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Estimated Potential GDP - What Would Milton Friedman Say?

The CBO has revised downward the estimate of potential GDP, implying a relatively small output gap. I wonder about the downward revision (although I have the highest regard for the estimates CBO has generated.)

Figure 1: Log GDP (blue), potential GDP from Jan. 2015 (bold gray), potential GDP from Feb. 2014 (gray), and potential GDP as estimated using a modified Ball-Mankiw approach (red). NBER defined recession dates shaded gray. Source: BEA, 2014 Q4 advance release, CBO, Budget and Economic Outlook, Jan. 2015, and Feb. 2014, NBER, and author's calculations.

The output gap using the estimated potential from the CBO is about -1.9% (in log terms); using the estimated potential from last year's Outlook would've implied a -3.5% gap. While I know the developing consensus is that the economy is approaching potential, I do wonder why inflation is so low, and dropping, if we are near capacity. After all,… Read More …