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Subject:

Output Gap

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Thu, 1 Nov 2001 09:02:25 -0000

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 ```I don't know if it'll help but the model of the output gap suggests that the gap is the difference between the actual level of AD and the level of AS which can be produced with no pressure on resources, ie. the equilibrium level of AS. Thus the output equation becomes: C+I+G+X = f(aL, bK, c)+M. If AD exceeds the equilibrium AS then we have a positive output gap and if AD is less than equilibrium AS then we have a negative output gap. Each period the level of AD is met by AS and so increases in AD can be met either by increased domestic production, f(aL,bK,c), or by increased imports. The increase in AS may be non-inflationary if productivity rates improve (the a,b and c constants) or inflationary if utilisation rates increase. In terms of measurement of the gap itself there is a huge problem. We can observe the level of AD at any moment and likewise we can observe the level of AS but we cannot observe the equilibrium level of AS. Three possibilities exist. Firstly we could track utilisation rates and import penetration. If capacity utilisation rates go above 50% then history suggests that the UK will experience inflationary pressure - we will have opened up a positive output gap. If unfilled vacancies exceed 200,000 (assumed to be 1/3rd of all vacancies) then history suggests that inflationary pressure will build. Secondly we could extrapolate the level of non-inflationary AS to get some idea of trend. Pick two periods when the level of AS was non-inflationray and extrapolate a trend growth rate from the average between them. For example Q4 1984 and Q4 1994 are periods of stable inflation so we can assume these are periods of equilibrium AS. AS increased by 0.6% per quarter between these two periods (2.5% pa) so we can assume that this is the trend rate of growth in equilibrium AS. Thirdly it might be possible to estimate a soution for the AS function. The May 1994 Inflation Report suggests the Bank of England's model has the following AS function. Q=0.7L+0.3K+T where Q is the change in domestic productive potential, L is the growth in the labour force, K is the growth in the capital stock and T is total factor productivity (assumed to be 1.25% each year). Thus a 1% change in L and K will result in Q rising by 2.25% (0.7*1+0.3*1+1.25). I hope this helps clear up any confusion. I note that the output gap is on the new AS specification - how detailed do they want students to be? The AQA spec. doesn't bother distinguishing between short run actual increases in growth and long run potential increases - makes it difficult to understand. Roger Loxley Head of Economics and Politics RGS Newcastle ================================================ Standard Disclaimer:This message is confidential. You should not copy it or disclose its contents to anyone. You may use and apply the information only for the intended purpose. Internet communications are not secure and therefore the Royal Grammar School Newcastle does not accept legal responsibility for the contents of this message. Any views or opinions presented are only those of the author and not those of the Royal Grammar School Newcastle. If this email has come to you in error please delete it and any attachments. Please note that the Royal Grammar School Newcastle may intercept incoming and outgoing e-mail communications. ```

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