Unit 2 & 4: The Output Gap

What is the output gap?

The output gap is the difference between the actual level of GDP and its estimated potential level. It is usually expressed as a percentage of the level of potential output.

Negative and Positive Output Gaps

Negative Output Gap

• When the level of actual GDP is less than potential GDP
• Some factor resources are under-utilized e.g. demand-deficient unemployment
• Main problem is likely to be higher unemployment and possible deflation risk

Positive Output Gap

• Actual GDP is greater than the estimated potential GDP
• Some resources working beyond usual capacity (shift work & overtime)
• Main problem is rising demand-pull and cost-push inflationary pressures

What are the main difficulties in estimating the size of the output gap for an economy?

The output gap is a measure of the difference between the actual output of an economy and its potential output.

Estimating the output gap is difficult because we cannot observe directly the supply potential of an economy directly

Problems in estimating the output gap include:

• Inaccurate data on the labour force for example difficulties in measuring the scale of net inward labour migration
• Problems in accurately measuring productivity
• Surveys of producers about spare capacity may be inaccurate
• Gaps in knowledge about how much businesses are investing and the potential output from new capital e.g. in digital sectors
• Uncertainties about the number of people who may have left the labour market as “discouraged workers”
• It is hard to measure the amount of under-employment in the labour market at different stages of the economic cycle