“Miiind the gap”

That´s how it sounded at London´s Waterloo tube station. But we should not ‘mind the output gap’ in economic parlance. Back in the early 1960s, Arthur Okun introduced the concept to argue that welfare could be increased if we just closed the gap, and kept it closed most of the time. And that to do it fiscal policy was the best instrument with monetary policy relegated to a supporting role, basically seeing to it that interest rates didn´t rise.

But inflation soon became a problem and then we had the “gap models” of inflation. According to those models, a reduction in inflation required increasing the gap, in other words making resources, labor in particular, temporarily ‘redundant’ so that inflation could be siphoned from the system.

Taylor-type rules followed to instruct how a central bank should proceed in order to stabilize the economy i.e. keep inflation low and stable and output close to potential. If, for some reason, a large negative gap should develop, interest rates could be reduced because ‘slack’ would keep inflation at bay. If ‘slack’ persisted we should see inflation fall (and even become deflation), indicating monetary policy was not doing its job.

The corollary is that if we think there is a large output gap but inflation does not become disinflation or deflation, the conclusion must be that our ‘view’ of the gap is illusory, i.e. the gap is much smaller than we think. The implication is that we´re in a “new normal” and that trying to go back to the “old normal” is self-defeating i.e. inflationary!

The best, I think, is to forget about real output gaps and instead concentrate on nominal spending shortfalls (not ‘gap’ mind you). If one can leave ‘inflation’ out of the discussion that would also be a plus.

Krugman, Ryan Avent and David Beckworth discussed the large gap-no disinflation puzzle. I think David Beckworth put it best, partly because he was the last to do a post on the topic and partly because he provides ample illustration.

His thinking:

Below is a table that compares the output gaps and inflation rates that occurred after the troughs of 1933 and 2009.  Again, we see that inflation rates were not that different.

Gaps_1

The only big difference between the periods is the output gaps. The mid-1930s output gap was far larger than the current one and yet that period had a similarly-sized rate of inflation. For me, then, the interesting question is why has inflation during the last two largest U.S. economic crises been similar? Why were they both gravitating around 2%? Ryan Avent has an answer that I suspect is true to some extent for both periods:

[T]he Fed’s observed success in averting deflation should lead one to ask whether its control over inflation expectations suddenly evaporates once those expectations hit 2%. My view is that it does not—why should it, after all?—and that the main constraint on a faster economic recovery is the Fed’s reluctance to push inflation over 2%.

And his punch line:

This makes a lot of sense for the 1930s too since it is well documented the Fed was concerned about inflation getting too high during this time. There were a few years of higher-than-normal inflation, but the average inflation rate was kept in line by the Fed. Even at the expense of creating a recession in 1937-1938. History repeats itself.

Yes, the Fed can make inflation be whatever it wants it to be, independent of the ‘size of the output gap’!

If that´s true, the Fed can also make another nominal variable, the nominal spending level, be whatever it wants it to be. In the present and in any, even if less drastic situation, it is surely a much better ‘target’ for monetary policy.

2 thoughts on ““Miiind the gap”

  1. Pingback: “Miiind the gap” | Fifth Estate

  2. Pingback: Some plots of Canadian prices | Economic Sophisms

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