Output Gaps & the AD-AS Model
Economics: IB Diploma, topic 2.2.9
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).
Output gaps in the AD-AS model
- In the short run, GDP falls and rises in every economy, as the economy dips into recession or expands out of recession.
- The AD/AS diagram illustrates recessions when the equilibrium level of real GDP is substantially below potential GDP, and booms when this equilibrium level is temporarily above potential GDP.
The implications of potential output
- Potential output represents the productive capacity of the economy, or the full employment level of GDP.
- 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.
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Positive output gap
- A positive output gap is defined as: “when the actual level of real GDP is more than the potential underlying level of real GDP”. Potential output is shown by the vertical LRAS curve.
- This graph shows an equilibrium point where real GDP is greater than the potential output shown by the LRAS.
- This output gap is also known as an 'inflationary output gap.'
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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”. Potential output is shown by the vertical LRAS curve.
- This graph shows an equilibrium point where real GDP is less than the LRAS, and therefore there is 'spare capacity'.
- This output gap is also known as a 'recessionary output gap.'
Policy implications
- In a recessionary gap, the economy is in equilibrium but with less than full employment.
- In an inflationary gap, demand pushes the economy past potential output creating inflationary pressure.
- The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms to return aggregate demand to match potential output.
Test yourself on Output Gaps & the AD-AS Model
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?
What is an obvious way for a government to close a recessionary output gap?