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Chapter 13 GDP Output Gap
Put out
Adapted from an article in the Economist, July 2nd, 2009.
Uncertainty over the size of the output gap complicates the task of
central banks
The output gap is the difference between actual economic output and the
most the economy could produce given the capital, know-how and people
available. When actual output exceeds potential, demand for products and
labour bids up prices and wages, fuelling inflation. When actual output falls
short, competition for scarce sales and jobs puts downward pressure on
Estimating how big the output gap is, and how much of a deflationary threat it
still poses, is not easy. The Congressional Budget Office (CBO) estimates
that the gap topped 6% in the first quarter of this year and will average more
than 7% in 2009, which would be the largest figure on record. Given that core
inflation was so low when the recession began, it is not a stretch to believe
that, with so much slack in the economy, it could yet turn negative. But this
view has been challenged in a note by John Williams and Justin Weidner of
the Federal Reserve Bank of San Francisco. Rather than follow the
conventional route of deriving an inflation forecast from an estimate of
potential output, they do the opposite: they infer the output gap from the
behaviour of inflation. As in the euro zone where consumer prices fell for the
first time ever in the 12 months to June, and Japan where inflation excluding
perishable food was -1.1% in May, inflation in America is now negative
because of a drop in fuel prices last year. But core inflation is 1.8%, within its
range this decade. The authors take this as evidence that the output gap may
have been only 2% in the first quarter, implying little or no threat of deflation.
NAIRU’s non-alignment
This divergence in estimates highlights the biggest problem in relying on the
output gap: it is a slippery thing to measure. How do you really gauge a firm’s
capacity, especially in services? How many of those not working could work?
How fast is productivity growing over time? Economic shocks make the task
even harder. They may render big chunks of the capital stock obsolete: many
idle car factories, for example, may never reopen. Workers thrown out of a
shrunken industry like finance or construction may take years to retrain for
another. Some may never succeed. Although unemployed, they are not really
competing for the jobs that fall vacant and are thus not putting much
downward pressure on wages. That means the “non-accelerating inflation rate
of unemployment”, or the Nairu, may have risen. In other words, when actual
output falls, it can drag potential output down with it—the main reason why Mr
Williams and Mr Weidner believe that the gap is smaller than the CBO’s
©McGraw-Hill 2009
Economics for Business 3e David Begg and Damian Ward
That recessions can reduce potential output is not controversial. The question
is: by how much? In its latest Economic Outlook, the OECD concludes that
the collapse in business investment will cause potential output to grow more
slowly in America this year and next but that it will not fall. It does think the
Nairu will rise measurably in the euro area, where relatively rigid labour
markets mean someone who loses a job will take much longer to find another,
during which time his skills atrophy. But in the United States, whose job
market is more flexible, the Nairu will barely rise (see chart).
If Mr Williams and Mr Weidner are wrong and the output gap is large, then
there are other explanations for why American inflation has not fallen further.
The simplest is that not enough time has elapsed. Chris Varvares of
Macroeconomic Advisers, a forecasting consultancy, thinks that core inflation
will fall to close to zero in 2011. While it has been firm so far this year, he
argues it will fall noticeably later this year as residual seasonal factors recede.
Even if inflation were to fall to between zero and 1.5%, say, that would be a
small drop given the CBO’s estimate of the output gap. A comparable gap in
1981-83 produced a drop in core inflation of six percentage points. But in the
early 1980s, inflation had fluctuated so much for so long that workers and
firms quickly adapted their wage- and price-setting behaviour to the latest
trends, so inflation responded more swiftly to falling demand. Since then,
inflationary expectations have stabilised at around 2%, which means that
inflation responds more sluggishly to demand (as the recessions of 1990-91
and 2001 demonstrated). The OECD notes that when Finland and Canada
experienced large and persistent output gaps in the 1990s, inflation fell quite
far but did not become deflation, which it attributes in part to the success of
central banks in anchoring expectations with inflation targets.
Such expectations may rise if investors worry that central banks will print
money to finance governments’ rising fiscal deficits. But even if they remain
©McGraw-Hill 2009
Economics for Business 3e David Begg and Damian Ward
well anchored, expectations alone do not explain why inflation does not
respond more to economic slack. A large and persistent output gap in the
1990s eventually tipped Japan into deflation in 2000; inflation expectations
also turned negative. As long as the gap persisted, deflation should have
accelerated. It did not, ranging from -0.3% to -0.9% between 2000 and 2003.
According to Ken Kuttner, an economist at Williams College, Japan’s output
gap may have been smaller than thought; workers may have resisted pay
cuts; and perhaps most important, at low rates of either inflation or deflation
firms may change prices less frequently, reducing the impact of output gaps.
If so, this would provide a buffer to deflation in the rich world today, despite
the presence of large gaps. But the thought is not entirely comforting. It also
means that if inflation does fall to zero or turns slightly negative, it could be
difficult to get it back up. The best cure for deflation remains prevention.
1 Explain both the short and long run relationship between unemployment and
2 “…when actual output falls, it can drag potential output down with it—the
main reason why Mr Williams and Mr Weidner believe that the gap is smaller
than the CBO’s estimates.” Draw a diagram illustrating this argument.
3 “at low rates of either inflation or deflation firms may change prices less
frequently, reducing the impact of output gaps.” Which school of economic
thought is this statement most closely associated with?
©McGraw-Hill 2009
Economics for Business 3e David Begg and Damian Ward