The link between the output gap and levels of government borrowing

Borrowing and Output Gap
Borrowing and Output Gap

An interesting graph showing relationship between the output gap and levels of government borrowing.

A negative output gap indicates GDP is below full capacity and there is unemployed resources. Therefore, in a deep recession, like 2009, the output gap will rise.

In a boom, we will have a positive output gap as firms struggle to keep up with orders and demand.

As we would expect, the current recession, has led to a sharp rise in government borrowing. In fact, the rise has been unusually steep. This is because:

  • The recession has hit many good sources of tax revenue like stamp duty and income tax from city workers.
  • bank bailouts
  • Underlying structural deficit from higher spending plans

It is a similar story in the 1992 recession. A negative output gap leading to higher borrowing.

But, the interesting case is the 1981 recession. Firstly, the negative output gap was very high – over 6% of GDP. But, as output fell – so did government borrowing.

This was because the tightening of fiscal policy – higher taxes and lower spending was a cause of the recession. The Thatcher government of 1979, pursued an aggressive combination of fiscal and monetary policy to reduce inflation. They were successful in causing a reduction in inflation, but, it led to a deep recession. However, the output gap soon reversed as we entered into the Lawson boom of the 1980s.

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