A Shot in the Dark: UK Policy Based on the Output Gap

Jessica Ullom-Minnich & Skyler Ramirez-Ortiz

In early March, the UK announced its budgetary plan for the coming years. The plan, which was expected to be largely contractionary, reversed its plans in light of the impact that both Brexit uncertainty and continued pandemic lockdowns have had on the economy. The Office of Budget Responsibility (OBR) has revised its expectations of future growth. It now anticipates growth of “4% in 2021, down from 5.5% in the previous forecast, but then... 7.3% in 2022, the fastest rise in eight decades.” In response to these estimates, the new budget includes expansionary policies like an extended Coronavirus job retention plan and increased grants and low-interest loans. On the whole, the plan is expected to increase spending by about ￡35 billion and cut taxes by an additional ￡24 billion. This is effectively an increase of 3% of GDP, not counting multiplier effects. The OBR has added that they hope these measures will close the negative output gap in the UK economy. In a few years time, as output grows substantially, the government is expected to raise taxes to the highest levels since the 1960s.

The IS-LM-PC model provides valuable insights into the logic behind this policy. To set up this analysis, assume an economy in medium-run equilibrium before Brexit/Covid-19 lockdowns. We know that both Brexit and Covid-19 have likely shifted the IS curve inward. Brexit decreased business confidence and thus investment, while lockdowns caused many to lose their jobs and reduce their consumption. In the short run, this creates a new equilibrium with higher interest rates and lower output, provided monetary policy does not change. However, a medium-run perspective requires knowledge of the position of the Philip curve. For example, if new tariffs raised the prices of important raw materials, businesses would have to use larger markups to afford their inputs. This would shift the Phillips curve upward. If the shift was significant enough, the UK economy could already be in medium-run equilibrium- even with the reduced output. This would mean that expansionary policy could only result in a temporary increase in GDP that would bring with it a large increase in the inflation rate. However if, on the other hand, the Phillips curve has remained where it originally was, then the action from the OBR may be able to force the IS curve out again and quickly reestablish equilibrium with a minimal change in inflation. Even as UK policymakers look toward the future, the consideration of medium-run equilibrium still applies. The article suggests that in several years when economic growth is high again, taxes will be raised substantially. If policymakers manage to get the economy back to equilibrium before this dramatically increased growth, higher taxes could prevent the IS curve from shifting out and moving the economy out of equilibrium once more. However, if the economy has not yet fully recovered and the output gap is still negative, the increased taxes would be counterproductive. The government’s ability to be effective in any of this relies on its ability to effectively predict where the Phillips curve is. More precisely, they need to determine exactly how large the output gap, the difference between current output and potential output, is.

The data table above was taken from the UK Treasury’s website. It lists several independent estimates for what the output gap currently is (as of Feb 2021) and also what it will be as far into the future as 2025. Particularly of note is the diversity of the measurements. According to the table, the current UK output gap could be anything from -5.2% to 7.5%. Taken in comparison with the OBR’s estimate at the bottom of the page (-1.1%) it is apparent that the eventual impact of policy based on the predicted output gap is anything but certain. The fundamental problem is that “despite their policy relevance, output gaps are notoriously difficult to measure (especially in the vicinity of a large shock...), and there is no consensus in the profession on the best method for estimating them.” Traditionally, the primary methods for estimating potential output have relied on “decomposing observable output ... subject to various assumptions.” Naturally, problems occur when there are either issues with these assumptions or the observable data itself. In fact “endpoint problems” in which current data is being constantly revised, are very common in most models. One new method attempting to compensate for this issue is the method used by Marko Melolinna and Mate Toth in their paper that uses financial variables -in addition to traditional ones like real GDP- as signals for the business cycle to better predict real-time output gaps. This is based on the logic that the financial system can either “act as an amplifier of shocks or can be the source of shocks that trigger business cycle fluctuations in the first place.” On the whole, this new model presents a view of the UK’s economy that tends to have a more optimistic view of the UK output gap in the post-2008 financial crisis world. This is because in the model a “larger part of the crisis-related downturn is attributed to cyclical rather than structural factors.” The results of this study, while promising, still have progress to make. Some of their results (pictured below) show their model’s real-time estimates of the output gap compared with the full sample predictions. Even though these estimates generally trend together, they are often different enough that a policy based on the real times estimates could significantly miss the mark and mistakenly under-account or over-account for the output gap. What this means in the context of the UK’s new budget plan is that the OBR’s estimates of the output gap are very likely to be flawed in some respect. If policymakers were to wait long enough to be more confident in the output gap estimates, it would already be too late to take action off of them. There is simply too much diversity among estimates of the current output gap and an empirical discrepancy between real-time estimates and ex post facto estimates of the output gap. Even if the fiscal policy is headed in the right direction, miscalculation means there is a high likelihood of seeing the UK’s inflation rate change in the near future as they get closer and closer to closing the output gap.

Bibliography

"A Game of Two Halves." The Economist, Mar 06, 2021, 21-22, https://ezproxy.plu.edu/login?url=https://www-proquest-com.ezproxy.plu.edu/magazines/game-two-halves/docview/2497407324/se-2?accountid=2130.

Blanchard, Olivier. Macroeconomics. 7th ed. Boston, MA: Pearson, 2017.

Macroeconomic Co-ordination and Strategy Team, The. "Forecasts for the UK Economy: A Comparison of Independent Forecasts." February 2021. Accessed April 11, 2021. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/962029/Forecomp_February_2021.pdf

Melolinna, Marko, and Mate Toth. “Output Gaps, Inflation and Financial Cycles in the UK.” Empirical Economics 56, no. 3 (March 2019): 1039–70. https://search-ebscohost-com.ezproxy.plu.edu/login.aspx?direct=true&db=ecn&AN=1757826&site=ehost-live&scope=site.