Studying Growth in the Modern Classical Approach: Theoretical and Empirical Implications for the Analysis of Potential Output

Abstract

The main characteristics of the modern classical approach to growth are studied with particular reference to the notion of ‘potential output’. In contrast to mainstream approaches, which consider potential output to be exogenous and supply-determined, it is here regarded as endogenous and path-dependent. A tentative analysis is carried out of the implications of such a conception in empirical research, with special reference to the effects of the crisis on potential growth. Mainstream estimation methods (especially those used by international institutions) are shown to be deeply influenced by theory, but also to provide dubious and puzzling results. Very different empirical results and policy implications may be obtained from the standpoint of the alternative theoretical framework provided by the modern classical approach. On this basis, the paper proposes that the long-term policy target should be set in terms of the rate of unemployment rather than potential output or potential growth.