I’m Puzzled as to Why Economists are Puzzled

Here’s an interesting WSJ report on Canada:

And the Bank of Canada has signaled it’s aware of the downside risk to inflation prices in light of the long string of below-target inflation numbers.

The broad weakness in price pressure across a number of economists is hard to account for, Roberto Cardarelli, chief of the IMF team covering Canada, said a press briefing Wednesday.

“Inflation is a puzzle, and it’s not just a puzzle in Canada,” Mr. Cardarelli said.

It’s believed that one of the key drivers of inflation is the amount of slack in an economy – the difference between actual growth and the growth an economy could produce without pushing inflation higher.

It is also referred to as the “output gap,” as it’s the difference between an economy’s actual output and its potential output. When an economy is reaching full capacity, labor and other inputs become scarcer and more expensive, and that creates inflation.

But inflation in Canada remains soft despite the fact that the gap has narrowed considerably since the recession, Mr. Cardarelli said.

What’s the big puzzle?  In the textbook AS/AD model, when AD shifts left output falls and the price level (or inflation) also declines. Then the self-correcting mechanism kicks in.  AS shifts right, causing prices (or inflation) to fall further and output gradually rises back to the natural rate.  As long as NGDP is stable, the rising output will be associated with low inflation.

It seems like lots of economists abandoned the excellent AS/AD model and replaced it with a very unreliable output gap model.  If they had studied the Great Depression they would have realized that NGDP growth drives inflation, not output gaps.  In 1933 NGDP growth was very rapid but unemployment was 25%.  The WPI rose by more than 20% in the 12 months after March 1933, which confirms the NGDP model, but is completely inconsistent with the output gap model.

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