Output Gap

What is the output gap?

The output gap is the difference between an economy’s actual output (actual GDP) and its maximum sustainable output (potential GDP), expressed as a percentage of potential GDP. It measures how far an economy is operating from full capacity.

Formula:
Output gap (%) = (Actual GDP − Potential GDP) / Potential GDP × 100

Because potential GDP cannot be observed directly, it must be estimated. Common approaches use long‑run trend lines or statistical filters applied to historical GDP data; many estimates also incorporate assumptions about full employment and productivity.

How it works

• Actual GDP is the economy’s measured production.
• Potential GDP represents production at full, sustainable utilization of labor and capital (often linked to full employment).
• The output gap shows whether the economy is underperforming (negative gap) or overheating (positive gap).
• Estimates vary because potential GDP relies on models and assumptions.

Positive vs. negative output gaps

• Positive output gap
• Actual output > potential output.
• Signals strong demand and high resource utilization.
• Risks: inflationary pressure as wages and prices rise and firms run beyond normal capacity.
• Negative output gap
• Actual output < potential output.
• Signals weak demand and underused resources.
• Risks: falling prices and wages, higher unemployment, slower growth or recession.

Both types of deviation indicate an imbalance and potential inefficiency in the economy; the policy challenge is to return output to its potential in a sustainable way.

Advantages and limitations

Advantages
– Summarizes the economy’s performance relative to capacity.
– Helps indicate inflationary or recessionary pressures.
– Informs policymaking (monetary and fiscal) and private financial decisions.

Limitations
– Potential GDP is unobservable and model‑dependent, so estimates vary.
– Sensitive to assumptions about labor force, productivity and other interrelated economic factors.
– Short‑term shocks and structural changes can make estimates inaccurate.

Policy responses

• To reduce an inflationary (positive) gap: tighten policy — raise interest rates, reduce government spending or transfer payments, and adopt other contractionary fiscal measures.
• To close a negative gap: loosen policy — lower interest rates, increase government spending or transfer payments, and use stimulative fiscal measures.
  Policy choice depends on the underlying causes and the tradeoffs between inflation, growth, and employment.

Example (U.S., Q4 2020)

• Actual GDP (Q4 2020): $21.48 trillion (BEA).
• One estimate of potential GDP (Q4 2020): $21.17 trillion.
• Estimated output gap ≈ (21.48 − 21.17) / 21.17 ≈ 1.5% (positive).
  Estimates differ across institutions and methods; the example above illustrates how small differences in assumed potential GDP can change the gap and its interpretation.

FAQs

• What is potential output?
• The level of output achievable when the economy fully and sustainably utilizes labor and capital. It is estimated, not directly measured.
• How can output deviate from potential?
• Positive deviation occurs when demand pushes output above sustainable levels; negative deviation occurs when demand is too weak and resources are underutilized.
• What happens to the output gap in a recession?
• The output gap is typically negative: actual output falls below potential.
• What can governments do to close the gap?
• Tools include adjusting taxes, government spending, and policies that influence interest rates; central banks mainly use interest-rate policy while fiscal authorities use spending and taxation.

Key takeaways

• The output gap quantifies how far an economy is from its estimated productive capacity.
• It is useful for gauging inflationary or recessionary pressures but depends on uncertain estimates of potential GDP.
• Policymakers use the output gap to guide monetary and fiscal decisions aimed at stabilizing growth, employment, and inflation.