- An output gap is the difference between the actual level of output (real GDP) and the maximum potential level of output
- A positive output gap occurs when real GDP is greater than the potential real GDP
- A negative output gap occurs when the real GDP is less than the potential real GDP
- There is spare capacity in the economy to produce more goods/services than are being produced
- It is difficult to measure output gaps accurately
- This is because it is hard to know exactly what the maximum productive potential of an economy is
- Rapidly rising prices can indicate a positive gap is developing
- Rising unemployment and slowdown in economic growth can indicate that a negative gap is increasing
A Negative Output Gap
An Keynesian (top) and Classical (bottom) diagram illustrating an economy that has a negative output gap (Y1- YFE) and is currently producing less than its potential output
Diagram Analysis
- The potential output of this economy is at YFE
- The economy is in a short-run equilibrium at AP1Y1
- A negative output gap exists at Y1 - YFE
- This effectively gives the economy sparer capacity in the short-term
- One cause of this may be that the AD has recently decreased due to a fall in consumption
- The Classical view is that the output will return to YFE in the long-run, but at a lower average price level
- The Keynesian view is that an economy may be stuck in a negative output gap for a long period of time
A Positive Output Gap
An AD/AS diagram illustrating an economy that has a positive output gap (YFE - Y1) and is currently producing more than its potential output
Diagram Analysis
- The potential output of this economy is at YFE
- The economy is in a short-run equilibrium at AP1Y1
- A positive output gap exists at YFE - Y1
- This effectively gives the economy more productive capacity in the short-term
- One cause of this may be that workers are willing to work overtime once full capacity is reached
- It is not sustainable and the Classical view is that the output will return to YFE, but at a higher price level