Recessionary and inflationary output gaps describe how far the economy’s short-run equilibrium real GDP is from its full-employment level. They help explain cyclical unemployment, overheating, and pressures on the price level in the AD-AS framework.

Core idea: actual vs. full-employment output

In the AD-AS model, the economy’s short-run equilibrium occurs where aggregate demand (AD) intersects short-run aggregate supply (SRAS), determining an equilibrium price level and real output ($Y$). The benchmark for comparison is full-employment output (also called potential output), typically shown by the vertical long-run aggregate supply level ($Y^*$).

When the short-run equilibrium level of output differs from $Y^*$, the economy is not producing at its sustainable capacity, and unemployment will deviate from its long-run “normal” level.

Visual identification on an AD-AS graph

To identify an output gap, focus on the horizontal (real GDP) axis:

This diagram shows a short-run equilibrium where AD intersects SRAS to the left of LRAS (potential output). The horizontal distance from potential output $Y_P$ to actual output $Y_1$ is labeled as the recessionary gap, illustrating $Y_1 < Y^</em>$. It reinforces that the output gap is measured along the real GDP axis, not vertically on the price level axis.* Source

• Mark $Y^*$ as the full-employment level of output.

• Locate the short-run equilibrium output $Y_1$ at the intersection of AD and SRAS.

• Compare $Y_1$ to $Y^*$:

  • If $Y_1 < Y^*$, the economy has a recessionary gap.

  • If $Y_1 > Y^*$, the economy has an inflationary gap.

  • If $Y_1 = Y^*$, there is no output gap (full-employment output).

Recessionary output gap (underproduction)

A recessionary gap exists when short-run equilibrium real GDP is below full-employment real GDP ($Y_1 < Y^*$). The economy is producing less than its sustainable capacity.

Key implications (as described in the AD-AS model):

• Employment is lower than at full employment because firms need fewer workers to produce $Y_1$.

• Unemployment is higher than the economy’s normal long-run level because labor is underutilised.

• Output is “too low” relative to potential, so the economy experiences slack in product and labor markets.

Typical interpretation in context:

• The gap reflects a short-run equilibrium that is not consistent with the long-run sustainable level of output.

• The distance between $Y^*$ and $Y_1$ represents the magnitude of underproduction in real terms.

Inflationary output gap (overheating)

An inflationary gap exists when short-run equilibrium real GDP is above full-employment real GDP ($Y_1 > Y^*$).

This AD–AS diagram depicts an economy producing beyond potential: AD and SRAS intersect to the right of LRAS at $Y_1$. The inflationary gap is shown as the horizontal distance $Y_1 - Y_P$, making the “overheating” concept concrete as $Y_1 > Y^</em>$. It visually connects above-potential output with the short-run equilibrium outcome on the AD–AS graph.* Source

The economy is producing beyond its sustainable capacity in the short run.

Inflationary gap: a situation where actual real GDP exceeds potential real GDP ($Y_1 > Y^*$), implying the economy is overheating.

Key implications:

• Employment is higher than at full employment in the short run as firms expand production above normal capacity.

• Unemployment is lower than the normal long-run level due to unusually strong labor demand.

• Operating above sustainable capacity tends to be associated with upward pressure on the price level because resources become strained (for example, firms compete more aggressively for workers and inputs).

Measuring the size and sign of the gap

The output gap can be expressed as a level difference between potential and actual real GDP.

$\text{Output Gap} = Y^* - Y_1$

$Y^*$ = full-employment (potential) real GDP (billions of dollars, or an index)

$Y_1$ = short-run equilibrium real GDP (billions of dollars, or an index)

A positive value ($Y^* - Y_1 > 0$) indicates a recessionary gap, while a negative value indicates an inflationary gap.

Interpreting “below, at, or above” full employment

The syllabus statement emphasises three possible short-run outcomes:

• Below full employment: recessionary gap, higher unemployment than normal.

• At full employment: no gap, output equals $Y^*$.

• Above full employment: inflationary gap, lower unemployment than normal and heightened inflation pressure.