Output Gap

The output gap is the difference between the actual output of an economy and its potential output, expressed as a percentage of potential output. The output gap is a key indicator of the state of the economy and of the pressures on inflation.

Definition

Potential output is the level of output that the economy can produce when its resources are fully employed, without generating inflationary pressure. The output gap is positive when actual output exceeds potential, and negative when it falls short.

Potential output is not directly observable, and it must be estimated. The estimates are based on statistical methods, which extract the trend from the data, or on production functions, which estimate the productive capacity of the economy from its inputs.

Measurement

The statistical methods include the Hodrick-Prescott filter, which separates the trend from the cyclical component of output, and other smoothing techniques. The methods are simple but subject to the criticism that the trend can be affected by the cycle, and that the estimates are revised as new data become available.

The production function approach estimates potential output from the capital stock, the labour force, and the trend of productivity. The approach provides a structural estimate, but it requires data on the inputs and on their utilisation.

The estimates are subject to substantial uncertainty, and they are revised over time. The revisions can be large, which complicates the use of the estimates for policy.

Significance

The output gap is used to assess the inflationary pressures in the economy. A positive gap indicates that demand exceeds the capacity of the economy, which tends to raise inflation, while a negative gap indicates slack, which tends to reduce inflation.

The gap is used in the design of fiscal and monetary policy. The assessment of the gap informs the judgment about the appropriate stance of policy, and it is used in the estimation of the structural budget balance, which adjusts the budget for the effects of the cycle.

The gap is also used in the analysis of the effects of policy and of the sustainability of the public finances. The estimate of the gap affects the assessment of the cyclically adjusted fiscal position and of the fiscal effort.

Limitations

The output gap is subject to substantial uncertainty, and the estimates are sensitive to the methods and to the assumptions. The uncertainty complicates the use of the gap for policy, since the appropriate stance may depend on the estimate.

The gap can also be misleading when the economy is subject to structural change, since the potential output may shift. The estimates of potential output may be too low or too high, and the gap may be misestimated.

The use of the gap for policy must therefore be cautious, and it must take account of the uncertainty and of the possibility that the economy has changed. The estimates are best used as one input among several in the assessment of the state of the economy.

Estimating Potential Output

The estimation of potential output is one of the most difficult tasks in macroeconomics, since potential output is not observed. The estimates are based on statistical methods or on production functions.

The statistical methods, including the Hodrick-Prescott filter, separate the trend from the cycle. The methods are simple but subject to the criticism that the trend can be affected by the cycle, and that the estimates are revised as new data become available.

The production function approach estimates potential output from the capital stock, the labour force, and the trend of productivity. The approach provides a structural estimate, but it requires data on the inputs and on the utilisation of the capacity.

The Uncertainty of the Estimates

The estimates of the output gap are subject to substantial uncertainty, and they are revised over time. The revisions can be large, particularly at the turning points of the cycle, which are the moments when the estimates are most needed.

The uncertainty arises from the difficulty of distinguishing the trend from the cycle, from the measurement of the inputs, and from the assumptions of the methods. The uncertainty complicates the use of the estimates for policy, since the appropriate stance may depend on the estimate.

The communication of the uncertainty is important, and the authorities should present the estimates as ranges rather than as precise figures. The use of the estimates for policy should be cautious, and the estimates should be updated as information accumulates.

The Role in Policy

The output gap is used in the design of fiscal and monetary policy, and in the estimation of the structural budget balance. The structural balance is the budget balance adjusted for the effects of the cycle, and it is used to assess the fiscal stance.

The use of the gap in policy is subject to the criticism that the estimates are too uncertain to guide the policy. The response has been to develop frameworks that are robust to the uncertainty, and to use a range of indicators rather than a single estimate.

The gap is also used in the analysis of the effects of the financial crisis, where the persistent shortfall of output relative to the pre-crisis trend has been interpreted as evidence of hysteresis.

Summary

The output gap is the difference between actual and potential output, and it is central to the analysis of inflation and to the design of policy. Its estimation is subject to substantial uncertainty, and its use for policy must take account of that uncertainty.

See also

• Economic Indicators
• Okun’s Coefficient
• Business Cycle