The definition of output gaps

An output gap measures the difference between what an economy is actually producing and what it could potentially produce.

Types of output gaps:

• Negative output gap - Exists when actual output falls short of potential output.
• Positive output gap - Occurs when actual output exceeds potential output.
• Zero output gap - Happens when actual output matches potential output, meaning the economy is at full capacity without excess strain or slack.

Negative output gaps and their causes

A negative output gap arises when the economy produces less than its full potential.

Causes of negative output gaps

Insufficient aggregate demand is the primary cause of negative output gaps. Low levels of spending can result in reduced production.

Consequences of negative output gaps

• Unemployed resources - The economy fails to achieve its maximum possible output.
• Lower production levels - This can lead to slower growth and reduced living standards.
• Deflationary pressures - With spare capacity, prices may fall or remain stable, but this can also discourage investment.

Positive output gaps and their sustainability

A positive output gap indicates that an economy is temporarily producing beyond its long-term potential.

Causes of positive output gaps

• High aggregate demand - Surges in spending can push firms to exceed normal output levels.
• Temporary resource overuse - To meet demand:
  • Machinery might operate non-stop.
  • Employees could work extended overtime hours.

Reasons positive output gaps cannot be sustained

• Equipment limitations - Machines will eventually need repairs or servicing.
• Labour constraints - Workers may burn out or demand reduced hours.
• Inflationary risks - Operating above capacity can drive up wages and prices, creating instability.

Positive output gaps are short-lived because economies naturally return to their potential output as these pressures build.

Representing output gaps in economic diagrams

Output gaps are commonly illustrated using aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) curves. These diagrams show how actual output (Y) relates to full employment output (Y_fe).

Diagram for a negative output gap

• The LRAS curve is vertical at Y_fe, indicating potential output.
• The AD curve intersects SRAS to the left of LRAS, so actual output (Y) is less than Y_fe.
• This creates a gap to the left, showing spare capacity and unemployed resources.

Diagram for a positive output gap

• The LRAS curve remains vertical at Y_fe.
• The AD curve intersects SRAS to the right of LRAS, so actual output (Y) exceeds Y_fe.
• This creates a gap to the right, highlighting overutilisation and potential inflation.