The sticking point

Gavyn Davies has an interesting post up discussing the possible size of the output gap, and hence whether demand management policies can be used to increase output in the short run. To see why the size of the output gap is important for current policy, consider two extremes. If current output is actually well below potential output, then expansionary monetary or fiscal policy would be capable of increasing output back up to potential without significantly increasing inflation. If on the other hand potential output is in fact much lower than the pre-recession trend (see Gavyn’s excellent group of diagrams for various countries) and¬†output is currently equal to potential, expansionary monetary and fiscal policy would just lead to higher inflation with no change in output or employment. These are the two extremes but they show the basics of the problem for anyone unfamiliar with the theory.

Gavyn discusses an interesting issue relating to the breaking down of this relationship when inflation decreases (i.e. disinflation sets in). Take this quote from Gavyn in which he discusses a previous study;

In 2010, Andre Meier at the IMF published an analysis of persistently large output gaps, which I have previously summarised, in which he concluded that global inflation should be dropping each year by about 0.5 per cent, but that this would stop happening as the rate of wage and price inflation approached zero. The estimated impact of the output gap on inflation would therefore be expected to decline as inflation falls. This prediction seems to have proven accurate.

This is part of a larger body of literature on asymmetric price adjustment originating from such work as this by Greg Mankiw. What I would like to do is explain the theory without getting too wonkish, so here goes.

Consider a starting point where the economy is at full employment, inflation is on target and GDP is equal to potential. Then consider some negative aggregate demand shock. Most of us would instantly assume this aggregate demand shock would cause the prices of goods in the economy to fall, as firms respond to the falling demand for their goods by reducing their price in order to retain market share and sell their output.   If goods in the economy are imperfect substitutes i.e. if consumers place higher value on other aspects of products other than price (think of the brand effect of owning an iPod compared to other mp3 players), then when a firm decreases its price below its competitors it gains only a fraction of the additional market share that it would receive if goods were perfect substitutes.

If the additional market share for a given price decrease is sufficiently small, it is optimal for the firm to simply leave its price as it is and maintain a higher revenue per good sold, but sell fewer goods. When we aggregate this over firms, this provides an explanation of why in the face of negative aggregate demand shocks, output may decrease significantly without any appreciable fall in prices. Thus by extension, if such a situation arises, expansionary fiscal and monetary policy can expand output back to potential without an appreciable increase in inflation.

The beauty of the theory is that we still retain the result that expansionary policy when output is equal to potential leads to increases in inflation rather than increases in output i.e fiscal and/or monetary policy cannot lead to permanent increases in output growth. But why? Given that a firm gains very few customers from cutting prices below its customers, it similarly loses few when raising prices above customers. Hence when a positive aggregate demand shock hits the economy from our starting point of full employment, firms have every incentive to increase prices as the demand for their product increases. Hence on aggregate, output responds very little and inflation increases.

If the theory holds, then it is entirely plausible that the weak output growth that many developed economies are now experiencing could be reversed by expansionary monetary (if you think such a thing is currently possible, which I do) or expansionary fiscal policy, without leading to an appreciable increase in inflation.