potential output).2 When the level of output exceeds potential – that is to say there is a positive output gap – inflation tends to accelerate. Similarly, inflation tends to fall when the level of output is below potential. There are a number of measures of the output gap, but the balance of labour demand and supply is a central feature in most of them.
It determines the cyclical impact on unemployment, wages and consumer prices (this relationship, known as the Phillips curve, was originally specified between wages and unemployment but is now often modelled between consumer price inflation and output).3 There is always some unemployment since it takes time to find a new position and the skills of job seekers may not match up with current vacancies.4 For example, many part-time workers in hospitality and retail were made redundant following the Canterbury earthquakes, whereas the vacancies arising from the rebuild are typically full-time construction jobs.5 When the level of unemployment deviates from its long-run “natural rate” it puts pressure on wages, in a similar fashion to the output gap and prices.