- Output gap
- The output gap is the difference between the economy's current level of activity and the potential level consistent with stable inflation in the long term.
- Potential output
- Potential output is the amount of real GDP an economy can produce by fully employing its existing labour, physical capital and technology.
Growth rates and the two kinds of output gap
Can you name the three growth terms and the two kinds of output gap?
Actual growth can run faster or slower than the economy's capacity grows, and the gap between actual and potential output opens and closes.
Actual growth is the percentage rise in real GDP the economy achieves from one year to the next.
Can you think of an example?
Real GDP rises from £500 billion to £510 billion in a year. Actual growth is 2 per cent, whatever happened to the economy's capacity.
Trend growth is the long-run average rate at which real GDP grows, smoothing out booms and recessions, and it follows the growth of potential GDP.
Can you think of an example?
Real GDP grows 4 per cent, then 0, then 2 per cent over three years. Averaged out, trend growth over the period is about 2 per cent a year.
Potential growth is an increase in the economy's productive capacity, shown as an outward shift of the PPF or a rightward shift of LRAS.
Can you think of an example?
More people join the workforce and new software raises output per hour, so the economy can produce more at full employment than it could last year.
A negative output gap is when actual output is below potential, with low use of capital and labour and so some spare capacity.
Can you think of an example?
In a recession, factories run below capacity and unemployment rises above its natural rate. Output could rise quickly without much pressure on prices.
A positive output gap is when actual output is above potential, with resources overused, putting upward pressure on wage growth and inflation.
Can you think of an example?
In a boom, firms cannot fill vacancies, staff work long overtime and machines run all night. Firms bid up pay and raise prices.