What is an 'Output Gap'?

An 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 a positive output indicates an economy that is outperforming expectations because its actual output is higher than the economy's recognized maximum capacity output. A negative output gap is rare.

BREAKING DOWN 'Output Gap'

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

Positive and Negative Output Gaps

An output gap, whether positive or negative, is an unfavorable indicator for an economy, at least in terms of efficiency. A positive output gap indicates 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. The output gap is a difficult metric to accurately calculate because it is difficult to estimate an economy's optimal level of 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 associated with employment levels in an economy. Central banks commonly view full employment as a result of a zero output gap and, thus, indicates that the economy is operating at maximum efficiency. Therefore, when considering policy decisions, a country's central bank typically examines each metric to understand the corresponding metric.

For example, if employment levels are below the ideal full employment level, this indicates low demand in the economy and the likelihood of 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 case, monetary policymakers are likely to institute measures such as lowering interest rates to boost economic growth.

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