Output Gaps
Definition
Long-term trend rate of growth: the average rate at which potential output rises over time.
Actual growth rate: the rate of change of real GDP, which varies around the trend as demand rises and falls.
Output gap: the difference between actual output and the trend, or potential, level of output.
- The output gap captures the state of demand relative to the economy's capacity, not the direction of growth.
- Because actual output moves around the trend, the gap can be positive in a boom and negative in a downturn.
Positive and Negative Gaps
Definition
Positive output gap: when actual output exceeds the trend level, straining capacity.
Negative output gap: when actual output is below the trend level, leaving spare capacity.
- A positive gap brings inflationary pressure, because demand presses on limited capacity and pushes up prices.
- A negative gap brings spare capacity, higher unemployment and weak price pressure, because demand falls short of what the economy could produce.
Showing the Gap
- Draw a vertical LRAS marking trend output, with the average price level on the vertical axis and real output on the horizontal axis.
- A negative output gap appears where the AD and SRAS equilibrium output lies to the left of the LRAS trend level.
- A positive output gap appears where equilibrium output lies to the right of the LRAS trend level, beyond sustainable capacity.
Example
- In a deep recession, weak demand leaves output below trend, a negative output gap.
- In a strong boom, output pushed above trend gives a positive output gap.
Example
- In the 2008-09 financial crisis, UK output fell well below trend, opening a large negative output gap with high unemployment and weak inflation.
- The 2020 Covid-19 lockdowns opened an even sharper negative gap as activity was suspended, though the disruption also lowered potential output itself.
Measurement Difficulties
- Potential output cannot be observed directly, so the trend level must be estimated.
- Estimates are revised as more data arrive, so real-time judgements of the gap can be wrong.
- Policy based on the gap must therefore allow for that uncertainty.
How reliable are estimates of the output gap?
- It holds because the sign of the gap signals whether inflation or unemployment is the greater risk, which usefully guides fiscal and monetary policy.
- But potential output is unobservable and estimated, and figures are revised, so a gap judged negative today may later prove to have been positive.
- On balance, the output gap is a helpful guide rather than a precise measure, so policymakers should treat it cautiously and read it alongside other indicators.
Exam technique
- Define the gap as actual output minus trend output, and state its sign.
- Show it on an AD/AS diagram by placing equilibrium output to the left or right of vertical LRAS.
Common Mistake
- Do not confuse a negative output gap with negative economic growth; a negative gap is a level below potential, not a fall in output.
- Do not treat a measured output gap as precise, as potential output is estimated and revised.
Self review
- Distinguish the actual growth rate from the long-term trend rate.
- Define an output gap.
- What does a positive output gap imply for inflation?
- What does a negative output gap imply for unemployment?
- Why are output gaps difficult to measure?
