Today my post is ECON101 stuff. It is going to be about output, unemployment, and Okun’s Law – one of the basic concepts in Economics – but in the context of New Zealand for the period from 2000 to 2014. In the second part of the post I will also dicuss the effects of the decrease in New Zealand’s OCR in March 2016. This is part of one of my assignments for Macroeconomics and therefore I take it as an opportunity to use it as content for today’s post!
So let’s look at the theory first. Okun’s Law states that there is a negative relationship between a country’s output gap and deviations from the natural rate of unemployment (NAIRU), i.e. unemployment higher than normal corresponds to a recessionary (negative) output gap and unemployment lower than normal corresponds to an inflationary (positive) output gap (Krugman & Wells, 2009).
In order to visualize this relationship for New Zealand for the time period from 2000 to 2014, the following inputs are needed:
- The actual rate of unemployment and actual output from 2000 to 2014
- The estimated natural rate of unemployment
New Zealand’s unemployment rate (ILO estimates) and its real GDP (constant 2005 US$) can be obtained from the World Bank database. In addition, its natural rate of unemployment comes from the Macroeconomics textbook and is estimated at 5.34 percent, which is the average unemployment rate from 1996 to 2006 (Krugman & Wells, 2009).
After having obtained these two data series and the natural unemployment estimate, potential GDP can be calculated as follows, where the unemployment rates are stated in decimals:
We are then ready to plot the results. The diagram above shows New Zealand’s actual GDP (constant 2005 US$) and potential output over time. One can see that from 2002 to 2008 potential GDP was below actual GDP. Since 2009 potential GDP has been above actual GDP. Overall, potential GDP has risen steadily over the period except from 2007 to 2008. Actual GDP has risen steadily over the period except from 2007 to 2009, i.e. one year less than potential GDP. The difference between actual and potential output was highest in 2007 ($2.07 billion) and lowest in 2012 (- $2.12 billion). Furthermore, the output gap can also be calculated as output gap as percentage of potential GDP and unemployment can be shown as the difference between actual and natural unemployment:
Taken together, the diagram below highlights the negative relationship between New Zealand’s output gap and cyclical unemployment as stated in the beginning. If unemployment is below its long-term trend, New Zealand’s economy is overheating, meaning that it is running above capacity and experiences a positive output gap. Conversely, if unemployment is above its long-term trend, New Zealand’s economy is running below capacity and experiences a negative output gap.
The diagram shows that New Zealand is now almost back at full capacity. In 2014, the recessionary output gap decreased to 0.27 percent of potential GDP. This trend is likely to continue in 2015 and 2016 and therefore the output gap is expected to become positive at some point in the near future. However, on 10 March 2016 the Reserve Bank of New Zealand decided to lower the Official Cash Rate (OCR) by 25 basis points to 2.25 percent (RBNZ, 2016). We are now ready to analyse what is likely to happen as a result of this intervention. Let me give you my answer first and I will explain it in depth: The lowering of the OCR will accelerate an overheating of the economy rather than accelerating a recovery from the 2008/09 recession.
In theory there are two possible scenarios; either New Zealand’s economy currently suffers from excess capacity or the economy is at its long run equilibrium close to its natural rate of output and unemployment. The ultimate effect of a decrease in the OCR will differ depending on these circumstances as shown in the panels (i) and (ii) below. In both scenarios a decrease in the OCR will initially increase aggregate autonomous spending (AE0) at any level of GDP. This assumption holds true, because intuitively a lower interest rate induces people to increase spending. The formal explanation is the following: either the opportunity cost of saving the money that people kept in their vault falls due to the fall of the OCR, because they do not earn as much interest as before and therefore go spend the money instead, or people can now borrow at a lower interest rate, which will render some unprofitable investments profitable, and will do so. Overall, the lowering of the OCR will both induce consumers and businesses to increase their autonomous spending. This will shift the planned aggregate spending line to AE’planned and the aggregate demand line to D’ in both scenarios. However, thereafter the outcomes differ.
Another important point I want to make on the go is that this is probably a re-run of the story of the early 2000s, where low interest rates set by the Federal Reserve (FED) triggered a housing boom in the US. A similar thing is happening in New Zealand; Auckland is at the forefront of this with skyrocketing house prices. But let’s get back to the theory for now.
In the first scenario New Zealand’s economy starts below its long-run equilibrium with excess capacity. The short-run aggregate supply curve (SRAS) is perfectly elastic, because firms can readily meet increased demand by scaling up production. This does not put inflationary pressure on the country’s price level P in this scenario, because there is an excess supply of labour (positive unemployment gap) and an excess amount of inventories, for example due to the earlier shortfall of aggregate demand in the global financial crisis (GFC). In this case, the lowering of the OCR pushes the economy back to its long-run equilibrium at point B where actual GDP is equal to potential GDP (Yn). The intervention of the Reserve Bank of New Zealand to lower the OCR by 25 basis points therefore has a positive long-run effect.
In the second scenario New Zealand’s economy is already at its long-run equilibrium (point A). This is the case when there is no output gap and unemployment is at its natural rate. An increase in the OCR in this scenario triggers a positive output gap coupled with an increase in the price level to P1 in the short-run because the short-run supply curve is not perfectly elastic in this case. As actual output increases to levels above potential output, unemployment falls below its natural rate and becomes relatively scarce in the economy (at least skilled labour). This will allow workers to bargain for higher wages. In the long-run firms will need to adjust by cutting back on their supply. They will be affected by the higher price level through the rise of input prices (labour, capital). This moves the economy back to its natural rate of output (Yn) at an even higher price level P3 (point C). Hence the decrease in the OCR causes an overheating of New Zealand’s economy in the short-run; thereafter further inflation and a contraction of GDP in the long-run. In this case, the intervention has no long-run effect on GDP; the short-run boost in actual output is not sustainable. What is more, the intervention likely to harm the economy due to the costs of inflation (distortions, e.g. for home-owners in the housing market; menu costs).
In summary, it can be argued that New Zealand is in the second scenario, because it is (1) close to its natural output level and (2) the unemployment rate has come down to 5.6 percent over the last two years. The lowering of the OCR will therefore do more harm than good. If this intervention had happened for example in 2011 or 2012, then the economy would have benefited from a faster recovery from excess capacity and an excess labour supply after the GFC. Now, however, this intervention is expected to trigger an inflationary output gap through channels like a housing boom. In the long-run this boom will be unsustainable. It is forecast to trigger inflation, a contraction of output, which is bringing GDP back to its natural level, and an increase in unemployment rates, which is bringing unemployment back to its normal level.
So that’s me for today. I hope you enjoyed the analysis,
Krugman, P., & Wells, R. (2009). Macroeconomics (2nd ed.). New York, N.Y.: Worth Publishers.
RBNZ (2016, 10 March). Official Cash Rate reduced to 2.25 percent [online]. Wellington: Reserve Bank of New Zealand. Retrieved from: http://www.rbnz.govt.nz/news/2016/03/official-cash-rate-reduced-to-2-25-percent
World Bank (2016). World Development Indicators: New Zealand [Data file]. Retrieved from: http://data.worldbank.org/country/new-zealand