the output gap
The output gap is used in assessing the degree of demand-pull inflationary pressure in the economy at a particular time. In recent years, macro-economic policy has placed increasing emphasis on output gap even though cannot be observed directly!
Measuring the output gap is difficult. Economists need to measure the true level of aggregate demand (AD = C+I+G+X-M) and also aggregate supply – a measure of the productive potential of the economy in a given time period.
Aggregate supply (AS) is determined by a number of factors. These include the utilisation rates of existing labour and capital inputs, the change to the capital stock and the effective labour supply and also the rate of growth of factor productivity. If AS expands each year, the economy can increase the real volume of output to meet an expansion of aggregate demand.
When aggregate demand is well below the productive potential of the economy (so called potential GDP) then a negative output gap exists. In simple terms, current output and spending is well below what the economy could normally sustain. In this situation there is spare capacity in the economy.
The implication is that the rate of inflation is likely to fall because inflationary pressure are falling.
It is important to note that a negative output gap does not tell us what the rate of inflation is going to be – merely it suggests the direction in which inflation is likely to move.
When actual GDP lies well above potential GDP, there is a positive output gap, meaning that inflation pressures will be rising. This often happens at the end of a period of sustained economic growth above the long-term average growth of national output.
The chart above is the estimated output gap for the UK economy - taken from the IMF World Economic Outlook of May 2001. The deep recession of the early 1980s left the UK economy with a substantial amount of spare capacity. However the strength of the consumer boom in the late 1980s created a substantial positive output gap - leading to an acceleration in consumer price inflation in 1989-90.
By the end of the 1990-92 recession, once again actual GDP was some distance behind potential GDP. This gradually eroded during the mid late 1990s - but in the recent years the British economy has been growing at or around the long term trend rate of growth (i.e., about 2.5% per year). There is currently no major inflationary of deflationary gap in the British economy.
The Japanese economy has operated well below its enormous productive potential in recent years because the domestic economy has experienced a deep and prolonged recession.
This is one reason why the Japanese economy has moved closer to price deflation and unemployment is rising at an accelerating rate
The United States enjoyed a sustained economic boom from 1995-2000. Despite improvements to their supple-side economic performance (notably a much higher rate of growth of productivity), the strength of aggregate demand in the USA led to a rise in the inflationary gap - prompting fears of a return to higher rates of inflation. However a sharp slowdown in the rate of growth in the states in 2001 will have reduced the size of the output gap.
Over time, the path of national output (GDP) comprises a trend and a cyclical component. The trend rate of growth for an economy is determined by the supply-side capacity of a country - i.e. the extent to which long run aggregate supply can increase year-on-year to meet a higher level of aggregate demand.
The output gap is the difference between the actual level of national output and its potential level, usually expressed as a percentage of the level of potential output.
When actual GDP is > potential, there is a positive output gap
When actual GDP is < potential, there is a negative output gap When output is above potential, inflation tends to rise. Similarly when output is below potential, there is downward pressure on inflation. Therefore in the short run, there is a trade-off between economic growth and inflation (see also the revision notes on the Phillips Curve). If actual GDP remains persistently above potential, we expect to see acceleration in both price and cost inflation. Of course, external factors might hold down inflation (for example, an unexpected fall in international commodity prices)
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