Question:

Economics - Positive output gap?

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I know that a positive output gap exists when the actual GDP exceeds the potential GDP of the economy. However I can't get my head round this since how can an economy produce more than their potential?

It becomes even more confusing when another definition comes along - where the rise in GDP is above the trend rate.

Can anyone clear this up for me?

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1 ANSWERS


  1. You are right, in real terms the GDP actually produced cannot be more than the potential full employment GDP capacity of the economy. When we talk about a positive gap we mean that the aggregate demand ( Consumption, Investment, Govt expenditure plus net exports) exceeds the potential GDP. Clealr, the demand cannot be fully met except for a short while by draing down from inventories or stocks built up earlier or imports.. So, the prices rise. So in nominal terms the GDP increases. Real Output cannot increase beyond potential GDP capacity. That is why when the economy reaches near the potential GDP level, inflation increases and the Govt. and the Central Bank starts cutting govt. expenditure, raises taxes, reduce money supply growth through rise in banks' reserve requirements, open market operations and raising interest rates so that demand growth slows down and prices soften and demand supply gap reduces.

    When they talk aboutb GDP growing above the trend rate, they actually express their concern that the economy might be reaching the capacity limitation soon. It is difficult to estimate the potential GDP accurately as the capacity creation and capacity depletion takes place at varying rates across different parts of thev economy at different points of time. Economists study the trand rate of growth over time especially during period of inflation , price stability and depression. Together with the growth rate trend and trend in prices and employment economists try to guess how far the economy is from the potential GDP. They assume that the trand rate of growth is the average annual growth rate in potential GDP. These are therefore not to be taken literally but understodd in the context of economic measurement, forcasting and policy making. So please do not get puzzled. These notions have special contextual meaning and are application oriented.

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