Output Gap
What is Output Gap?
The output gap is the difference between actual real GDP and potential real GDP.
The output gap can be positive (an inflationary gap) or negative (a recessionary gap). It represents the amount by which an economy's actual output differs from its potential output. Policymakers often try to minimize the output gap.
Output Gap: a worked example
Compare two economies in the same period. Aldwin has potential real GDP of $600B and actual real GDP of $570B, so its output gap is 570 minus 600, or negative $30B. As a share of potential that is 30 ÷ 600 × 100 = 5%, written as negative 5%. The minus sign marks a recessionary gap, with unemployment above the natural rate and equilibrium output to the left of long-run aggregate supply. Brindle has potential of $400B and actual of $412B, so its gap is 412 minus 400, or positive $12B, which is 12 ÷ 400 × 100 = 3% of potential, an inflationary gap. Aldwin's deviation is larger in both dollars and percentage terms, and the two economies need opposite treatments: stimulus for Aldwin, restraint for Brindle.
The mistake students make with output gap
The sign gets flipped. Students compute potential minus actual, get a positive number for an economy in a slump, and then report a positive output gap, which reads like good news. The gap is always actual minus potential: positive means output above potential and an inflationary gap, negative means output below potential and a recessionary gap. A second error compares this year's real GDP with last year's rather than with potential. Output can grow quickly and still leave a large negative gap if it started far below potential.
Output Gap questions
What does a negative output gap mean?
A negative output gap means actual real GDP is below potential real GDP, the situation known as a recessionary gap. Factories run below capacity, unemployment sits above the natural rate, and the economy operates inside its production possibilities curve. Because slack exists, expansionary fiscal or monetary policy can raise output with relatively little upward pressure on the price level until the gap closes.
How do economists estimate potential GDP?
Potential GDP cannot be observed directly, so it gets estimated from the supply side: the size of the labor force, the capital stock, and productivity trends, combined with an estimate of the natural rate of unemployment. Since every input is itself an estimate, published output gaps are revised often and different agencies report different numbers for the same period. On an AP exam potential GDP is simply given to you.
Why do policymakers care about the output gap?
The output gap tells policymakers which direction to push and how hard to push. A large negative gap argues for lower interest rates or higher government spending, since idle resources mean extra demand mostly raises output. A positive gap argues for restraint, since extra demand mostly raises prices. Misreading the gap is expensive: stimulus applied to an economy already at potential produces inflation rather than growth.
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