Revision - Linking Output Gap to other Macro Issues

How much spare capacity does an economy have to meet a rise in demand? How close is an economy to operating at its productive potential? These sorts of questions link to an important concept – the output gap. The output gap is the difference between the actual level of national output and its potential level and is usually expressed as a percentage of the level of potential output. In this revision blog we link the output gap to aspects of macroeconomic performance.

Negative output gap – unemployment and deflation risks

If actual GDP is less than potential GDP there is a negative output gap. Some factor resources are under-utilised and the main macroeconomic problem is likely to be higher than average unemployment and also weak business profits and investment.

A second possible consequence from an economy operating with a large negative output gap is that there is deflationary pressure on prices and wages. Businesses left with unsold goods and services and a large margin of productive slack might choose to engage in heavy price discounts, or look to squeeze their costs including prices paid to suppliers and wages paid to their employees.

A rising number of people out of work indicate an excess supply of labour in the factor market which means there is downward pressure on real wage rates.

A negative output gap also causes a worsening of government finances – we have seen in the current recession how badly tax revenues have been affected by the slump in demand, profits and the subsequent rise in unemployment. The UK Treasury estimates that this ‘credit-crunch’ recession may have led to a permanent fall in real national output of perhaps 5% of GDP.

Positive output gap – upward pressure on inflation and a widening trade deficit

If actual GDP is greater than potential GDP then there is a positive output gap. Some resources including labour are likely to be working beyond their normal capacity e.g. making extra use of shift work and overtime. The main problem is likely to be an acceleration of demand pull and cost-push inflation. Shortages of labour put upward pressure on wage rates, and in the next time period, a rise in wage rates shifts SRAS upwards until actual and potential GDP are identical – assuming labour markets are flexible.

Excess demand in an economy can also lead to a worsening of a country’s trade balance as imports of goods and services flow in to satisfy the demands of consumers and manufacturers.