Following a rapid phase-out of fossil-fuel dependency, Nordia's industrial sector has undergone significant structural transformation. While massive public investments in renewable infrastructure have boosted aggregate demand, the decommissioning of older thermal plants has permanently retired traditional capital. Economists estimate that the country's sustainable capacity frontier has shifted unpredictably.
This structural realignment complicates the central bank’s stabilization policies. If monetary authorities underestimate the friction of reallocating labor to green industries, they risk overstimulating the economy, sparking wage-push inflation. Conversely, if they mistake transitional frictions for a permanent loss of capacity, excessively tight monetary policy could choke off necessary capital investment. Consequently, policymakers face immense difficulties in measuring the output gap (line 14) to calibrate interest rate adjustments.
With reference to Extract C (line 14), explain the meaning of the term 'output gap'. Use an aggregate demand and aggregate supply (AD/AS) diagram in your answer.
