Output Gap and Inflation Target Monetary Policy

Question: Describe, including a Philips curve diagram, how and why the output gap between equilibrium and actual output is used by policymakers to target inflation. With reference to the IS/PC/MR model and the extract from Minutes of the Monetary Policy Committee for January 2015, explain the Bank of Englands decision to hold interest rates at 0.5% and to maintain asset purchases, known as Quantitative Easing (QE)? Answer: Output Gap and Inflation Target When the economy experiences downturn then there is a decline in the economys output of goods and service. But when the economy recovers then that output, popularly known as countrys GDP increases. Policy makers and economist take interest in these ups and downs in the economy which is called business cycle. But what they are more concerned with is how close the gap between current output and potential output is. Their main interest is not only on the increase or decrease in GDP but also on the extent to which the GDP is above or below the potential level. This difference in the current or actual output and the potential output is the output gap. The potential output is defined as the maximum output an economy can produce when it is most efficient or in other words is at full capacity. The potential output is sometimes referred to as production capacity of the economy. With the rise and fall in GDP, the output gap can be positive and negative. A positive output gap occurs when current output exceeds the potential output. This happens when there is high demand and to meet this demand the workers operate above their efficient capacity. A negative output occurs when there is spare capacity and the economy has weak demand. The negative output gap is characterized when the potential GDP exceeds the potential GDP. (Abel and Bernanke, 2001) The presence of an output gap is represents that an economy is not at its efficient level- it is either overworking or underworking its resources. Policymakers tend to use the potential output to measure the dimension of inflation. In this regard, the output gap is like an indicator which analyzes the demand and supply components of economic activity. In short we can say state that the output gap evaluates the degree of inflation in the economy and it helps to establish an important linkage between the real side of the economy which includes the production of goods and services and inflation. During recession, a fall in aggregate demand causes output gap to be negative where potential GDP exceeds actual GDP. This output gap is directed by the increase in unemployment and unemployed resources. The level of output gap helps to recognize the level of inflation in the economy. The negative output gap determines inflation to be low. In this situation the monetary policy tend to be lax where a low rate of interest would be required to accentuate growth and diminish negative output. A positive output gap is a situation where the rate of growth is above the trend growth and this leads to a rise in inflationary pressure. Now this output gap is related to unemployment. The non accelerating inflation rate of unemployment (NAIRU) is that unemployment rate that is consistent with constant inflation rate. The deflection of unemployment rate from its NAIRU is related with the diversion of output from its potential level. If the policymakers are able to state that the actual employment rate is equal to the NAIRU, then the economy will be able to produce the maximum output without overutilizing the resources in short there would be no output gap and no inflation in the economy. As we have analyzed that output gap has close association with the rate of inflation. So we can establish a relationship between inflation and unemployment. The relationship between the level of unemployment and the rate of inflation in the economy is shown with the help of the Phillips curve. The policymakers could explain the tradeoff between the unemployment and inflation. The Phillips curve helps to explain that as unemployment in creases, the rate of inflation lowers. The reason behind this tradeoff between the inflation rate and the rate of unemployment is that with an increase in aggregate demand the real GDP increases and therefore firms hire more workers and thereby the level of unemployment falls. But as the economy touches the full capacity, we can witness some inflationary pressures. This is because as the level of unemployment is lowered, the workers get the urge to demand more money wages which leads to a wage inflation. Also firms can increase the prices because of this rising demand. So we can see that as the level of unemployment is decreasing the economy is experiencing higher inflation rate. (Imf.org, 2015) The deviation of the unemployment from NAIRU is related to the output gap which is the deviation of the actual output from its potential level. Thus the output gap acquires a central position in the course of policy making. Most of the central banks aim at attaining the full capacity level where full employment leads to no output gap. And almost all central bank attempts to control the rate of inflation and output gap plays an important role in determining the inflation pressure. The output is responsible for indication the over performing or underperforming nature of the economy and so monetary policies are in immediate requirement in this regard. The monetary policy can be implemented by the central bank to enhance growth when the economy is under recession and there is a negative output gap. This is done by lowering the interest rates in order to increase the demand and restrict inflation to fall below the central banks target on the inflation rate. Again in the boom period, there exist positive output gap which initiates inflation rate to grow and in this context the central bank can stimulate growth in the economy by increasing the interest rates. Thus the policy makers are increasingly using the output gap to target inflationary pressures in the economy. But there crept up certain difficulties in estimating the output gap, so the policymakers use other economic indicators like employment, utilizing the capacity, shortages in labor, money and credit growth and inflation relative to expectations to assess the overall capacity pressure within the economy. (Claus, n.d.) Bank Of England And Low Interest Rate Based On Inflation Targeting Model The inflation targeting model is described by a three equation model IS-PC-MR. over the years the main policy goal of most of the central bank is targeting inflation which is conducted by the implementation of the monetary policy. The key policy instrument in this case is the nominal interest rate. The model assumes that the central banks systematically try to minimize the fluctuations of output around its natural rate of full employment and fluctuations of inflation about its target. The model assumes that the rate of inflation goes through a slow and persistent process and its takes around a year for the monetary policy to impact the output and this in turn takes around a year for the output to affect the inflation rates. The model also assumes that the central bank sets the nominal interest rate (i) and can evaluate the real rate of interest based on i and the expected rate of inflation which is nothing buyt the inflation of the previous period considering the adjustment lag. The equation given below describes the above assumption: The model is implemented on the basis of three set of equations: IS curve: (Mankiw, 2007) The equation of the IS Curve is Where C is the consumption, I is the investment, G is the government expenditure, EX is the exports, IM is the imports and Y denotes the real GDP. In this model, any change in the real interest rate affects the spending. As r increases, the borrowings of the consumer fall which is depicted by a fall in the C. this fall also leads to a decrease in the real GDP. Again if r declines then I will fall because investment and real interest rate are inversely related. A fall in the level of investment leads to a decline in the real GDP,Y. Also if r declines then the level of export falls but the imports rise leading to a fall in the Y. So the central bank has to adjust r to determine the level of real GDP of the economy. Phillips curve (PC): It establishes an inverse relationship between the level of unemployment and the rate of inflation. The equation of the Phillips curve is given by: (Stock and Watson, 2008) Where is the inflation rate, e is the expected inflation rate, Y is the actual GDP and Ye is the potential GDP. So as Y exceeds Ye, there is positive output gap which leads to increase in inflation rate and as Ye exceeds Y, there arises negative output gap which lowers down the inflation rate. So in order to reduce inflation, it is the duty of the central bank to create an output gap. And creation of output gap is done by increasing the real rate of interest by the central bank. (Ma, 2014) Monetary Policy Reaction Function (MR): The monetary policy rule helps to explain the mechanism of adjusting the real interest rate to target inflation in response to different shocks within the economy. The objective of the model is to stabilize inflation by minimizing output fluctuations. (Bain and Howells, 2015) The MR works when the central bank raises the real interest rate in order to slump the economy and thereby reducing inflation. As inflation declines people adjust their expectations to be low. This will drive down the PC to the level of expected inflation. The lower inflation enables the central bank to decline in the interest rate and inflation falls. Gradually the target rate of inflation is acquired and the economy reaches the full employment. (Bain and Howells, 2003) Based on the Minutes Of The Monetary Policy Committee Meeting 7 and 8 January 2015 The CPI inflation was around 0.55 IN December 2014 and it declined below the target of 2%. The main reason behind the fall is the steep fall in the wholesale energy prices last year. Since the inflation is below its target, the unemployment is well above the sustainable rate. This can be explained by the PC which defines an inversely relationship between the inflation rate and the unemployment rate. In order to stimulate growth in the economy, there is an immediate need to return the inflation rate to its target and eliminate the economic slack. (BBC News, 2015) (Neuenkirch, 2013) There were significant developments after the Inflation report of November which included fall in oil price, the spot price of Brent crude oil had decreased to $50 per barrel. It was expected by the bank staff that the CPI would be below zero during the first half of 2015. The market interest had fallen due to the tight UK monetary policy. The outlook justified that it is necessary to maintain the current level of Bank Rate and the asset stock purchases (Aldrick, 2012)which is financed by the issuance of reserves of the central bank. The adjustment in the monetary policy would be adjusted to ensure that CPI inflation returned back to 2% target. The two members who voted for the increase in the Bank rate was of the view that the sharp fall in the inflation rate below 2% target was initiated by other temporary factors. (MINUTES OF THE MONETARY POLICY COMMITTEE MEETING 7 and 8 January 2015, 2015)Thus the decision by the Bank of England to maintain the interest rate at 0.5% requires a pr oper implementation of the UK monetary policy which would by the MR signifies that it should aim at improving the unemployment scenario to raise the inflation rate to its target. (Tradingeconomics.com, 2015)This will lower the real interest rate from the first equation which in turn increased the level of investment and thus improve the real GDP. Thus, improvement in the real GDP by the growth in the level of investment is justified by the IS curve. (Fender, 2012) Thus, Bank of Englands decision to hold interest rate at 0.5% would drive up the inflation to its target and thereby increasing the level of investment. This increase in the level of investment will drive up the aggregate demand and in short this will help to stimulate growth in the economy by increasing the real GDP. (Dow, Klaes and Montagnoli, 2009) (Gerdesmeier, Mongelli and Roffia, 2010) (Tradingeconomics.com, 2015) References Abel, A. and Bernanke, B. (2001).Macroeconomics. Boston: Addison-Wesley. Aldrick, P. (2012).Economists call time on quantitative easing after Bank votes to hold. [online] Telegraph.co.uk. 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