If you take a course in business cycle theory or monetary policy, you will encounter a concept called “the output gap”. Defined as the distance between actual and so-called “potential” production, it seems to be something intangible and hard to understand. But take a look at this month’s charts, and it becomes crystal clear.
The output gap is a measure of resource utilization in the economy. Conceptually it is defined as actual GDP minus so-called potential GDP. Potential GDP can be thought of as the economy’s normal productive capacity but is not directly measurable, and often approximated from a long-term trend. When GDP grows fast it tends to surpass the trend leading to a positive output gap. Conversely, when GDP stalls it tends to fall below the trend (negative output gap).
Still puzzled? Have a glance at the chart below and see what this gap really is!
Small output gap = stabilize unemployment
The output gap is a measure of resource utilization in the economy. This becomes very clear when comparing the output gap to unemployment. A positive output gap corresponds to low unemployment, and thus high resource utilization. Conversely, a negative output gap corresponds to high unemployment, and thus low resource utilization. Recall that the output gap tends to turn negative when GDP has stalled or is falling. This is precisely when unemployment is rising.
Conclusion: When the central bank aims for a small output gap, what it really does is trying to stabilize unemployment. And that’s a pretty good thought!
Do you want to find out more about how a central bank decides to change the interest rate? Try our case on the Norwegian central bank’s dilemma!
Still curious? Try the European Central Bank’s monetary policy game Economia!