Growth Accounting, Potential Output, and the Current Recession

An important question facing policymakers is how much slack the economy has. One interpretation of the surge in inflation in the 1970s is that the Federal Reserve overestimated the level of potential output and, hence, thought the economy had a lot more slack than it actually did (Orphanides 2002). This Economic Letter looks at potential output from the perspective of growth accounting, which assesses some of the key supply-side factors determining sustainable, noninflationary potential output. Perhaps most importantly, we find that the underlying pace of efficiency improvements—“technological progress, ” broadly construed—has remained strong during the recession. This strength offers a reason for cautious optimism about potential output and the long-term health of the American economy. More immediately, stronger potential relative to the same observed output implies substantial slack in the economy. Inputs, utilization, and total factor productivity Growth accounting decomposes output growth into changes in inputs of labor and capital (buildings, computers, machine presses, etc.) and the efficiency with which these factors are combined. This method does not seek to explain why inputs change the way they do: Some changes might be warranted, efficient responses to the shocks hitting the economy. But, as we discuss, growth accounting can stil