CONCEPT – OUTPUT GAP IN AN ECONOMY

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 CONCEPT – OUTPUT GAP IN AN ECONOMY

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1. Reality versus Capability: There is a difference between what an economy is producing and what it can produce. During economic downturns an economy’s output of goods and services declines. When times are good, that output increases.
2. Business Cycles: These ups and downs are called “business cycles”. We can try to find how close current output is to an economy’s long-term potential output.
3. Output Gap: The output gap is an economic measure of the difference between the actual output of an economy and its potential output. Potential output is the maximum amount of goods and services an economy can produce when it is at full capacity. Often, it is referred to as the production capacity of the economy.
4. Change in output gap: The output gap can go in two directions: positive and negative. Neither is good, as a positive output gap occurs when actual output is more than full-capacity output. How? Demand is very high and, to meet it, factories and workers operate far above their most efficient capacity. A negative output gap occurs when actual output is less than what an economy could produce at full capacity. A negative gap means that there is spare capacity (slack) in the economy due to weak demand. So an output gap suggests that an economy is running at an inefficient rate (overworking or underworking).
5. Inflation and unemployment: Policymakers often use potential output to gauge inflation and define it as the level of output consistent with no pressure for prices to rise or fall. So, the output gap measures the degree of inflation pressure in the economy and is an important link between the real side of the economy and inflation.
6. Trends: All else remaining equal, if the output gap is positive over time, so that actual output is greater than potential output, prices will begin to rise in response to demand pressure. If actual output falls below potential output over time, prices will begin to fall to reflect weak demand. The unemployment gap is a concept closely related to the output gap. Both are central to the conduct of monetary and fiscal policies.
7. Policymaking and Employment: For many central banks, including the U.S. Federal Reserve (but not RBI), maintaining full employment is a policy goal. That corresponds to an output gap of zero. Nearly all central banks seek to keep inflation under control, and the output gap is a key determinant of inflation pressure. During a recession, a negative output gap exists. The Central Bank can adopt a monetary policy designed to stimulate economic growth by lowering interest rates (to boost demand and prevent inflation from falling below the central bank’s inflation rate target). In a boom, an upward pressure on inflation is created and may prompt the central bank to “cool” the economy by raising interest rates.

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