Closing the Output Gap in the United Kingdom - Essay Example

Closing the Output Gap in the United Kingdom How can we close the output gap in the United Kingdom? To answer the question, we review what the major textbooks say on the output gap, analyze the economic data of the United Kingdom using a reliable source, and forward our recommendations. 1.0. The literature on output gap Dornbusch et al. defines the output gap as the “difference between actual and potential GDP” (2008, p. 599). GDP refers to the gross national product. Potential GDP or output is the “output that is produced when all factors are fully employed” (2008, p. 600). Thus, potential output is full employment output (Dornbusch et al. 2008, p. 15). Of course, actual output is the recorded GDP of a given time that can be in nominal or real values. The nominal value refer to the value of the GDP synchronic to the prices or price reference of a given year while the real GDP can be valued in terms of a base or a reference prices of a reference year. Articulating mathematically the concept of an output gap, Dornbush et al. (2008, p. 15) defines it as: Output gap actual output – potential output. Dornbush et al. (2008, p. 15) explained that the concept of an output gap provides a way of measuring the magnitude of the cyclical deviations of actual output from the potential output. The concept “potential output” is also interchangeable with the term “trend output” (Dornbusch et al. 2008, p. 15). From the economic perspective of Dornbusch et al., the output gap is negative during a recession and positive during an expansion (2008, p. 15). In a recession, resources are unemployed and actual output is below potential output. In contrast, during a positive gap or expansion, workers overtime and machineries are utilized more than the usual (Dornbusch 2008, p. 15). Positive gap or expansion is also known as an economic recovery (Dornbusch 2008, p. 15). For Mankiw (2006, p. 425), potential output or full employment output is more accurately the natural rate of output because “it shows what the economy produces when the unemployment is at its natural or normal rate”. At the same time, Mankiw pointed out that “the natural rate of output is the level of production toward which the economy gravitates in the long run” (2004, p. 425). According to classical viewpoint, the potential output or the natural rate of output depends on labour, capital, natural resources, and technological knowledge and, therefore, shifts in the potential output or natural rate of output depend on changes in the said variables (Mankiw 2004, p. 425). An output gap can promote price volatility. According to Dornbusch 2008 (p. 105), if actual output is higher than potential output, prices will rise in the next period. In a reversed situation, prices will fall in the next period. Thus, when economic agents fail to anticipate correctly how prices will move, a gap may be perpetuated thereby exacerbating price fluctuations and the output gap. In contrast, Romer (2006, p. 254) argued that changes in the demand side have no real effects. Articulating a classical point of view, Romer (2006, p. 254) stressed that the long-run aggregates supply curve is vertical. For Romer (2006, p. 254), the long-run aggregate supply curve is also known as the natural rate of output or potential or full employment output. Wickens (2008, p. 4) argued that it more important “to raise the rate of growth of potential ouput through supply-side policies than to move the economy back toward the trend path of potential output by demand-side stabilization policies.” Figure 1 . Recessionary gap Source: Baumol and Blinder (2009, p. 182), Figure 7 Baumol and Blinder (2009) do not discuss a notion of an output gap but as shown by Figure 1 above, Baumol and Binder (2009) has a notion of a recessionary gap that is highly similar to the Dornbusch et al.’s (2009, p. 15) notion of a negative output gap. As we can see from Figure 1, Baumol and Blinder’s (2009, p. 182) consider that a recessionary gap exists when aggregate demand C + I + G + (X - M) is not enough to push actual GDP to be equal to potential GDP. In the language of Baumol and Blinder (2009, p. 182), this is when the equilibrium GDP is not equal to the potential GDP because the C + I + G + (X - M) is inadequate. The Baumol and Blinder’s (2009, p. 182) notion of potential GDP is consistent with the articulation of the notion in Dornbusch et al. (2008, p. 15): according to Baumol and Blinder (2009, p. 182), potential GDP is full employment output. Baumol and Blinder (2009, p. 182) elaborated that an equilibrium GDP that is below potential GDP can emerge in any of the following situations: 1) when consumers or investors are unwilling to spend at normal rates; 2) when the price level is considered “too high” by market agents; or when 3) foreign demand for goods is weak. Unemployment takes place because not enough output is demanded to keep the entire labour force at work (Baumol and Blinder 2009, p. 183). It is important to emphasize that in the Baumol and Blinder (2009, p. 324), expectations can have an important role in affecting aggregate demand and can move an economy towards a recessionary gap. In the September 11, 2001, terrorist attack for instance, Baumol and Blinder noted that terrorism brought down both expectations in the United States consequently affecting spending levels (2009, p. 324). Note that the GDP values mentioned in Baumol and Blinder (2009, p. 182) refer to real GDP. In the Baumol and Blinder (2009, p. 182) perspective, from a recessionary gap, full employment can be reached by raising total expenditures but the same job can be done as well by a sufficient large drop in the price level. Baumol and Blinder (2009, p. 324) even emphasized that even if fiscal and monetary policy makers do nothing in a recessionary gap, the economy’s self-correcting mechanism can gradually erode the economy’s recessionary gap. For Baumol and Blinder (2009, p. 324), employing a large dose of expansionary fiscal and monetary policy may result in a faster movement towards full employment or potential GDP but it can result to a higher inflation using an analysis that employs a model of a Phillips curve. For Baumol and Blinder (2009, p. 324), the range of policy options open to policy maker is either to wait for the economy’s self-correcting mechanisms to restore the unemployment rate down to the natural rate or hasten the process through expansionary fiscal and monetary policies leading to the same natural rate but a higher permanent inflation rate. Baumol and Blinder (2009, p. 325) had emphasized that the costs of “permanently higher inflation rate” are difficult to measure. Thus, there is a controversy over the costs and benefits of fighting unemployment through “demand management” (Baumol and Blinder 2009, p. 325). According to Baumol and Blinder (2009, p. 325), there are economists who consider it unwise to “accept the inflationary consequences of reducing unemployment faster” (Baumol and Blinder 2009, p. 35). According to Baumol and Blinder (2009, p. 325), American and European policy makers differ in their attitudes in fighting unemployment: most policy makers in the United States favour the use of expansionary fiscal and monetary policies to address unemployment but “European authorities have often avoided expansionary stabilization policies and allowed unemployment to remain high, rather than accept even slightly higher inflation”. On the other hand, Hall and Lieberman (2004, p. 544) argued that the chief economic cost of unemployment is the “opportunity cost of lost output. Hall and Lieberman pointed out that when there is cyclical unemployment, “the nation produces less output, and so some groups or groups within society must consume less output” (2004, p. 544). Meanwhile, Baumol and Blinder’s (2009, p. 183) notion of an inflationary gap is similar to the Dornbush et al. (2008, p. 15) notion of a positive output gap. Again, a key concept in Baumol and Blinder (2009, p. 183) is equilibrium GDP that corresponds to Dornbusch et al. (2008. p. 15) notion of actual GDP. Figure 2. Inflationary gap Source: Baumol and Blinder (2009, p. 183), Figure 8 In Baumol and Blinder (2009, p. 183), the inflationary gap is the difference between the equilibrium level of output demanded and the full employment level of output. To move into equilibrium, Baumol and Blinder (2009, p. 183) pointed out that the price level will have to rise enough to drive expenditures down. Thus, in the Baumol and Blinder concept (2009, p. 183), the excess of GDP demanded over potential or full employment GDP is the inflationary gap. 2.0. Closing the output gap in the United Kingdom One perspective in the output gap is that the output gap is unavoidable given a business cycle. Viewed this way, there is no need to close the output gap the business cycle constitutes as the market’s attempt to adjust to move itself towards equilibrium. As one of the materials mentioned, a recession will lead to lower prices in the next period, boosting demand. However, another view on the output gap is that an output gap takes place as markets becomes temporarily unable to move itself towards equilibrium to take place at the full employment level. Thus, following this view, a good move may be to use discretionary fiscal and monetary policies. Alternatively, we can describe the situation this way. One view holds that the economy can be equilibrium but the equilibrium may not happen at the full employment level thereby requiring demand management policies. The other view holds view holds that there is no need to execute demand management policies so long as prices are free to adjust, the price changes in the next period will allow markets to move the economy towards a situation in which actual output corresponds to potential output or full employment output. Doing otherwise will be costly for the economy and may mean higher “permanent inflation”. Looking at the situation of the United Kingdom in Figure 3 (next page) from the data and perspective of the Organisation of Economic Cooperation and Development, we that there is an indication that there is an economic cycle that seems to be followed by the economy of the United Kingdom from 1980 to 2005. Figure 3. Actual real GDP of the United Kingdom, Euro Area and OECD, 1980-2005 Source: OECD (2007, p. 19), Figure 1.1 Based on Figure 3, it seems that there is a trend towards closing the output gap as the UK economy moves towards 2005. Europe and the OECD seem to follow the same trend. Provided the OECD data is accurate, Figure 3 even suggests that the United Kingdom, near 2005, has closed the output gap better compared to the Euro Area and the OECD. It is possible that the apparent better management of the UK economy in closing its output gap is be related with the observation of Baumol and Blinder (2009, p. 325) that the UK has tended to adhere to non-expansionary fiscal and monetary economy in managing its economy. For this writer, the keys towards maintaining a low output cap or closing the output gap in the economy of the United Kingdom involve three basic policies. 1. Keep markets fully free, eliminate institutional obstacles in the free movement of factor and goods prices. Institutional obstacles can come in the form of price setting rather than relying on market mechanisms or operation of a free market. 2. Avoid discretionary fiscal and monetary policies. Discretionary fiscal and monetary policies disable the ability of market agents to anticipate government actions as well as the price levels. Thus, discretionary fiscal and monetary policies can lead to disequilibrium between supply and demand. 3. Assist market agents to be fully informed on market movements and prices. The three recommendations above may not be valid in situation where there are very high political costs in waiting the economy to adjust. Political unrests can happen and there may be a situation of terrorism or widespread disorder. Political stabilization can be bought through expansionary fiscal and monetary policies but it can mean a higher permanent inflation as mentioned by Baumol and Blinder (2009, p. 325). Reference List Baumol, W. and Blinder, A., 2009. Macroeconomics: Principles and policy. 11th ed. United Kingdom & other countries: South-Western Cengage Learning. Begg, D., Fischer, S., and Dornbusch, R., 2005. Economics. 8th ed. London: McGraw-Hill. Dornbusch, R., Fischer, F., and Startz, R., 2008. Macroeconomics. 10th International ed. London & other cities: McGraw Hill. Hall, R. and Lieberman, M., 2005. Macroeconomics: Principles and applications. 3rd ed. Mason: Thomson South-Western. Mankiw, N., 2004. 3rd ed. Principles of macroeconomics. Mason: Thomson South-Western. Organisation for Economic Cooperation and Development (OECD), 2007. OECD economic surveys: United Kingdom. Romer, D., 2006. 3rd ed. Advanced macroeconomics. New York: McGraw-Hill. Wickens, M. 2008. Macroeconomic theory: A dynamic general equilibrium approach. Oxfordshire: Princeton University Press. Read More