Output gap

There is a difference between what an economy is producing and what it could sustainably produce. That difference, the output gap, guides much of macroeconomic policy.

The output gap is the difference between an economy's actual output and its potential output, the level it could sustain with its resources fully and efficiently employed. A negative gap means the economy is producing below potential, with slack; a positive gap means it is running above sustainable capacity and likely overheating.

Slack and strain

When the output gap is negative, resources are idle: unemployment is above its natural rate, factories run below capacity, and there is room to grow without stoking inflation. When the gap is positive, the economy is straining beyond what it can sustain, and the result is upward pressure on prices and wages. The output gap thus measures whether the economy has slack to take up or is overheating, which is exactly what policymakers need to know.

Why it guides policy

The output gap is central to demand-management policy. A large negative gap argues for stimulus, since there are idle resources to bring back into use with little inflationary cost. A positive gap argues for restraint, to cool an economy running too hot. Central banks weighing whether to raise or cut interest rates are, in effect, judging the size and direction of the output gap, alongside inflation, which tends to rise when the gap turns positive.

The trouble with measuring it

The output gap's great weakness is that potential output cannot be observed, only estimated, and estimates are uncertain and frequently revised. An economy can appear to have slack that is not really there, or to be at capacity when it could grow further, and getting this wrong leads to policy errors, tightening too soon and choking recovery, or stimulating an economy already at its limit and fuelling inflation. Much of the difficulty of real-time policy is not knowing the gap precisely.

The output gap captures a fundamental question, is the economy below, at, or above its sustainable capacity, whose answer should shape policy. Its conceptual clarity and its practical unmeasurability sit awkwardly together, which is why so much macroeconomic disagreement comes down to differing estimates of a number no one can directly see.