Following a series of supply-side disruptions, the UK economy has faced persistent capacity challenges and changing labor market dynamics. By late 2023, while consumer demand showed signs of recovery, business investment remained subdued compared to historical trends. Economists have noted that the UK's long-run productive capacity has grown at a slower rate than initially projected before these shocks.
This slower trend growth complicates monetary policy decisions. If the central bank underestimates the economy's productive ceiling, it risks over-stimulating demand and triggering wage-price spirals. Conversely, if it overestimates capacity, keeping interest rates too high could needlessly restrict growth. As a result of these conflicting indicators, policymakers face significant uncertainty when estimating the size of the output gap (line 15) and determining the appropriate path for interest rates.
With reference to Extract C (line 15), explain the meaning of the term 'output gap'. Use an aggregate demand and aggregate supply (AD/AS) diagram in your answer.
