output-gaps

Actual Growth & Long-term Growth

• Actual growth can be differentiated from the idea of long-term trends in growth rates

• A long-term growth trend is the underlying trend rate of economic growth over a longer period of time

  • This is determined by the constant increases in the productive capacity of an economy (aggregate supply)

    • The increase in productive capacity is illustrated by a rightward shift of the long-run aggregate supply curve (LRAS)

  • Use of long-term growth trends can reduce the impact of outliers in the data

Positive & Negative Output Gaps

• An output gap is the difference between the actual level of output (real GDP) and the maximum potential level of output

  • A positive output gap occurs when real GDP is greater than the potential real GDP

  • A negative output gap occurs when the real GDP is less than the potential real GDP

    • There is spare capacity in the economy to produce more goods/services than are being produced

• It is difficult to measure output gaps accurately

  • This is because it is hard to know exactly what the maximum productive potential of an economy is

  • Rapidly rising prices can indicate a positive gap is developing

  • Rising unemployment and slowdown in economic growth can indicate that a negative gap is increasing

A negative output gap

Diagram analysis

• The potential output of this economy is at Y_FE

• The economy is in a short-run equilibrium at AP₁Y₁

  • A negative output gap exists at Y₁ – Y_FE

    • This effectively gives the economy sparer capacity in the short-term

  • One cause of this may be that the AD has recently decreased due to a fall in consumption

  • The Classical view is that the output will return to Y_FE  in the long-run, but at a lower average price level

  • The Keynesian view is that an economy may be stuck in a negative output gap for a long period of time 

A positive output gap

Diagram analysis

• The potential output of this economy is at Y_FE

• The economy is in a short-run equilibrium at AP₁Y₁

  • A positive output gap exists at Y_FE – Y₁

    • This effectively gives the economy more productive capacity in the short-term

  • One cause of this may be that workers are willing to work overtime once full capacity is reached

    • It is not sustainable and the Classical view is that the output will return to Y_FE, but at a higher price level