The Output Gap…ing Hole

From the Federal Reserve Bank of San Fransisco released a chart comparison between actual RGDP and the potential RGDP trend. Needless to say, the implication is very depressing. Paul Krugman comments in the same vein.

Why is this so depressing? Backward-looking indicators of inflation are pointing to levels that are well below trend, while forward-looking indicators are pointing to inflation coming in right around trend. We need (and have needed) a period of inflation much higher than trend to close the output gap.

However, contrary to Krugman — it is time to “tighten our fiscal belt”, forever. We need a central bank that sets an explicit target for NGDP (or nominal spending) growth, and is contracted to do everything in its power to hit that target so that the long term trend is always stable NGDP growth. The economy, of course, will fluctuate in the short-term, but under a policy of level targeting, the Fed should offset these fluctuations by increasing or decreasing its short-term target.

Also, as part of stabilization policy, we need complementary currency systems which are counter-cyclical (Swiss WIR, Yamoto LoVE) which will stabilize short-term fluctuations in NGDP.

Pairing a forward-looking monetary policy, with a (many?) counter-cyclical currency would make fiscal policy obsolete.


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