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.

The persistence of sluggish growth and weak macroeconomic recovery have robbed the sleep of many economic policymakers and academicians. For instance, in the Economic Report of the US President for 2009, the Council of Economic Advisors (CEA) forecasted a fast rebound of economic growth in the aftermath of the global financial recession. However, macro scholars have responded to the CEA’s claim—“recessions are followed by quick rebounds”—with vehement blog debates.[4]

The debate was highly technical and predominantly based on whether the growth time series have unit roots. With the empirical evidence of more than a decade, we know now that the recession was not followed by a quick growth rebound. The researchers identified that the secular fall in growth was due to a productivity slow down, legacies of debt crises, chronic deficiency of demand, labour market challenges, and decline in the equilibrium real interest rates.

With the zero lower bound on nominal interest rates, monetary policy has proved inefficacious as a countercyclical policy tool to reset the economy to pre-crisis growth levels. At the same time, the world’s nations missed the chance to reset their economies to pre-crisis levels through “fiscal re-dominance,” due to a wave of fiscal austerity and tight fiscal rules.

The output gap is a crucial variable in macroeconomic policymaking, by both central banks and fiscal authorities. The central banks base their inflation targeting for setting the policy interest rate on the deviation of inflationary expectations from its nominal anchor and a measure of the output gap to capture “economic slack.” Similarly, fiscal authorities measure the “cyclically-adjusted fiscal stance” to analyze public debt sustainability.

In India, the Ministry of Finance has not used cyclically neutral fiscal constructs for policymaking. However, the Reserve Bank of India’s inflation targeting is inclusive of output gap estimations. The recurrence of forecasting errors in growth by multilateral agencies, including the IMF, points to the fact that a weak economic recovery was not widely expected. This led to a rethinking of the “output gap” itself.

A recent blogpost in voxEU by IMF economists pointed out that “the frequency of output gap discussions is positively correlated with a country’s income level: 66% of IMF staff reports covering advanced economies mentioned the output gap, versus 29% for emerging markets, and only 5% for low-income countries. In the latter, structural issues are often of greater relevance.[5] The IMF scholars found a limited connection between the size of the output gap and policy recommendations. They suggest caution in using output gap estimates for policymaking during the Covid-19 recovery. Ex ante, a higher output gap is expected to be linked with a tighter monetary policy stance. However, analyzing both levels and changes in output gaps and policy advice, they found only a slight positive link between the level of the output gap and the recommended tightening of monetary policy, but a very limited trend for fiscal policy and public debt management.

Economic cycles are defined as a succession of crises that follow periods of prosperity, though these peaks and troughs do not follow a given frequency or periodicity.[6] The assumption that demand shocks have only a transitory impact on the economy needs a relook. The persistent effects of recessions imply that “cycles” itself affect the trend. With the persistence of cyclicality, the economy will not rebound to its prior trend and persistence can be seen as the permanent “scars” left by the recession. In crisis, the output gap may be extremely difficult to measure and more difficult to interpret. Empirical evidence does not support that demand shocks are transient. Demand shocks can have a permanent impact on output. It is argued that there are no obvious silver bullets that address the paucities of output gap construction; however, Romer (NBER, 2020)[7] suggested the use of “confidence intervals” when presenting output gap results, and emphasizing both upside and downside risks in (Covid-19 induced crisis and growth recovery) policy discussions would be useful.

Though output gaps remain a popular measure for capturing “slack,” their relevance for policymaking in the Covid-19 crisis is controversial, due to the methodological challenges of arriving at a measure of potential output. In the context of emerging economies, the business cycles and the level of economic growth need a different interpretation incorporating “hysteresis.”

[1] Chakraborty is Professor at NIPFP and Research Associate at Levy Economics Institute; and Kaur is Economist at NIPFP.

[2] (https://scholar.harvard.edu/files/gopinath/files/cycleisthetrend.pdf)

[3] (https://www.imf.org/en/Publications/WP/Issues/2020/05/29/Hysteresis-and-Business-Cycles-49265)

[4] (https://www.imf.org/en/Publications/WP/Issues/2017/11/16/Booms-Crises-and-Recoveries-A-New-Paradigm-of-the-Business-Cycle-and-its-Policy-Implications-45368) .

[5] (https://voxeu.org/article/output-gaps-practice-proceed-caution)

[6] (https://core.ac.uk/download/pdf/6822691.pdf)

[7] (https://www.nber.org/papers/w26672


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