When GDP falls short of potential, the output gap is negative. Over time, an economy can grow without unwelcome inflation only as fast as its potential GDP grows. Think of this as the safe speed limit for economic growth.
Understanding potential GDP is important to Federal Reserve policymakers as they decide when and how to change interest rates or use their other tools to deliver on their mandate of price stability and maximum sustainable employment.
Having good estimates of potential output allows them to calibrate their choices based, in part, on projections of the output gap. Similarly, Congress and the President will look to the output gap to contemplate whether the economy needs fiscal stimulus or restraint. Potential GDP depends on the size of the labor force and the pace of productivity growth output per hour of work , which itself is dependent on the amount of capital investment. That is, potential GDP growth can accelerate if more people enter the labor force, more capital is injected into the economy, or the existing labor force and capital stock become more productive.
As shown in Figure 3, Congressional Budget Office CBO estimates of potential GDP growth fell in the early s as labor force growth declined because of factors including population aging and slowing productivity growth.
Their estimate of potential has been relatively stable since. Actual GDP growth, on the other hand, shows large cyclical patterns—falling sharply during recessions and increasing more modestly above potential during expansions. The underlying components of potential GDP are not directly measurable.
This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Real gross domestic product real GDP is an inflation-adjusted measure of the value of all goods and services produced in an economy.
Above Full Employment Equilibrium Definition Above full employment equilibrium refers to an economy operating at a level where its real GDP temporarily outstrips its potential level. What Are Government Purchases? Government purchases are expenditures by federal, state, and local governments, which combined are a key factor in determining GDP. What Is a Production Gap? A production gap is an economic analytical term denoting the difference between actual industrial production from its perceived potential production.
What Is Aggregate Demand? Aggregate demand is the total amount of goods and services demanded in the economy at a given overall price level at a given time. Partner Links. Related Articles. Macroeconomics Real GDP vs. National Debt Explained: History and Costs.
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The difference between actual output and potential output is called the output gap, which is expressed as a percentage of potential output see the boxed insert. The short-run fluctuations of actual output around potential output determine the business cycle —economic expansions and contractions, or recessions.
A negative output gap occurs when actual output is below potential output. When an economy is functioning below potential, it has a negative output gap and is underutilizing its resources. That is, many offices and factories might be closed or running below full capacity and the unemployment rate is most likely on the rise, indicating that the economy is below full employment.
In business cycle terms, this usually means that the economy is in a recession. Notice on Figure 2 how recessions shaded areas correspond with negative output gaps the red line drops below the blue line. A positive output gap—when actual output is higher than potential output—occurs when the economy is "overachieving.
For example, think about the week or so before final exams. You might cancel your social activities, study late into the night, and then wake up early to study a little more. You might be able to keep such a schedule for a little while, but most people would likely find it unsustainable in the long run. For the economy, this might occur because workers are working extra shifts or production lines and machines are running without recommended downtime and maintenance.
In business cycle terms this usually means that the economy is expanding. When this occurs, the unemployment rate is likely low and decreasing. In short, a positive output gap occurs when actual output exceeds potential output, which means the economy is fully employed and overutilizing its resources. Although the economy can expand at a rate that exceeds its long run potential, that pace is unsustainable in the long run.
NOTE: As the economy expands, the output gap narrows and in most cases becomes positive. As the economy contracts, the output gap expands and becomes negative. Graphically, the synchronization between the output gap becoming negative and the beginning of recessions is evident, but irregular. When they are expressed as a percentage of real potential GDP, however, the gaps become more apparent Figure 4.
Swings into negative territory can be very disruptive on people's live. For example, the negative output gap associated with the Great Recession of moved the unemployment rate from 4. Unemployed people endure hardships such as having to live off of savings or going into debt to pay for expenses and possibly even losing homes and cars.
They might also have difficulty finding a new job after prolonged unemployment. Potential output is important because policymakers consider the output gap when determining whether the economy needs more or less stimulus.
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