Output Gap

Definition

The output gap is the difference between an economy's actual output and its potential output. It is a measure of the state of the business cycle and the degree of utilization of an economy's productive capacity.

5 Must Know Facts For Your Next Test

1. A positive output gap indicates that actual output is above potential output, signaling an economy is operating at full capacity and may experience inflationary pressures.
2. A negative output gap suggests actual output is below potential output, meaning the economy has idle resources and is operating below its productive capacity.
3. The output gap is a key indicator used by policymakers to assess the state of the economy and determine appropriate monetary and fiscal policies.
4. Factors that can influence the output gap include changes in productivity, labor force, capital stock, and technological progress.
5. Reducing the output gap, either positive or negative, is a primary goal of macroeconomic stabilization policies.

Review Questions

• How does the output gap relate to the tracking of real GDP over time?
  • The output gap is closely tied to the tracking of real GDP over time. A positive output gap, where actual output exceeds potential output, indicates the economy is operating above its sustainable level and may experience inflationary pressures. Conversely, a negative output gap, where actual output falls short of potential output, suggests the economy has idle resources and is operating below its productive capacity. Monitoring the output gap provides valuable insights into the business cycle and the overall state of the economy, which is crucial for policymakers when tracking real GDP and making appropriate macroeconomic decisions.
• Explain how the output gap can influence changes in unemployment over the long run.
  • The output gap is a key determinant of changes in unemployment over the long run. When the output gap is positive, and the economy is operating above its potential, firms may face capacity constraints and be unable to meet demand, leading to a decline in unemployment as they hire more workers. Conversely, a negative output gap, where actual output is below potential, indicates the economy has idle resources, including underutilized labor. In this scenario, firms may reduce hiring or even lay off workers, causing unemployment to rise. Policymakers often use the output gap as a guide to implement policies, such as adjusting interest rates or government spending, to help close the gap and promote full employment over the long run.
• Evaluate the role of the output gap in informing macroeconomic stabilization policies.
  • The output gap is a critical metric used by policymakers to assess the state of the economy and guide macroeconomic stabilization policies. When the output gap is positive, indicating the economy is operating above its potential, policymakers may implement contractionary policies, such as raising interest rates or reducing government spending, to cool the economy and prevent inflationary pressures. Conversely, when the output gap is negative, and the economy is operating below its potential, policymakers may employ expansionary policies, like lowering interest rates or increasing government spending, to stimulate demand and close the gap. By closely monitoring the output gap, policymakers can make informed decisions to stabilize the economy, promote full employment, and ensure sustainable long-term growth.

Related terms

Potential Output:

The maximum level of output an economy can sustain over the long run given its available resources, technology, and labor force.

Business Cycle:

The fluctuations in economic activity, such as employment, industrial production, and real GDP, that occur over time.

Productive Capacity: The maximum level of output an economy can produce with its available resources and technology.