2.5.2 Output Gaps

• Actual growth can be differentiated from the idea of long-term trends in growth rates
• A long-term growth trend is the underlying trend rate of economic growth over a longer period of time
  • This is determined by the constant increases in the productive capacity of an economy (aggregate supply)
    • The increase in productive capacity is illustrated by a rightward shift of the long-run aggregate supply curve (LRAS)
  • Use of long-term growth trends can reduce the impact of outliers in the data

• An output gap is the difference between the actual level of output (real GDP) and the maximum potential level of output
  • A positive output gap occurs when real GDP is greater than the potential real GDP
  • A negative output gap occurs when the real GDP is less than the potential real GDP
    • There is spare capacity in the economy to produce more goods/services than are being produced
      
      
• It is difficult to measure output gaps accurately
  • This is because it is hard to know exactly what the maximum productive potential of an economy is
  • Rapidly rising prices can indicate a positive gap is developing
  • Rising unemployment and slowdown in economic growth can indicate that a negative gap is increasing
    
    

A Negative Output Gap

An Keynesian (top) and Classical (bottom) diagram illustrating an economy that has a negative output gap (Y₁- Y_FE) and is currently producing less than its potential output

Diagram Analysis

• The potential output of this economy is at Y_FE
• The economy is in a short-run equilibrium at AP₁Y₁
  • A negative output gap exists at Y₁ - Y_FE
    • This effectively gives the economy sparer capacity in the short-term
  • One cause of this may be that the AD has recently decreased due to a fall in consumption
  • The Classical view is that the output will return to Y_FE  in the long-run, but at a lower average price level
  • The Keynesian view is that an economy may be stuck in a negative output gap for a long period of time

A Positive Output Gap

An AD/AS diagram illustrating an economy that has a positive output gap (Y_FE - Y₁) and is currently producing more than its potential output

Diagram Analysis

• The potential output of this economy is at Y_FE
• The economy is in a short-run equilibrium at AP₁Y₁
  • A positive output gap exists at Y_FE - Y₁
    • This effectively gives the economy more productive capacity in the short-term
  • One cause of this may be that workers are willing to work overtime once full capacity is reached
    • It is not sustainable and the Classical view is that the output will return to Y_FE, but at a higher price level