Singh, Manjit Kaur J.

4FM1

Underlying Theory of The Output Gap

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.
Unemployment and Inflation
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 unemployment gap is a concept closely related to the output gap. Both are central to the
conduct of monetary and fiscal policies. The nonaccelerating inflation rate of unemployment
(NAIRU) is the unemployment rate consistent with a constant rate of inflation. Deviations of the
unemployment rate from the NAIRU are associated with deviations of output from its potential
level. Theoretically, if policymakers get the actual unemployment rate to equal the NAIRU, the
economy will produce at its maximum level of output without straining resources—in other words,
there will be no output gap and no inflation pressure. The output gap can play a central role in
policymaking.
For many central banks, including the Bangko Sentral ng Pilipinas (BSP), 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, it has immediate implications for monetary policy. 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.
Main Features of Inflation Targeting
A number of countries have adopted Inflation Targeting (IT) since the early 1990s in an
attempt to reduce inflation to low levels. In this framework, a central bank estimates and makes
public a projected, or “target,” inflation rate and then attempts to steer actual inflation toward that
target, using such tools as interest rate changes. Because interest rates and inflation rates tend to
move in opposite directions, the likely actions a central bank will take to raise or lower interest
rates become more transparent under an inflation targeting policy. Advocates of inflation targeting
think this leads to increased economic stability. Inflation targeting, as that term has become to be
understood, involves rather more than just targeting the rate of inflation as an objective of
economic policy. It is taken here to include the following: (i) the setting by government (normally)
of a numerical target range for the rate of (price) inflation; (ii) the use of monetary policy as the
key policy instrument to achieve the target, with monetary policy taking the form of interest rate
adjustments; (iii) the operation of monetary policy in the hands of an 'independent' Central Bank;

Inflation targeting is straightforward, at least in theory. The central bank forecasts the
future path of inflation and compares it with the target inflation rate (the rate the government
believes is appropriate for the economy). The difference between the forecast and the target
determines how much monetary policy has to be adjusted. Some countries have chosen inflation
targets with symmetrical ranges around a midpoint, while others have identified only a target rate
or an upper limit to inflation. Most countries have set their inflation targets in the low single digits.
A major advantage of inflation targeting is that it combines elements of both “rules” and
“discretion” in monetary policy. This “constrained discretion” framework combines two distinct
elements: a precise numerical target for inflation in the medium term and a response to economic
shocks in the short term. Rather than focusing on achieving the target at all times, the approach
has emphasized achieving the target over the medium term—typically over a two- to three-year
horizon. This allows policy to address other objectives—such as smoothing output—over the short
term. Thus, inflation targeting provides a rule-like framework within which the central bank has
the discretion to react to shocks. Because of inflation targeting’s medium-term focus, policymakers
need not feel compelled to do whatever it takes to meet targets on a period-by-period basis.

Inflation targeting requires two things. The first is a central bank able to conduct monetary
policy with some degree of independence. No central bank can be entirely independent of
government influence, but it must be free in choosing the instruments to achieve the rate of
inflation that the government deems appropriate. Fiscal policy considerations cannot dictate
monetary policy. The second requirement is the willingness and ability of the monetary authorities
not to target other indicators, such as wages, the level of employment, or the exchange rate. Having
satisfied these two basic requirements, a country can, in theory, conduct a monetary policy
centered on inflation targeting.