Macroeconomics: Negative and positive output gap

Output gap: the difference between an economy's actual and potential GDP.

An output gap is said to exist when an economy is NOT producing at full capacity.

 A negative output gap occurs when the economy's actual output is below its potential output. The negative output gap in the UK. Actual GDP is estimated to be some distance below productive potential - this is because of the recession:

• 1/ Aggregate demand fell during the downturn causing businesses to sell less and then contract supply as a response to weaker demand. For many businesses price discount were used to offload excess stocks. Others took the decision to close down some of their production operations. Real GDP fell by more than 6 per cent from the peak of the economic cycle to the trough.
• 2/ As a result of lower production and employment, actual GDP is less than potential GDP. This implies that the level of spare capacity in the economy has risen.
• 3/ When spare capacity is high businesses have less power to raise prices even when costs are rising. Partly this is due to demand being more elastic in a recession as consumers become price conscious and savvy when it comes to finding a bargain.
• 4/ Higher spare capacity reduces the need for fresh capital investment designed to increase potential supply. The real level of investment is down by more than 25% in the UK during the downturn. (May 2012, Blog from Tutor2u)
• The danger is that a deep recession or perhaps a double-dip downturn will hurt long run aggregate supply for example as workers become structurally unemployed and as fewer new businesses start up to replace those that have fallen by the wayside.

Negative output gap – unemployment and deflation risks

• If actual GDP is less than potential GDP there is a negative output gap. Some factor resources are under-utilised and the main macroeconomic problem is likely to be higher unemployment and also weak business profits and investment.
• Another consequence - there is deflationary pressure on prices and wages. Businesses left with unsold goods and services and a large margin of productive slack might choose to engage in heavy price discounts, or look to squeeze their costs including prices paid to suppliers and wages paid to their employees.
• A rising number of people out of work indicate an excess supply of labour in the factor market which means there is downward pressure on real wage rates.
• A negative output gap also causes a worsening of government finances – we have seen in the current recession how badly tax revenues have been affected by the slump in demand, profits and the subsequent rise in unemployment. The UK Treasury estimates that this ‘credit-crunch’ recession may have led to a permanent fall in real national output of perhaps 5% of GDP.

Positive output gap arises when an economy's actual output is above that of its potential output. This might seem impossible and indeed in the long run an economy cannot produce more than its productive capacity allows. 

—For a short time, however, an economy may be able to produce more if workers work overtime, some people who are not usually in the labour force enter it, and machinery is used flat out. It will not be possible to sustain this output in the long run, unless AS increases.

• The output gap is used in assessing the degree of demand-pull inflationary pressure in the economy at a particular time.
• Measuring the output gap is difficult. Economists need to measure the true level of aggregate demand (AD = C+I+G+(X-M) and also aggregate supply – a measure of the productive potential of the economy in a given time period.
• When aggregate demand is well below the productive potential of the economy (so called potential GDP) then a negative output gap exists. In simple terms, current output and spending is well below what the economy could normally sustain. In this situation there is spare capacity in the economy. 
• The implication is that the rate of inflation is likely to fall because inflationary pressure is falling. 
• It is important to note that a negative output gap does not tell us what the rate of inflation is going to be – merely it suggests the direction in which inflation is likely to move.
• When actual GDP lies well above potential GDP, there is a positive output gap, meaning that inflation pressures will be rising. This often happens at the end of a period of sustained economic growth above the long-term average growth of national output.