Output gap

The output gap is the difference between an economy’s actual output and its potential output at full capacity.
Updated: Jun 27, 2024

3 key takeaways:

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  • The output gap measures the discrepancy between actual economic performance and the maximum potential output.
  • A positive output gap indicates an economy operating above its potential, while a negative gap signifies underperformance.
  • Monitoring the output gap helps policymakers implement measures to stabilize the economy.

What is the output gap?

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The output gap is an economic indicator that quantifies the difference between the actual output of an economy and its potential output when operating at full capacity. Potential output refers to the maximum level of goods and services an economy can produce sustainably without increasing inflation. When the actual output falls short of this potential, it results in a negative output gap, indicating underutilized resources and economic inefficiencies. Conversely, a positive output gap occurs when the actual output exceeds the potential, often leading to inflationary pressures as resources are stretched beyond their sustainable limits.

How is the output gap calculated?

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The output gap is typically expressed as a percentage of the potential output. It can be calculated using the formula:

[ \text{Output Gap} = \left( \frac{\text{Actual Output} – \text{Potential Output}}{\text{Potential Output}} \right) \times 100 ]

For example, if an economy’s actual GDP is $1.9 trillion and its potential GDP is $2 trillion, the output gap would be:

[ \text{Output Gap} = \left( \frac{1.9 \text{ trillion} – 2.0 \text{ trillion}}{2.0 \text{ trillion}} \right) \times 100 = -5\% ]

This negative output gap indicates the economy is producing 5% below its full capacity.

Implications of the output gap

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  • Negative output gap: A negative output gap suggests that the economy is underperforming, with resources such as labor and capital not being fully utilized. This can lead to higher unemployment rates and lower income levels. Policymakers may respond with stimulus measures, such as lowering interest rates or increasing government spending, to boost economic activity and close the gap.
  • Positive output gap: A positive output gap indicates an economy operating above its sustainable capacity, which can lead to inflationary pressures as demand outstrips supply. In response, policymakers might implement contractionary measures, such as raising interest rates or reducing government spending, to cool down the economy and prevent overheating.

Factors affecting the output gap

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  • Economic shocks: Events such as financial crises, natural disasters, or pandemics can disrupt economic activity and widen the output gap.
  • Technological advancements: Innovations can increase potential output by improving productivity, potentially reducing a negative output gap or creating a positive one.
  • Policy decisions: Government fiscal and monetary policies play a crucial role in influencing the output gap by affecting demand and overall economic activity.

Importance of the output gap in economic policy

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The output gap is a vital tool for central banks and governments in designing and implementing economic policies. By monitoring the output gap, policymakers can gauge the overall health of the economy and take appropriate actions to promote stability and growth. For instance, addressing a negative output gap can help reduce unemployment and stimulate economic activity, while managing a positive output gap can help control inflation and ensure sustainable growth.

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  • Gross Domestic Product (GDP)
  • Economic growth
  • Fiscal policy
  • Monetary policy
  • Inflation and deflation

Understanding these related topics can provide a comprehensive view of how the output gap interacts with various economic factors and influences policy decisions.

Sources & references
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AI Financial Assistant
Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.