What is economic slack?

Economic slack is a phrase used to describe the amount of resources in the economy that are not used. Machines left idle in a factory or people who cannot find a job represent slack to an economist.

The reason that slack exists is usually due to insufficient demand relative to what the economy is capable of producing. This is why economists want to keep track of it as it can give important signals about what is happening in the economy.

Why do central banks monitor slack?

If there is a large amount of slack in the economy it tends to mean many people are looking for a job. Even if the economy starts growing, there is still little pressure on producers at that stage to raise wages. This in turn means that they do not need to raise the prices of their products to cover higher wage costs. As a result, there is no danger of inflation getting out of control, so for the central bank it might mean that it can keep interest rates unchanged. The central bank may even consider providing stimulus to the economy, for example by cutting interest rates or using non-standard measures, to prevent inflation from falling too low for too long or even deflation kicking in.

After a while, however, as employment picks up and companies produce more, slack starts to disappear. The economy is about to hit its full capacity. It becomes difficult to find new employees and producers need to raise wages in order to keep existing ones. As a result, sharper price increases can be expected. For the central bank, this means that it is probably time to raise interest rates to keep prices stable.

The amount of slack therefore provides information about current and future inflationary pressures in the economy. It is one of the factors that can help the central bank make monetary policy decisions – when to raise or cut interest rates. The timing of such a policy move is crucial. Raising interest rates too early could hurt an economic recovery but doing so too late could result in higher inflation.

How is economic slack measured?

There are significant challenges in measuring slack, which is one reason why the concept is often discussed in economic debates. To measure it, economists often use the output gap, which is the difference between what is actually being produced in an economy (actual output) and what it has the capacity to produce (potential output). Actual output is measured by gross domestic product. Potential output is a concept that refers to the amount of goods and services that an economy is capable of producing when its resources, such as the workforce, equipment, infrastructure, and technology, are used in an efficient way that can be sustained over time.

Actual output can be lower or higher than potential output. If it is lower, economists talk about a negative output gap. This happens when there is spare capacity, or slack, in the economy. If the actual output is higher than the potential output, economists talk about a positive output gap. This happens when demand is very high and the economy is operating above what it can sustainably maintain.

Being a theoretical concept, potential output cannot be measured directly and experts use different methodologies to estimate it. Consequently, they get different results. To make matters even more tricky, estimates of potential output are often the most uncertain for the period that interests central bankers the most: the recent past and present. As a result, slack and the output gap are rarely out of economic debates.

Source: European Central Bank

Published: 18 Jul 2018

The above presentation was created for educational purposes.

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