Positive Output Gap
The Race Car Analogy and Basic Concepts
Imagine a race car (the economy) and its driver. The car's potential speed is 180 km/h—this is its potential output, the maximum it can go safely for a long time without breaking down. If the driver pushes the car to 200 km/h for a short time, that's the actual output exceeding its potential. This gap between 200 km/h and 180 km/h is the positive output gap.
In an economy, this happens when everyone who wants a job has one (very low unemployment), factories run extra shifts, and machines are used non-stop. It feels great, but like the race car, the engine (the economy) can overheat. This heat appears as inflation—prices of goods and services start to rise quickly because demand is higher than what the economy can comfortably supply.
How We Measure It: The Formula
Economists calculate the output gap using a simple formula. It compares the real output (GDP) to the potential output. The result is usually shown as a percentage of potential output.
$\text{Output Gap} = \frac{\text{Actual GDP} - \text{Potential GDP}}{\text{Potential GDP}} \times 100$
If the result is positive, we have a positive output gap. For example, if Potential GDP is $100 billion and Actual GDP is $105 billion, the output gap is +5%.
Real-World Example: The Post-Pandemic Boom
A recent example of a positive output gap could be seen in some economies right after the COVID-19 pandemic restrictions ended. Governments had given people money (stimulus checks), and people were eager to spend it on travel, dining out, and new goods. Suddenly, demand for everything was incredibly high. Restaurants were fully booked, airlines couldn't find enough staff, and stores ran out of products. This demand pushed the economy's actual output above its long-term potential. The result? We saw a sharp rise in inflation in many countries around the world, which is the classic symptom of a positive output gap.
Positive vs. Negative Output Gap at a Glance
To better understand the positive output gap, it helps to compare it with its opposite. The table below shows the key differences.
| Feature | Positive Output Gap | Negative Output Gap |
|---|---|---|
| Comparison | Actual GDP > Potential GDP | Actual GDP < Potential GDP |
| Economic State | Overheating, boom | Recession, slump |
| Unemployment | Very low (below natural rate) | High |
| Inflation | Rising (high) | Falling or low (risk of deflation) |
Important Questions
Not always, but it is a warning sign. In the short term, it means businesses are profitable and people have jobs. However, if it lasts too long, it creates inflation, which can hurt people's purchasing power and force the central bank to raise interest rates, potentially causing a recession.
Governments and central banks try to cool down the economy. They might raise interest rates (making borrowing more expensive) or reduce government spending. This reduces demand, bringing actual output back down to potential output and controlling inflation.
No, we can't. Potential GDP is an estimate. Economists use different methods to calculate it, like looking at trends in growth or the amount of labor and capital available. Because it's an estimate, the size of the output gap is also an estimate.
Footnote
- [1] GDP (Gross Domestic Product): The total value of all goods and services produced in a country during a specific period. Actual GDP is the real measured value. Potential GDP is an estimate of what the country could produce if all its resources (labor, capital) were used at a normal, sustainable rate, without causing high inflation.
- Inflation: A general increase in the prices of goods and services in an economy over a period of time. When inflation is high, each unit of currency buys fewer goods and services.
- Business Cycle: The natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). The positive output gap occurs during the peak of an expansion.