What Is an Output Gap?

What Is an Output Gap?

Let me explain what an output gap is. It's the difference between the actual output of an economy and its maximum potential output, expressed as a percentage of gross domestic product (GDP). You should know that a country's output gap can be either positive or negative. If it's negative, that means actual economic output is below the economy's full capacity. On the other hand, a positive output suggests the economy is outperforming expectations, with actual output higher than the recognized maximum capacity.

Key Takeaways

Here's what you need to remember about the output gap. It's the difference between an economy's actual output and its maximum potential output, shown as a percentage of GDP. This gap compares actual GDP to potential GDP, which is the maximum-efficiency output. Whether positive or negative, it's an unfavorable sign of the economy's efficiency. Policymakers use it to gauge inflationary pressure and make decisions. Keep in mind, though, that while it's important, the output gap isn't always reliable since potential output is estimated.

How an Output Gap Works

Understand that the output gap compares actual GDP to potential GDP or maximum-efficiency output. Calculating this is tricky because you can't directly measure an economy's optimal efficiency level. Economists don't fully agree on the best way to measure potential GDP, but most say full employment is key to maximum output.

One way to project potential GDP is by running a trend line through actual GDP data over decades to smooth out short-term fluctuations. By following that trend, you can estimate current GDP or predict it for the near future.

The calculation itself is straightforward: divide the difference between actual and potential GDP by the potential GDP. Remember, potential output isn't observable, so it's often based on historical data.

Positive and Negative Output Gaps

No matter if it's positive or negative, an output gap signals inefficiency in the economy. A positive gap shows high demand for goods and services, which might seem good, but it forces businesses and workers to operate beyond maximum efficiency to meet that demand. This often leads to inflation as labor costs and prices rise.

A negative gap means there's low demand, causing companies and employees to work below their best levels. This points to a slow economy, with declining GDP growth and possible recession, as wages and prices fall due to weak demand.

Advantages and Disadvantages of the Output Gap

The output gap is a crucial economic indicator, but it has both benefits and drawbacks. Let me break it down for you.

On the advantages side, since it uses GDP in its calculation, it gives a clear picture of the economy's performance—whether it's underperforming or growing too fast. This helps determine inflation rates. Policymakers rely on it to decide on fiscal and monetary policies, like when the Federal Reserve adjusts interest rates to control inflation. Even everyday people like you can use it for financial decisions, such as timing a mortgage refinance if rates might rise.

Now, the disadvantages: It's hard to measure because actual output is known, but potential output is just an estimate. There's no single way to calculate potential output—some use trend output, others trend growth. Also, economic relationships are complex; things like a weaker workforce or tight lending during bad times can affect potential output significantly.

Real-World Example of an Output Gap

Take the U.S. as an example. Actual GDP was $21.48 trillion in the fourth quarter of 2020, per the Bureau of Economic Analysis. The Federal Reserve Bank of St. Louis estimated potential GDP at $21.17 trillion, giving a positive output gap of about 20.16% (actual minus projected, divided by projected).

This is just one estimate, but consensus was a positive gap in 2020. In response, the Fed had been raising rates since 2016, from under 1% to 1.25% by early 2020. But the global financial crisis led to a drop back below 1% in mid-March 2020.

Output FAQs

What is potential output? It's what an economy can produce at full-employment GDP, the highest level when things are going well. Unlike actual output, it's estimated, not measured.

How can an economy's output deviate from its potential? It can be positive, meaning it's above expectations with higher actual output, or negative, when below full capacity.

What would help a government reduce an inflationary output gap? Reducing spending, cutting transfer payments, and limiting bond issues can help.

What happens to the output gap in a recession? It's lower than potential, meaning actual output is below what's possible.

What can the government do to move the economy back to potential GDP? They can adjust taxes, rebates, interest rates, or spending, depending on if the gap is positive or negative.