What is 'GDP Gap'

GDP gap is the forfeited output of a country's economy resulting from the failure to create sufficient jobs for all those willing to work.

BREAKING DOWN 'GDP Gap'

A GDP gap denotes the amount of production that is irretrievably lost. The potential for higher production levels is wasted because there aren't enough jobs supplied.

A consistently large GDP gap can cause severe consequences on a country's economy – especially the labor market, long-term economic potential and the country's public finances. And the longer a GDP gap lasts, the longer the labor market will under-perform. The effect was evident in an October 2013 unemployment rate of 7.3 percent, compared with an average annual rate of 4.6 percent in 2007, before the brunt of the recession struck.

Damage inflicted on an economy’s long-term potential happens through what economists term “hysteresis effects.” In essence, idle workers and capital remain so for long stretches due to an economy operating below its capacity. This can cause long-lasting damage to workers, whose skills may atrophy or become obsolete, and thus unemployable, and the broader economy. 

An underperforming economy can result in reduced investments in areas that pay dividends over the long term, such as education, research and development. Such reductions are likely to impair an economy’s long-run potential.

A large GDP gap can lead to a struggling overall economy with a weak labor market and lost tax revenues, as unemployed or underemployed workers pay little or no income taxes, or at least less than they would have if fully employed. Additionally, a higher incidence of unemployment increases public spending on social safety-net programs. Reduced tax revenue and increased public spending both exacerbate budget deficits.

Okun's Law and GDP Gap

Research has shown that for each dollar U.S. GDP moves away from potential output, the U.S. cyclical budget deficits increases 37 cents. 

Okun's Law can be used to reassert this analysis. Based on regression analysis of U.S. data, it shows a correlation between unemployment and GDP. Okun's law can be stated as: For every 1 percent increase in cyclical unemployment (actual unemployment – natural rate of unemployment), GDP will decrease by β percent.

In other words:

%GDP gap = −β x %Cyclical unemployment

This can also be expressed as:

where:

  • Y is actual output
  • Y* is potential output
  • u is actual unemployment
  • ū is the natural rate of unemployment
  • β is a constant derived from regression to show the link between deviations from natural output and natural unemployment.
RELATED TERMS
  1. Okun's Law

    Okun's law is the relationship between an economy's unemployment ...
  2. Unemployment

    Unemployment is the term for when a person who is actively seeking ...
  3. Recessionary Gap

    A recessionary gap is a macroeconomic term that describes the ...
  4. Natural Unemployment

    The lowest rate of unemployment that an economy can sustain over ...
  5. Unemployment Income

    Unemployment income is an insurance benefit that is paid as a ...
  6. Stock Market Capitalization To ...

    The stock market capitalization to GDP ratio is used to determine ...
Related Articles
  1. Insights

    Healthiest And Safest European Economies

    Economic indicators are to economists what symptoms are to doctors: signs of the relative well-being of the patient.
  2. Financial Advisor

    How Labor Force Participation Rate Affects U.S. Unemployment

    While a falling unemployment rate sounds like a good thing, it can actually be indicative of people leaving the labor force because they can't find a job.
  3. Insights

    One Reason Jobs Shrink: Superstar Companies

    Are superstar companies that dominate their industries but employ relatively few workers to blame for labor’s falling share of GDP?
  4. Personal Finance

    Where Unemployment Hits Hardest

    A look at the demographics of unemployment, and what that means for workers around the nation.
  5. Personal Finance

    U.S. Labor Participation Rate at Record Lows

    In absolute terms, labor participation hit an all-time low.
  6. Insights

    How Is the GDP of India Calculated?

    India is a front-runner among developing economies. Investopedia explains how India calculates its GDP, an indicator of economic health and performance.
  7. Investing

    Something Gross in GDP

    GDP is used to gauge the strength of the economy, but what is it actually measuring?
  8. Insights

    What is jobless growth?

    What are the effects that a jobless growth economy has on workers and investors alike. Learn about these effects here.
  9. Trading

    Playing the Gap

    Disruptions in stock patterns are known as gaps. Learn how you can earn money by analyzing these disruptions in normal price patterns.
RELATED FAQS
  1. What is GDP and Why Is It So Important To Investors?

    The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy. What does ... Read Answer >>
  2. How does the stock market affect gross domestic product (GDP)?

    Find out how the stock market affects gross domestic product (GDP) through two different channels: financial conditions and ... Read Answer >>
  3. What's the difference between cyclical unemployment and seasonal unemployment?

    Learn about the key differences between cyclical and seasonal unemployment. Read about distinguishing features of each of ... Read Answer >>
  4. How can I use the rule of 70 to estimate a country's GDP growth?

    Find out about the rule of 70, what it is used for and how to use it to determine the number of years a country's GDP takes ... Read Answer >>
  5. How did the Great Recession affect structural unemployment?

    Structural unemployment is difficult to measure, but there are hints in the data that the spike in unemployment following ... Read Answer >>
  6. What is the difference between frictional unemployment and structural unemployment?

    Learn about structural unemployment and frictional unemployment, the differences between the two and their main characteristics. Read Answer >>
Trading Center