Archive for January 11th, 2010

Basics of Outut Gap

January 11, 2010

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.

Political Limits to globalization

January 11, 2010

Daron Acemoglu and Pierre Yared have written a new paper titled the same.



Our main contribution in this paper is to show that military spending, in our interpretation as a proxy for nationalist sentiment and militarism, is negatively associated with trade. We present two types of evidence.

First, we show that between 1985 and 2005, countries that experience a greater increase in military expenditure or the size of the military show a relative decline in the volume of trade (compared to other countries in the sample). Moreover, countries whose trading partners (neighbors) show greater increases in military expenditure or the size of the military also show a similar decline. These patterns are robust across di¤erent specifications and in different subsamples.

Second, we investigate bilateral trade patterns again between 1985 and 2005. The data suggest that trade between two countries grows less rapidly when both become more militarized. While not as robust as the first set of findings, this pattern is generally present in a variety of different specifications.


Our results come with several caveats. First, it is unclear to what extent these empirical patterns reflect causality since trade and militarization simultaneously a¤ect each other and may themselves be a¤ected by a third factor. Second, we do not have an explanation for the apparent rise in nationalism and militarization around the world.

Hmm. Nice linkage of the two concepts – militarism and trade. This is a typical Acemoglu approach. The paper is preliminary stuff. A more elborate paper would help understand the linkages better.

, because it contributes to tensions or leads to skirmishes between countries.for example, 2008). To go beyond anecdotal evidence, in this paper we proxy nationalist and militarist sentiments by military spending. In addition to being a useful proxy, military spending might itself impact trade, Kaganto nationalism and militarism. Despite the increasing reach of globalization, anecdotal evidence suggests that nationalism and militarism are strong around the world, in countries ranging from the United States to China, Russia and India (e.g., Robert  are relatedIn this paper, we emphasize that globalization, which depends on political decisions of nation states, has political limits, and that these limits

Monetary Policy under ZIRP

January 11, 2010

Though a lot has been written about ZIRP or Zero Interest Policy, but still there is always space for more.

Charles T. Carlstrom and Andrea Pescatori of Cleveland Fed have written a nice short article on monetary policy when interest rates are near zero:

This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes some of the ways in which monetary policy might be conducted in this situation. We conclude by emphasizing that to be effective in an environment of zero short-term nominal interest rates, monetary policy needs to be unequivocally committed to avoiding expectations of deflation. We also argue that price-level targeting might be a good device for communicating such a commitment. While this policy prescription follows from the assumption that the zero interest rate bound is a consequence of a negative demand shock hitting the economy, it is worth stressing that falling prices can also be the consequence of a supply shock, namely particularly high productivity growth (not a bad thing!). This would clearly call for different policy actions than the ones described here.

Price Level targeting was first (and perhaps only) practiced by Sweden in 1930s. Since then it has been debated extensively but nothing much has happened in terms of policy action. Conceptually it looks superior than inflation rate targeting but there are practical difficulties.

Still, I think we need more research to make price level targeting more workable. Most research does not go beyond suggesting it as a measure.

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