The “Output Gap” and Excess Labor Employment

A Look At The Evidence From A Small Firm Perspective

By William C. Dunkelberg and Jonathan A. Scott

William C. Dunkelberg is professor of economics at the School of Business and Management, Temple University, and chief economist of the National Federation of Independent Business. He is a nationally known authority on small business, entrepreneurship, consumer behavior and consumer credit, and government policy. Previously he was with Purdue, Stanford, and the University of Michigan. He is a fellow and past president of the National Association for Business Economics. He has a BA, MA, and Ph.D. degrees from the University of Michigan.

Jonathan A. Scott is associate professor of finance at the Fox School of Business and Management, Temple University. His research over the past 25 years has focused on small firm access to credit markets. He has published in the Journal of Financial Economics and other scholarly journals and has received numerous teaching awards. Previously he was with Southern Methodist University and the Federal Home Loan Bank of Dallas. He received his BA from the University of Cincinnati and his Ph.D. from Purdue University.

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.

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