August 12, 2020

The Neutral Level of NGDP and the NGDP Gap: Q2 2020

Neutral Level of NGDP and NGDP Gap (Percent Change between Actual & Neutral Levels of NGDP)

The nominal GDP (NGDP) gap, a measure of unexpected changes in the dollar size of the US economy, is the percent difference between the actual and the neutral level of NGDP. The neutral level of NGDP, in turn, is a sum of all dollar incomes expected by households and businesses coming into a specific time period. In the second quarter of 2020, the NGDP gap reached a new low, hitting −12.12 percent (see figures above).

This large negative value for the NGDP gap indicates that the COVID-19 crisis has morphed from a supply shock—a sudden decline in the productive capacity of the US economy—into an even larger spending shock. Since every dollar spent is a dollar earned, this spending shock also indicates a similarly large income shock. Finally, the large NGDP gap also implies that monetary conditions are effectively tight.   

The neutral level of NGDP was $22.09 trillion in the second quarter of 2020 (see figures above). Actual NGDP came in at Measures of NGDP, Q1 2020 vs. Q2 2020$19.41 trillion. There was, in other words, a $2.68 trillion shortfall in the dollar size of the economy or, equivalently, a 12.12 percent NGDP gap. By way of comparison, the Congressional Budget Office (CBO) output gap reveals that the real economy was 10.83 percent smaller than its true potential over the same period. Relative to the previous quarter, actual NGDP declined by −9.98 percent (−34.34 percent on annualized basis). The NGDP gap decline was larger than the actual nonannualized NGDP decline this quarter because the former shows the percent deviation of NGDP from where it was expected to be, whereas the latter shows the percent deviation of NGDP from its value in the previous quarter.

A Closer Look at the NGDP Gap

As noted, the NGDP gap requires an estimate of the neutral level of NGDP. The neutral level of NGDP is estimated by taking an average forecast of NGDP, or equivalent total nominal income, for a given quarter based on forecasts for that period from the preceding 20 quarters. The forecast data used here are taken from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters.

The NDGP gap measures the percent difference between this average forecast and the actual level of NGDP. If the actual level of NGDP is less than the neutral level, then monetary conditions are contractionary. If actual NGDP is greater than the neutral level, then monetary conditions are expansionary.

The rationale for this understanding is twofold. First, members of the public make many economic decisions, such as whether to take out a mortgage or a car loan, on the basis of forecasts of their nominal income. Similarly, firms may finance with debt and commit to multiyear contracts on plants, raw materials, and labor on the basis of forecasts of their nominal income. Second, the actual realization of nominal incomes may turn out to be very different from what is expected and, as a result, may be disruptive for households and firms that are not be able to quickly adjust their economic plans. These disruptions can be avoided by maintaining total nominal income or NGDP on the growth path expected by the public. In other words, the Fed should aim to close the NGDP gap in order to keep monetary conditions neutral.

For more information on how the NGDP gap is constructed and how it may be used to understand policy, please see “The Stance of Monetary Policy: The NGDP Gap," a policy brief by David Beckworth. Also, see the NGDP gap web page hosted by the Mercatus Center that provides access to current and vintage data on the NGDP gap.

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