
4.91! unemployment rate, concon-

siders some possible explanations of the unexpectedly
unexpectediy poor performance of
rang,, of estimates
estimates of the growth
productivity in 1973-4, and provides a raj~~~
the inability
inabi",ity to isolate
·,c.olate the source
souq::e of
of potential output that reflects i:he
behavior of procuctivity in 1974.
;97L_
the unusual behavior

Perry simply excludes

1974 and reports small resicuals
1(175 and 1976.
1Cl76.
resic.uals in 1973,.
1973, 1975

Clark tries

alternate dummies which invclve
dowm1ard :,hift
in potential output in
involve a downward
~hiftin
1974 and a more intense cyclical
cyc1ical p,,ttern
producti"itY in the 1974—5
1974-5
pattern of producti”ity

recession.

Clark is unable to choose betweun
between the two explanations

(although they have very different
difforent ·'rnp·,icat
mpl icat ons for ·;he
the current level of
potential output) and the evidence presented in the
tile Clark and Perry papers
does not permit a definitive evaluation
evalua·,:inn of
o-f i:lark''.i
Clark’s dummies relative to
Perry's
Perry’s dummy:
dummy

The approach used

11
ii

both the Pery
Per·y ,ind
Clark papers
~ndClark

1 50

suffers from inadequate attention
attention to the selection of potential levels of
labor input and provides little solid evidence on which to base projections
of future growth rates.
rates,
I.
1.

The full employment unemployment rate.

When the CEA designated

1962, they rationalized the choice in
4% as the target unemployment rate in 1962,
terms of aa simple {nonexpectational)
(nonexpectational) Phillips Curve trade-off model.

The

trade-off model doesn’t
doesn't yield a unique choice for the full employmentemploymentmodel is valid, it at least
unemployment rate (Uf)
(hf) but if we assume that model
represents a well defined methodology for selecting hf.
Uf.

Since that time,

there has been a great deal of additional theoretical and empirical
research on the relation between inflation and unemployment, including the
development of the natural rate model. This research raised the possibility

natural, or
of a vertical Phillips Curve and an (in principle) well defined natural,
if not so natural
natural,, at least unique noninflationary (or nonaccelerating) rate
of unemployment.

Yet studies like Clark, Rasche-Tatom and Perry’s
Perry's continue

to key the full employment levelof
level of labor
,abor input to the 4% unemployment rate
in 1955 and then to translate this via changing
changing demographic composition of
the labor force to a 4.9% rate in the 1970's.
1970’s.

Clark and Perry tell us that

this unemployment rate series represents aa constant degree of labor market
tightness, but does not bear aa direct relation to the noninflationary rate
rate
of unemployment and is not the outcome of aa study of inflation dynamics.

their potential unemployment rate should not be confused with the noninflanoninfla-

tionary rate of unemployment, should their measure of productive capacity be
confused with the traditional concept of potential output?

Until a more

serious effort is made to introduce a meaningful concept of potential labor
input, the level of potential output estimated by such studies must be
151

treated with skepticism.

level of
Having identified their potential level

these
labor input with aa constant degree of labor market tightness, these
studies may still
still be able to yield meaningful insights about cyclical

behavior of output relative to employment (e.g. as in Okun's
Okun’s Law) and
the trend rate of growth in output, but the level of potential output
remains arbitrary as long as there is no rationale
raticnale (aside from historical
continuity) for the specific constant degree cf labor market tightness

employed in the analysis.
2.

Explaining and forecasting growth rates of potential output.

The methodology used to determine growth rates of potential output is
ical component (by relating
relating
to purge the data on actual output of its eye'
cyclical
participation rates, hours per worker and productivity to cyclical
variables} and then to extract the secular trr·nd
variables)
trend via estimation of aa
time trend.

Ex post, this method seems capable
capab1e of reasonably determining
determining

historic trend rates of growth
grov1th of output.

Hovever, changes in the trend
Hov·ever,

rate of growth can only
only be observed ex post and corrected for by time
trend dummies.
extrapoladun~iiies. And projections of future grov1th
growth rates involve extrapolarates~~
con.:'ectures about whether
tion of recent historic growth rates
pjy~sconcectures
recent rates are 1likely
i ke ly to continue, the recent slowdown wil
will1 worsen, or

future rates will rebound.

There is typically little direct support for

such conjectures in the econometric analyses i:hemse
l ves.
~:hemse1ves.
3.

The explicit treatment of capital s':ock data in projections of
~

potential
potential output.

Clark’s paper from earlier studies
What differentiates Clark'~

and from Perry’s
Perry's paper is Clark’s
Clark's explicit treatment of the capital
capital stock
stock
as an input rather than capturing its influence via
vi a time
ti me trends in the

labor productivity equation.

My initial reaction
reaccion was that this was a

152

reasonable extension, although the whole history of debate over the bafbaffling problem of developing aa meaningful measure of the aggregate capital

stock made me aa bit wary.

My initial favorable reaction was quickly

included--by imposing
cooled by the arbitrary way in which capital was included——by
fixed weights on labor and capital to form an index of total factor
inputs.

Perry’s discussion of the difficulty in obtaining statistically
Perry's

significant coefficients on capital in aggregate production functions
Clark’s procedure
procedure and reinforces my disdisboth provides a rationale for Clark's

trust of the imposition of the arbitrary weights and my concern that
problems of measuring capital may indeed make Perry’s
Perry's approach more
reliable.

Clark's
Clark’s defense of his treatment of capital seems to be that

it does not make a great deal of difference so that using labor input
and labor productivity would not have altered his results.

I don't
don’t know

whether this is a defense for usin9
using or not using capital!
The Rasche—Tatom
Rasche-Tatom Paper
The Rasche-Tatom paper employs a methodology which allows for
explicit treatment
treatment of one of the alleged vi11ains
villains in the mystery--the
th~ relative price of energy since
since 1973.
influence of the sharp rise in thç
1973.
By including the relative price of energy to proxy the input of energy
developin production, Rasche and Tatom find that they can explain recent developments through 1975 without resort to special dummies for the 1973-5 period.

Their results also suggest aa lower level of potential output in recent
years even without any allowance for such factors as the increasing
proportion of capital spending devoted to pollution abatement and the
slowdown in the trend rate of growth in productivity after
after 1967 or 1969.
1969.

153

substiAn increase in the relative price of energy should induce substitution out of energy into labor and capital thus Increasing
increasing the labor and
capital requirements per unit of output and decreasing the energy r~qui
requirere—
ments per unit of output. Both Perry and Clark accept this as a plausible

response to a change in the relative price of energy but attempt to
dummies for aa given
capture it in their productivity equations with either dunnies
year or time trend dummies.
dinitfes.

The issue then is the magnitude of this

effect on the level of potential output and the duration of its effect on
growth rates. Given the fixed levels of potential labor and capital
inputs at the point of change in the relative price of energy, the
increase in capital and labor requirements per unit of output translates
into a decline in potential output.

The greater the substitutability of

capital and labor for energy, the greater the resulting decline in
potential output.
This procedure raises a number of questions:
l.
1.

The results can be heavily influenced by the form
form of the

production function and the constrai
nts imposed in estimating the coef—
constraints
coeffiçients. How did the Cobb Douglas form and restrictions imposed on the
ficients.
parameters influence the sensitivity of potential output to the change in
the relative price of energy? I share Perry’s
Perry's view that the Rasche-Tatom
methodology has led to a serious overestimate of the resulting decline ip
in

potential output. Yet II do not find their general approach, that of
input,
including the relative price of energy as a proxy for energy Input,
unreasonable.

Additional research with less restrictive assumptions

about the production function would be useful.

No allowance is made for an influence of the relative price
“54
154

of energy on either the "potential"
1eve 1 of capacity utilization or
“potential” level
technical conconthe rate of obsolescence. Both factors are treated as technical,

stants rather than choice variables subject to influence by changes in
relative prices.

Yet one of the most important channels through.
through which

the sharp increase In
in the relative price of energy might be expected to

operate is by affecting the optimal rate of replacement investment.
The theory or nontheory of replacement investment is an important gap
in our conventional macro treatment of investment.
Rasche-Tatom paper, a 1975 paper by Myers and
In contrast to the Rasche—Tatoni
1/
11
Nakamura
on the effects of energy on productivity explicitly models the
Nakamura-

influence of a rise in energy priceson
prices on the optimal rale
ra1;e of replacement.
"vintage" (putty clay) model, and their vintage production
They use a “vintage”

function includes energy along with labor and capital. An increase in
the price of energy is shown to effect the condition which determines
the shutdown point for aa given vintage.

Increased energy prices result

in an accelerated obsolescence of existing plant and equipment; the’
the
increase in the rate at which old vintages are replaced with new (higher

technology) vintages tends to increase labor productivity.

On the other

capihand, the increased energy prices induce a substitution to labor and capi-

tal from
from energy so that the amount of labor and investment required per
unit of output tends to increase, reducing labor productivity. The net

result on productivity is ambiguous and therefore must be determined
empi ri ca lly.
empirically.

Thus the effect of energy on productivity may be more complicomp 1i-

cated than the Rasche—Tatom
Rasche-Tatom analysis suggests.

155

Another questionable feature of the Rasche-Tatom analysis

is the failure to allow for aa gradual response pf
of production decisions
to changes in the relative price of energy.

The discussion
discussion of their

projections of futurç
futur~ growth rates, on the other hand,
hand, makes referreference to a gradual response to energy developments.

This seems to

involve conjectures quite unrelated to the explicit econometric
analysis of the paper.

Summing Up
outset——the level
Of the three issues we identified at the outset--the
level
issue, the cyclical issue, and the rate of.growth
of, growth issue--the
issue——the papers

do the best job on the cyclical issue.

But the main focus of the

papers is on the level and rate of growth issues and their approaches

shortcomings,
to these issues have serious shortcomings.

The level issue is simply

unanswered due to failure to identify an appropriate potential level

of 'labor
labor input.

In addition, the effect of the increase in the relarela-

tive price of energy on the level of potential output remains ununsettled.

Rasche and Tatom have probably overstated the effect, but

Clark's
Clark’s results also suggest the possibility of a substantial once
and for all decline in potential output.

As for the projection of

future growth rates in three papers, at least in this case, time will
permit us to judge whose conjectures were most accurate.

Footnotes
Footnotes
Jj
jJ

J.
Po 11 uti on Effects on
3. G. Myers and L. Nakamura, "Energy
“Energy and Pollution

Productivity: AA Putty Clay Approach,"
Approach,” National Bureau of
Economic Research (mimeo), 1976.
156

U.S. PRODUCT!
PRODUCTIVE
VE CAPACITY: A
A COI44ENT
COMMENT
Pham Chi Thanh
I find myself in a somewhat unenviable position. The three papers

you heard this morning represent three different approaches to the
measurement of U.S. productive capacity.

The three conclusions
conc1 us ions that

another--almost to the
emerged differ quite significantly from one another——almost

point of being contradictory. It is virtually an impossible task as a
discussant, therefore, to be nice to all of the authors since if one
agrees with one, one will
wi 11 probably haye
have to disagree with another. The
perhaps is to play the role of a Devil’s
Devil's Advocate to all
easiest way out perhaps
three papers, and so I will try to catch the Devil by the ideological
tail first.

Although the three papers represent three different approaches,
it is in the conclusions and their ideological implications that they
differ sharply. George Perry is obviously a liberal Keynesian who shows
his concern about the high level of unemployment. To say that there is
a large gap between actual output a,,d
a1,d potential output is to imply that
there is room for the government to interfere. Bob Rashe and Jack Tatom
are just about at the opposite pole, being conservative. When they show
that actual output is only a little below potential and that it will

reach its potential maybe within a year, they are trying to sell us the
American
Dr. Thanh is Chairman of the Department of Economics, The knerican
University, Washington, D.C.

University, Washington, D.C.

157

idea that no government interference is good interference.

“Demand
"Demand

inflationary," as they
management policies are both unnecessary and Inflationary,”

put it.

It seems quite strange to hear such an idea expressed so

Keynes' famous lecture on “The
"The End of
seriously some fifty years after Keynes’

Laissez Faire.”
Faire." Peter Clark, on the other hand, seems to have managed
to put himself in the middle. I have the impression that he may be a
little bit conservative at heart but, being on the staff of the PresPresident’s
ident's Council of Economic Advisers, he cannot very well advocate nonnoninterference by the government.
Having speculated
about the
the three
three ideologies,
it is
is probably
probably fair
fair
ideologies, it
Having
speculated about

to reveal now with whom I side, if only to indicate the line of critique
that II am going to deploy.

Coming from
from a radical center like American

University, it would seem to be aa foregone conclusion.

I certainly

share George Perry's
Perry’s concern about high unemployment and his belief that
the government might be able to interfere to alleviate it, although II do

not agree with his approach to the problem of measurement of potential
output. From a pure theoretical point of view, Rashe and Tatom’s
Tatom's
deapproach is a better one, although there are a number of technical details that I found unsatisfactory. By way of substantiating these

remarks, let me begin with some background first.
To relate a given level of effective demand to aa unique volume of
employment is one of Keynes’
Keynes' famous contributions to short run analysis.
This is perfectly legitimate.

If the period is sufficiently short, one

can reasonably assume that other factors of production are fixed. After
all, the structure of social capital, for example, can only change

158

gradually.
gradually,

Thus Keynes believes that there exists aa level of aggregate

effective
effective demand that would generate full utilization of the labor force.
Keynes was aware, of course, that even in the short run full employment

does not imply a zero rate of unemployment since there will always be
frictional and/or voluntary unemployment.

On the other hand, to relate

a given rate of unemployment to aa unique level of aggregate supply is
Arthur Okun's
Okun’s contribution (now commonly
Okun’s La'(I),
Law), which
commonly referred to as Okun's

potential GNP debate.
led to this potential

Okun's
Okun’s Law is about the long-run
long—run

rather than the short-run
short—run -- at least that is how it has been used, with
--

some confusion, in the last fifteen years or so.

The general consensus

seems to be that, even in the long-run, full utilization of the labor
force implies aa certain rate of unemployment.
stenining from recent revelation.
stem~ing

This is not a new belief

Marx, for example, wrote intensively

“reserve army of the unemployed"
unamployed’ and, in modern times, one often
on the "reserve
often

hears the term the "natural"
“natural’ rate of unemployment from a conservative
1like
i ke Milton Friedman as well
we 11 as from a liberal
1 i bera 1 like Edmund Phelps.

Indeed, no rate of unemployment in the short run can be regarded as

"natural"
“natural” by anyone in any sense.
Almost everyone seems to subscribe to the view that in the long
run there is a minimum rate of unemployment that can not be reduced
permanently by fiscal or monetary measures.
''benchmark" unemployment rate.
~

This is the so-called
so~called

The obvious initial confusion was that

it was measured by the simple head count, which is appropriate only in
the short run.
run,

This is because unemployment, like sickness, takes its

toll in all age groups and in both sexes,
sexes.

159

For some reason, certain

groups like female and young males, particularly black, are more
susceptible to the disease than others.

It follows, therefore, if the

composition of the labor force changes, the benchmark rate will change
accordingly. George Perry’s
accordingly.
Perry's ingenious device of unemployment weights
is well—known
well-known and addresses itself directly to the long—run
long-run measure of
the benchmark rate.

In this respect, Peter Clark’s
Clark's work on labor force

and participation rates also deserves praise. The only thing that I am
unhappy about is
Is the easy and convenient reference to “cyclical
"cyclical variavariations” and "trend
“trend break.”
tions"
break." Of course, they are necessary to suit their
econometrics but these do not provide an explanation.

To give an

example, Perry’s
Perry's 1967 trend break happens to coincide with a remarkable
phenomenon. Beginning in about 1966, the hourly wage of unskilled and
semi-skilled workers falls relatively to the hourly wages of skilled
workers.

This was also the beginning of a period of expansion by U.S.

multinational firms.

They started to move their labor-intensive propro-

cesses of production abroad where unskilled and semi-skilled labor was
cheaper than in the U.S.

One can imagine that a great proportion of

females and young males, who were new in the ‘labor
labor market, belonged to
this unskilled and semi-skilled category.

To emphasize the point more

strongly, one could say that the largest 500 firms in the U.S. can propro-

vide the same level of output with significantly less manpower by moving
some of their production away from the U.S. and then importing these

goods back to the home market.

Clark's exclusion of
That is why Peter Clark’s

"output generated from the rest of the world,”
world," which seems perfectly
“output

reasonable and innocent on the surface, might have an important bearing

160

on domestic output and the actual volume of employment.

It would be

nice to know how much of the “output
"output generated from the rest of the

world”
world" was actually produced by U.S. multinational corporations.
Now, since all
ail authors in their revision of the Council of economic
Economic

Advisers' early estimates of potential GNP have looked upon the benchbenchAdvisers’

mark unemployment rate as a long-run concept, they all naturally extend
their analyses to take account of other factors of production
production such as
capital and energy resource.

capEveryone knows that the presence of cap-

ital input will pose great difficulty.

Even in pure theory, the

capital problem has never been quite settled. When one wants to deal
headache and I can sympathize with
with it econometrically it is a real hea4ache
Perry's complaint. Unlike non-durable
non-durah1e goods which can be handled
George Perry’s

with the help of an index, the evaluation of capital involves not only
a1so one that involves
invo 1ves time itself.
itse 1f. AA new
a cross-section index but also

o'ld airplane as it is from aa new motor
airplane is as different from an old
spea.king, however, the evaluation of capital is nomore
no more
car. Strictly speaking,

complicated than the evaluation of labor.

vionders how are we to
Perry wonders

since, withwithmeasure the flow of the productive services from a machine sinèe,

out incurring any new investment, we can expand its productivity by
extending the number of hours it is used. Well, the same applies to aa
worker.

f1 ow of productive services from a worker can always
a1ways be
The flow

1anger hours rather than adding an
expanded by making him or her work longer

extra person to the labor force.
Although Peter Clark and Rashe and Tatom recognize the difficulty,
strange tthing
they brave a try at the capital stock. The s~~ange
hing is that they

161

pay so much attention to obtaining a measure of the labor force and

unemployment that is better than the simple head count, but did not do
the same with respect to capital stock. Just as the simple head count
will give a wrong picture of labor input and unemployment, counting

machines will give a wrong picture of capital input.

Indeed, as far as

capital stock is concerned, it is very important to know the composition
of social capital, and the average life of plants and capital equipment
as well as the rate of accumulation. Any change in these will affect
the volume of output produced, and therefore the relationship between
output and labor utilization.
Knowledge of the rate of accumulation is of particular importance
when energy resource is recognized as another factor of production.
Even in the theoretical literature the introduction of an exhaustible
energy, into the analysis of growth is aa new thing.
resource, such as eneryy~
Tatom's effort in incorporating this into their
II applaud Rashe and Tatom’s

estimate of potential output.

Their use of a Cobb-Douglas production

function is however unfortunate. While there are good reasons in the
theoretical literature for the use of a Cobb-Douglas production function,
particular
there is no compelling reason for using it here. This partjcular

production function is used in the theoretical literature because it is
the best weapon to defend growth theory. Two of the special properties
of the Cobb-Douglas production function are that (i) output falls to
zero whenever one input falls to zero so that every input is essential
and (ii) the Average Product and Marginal Product of every input goes
infinity as the Input
input falls to zero.
to Infinity

162

Unless we make such assumptions,

there cannot be any economic growth when exhaustible resource is a
factor of production If
if the stock of resource is finite and If
if its
average product is unbound
unbound only a finite quantity of output can ever

be produced. Therefore if growth is to be possible, this must not
happen. But that is the theoretical literature, where one is at liberty
one's line of defense.
to make any assumption to suit one’s

For the problem

at hand, the use of a Cobb—Douglas
Cobb-Douglas functon, besides its usual distorted
involves also the implication of Infinite
infinite subsubpicture of production, Involves
stitution possibility between energy and other input.

If the price of

one Input
input rises relative to another, we substitute. Well, the concept

of substitution at the macro level in economics is a strange one.

misunderis like a beautiful woman, always being loved and always being misunder-

stood.

Substitution in the macroeconomic sense does not mean input can

always be ininedlately,transformed.
immediately transformed. AA drastic fall in wage rate today
does not mean that each Greyhound bus from Chicago to St. Louis will
now be driven by ten drivers.

A drastic rise in the price of fuel does

not mean that the bus will be pushed liy
1w drivers to St. Louis all the
way from Chicago.

Substitution in the
th" macro sense must be understood

as scrapping old equipment and replacing it with new, accompanied by aa
1abor intensity and/or different fuel consumption.
different labor

Very high

fuel
wiil lead to the production of new cars which consume less gas.
fuel cost will

In other words, it takes time and needs the help of technical progress.
Tatom make the
In using a Cobb--Douglas
Cobb—Douglas production functon, Rashe and Tatoni
same specification error as the followers of Solow made more thap
than a
decade ago. The elasticities a, 8Band
and yyin
in their paper are the

163

"surrogate" elasticities. They do not tell us about the
so-called “surrogate”
information about the production
relative shares nor do they give any Information
process. Therefore, the calculation of potential output based on such
is quite futile.
Th.eir estimate of demand for energy is
a function
function is~quite
futile. Their

based on the assumption that energy will always be used, up to the
point where the value of its marginal product is equated to its price.
Beside the implication of Instant
instant substitution that I mentioned earlier,
this assumption also carries another extraordinary implication. Their
estimated value of the output elasticity for energy is 94%
9.4% which implies
that the share of energy factor in the U.S. national income is almost
10%!
1O%t

Earlier, I said that the knowledge of the rate of saving is of
particular importance when energy resource is recognized as another
factor of production.

If income is to grow steadily, then the rate of

saving affects not only the rate of growth but also the level of output
produced.

Tatom's calculation of growth rate of 3% is
Rasche and Tatom’s

therefore more of a wild guess than aa meaningful estimate.

In general, I think it is possible to estimate potential output,
which corresponds to given levels of input utilization. But to do so,
one needs to be able to estimate capital stock and energy resource
utilization correctly. The three papers do not give satisfactory calcalculations in this respect.

From a more general viewpoint, I also think

the debate misses aa fundamental point. Everyone obviously likes to see
a lower rate of unemployment and it may be possible to reduce it to aa
long run minimum rate by expanding output. But this is a shortsighted

164

view.

Faster growth rate or higher production also means using up

exhaustit)le resources
resourcr::, at a faster rate.
rate.,
exhaustible

i:Jrong choice may mean
mr~an drying
dr~ring
Af\ wrong

up resources at a point in
-in time
time that we cannot afford to
tn do so.
so~ The
prob1 em is not a simple
s imp·i e trade-off like the inflation-unemployment
problem
trade-off of the good old days of the Phillips’
Phillips' curve.

It is more like
1 ike

a trade-off between
betwi!en 1low
ow unemployment
unenip I oyment now and high unemployment later
1ater

or relative abundance
abundo.nce now and poverty later.
later"

The choice involves

future generations
gcneratioris yet to be born, and
crnd therefore,
tht:reforeo\ no
r.o social
socia"I contract
contra.ct

is possible. I think that unless we can address ourselves to this prob—
len, the estimation of potential GNP or benchmark unemployment rate

does not have much meaning beyond an intellectual exercise.

165

Full text of U.S. Productive Capacity: Estimating the Utilization Gap : Proceedings of a Conference Cosponsored by Center for the Study of American Business and Federal Reserve Bank of St. Louis, October 7, 1977

FRASER