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ECON-BUSINESS-EDUCATORS  November 2001

ECON-BUSINESS-EDUCATORS November 2001

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Subject:

Output Gap

From:

"r.loxley" <[log in to unmask]>

Reply-To:

For teachers and lecturers interested in curriculum issues affecting the te <[log in to unmask]>

Date:

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

Content-Type:

text/plain

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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





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