Output Gap and Inflation

In a recession, a fall in aggregate demand leads to a negative output gap. A negative output gap is a situation where actual GDP is less than potential GDP. This output gap is indicated by the rise in unemployment and unemployed resources.

The level of the output gap is crucial for determining inflationary pressures in the economy. A large negative output gap suggests inflation should be low. It is a situation where monetary policy will be lax (low interest rates to stimulate growth and reduce negative output gap).

A positive output gap - where growth is above the trend rate of growth, should lead to inflationary pressures.

A very simple measure of the output gap may be to assume productive capacity increases at 2.5% a year (close to the UK's average post war growth rate). Therefore, if you have a fall in GDP of 6% (like 2009), you would expect a large negative output gap, and minimal inflationary pressures.

Measuring Output Gap in Practise.

In practise it can be more difficult to measure the output gap. For example, in the aftermath of a recession, there may be much less spare capacity than you might anticipate.

• Unemployed workers may leave the labour market and become economically inactive.
• Firms close down leaving depressed areas and regions
• Banks may have lost money in recession and therefore become very strict with their lending.

Also the situation may be confused by supply constraints in some industries, but spare capacity in others.
Nevertheless it is possible to make an estimate of how much spare capacity there is in the economy.

UK Output Gap and Inflation

source: HM Treasury (see bottom)

This graph shows the UK's estimated output gap (by HM Treasury) and inflation.
As you might expect there is often an inverse relationship. In the late 1980s, the Lawson boom led to a positive output gap and inflation rose to just under 10%. After the 1991/92 recession, the output gap became negative and inflation fell.

However, the 2008 rise in inflation was unrelated to the output gap. This is because the inflation was temporary and cost push inflation.

The graph doesn't show the recent rise in CPI inflation to 4%, but this rise in inflation has not been combined with a decline in the negative output graph.

The HM Treasury report suggests that many factors can affect inflation apart from the output gap.

• Indirect taxes.
• Effect of devaluation on import prices
• Rise in commodity prices.
• Inflation expectations.

Graph showing Contributions to Inflation in UK

Nevertheless, estimating the output gap helps give a broader understanding of the nature of inflation and the degree of underlying (demand pull inflation)

References

• Inflation and Output Gap in UK - HM Treasury

Related

• Government borrowing and output gap
• Exchange rates and inflation
  

Economics of High Speed Rail Links

A recent report criticised a proposed new High Speed rail link between London and Birmingham (HS2) on the grounds that:

• Cost of building scheme (£17bn) is hard to justify given benefits would be limited to relatively small number of passengers.
• Benefits of reducing CO2 emissions are limited.
• There is a stronger argument for using government spending to improve existing rail infrastructure, e.g. longer trains and making better use of existing lines.

Supporters argue that demand for rail travel is continuing to grow. By 2020, projected rail use will have outstripped capacity. Investment is needed to provide more services and meet future demand. By providing extra capacity, it will relieve congestion on roads and improve the infrastructure of the UK economy. Also, by offering better quality, faster rail services, it will encourage more people to choose train. Like building new roads increased demand for car travel, building faster lines will create demand for train use.

Report calls for Rail scheme to be scrapped at Independent.

There may be a good case that investment funds may be better used on existing capacity. However, in this debate it is useful to take into account external benefits which are often ignored in public debate about the desirability of various transport schemes.

Death Rate by Mode of Transport

By comparing death rates by billion passenger KM, train travel is much safer than car use. A fatality rate of 1.9 per billion KM, compared to 0.3 billion KM for train.

Source: ONS - Social Trends 40

• Fatality rates of transport should be given a significant economic cost. If one form of transport is fives times safer than another, then this is a significant external benefit, which justifies government subsidy.
• The other issue is time. A new high speed train link helps save time for both rail users and car users who benefit from lower levels of congestion.
• The growth in train travel in the UK, is despite the fact that services are often overcrowded with a perception of being late and expensive. If train services are quicker, it will attract more people to choose train travel rather than drive.
• Related to the issue of time, is the fact that train travel offers opportunity to work. In the age of iPads and laptops, train travel can become an opportunity to work rather than get stressed driving through the streets of Birmingham.

This doesn't mean all high speed rail networks should automatically go ahead. But, when deciding, greater mention should be made of other externalities. Train travel does justify government subsidies, but often in the UK we have made decisions on the rail network based on simple profit and loss. This has left the UK, with a transport infrastructure which increases cost on business.

Related

• Growth of rail travel in UK
  
• Cost Benefit Analysis