Tag Archives | Potential GDP

The Macroeconomic Case for Central Bank Independence – I

The Long Run Phillips Curve shows that any policy that tries to increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and lower GDP growth rate in the long run.

In a pioneering paper titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”, engineer turned economist E.W Phillips noticed a statistical correlation between two macroeconomic variables that would define economic policies in the decades to come. He noticed an inverse relationship between unemployment and inflation, i.e. when unemployment was low, inflation was high and vice-versa. Graphically, this is a downward sloping curve as shown below.

Figure 1: The original Phillips curve for the period 1948 to 1957, showing the inverse relationship between inflation and unemployment.

Figure 1: The original Phillips curve for the period 1948 to 1957, which shows the inverse relationship between inflation and unemployment.

This particular statistical relationship had huge implications for fiscal and monetary policy. The correlation between the two macro variables was now seen as a trade-off – an economy can lower unemployment if it tolerates a bit of inflation. Noted economists Solow and Samuelson used this relationship to advocate large governmental (deficit) spending and lower interest rates. The rationale behind this was that as long as you can lower unemployment rate, through increased GDP growth, a slightly higher level of inflation can be tolerated. It was believed that the welfare gain through higher growth and lower unemployment would offset the welfare loss due to a higher rate of inflation.

This line of reasoning was employed in the US in the 1960s – the decade of previously unprecedented economic growth – to reduce unemployment to record lows while inflation went up only slightly. Democratic President Lyndon B Johnson initiated “The Great Society”, which involved huge government expenditure to boost growth and lower unemployment. In the 1969 Economic Report of the President to the Congress, the Phillips Curve was again used to justify the large deficit spending in infrastructure, war expenditure (Vietnam), education, Medicare and Medicaid and finally, welfare benefits. Notice that the unemployment rate was reduced from 7% in 1961 to less than 4% in 1968, with inflation increasing from about 1% to 4% in the same period.

 

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Then came the great stagflation. The first part of 1970s saw the US and UK economy go through something unusual that could not be explained by the Phillips Curve. Inflation and unemployment both increased simultaneously. This peculiar phenomenon was called as stagflation (a term coined by British Chancellor of the Exchequer, Iain McLeod to denote stagnation plus inflation). The US stagflation is wrongly attributed, even today in most economic textbooks, to the infamous oil price shocks in the early 1970s. However, that is simplistic and flawed reasoning. The real cause of the episode of stagflation in the US is the buildup of inflation momentum. By the time of the OPEC oil shock, inflation in the US had doubled from 3% to 6% due to the expansionary fiscal and monetary policy followed in the 1960s. The high US inflation caused the dollar to depreciate in the world markets and since oil was invoiced in dollars, the OPEC was forced to increase their prices.

The Long Run Phillips Curve

The US stagflationary episode is better explained by the Expectations Augmented Phillips Curve (EAPC). The Chicago School monetarists led by Milton Friedman deconstructed the inflation-unemployment tradeoff suggested by the Phillips Curve.  The EAPC demonstrated that the Phillips curve tradeoff holds true only in the short run and it turns vertical in the long run. The policy implication of the long run Phillips Curve is that though lower levels of unemployment can be achieved in the short run by compromising on inflation, in the long run, both inflation and unemployment will end up being higher. This is shown in the graph below. Taking 1981 as the end period (before Paul Volcker’s war on inflation in the 1980s), it can be seen that unemployment has increased by half a percentage point, while inflation has increased by about 8 percentage points from 1961.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Theoretically, in a long enough period, there can be several short run Phillips curves where high GDP growth rates can be achieved with small increases in inflation. In the long run, however, the Phillips curve will be vertical, denoting that there is no tradeoff between the two variables.

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

Relevance Today:

Due to the inherent nature of democratic cycles, most policy makers in developing countries still try to trade off high GDP growth rate with inflation. Since the political term is for five years, there is a tendency to ride on the short run Phillips Curve. Furthermore, the level of economic activity (GDP) reacts much quicker than inflation – it takes time for the population to adjust their inflation expectations and renegotiate their contracts. Thus, it is always tempting for policy makers to push through policies that increases GDP growth rate immediately (especially, if the elections are around the corner) and worry about inflation in the next term or leave it as a parting gift for the next government.

India saw incredible growth rate between 2004 and 2009 mainly because of policies (both monetary and fiscal) that pushed the GDP growth rate above its potential GDP (See post on Potential GDP). Expansionary fiscal policy through increased welfare spending (MGNREGA, MSP, etc) along with interest rate cuts by the RBI (through sustained pressure by the Finance Ministry) saw GDP growth rates touch 9% for three years. The long run Phillips curve took effect after 2010 where India underwent a stagflationary period of increased inflation and lower growth.

Much of India’s fiscal policy still aims to take advantage of the short run Phillips curve, despite the knowledge of the consequences it entails. This is precisely the reason why leaving monetary policy in the hands of the government will have disastrous effects. The inherent growth bias in politicians will naturally opt for lower interest rates to push up growth. An independent central bank is not prone to time bound election pressures and will thereby maintain price stability in the long run, which, by itself is conducive to sustainable growth.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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Potential Output – Importance and Estimation

Potential output is of vital importance in macroeconomic policy making, despite imperfections in its estimation.

In order to have an effective monetary and fiscal policy, policy makers need to gauge the level of economic activity in the economy and whether this level is consistent with the potential level. In economic terms, policy makers look at the real output and its deviation from potential output, called the output gap. Potential output – the trend growth in the productive capacity of an economy – is an estimate of the level of GDP attainable when the economy is operating at a high rate of resource use.  This is not a technical ceiling on the maximum level of output attainable. Rather, it is an estimate of maximum sustainable output – output that can be sustained in the long run without leading to macroeconomic instability.

While this may seem like a purely academic and statistical exercise, in reality, understanding and proper estimation of potential output has grave consequences for the economy. If actual output is lower than potential output, that is, if the output gap is negative, then the economy is performing below its potential – resources and capacity are underutilized and unemployment is higher than what it should be. On the other hand if the output gap is positive (actual output is higher than potential output), the economy is overheated, demand exceeds supply and inflationary pressures on the economy is high. As is self-evident, neither state is desirable. The manifestation of the output gap is usually through inflation in the economy. A positive output gap results in higher inflation and a negative output gap results in deflation.

For policy makers, therefore, understanding potential output and the output gap is of crucial importance. Negative output gap should ideally be followed by an expansionary fiscal and monetary policy, so as to increase spending and demand in the economy, which will result in actual output converging towards potential output. A contractionary monetary and fiscal policy is required in the case of a positive output gap to reduce the demand in the economy and to provide liquidity to the suppliers to increase their production.

Many central bankers around the world indeed use the concept of potential output in determining the rate of interest. In deciding the policy rate, central bankers use a popular rule of thumb called the Taylor rule, which reduces the complexities in choosing the interest rate to a formula that incorporates the difference between the actual and targeted inflation rate and the difference between the actual and potential GDP[1].

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

As can be seen from the graph, real GDP has exceeded potential GDP during the boom years in the late 1990s and has significantly fallen below the potential GDP after the recession off 2007. It can also be seen that inflation reacts to the output gap. Inflation is above the targeted rate of 2% when output gap is positive and vice versa.

Estimating Potential Output

Despite its overwhelming importance to policy making, there seems to be no consensus amongst economists regarding the best method to estimate potential output. Different countries and organizations use different methods based on country specific circumstances. However, no method has been able to provide consistently robust estimates and each method has its own set of lacunae.

The various methods of estimating potential GDP can be broadly classified into two categories: the production function approach and the statistical approach. The first approach, followed by the Congressional Budget Office, USA, relates the level of output to level of technology and factor inputs, namely capital and labour. Potential Output, thus, would be the output if both labour and capital are fully utilized in an efficient manner. This manner would also require certain assumptions regarding the specific form of the production to be made. Usually, a constant returns to scale production function, such as the Cobb-Douglas production function, is used.

However, for emerging market economies, where reliable data on labour and capital is unavailable, time-series statistical techniques have become quite popular. A widely used approach in the Indian context is the Hodrick-Prescott filter, which decomposes the actual real GDP into two components – a trend and a cyclical component – and potential output is proxied by the trend component.  In other words, the GDP growth rate has an underlying structural component (trend) and another component that is seemingly random due to natural variations in the business cycles and external demand and supply shocks (cyclical). The purpose of the statistical tools is to remove the cyclical part and project the long run potential GDP based on the trend growth rate.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

The graph below shows the estimates of output gap for India using various statistical techniques. While there are differences between the different techniques, broad generalizations can be derived: the economy was overheated for a prolonged period between 2005 and 2012 and has been in slack ever since.

Irrespective of which method is used, it is important to understand the shortcomings in these approaches. However, the presence of short-comings should not be a reason to undermine the immense importance of the concept of potential output in determining macroeconomic policies.

Anupam Manur is a policy analyst at Takshashila Institution. He can be found on twitter @anupammanur

 

[1] Specifically, it is: it = i* + α (πt – π*) + β (yt – y*), where it is the policy rate; πt and π* are the actual and targeted inflation rates, respectively; yt and yt* are actual and potential output, respectively; and i* is the federal funds rate consistent with on-target inflation and output.

 

 

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