how an output gap works
the output gap is a comparison between actual gdp and potential gdp or output and maximum efficiency output 1 this is difficult to calculate because you can t estimate an economy s optimal level of operating efficiency there is little consensus among economists about the best way to measure potential gdp but most agree that full employment is a key component of maximum output 2one method that can be used to project potential gdp is to run a trend line through actual gdp over several decades or enough time to limit the impact of short term peaks and valleys by following the trend line you can estimate where gdp currently sits or what it will be at a particular point in the near future 2determining the output gap is a simple calculation of dividing the difference between the actual and potential gdp by the potential gdp because potential output isn t observable it s often determined using historical data positive and negative output gapsan output gap is an unfavorable indicator of an economy s efficiency regardless of whether it s positive or negative a positive output gap indicates a high demand for goods and services in an economy which may be considered beneficial for an economy 1 but the effect of excessively high demand is that businesses and employees must work beyond their maximum efficiency level to meet the level of demand a positive output gap commonly spurs inflation in an economy because both labor costs and the prices of goods increase in response to the increased demand a negative output gap on the other hand indicates a lack of demand for goods and services in an economy and can lead to companies and employees operating below their maximum efficiency levels 1 this type of output gap points to a sluggish economy and portends a declining gdp growth rate and potential recession as wages and prices of goods typically fall when overall economic demand is low advantages and disadvantages of the output gapthe output gap is a very important economic indicator while there are distinct advantages to using this metric its use does come with certain drawbacks we ve listed some of the most common benefits and limitations to using the output gap below because the output gap relies on the gross domestic product in its calculation it helps provide a picture of how the economy is doing more specifically it can be used as a way to determine whether the economy is underperforming or is growing too quickly 1 that s because this gap can help determine the rate of inflation in an economy the output gap can help policymakers come up with solutions to move the economy in a more favorable direction therefore it plays a very key role in how they make their decisions about both fiscal and monetary policy 13 for instance the federal reserve will raise interest rates to curb inflation and vice versa because the output gap is used by both economists and analysts on the street the general public can also use it to make informed decisions about their finances and investments 4 for example a homeowner may decide to hold off on refinancing their mortgage if the output gap means there s a chance that interest rates will increase one of the main problems with the output gap is that it is hard to measure the level of actual output is easy to determine because we know what s happening but potential output isn t that easy to calculate because we can t determine it the latter is a figure that can only be predicted or estimated 1