Output gaps represent the difference between an economy’s actual output and its potential output. Understanding them helps evaluate economic performance and informs policy decisions.
What is an output gap?
An output gap is the difference between an economy's actual output (real GDP) and its potential output—the level of output that can be produced when all resources are fully and efficiently employed without putting upward or downward pressure on prices. This potential output represents the economy's productive capacity, and deviations from it indicate either underutilisation or overutilisation of resources.
Output Gap = Actual Output (Real GDP) − Potential Output
A positive output gap occurs when actual GDP exceeds potential GDP.
A negative output gap occurs when actual GDP is below potential GDP.
These gaps are central to assessing macroeconomic performance, as they provide a basis for identifying inflationary or recessionary conditions. Economies rarely operate precisely at their potential output due to constantly changing demand, supply shocks, and cyclical fluctuations.
Positive output gap
A positive output gap arises when the economy is operating above its sustainable capacity. In this case, real GDP is higher than potential output, usually due to a surge in aggregate demand.
Characteristics of a positive output gap
The economy is overheating, characterised by excessive demand for goods and services.
Firms respond by increasing production beyond normal capacity—this may include hiring more workers, increasing overtime, and running capital equipment for longer hours.
Inflationary pressure, particularly demand-pull inflation, builds as firms raise prices in response to stronger demand.
Labour markets tighten, causing wage inflation as businesses compete for limited skilled workers.
The unemployment rate may fall below the natural rate (also referred to as NAIRU: Non-Accelerating Inflation Rate of Unemployment).
Causes of a positive output gap
Increased consumer confidence and borrowing, leading to higher consumption.
Expansionary fiscal policy: tax cuts or increased government spending stimulating demand.
Expansionary monetary policy: low interest rates and easy credit boosting consumption and investment.
Strong export demand, particularly in economies reliant on external markets.
Speculative booms, such as housing or equity market bubbles, which increase perceived wealth and encourage spending.
Risks associated with a positive output gap
Accelerating inflation as aggregate demand exceeds supply.
Erosion of real incomes if wages do not keep up with rising prices.
Overuse of resources, leading to physical and human capital wear and fatigue.
Potential economic instability if the economy crashes back to potential output, resulting in a sharp downturn.
Policy tightening may be required, potentially causing adverse side effects like reduced investment or financial volatility.
Negative output gap
A negative output gap occurs when the economy is underperforming relative to its capacity. In this scenario, actual GDP is below potential output, indicating underutilisation of factors of production.
Characteristics of a negative output gap
The economy has spare capacity, meaning many resources—labour and capital—are unused or underused.
High unemployment levels due to a fall in aggregate demand.
Deflationary or disinflationary pressure arises as producers cut prices to stimulate demand.
Lower consumer confidence, leading to reduced consumption and business investment.
Idle machinery, underused buildings, and underemployed labour are common.
Causes of a negative output gap
Fall in aggregate demand due to economic shocks, such as financial crises or pandemics.
Tight fiscal or monetary policy: increased taxation, reduced spending, or high interest rates.Global economic downturns that reduce demand for exports.
Declining investment due to uncertainty or low profitability.
Structural issues, such as lack of access to finance or labour market rigidity, may worsen the gap.
Consequences of a negative output gap
Cyclical unemployment: job losses due to lack of demand, particularly in discretionary goods and services.
Low inflation or deflation, which can lead to delayed consumption and reduced profits.
Reduced tax revenue and increased welfare spending, leading to higher budget deficits.
Lower living standards and increased inequality as job losses disproportionately affect lower-income households.
Potential long-term damage if firms close permanently or workers become deskilled.
Difficulties in measuring output gaps
While output gaps are critical indicators, they are notoriously difficult to measure accurately due to several inherent challenges:
Estimating potential output
Potential output is not directly observable; it must be estimated using statistical and economic models.
These models often rely on past data, which may not accurately reflect current technological or structural changes in the economy.
Different institutions (such as central banks or international organisations) may produce different estimates of potential output, leading to differing assessments of the output gap.
Productivity fluctuations
Labour productivity can vary due to changes in technology, management practices, or workforce skill levels.
Sudden increases or declines in productivity make it harder to define the economy’s sustainable output level.
For example, if productivity surges due to automation, potential output may be higher than previously estimated.
Informal economy
Unrecorded economic activity—such as cash-in-hand work or unregistered businesses—is not captured in official GDP statistics.
Countries with large informal sectors may underestimate actual output, making the negative output gap appear larger than it is.
Informal activity can also obscure real employment figures, making unemployment appear higher or lower than the reality.
Labour market dynamics
Labour force participation changes over time due to demographic trends, migration, or social changes (e.g. more women joining the workforce).
Natural rate of unemployment may shift due to changes in regulation, union strength, or globalisation.
These shifts affect the calculation of potential output, and hence, the perceived size of the output gap.
Data lags and revisions
GDP data are frequently revised months or years after their initial release.
Policymakers often base decisions on incomplete or outdated information, potentially leading to inappropriate policy actions.
Time lags also affect data on employment, inflation, and productivity.
Using AD/AS diagrams to illustrate output gaps
The Aggregate Demand and Aggregate Supply (AD/AS) model visually illustrates output gaps and their macroeconomic consequences.
Negative output gap in AD/AS model
Occurs when AD intersects SRAS (Short-Run Aggregate Supply) to the left of LRAS (Long-Run Aggregate Supply).
This point represents an equilibrium level of output below the economy's full capacity.
The distance between actual output (Y₁) and potential output (Y*) is the negative output gap.
Diagram Description:
The AD curve is relatively low due to weak demand.
The price level is stable or falling.
Firms produce less, and unemployment is high.
There is significant slack in the economy.
Positive output gap in AD/AS model
Occurs when AD intersects SRAS to the right of LRAS, indicating output beyond the economy’s productive capacity.
The actual output (Y₂) exceeds potential output (Y*), creating a positive output gap.
Diagram Description:
Strong demand pushes AD rightward.
Prices rise due to shortages of labour and capital.
Inflationary pressures build.
Firms may overuse resources, leading to unsustainable expansion.
Link to economic policy
Output gaps are a key guide for macroeconomic stabilisation policy. Policymakers seek to adjust fiscal and monetary levers to close output gaps and stabilise the economy.
Policy responses to a negative output gap
Expansionary policies are designed to increase aggregate demand:
Monetary policy:
Lowering interest rates to stimulate borrowing and investment.
Quantitative easing to increase money supply and liquidity.
Central banks may also use forward guidance to shape market expectations.
Fiscal policy:
Increasing public spending on infrastructure, education, or welfare.
Cutting taxes to raise household disposable income and business profitability.
Goals:
Boost consumption and investment.
Reduce unemployment.
Prevent deflation and support price stability.
Policy responses to a positive output gap
Contractionary policies are used to cool down the economy and control inflation:
Monetary policy:
Raising interest rates to discourage borrowing and reduce demand.
Reducing central bank asset holdings to tighten money supply.
Fiscal policy:
Cutting public expenditure or delaying investment projects.
Raising taxes to reduce disposable income and consumption.
Goals:
Curb excessive demand and reduce inflation.
Return output to sustainable levels without triggering a recession.
Automatic stabilisers
Built-in mechanisms in the economy adjust output without active intervention:
Progressive taxation: higher incomes are taxed at higher rates, reducing disposable income in booms.
Welfare payments: rise during downturns, maintaining a basic level of demand.
These stabilisers smooth the business cycle and reduce the amplitude of output gaps.
Importance of timely intervention
Time lags between recognising an output gap and the impact of policy can reduce effectiveness.
Policy overshooting may occur if governments react too late or too strongly, worsening instability.
Accurate and timely data collection and modelling are essential for effective policy responses.
FAQ
Determining the presence and size of an output gap in real-time is challenging due to several uncertainties. Firstly, potential output is not directly observable and must be estimated using complex economic models, which rely on assumptions that may change over time. These models often involve calculating trends in productivity, labour force participation, and capital stock—each of which can vary unpredictably. Secondly, data on actual output (GDP) are often revised after initial release, meaning real-time figures may not accurately reflect the economy’s true state. Thirdly, structural changes such as automation, shifts to remote working, or demographic shifts can alter productive capacity, further complicating estimates. Additionally, external shocks like global supply chain disruptions or energy price volatility can temporarily distort output levels. Policymakers must often rely on imperfect, lagging data and judgment, which increases the risk of misinterpreting the gap and applying inappropriate policies.
Output gaps manifest differently in developed and developing economies due to structural and institutional differences. In developed economies, output gaps are generally smaller and more cyclically driven, influenced by demand-side fluctuations such as changes in interest rates, consumer confidence, or global trade patterns. These economies typically have more robust statistical systems and policy tools to estimate and respond to output gaps effectively. In contrast, developing economies often face larger and more persistent output gaps. Structural issues—like inadequate infrastructure, limited access to capital, and lower human capital—mean that even when demand increases, these economies may struggle to expand supply quickly. Additionally, measuring potential output is more difficult due to data limitations and the size of the informal economy, which is often substantial. These countries may also be more vulnerable to external shocks, such as commodity price volatility or capital flight, which can widen output gaps unpredictably. As a result, addressing output gaps in developing economies requires longer-term supply-side improvements alongside demand management.
Yes, an output gap can exist even when unemployment is low, particularly if other factors suggest the economy is operating above or below its productive potential. For example, a positive output gap can occur when unemployment falls below the natural rate, leading to overheating and inflationary pressures. However, this low unemployment may be unsustainable and could reflect a temporary boom fuelled by excess demand. Conversely, a negative output gap may still exist despite low headline unemployment if significant underemployment persists—where workers are employed part-time but want full-time work, or if they are in jobs that do not match their skill level. Additionally, if labour force participation is declining or productivity is falling, actual output may still be below potential. Therefore, unemployment figures alone are not always a reliable indicator of output gaps. Policymakers must assess a wide range of indicators—such as capacity utilisation, wage growth, inflation trends, and productivity data—to determine the output gap accurately.
Investment plays a vital role in closing both positive and negative output gaps by influencing both aggregate demand and long-run productive capacity. In the short run, increased investment boosts aggregate demand through higher spending on capital goods, which can help close a negative output gap by raising real GDP and reducing unemployment. For instance, infrastructure projects or business expansions directly increase demand for labour, materials, and services. In the long run, capital investment enhances an economy’s productive potential by increasing capital stock, improving technology, and raising labour productivity. This can shift the Long-Run Aggregate Supply (LRAS) curve rightward, helping to accommodate growing demand and preventing the emergence of a positive output gap that leads to inflation. Furthermore, targeted investment in sectors such as energy, transport, and digital infrastructure can address structural bottlenecks, making growth more sustainable. Governments often use investment as a key policy tool in fiscal stimulus packages to reduce spare capacity and stimulate long-term growth.
Output gaps have a direct influence on how central banks manage their inflation targets, primarily through their impact on inflationary or deflationary pressures. A positive output gap, where demand exceeds the economy's supply capacity, typically results in rising prices and wage inflation. In this scenario, central banks may respond by tightening monetary policy—raising interest rates or reducing money supply—to bring inflation back to target levels. On the other hand, a negative output gap tends to create downward pressure on prices, increasing the risk of deflation. Here, central banks may adopt expansionary monetary policy, such as cutting interest rates or engaging in quantitative easing, to stimulate demand and push inflation towards their target (often 2%). Importantly, central banks also consider forward-looking indicators, such as inflation expectations and wage growth, alongside output gap estimates. Given the estimation difficulties of potential output, central banks often act cautiously, balancing inflation control with the risks of stifling growth or worsening unemployment.
Practice Questions
Explain, using an AD/AS diagram, how a negative output gap may arise in an economy.
A negative output gap occurs when actual output is below potential output, typically due to a fall in aggregate demand. This may be caused by declining consumer confidence, higher interest rates, or reduced government spending. In an AD/AS diagram, this is shown by the AD curve intersecting the SRAS curve to the left of the LRAS. The resulting equilibrium output is lower than the economy’s full capacity. This leads to spare capacity, rising unemployment, and downward pressure on prices. Policymakers may respond with expansionary measures to stimulate demand and close the gap.
Assess the likely economic effects of a positive output gap on inflation and employment.
A positive output gap occurs when actual output exceeds potential output, often due to a surge in aggregate demand. This puts pressure on existing resources, resulting in higher employment levels and possible wage inflation as labour becomes scarce. Firms may raise prices in response to increased costs and demand, leading to demand-pull inflation. While employment rises in the short run, the economy may overheat, risking unsustainable growth. Persistent inflation can erode real incomes and force monetary tightening. Therefore, while short-term employment gains are likely, they may be offset by longer-term macroeconomic imbalances
