Question

Why the output gap is an important measure for the Economy?

Answer 1

The output gap occurs due to the business cycle fluctuations in the economy, in times of recession the actual output of the economy will fall below the potential output and in times of boom the actual GDP will cross the potential GDP , this is called the inflationary gap. The output gap is the difference between the actual and the potential GDP, when the actual GDP falls below the potential GDP that is a recessionary gap. When the actual GDP is higher than the potential GDP , that is an inflationary gap.

The output gap suggest that there is inefficiency in the economy, that is the economy is either over heating or producing far below its capacity. The policy markers use the output gap to determine the inflationary pressures in the economy as well as the demand and supply factors. When there is an inflationary gap, the actual output will be greater than the potential output so the inflation will rise. If there is a recessionary gap the actual output will be less than the potential, so there will be a decline in the rate of inflation and decrease in the demand as well. At the potential output the economy will be at the full employment level of output at the natural rate of unemployment. If the output falls below the potential the unemployment rate will increase and vice versa so the policy makers always look at the output gap to lead the economy towards the full employment level of output. The Central bank and the Government will closely watch the output gap to manufacture their policy for correcting the economy.