What is an 'Output Gap'

The output gap is an indicator of the difference between the actual output of an economy and the maximum potential output of the 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 indicates that actual economic output is below the economy's full capacity for output, while the less commonly seen positive output indicates an outperforming economy that is managing actual output higher than the economy's recognized maximum-capacity output.

BREAKING DOWN 'Output Gap'

The output gap measure can be viewed as both a measure of economic efficiency and as an alternate evaluation metric of a country's GDP, since it is essentially a comparison between actual GDP (output) and potential GDP (maximum-efficiency output).

An output gap, whether positive or negative, is an unfavorable indicator for an economy, at least in regard to efficiency. A positive output gap is interpreted as indicating extremely high demand for goods and services in an economy, which might be considered as a plus for the economy. However, the effect of the excessively high demand is that businesses and employees must work beyond their maximum efficiency level in order to try to meet the level of demand. A positive output gap commonly spurs inflation in an economy as both labor costs and the prices of goods rise in response to the increased demand.

Alternatively, a negative output gap indicates a lack of demand for goods and services in an economy, and leads to companies and employees operating below their maximum efficiency level. A negative output gap is generally a sign of a sluggish economy, and forecasts a declining GDP growth rate and potential recession as wages and prices of goods typically fall when overall economic demand is low.

The output gap is a difficult metric to ascertain accurately, since it is difficult to estimate an economy's level of optimal operating efficiency.

The Output Gap and Unemployment

In addition to being an indicator of potential inflationary or deflationary pressures within an economy, the output gap is also related to the level of employment in an economy. Central banks commonly view full employment as corresponding with a zero output gap and thus indicating the economy as operating at maximum efficiency. Therefore, when considering policy decisions a country's central bank usually examines both metrics in order to get an indication of the corresponding metric. For example, if employment levels are below the ideal full employment level, that is an indication that there is low demand in the economy and that there is likely a negative output gap. Alternatively, recognition of an existing negative output gap is an indicator that unemployment is likely to increase because of the relative lack of economic demand. In either instance, monetary policymakers are likely to institute measures such as lowering interest rates in order to boost economic growth.

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