More Gaps in the Output Gap Theory

We can’t help ourselves. We feel like the proverbial dog with a bone. If you’re fed up with the ‘Output Gap’ then you may want to skip the next few paragraphs and just head on down to the item on ‘Pauline-Hansonomics.’

We almost think we should pay the RBNZ a royalty for using the chart below…

We intimated it on Monday, but we still can’t fathom out how it’s possible for the red line ‘Actual GDP’ to be above the blue line ‘Potential GDP.’ It doesn’t seem possible.

Surely if ‘Actual GDP’ is greater than predicted ‘Potential GDP’ the blue line would just shift up to where I’ve placed the green line. The green line becomes the new ‘Potential GDP’ as the economy has shown it can produce at a higher level than previously thought.

It can’t possibly produce more than it produces. For example, if Born Again Keynesian (BAKs) economists forecast the economy can produce 100 units per day, but it actually produces 105 units per day, then the economy isn’t producing at 105% of its potential, it is producing at 100% of its potential. It’s just that the bar has been raised.

Therefore at any point in time, there must always be either a negative Output Gap or a neutral Output Gap. There can never be a positive Output Gap. And thus – conveniently for free-spending Keynesian theory – there will never be inflation…

The BAKs may wish to look at the chart of the Kiwi dollar above! Inflation does exist.

Perhaps the best response to this sort of flimsy economic modeling is to handover to our friends at Wikipedia for this comment on a for-runner to the Output Gap, the Phillips Curve:

“Most economists no longer use the Phillips curve in its original form because it was shown to be too simplistic. This can be seen in a cursory analysis of US inflation and unemployment data 1953-92. There is no single curve that will fit the data…”

In other words, if the model doesn’t tell you what you want it to tell you then ditch the model…

And make up a new one. Voila! The Output Gap.