Selected Essays of James Tobin
Chapter 18: Supply constraints on employment and output: NAIRU versus natural rate
18. Supply constraints on employment and output: NAIRU versus natural rate* ‘POTENTIAL OUTPUT’ AND THE TWO-REGIME MODEL Every macroeconomic theory needs a concept of the economy’s productive capacity, the overall constraint on the eﬀectiveness of increasing aggregate demand in increasing actual output and employment. This is not a technocratic physical limit, such as could be relevant to a wartime emergency. In the United States in World War II the entire population was working overtime, unemployment was 1 per cent, plants were operating on shifts around the clock, and quantitative controls dictated by central government priorities displaced market prices and wages in allocating resources. This regime performed miracles. In 1944, nearly half the GNP was commandeered for war, and the remainder was greater than the entire prewar GNP. Clearly, this kind of economy is infeasible in peacetime. What we mean by potential GDP in peacetime is what a market economy, without rationing and other quantitative controls, with households and businesses making most of the decisions aﬀecting prices and resource allocations, can produce. Accordingly, capacity Net Domestic Product is sustainable GDP minus allowance for the depreciation and depletion of productive resources. These are not unambiguous concepts, because there is generally no sharp dividing line beyond which additions to demand cease to induce response in increased production. That is why it is natural to deﬁne the capacity constraint in terms of the eﬀects of additional demand on prices (including nominal wage rates). In Keynes’s General Theory (1936), potential output...
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