Negative output gaps
Output gaps help identify weaknesses and problems in an economy.
A negative output gap exists when AD is insufficient to enable the economy to reach its capacity at [Y], and there is downward pressure on output, employment [Y2], and the price level [P2].
The consequence of this is rising unemployment and deflation – two problems to be avoided.
With a positive output gap, aggregate demand exceeds an economy’s potential, at Y. This can be troublesome as it can create inflationary pressure, which is a significant economic problem.
When aggregate demand exceeds long run aggregate supply (or LRAS) - any increase in AS, such as V to W above, which attempts to meet this new demand is likely to be unsustainable – the price level is driven up to P3 - creating inflation.
A negative output gap exists when actual aggregate demand is below an economy’s potential, at Y.
Closing output gaps and the multiplier
In order to close an output gap, government may need to inject new spending into the economy - how much depends on the size of the multiplier. For example, of the output gap is estimated to be $400bn, and the multiplier is 2.0, then only $200bn of new government spending is required to close the current output gap.
Trend rates
Output gaps can also be identified by comparing the actual growth rate of an economy with its trend rate of growth.
The trend rate of growth is the average rate over a period of time. When actual is below trend there is a negative output gap and when actual is above trend there is a positive output gap.
The US faces a $380bn output gap in 2021
Issues
There are significant difficulties in estimating potential output, which means that other indicators of pressure on an economy's capacity are also used, including:
- Levels of employment
- Average hours worked
- Capacity utilisation
- Surveys of the capacity pressures firm face
- Labour shortages
- Inflation relative to 'expectations of inflation'
Despite these difficulties, assessing the extent of any output gaps is an important activity for central banks and other policy makers.
