Potential output in monetary policy

When it comes to “potential output” there is often a view that the economies potential to produce is determined by the labour, land, and forms of capital that are available to create this output from – and this is right!  Furthermore, each of these factors tends to produce a diminishing amount of additional output as you use more of it.  Although the factors of production are often complementary this often implies a situation where – in the long-run – the potential for output (and growth in said output) in a nation is fundamentally about technological change and the quality of institutions.

However, in a recent speech by John McDermott of the RBNZ he points out that, when it come to considering monetary conditions, the type of “potential output” we are interested in is a bit different.

The story I gave in the first paragraph is one of the long-run steady state, the situation where an economy settles down to where factors of production are utilised efficiently to create output.  However, when considering monetary policy the Bank is interested in the short-medium term, where capital and labour may be allocated poorly and the Bank’s efforts to stimulate demand will instead create inflation instead of pushing the economy back to its long-run potential.

There are a lot of interesting points in McDermott’s speech, I recommend reading it yourself.  However, it is important to keep in mind that the potential output discussed by an organisation like the Productivity Commission, and the potential output discussed by the RBNZ, are very different.  The RBNZ is saying “given where policy is, and the structural impediments in goods, labour, and capital markets, how far can we support the economy by stimulating demand” – their potential output tells us how far they think they can achieve this aim.  The PC is asking “looking past the business cycle, in the long-run how do current institutions and policies influence the output in the economy”.

Hysteresis, and associated ideas of multiple equilibrium, is the area that potentially ties these together – but these would need to be due to fundamental flaws in central bank policy stemming from a direct refusal to consider what potential output really is when setting policy, they are not the result of considering potential output in the way McDermott has suggested.