Inflationary and Recessionary Gaps
Output gaps — when the economy is too hot or too cold
- Define the output gap and explain why CBs obsess over it
- Tell an inflationary gap from a recessionary one from the data mix
- Predict policy response from the gap state
Every economy has a theoretical 'maximum sustainable output' — what it can produce without overheating. The gap between that and reality tells you whether the CB will hike, hold, or cut. It's the invisible compass behind most monetary decisions.
What is the output gap?
Output gap = actual GDP − potential GDP. Potential is what the economy can produce at full employment without sparking inflation. Positive gap (above potential) = inflationary. Negative gap (below potential) = recessionary. CBs estimate it constantly; it's the spine of policy decisions.
Economy running above capacity. Low unemployment, hot wages, rising prices. CB hikes to slow demand back to potential. Currency-positive.
Economy running below capacity. Rising unemployment, idle factories, falling prices. CB cuts to stimulate demand. Currency-negative.
Why it's hard in practice
Potential GDP isn't observable — it's an estimate, and estimates differ. Pre-COVID Fed thought US potential was ~2% growth; post-COVID maybe 1.5% due to retirements + lower productivity. A CB that overestimates potential will keep rates too low and let inflation run — the cardinal error of 2021.
Unemployment is at multi-decade lows, wages +5% YoY, CPI 4%. Likely output-gap state?
- Output gap = actual GDP − potential GDP
- Positive gap = inflationary (CB hikes)
- Negative gap = recessionary (CB cuts)
- Potential GDP is estimated, not observed — a key source of policy error
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