Chris Giles of The FT wrote a very good article explaining the output gap using Goldilocks and the three bears. As you may know in the story Goldilocks found the first bowl of porridge too hot, the second bowl too cold but the third bowl just right. We can use this analogy with regard to the economy:
- running too hot – a positive output gap – the economy is overheating and higher interest rates and less government spending is needed to slow the economy down.
- running too cold – a negative output gap – the economy has a lot of spare capacity and needs to be stimulated by dropping interest rates and increasing government spending.
- running just right – no gap – there is neither a requirement for an expansionary monetary and fiscal policy nor a contractionary monetary and fiscal policy.
Just as Messrs Friedman and Phelps had predicted, the level of inflation associated with a given level of unemployment rose through the 1970s, and policymakers had to abandon the Phillips curve. Today there is a broad consensus that monetary policy should focus on holding down inflation. But this does not mean, as is often claimed, that central banks are “inflation nutters”, cruelly indifferent towards unemployment.
If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.
However policymakers rely on estimates of the output gap – which compares actual GDP with a country’s full capacity when all resources are fully employed. The concern that the Bank of England have is that official data shows that the UK economy is showing sluggish growth rates with a tight labour market.
Almost all employment indicators suggest the economy close to overheating – recruitment difficulties and industry facing capacity constraints. This is in contrast to economic growth which suggest that there is room for expansion. Add to this the uncertainty about Brexit, the reliability of the output gap even more dubious. Current techniques might correctly measure the output gap but what about the contribution of potential capital projects which are underway?
Some economists have suggested that output gaps are inherently political and chosen to rationalise existing policies, rather than to set the correct prescriptions. However for economists is there an alternative to taking the temperature of an economy.