Output Gap

Actual output measured against what the economy could produce without pushing prices up. It is estimated, never observed - which is why every inflation argument quietly leans on it.

Two lines, one distance

The output gap is actual output minus potential output, expressed against potential. Potential is what the economy could produce if labour and capital were used at a pace that does not accelerate prices. It is a benchmark, not a ceiling and not a wish.

Why it can never be observed

Actual output is measured; potential is estimated. Nobody can see potential directly, because it depends on how hard the economy can be run before wages and prices start climbing, and that limit moves with productivity, participation and the capital stock.

Two economists can look at the same quarter and disagree about the gap without either being sloppy. That does not make the idea useless. It means the gap is a model output, and it should be read as a direction with error bars rather than a precise reading.

Why inflation follows it

When actual output sits below potential there is slack: workers and machines are idle, and firms cannot easily raise prices. When actual runs above potential the gap is positive, resources are stretched, and the pressure shows up in prices and wages. The deep negative gap left behind by a recession can take years to close.

The link is not mechanical, and this is where inflation expectations enter. The same positive gap pushes prices harder when expectations are already high than when they are anchored. One checkable use: never accept a claim about inflation pressure without asking which way the gap is moving, and by how much it is estimated to be.

Related: GDP · Recession · Real vs Nominal

Next: Recession