Introduction
Potential output and the output gap are persistently sought economic indicators closely tied to macroeconomic policies. The output gap is a major factor influencing macroeconomic policy stances. The output gap provides a glimpse of aggregate demand in an economy and suggests the level of aggregate demand needed to achieve a non-accelerating inflation rate of unemployment. The output gap is also commonly known as the business cycle.
Concept of the output gap
Output gap is the difference between actual GDP and potential GDP. The output gap is positive when actual GDP is greater than potential GDP and is negative when actual GDP is less than potential GDP. Now, let’s dive deep into potential GDP. Potential output or GDP is the amount of real GDP an economy can produce fully employing its existing levels of factors of production within the existing market and legal institutions. What does “fully employing of resources” mean? Does full employment mean utilizing all the resources to the maximum extent? The general understanding of full employment entails the utilization of all resources to their maximum extent, but economists view full employment quite differently. Full employment is the situation where an economy is operating at full capacity given the existing available resources, institutional constraints, and legal provisions. Despite complications in calculating Potential GDP, economists have devised methods to estimate the potential GDP. HP Filter (1997) and Hamilton Filter (2017) are popular tools for estimating the potential GDP. The scope of this article does not permit us to explore further into these tools.
Once the potential GDP is estimated, the output gap can be estimated as the difference between actual GDP and Potential GDP divided by Potential GDP multiplied by 100.
The output gap is quite easy to understand. The negative output gap signals that the economy is operating below full employment, while the positive output gap indicates that the economy has overheated.
Figure 1 presents the output gap of Nepal between 1978 and 2022. The output gap below zero indicates contraction, while the output gap above zero signifies expansion in economic activities. The output gap is negative when the economy encounters external shocks such as Earthquake in 2015 and the COVID pandemic in 2020.
Figure 1: Output Gap from 1978 to 2022
Output gap and other macroeconomic
variables
The movement of the output gap and
other macroeconomic variables are persistently looked at. Output gap is one of the major indicators of macroeconomic health, so a positive or negative output
gap must corroborate with the movement in other macroeconomic variables.
|
Variables |
Percent |
Annual Growth (%) |
||||
|
Lending Rate |
T-bill Rate |
Imports |
Exports |
Paddy Production |
Remittances |
|
|
Output gap |
0.540 |
0.222 |
0.368 |
0.145 |
0.321 |
0.276 |
Source: Author’s estimation
Table 1 presents the correlation of the output gap with some macroeconomic variables. The table presents a mere correlation, so it only shows the movement of output gap and other variables. Output gap has a relatively strong positive correlation with lending rate, imports, and paddy production. The negative output gap signals a recessionary period and investors are reluctant to expand investment in gloomy periods that significantly lower the demand for credit, consequently, the lending rate falls. Similarly, a quarter of Nepal’s GDP relies on the agriculture sector and paddy occupies about 20 percent of the stake in the GDP of the agriculture sector, so it is plausible to have a positive correlation between the output gap and paddy production.
Figure 2: Trend of output gap and lending rate (in percent)
Source: NRB (2022)
Figure 2 presents the trend of output
gap and lending rate. The output gap and
lending rate have a similar trend path. As the economy recovers, the lending
rate increases and vice-versa. It seems that the lending rate reacts slowly to
the output gap, but follows the trend of the output gap.
Figure 3: Trend of output gap and
import growth (in percent)
Source: NRB (2022)
Figure 3 depicts the trend of output
gap and import growth. The output gap and import growth have a similar
trend. The reason for such a co-movement
of output gap and import growth might be (i) consumption is the principal
driver of imports; the negative output gap evaporates the spending capacity of
consumers dwindles consumption and imports decrease eventually and (ii) the negative output gap also dwindles the expansion of developmental activities
that ultimately squeezes the demand for industrial as well as construction
materials. Interestingly, the downward swing of these two variables occurs in
the same period; but imports lead the way during the upturning momentums.
Conspicuously, imports can act as the leading indicator of an economy.
Macroeconomic policy stance and output
gap
Active demand management policies have
shrouded the macroeconomic policy arena. Fiscal policy and monetary policy are
the two principal macroeconomic policies formulated and implemented in the
majority of world economies. The former is the policy by the government, while
the latter is devised by the central bank or monetary authority.
Policy stance is the way policy stands,
especially when deliberately adopted. Policy stance heavily relies on current
and expected economic circumstances and the nature and origination of shocks
in the economy. The evanescent economic shocks may need rapt attention, but not
immediate action by the policymakers while enduring economic shocks require
both rapt attention and immediate actions by the policymakers.
Figure 4: Trend of output gap and bank
rate
Source: NRB (2022)
The trend of output gap and bank rate
in Figure 4 reveals that Nepal Rastra Bank has been responding to the crisis by
lowering the bank rate. During the COVID period, NRB responded by swiftly
lowering the bank rate by 150 basis points. This shows that policy stances
closely follow the output gap.
The output gap plays an important role
in adopting a favorable policy stance. Before the 1980s, macroeconomic policy
stances were solely driven by the output gap. Economists had a common consensus
on adopting expansionary macroeconomic policies if the output gap is negative
and contractionary macroeconomic policies if the output gap is positive. However,
a such consensus soon faded away with economic shocks originating from the supply
side known as the supply side shocks.
Conclusion
The output gap is the estimate that
indicates the business cycles of an economy. Policy stances heavily rely on
output gaps. Nepal’s macroeconomic policy stance follows the current and
expected output gap. The government of Nepal and Nepal Rastra Bank quickly
embraced an expansionary fiscal and monetary policy respectively in the wake of
the COVID crisis. Both institutions vehemently adopted expansionary policies to
subdue the mounting pressures in the economy. This signifies that policy
stances are properly, but may not be strictly, guided by the output gap;
however, it stands as one of the major policy indicators that put it into the
limelight of economists, policymakers, and all other stakeholders.
References
NRB (2022). Database of Nepalese Economy. https://www.nrb.org.np/database-on-nepalese-economy/
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