What Is an Output Gap?
The term output gap refers to the difference between the actual output of an economy and the maximum potential output of an economyexpressed as a percentage of gross domestic product (GDP). A country's output gap may be either positive or negative. A negative output gap suggests that actual economic output is below the economy's full capacity for outputwhile a positive output suggests an economy that is outperforming expectations because its actual output is higher than the economy's recognized maximum capacity output.
- Anoutput gap is a difference between an economy's actual output and its maximum potential output expressed as a percentage of gross domestic product.
- The output gap is a comparison between actual GDP (output) and potential GDP (maximum-efficiency output).
- A positive or negative output gap is an unfavorable indicator of an economy'sefficiency.
- Policymakers often use the output gap to determine inflationary pressure so they can make policy decisions.
- Although it's an important economic indicator, the output gap isn't always reliable because the potential output must be estimated.
How an Output Gap Works
The output gap is a comparison between actual GDP and potential GDP or output and maximum-efficiency output. This is difficult to calculate because you can't estimate an economy's optimal level of operating efficiency. There is little consensus among economists about the best way to measure potential GDP but most agree that full employment is a key component of maximum output.
One method that can be used to project potential GDP is to run a trend line through actual GDP over several decades or enough time to limit the impact of short-term peaks and valleys. By following the trend line, you can estimate where GDP currently sits or what it will be at a particular point in the near future.
Determining the output gap is a simple calculation of dividing the difference between the actual and potential GDP by the potential GDP.
Because potential output isn't observable, it's often determined using historical data.
Positive and Negative Output Gaps
An output gap is an unfavorable indicator of an economy'sefficiency, regardless of whether it's positive or negative.
A positive output gapindicatesa high demand for goods and services in an economy, which may be considered beneficial for aneconomy. But the effect ofexcessively high demand is that businesses and employees must work beyond their maximum efficiency level to meet the level of demand. A positive output gap commonly spurs inflation in an economy becauseboth labor costs and the prices of goods increasein response to the increased demand.
A negative output gap, on the other hand, indicates a lack of demand for goods and services in an economyand can leadto companies and employees operating below their maximum efficiency levels. This type of output gap points to a sluggish economyand portendsa declining GDP growth rate and potential recession as wages and prices of goods typically fall when overall economic demand is low.
Advantages and Disadvantages of the Output Gap
The output gap is a very important economic indicator. While there are distinct advantages to using this metric, its use does come with certain drawbacks. We've listed some of the most common benefits and limitations to using the output gap below.
Because the output gap relies on the gross domestic product in its calculation, it helps provide a picture of how the economy is doing. More specifically, it can be used as a way to determine whether the economy is underperforming or is growing too quickly. That's because this gap can help determine the rate of inflation in an economy.
The output gap can help policymakers come up with solutions to move the economy in a more favorable direction. Therefore, it plays a very key role in how they make their decisions. about both fiscal and monetary policy. For instance, the Federal Reserve will raise interest rates to curb inflation and vice versa.
Because the output gap is used by both economists and analysts on the street, the general public can also use it to make informed decisions about their finances and investments. For example, a homeowner may decide to hold off on refinancing their mortgage if the output gap means there's a chance that interest rates will increase.
One of the main problems with the output gap is that it is hard to measure. The level of actual output is easy to determine because we know what's happening. But potential output isn't that easy to calculate because we can't determine it. The latter is a figure that can only be predicted or estimated.
How the potential output is measured can be problematic. In fact, there isn't just one way to do so. Analysts and economists may use different filters or models to do so. For instance, some experts may compute the potential output as the trend output while others consider it as the trend growth.
Another limitation to the output gap lies in how intertwined relationships are within the economy. For example, a less active workforce will lead to a drop in output. Similarly, distressed small businesses and corporations and tighter lending standards during tough economic times can also have a big impact on the potential output.
It provides a picture of how the economy is doing.
Policymakers are able to use output gap to help make decisions.
Consumers and investors can make informed decisions about their finances and investments.
Output gap is hard to measure because we can't observe potential output.
There is no uniform way to measure potential output.
Potential output relies heavily on relationships that are intertwined in the economy.(Video) The Output Gap
Real-World Example of an Output Gap
The actual GDP in the U.S. was $21.48 trillion through the fourth quarter of 2020, according to the Bureau of Economic Analysis. According to the Federal Reserve Bank of St. Louis, the potential GDP for the U.S. in the fourth quarter of 2020 was $19.41 trillion, meaning the U.S. had a positive output gap of about 10.7% (projected GDP subtracted from actual GDP/projected GDP).
Keep in mind that this calculation is just one estimate of potential GDP in the U.S. Other analysts may have different estimates, but the consensus is that the U.S. was facing a positive output gap in 2020.
Not surprisingly, the Federal Reserve Bank in the U.S. has consistently been raising interest rates since 2016, in part in response to the positive gap. Rates were at less than 1% in 2016 and hit as high as 1.25% in the early part of 2020. The global financial crisis, though, forced the Fed to drop rates back down below 1% in mid-March 2020.
Potential Output FAQs
What Is Potential Output?
Potential output is what an economy can produce if it operates at full-employment-GDP. This is generally the highest level if and when the economy is doing very well. Unlike actual output, which is what currently happens, potential output cannot be measured and, therefore, relies on estimation.
How Can an Economy's Output Deviate From Its Potential?
An economy's output gap can deviate from its potential in one of two ways. A positive output indicates the economy is performing well above expectations. That's because the actual output is higher than its potential. It may also be negative when the output is below full capacity.
What Would Help a Government Reduce an Inflationary Output Gap?
Governments may find that reducing government spending as well as cutting down transfer payments and their bond and security issues can help reduce an inflationary output gap.
What Happens to the Output Gap When the Economy Is in Recession?
When an economy is in recession, it means that its actual output gap is lower than the potential output gap.
What Can the Government Do to Move the Economy Back to Potential GDP?
Governments can move the economy back to its potential GDP by taking a number of steps, including (but not limited to) reviewing tax rates and rebates, making moves on interest rates, and cutting or increasing government spending. The direction they choose depends on whether the actual output is positive or negative.
The output gap is a comparison between actual GDP (output) and potential GDP (maximum-efficiency output). A positive or negative output gap is an unfavorable indicator of an economy's efficiency. Policymakers often use the output gap to determine inflationary pressure so they can make policy decisions.What do you mean by output gap? ›
The output gap is an economic measure of the difference between the actual output of an economy and its potential output. Potential output is the maximum amount of goods and services an economy can turn out when it is most efficient—that is, at full capacity.What are the negatives of a negative output gap? ›
In this situation, the economy is producing less than potential. There will be unemployment, low growth and/or a fall in output. A negative output gap will typically cause low inflation or even deflation. A negative output gap may imply a recession (fall in GDP) or just very low economic growth.How do you calculate output gap examples? ›
To arrive at an output gap, divide the difference between the actual GDP and potential GDP by the potential GDP and multiply it by 100.How is a positive output gap related to the business cycle? ›
In business cycle terms this usually means that the economy is expanding. When this occurs, the unemployment rate is likely low and decreasing. In short, a positive output gap occurs when actual output exceeds potential output, which means the economy is fully employed and overutilizing its resources.What is the output gap in the US economy? ›
Basic Info. US Output Gap is at 1.26%, compared to 1.11% last quarter and 0.51% last year. This is higher than the long term average of -0.62%.What is the output gap quizlet? ›
The output gap is the difference between the actual level of national output and its potential level (long-run, trend rate of economic growth) and is usually expressed as a percentage of the level of potential output (ie. 80% of full capacity).What are the positives of a positive output gap? ›
If the demand for products is greater than the capacity to supply them for a period of time, there is a positive output gap. A positive output gap usually results in: higher inflation. lower unemployment.Is output gap positive or negative? ›
A negative output gap indicates there's slack in the economy as resources are being underutilized. The economy is performing below potential. A positive output gap means any slack has evaporated and resources are being fully employed, maybe even to the point of overcapacity.How do you show a negative output gap? ›
Output gaps can also be identified by comparing the actual growth rate of an economy with its trend rate of growth. The trend rate of growth is the average rate over a period of time. When actual is below trend there is a negative output gap and when actual is above trend there is a positive output gap.
An output gap is a difference between an economy's actual output and its maximum potential output expressed as a percentage of gross domestic product. The output gap is a comparison between actual GDP (output) and potential GDP (maximum-efficiency output).What is the output gap with employment? ›
Output gaps measure the difference between actual real GDP and potential GDP. When the economy is producing potential output, employment is at the 'natural employment' rate.What are the determinants of output gap? ›
Output gap can be affected by different factors, such as inflation, trade openness, lending rate (a proxy for interest rate), and FDI.
A negative GDP gap represents the forfeited output of a country's economy resulting from the failure to create sufficient jobs for all those willing to work. A large positive GDP gap, on the other hand, generally signifies that an economy is overheated and at risk of high inflation.What is a positive output gap on the ad as model? ›
Positive and negative gaps in the AD-AS model
The difference between current output and the full employment output is called a “gap”. Negative output gaps mean that an economy is producing less than full employment, while positive output gaps mean that an economy is producing more than full employment output.
Here's what will happen: As a result of the negative supply shock, output goes down, but inflation and unemployment go up. The increase in unemployment will theoretically lead to lower wages (because their is less competition for labor, so firms do not have to compete for workers with higher wages).What is the output gap in production function? ›
Output gap is the difference between the actual output and the potential output, expressed as a percentage of the potential output. A positive output gap means that the economy is producing more than its potential, while a negative output gap means that the economy is producing less than its potential.What is the output gap in the business cycle? ›
In the business cycle model, a nation's potential output at any given time is represented as the long-run growth trend. Output gaps exist whenever the current amount that a nation is producing is more or less than potential output.