AQA Specification focus:
‘The difference between positive and negative output gaps.’
Economic performance depends not only on growth but also on how actual output compares with potential output. Understanding output gaps helps explain inflation, unemployment, and cyclical fluctuations.
Understanding Output Gaps
An output gap measures the difference between an economy’s actual output (real GDP) and its potential output (trend level of GDP if resources are fully employed).
Output Gap: The difference between actual real GDP and potential real GDP, expressed as a percentage of potential GDP.
Output gaps can be positive or negative, and each has distinct implications for inflationary pressure, unemployment, and macroeconomic policy.
Positive Output Gaps
A positive output gap occurs when actual output exceeds potential output. This usually reflects an overheating economy where aggregate demand is growing faster than long-run productive capacity.
Positive Output Gap: When real GDP is greater than the economy’s potential GDP, often causing inflationary pressures.
Features of a Positive Output Gap
Rising demand strains available resources.
Labour shortages lead to higher wages.
Increased utilisation of capital beyond sustainable levels.
Firms may increase prices to ration scarce resources.
Economic Consequences
Inflationary pressures: Demand-pull inflation is common as aggregate demand exceeds aggregate supply.
Falling unemployment: Labour markets tighten, with voluntary overtime and temporary workers filling gaps.
Unsustainable growth: Productivity may decline if firms push resources beyond efficient use.
Balance of payments issues: High domestic demand may increase imports.
Negative Output Gaps
A negative output gap exists when actual output falls below potential output. This is common during recessions when aggregate demand contracts.
Negative Output Gap: When real GDP is lower than the economy’s potential GDP, indicating underutilisation of resources.
Features of a Negative Output Gap
High levels of spare capacity in firms.
Rising unemployment as labour is not fully utilised.
Low levels of investment due to weak demand.
Deflationary or disinflationary pressures.
Economic Consequences
Unemployment rises: Involuntary unemployment increases, especially cyclical unemployment.
Reduced inflation: Falling demand reduces upward pressure on prices; deflation may occur if gap is severe.
Lower living standards: Income and consumption levels stagnate or fall.
Government budget pressures: Lower tax revenue and higher welfare spending increase fiscal deficits.
Causes of Output Gaps
Positive Output Gaps
Excessive demand-side growth, fuelled by expansionary fiscal or monetary policy.
Boom conditions in credit markets, encouraging borrowing and spending.
High business confidence and investment outpacing supply growth.
Negative Output Gaps
Demand-side shocks, such as global financial crises or sudden falls in exports.
Tight fiscal or monetary policy, reducing spending and investment.
Structural weaknesses limiting firms’ ability to compete.
Policy Implications
Output gaps guide policymakers in designing stabilisation measures.
Positive Output Gap Policies:
Contractionary fiscal policy (higher taxes, reduced spending).
Contractionary monetary policy (higher interest rates, reduced money supply).
Supply-side policies to increase long-run capacity, easing inflationary pressures.
Negative Output Gap Policies:
Expansionary fiscal policy (government spending programmes, tax cuts).
Expansionary monetary policy (lower interest rates, quantitative easing).
Supply-side reforms to restore competitiveness and productivity.
Output Gaps and the Economic Cycle
Output gaps are linked to phases of the economic cycle:
Positive gaps align with booms, when demand is strong.
Negative gaps align with recessions, when demand falls.
Policymakers aim to stabilise output gaps and keep inflation and unemployment within acceptable limits.
Measuring Output Gaps
Estimating potential GDP is challenging, meaning output gap figures are often approximations. Economists use indicators such as:
Unemployment levels (to detect spare capacity).
Inflation trends (to assess excess demand or supply).
Capacity utilisation surveys of businesses.
While measurement is imperfect, the concept of positive vs negative output gaps remains central for understanding macroeconomic stability.
FAQ
Expectations about inflation, growth, and future demand can influence the output gap.
If firms expect strong demand, they may invest more and hire additional workers, temporarily pushing output above potential, widening a positive output gap.
Conversely, pessimistic expectations can reduce investment and spending, deepening a negative output gap even if capacity exists.
Potential output cannot be directly observed and must be estimated, often using models or surveys.
Key difficulties include:
Estimating productivity growth and technological change.
Assessing hidden unemployment or underemployment.
Distinguishing between temporary fluctuations and permanent changes in capacity.
As a result, published output gap figures may vary between institutions.
Central banks use output gap estimates to decide whether to tighten or loosen policy.
Positive output gaps often trigger higher interest rates to cool inflation.
Negative output gaps may lead to rate cuts or quantitative easing to boost demand.
These decisions aim to stabilise inflation while encouraging sustainable growth.
Yes, although rare.
If productivity rises rapidly, output can exceed previous potential without creating inflationary pressure.
Globalisation and imports may also hold down prices, even when demand is high.
However, such scenarios are usually temporary, and persistent positive gaps often lead to inflation.
During a negative output gap, tax revenues fall as incomes and spending drop, while welfare payments rise, worsening deficits.
In a positive output gap, the opposite occurs:
Higher tax receipts from income, profits, and consumption.
Lower government spending on unemployment benefits.
This cyclical effect is known as the “automatic stabilisers” in fiscal policy.
Practice Questions
Define a negative output gap. (2 marks)
1 mark for identifying that actual output (real GDP) is less than potential output.
1 mark for stating that it indicates underutilisation of resources (e.g., unemployment or spare capacity).
Explain two possible consequences of a positive output gap for the UK economy. (6 marks)
Up to 3 marks for each explained consequence, maximum of 6 marks in total.
1 mark for identifying a valid consequence (e.g., inflationary pressure, falling unemployment, unsustainable growth, balance of payments problems).
1 mark for providing further detail of the consequence (e.g., demand-pull inflation occurs as aggregate demand exceeds aggregate supply).
1 mark for linking back to the economy (e.g., households face reduced purchasing power due to rising prices, or the current account deficit may widen due to increased imports).
