What Is Output Gap?

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The output gap can expand or shrink depending on the actual and potential output difference. Comparing the actual production of an economy to its potential output can give valuable insight into the economy’s health. Potential output is frequently referred to as the economy’s productive capacity.

Key Takeaways

  • The output gap is a measure to gauge the functioning of the economy. It utilizes the economy’s actual and anticipated GDP, and the difference between these parameters is called the output gap.Output gaps help in the identification of economic vulnerabilities and problems, as well as alerting policymakers on the appropriate policy mix to remedy the gap.A positive gap suggests that the current level of economic activity cannot be sustained for long as it is beyond the economy’s capacity.A negative gap indicates an economy’s lack of demand for goods and services. It can result in firms and people operating at less than their maximum efficiency.

Output Gap Explained

Output gap indicates that an economy is operating inefficiently, either over- or under-utilizing its resources. Policymakers frequently use the potential output to measure inflation and generally define it as the level of output at which there is no upward or downward pressure on prices. The gap summarizes this context’s relative demand and supply components of economic growth. As a result, the gap assesses the level of inflationary pressure in the economy. It is a crucial connection between the economy, which generates goods and services — and inflation.

A gap aids in identifying economic vulnerabilities and difficulties and informing policymakers about the optimal policy mix to address the gap. They can also assist in determining the success of a given policy, including fiscal, monetary, and supply-side policy.

The production gap is an extremely crucial economic metric. Like GDP, the output gap can expand or shrink. Neither is perfect. Real output surpasses maximum output, creating a positive gap. This happens when factories and workers operate beyond their capability to meet demand. A negative gap occurs when real output is below full capacity. A negative gap suggests surplus capacity due to inadequate demand.

Output Gap Formula

This economic measure is expressed as a percentage of potential output, estimated using the potential gross domestic product (GDP). Certain online sites also have an inbuilt output gap calculator. Simply entering the actual and potential GDP figure will calculate output GDP for you.

Below is an equation showing that the gap is actual output minus potential output divided by potential output and multiplied by 100.

Output Gap = Actual Output – Potential Output ÷ Potential Output * 100

Positive Output Gap

A production gap arises when there is a disparity between an economy’s potential output and its actual output. Identifying gaps enables policymakers to choose the optimal policy mix for the current environment.

A positive output gap indicates that the current level of economic activity is unsustainable over the long term because it exceeds the economy’s capacity, producing severe economic damage. This relies on the gap’s magnitude. The larger the disparity, the less viable it becomes.

Aggregate demand exceeds an economy’s production capacity when the gap is positive. This may be problematic for an economy, as this excess demand can lead to a variety of issues, such as:

Inflation Due To Demand-Pull

Given that it may be difficult for them to expand supply, corporations may raise prices in response to demand exceeding capacity.

When aggregate demand exceeds long-term aggregate supply, any increase in aggregate supply that attempts to fulfill this additional demand is likely unsustainable; hence, the price level rises, causing inflation.

Labor Deficits And Trade Difficulties

If aggregate demand exceeds an economy’s capacity, some industries will likely have labor shortages. This will further limit the capacity of the economy to develop and boost production.

A positive production gap may result in increased imports and decreased exports. First, domestic households may switch to imports due to domestic supply limitations. Second, domestic enterprises may target local customers rather than the export market.

Negative Output Gap

A negative gap develops when aggregate demand is inadequate to allow the economy to operate at full capacity, exerting downward pressure on production, employment, and price.

This results in increased unemployment and the prospect of deflation, both of which should be avoided. A negative production gap suggests that resources are being underused, resulting in economic slack. The economy is operating below its capacity. A negative output gap shows an economy’s lack of demand for products and services. It can result in businesses and workers performing below their optimal efficiency. This sort of production gap indicates a sluggish economy. It portends a slowing GDP growth rate and possible recession, as wages and prices of goods often decline when economic demand is low.

Merits And Demerits

Considering the gap may be beneficial in various ways. For example, it can tell if the economy is underperforming or rising too rapidly; it helps policymakers fix the economy by suggesting changes in monetary and fiscal policies. In addition, the public may use it to make financial and investment decisions.

There are also certain drawbacks to measuring the gap. First, it is difficult to measure as getting estimates of potential output is difficult. Moreover, there is a lack of uniformity as experts’ opinion differs because a few calculate it as trend output. In contrast, others consider its trend growth. Still, it faces limitations as economic activities are interconnected, and their relationship cannot be established.

This has been a guide to the Output Gap and its definition. Here, we explain the positive and negative gap, formula, merits, and demerits. You may learn more from the following articles –

Calculating this gap is easy by using the output gap formula. 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.

It might be quite challenging to quantify and comprehend the output gap. Because assessing gaps requires both current and prospective GDP, this is the case. However, it is extremely difficult to estimate potential GDP with precision. Moreover, estimating or gauging potential GDP can be challenging for any economy, making it challenging to measure the output gap.

The use of taxes or government expenditure to stabilize the economy is termed fiscal policy. Expansionary fiscal policy closes recessionary gaps by decreasing taxes or increasing expenditure. Likewise, one can close inflationary gaps by increasing taxes or decreasing spending as a contractionary fiscal policy.

  • Inflationary GapRecessionary GapGlobal Trade