2.5.2 Output Gaps

a) Distinction Between Actual Growth Rates and Long-Term Trends in Growth Rates

Actual Growth Rate

The actual growth rate is the annual percentage increase in real GDP.

What does Actual Growth rate reflect ?

It reflects the economy’s short-term performance, influenced by demand and supply shocks, fiscal and monetary policies, and other cyclical factors.

Example

If a country's real GDP grows from $1 trillion to $1.05 trillion, the actual growth rate is 5%.

Long-Term Trend Growth Rate

The long-term trend growth rate is the average rate at which an economy can grow over a sustained period without generating inflationary pressures.

It is determined by fundamental factors such as technology, labour force growth, capital accumulation, and productivity improvements.

Example

An economy may have a long-term trend growth rate of 2.5% annually due to steady technological advancement and population growth.

Key Differences

Short-Term vs. Long-Term

Actual growth rates fluctuate more due to short-term factors, while trend growth rates indicate long-term sustainable growth.

Volatility

Actual growth rates can be highly volatile, whereas trend growth rates are relatively stable.

b) Understanding of Positive and Negative Output Gaps and the Difficulties of Measurement

Positive Output Gap

Occurs when actual GDP exceeds potential GDP. Indicates that the economy is producing above its sustainable capacity, often leading to inflationary pressures.

Example

During economic booms, such as the late 1990s dot-com bubble, the U.S. experienced a positive output gap.

Negative Output Gap

Occurs when actual GDP is below potential GDP. Indicates underutilisation of resources, high unemployment, and deflationary pressures.

Example

During the 2008 financial crisis, many economies faced negative output gaps due to reduced demand and high unemployment.

Difficulties of Measurement

Estimation of Potential GDP

Potential GDP is not directly observable and must be estimated, leading to potential inaccuracies

Data Revisions

Economic data is often revised, which can change the assessment of output gaps.

c) Use of an AD/AS Diagram to Illustrate an Output Gap

AD Diagram

The Aggregate Demand (AD) curve

It represents the total quantity of goods and services demanded at different price levels.

AS Diagram

The Aggregate Supply (AS) curve

It represents the total quantity of goods and services that producers are willing and able to supply at different price levels.

Potential Output (Y*)

The level of output the economy can produce at full employment (long-term trend).

Illustrating Output Gaps

Positive Output Gap

Occurs when the AD curve intersects the AS curve to the right of potential output (Y*).

Example: AD intersects AS at a point where actual output (Y) > Y*.

Diagram

Draw AD and AS curves with the intersection to the right of Y*, indicating actual output above potential.

Negative Output Gap

Occurs when the AD curve intersects the AS curve to the left of potential output (Y*).

Example: AD intersects AS at a point where actual output (Y) < Y*.

Diagram

Draw AD and AS curves with the intersection to the left of Y*, indicating actual output below potential