Output Gap: What It Means, Pros & Cons of Using It, Example

What Is an Output Gap?

The term output gap refers to the difference between the actual output of an economy and the maximum potential output of an economy expressed as a percentage of gross domestic product (GDP). A country's output gap may be either positive or negative. A negative output gap suggests that actual economic output is below the economy's full capacity for output while a positive output suggests an economy that is outperforming expectations because its actual output is higher than the economy's recognized maximum capacity output.

How an Output Gap Works

The output gap is a comparison between actual GDP and potential GDP or output and maximum-efficiency output. This is difficult to calculate because you can't estimate an economy's optimal level of operating efficiency. There is little consensus among economists about the best way to measure potential GDP but most agree that full employment is a key component of maximum output.

One method that can be used to project potential GDP is to run a trend line through actual GDP over several decades or enough time to limit the impact of short-term peaks and valleys. By following the trend line, you can estimate where GDP currently sits or what it will be at a particular point in the near future.

Determining the output gap is a simple calculation of dividing the difference between the actual and potential GDP by the potential GDP.

Positive and Negative Output Gaps

An output gap is an unfavorable indicator of an economy's efficiency, regardless of whether it's positive or negative.

A positive output gap indicates a high demand for goods and services in an economy, which may be considered beneficial for an economy. But the effect of excessively high demand is that businesses and employees must work beyond their maximum efficiency level to meet the level of demand. A positive output gap commonly spurs inflation in an economy because both labor costs and the prices of goods increase in response to the increased demand.

A negative output gap, on the other hand, indicates a lack of demand for goods and services in an economy and can lead to companies and employees operating below their maximum efficiency levels. This type of output gap points to a sluggish economy and portends a declining GDP growth rate and potential recession as wages and prices of goods typically fall when overall economic demand is low.

Advantages and Disadvantages of the Output Gap

The output gap is a very important economic indicator. While there are distinct advantages to using this metric, its use does come with certain drawbacks. We've listed some of the most common benefits and limitations to using the output gap below.

Advantages

Because the output gap relies on the gross domestic product in its calculation, it helps provide a picture of how the economy is doing. More specifically, it can be used as a way to determine whether the economy is underperforming or is growing too quickly. That's because this gap can help determine the rate of inflation in an economy.

The output gap can help policymakers come up with solutions to move the economy in a more favorable direction. Therefore, it plays a very key role in how they make their decisions. about both fiscal and monetary policy. For instance, the Federal Reserve will raise interest rates to curb inflation and vice versa.

Because the output gap is used by both economists and analysts on the street, the general public can also use it to make informed decisions about their finances and investments. For example, a homeowner may decide to hold off on refinancing their mortgage if the output gap means there's a chance that interest rates will increase.

Disadvantages

One of the main problems with the output gap is that it is hard to measure. The level of actual output is easy to determine because we know what's happening. But potential output isn't that easy to calculate because we can't determine it. The latter is a figure that can only be predicted or estimated.

How the potential output is measured can be problematic. In fact, there isn't just one way to do so. Analysts and economists may use different filters or models to do so. For instance, some experts may compute the potential output as the trend output while others consider it as the trend growth.

Another limitation to the output gap lies in how intertwined relationships are within the economy. For example, a less active workforce will lead to a drop in output. Similarly, distressed small businesses and corporations and tighter lending standards during tough economic times can also have a big impact on the potential output.

Real-World Example of an Output Gap

The actual GDP in the U.S. was $21.48 trillion through the fourth quarter of 2020, according to the Bureau of Economic Analysis. According to the Federal Reserve Bank of St. Louis, the potential GDP for the U.S. in the fourth quarter of 2020 was $19.41 trillion, meaning the U.S. had a positive output gap of about 10.7% (projected GDP subtracted from actual GDP/projected GDP).

Keep in mind that this calculation is just one estimate of potential GDP in the U.S. Other analysts may have different estimates, but the consensus is that the U.S. was facing a positive output gap in 2020.

Not surprisingly, the Federal Reserve Bank in the U.S. has consistently been raising interest rates since 2016, in part in response to the positive gap. Rates were at less than 1% in 2016 and hit as high as 1.25% in the early part of 2020. The global financial crisis, though, forced the Fed to drop rates back down below 1% in mid-March 2020.

Potential Output FAQs

What Is Potential Output?

Potential output is what an economy can produce if it operates at full-employment-GDP. This is generally the highest level if and when the economy is doing very well. Unlike actual output, which is what currently happens, potential output cannot be measured and, therefore, relies on estimation.

How Can an Economy's Output Deviate From Its Potential?

An economy's output gap can deviate from its potential in one of two ways. A positive output indicates the economy is performing well above expectations. That's because the actual output is higher than its potential. It may also be negative when the output is below full capacity.

What Would Help a Government Reduce an Inflationary Output Gap?

Governments may find that reducing government spending as well as cutting down transfer payments and their bond and security issues can help reduce an inflationary output gap.

What Happens to the Output Gap When the Economy Is in Recession?

When an economy is in recession, it means that its actual output gap is lower than the potential output gap.

What Can the Government Do to Move the Economy Back to Potential GDP?

Governments can move the economy back to its potential GDP by taking a number of steps, including (but not limited to) reviewing tax rates and rebates, making moves on interest rates, and cutting or increasing government spending. The direction they choose depends on whether the actual output is positive or negative.