Output gaps

What is a positive output gap?

When actual GDP > potential GDP

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→ Only possible in short term

→ Labour becomes more productive

→ Overtime workers become more tired

Why are positive output gaps a problem?

Only possible in the short term

→ Upward pressure on the price level

→ Competition (↑) → inflation (↑)

→ People have perfect information → rational (↑)

→ Bargain for higher wages → COP (↑)

→ SRAS shifts to the left → returns back to YFE

{However, encourages policy makers to pursue SSP}

What is a negative output gap?

When potential GDP > Actual GDP

Why are negative output gaps a problem?

Output (↓)

→ High unemployment → Tax revenue (↓)

→ GDP (↓) → DD (↓) → PL (↓) → deflationary spiral

→ C (↓) → Prices lower even more

What does the significance of an output gap depend upon?

→ School of thought

→ Cause of the output gap

School of thought: NEOCLASSICAL

Negative output only in the short term

→ Workers willing to accept lower wages

→ SRAS shifts to right

→ When AD1
→ Perfect info → accept lower wages

→ No spare capacity → people need RDY

→ No need for government intervention

School of thought: KEYNESIAN

Argue that they’re problematic

→ Especially when big shocks → Far from YFE

→ Consumers/firms lack confidence → hurts animal spirits

→ May lack occupational mobility → hysteresis

→ Potential GDP (↓) → labour quality (↓)

→ Wages sticky downwards

Cause of output gap:

POSITIVE:

→ Good thing: economy is growing quickly

{may be debt fuelled}

→ Unsustainable → interest (↑) → RDY (↓) → C (↓)

→ Mortgage payments (↑) → future borrowing (↓)

→ Defaults (↑) → can’t get loans in the future

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GOVERNMENT SPENDING:

→ Causes positive OG

→ Capital expenditure → PC (↑) → AS shifts to the right

→ Geographical mobility (↑)