Monday, February 21, 2011

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)



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