The output gap is a measure of the difference between actual output (Y) and potential output (Yf).
The output gap = Y- Yf
Negative Output Gap
This occurs when actual output is less than potential output gap. This is also called a deflationary (or recessionary) gap. In this situation the economy is producing less than potential. There will be unemployment, low growth and / or a fall in output. A negative output gap will typically cause low inflation or even deflation.
Positive Output Gap
This occurs when actual output is greater than potential output. This will occur when economic growth is above the long run trend rate (e.g. during an economic boom). It will involve firms asking workers to overtime.
With a positive output gap, there will be inflationary pressures. It will also tend to cause a bigger current account deficit as consumers buy more imports due to domestic supply constraints.
HM treasury forecast an output gap of -2.7% for 2012/13. This is the amount of spare capacity they feel the UK has.
Note: it can be difficult to measure the amount of spare capacity – See: What is the UK’s actual output gap?
Lost Output During 2008-12 Recession
This shows how actual real GDP fell behind the trend growth rate of GDP.
What Determines Size of Output Gap?
- Level of unemployment. Higher unemployment increases the negative output gap.
- Levels of spare capacity. If firms report they are under-utilising capacity, there is a bigger negative output gap.
- Productivity growth. If productivity growth falls, this decreases the growth of potential ouptut and therefore limits the negative output gap.
- Inflation. Inflation can be a guide to the output gap. If inflation is high and firms pushing up prices, this suggests there is a positive output gap.
Output Gap and Economic Growth
Output gap and real GDP
Output Gap using AD/AS analysis
In this diagram the level of full capacity (Yf) is shown by the point where the AS curve is inelastic (equivalent to inelastic LRAS). However, in short term, output Y1 is less than Yf indicating spare capacity.