The “Output Gap” and Excess Labor Employment

Abstract

The debate surrounding the current status of monetary policy and inflation has appealed to the existence of an output gap that will prevent the resurgence of substantial inflation. This paper presents evidence that the expansion in the late 1990s was unusual and should not be used as a basis for benchmarking the output gap at zero. In particular, there was an unusual psychology that prevailed in the late 1990s and 2000 that led to excessive capital spending and hiring. If policymakers overestimate the magnitude of the output gap by overestimating excess labor supply, they run the risk of making timing errors in the implementation of economic policy.