The updated Okun method for estimation of potential output with alternative measures of labor underutilization

Abstract

This paper extends the Updated Okun Method (UOM) for estimation of potential output proposed in Fontanari et al. (2020), which, from a demand-led growth perspective, regards potential output as an empirical approximation to full-employment output, as in A.M. Okun's (1962) original method. Based on the apparent incapability of the official rate of unemployment to fully account for labor underutilization, we offer estimates of Okun's law both with alternative unemployment indicators and with an indicator of ‘standardized hours worked’ which we propose as a novel measure of the labor input. The paper reflects on the possible different empirical measures of full employment. The different estimates of potential output that we obtain show greater output gaps than those produced by standard methods, thus highlighting a systematic tendency of the latter to underestimate potential output. We define a ‘corridor’ of output gap estimates and propose a two-step procedure to identify the most relevant gap for policy purposes. JEL Codes: E60; E24; O40; E12; C30