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? Has the recession damaged the economy’s productive potential? These sorts of questions all link to an important concept – the output gap. The output gap is the difference between the actual level of national output and the estimated potential level and is usually expressed as a percentage of the level of potential output.
Negative output gap – downward pressure on inflation
If actual GDP is less than potential GDP there is a negative output gap. Some factor resources such as labour and capital machinery are under-utilized and the main problem is likely to be higher than average unemployment.
A rising number of people out of work indicate an excess supply of labour, which causes pressure on real wage rates. We have seen millions of people in the labour market have to accept lower pay rises in recent years, many have seen wage freezes or actual wage cuts at a time when businesses have been under huge pressure to control their costs.
Positive output gap – upward pressure on inflation
• 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.
• A positive output gap is associated with countries where an economy is over-heating because of fast and rising demand - a good example of this might be countries such as India and China