What is a negative output gap

ILO:a) Distinction between actual growth rates and long-term trends in growth ratesb) Understanding of positive and negative output gaps and the difficulties of measurement

c) Use of an AD/AS diagram to illustrate an output gap (level of spare capacity) in an economy

Trends in the growth rate are shown by changes in real GDP over time; these may be compared with changes in capacity over time or compared with the trend or sustainable rate of growth.How could we illustrate the difference between actual growth and long-term trend in growth using a diagram?

Explain when an economy would need Govt intervention?

The difference between actual real GDP and maximum potential real GDP is the output gap. If actual real GDP is less than potential real GDP, then there is a negative output gap. This signifies that the economy is operating with spare capacity and unemployment is likely to be relatively high. 

In the short run, it may be possible for actual real GDP to be greater than potential real GDP: a positive output gap. In this case, the economy is operating at over-capacity and inflationary pressures are likely to be increasing.

Keynesian economists believe that a negative output gap can exist in the long run as well as the short run:

Classical economists believe that in the long run all markets will clear therefore a negative and positive output gaps can only exist in the short run:

It is very difficult to estimate the size of the output gap for an economy, as it involves estimating the economy’s maximum potential output level.Potential output may be estimated using a production function approach or a statistical approach, but there are measurement issues associated with both. For the advanced economies, potential output is usually calculated using a production function approach, based on estimates of labour supply, capital stock and total factor productivity.Thus, any output gap measure constructed using this methodology would reflect measurement error for each of these variables.Estimating the output gap of an emerging market economy poses additional challenges. There are significant data-quality issues for most emerging market economies. 

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb080304.pdf

Assess the importance in understanding the output gap for a country like China when deciding upon macro policy?
​(10 marks)

China wage growth is soaring | World

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The output gap is an economic measure of the difference between an economy’s actual and prospective production. Potential output is the greatest quantity of products and services an economy can produce at maximum efficiency or full capacity. The output gap is utilized by monetary planners while arriving at their policy decisions.

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Source: Output Gap (wallstreetmojo.com)

The output gap can expand or shrink depending on the actual and potential output difference. Comparing the actual production of an economy to its potential output can give valuable insight into the economy’s health. Potential output is frequently referred to as the economy’s productive capacity.

• The output gap is a measure to gauge the functioning of the economy. It utilizes the economy’s actual and anticipated GDP, and the difference between these parameters is called the output gap.
• Output gaps help in the identification of economic vulnerabilities and problems, as well as alerting policymakers on the appropriate policy mix to remedy the gap.
• A positive gap suggests that the current level of economic activity cannot be sustained for long as it is beyond the economy’s capacity.
• A negative gap indicates an economy’s lack of demand for goods and services. It can result in firms and people operating at less than their maximum efficiency.

Output Gap Explained

Output gap indicates that an economy is operating inefficiently, either over- or under-utilizing its resources. Policymakers frequently use the potential output to measure inflation and generally define it as the level of output at which there is no upward or downward pressure on prices. The gap summarizes this context’s relative demand and supply components of economic growth. As a result, the gap assesses the level of inflationary pressure in the economy. It is a crucial connection between the economy, which generates goods and services — and inflation.

A gap aids in identifying economic vulnerabilities and difficulties and informing policymakers about the optimal policy mix to address the gap. They can also assist in determining the success of a given policy, including fiscal, monetary, and supply-side policy.

The production gap is an extremely crucial economic metric. Like GDP, the output gap can expand or shrink. Neither is perfect. Real output surpasses maximum output, creating a positive gap. This happens when factories and workers operate beyond their capability to meet demand. A negative gap occurs when real output is below full capacity. A negative gap suggests surplus capacity due to inadequate demand.

Output Gap Formula

This economic measure is expressed as a percentage of potential output, estimated using the potential gross domestic product (GDP). Certain online sites also have an inbuilt output gap calculator. Simply entering the actual and potential GDP figure will calculate output GDP for you.

Below is an equation showing that the gap is actual output minus potential output divided by potential output and multiplied by 100.

Output Gap = Actual Output – Potential Output ÷ Potential Output * 100

Positive Output Gap

A production gap arises when there is a disparity between an economy’s potential output and its actual output. Identifying gaps enables policymakers to choose the optimal policy mix for the current environment.

A positive output gap indicates that the current level of economic activity is unsustainable over the long term because it exceeds the economy’s capacity, producing severe economic damage. This relies on the gap’s magnitude. The larger the disparity, the less viable it becomes.

Aggregate demand exceeds an economy’s production capacity when the gap is positive. This may be problematic for an economy, as this excess demand can lead to a variety of issues, such as:

Inflation Due To Demand-Pull

Given that it may be difficult for them to expand supply, corporations may raise prices in response to demand exceeding capacity.

When aggregate demand exceeds long-term aggregate supply, any increase in aggregate supply that attempts to fulfill this additional demand is likely unsustainable; hence, the price level rises, causing inflation.

Labor Deficits And Trade Difficulties

If aggregate demand exceeds an economy’s capacity, some industries will likely have labor shortages. This will further limit the capacity of the economy to develop and boost production.

A positive production gap may result in increased imports and decreased exports. First, domestic households may switch to imports due to domestic supply limitations. Second, domestic enterprises may target local customers rather than the export market.

Negative Output Gap

A negative gap develops when aggregate demand is inadequate to allow the economy to operate at full capacity, exerting downward pressure on production, employment, and price.

This results in increased unemployment and the prospect of deflation, both of which should be avoided. A negative production gap suggests that resources are being underused, resulting in economic slack. The economy is operating below its capacity. A negative output gap shows an economy’s lack of demand for products and services. It can result in businesses and workers performing below their optimal efficiency. This sort of production gap indicates a sluggish economy. It portends a slowing GDP growth rate and possible recession, as wages and prices of goods often decline when economic demand is low.

Merits And Demerits

Considering the gap may be beneficial in various ways. For example, it can tell if the economy is underperforming or rising too rapidly; it helps policymakers fix the economy by suggesting changes in monetary and fiscal policies. In addition, the public may use it to make financial and investment decisions.

There are also certain drawbacks to measuring the gap. First, it is difficult to measure as getting estimates of potential output is difficult. Moreover, there is a lack of uniformity as experts’ opinion differs because a few calculate it as trend output. In contrast, others consider its trend growth. Still, it faces limitations as economic activities are interconnected, and their relationship cannot be established.

Frequently Asked Questions (FAQs)

How to calculate the output gap?

Calculating this gap is easy by using the output gap formula. To arrive at an output gap, divide the difference between the actual GDP and potential GDP by the potential GDP and multiply it by 100.

Why are output gaps difficult to measure?

It might be quite challenging to quantify and comprehend the output gap. Because assessing gaps requires both current and prospective GDP, this is the case. However, it is extremely difficult to estimate potential GDP with precision. Moreover, estimating or gauging potential GDP can be challenging for any economy, making it challenging to measure the output gap.

How do I close output gaps?

The use of taxes or government expenditure to stabilize the economy is termed fiscal policy. Expansionary fiscal policy closes recessionary gaps by decreasing taxes or increasing expenditure. Likewise, one can close inflationary gaps by increasing taxes or decreasing spending as a contractionary fiscal policy.

Recommended Articles

This has been a guide to the Output Gap and its definition. Here, we explain the positive and negative gap, formula, merits, and demerits. You may learn more from the following articles –

• Inflationary Gap
• Recessionary Gap
• Global Trade