Thomas Lubik and Stephen Slivinski of Richmond Fed explain the basics of output gap in their short note. Much of the policy based discussion is based on how much the output gap is. So. it is nice to brush through basics.
The output gap is a measure of how far away an economy is from a desirable level of output. It can be important in policy discussions because it presents a gauge of when the economy might be overheating or underperforming and can have immediate implications for the stance of monetary policy.
A typical story is that during a recession actual economic output drops below a desirable, or “potential,” level, which creates a negative output gap. In a boom, output rises above its potential level, resulting in a positive gap.
In the latter case, the economy can be described as “overheating.” This would generate upward pressure on inflation and might prompt the central bank to “cool” the economy by raising interest rates. On the other hand, an economy that is performing below its potential may require a more stimulative monetary policy.
The authors explain there are two ways to calculate output gap:
- Potential output – actual output
- Natural output – actual output
“Potential” output is the level that would occur if product and factor markets were perfectly competitive – meaning there are no real rigidities, such as the existence of monopolistic producers that can restrict output to artificially low levels.
“Natural” output, on the other hand, describes the level of output that can be achieved under imperfectly competitive markets. Here there are real rigidities, but no nominal distortions such as the costly and time-consuming process needed for prices to adjust.
However, there are not much differences when the gap is calculated using the two approaches.
The authors also explain the various ways in which the gap could be calculated – CBO, their own model and Fed Model. They also look at the estimate of output gap from these models. They say the output gap though useful is very difficult to estimate:
The output gap is meant to be a useful indicator for monetary policymakers because it signals to what extent the over- or underemployment of productive resources during the business cycle might feed inflation. The main challenge, however, is to compute the output gap “correctly.”The computations can be based on purely statistical measures derived from historical data or be based on an approach suggested by modern theory. Different models produce different gaps, however. This suggests that the uncertainty surrounding the various measures renders the output gap a potentially faulty gauge for assessing the economic situation and guiding monetary policy.
A nice primer. Typical economics problem. Output gap is a very useful concept but difficult to estimate.