“Given the conclusion that the country is experiencing an output gap, an analyst would expect a further decline in the rate of inflation in the next year”
Can anybody explain the reasoning behind this staement?
When there’s an output gap, you can expect government stimulus: lower interest rates.
Lower interest rates: lower inflation.
You didn’t mention which side the output gap is on.
Judging by the word ‘further’, I’d assume the gap is on the downside. And since the inflation is expected to continue it’s downtrend, that means the government won’t provide stimulus, nor will the central bank. Unemployment is high, aggregate demand is low, the economy is slowing down, and therefore, prices are slowing down their inflation.
This assumes that the negative output gap persists, with no fiscal or monetary intervention, at least nothing that would make a short-term impact on prices, which they rarely do in either case.
Fixed
Fixed that for you.
The government doesn’t stimulate the economy by raising interest rates; it stimulates the economy by lowering interest rates.
Not really, no.
First off, lowering interest rates will raise inflation. Second, if by government you mean the central government, then no.
I’m not sure why you’d think either of them would be the opposite, but I’m sure you have an explanation, whether true or otherwise.
im with mrsmart here.
output gap means there is overcapacity, so little probability of price rises at a micro level, so generally low inflation.
interest rates are a distraction. sure if rates went up, then capital costs rises, so prices rise. and the reverse is obviously true.
I appreciate your post, but this wasn’t exactly what I was trying to get across.
Output gap means a mismatch between current aggregate production and potenial aggregate production, it could mean under, or over-capacity. Let’s assume demand-side economics in this discussion. Prices go down if the output gap is negative, and baring any fiscal or monetary intervention with immediate effects on short term demand, price inflation will be eliminated, or decelerate. Let us not mention interest rate levels here since it is irrelevant to our model. I am not sure what the OP model assumes, but there are several ways an “output gap” can mean slowing down of inflation in the next year, assumed to be the “short-term”. Since this is a cross-sectional model, let’s assume price level means inflation to adjust for time.
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Output gap = positive, equilibrium reached, whether due to intervetion, or market forces, inflation goes down
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Output gap = negative, no intervenion impact, demand goes down, inflation goes down
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Output gap = negative, production adjusts prices down to accomodate lower demand, inflation goes down (Supply side)
It’s difficult to draw concrete conclusions without drawing out some assumptions. Is one-year a sticky timeframe? Do we assume intervention by default? Is this a stationary system? Moving away from academia for the moment, economies cycle, and they exhibit output gaps all the time. You can have decelerating inflation on either side of “potential output”, depending on when you’re looking.
I’m with magician.
Output gap means actual GDP lower than GDP trend, so there’ll be lower interest rates with further decline in inflation for the short-term (i.e. 1 year), but i’d say in the longer term the lowering of interest rates will make inflation to rise.
That’s not what it means, not completely anyway.
And what do interest rates have to do with anything?
“in the next year” is not enough time for interest rates to drop, new capital projects to come online, and supply to increase to reduce inflation. which is also a lagging indicator.
so interest rates are not part of the answer.
all it is saying is factories have no motivation to increase prices. no wage pressures, capital projects online - but under utilised. interest rate _outlook_ negative or flat.
I’m probably wrong on this whole thing.
Not feeling good today. Sorry.
Sorry to hear. Get well soon.
Thanks.
It’s been a rotten few weeks: euthanizing my horse, my wife’s accident, too much work.
I appreciate the thoughts.
Sorry to hear that magician. Hope everything is ok now. You have been vey helpful.
Your ‘fixed’ was 1/2 right 1/2 wrong. Government stimulus would be to lower interest rates.
As the output gap then began to shrink, inflation would rise and gov would be inclined to then raise rates.
You were correct that higher int rates do lead to lower inflation