Positive output gaps

An output gap exists when there is a difference between the potential output that an economy is capable of producing, and the current level of output. Identifying output gaps allows policy makers to select the most appropriate policy mix for the current circumstance.

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.

Characteristics of a positive output gap

A positive output gap means that the current level of economic activity is unsustainable in the long run given that the capacity of the economy is not capable of operating at this level, with causing significant economic harm. Of course, this depends on the size of the output gap. The greater the gap, the less sustainable it is.

It is convenient to model output gaps by using the aggregate demand-supply framework. With a positive output gap, aggregate demand exceeds an economy’s ability to produce, at Y in the graph.

Positive output gap

This can be troublesome for an economy as this excess demand can create specific problems, including:

Demand-pull inflation

Excess demand above capacity can lead firms to raise prices, given that they may find it difficult to increase supply.

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 P1 - creating inflation.

Labour shortages

If aggregate demand exceeds an economy's capacity, it is likely that there will be shortages of labour in specific industries. This will further constrain the economy's ability to expand and increase production.

Trade problems

A positive output gap can lead to an increase in imports and a reduction in exports. Firstly, domestic households may switch to imports as a result of shortages of domestic supply, and, secondly, domestic firms may target local consumers rather than the export market.

Trend growth rates

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.

Positive 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

Negative output gap

What is a negative output gap?.

Output gap
Fiscal policy

How can fiscal policy influence aggregate demand?

Fiscal policy
Supply-side policy

How effective is supply-side policy?

Supply-side policy

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