Output Gap

Updated: Mar 21

Key Terms

Output Gap: Is the difference between actual GDP or actual output and potential GDP, in an attempt to identify the current economic position over the business cycle.


 

What is an Output Gap?

The macroeconomy is prone to external shocks that may lead to a change in the overall equilibrium position, hence real GDP may deviate from full employment at any point in time either below or above. The difference between actual GDP and full employment is known as an output gap.


The output gap can be either positive or negative depending on if actual GDP is below or above full employment. If real GDP is above full employment the output gap is positive, if real GDP is below full employment the output gap is negative.


Identifying Output Gaps on Graphs

Output gaps can be identified through aggregate supply/demand graphs as well as production possibilities curves. These can be seen in the graphs below:


(We can see a negative output gap being depicted on this AD/AS graph. This can be seen as the current equilibrium at P1 and Y1 is below the Y0 – Full Employment. The output gap can be worked out by Y1-Y0 which in this case would be negative.)


(In this case we can see another negative output gap, however this one is depicted on a production possibility curve (or frontier) as the point is below our potential capacity.)


Causes and Consequences of an Output Gap

We now need to understand how an output gap may occur. An output gap may occur due to the economy already being at full employment, and there is a form of government spending or export demand which would lead to an increase of the GDP above full employment in the short run, leading to a positive output gap. This is because the aggregate demand will move up the aggregate supply curve, this could even occur due to the multiplier effect where the government expenditure actually ended up being more then needed. In the long run this will be unsustainable due to the increase in price levels leading to higher costs, however it will have no major impact on the GDP in the long run.


A negative output gap can occur when real GDP falls below the full employment level, this could occur due to negative external shocks that may affect the aggregate demand, for example COVID-19! It could also occur due to government expenditure cuts; the consequences depend solely on whether the decrease is temporary or permanent as well as what type of perspective is taken Keynesian or Neo-Classical. From a Keynesian perspective a negative output gap is more consequential than from a Neo-Classical view, as under the Neo-Classical approach the aggregate supply is vertical meaning that the economy would return back to equilibrium, the criticism is how long would that take?


 

The Multiplier, Accelerator Effect and Output Gaps - Madex Economics
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Sources/Further Reading:

Output Gap – Wikipedia – https://en.wikipedia.org/wiki/Output_gap#


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