A countrys actual output ______ its potential output.

Comparing an economy’s actual output with its potential output can provide useful information about the economy’s health.

The difference between actual output and potential output is known as the output gap, as discussed in a recent Page One Economics article by Scott Wolla. This economic measure is expressed as a percentage of potential output, which is estimated using potential gross domestic product (GDP), where:

• A negative output gap indicates there’s slack in the economy as resources are being underutilized. The economy is performing below potential.
• A positive output gap means any slack has evaporated and resources are being fully employed, maybe even to the point of overcapacity. In this case, the economy is performing above potential.

Monetary policymakers use the output gap to help inform their policy decisions, noted Wolla, who is an economic education coordinator at the St. Louis Fed. While it’s an important economic measure, the output gap has its drawbacks: Estimates of potential GDP rely on historical data rather than on current observable trends. Wolla pointed out that any errors in these estimates can reduce the effectiveness of policy.

What Is Potential GDP?

GDP is the total market value of all final goods and services produced in an economy in a given year. In other words, GDP measures an economy’s output—and tells us the size of the economy in dollar terms.

While economists look to GDP to help assess the well-being of an economy, they also consider how much the economy could produce. To do this, they compare the economy’s actual output (which GDP gives us) with its potential output (or potential GDP).

“Potential output is an estimate of what an economy could feasibly produce when it fully employs its available economic resources,” Wolla explained.

He noted that the Congressional Budget Office (CBO) estimates potential output by estimating potential GDP, with the latter defined as the economy’s maximum sustainable output.

“The word ‘sustainable’ is important—it doesn’t mean that the entire working-age population is working 18 hours per day or that factories are operating 24/7,” Wolla wrote. “Rather, it means that economic resources are fully employed—at normal levels.”

This FRED chart from Wolla’s article plots real potential GDP and actual real GDP using data from the CBO and Bureau of Economic Analysis. (Real GDP allows for a clearer picture of economic growth by stripping out the effects of inflation.)

What the Output Gap Tells Us about Business Cycles

Is it possible for the economy’s actual output to surpass its potential output? “Although rare, it’s possible for actual output to be higher than potential output,” Wolla wrote. “It is far more common, though, for actual output to be lower than potential output.”

He explained that short-run changes in actual output relative to potential output determine business cycles—i.e., periods of economic expansion (when the economy is growing) or recession (when the economy is shrinking). For instance, the output gap tends to get bigger and become negative when the economy contracts. In contrast, the gap tends to narrow and sometimes becomes positive when the economy expands.

Watch this brief video about using FRED to identify past periods when the economy was performing below or above its potential.

How-to steps from this video:

1. Go to https://fred.stlouisfed.org.
2. Search for “Real Gross Domestic Product.” This measures economic output.
3. Hit the “Edit Graph” button.
4. Under “Edit Lines,” in the Customize data section, type and add “Real Potential Gross Domestic Product.” This measures potential economic output.
5. In the Formula field, apply the formula a-b.
6. Under “Format,” in the Graph type field, select “Area.” The shaded area represents the output gap.

Swings in Negative and Positive Output Gaps

Wolla explained that swings into negative territory can be very disruptive. He pointed to two recessionary periods to illustrate the impact on labor markets.

• The negative output gap around the Great Recession of 2007-09 was associated with a sharp rise in the unemployment rate: from 4.4% in the spring of 2007 to 10% in late 2009.
• The COVID-19 recession, which was much shorter (February to April 2020), saw an even sharper rise in unemployment: from 3.5% to 14.8% over that period.

Conversely, a positive output gap occurs when the economy is outperforming its potential. When this happens, the unemployment rate is typically very low. “While this might be feasible in the short run, it is rare and, ultimately, unsustainable over time,” Wolla explained. He offered the examples of workers taking on extra shifts or production lines and machines running without recommended downtime or maintenance.

How the Output Gap Helps Inform Monetary Policy

The output gap is among the economic indicators that policymakers consider when deciding whether the economy needs some form of stimulus. For instance, when the economy is facing a negative output gap, the Federal Open Market Committee (FOMC)—the Federal Reserve’s main monetary policymaking body—may lower its target range for the federal funds rate. Lowering interest rates can help ease financial conditions for consumers and businesses. “When necessary, the FOMC might also use unconventional monetary policy tools such as large-scale asset purchases,” Wolla noted. When the output gap is positive, the FOMC may consider opposite measures—such as raising interest rates—to cool an economy that’s outpacing its potential.

However, some economists and policymakers have concerns about potential GDP since it uses past data to estimate the future trend. If those estimates are flawed, policy that is based on them can be flawed too, Wolla noted. However, he added, to account for changes in the economy that affect potential output, the CBO updates its projections regularly.

If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

The term output gap refers to the difference between the actual output of an economy and the maximum potential output of an economy expressed as a percentage of gross domestic product (GDP). A country's output gap may be either positive or negative. A negative output gap suggests that actual economic output is below the economy's full capacity for output while a positive output suggests an economy that is outperforming expectations because its actual output is higher than the economy's recognized maximum capacity output.

• An output gap is a difference between an economy's actual output and its maximum potential output expressed as a percentage of gross domestic product.
• The output gap is a comparison between actual GDP (output) and potential GDP (maximum-efficiency output).
• A positive or negative output gap is an unfavorable indicator of an economy's efficiency.
• Policymakers often use the output gap to determine inflationary pressure so they can make policy decisions.
• Although it's an important economic indicator, the output gap isn't always reliable because the potential output must be estimated.

The output gap is a comparison between actual GDP and potential GDP or output and maximum-efficiency output. This is difficult to calculate because you can't estimate an economy's optimal level of operating efficiency. There is little consensus among economists about the best way to measure potential GDP but most agree that full employment is a key component of maximum output.

One method that can be used to project potential GDP is to run a trend line through actual GDP over several decades or enough time to limit the impact of short-term peaks and valleys. By following the trend line, you can estimate where GDP currently sits or what it will be at a particular point in the near future.

Determining the output gap is a simple calculation of dividing the difference between the actual and potential GDP by the potential GDP.

Because potential output isn't observable, it's often determined using historical data.

An output gap is an unfavorable indicator of an economy's efficiency, regardless of whether it's positive or negative.

A positive output gap indicates a high demand for goods and services in an economy, which may be considered beneficial for an economy. But the effect of excessively high demand is that businesses and employees must work beyond their maximum efficiency level to meet the level of demand. A positive output gap commonly spurs inflation in an economy because both labor costs and the prices of goods increase in response to the increased demand.

A negative output gap, on the other hand, indicates a lack of demand for goods and services in an economy and can lead to companies and employees operating below their maximum efficiency levels. This type of output gap points to a sluggish economy and portends a declining GDP growth rate and potential recession as wages and prices of goods typically fall when overall economic demand is low.

The output gap is a very important economic indicator. While there are distinct advantages to using this metric, its use does come with certain drawbacks. We've listed some of the most common benefits and limitations to using the output gap below.

Because the output gap relies on the gross domestic product in its calculation, it helps provide a picture of how the economy is doing. More specifically, it can be used as a way to determine whether the economy is underperforming or is growing too quickly. That's because this gap can help determine the rate of inflation in an economy.

The output gap can help policymakers come up with solutions to move the economy in a more favorable direction. Therefore, it plays a very key role in how they make their decisions. about both fiscal and monetary policy. For instance, the Federal Reserve will raise interest rates to curb inflation and vice versa.

Because the output gap is used by both economists and analysts on the street, the general public can also use it to make informed decisions about their finances and investments. For example, a homeowner may decide to hold off on refinancing their mortgage if the output gap means there's a chance that interest rates will increase.

One of the main problems with the output gap is that it is hard to measure. The level of actual output is easy to determine because we know what's happening. But potential output isn't that easy to calculate because we can't determine it. The latter is a figure that can only be predicted or estimated.

How the potential output is measured can be problematic. In fact, there isn't just one way to do so. Analysts and economists may use different filters or models to do so. For instance, some experts may compute the potential output as the trend output while others consider it as the trend growth.

Another limitation to the output gap lies in how intertwined relationships are within the economy. For example, a less active workforce will lead to a drop in output. Similarly, distressed small businesses and corporations and tighter lending standards during tough economic times can also have a big impact on the potential output.

Pros

• It provides a picture of how the economy is doing.

• Policymakers are able to use output gap to help make decisions.

• Consumers and investors can make informed decisions about their finances and investments.

Cons

• Output gap is hard to measure because we can't observe potential output.

• There is no uniform way to measure potential output.

• Potential output relies heavily on relationships that are intertwined in the economy.

The actual GDP in the U.S. was $21.48 trillion through the fourth quarter of 2020, according to the Bureau of Economic Analysis. According to the Federal Reserve Bank of St. Louis, the potential GDP for the U.S. in the fourth quarter of 2020 was $19.41 trillion, meaning the U.S. had a positive output gap of about 10.7% (projected GDP subtracted from actual GDP/projected GDP).

Keep in mind that this calculation is just one estimate of potential GDP in the U.S. Other analysts may have different estimates, but the consensus is that the U.S. was facing a positive output gap in 2020.

Not surprisingly, the Federal Reserve Bank in the U.S. has consistently been raising interest rates since 2016, in part in response to the positive gap. Rates were at less than 1% in 2016 and hit as high as 1.25% in the early part of 2020. The global financial crisis, though, forced the Fed to drop rates back down below 1% in mid-March 2020.

Potential output is what an economy can produce if it operates at full-employment-GDP. This is generally the highest level if and when the economy is doing very well. Unlike actual output, which is what currently happens, potential output cannot be measured and, therefore, relies on estimation.

An economy's output gap can deviate from its potential in one of two ways. A positive output indicates the economy is performing well above expectations. That's because the actual output is higher than its potential. It may also be negative when the output is below full capacity.

Governments may find that reducing government spending as well as cutting down transfer payments and their bond and security issues can help reduce an inflationary output gap.

When an economy is in recession, it means that its actual output gap is lower than the potential output gap.

Governments can move the economy back to its potential GDP by taking a number of steps, including (but not limited to) reviewing tax rates and rebates, making moves on interest rates, and cutting or increasing government spending. The direction they choose depends on whether the actual output is positive or negative.