Paul Krugman - Potential Mistakes - Potential supply without potential demand?

Today Paul Krugman wrote about how potential real GDP can be miscalculated during extremes like when the economy is up against the zero lower bound.

My quick, very quick take on this is that when you determine potential output on available resources, you get a very different number when you do not include the constraints of demand. If for example, you drop real labor income by 5%, the economy is not going to be able to sell as much real output to labor. If you keep real labor income suppressed, potential output will be lower.

The potential output based solely on labor and capital resources will over estimate what the economy is potentially capable of when there is an increasing constraint from demand.

Potential output must be a function of potential supply and potential demand (effective demand).

Krugman did not refer to demand once in his article. He needs to re-define potential output taking into consideration the dynamics of potential demand.

Comments

[Steve roth]

Careful with words here I think. Capacity, potential supply, will not be utilized because of insufficient effective demand.

[Edward Lambert]

I am preparing a post now to clarify this issue.

[Marko]

We need to drop potential gdp measures altogether , and instead calculate both "potential supply" and "potential demand" , always assuming constant leverage ( i.e. debt/gdp , across the economy ).

Then you'd have measures that would indicate whether the economy is being held back on the supply side or the demand side and could tailor the policy response appropriately.

The way things are today , the only way we know to respond is to blow another asset bubble so we can lever-up even more.

[Edward Lambert]

Marko,
I second your views.