2.5.2 Output Gaps

• What is an output gap?

  Difference between actual GDP and estimated GDP
• What is a positive output gap?

  When GDP is higher than estimated
• What does a negative output gap indicate?

  Spare capacity in the economy
• Why is measuring the output gap difficult?

  Exact position of LRAS is unknown
• How can output gaps be illustrated?

  Using AS and AD diagrams
• What does LRAS represent in economic diagrams?

  Full capacity output of the economy
• What does an equilibrium to the right of LRAS indicate?

  Economy working over capacity in short term
• What does an equilibrium to the left of LRAS indicate?

  Economy working under capacity
• What happens at AD1 in the diagram?

  It indicates a negative output gap
• Why is it not possible to measure the productive potential of an economy?

  There is no single monetary value for key variables
• What do AS and AD diagrams illustrate regarding output gaps?

  • LRAS shows full capacity output
  • Links GDP trend line to actual GDP
  • Equilibrium indicates over or under capacity
• What does an equilibrium to the right of the LRAS indicate?

  Economy is working over capacity
• What does an equilibrium to the left of the LRAS indicate?

  Economy is working under capacity
• How do classical economists view a positive output gap?

  It will be filled by long-run economic growth
• What do classical economists believe will correct a negative output gap?

  Rising AD or falling SRAS due to lower costs