Output Gap

Published Oct 25, 2023

Definition of Output Gap

Output gap refers to the difference between an economy’s actual output and its potential output. It measures the underutilization or excess utilization of resources in an economy. When actual output is greater than potential output, the economy is said to be operating above its capacity, leading to inflationary pressures. On the other hand, when actual output is less than potential output, the economy is operating below its capacity, resulting in unemployment and idle resources.

Example

To understand output gap, let’s consider a hypothetical economy with a potential output of 100 units of goods and services. Due to a recession, the actual output in the economy decreases to 80 units. This indicates that there is an output gap of 20 units, representing the extent to which the economy is operating below its potential.

The presence of an output gap implies that there is unused productive capacity in the economy. In this scenario, there may be high unemployment rates and businesses operating below their optimal levels. The government and policymakers can take measures to stimulate demand and increase output to close the output gap.

Why Output Gap Matters

Understanding and measuring the output gap is crucial for policymakers, as it helps them assess the health of an economy and make informed decisions. When the output gap is positive, indicating an overheating economy, policymakers may implement contractionary measures such as tightening monetary policy or increasing taxes to reduce inflationary pressures.

Conversely, when the output gap is negative, indicating a recession or economic downturn, policymakers may implement expansionary measures such as fiscal stimulus, lowering interest rates, or implementing policies to encourage investment and consumption. Closing the output gap and achieving full utilization of resources can lead to greater economic stability and growth.