How much spare capacity does an economy have to meet a rise in demand? How close is an economy to operating at its productive potential? Has the recession damaged the economy’s productive potential? These sorts of questions all link to an important concept – the output gap. The output gap is the difference between the actual level of national output and its potential level and is usually expressed as a percentage of the level of potential output.
Negative output gap – downward pressure on inflation
• The actual level of real GDP is given by the intersection of AD & SRAS – the short run equilibrium.
• If actual GDP is less than potential GDP there is a negative output gap. Some factor resources such as labour and capital machinery are under-utilized and the main problem is likely to be higher than average unemployment.
• A rising number of people out of work indicate an excess supply of labour, which causes pressure on real wage rates.
• In the next time period, a fall in real wage rates shifts SRAS downwards until actual and potential GDP are identical – assuming labour markets are flexible.
Positive output gap – upward pressure on inflation
• If actual GDP is greater than potential GDP then there is a positive output gap.
• Some resources including labour are likely to be working beyond their normal capacity e.g. making extra use of shift work and overtime.
• The main problem is likely to be an acceleration of demand-pull and cost-push inflation.
• Shortages of labour put upward pressure on wage rates, and in the next time period, a rise in wage rates shifts
• SRAS upwards until actual and potential GDP are identical – assuming labour markets are flexible.
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