Thinking about levels when it comes to macroeconomic policy targets

In a piece last week at The New York Times’s the Upshot, Neil Irwin highlighted probably the biggest question for the U.S. economy in 2017: How far is it from its potential? That question could launch a thousand blog posts, so let’s focus on one small aspect.

Irwin’s column features a graph of potential gross domestic product measured in trillions of dollars, based on the latest Congressional Budget Office projections, alongside actual GDP charted over time. Actual GDP, at about $19 trillion, seems set to reach CBO’s estimate of its potential of just over $20 trillion soon. GDP approaching its potential level may be something to enjoy, but it’s far from something policymakers should be bragging about.

Whether or not this specific estimate of potential is correct, what policymakers should focus on in that graph is not only where the two measures of GDP are about to intersect, but the gap between actual and potential GDP over time means for macroeconomic policymaking.

On one hand, policymakers could look at the graph to see that the line of actual GDP is just about to intersect with the line of potential GDP and be relatively content with the state of the wider economy. An economy almost at its potential is an economy where demand problems are about to be eliminated.

On the other hand, policymakers could instead focus on the area between actual GDP and potential GDP. The area covered in the gap between those two lines over the years since the start of the Great Recession is the total amount of GDP growth lost due to insufficient demand in the economy. The area between those lines represents trillions of dollars of economic output that could have happened if macroeconomic policy had more aggressively boosted economic growth. Those lost dollars between actual and potential economic output also represents millions of jobs and accompanying paychecks that were forgone as well.

What’s more, the gap in Irwin’s graph may be a low estimate of these lost dollars because potential GDP may be higher than CBO currently projects. If estimates of the economy’s potential are too low because more workers could be employed or productivity growth is set to increase, then the gap between potential and actual GDP would be higher both in the present and the past.

The distinction between the intersection of actual and potential GDP and the gap between the two also is helpful in thinking about the targets for macroeconomic policy. Imagine Irwin’s graph but instead of GDP, the variable being graphed is the price level in the economy. If the Federal Reserve wants to see prices go up by 2 percent a year, then the targeted price level (analogous to potential GDP) would increase by 2 percent every year. Currently, however, the Fed seeks to meet an inflation target, which means it is just trying to get actual inflation back to 2 percent. In other words, just getting back to the line is the goal.

But if the Fed had a price-level target, which may do a better job of convincing employers and employees of the changes in prices, then the goal is to have as little deviation between the two lines and to have corresponding and offsetting deviations. If we think of overshoots of inflation as having a “positive” area and undershoots as having “negative” area, then the goal of price-level targeting is minimizing the total gap between the two lines.

The same logic also could apply to a nominal gross domestic level target for monetary policy. In this case, the Fed would seek to eliminate the total deviation from a targeted path of nominal GDP growth against actual nominal GDP. On a podcast hosted by David Beckworth of the Mercatus Center, Brown University economist Gauti Eggertsson pitches this idea as “nominal GDP debt.” If policymakers think of overshoots of the targeted nominal GDP trend as “growth surpluses” and undershoots as “growth deficits,” then a nominal GDP level target set them up to make sure the U.S. economy doesn’t have “growth debt” over time.

Looking at Irwin’s original graph of actual GDP compared to potential GDP, it may seem to policymakers that the job of boosting economic growth is almost finished. But such thinking might provide little comfort given the potential left idle and the economic possibilities left unfulfilled. Whatever the case, policymakers might be more amenable to level targeting of the pairs of trend lines for inflation and for nominal GDP growth since both of these measures would enable them to get these targets back to level ground.