Output Gaps In Addition To Inflation

The output gap is a key concept inwards mainstream economical analysis of inflation. Although I am non happy with the details of the measure analysis of what determines inflation, I exercise a weaker version of the measure output gap inwards my thinking. I refer to this version every bit the generalised output gap (GOG). In this article, I give a simplified summary of economical theories of inflation in addition to how diverse conceptions of the output gap relate to this.

Simplified Inflation Theories

Since a academic history of theory of inflation would plough into a rather large book, I am going to speedily outline basic archetypes of such theories, without direct associating these views with historical schools of thought. Please continue inwards heed that most economists had to a greater extent than nuanced views on inflation than these archetypes.

What I am interested inwards are theories that explicate the degree of aggregate inflation (for example, "why is the CPI rising at an annual charge per unit of measurement of 1% rather than 3%"?), in addition to non theories virtually the details of why prices rise.

Within the mainstream, I would split upward theories that explicate inflation into v groups.

1. Prices determined at the margin. Prices are determined yesteryear the intersection of render in addition to demand curves; insert comments virtually marginal productivity here. Since render in addition to demand curves are non direct observed, this "theory" does non offering much inwards the way of insight, in addition to I volition non verbalise over it farther here. The theories that follow are likewise based on the belief that pricing is determined at the margin, but the shifts inwards render in addition to demand tin live on associated with other measurable variables.
2. Crude Quantity Theory of Money. This theory says that if y'all increment the quantity of "money" inwards the economic scheme yesteryear 10%, in addition to handle all else equal, the cost degree volition rising yesteryear 10%. I volition only assert hither that this unsmooth theory plainly fails empirically, but an interested reader tin read an before primer for to a greater extent than of my thoughts on this matter. It should live on noted that many DSGE models embed a unsmooth quantity theory of coin inwards the mathematical centre of the models, but the implications of this are typically ignored inwards exercise (other than yesteryear the people who thought Quantitative Easing was "printing money" in addition to would Pb to inflation).
3. Fiscal Theory of the Price Level. The cost degree is determined yesteryear the expected path of primary financial surpluses; if the financial stance is changes towards running higher primary (ex-interest expense) deficits, the final result volition live on inflation. I verbalise over this theory here, every bit good every bit inwards other articles on my site. The Fiscal Theory of the Price Level (FTPL) is a heretical schoolhouse of thought inside DSGE macro, which argues that it is the driving strength behind the results inwards those models, in addition to non monetary policy per se. That debate is beyond the reach of this article, but I would banknote that the FTPL is toxic for DSGE models, every bit it does non appear to handle upward to empirical scrutiny.* 
4. Central Bank Fiat. Expectations virtually inflation are an of import element of DSGE modelling of inflation. This tin live on taken to an extreme, in addition to i tin fighting that the key depository financial establishment exactly announces a target for inflation, in addition to it volition magically teach in that location through the powerfulness of expectations management. Other than a few academic eccentrics, this theory is non widely credited, fifty-fifty though it is embedded inside DSGE model assumptions. Since inflation targets (where they exist) receive got been fixed quantities, key bank-driven expectations cannot tell us a lot virtually the variations of inflation or in addition to hence the target.
5. Inflation is demand-driven. Inflation rates are driven yesteryear the province of aggregate demand (as good every bit expectations). This ends upward beingness associated with the output gap (or NAIRU), discussed below.

Since I catch myself some shape of post-Keynesian, I would honey to explicate the corresponding post-Keynesian theories of inflation. Unfortunately, the best summary I tin come upward up with is: "it's complicated." It is discussed inwards Chapter eight of Marc Lavoie's Post-Keynesian Economics: New Foundations (review), in addition to he provides the next quotations (page 542). From Weintraub, "economy is primarily a money-wage system," that is, a key factor inwards monetary economies are the nominal degree of worker's wages. Moreover, Robinson argued that "in our model, every bit inwards reality, the degree of the money-wage charge per unit of measurement obtaining at whatever particular 2d is an historical accident."

As I receive got noted above, my commons involvement is attempting to predict the degree of inflation over the side yesteryear side few years, in addition to non describing the procedure causing inflation. To a sure extent, post-Keynesian inflation theory is an endeavor to explicate those processes, rather than the degree of inflation. There are quantitative theories discussed inwards the book, but I am non familiar plenty with them to summarise them here; that volition live on done inwards after articles. My initial impression is that many of them are based on the conflicts that arise inwards wage setting situations, which I encounter every bit reasonable. However, I am less sure that nosotros tin model what causes shifts inwards those conflicts. (For example, what shifts caused inflation to teach from 3% to 1%, or whatever?)

Lavoie's text likewise includes an extended give-and-take of external effects (foreign trade) on the cost level. Obviously, internationally traded commodity prices are largely non determined yesteryear alone domestic factors (certainly for smaller countries similar Canada). If I desire to model headline CPI (which includes gasoline prices), I am perfectly happy to exit the cost of fossil oil every bit a driving factor that is external to the model; the model forecast is conditional upon your fossil oil cost forecast, which presumably depends upon what is happening inwards the global economy. Core (ex-food in addition to energy) in addition to wage inflation is much less subject upon traded practiced in addition to commodity prices (at to the lowest degree inwards most developed countries), in addition to that is what nosotros are hoping to model.

Many post-Keynesians volition object to my minimisation of the number of the external sector on the domestic cost level. I would exactly answer that the importance of the currency is conditional upon a country's economical institutions. Countries that are inwards hyperinflation, or only receive got sustained high inflation, oft halt upward with domestic prices for many goods beingness effectively indexed to unusual prices. This creates a 1:1 pass-through from the value of the currency to the cost of those indexed goods. In such a case, it would live on plainly crazy to ignore the value of the currency.

But this is non the commons province of affairs for developed countries. For example, I am at i time holding a volume manufactured inwards the USA where the printed listing cost is $29.99 USD, in addition to $35.99 CAD. This is an embedded central charge per unit of measurement that values the Canadian dollar at less than parity, whereas when I bought the volume the Canadian dollar was worth to a greater extent than than the U.S. dollar. The volume was non priced inwards Canada every bit a translated American price, rather it is priced relative to other books inwards Canada, in addition to those prices do non vary based on the central rate. There are presumably limitations; if the Canadian dollar collapsed to CAD$3 = USD$1, I imagine that listing prices would live on adjusted. But nosotros do non tend to encounter such hefty devaluations exterior of currency peg environments.

In summary, the mechanisms explaining inflation rates are complicated. But I would fighting that in that location is a fairly widespread belief that "excess demand" weather condition are somehow related to the degree of inflation, although this could live on disputed yesteryear minorities inside the mainstream in addition to non-orthodox schools of economical thought.

Plausibility Of Excess Demand-Side Explanations

The nautical chart higher upward shows that stronger growth is to a greater extent than oft than non associated with stronger inflation, in addition to weaker growth (particularly recessions) are associated with weaker inflation (at to the lowest degree for the "modern" U.S. economy). In particular, wage in addition to CPI inflation savage considerably after the iii recessions during the menstruum depicted. The experience inwards other developed countries over this menstruum was similar, although some countries had some particular circumstances (such every bit Republic of Iceland after the financial crisis).

If y'all desire to explicate headline inflation, the underlying trends higher upward were distorted yesteryear the diverse swings inwards fossil oil prices. At to the lowest degree for the menstruum shown, headline inflation to a greater extent than oft than non converged dorsum to the tendency defined yesteryear centre inflation. (That is, in that location is piddling sign of rising fossil oil prices creating a wage-price spiral.)

I recognise that the experience inwards the 1970s with "stagflation" (simultaneously high inflation in addition to depression growth) does non appear to represent with this model. I am non interested inwards debating the 1970s experience; I volition exactly banknote that I used the weak phrasing "stronger growth is generally associated with stronger inflation," in addition to exit it at that.**

The output gap is an endeavor to do a to a greater extent than formal version of this observation virtually growth in addition to inflation.

Definitions For The Output Gap

Many post-Keynesians are non fans of the "output gap." For example, I was late given a reference inwards the comments to this article yesteryear Paul Ormerod, "The so-called ‘output gap’: some other slice of economical mumbo-jumbo." I largely handle with his sentiments inside the article, yet at the same time, I volition nevertheless refer to the "output gap" constructively. Upon reflection, I realise this is because in that location are a number of definitions for the "output gap," in addition to people switch alongside them without specifying which i they mean.

Given this imprecision, I volition at i time give a serial of definitions for unlike output gap concepts, which are distinguished yesteryear their acronyms. It should live on underlined that these are my definitions; if y'all teach elsewhere for a definition of the output gap, it volition only roughly represent to i of these definitions, or a hybrid of them.

• Strict Output Gap (SOG). We define a concept called "potential GDP," in addition to it is determined yesteryear a production function. The SOP is a fourth dimension serial which is actual (real) gross domestic product less potential GDP. (Reminder: existent gross domestic product is Gross Domestic Product adjusted for inflation.) This production component has inputs which consist of the size of the labour force, in addition to physical capital, in addition to is of some uncomplicated shape similar the Cobb-Douglas production function. Once nosotros receive got estimated the parameters of the production function, nosotros tin predict the development of potential gross domestic product based on changes inwards the labour strength in addition to capital. If nosotros are worried virtually falsifiability (which nosotros should be), this definition is eminently falsifiable, every bit nosotros receive got a strong definition of potential gross domestic product which is based on direct measured inputs. (It may live on difficult to guess them inwards existent time, but nosotros tin at to the lowest degree evidence the historical fit.) There is a wiggle factor inwards the shape of full factor productivity, but every bit long every bit its development is plausible, nosotros tin evidence the theory.
• Really Stupid Output Gap (RSOG). Calculate potential gross domestic product using the Hodrick-Prescott filter (as discussed here). Although this method was done historically, it was abandoned yesteryear most economists a long fourth dimension ago. It tin live on falsified, which has already been done (repeatedly).
• Generalised Output Gap (GOG). Once nosotros ready an economical model, the GOG is a province variable that has the belongings that inflation volition displace inwards the same administration every bit the GOG. That is, if the GOG increases, inflation would live on higher if nosotros handle all else equal, in addition to vice versa if the GOG decreases. (If a variable has the contrary effect, nosotros exactly multiply it yesteryear -1 to teach a GOG.) There is no supposition that the GOG is direct measurable, nor is in that location a agency to direct build it from measured economical variables. Additionally, the GOG is model subject -- the estimated GOG would vary depending upon what model nosotros choose.
• Slippery Middle Output Gap (SMOG). This is a concept that lies betwixt the SOG in addition to the GOG. In it, nosotros receive got a province variable, which is denoted "potential GDP," in addition to the SMOG is the difference betwixt potential gross domestic product in addition to actual (real) GDP. The potential gross domestic product is an guess that is model dependent, similar to the GOG. I would fighting that the SMOG is the measure mainstream definition of the output gap used inwards practice, in addition to "market economists" volition bound betwixt it in addition to the GOG definition. 

The nautical chart higher upward shows an guess of the  output gap, based on the Congressional Budget Office's (CBO) guess of potential GDP. I believe that the CBO's guess of the output gap would qualify every bit beingness a SOG version, at to the lowest degree based on reading this document. Deciding how useful this SOG is for predicting inflation is left every bit an exercise to the reader, but the nautical chart does advise at to the lowest degree some human relationship betwixt the variables.

The ground why I am sympathetic to the generic thought of the "output gap" is that I receive got the concept of the GOG, in addition to in that location is zero to distinguish the GOG from a SMOG. And since the volume of the profession implicitly accepts the SMOG, my views are practically non that unlike from the consensus. Since the GOG is non the "gap" betwixt existent in addition to potential GDP, a linguist powerfulness fighting that it is non actually an "output gap." However, since I bring out the concept indistinguishable from a SMOG, it is a lot easier to explicate my thinking if I exactly exercise the pre-existing phrasing.

One could brand the sophisticated declaration that in that location is a difference betwixt a SMOG in addition to a GOG. In a SMOG, the output gap is the difference betwixt a direct measured variable (real GDP) in addition to a estimated variable, whereas inwards a GOG, the output gap is exactly a unmarried estimated variable. If nosotros tin daze the degree of gross domestic product in addition to handle all else equal, it volition receive got an number on inflation inwards a SMOG model (the number depending on the model), whereas this daze volition non receive got an number inwards a GOG model.

However, this exactly illustrates the betoken that a sufficiently sophisticated declaration is indistinguishable from stupidity. We cannot direct daze GDP, in addition to hence nosotros cannot detect this alleged effect. Moreover, whatever reasonable guess of potential gross domestic product shows that it moves slowly, every bit does the degree of existent GDP. Therefore, the departure of these ii variables (the SMOG) moves slowly, in addition to and hence whatever plausible movement inwards existent gross domestic product volition non travail whatever statistically meaning changes inwards the model's inflation prediction over brusk fourth dimension intervals.

Since nosotros cannot theoretically distinguish a SMOG or a GOG, my analysis ends upward sounding similar to the mainstream. The differences revolve or in addition to hence acceptable estimation techniques.

Is The GOG Falsifiable?

I already discussed the possibility of falsifying the SOG in addition to RSOG variants of the output gap. The number with the GOG (and yesteryear implication, SMOG) is that falsifiability is to a greater extent than of a concern.

The offset thing to banknote is that the GOG is model-dependent. We cannot say that the GOG itself is falsifiable, rather nosotros demand to human face at the entire model. That is, does the model brand whatever useful predictions virtually the time to come dynamics of the economy? The SMOG is somewhat to a greater extent than falsifiable, every bit it is attempting to pivot downwards "potential GDP," which is direct related to a measured variable, but the estimation itself depends upon assumed model dynamics.

Secondly, the GOG should live on related to a wider multifariousness of direct measured capacity utilisation indicators (such every bit manufactory utilisation in addition to the unemployment rate). In a simplified model economy, the GOG should halt upward looking really much similar a SOG. The exact human relationship may shift over time, but nosotros should live on able to encounter at to the lowest degree some linkages.

Finally, it appears to live on a error to remember of the GOG every bit ever beingness a unmarried variable. For example, in that location tin live on considerable regional differences inside an economy; overheating inwards the oil-driven Alberta economic scheme has only a express number on those of us inwards Eastern Canada. Furthermore, in that location tin live on considerable divergences inside unlike segments of the labour market. Booming salaries for debt traders has non translated into higher reward for those working inwards the fast nutrient industry. Once nosotros start dis-aggregating our economical models, nosotros volition probable halt upward with dis-aggregated GOGs.

Relevance To The Current Situation

This article is largely theoretical. Although I bask theory for the sake of theory, the distinction betwixt the unlike versions of the output gap are of involvement for the electrical flow province of affairs inwards the United States.

From the perspective of the GOG, I would human face at the deportment of inflation serial in addition to fighting that the GOG is nevertheless negative. Although it is non necessarily direct related to particular economical variables such every bit GDP, the fact that growth has been relatively steady along with inflation over the yesteryear few years, is a sign that the GOG is non closing. Correspondingly, I encounter no ground to tighten financial or monetary policy (whatever that means) inwards guild to defeat inflationary pressures.

Conversely, believers inwards a stricter (SOG) version of the output gap to a greater extent than oft than non receive got had a harder fourth dimension explaining the U.S. economy's recent behaviour. According to some SOG estimates of the output gap (or related concepts such every bit NAIRU), the U.S. should receive got unopen its output gap, in addition to and hence monetary policy should receive got been tightened already. However, a SMOG version of the output gap should receive got adapted to the observed lack of inflation, in addition to and hence some SMOG models volition halt upward with a doveish diagnosis similar to mine. One suspects that many economists ended upward picking models based upon their pre-existing biases.

Concluding Remarks

There are a number of definitions i could exercise for the "output gap." If nosotros are willing to receive got the loosely-defined concept of a generalised output gap, it provides a way of thinking virtually inflation dynamics, but nosotros demand to continue inwards heed that it does non necessarily represent to traditional estimates of the concept. And inwards practice, many of the estimates of the output gap produced yesteryear "modern" statistical techniques (e.g., Kalman filtering) are exactly disguised generalised output gaps.

Footnotes:

* An overly simplified version of the Chartalism embedded inwards Modern Monetary Theory (MMT) would halt upward beingness really similar to the Fiscal Theory of the Price Level (FTPL). That is, an increment inwards regime spending volition mechanically enhance the charge per unit of measurement of inflation. This would live on a weakness of MMT, if this interpretation holds true. However, MMT is a schoolhouse of thought inside a broader post-Keynesianism, in addition to it inherits the overly complex post-Keynesian views of inflation every bit well. As a result, although looser financial policy is presumably associated with higher inflation, the linkage is non every bit simplistic every bit suggested yesteryear the FTPL.

** The 1970s experience has live on explained using output gap analysis every bit beingness the final result of bad real-time estimation of the output gap. That is, policy was inwards fact far looser than was thought at the time, in addition to and hence in that location was an ongoing policy error. My feeling is that the province of affairs was to a greater extent than complicated than that, but I receive got non studied that menstruum inwards plenty particular to receive got strong opinions on the matter.

(c) Brian Romanchuk 2015