Q&A: What do we need to know about output gaps?

Q&A: For AS macroeconomics, what do we need to know about output gaps?

For AS level (the AQA board)

“An understanding of potentially inflationary, positive, and potentially deflationary, negative, output gaps is also expected in the context of the economic cycle. Candidates should understand that positive output gaps occur when actual GDP is above the productive potential of the economy, and negative output gaps occur when actual GDP is below the economy’s productive potential.”

Our focus in this blog is on the negative output gap in the UK. Actual GDP is estimated to be some distance below productive potential - this is because of the effects of the recession:

1/ Aggregate demand fell during the downturn causing businesses to sell less and then contract supply as a response to weaker demand. For many businesses price discount were used to offload excess stocks. Others took the decision to close down some of their production operations. Real GDP fell by more than 6 per cent from the peak of the economic cycle to the trough.

2/ As a result of lower production and employment, actual GDP is less than potential GDP. This implies that the level of spare capacity in the economy has risen.

3/ When spare capacity is high businesses have less power to raise prices even when costs are rising. Partly this is due to demand being more elastic in a recession as consumers become price conscious and savvy when it comes to finding a bargain.

4/ Higher spare capacity reduces the need for fresh capital investment designed to increase potential supply. The real level of investment is down by more than 25% in the UK during the downturn.

Nobody can be quite sure about the size of the output gap - perhaps the best estimates are provided by economists at the OECD. But is it clear that the British economy has a large margin of capacity available to meet rising aggregate demand as a recovery takes hold.

The danger is that a deep recession or perhaps a double-dip downturn will hurt long run aggregate supply for example as workers become structurally unemployed and as fewer new businesses start up to replace those that have fallen by the wayside.