Question

What role does the output gap play in setting monetary policy?

Answer 1

Introduction

Output gap measures are used as if they were essential and reliable for assessing macroeconomic policies. Both fiscal and monetary policy reaction functions use output gap estimates as an input in assessing the appropriate settings for relevant instruments (e.g., the structural fiscal balance or the interest rate). While fiscal and monetary authorities analyse a wide variety of indicators in assessing the cyclical position of the economy (including deviations of unemployment from its natural rate), they frequently resort to the output gap to summarize their assessment of economy-wide spare capacity.

The output gap is an economic measure of the difference between the actual output of an economy and its potential output. Potential output is the maximum amount of goods and services an economy can turn out when it is most efficient—that is, at full capacity. Often, potential output is referred to as the production capacity of the economy.­

Just as GDP can rise or fall, the output gap can go in two directions: positive and negative. Neither is ideal. A positive output gap occurs when actual output is more than full-capacity output. This happens when demand is very high and, to meet that demand, factories and workers operate far above their most efficient capacity. A negative output gap occurs when actual output is less than what an economy could produce at full capacity. A negative gap means that there is spare capacity, or slack, in the economy due to weak demand.­

An output gap suggests that an economy is running at an inefficient rate—either overworking or underworking its resources

Inflation & Unemployment

Policymakers often use potential output to gauge inflation and typically define it as the level of output consistent with no pressure for prices to rise or fall. In this context, the output gap is a summary indicator of the relative demand and supply components of economic activity. As such, the output gap measures the degree of inflation pressure in the economy and is an important link between the real side of the economy—which produces goods and services—and inflation. All else equal, if the output gap is positive over time, so that actual output is greater than potential output, prices will begin to rise in response to demand pressure in key markets. Similarly, if actual output falls below potential output over time, prices will begin to fall to reflect weak demand.

The output gap can play a central role in policymaking. For many central banks, including the U.S. Federal Reserve, maintaining full employment is a policy goal. Full employment corresponds to an output gap of zero. Nearly all central banks seek to keep inflation under control, and the output gap is a key determinant of inflation pressure.­

Because the output gap gauges when the economy may be overheating or underperforming,­

Typically during a recession, actual economic output drops below its potential, which creates a negative output gap. That below-potential performance may spur a central bank to adopt a monetary policy designed to stimulate economic growth—by lowering interest rates, for example, to boost demand and prevent inflation from falling below the central bank’s inflation rate target.­

In a boom, output rises above its potential level, resulting in a positive gap. In this case, the economy is often described as “overheating,” which generates upward pressure on inflation and may prompt the central bank to “cool” the economy by raising interest rates.­

Governments can also use fiscal policy to close the output gap. For example, fiscal policy that is expansionary—that raises aggregate demand by increasing government spending or lowering taxes—can be used to close a negative output gap. By contrast, when there is a positive output gap, contractionary or “tight” fiscal policy is adopted to reduce demand and combat inflation through lower spending and/or higher taxes.­

Some policymakers have recently suggested that, in an increasingly integrated world economy, the global output gap can affect domestic inflation. In other words, all else equal, a booming world economy may increase the potential for inflation pressure within a country. For example, stronger global demand for computers raises the price U.S. producers can charge their foreign customers. But because all computer producers are facing a stronger global market, U.S. producers can charge more for their output at home as well. This is known as the “global output gap hypothesis” and calls for central bankers to pay close attention to developments in the growth potential of the rest of the world, not just domestic labor and capital capacity.­

But there is so far no conclusive evidence to support the notion that a global output gap influences domestic prices. Still, the global output gap may become increasingly important if the world’s economies continue to integrate.

Because of the difficulties of estimating potential output and the output gap, policymakers need several other economic indicators to get an accurate reading of overall capacity pressure in the economy. Among those indicators are employment, capacity utilization, labor shortages, average hours worked and average hourly earnings, money and credit growth, and inflation relative to expectations.­

These alternative measures of capacity can help policymakers enhance their measurement of the output gap. Even though it is difficult to estimate, the output gap has guided and will continue to guide policymakers.­