ECONOMICS A Yawning Gap

If you attended the New Zealand Econometric Study Group’s 14th meeting at the University of Auckland on 30-31 July, you would have had jolly time listening to speakers dazzling their audience on an array of topics.
First up, after registration and the introduction, was “Robust covariance matrix estimation: HAC estimates with long memory/Antipersistence correction,” presented by Peter M Robinson from the London School of Economics. If that didn’t have you dancing deliriously in the aisles, you could have tapped your feet later in the day to “Alternative specifications of stochastic volatility asset return models: Theoretical and empirical comparisons,” presented by John L Knight from the University of Western Ontario.
It wasn’t until the last two hours of the two-day conference that Ozer Karagedikli, from the Reserve Bank, strutted his stuff with presentation entitled “Estimating the output gap: Kalman filter approach.”
Ozer Karagedikli and colleague, L Christopher Plantier, have been working on paper with the same title, although the version uncovered by your columnist was still in draft form and bore the instruction “please do not quote”. Fair enough. But let’s at least recognise why the authors of the paper are pouring their energies into this stuff: “The output gap plays crucial role in thinking of many inflation targeting central banks…”
It certainly does.
In the run-up to the publication of the Reserve Bank’s September Monetary Policy Statement, bank economists were enlightening us with their views of what governor Alan Bollard would do to the official cash rate. Unanimously, they expected him to lift it by 0.25 percent (he obliged them by doing just that) but they differed on whether there will be further rises this year.
ANZ economists – who foresaw another rate rise in October – made special mention of the output gap. It was inflationary, they observed, and they were sure this would loom large in Reserve Bank thinking about inflationary pressures.
The gap is the difference between real GDP and potential GDP and is regarded by central bank economists as useful aggregate measure of strains on economic resources. It is calculated by gathering information on firms’ capacity utilisation and indicators from the labour market. High capacity utilisation generally is sign of resources being in short supply – or under strain – and the gap is “positive”. Similarly, low unemployment rate means firms are likely to struggle to crank up production and employers may have to cough up more money to encourage their staffs to work longer hours and/or hire more people.
Underpinning these calculations are theories about rates of wage inflation being function of the rate of unemployment, although some people say the rate of price inflation is function not of unemployment but the amount of unemployed capacity. The more unemployed (or unutilised) capacity is reduced, the more prices will rise and the greater is the prospect of bottlenecks.
Mind you, capacity is difficult to measure and there will be differences of opinion about it.
It’s bit like measuring the difference between the All Blacks 19 points against South Africa’s 23 points in the final match of this year’s tri-nations series, then calculating the team’s capacity to have scored 30 points. The disappointment gap (in the case of the All Blacks) is the difference between the actuality and the capacity, and All Blacks’ fans will disagree about the capacity.
In its submission to the Monetary Policy Review in 2000, the Council of Trade Unions said: “It is of concern to the CTU that the Reserve Bank has estimated positive output gap at the same time there are some 200,000 jobless in the economy. It is hard to understand how the Reserve Bank sometimes arrives at view that there is no spare capacity in the economy when there are so many indicators that suggest the opposite.”
The real problem is how to measure something that doesn’t exist. It’s concept, turned into hard data by referring to screeds of historical data. Let’s suppose the real capacity of the economy is growing not at two to three percent, as in the past, but at three to four percent. This would give another one percent of under-utilised capacity and the Reserve Bank’s capacity to make proper diagnosis would be stretched somewhat.
But the output gap is one of several diagnostic tools used by the Reserve Bank. Economic consultant Brian Easton likens its use to doctor taking patient’s temperature – the reading will be compared with what the doctor thinks is normal, although “normal” varies for individuals and in different circumstances. But doctor would use other indicators as well to make the diagnosis.
As it happened, the September Monetary Policy Statement made scant reference to the output gap. It was dutifully recorded in statistical tables and was illustrated in graph. But that was about it.

Bob Edlin is regular contributor to Management.

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