outputgap

The output gap is an economic metric that measures the difference between actual real gross domestic product (GDP) and an estimate of the economy’s potential output, typically expressed as a percentage of potential output. If actual GDP exceeds potential, the gap is positive and signals demand above sustainable capacity; if actual GDP is below potential, the gap is negative and indicates underused resources.

Potential output, sometimes called the full-employment level of output, represents the maximum sustainable level of production given available capital, labor, and technology, with inflation remaining relatively stable. It is not directly observable and must be estimated using models that incorporate factors such as the capital stock, the growth rate of the labor force, total factor productivity, and capital utilization. The positive or negative gap is about the deviation from this estimated level of potential output.

Estimating the output gap relies on several methods. Statistical filters, such as the Hodrick-Prescott filter, extract a trend growth path from real GDP to serve as Y*. Production-function approaches build potential output from estimates of inputs and productivity. Some analyses use the relationship between unemployment and output (Okun’s law) to infer the gap indirectly. Each approach has strengths and limitations, and estimates can differ across countries and over time.

In policy discussions, central banks and governments use the output gap to gauge inflationary pressures and guide policy. A large positive gap suggests built-up inflation risk and potential tightening, while a substantial negative gap implies slack, weaker inflation, and room for stimulus. Limitations include uncertain estimation of potential output and the sensitivity of the gap to methodological choices.