Sunday, October 30, 2011

The Long Run Equilibrium Price Level

With nominal GDP targeting, the equilibrium price level at any future date is the target for nominal GDP divided by the level of potential output. While the level of potential output cannot be observed either now or in the past, much less perfectly forecasted, the Congressional Budget Offices does provide estimates of past, current, and future values of potential output. Certainly these estimates could be criticized, and future values forcasted for 10 years from now must be taken with a grain of salt, but it provides a good starting point to explore price level and inflation performance.

In the diagram below, the price level, as measured by the GDP chain-type index, is shown in blue. The trend price level from the Great Moderation is shown in red. The Goldman-Sachs/Reagan-Volcker equilibrium price level is shown in green. And the equilibrium price level from the trend growth path of nominal GDP from the Great Moderation is shown in black.


The price level is currently 1.8 percent below the trend of the Great Moderation. An inflation rate of 3.6 percent would return the price level to trend after one year. An inflation rate of 3 percent would return the price level to trend after two years. An inflation rate of 2.6 percent would return the price level to trend after three years. Last quarter's inflation rate of 2.5 percent is close to what would be needed for a three year adjustment path.

The equilibrium price level implied by the trend growth path of nominal GDP for the Great Moderation is found by dividing nominal GDP by the CBO estimate of potential output. It is currently 6.4 percent above the trend price level of the Great Moderation. This equilibrium price level is 8.3 percent above the current price level. An inflation rate of 11.2 percent would be necessary to return the price level to equilibrium in one year. An inflation rate of 7.2 percent would allow the price level to adjust to equilibrium after 2 years. An inflation rate of 5.5 percent would allow the price level to adjust to equilibrium after 3 years.


The equilibrium price level implied by the Goldman-Sachs/Reagan-Volcker alternative growth path is currently 1.9 percent above the trend price level of the Great Moderation and 3.8 percent above the current price level. An inflation rate of 5.8 percent would allow the price level to adjust to equilibrium after one year. An inflation rate of 4.1 percent would allow the price level to adjust to equilibrium after 2 years. And an inflation rate of 3.2 percent would allow the price level to adjust to equilibrium after 3 years.


After these adjustments, the inflation rate implied by the trend price level of the Great Moderation would remain 2.3 percent. The equilibrium price level implied by the trend growth path of nominal GDP from the Great Moderation would imply an average inflation rate of 2.9 percent. The Goldman-Sachs/Reagan-Volcker growth path would generate a 2 percent inflation rate after the adjustment to equilibrium growth path for the price level.

The diagram below shows the inflation rates assuming the gradual, three year adjustment from the current price level to the equilibrium price levels.

Of course, "supply-side" reforms would raise potential output growth and reduce the equilibrium price levels and the inflation rates shown here. One implication of nominal GDP targeting is that price level and inflation depend critically upon supply-side economic performance.

2 comments:

  1. Very interesting posts of late. I really like your work.

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  2. It’s really tough to know how trend is going to work out with the GDP in this shape, I believe we just need to take one step at a time and always focus on long term targets. I find it relatively easier with OctaFX broker since I am operating with their swap free account, so that enables me to do long term trading with ease without worry of paying overnight charges and there are several other benefits, so all this works strongly in my favor.

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