Positive output gaps

Output gaps can help identify weaknesses and problems in an economy. An output gap indicates that there is a difference between what an economy can sustainably produce and the current level of aggregate demand.

Statistically, output gaps are calculated as actual GDP less potential GDP as a percent of potential GDP. (Source: Quandl

There are two types of output gap - positive and negative.

With a positive output gap, aggregate demand exceeds an economy’s abaility to produce, at Y in the graph. This can be troublesome for an economy as this excess demand can create inflationary pressure, which is a significant economic problem.

When aggregate demand exceeds long run aggregate supply (or LRAS) - any increase in aggregate supply (AS), such as V to W, which attempts to meet this new demand is likely to be unsustainable – the price level is driven up to P3 - creating inflation.

Positive output gap

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.

Output gaps can also be identified by comparing the actual growth rate of an economy with its trend rate of growth. When actual is above trend there is a positive output gap.

Negative output gap

The extent of the output gap provides important information to policy makers about when to implement a policy, and which policy, or policy mix, to select.

Video on positive output gaps
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