2.5.2 Output Gaps

Edexcel A-Level Economics (9EC0) | Theme 2.5.2

Specification Coverage: Edexcel unit 2.5.2 - Output Gaps. Students should be able to understand and explain what output gaps are, distinguish between negative and positive output gaps, analyse the Classical and Keynesian views of output gaps, and evaluate the difficulties of measuring potential GDP and the size of output gaps.

Key Concept: The Trend Rate of Growth

The trend rate of growth is the long-run average increase in an economy's productive potential, or LRAS.

It is the sustainable rate of growth without causing inflationary pressure.

Actual GDP fluctuates around this trend, creating output gaps.

What Is an Output Gap?

Definition: An output gap is the difference between the actual level of real GDP and the potential level of real GDP, which is the level of output produced when the economy is at full capacity.

\[ \text{Output Gap} = \text{Actual GDP} - \text{Potential GDP} \]

Negative Output Gap

A negative output gap, also called a recessionary gap, occurs when actual GDP is less than potential GDP.

Characteristics: Spare capacity, unemployment of resources, especially cyclical unemployment, and weak inflationary pressure or even deflationary pressure.

Cause: This is typically caused by a deficiency of aggregate demand.

PPF diagram showing long-run growth
Figure 1: Negative Output Gap - Classical View. The economy is producing at Y1, which is less than the full employment level of output Yfe, creating a negative output gap.
PPF diagram showing long-run growth
Figure 2: Negative Output Gap - Keynesian View. The economy is producing at Y1, which is less than the full employment level of output Yfe, creating a negative output gap.

Positive Output Gap

A positive output gap, also called an inflationary gap, occurs when actual GDP is greater than potential GDP.

Characteristics: Resources are used unsustainably, for example through excessive overtime or overuse of machinery, leading to demand-pull inflation, labour shortages, and possible current account problems.

Cause: This is usually caused by excessive aggregate demand.

PPF diagram showing long-run growth
Figure 3: Positive Output Gap - Classical View. The economy is producing at Y1, which is greater than the full employment level of output Yfe, creating a positive output gap.

The Role of Economic Views

Classical View: Output gaps are temporary. The economy self-corrects through price and wage flexibility. A negative output gap encourages falling prices and wages, while a positive output gap creates rising costs that reduce supply.

Keynesian View: The economy can be stuck in a negative output gap because of low confidence and sticky wages and prices. Government intervention is therefore needed to raise aggregate demand and close the gap.

Difficulties in Measuring Output Gaps

  • Potential GDP, or Yfe, cannot be observed directly. It has to be estimated, which makes measurement uncertain.
  • Economists therefore use indicators to infer whether there is an output gap.
  • A negative gap is often associated with high unemployment, low inflation, and low capacity utilisation.
  • A positive gap is often associated with low unemployment, rising inflation, and reports of skill shortages.

Exam Preparation

  • Define negative and positive output gaps clearly.
  • Draw accurate AD/AS diagrams for both types of output gap, clearly shading and labelling the gap.
  • Explain the economic characteristics of each gap, such as unemployment in a negative gap or inflation in a positive gap.
  • Analyse the different policy implications from the Classical and Keynesian perspectives on how to close a negative output gap.
  • Evaluate the difficulties involved in measuring the size of an output gap accurately.