Output Gaps
Economics: IB Diploma, topic 2.1.6
Output Gaps
An output gap is present when there is a difference between the actual level of real GDP in an economy and the potential level of real GDP (when all factors of production are fully employed).
Negative output gap
- A negative output gap is defined as: “when the actual level of real GDP is less than the potential underlying level of real GDP”.
- Negative output gaps means there is 'spare capacity'. So there will be unemployment (demand-deficient), and demand-pull inflationary pressure will be low because there are lots of resources and factors of production not being used.
Positive output gap
- A positive output gap is defined as: “when the actual level of real GDP is greater than the potential underlying level of real GDP”.
- Positive output gaps mean that an economy is temporarily producing beyond its productive potential. This is only possible for a short time, and leads to workers being paid overtime, and workers and machines being over-used. This causes inflationary pressure as wages and costs rise.
The implications of potential output
- Potential output represents the productive capacity of the economy.
- When an economy is producing it's potential output, unemployment equals the natural rate of unemployment ("NRU").
- This level of unemployment will fluctuate during the business cycle largely due to cyclical unemployment:
- During a boom, unemployment will be lower than the NRU.
- During a recession, unemployment will be higher than the NRU.
Test yourself on Output Gaps
What are the features of a positive output gap?
Which of the following is a feature of a negative output gap?
What is the long term impact of a positive output gap following the rise of wages and costs?