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Output Gaps: Uses and Limitation

Output Gaps: Uses and Limitation

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The concept of resource slack is central to understanding the dynamics between employment, output, and inflation. But what amount of slack is consistent with price stability? To answer this question, economists define baseline values for unemployment and output known as the natural rate of unemployment and potential output. The concepts of output and employment gaps can be useful to economists in several ways. First, they often guide the inflation forecasts of Federal Reserve staff and other researchers and market participants. Second, some economists argue that employment gaps are a useful guide for policy aimed at achieving maximum sustainable employment and price stability. In “Output Gaps: Uses and Limitation,” Roc Armenter briefly discusses two important examples of sophisticated measures of resource slack that are grounded in economic theory: the nonaccelerating inflation rate of unemployment and the output gap measure published quarterly by the Congressional Budget Office.
The concept of resource slack is central to understanding the dynamics between employment, output, and inflation. But what amount of slack is consistent with price stability? To answer this question, economists define baseline values for unemployment and output known as the natural rate of unemployment and potential output. The concepts of output and employment gaps can be useful to economists in several ways. First, they often guide the inflation forecasts of Federal Reserve staff and other researchers and market participants. Second, some economists argue that employment gaps are a useful guide for policy aimed at achieving maximum sustainable employment and price stability. In “Output Gaps: Uses and Limitation,” Roc Armenter briefly discusses two important examples of sophisticated measures of resource slack that are grounded in economic theory: the nonaccelerating inflation rate of unemployment and the output gap measure published quarterly by the Congressional Budget Office.

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Published by: Federal Reserve Bank of Philadelphia on Mar 10, 2011
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Business Review 
Q1 2011 1
www.philadelphiafed.org
Roc Armenter
isa senior economistin the ResearchDepartment of the PhiladelphiaFed. This articleis available freeof charge at www.philadelphiafed.org/research-and-data/publications/.
T
BY ROC ARMENTER 
Output aps: Uses and imitations*
*The views expressed here are those of theauthor and do not necessarily representthe views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
Economists have greatly improvedtheir understanding of the dynamics
he concept of resource slack is centralto understanding the dynamics betweenemployment, output, and inflation. But whatamount of slack is consistent with pricestability? To answer this question, economists definebaseline values for unemployment and output known asthe natural rate of unemployment and potential output.The concepts of output and employment gaps can beuseful to economists in several ways. First, they oftenguide the inflation forecasts of Federal Reserve staff and other researchers and market participants. Second,some economists argue that employment gaps are auseful guide for policy aimed at achieving maximumsustainable employment and price stability. In thisarticle, Roc Armenter briefly discusses two importantexamples of sophisticated measures of resource slack thatare grounded in economic theory: the nonaccelerating-inflation rate of unemployment and the output gapmeasure published quarterly by the Congressional BudgetOffice.
between employment, output, andinflation since the 1970s. The conceptof resource slack is central to thesedynamics. For example, economiststrack the share of unemployedworkers, allowing them to estimatehow quickly firms may be able toexpand employment without having toraise wages to attract workers. Othermeasures of slack are the percentageof industrial capacity available or theratio of inventories to sales.It is unreasonable to expect allworkers to be employed or industrialcapacity to be at 100 percent. Forexample, unemployed workers will takethe time to find the best job for themand perhaps may need time to relocate.What amount of slack isconsistent with price stability? Toanswer this question, economistsdefine baseline values forunemployment and output known,respectively, as the natural rate of unemployment and potential output.These are the levels of employmentand output consistent with theeconomy operating with stable prices.The output gap and employment gapare defined as the differences betweenthe actual level for each variable andthe baseline value. The actual levelmay be lower than the baseline level,and thus the output or employmentgap can be negative.The output and employment gapconcepts can be useful to economistsin several ways. First, output andemployment gaps often guide theinflation forecasts of Federal Reservestaff, as well as those of researchersand market participants. For example,if the output gap is positive  thatis, output is above its baseline level firms will be operating close tofull production capacity. Hence,firms will not be able to increaseproduction further without significantinvestments. These investments arecostly so it will take a while for firms toincrease production. In the meantime,
 
2 Q1 2011
Business Review 
www.philadelphiafed.org
firms will respond to increaseddemand by raising prices. Thus,positive output gaps can signal futureinflationary pressures. Since monetarypolicy operates with significant lags, itis important that policymakers have anaccurate inflation forecast.Second, some economists arguethat employment gaps are a usefulguide for policy aimed at achievingmaximum sustainable employmentand price stability, which are themandated objectives of monetarypolicy in the United States. Over themedium term, employment is drivenby fundamentals such as productivityand labor supply growth, and thesemedium-term measures are used toinfer simultaneously the natural rate of unemployment and the unemploymentgap. Most economists do not thinkmonetary policy is part of thesemedium-term fundamentals. Instead,attempts to drive employment oroutput above their fundamental levelswould result in unwanted inflation andno employment gains.Economists have developedsophisticated measures of resourceslack that are grounded in economictheory, yet remain workable inpractical terms. We will brieflydiscuss two important examples:the nonaccelerating inflation rate of unemployment (NAIRU) model andthe output gap measure publishedquarterly by the CongressionalBudget Office (CBO). However,even the latest models recognizethat there is a large amount of uncertainty about output andemployment gaps. Moreover, thereremain competing definitions of the output and employment gaps.Alternative measures sometimes offercontrasting implications for monetarypolicy. Therefore, it is important tounderstand the limitations of currentoutput gap estimates for both inflationforecasting and output stabilization.
MILTON FRIEDMAN ANDTHE NATURAL RATE OFUNEMPLOYMENT
Economists have long believed ina relationship between money, prices,and employment  some say since the18th century!
1
However, it was notuntil 1958 that A.W. Phillips providedthe first statistical analysis comparingwage inflation and unemployment, us-ing data for the United Kingdom since1861.
2
Phillips found that when unem-ployment was high, inflation was low.This negative relationship now bearshis name: the Phillips curve. A fewyears later Paul Samuelson and RobertSolow imported the Phillips curve tothe United States.
3
Samuelson andSolow used price inflation instead of wage inflation, a choice now preferredby most researchers. Figure 1 displaysa typical Phillips curve plot for the pe-riod 1948-1965. Each dot correspondsto the inflation and unemploymentrate during a quarter. The solid linedisplays the statistical relationship.Nowadays economists recognizethat the Phillips curve is more thana statistical relationship between twovariables. The modern view of thePhillips curve is rooted in the ideasthat Milton Friedman developed atthe University of Chicago during thelate 1960s.
4
Friedman believed thatattempts to increase employmentby increasing inflation were mis-guided. Only unanticipated inflation,Friedman argued, has the ability tostimulate employment. For example,if households and firms expect aninflation rate of 2 percent, a 3 percentinflation rate would effectively increaseoutput and employment by boostingreal demand. However, as workers andfirms came to expect a 3 percent infla-tion rate, they would embody such ex-pectations in wage demands and pricesetting. As a result, an inflation of 3percent would increase nominal outputcompared with 2 percent inflation, butsince all prices and wages adjusted by3 percent as well, there would be nochange in real output and employment.Friedman’s view was validatedwhen inflation rose persistently in the1970s despite a marked slowdown inemployment growth. Indeed, analystscoined the term stagflation to describethe combination of stagnant growthand inflation.The old view of the Phillips curvecould not explain the stagflationphenomenon. Figure 2 plots unemploy-ment and inflation rates for the period1970-1979. We include the Phillipscurve as given in Figure 1 for theperiod 1948-1965. The actual observa-tions are all northeast of the Phillipscurve: Both inflation and unemploy-ment rates were higher than the theorypredicted. This was not immediatelyrecognized, and many policymakersmistakenly believed that inflationwould reverse course and moderate.
5
1
Robert Lucas, in his Nobel lecture, traced theobservation back to the writings of David Hume.
2
See the article by A.W. Phillips.
3
See the study by Samuelson and Solow.
4
For a detailed discussion of the so-called NewKeynesian Phillips curve, see the article byKeith Sill on page 17.
Nowadays economists recognize that thePhillips curve is more than a statisticalrelationship between two variables.
5
The book by Thomas Sargent discusses theexperience of the 1970s in rich detail.
 
Business Review 
 
Q1 2011 3
www.philadelphiafed.org
(See
Did Oil Prices Cause the Inflationin the 1970s?
)Friedman defined a baseline valuefor employment in his theory and thuspostulated employment gaps as weknow them today. The so-called natu-ral rate of unemployment is the rate wewould observe if inflation were exactlyas expected. This definition is mainlytheoretical, but, as we shall see later,some current measures of employmentgaps are inspired by this definition.Friedman’s view came with somekey policy “lessons” that would belearned the hard way. First, attemptsto exploit the Phillips curve wouldbring about lower unemploymenttemporarily at best; further increasesin the money supply would be met byrising inflation. Second, in order tobe able to stabilize output in the shortterm without causing rising inflation,policymakers need to know whatthe natural rate of unemployment is.Friedman himself was deeply skepticalthat this could be done effectively.To do so, policymakers would needto accurately forecast the state of the economy. Finally, Friedman’sanalysis highlighted the importanceof inflation expectations in achievingprice stabilization. Nowadays centralbanks around the world realize thatany attempt to exploit the trade-off between inflation and employmentwill be short-lived, at best. Thus,central bank policy emphasizesprice stabilization in order to anchorinflation expectations.
6
SOME OUTPUT ANDEMPLOYMENT GAP MEASURES
Currently, there is an array of statistical procedures to approximatethe natural rate of unemployment or its
The Classical Phillips Curve 1948-195
Quarterly data, 1948-1965, seasonally adjustedSources: BLS/Haver for unemployment rate; BEA/Haver for PCE inflation rate
FIUE 16WDJÀDWLRQ
Quarterly data, 1970-1979, seasonally adjustedSources: BLS/Haver for unemployment rate; BEA/Haver for PCE inflation rate
FIUE 
6
The study by Jeffrey Lacker and John Weinbergcontains further discussion of the Phillips curveand the research on inflation and unemploy-ment.
PCE Inflation RateUnemployment Rate1086420-2-42.03.04.05.06.0 7.08.0PCE Inflation RateUnemployment Rate2.0
3.0
4.05.06.07.08.09.010.0
Phillips Curve 1948-1965
10128642014

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