Archive for January, 2021

Why “Output Gap” Is Inadequate

Lekha Chakraborty | January 4, 2021

by Lekha Chakraborty and Amandeep Kaur[1]

The macroeconomic uncertainty during the Covid-19 pandemic is hard to measure. Economists and policymakers use the “output gap” variable to capture “slack.” It is a deviation between potential output and actual output, which is a standard representation of a “cycle.” The potential output is an unobserved variable. There is an increasing concern about the way we measure potential output—decomposing the output into trends and cycles. This is because the business cycle is not always a “cycle.” Sometimes, the “cycle is the trend.”[2]

When macroeconomic crises and recessions tend to “permanently” push down the level of a country’s GDP, it is inappropriate to assume that output will bounce back to previous levels. The notion of the output gap is ill-conceived and ill-measured. Scholars have highlighted the significance of “hysteresis” (the dependence of economic path on history) in analyzing the output dynamics in crisis.[3] Against the backdrop of the Covid-19 pandemic crisis, there is a renewed interest in hysteresis and business cycles. The state of the economy and the level of GDP are history dependent (hysteresis). The concept of hysteresis has urgent relevance for designing apt fiscal and monetary policies to tackle low demand during recessions. continue reading…