Using the latest estimate of potential GDP (from July 2021), the output gap in the third quarter of 2021 remains negative (about –1.7%), even as inflation has jumped up considerably. Its main virtue was that it provided a crisp and inarguable empirical test that would allow us to check at a later date to see whether or not their scenario for why inflation would accelerate had actually come to pass. I thought the overall argument was a bit too simple at the time, but it made some sense. The measured output gap was quite a bit smaller than the likely fiscal impulse of the ARP. This was all a perfectly reasonable argument. The ARP critics’ main claim was that the package provided far too large a boost given the size of the output gap in early 2021. When actual GDP falls beneath this potential, it means aggregate demand is too slack and needs to be boosted. So potential GDP is what the economy could produce if labor was fully utilized in a sustainable (i.e., noninflationary) way. If the unemployment rate stays below this natural rate for too long, the theory goes, then empowered workers will push wage growth high enough to put ever-growing upward pressure on prices. In turn, the natural rate of unemployment is the lowest unemployment rate consistent with nonaccelerating inflation. More specifically, the output gap is the difference between actual gross domestic product (GDP) and potential GDP-with potential GDP being what the CBO estimates could be produced if the economy was operating with labor markets near the “natural rate” of unemployment. The output gap is essentially a proxy for how much aggregate demand (spending by households, businesses, and governments) lags behind the economy’s underlying productive capacity. These critics made a very specific quantitative argument: The output gap-as estimated by the Congressional Budget Office (CBO)-was just –4% at the end of 2020, but the ARP would provide a fiscal impulse well over twice as large as that, leading to the output gap flipping quickly from negative to positive and sparking inflation. Looking back on the American Rescue Plan debateīack in February and March, center-left critics of the ARP claimed that it was too large and would lead to inflation. The respective answers to these questions are “mostly not” and “absolutely not.” This raises two key questions: Does rising inflation mean critics of the American Rescue Plan (ARP) have been vindicated, as is often claimed lately? And does this mean that the Build Back Better Act (BBBA) currently being debate should be shelved and/or radically trimmed down in size? While there are plenty of good reasons to think it will begin decelerating by early 2022 and settle into more normal ranges rather than continuing to spiral upward, it has already proven more stubborn than many (well, at least I) expected. Inflation has jumped up beyond what many expected earlier in this year.
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