What Is a GDP Gap?
Let me explain what a GDP gap is—it's the difference between the actual gross domestic product (GDP) of an economy and its potential GDP, which follows the long-term trend. If you see a negative GDP gap, that means the economy is forfeiting output because it hasn't created enough jobs for everyone willing to work. On the flip side, a large positive GDP gap usually means the economy is overheated and could face high inflation.
You might also hear this called the output gap, which is just another name for the difference between real GDP and potential GDP.
Key Takeaways
- A GDP gap is the difference between an economy's actual GDP and potential GDP.
- Negative GDP gaps are common after economic shocks or financial crises and show an underperforming economy.
- A large positive GDP gap may signal that the economy is overheated and at risk of inflation.
- The term GDP gap can also simply describe the GDP difference between two national economies.
Understanding a GDP Gap
You calculate a GDP gap as (Actual GDP - Potential GDP) / Potential GDP. From a macroeconomic viewpoint, you want the smallest possible GDP gap, ideally none at all.
A negative gap means the economy is running below its full potential—it's underperforming and leaving money on the table compared to where it should be on trend. This leads to lost production and value because there aren't enough jobs.
These negative gaps often follow economic shocks or financial crises, reflecting a cautious business environment where companies hold back on spending or expanding production until recovery signs strengthen. This results in less hiring and possibly ongoing layoffs across sectors.
But a positive GDP gap isn't ideal either. It can indicate the economy is overheated and headed for a correction, with a larger gap raising the chances of high inflation at minimum.
Example of a GDP Gap
Take the US in the fourth quarter of 2020, where the Bureau of Economic Analysis reported actual GDP at $20.93 trillion. The Federal Reserve Bank of St. Louis estimated potential GDP at $19.41 trillion in 2020 dollars.
Plugging into the formula—($20.93 - $19.41) / $19.41—gives a positive GDP gap of about 0.8%. That's close to ideal for sustainable growth, but it's just a snapshot. Policymakers monitor this closely and adjust to align growth with the long-term trend.
GDP Gaps Between Nations
The GDP gap term also applies straightforwardly to the GDP difference between two countries. Lately, there's been more focus on the gap between the US, the world's top economy by GDP, and China.
In 2020, this gap was around $5.9 trillion, which is big but shows China closing in fast over the past decade. China has gained ground since the Great Recession through massive infrastructure spending and recovered quicker from the 2020 crisis than the US. Projections suggest China might surpass the US by 2028, though some economists doubt it due to China's aging population and rising debt.
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