Briefly, the output gap theory is that actual output can differ from the potential output given by the productive capacity of the economy, and that this gap affects inflation. Most commonly, actual output falls short of potential output, in which case the output gap is defined as negative, and producers tend to mark down prices in an attempt to stimulate more demand to take up the slack. Such situations typically arise from deficient demand, in response to which producers can leave some fraction of their capacity, including both labour and equipment, unused or
For most countries, actual output is either counted directly or can be estimated reasonably accurately from related observations such as electricity production, but by its nature, unused productive capacity is harder to observe. Given good economic statistics and knowledge of the
There are at least two weaknesses with this output gap approach to assessing inflationary pressure. First, the assumption that potential output varies smoothly seems heroic. Obviously, disasters such as war or earthquakes can wipe out large parts of industry at a stroke, but more subtly, productive capacity constructed and organised to suit a particular understanding of the state of the economy may be rapidly rendered obsolete if actual events falsify that view. The latter scenario is arguably applicable to the present
In an expanded analysis emailed to Reuters' clients (which does not seem to be freely available on the web) John Kemp presented a chart of advanced, emerging and world economy industrial production from the monthly World Trade Monitor published by the Netherlands' Centraal Planbureau (CPB). From this, he inferred, apparently by visual inspection with some kind of linear extrapolation of the recent trend in mind, that emerging economy output is roughly on trend and advanced economy output is catching up, so that, as he put it, "for the world economy as a whole, the output gap is probably small or non-existent".
This inference is based on a kind of optical illusion. The chart of CPB industrial production data (to be precise, the volume of industrial production excluding construction, expressed as an index based on the average level of industrial production over the year 2000) is reproduced below.
Here, global industrial production is calculated as a weighted sum of advanced and emerging economy values, where the weights are given by their shares of world production in 2000, comprising 65.1% and 34.9% respectively. First, as is evident from all three
By my reckoning, in December 2010, even the emerging economies had a (negative) output gap representing 16.7 output index units or 7.2% of trend output at that time, while for advanced economies the output gap was 17.6 output index units or 14.9% of trend. And naturally, when the smaller but nonetheless significant output gap in the emerging economies is weighted by their relatively small share of world production, it does little to mitigate, let alone offset, the larger output gap in the advanced economies, so that it is clear that a sizable output gap does exist at the global level. Based on the trend fitted to the world output