Output Gap

Output gap is the difference between actual output and potential output. Potential output is the highest amount of goods and services that an economy can produce when resources are fully employed. When the actual output is more than the potential output, it is called a positive output gap. The positive output gap is the distance between Y_P (potential output) and Y_A (the actual output) in Figure 1 below. But there is a negative output gap when the actual output is less than the potential output. The negative output gap is the distance between Y_A and Y_P in Figure 2 below. 

Figure 1: A positive output gap

The output gap is normally associated with the economic cycle which is fluctuation in the output of an economy. When there is a recession (a falling GDP), there will be negative output because the economy will produce below its capacity. Weak demand is responsible for a negative output gap in a period of recession.  There will be spare capacity because resources are not efficiently utilised. When there is economic growth, resources are overstretched in order to meet the associated high demand. Therefore, there is a positive output gap when there is economic growth.

Figure 2: A negative output gap

Output gap and inflation
A positive output gap would cause a rise in the prices of goods and services in an economy because total demand exceeds the productive capacity of the economy. In Figure 1 above, the price level rises from P_P to P_A due to a rise in aggregate demand from AD₁ to AD₂. A negative output gap would lead to a fall in prices as low demand makes the actual output to be less than the potential output. In Figure 2 above, a fall in aggregate demand from AD₁ to AD₂ resulted in a fall in the price level from P_P to P_A. The government can use policies (fiscal and monetary) to deal with the inflationary pressure and deflationary pressure associated with a positive output gap and negative output gap respectively.