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What is the Output Gap?

AS, A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 18 May 2023

The output gap is the difference between the actual level of GDP and its estimated potential level. It is usually expressed as a percentage of the level of potential output.

The output gap is an economic concept that measures the difference between actual output (real GDP) and potential output (the level of output that can be sustained without generating inflationary or deflationary pressures) in an economy at a given point in time. It provides an indication of the current state of the economy relative to its long-term trend or potential level.

The output gap is typically expressed as a percentage of potential output. It can be positive, negative, or zero, depending on whether actual output is above, below, or equal to potential output, respectively.

When the output gap is positive (output above potential):

  • Indicates an economy is operating above its sustainable capacity.
  • Implies there may be upward pressure on prices and inflationary risks.
  • Suggests a potential for tightening monetary policy to cool down the economy and prevent excessive inflation.

When the output gap is negative (output below potential):

  • Indicates an economy is operating below its full potential.
  • Implies there may be excess capacity and unemployment in the economy.
  • Suggests a potential for expansionary policies to stimulate economic activity and reduce unemployment.

Economists and policymakers closely monitor the output gap as it provides insights into the cyclical position of the economy. It helps in assessing whether an economy is operating at a sustainable level, facing inflationary pressures, or experiencing slack in resource utilization. The output gap is also useful for determining the appropriate stance of monetary and fiscal policies.

Estimating the output gap is challenging, and various methods are employed to measure it. These methods often involve statistical models and econometric techniques that consider factors such as actual GDP, potential GDP, labor market conditions, capacity utilization, and productivity. While estimates of the output gap are subject to uncertainties and revisions, they serve as a valuable tool for policymakers in assessing the overall economic conditions and informing policy decisions.

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