What is an Output Gap?
An output gap indicates 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 indicates that actual economic output is below the economy's full capacity for output while a positive output indicates an economy that is outperforming expectations because its actual output is higher than the economy's recognized maximum capacity output.
Calculating the Output Gap
The output gap is a comparison between actual GDP (output) and potential GDP (maximum-efficiency output) and is difficult to accurately calculate because it is difficult to 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 would be a key component of maximum output.
A 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, one can estimate where the GDP should be right now or at a point in the near future.
Determining the outcome gap is a simple calculation of dividing the difference between actual GDP and potential GDP by potential GDP.
Positive and Negative Output Gaps
An output gap, whether positive or negative, is an unfavorable indicator for an economy's efficiency. A positive output gap indicates a high demand for goods and services in an economy, which might be considered beneficial for an economy. However, 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.
Alternatively, a negative output gap 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. A negative output gap is a sign of 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.
Real World Example of an Output Gap
Actual GDP in the U.S. was $20.66 trillion through the third quarter of 2018, according to the Bureau of Economic Analysis. According to the Federal Reserve Bank of St. Louis, potential GDP for the U.S. in the third quarter of 2018 was $20.28 trillion, meaning the U.S. had a positive output gap of about 1.8% (projected GDP subtracted from actual GDP/projected GDP).
Keep in mind that this calculation is based on one estimate of potential GDP in the U.S. Other analysts might have different estimates, but the consensus is that the U.S. was facing a positive output gap in 2018.
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 had reached 2.5% by the end of 2018.