Latest Economic Growth Data Give Cheer To Market Monetarists, Or, What Is The NGDP Gap And Why Do We Care?

Includes: DIA, QQQ, SPY
by: Ed Dolan

The headlines for the latest report on U.S. economic growth mostly focused on the revised 4.1 percent growth rate for real GDP. As the following chart shows, that made it the best quarter in two years, and only the second quarter since the recovery began in which growth hit the 4 percent mark or better. A deeper look into the tables put out by the Bureau of Economic Analysis reveals another number that will bring even more holiday cheer to at least some economists: Nominal GDP growth has also begun to accelerate and the NGDP gap has finally started to close.

What is the NGDP gap and why do we care?

If you're a real econ wonk, you can skip this section. Otherwise you're probably wondering just what the NGDP gap is, and why we should care. Here goes.

Nominal GDP (NGDP) is simply gross domestic product expressed in current dollars, that is, measured according to the prices people actually pay for the goods and services they buy. That differs from the more widely reported real GDP data, which adjust prices to remove the effects of inflation. The rate of growth of NGDP is equal to the rate of growth of real GDP plus the rate of inflation. For example, if the real volume of goods and services produced by the economy grows at an annual rate of 3 percent and the average price level increases by 2 percent, then NGDP grows by 5 percent.

You might legitimately ask why we should care about NGDP. Yes, of course, we should care about real GDP- that measures how much actual stuff we have to eat and play with. It is natural, also, to care about inflation- no one likes to pay more for their stuff year after year. But what do we gain by adding together the rate of growth of real GDP and the rate of inflation to get the growth rate of NGDP as a single number?

The answer, according to a group of economists who call themselves market monetarists, is that the Fed can control NGDP more easily than it can control its separate components. In turn, these economists say, the rate of growth of NGDP drives the rest of the economy. If NGDP doesn't grow fast enough (5 percent per year is often used as a rough benchmark), then we will get low inflation, but real GDP growth will be substandard and unemployment will rise. If NGDP speeds up, it will push inflation up a little, but that will be tolerable if inflation is low to start with, and it will also get the real economy growing and bring unemployment down. Then, before the economy overheats, the Fed can taper off its monetary stimulus and NGDP will stabilize at a rate of growth that is sustainable in the long run.

Even the most ardent market monetarists don't claim this approach will tune the economy to perfection, but, they say, it will at least eliminate the worst of booms and busts.

Next, what is the NGDP gap? To understand the gap, we first need to calculate something called potential NGDP. That would be the level of nominal gross domestic product that the economy would produce if it were at "full employment," which probably means an unemployment rate of about 6 percent for the United States today. Potential NGDP is not the absolute maximum rate of production that the economy could achieve under boom conditions, but it is the maximum output that can be sustained in the long run without the risk of constantly accelerating inflation.

The NGDP gap is equal to potential NGDP minus actual GDP. If the economy is operating below potential, the gap is negative. If it is temporarily operating in boom mode, above its sustainable potential, the gap is positive.

Market monetarists watch the gap because they think the level of NGDP is even more important than its rate of growth. If the gap is negative, the Fed should apply more stimulus until the gap closes. As you can see, if the desired long-run growth rate of potential nominal GDP is 5 percent (composed, say, of 3 percent real GDP growth and 2 percent inflation), then the NGDP growth rate will have to be faster than 5 percent for a while to catch up. Similarly, the Fed would apply monetary restraint to temporarily slow NGDP growth below the long-run norm in order to cool off an overheated boom.

(Parenthetically, it is worth adding that some of the stimulus or restraint could, in principle, be applied through fiscal policy. Market monetarists think monetary policy has to do most of the heavy lifting, but some other economists, especially those who adhere to modern monetary theory, disagree. Exploring that debate would take us far beyond the bounds of this post. The only thing you need to know is that you are liable to cause great offense to your closest friends in the economics profession if you get market monetarism and modern monetary theory mixed up.)

What the latest NGDP data tell us

After that long digression, let's take a look at the recent behavior of NGDP to see why the latest data will be a relief to market monetarists. Let's start with a chart that shows the levels of actual and potential NGDP during the Great Recession. (The chart uses a version of potential NGDP calculated by the Congressional Budget Office. Some economists might quibble with the CBO methodology. Instead, we could estimate potential NGDP by simply extrapolating its historical trend. That trend would track a little above the CBO measure, but it would not greatly change the general picture.)

As the chart shows, actual NGDP plunged well below potential in 2008, opening a big negative output gap. Since about 2010, the lines have run almost parallel. The gap has stubbornly failed to close.

We can get a clearer picture by switching to a chart that plots the gap directly. There was clear progress from the bottom of the recession in mid-2009 until late 2010, when it briefly touched the -3 percent mark. The gap then widened again, not getting back to under -3 percent for a full year. After renewed gains in 2011, it again widened. By Q2 2013, the gap was still larger than it had been five quarters before. Only with the latest revision of the data for Q3 2013 has it closed to less than -2 percent.

One more chart will bring the latest data into even sharper perspective. This chart gives the percentage point change in the gap from each quarter to the next rather than the gap itself. The gap narrowed by a respectable 0.69 percentage points in Q3 2013. That is not only the second-best performance of the entire recovery; it also broke a disappointing run in which the gap actually got wider for four out of five quarters.

The bottom line

What do these charts prove? They do not prove that market monetarists are right in all their policy prescriptions. Something other than monetary stimulus might be moving the numbers. The charts do not prove that the Fed has been doing a good job, nor that now is the time for it to taper off on its policy of quantitative easing. Many modern monetarists would read these charts as proof that the Fed has been too timid and should not even be thinking about tapering yet.

Still, no matter how we interpret the cause, the latest NGDP numbers are yet another sign, along with data on real GDP, jobs, and the stock market, that the U.S. economy is looking quite a bit healthier than it did just a few months ago. We can all share that bit of cheering news regardless of which school of economics we claim as our own.

Follow this link to view or download a slideshow with additional charts based on the latest GDP data.

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here