Here is a question sent to me by email,
Inflationary gap, are you saying the blue line is potential GDP provided
Participation Rate is 66.7% (2001) or (?) and U3 at natural rate of
unemployment?
The question refers to the role of potential real GDP to determine the inflationary gap and if the low labor participation rate or U3 unemployment has an effect.
Here is the answer.
Hi _____,
The potential real GDP does not depend on unemployment nor participation rate. It only depends on utilization of capital in relation to labor share of income.
I realize there are many ways to evaluate under-employment looking at part-time work and changes in labor participation. Underemployment will show up in the capital utilization number in the equation for potential real GDP.
pot real GDP = real GDP - $3 trillion * (capacity utilization/labor share - 1)
In the equation, real GDP will rise over potential RGDP as capacity utilization rises. We see an inflationary gap grow (real GDP - potential real GDP). But there is a limit to how far it can rise. Here is the equation that establishes the limit on the inflationary gap.
Effective inflationary gap = $3 trillion * u/(1-u)
u = the unemployment rate
When the right side equals the left side, the business cycle has reached its top limit.
So, unemployment does not determine potential RGDP, ... rather... unemployment determines the limit of real GDP over potential RGDP.
So then you ask, what is the true unemployment in this second equation? It is the U3. You just need to know how many people are working. You do not need to know how much they are working because that is reflected in capital utilization and also in the productivity number.
Now, as unemployment falls, there may be slippage in the U3 as some people re-join the labor force. That is ok... Eventually when U3 reaches the point where effective inflationary gap equals the right side of the equation above, the business cycle has topped out. Think of it this way... What if some people re-joined the labor force, would the unemployment rate rise? maybe, maybe not... It depends on if they rejoin because they found work. The unemployment rate may fall with an increase in labor participation. If 50,000 people rejoin, and they all find jobs, U3 will decline.
U3 is determined by just a small percentage of the total economy. U3 for the whole economy is extrapolated from that small percentage.
If people were to rejoin the labor force, a certain percentage will find jobs, and a certain percentage will still be looking. The unemployment rate may tend to decline with an increase in labor participation if those people are being instantly employed. But then some will come back with hope, because they see some others finding jobs. On balance, the unemployment rate may not slip very much at all as the labor force participation changes.
The problem is that wages and hopes have fallen so much, that many people just went out of business, they left the labor market. And unless wages start to rise, they ain’t coming back. And that brings us back to the first equation above for potential RGDP. If wages and labor share actually rise, potential RGDP will rise too. The inflationary gap will decrease, which is just the difference between real GDP and potential RGDP. A smaller inflationary gap will then make the left side of the second equation be less. The result by raising labor share is you give more room between the left side and the right side of the second equation. This gives more room for unemployment to fall even more.
I realize my explanation is a little convoluted, jumping back and forth between the equations, but the essential answer to your question is there.
Edward
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