What happens when actual output differs from potential output?

When actual output differs from potential output, the economy experiences an output gap, which has significant implications for inflation, unemployment, and economic stability. Potential output represents the level of production an economy can sustain when operating at full capacity — with stable inflation and fully employed resources. When actual output rises above or falls below this level, imbalances emerge that policymakers must address.

A positive output gap occurs when actual output exceeds potential output. In this situation, resources become overstretched. Firms hire more workers, increase overtime, and push machinery beyond typical capacity. While output increases in the short run, these pressures often lead to demand-pull inflation because firms raise prices in response to strong demand and rising production costs. Such an economy risks overheating, forcing central banks to tighten monetary policy.

A negative output gap occurs when actual output falls below potential output. This gap typically appears during recessions or periods of weak aggregate demand. Firms cut production, unemployment rises, and resources go unused. The economy operates inefficiently, and living standards fall. Negative output gaps can also trigger deflationary pressure, as weak spending pushes prices downward. Policymakers often respond with stimulus measures to revive demand.

Output gaps matter because they signal underlying economic imbalances. Persistent positive gaps fuel inflation, while prolonged negative gaps erode human capital and productive capacity. Understanding where the economy stands relative to its potential helps governments and central banks choose appropriate stabilisation policies.

FAQs

Why is a positive output gap harmful?

A positive output gap leads to inflationary pressure because demand exceeds the economy’s ability to produce goods sustainably. Firms raise prices as inputs become scarce, and wages often rise due to tight labour markets. Although growth appears strong, it is unsustainable. If not addressed, inflation can destabilise the economy. Policymakers typically raise interest rates to cool demand and restore balance.

Why is a negative output gap a concern for policymakers?

A negative output gap indicates high unemployment and underused resources. Weak demand leads firms to reduce output, which further depresses income and spending. If left unchecked, this can cause long-term economic scarring, including skill erosion and lower investment. Governments and central banks respond with fiscal stimulus or lower interest rates to boost activity and close the gap.

Do output gaps disappear on their own?

In theory, economies tend toward potential output over time as wages and prices adjust. However, without policy support, this adjustment can be slow and painful. Long recessions or prolonged overheating can damage productive capacity, making recovery harder. Active stabilization policies help close gaps more quickly and reduce long-term costs.

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