What are some clear indicators of an inflationary gap?

by BainCapitalist

There are many, and deciding which ones are better than others is a subject of huge debate in macroeconomics. I’ll give you a couple examples:

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  1. Inflation rate. This can more specifically be CPI, PCE, or a core measure. The Federal Reserve Bank of the United States uses a PCE-Core inflation target to judge the stance of monetary policy.
  2. Price level. The difference between the price level and the inflation rate can be confusing, let me try to explain. Immediately after the bottom of a recession/depression, the economy will start to recover and experience a very high rate of inflation. However, at the moment this recovery starts, the price level is still low relative to where it was before the recession started. At this exact point, the inflation rate would say that monetary policy is expansionary but the price level indicator would say that it’s still contractionary and it will continue to be contractionary until the price level returns to its trend growth path.
  3. NGDP growth rate. Pretty simple. By definition, the growth rate of nominal NGDP is equal to the inflation rate plus the real growth rate. If real growth declines, then the Fed would respond by increasing inflation until the sum of inflation and real growth rates are equal to the target.
  4. NGDP level. Similar to the price level vs inflation rate idea I talked about in point two.
  5. The TIPS spread. This is basically a measure of what market actors expect inflation to be in the near future. Market Monetarists say that the actual value of the economic indicator doesn’t matter much, and the thing that’s actually important is what market actors expect the indicator to be in the future because markets are forward looking. They say that not relying on market expectations is analogous to trying to drive a car backwards – you’d only be able to see the road behind you, not the road ahead.
  6. The price of an NGDP futures contract – my personal favorite. It’s the same as the NGDP level targeting idea in point four, but this relies on the market expectations of NGDP, not the current level of NGDP.

There are lots more but I think that covers the most popular indicators.


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