What does the output gap measure?

The output gap measures the difference between actual GDP and potential GDP. Potential GDP refers to the maximum output an economy can produce without triggering inflation when all resources are utilized efficiently. When actual GDP falls short of potential GDP, it indicates an underperforming economy, often associated with unemployment and unused resources. Conversely, when actual GDP exceeds potential GDP, it can suggest an overheating economy, leading to inflationary pressures. This distinction helps policymakers and economists assess economic performance and make informed decisions regarding fiscal and monetary policies.

Understanding the output gap is crucial for analyzing economic cycles, as it highlights where the economy is operating relative to its full capacity, offering insights into potential growth, inflation, and overall economic health.