Appendix 1: The derivation of the potential output equation
In a neoclassical model, the level of capital stock (K) is determined by the following equation:
The real rate of return on capital (r) = the marginal product of capital (MPk) (a1)
Assuming a Cobb-Douglas production function, the marginal product of capital is equal to
(a2)
where L is the level of labour input.
Using (a1) and (a2), K can be expressed as the following function:
(a3)
Therefore, the level of capital is determined by the level of labour supply. With all else being equal, one percent fall in labour supply should lead to one percent fall in the level of capital in the long run. As a result, a permanent 1% fall in labour supply should lower the level of potential output by 1%.
Hence, 
captures the effect of gradual changes in the capital stock as a result of a permanent change in NAIRU.
