Potential Output and the Output Gap

Potential output is what an economy can sustainably produce; the output gap measures how far actual output is running above or below it.

Knowing that an economy produced a certain amount last year is useful, but it raises a natural question: was that a lot or a little compared with what the economy could have produced? Potential output is an estimate of how much an economy can produce when its workers, machines, and other resources are being used at a normal, sustainable rate - not idle, but not strained either. The output gap is the difference between actual output, measured by real GDP, and potential output, usually expressed as a percentage of potential.

What “potential” really means

Potential output is not the absolute maximum an economy could produce if everyone worked around the clock. It is the level that can be kept up without causing inflation to speed up. At potential, there is still some unemployment - people switching jobs or whose skills do not match available work - but not the extra unemployment that comes from a weak economy. Potential output grows over time as the labor force grows, as more capital is built, and as technology and skills improve, which are the forces covered in the lessons on long-run growth.

Two kinds of gaps

When actual output is below potential, the gap is negative, and it is called a recessionary gap. Resources are being wasted: factories run below capacity and more people are out of work than normal. Prices tend to rise slowly or, in severe cases, even fall.

When actual output is above potential, the gap is positive, and it is called an inflationary gap. The economy is running hot. Firms struggle to find workers, overtime becomes common, and machines are pushed hard. That kind of pace can be kept up for a while, but the pressure tends to push wages and prices up faster, which is why a positive gap is linked with rising inflation.

Calculating a simple output gap

Suppose economists estimate a country's potential output at 2 trillion dollars for the year, but actual real GDP comes in at 1.94 trillion dollars. The difference is negative 60 billion dollars. Dividing 60 billion by 2 trillion gives 3 percent, so the output gap is negative 3 percent - a recessionary gap. That 60 billion dollars represents goods and services the economy could have produced with its existing resources but did not.

Why policymakers care

The output gap is one of the main signals central banks and governments watch. A large negative gap suggests there is room to support the economy, through lower interest rates or fiscal stimulus, without much risk of inflation. A large positive gap suggests the economy may be overheating, which can be a reason to raise interest rates or reduce stimulus. The Taylor rule, covered in the money and banking module, uses the output gap directly as one of its inputs.

The measurement problem

There is an important catch: potential output cannot be observed directly. It must be estimated using statistical methods and assumptions about productivity and the labor force, and different agencies often produce different estimates. Estimates are also revised, sometimes substantially, as new data arrive. This means policymakers may find out only years later that the economy was further from, or closer to, its potential than they believed at the time.

Thinking a positive output gap is always good news

A common mistake is assuming that producing above potential is simply a success. In the short run it means strong employment, but it cannot last, because it usually pushes inflation higher and may be followed by a sharp slowdown. The healthiest situation is usually an economy growing steadily close to its potential.

Key takeaways

Potential output is what an economy can sustainably produce without speeding up inflation.
The output gap is actual real GDP minus potential output, often shown as a percentage.
A negative gap is a recessionary gap; a positive gap is an inflationary gap.
Central banks and governments use the gap to guide policy decisions.
Potential output must be estimated, so the gap is always uncertain.