Lecture Notes on Output Gaps

Definition

• Output Gaps occur when the actual level of output is different from the potential level of output (Full Employment level of output).
• Two types:
  • Negative Output Gap: Actual output < Potential output
  • Positive Output Gap: Actual output > Potential output

Negative Output Gaps

• Also known as deflationary or recessionary gaps.
• Occur often during recessions.

Classical Interpretation:

• AD and SRAS Model:
  • AD (Aggregate Demand) and SRAS (Short-Run Aggregate Supply) meet at actual output level Y1 and price level P1.
  • Potential output (LRAS - Long-Run Aggregate Supply) is to the right (greater than) actual output.
  • Distance between Y1 and YF (full employment output) represents the negative output gap.

Keynesian Interpretation:

• Keynesian LRAS Curve:
  • AD intersects below YF (full employment output), indicating actual output (Y1) < potential output (YF).
  • The gap between Y1 and YF is the negative output gap.

Positive Output Gaps

• Also known as inflationary gaps.

Classical Interpretation:

• AD and SRAS Model:
  • AD and SRAS intersect at actual output Y1 > potential output YF.
  • LRAS is to the left of actual output, indicating production beyond full employment level temporarily (overuse of resources).

Keynesian Interpretation:

• Difficult to show positive output gaps accurately on a Keynesian diagram due to its vertical LRAS section.

Using Output Gaps for Evaluation

• Useful in evaluating economic policies and macroeconomic objectives.

AD Shift Implications:

• Without Output Gap Consideration:
  • AD shift right increases actual growth, reduces unemployment, increases inflation, worsens trade position.
• With Output Gap Consideration:
  • Large Negative Output Gap: AD shift may not increase inflation, affects growth and unemployment.
  • Full Employment: AD shift can lead to inflation without affecting growth and unemployment.

LRAS Shift Implications:

• Without Output Gap Consideration:
  • Increase in actual and potential growth, decrease in unemployment, reduce cost-push inflationary pressure, improve trade position.
• With Output Gap Consideration:
  • Large negative output gap may render LRAS shift ineffective without sufficient AD.
  • In deep recession, demand-side policies (rather than supply-side) are required to spur economic growth.

Conclusion

• Output gaps are critical tools for evaluating economic growth, inflation, and policy implications.

• They provide a framework for critiquing macroeconomic performance and policy outcomes.

• Note: For exams, classical models are recommended over Keynesian models for demonstrating positive output gaps.