Output Gap
Candlefocus EditorTo define output gap, potential output or 'full capacity' refers to the level of output which occurs when an economy is at its peak performance. Potential output is determined by the total amount of labor and capital that is available. Output gap measures the difference between actual GDP and potential GDP as a percentage of potential GDP. A positive output gap means that a nation's output is higher than its potential output and may signal rising inflationary pressures in the future. Conversely, a negative output gap signals that the economy is producing below its full potential.
The output gap helps general economists, central bankers, and policymakers alike to get a better understanding of inflationary pressures and to adjust policy accordingly. It gives them the ability to intervene with fiscal, monetary, and employment policies that can help keep the economy operating at its maximum potential output.
In order to calculate the output gap, economists must first determine the current level of potential output. This is generally done by estimating the maximum amount of production that can be achieved given the existing level of capacity, including labor and capital. This aggregate level of output is then compared to the current level of output, or the actual GDP.
A reliable output gap is important for policymakers to be able to make informed decisions about how to handle potential inflationary pressures. However, there are many potential problems when estimating potential output, such as the accuracy of statistical data, changes in technology and the impact of labor productivity on production capacity. For example, products have become more complex and the labor skill sets to manufacture them have increased, making current measures of potential output difficult to accurately calculate. This makes it less easy to determine the output gap and can affect policymakers' ability to make informed and effective decisions.
In summary, the output gap is a crucial economic indicator that measures the difference between actual GDP and potential GDP as a percentage of potential GDP. It helps economists, central bankers, and policy makers to quickly determine if an economy is growing too quickly and if inflationary pressures may be soon arise. However, the output gap is not always reliable because potential output is difficult to calculate accurately, resulting in potential problems when estimating potential output.