How Can We Identify an Output Gap?
Aggregate demand and supply
What you will learn
- An output gap compares actual production with sustainable capacity.
- Use AD–AS to distinguish demand and supply disturbances
Essential definitions
- Output gap
- The difference between actual and potential real GDP, commonly expressed as a percentage of potential GDP.
- Inflationary gap
- Actual output above sustainable potential in the short run.
- Stagflation
- Weak or falling output alongside inflationary pressure.
Measure the shortfall or excess
An output gap is actual real GDP minus potential real GDP. To express it as a percentage of capacity, calculate (actual GDP − potential GDP) ÷ potential GDP × 100. Both GDP figures must use the same constant prices, currency scale and period. Potential is the denominator because it is the capacity benchmark.
If actual output is 760 billion and potential is 800 billion, the gap is −5%. A rise to 784 billion narrows it to −2%. Production is growing but remains below capacity. A positive gap means unusually intensive resource use, which can create pressure on wages and prices; it is not evidence that the potential estimate is a physical ceiling.
Locate the gap on the diagram
The AD–AS diagram has real GDP horizontally and the price level vertically. Find the AD–SRAS intersection and project it to the output axis. Compare that output with vertical LRAS at Yp. A point left of Yp shows a negative gap; one to its right shows a positive gap.
In the Keynesian model, an intersection in the spare-capacity region can persist because firms lack customers. In the neoclassical model, wage and cost adjustment tends to return output to potential. Explain which assumption you are using before predicting automatic recovery.
Identify the shock before responding
A fall in AD usually lowers output and the price level. A leftward SRAS shift lowers output but raises the price level. The difference matters: stimulating spending can repair weak demand, but after an energy shock it may worsen price pressure even while supporting jobs.
If AD rises while SRAS falls, both changes push prices up, but their output effects oppose each other. Their relative sizes determine the output result. Potential is also estimated, not directly observed, and may fall after lasting damage. Use employment, prices and industry evidence alongside the calculated gap rather than prescribing policy from one number alone.
Hypothetical output-gap calculation
- Actual GDP = 760 billion and potential GDP = 800 billion.
- Gap = (760 − 800) ÷ 800 × 100 = −5%.
- If actual GDP subsequently rises to 784 with potential unchanged, the gap becomes −2%.
The economy grows while its negative output gap narrows from 5% to 2% of potential.
Output gaps and classical adjustment
AD: P = 150 − 0.8Y. SRAS: P = 20 + 0.8Y. E2: Y=81.25, P=85. Short-run gap=-18.75%. After input costs adjust, the long-run position has Y=100 and P=70.
AD and SRAS can intersect away from potential in the short run. Below potential, unemployment can reduce wage growth and unit costs; SRAS moves down until output returns to potential. Above potential, input-cost pressure shifts SRAS up.
How to draw it and model assumptions
- Mark Yp with vertical LRAS.
- Mark initial E1 at potential, then short-run E2 left or right of Yp after the demand shock.
- Shift SRAS to the long-run position on LRAS; retain E2 so the temporary output gap stays visible.
Adjustment assumes flexible wages and prices over time, unchanged AD and unchanged capacity. It is not automatic or rapid under Keynesian assumptions.
Cost shocks, inflation and deflation
AD: P = 180 − 0.8Y. SRAS: P = 40 + 0.8Y. E2: Y=87.5, P=110.
A rise in unit production costs shifts SRAS up/left: the price level rises while real output falls. Productivity growth or cheaper inputs shifts SRAS down/right, allowing lower prices and more output.
How to draw it and model assumptions
- Hold AD fixed.
- Move SRAS upward for higher unit costs or downward for lower costs.
- Mark initial E1 and new E2, then compare the directions of the price level and real GDP.
AD and potential output held fixed for the initial cost shock. One price-level increase is not by itself permanently continuing inflation.
Apply and evaluate
- Potential-output uncertainty can make the policy stance difficult to calibrate.
- Combined shocks may require a policy mix rather than a single demand instrument.
Common misconceptions
- A negative output gap does not imply negative real GDP growth every period.
- A simultaneous rightward AD shift and leftward SRAS shift has an ambiguous output effect without magnitudes.
Knowledge check
Output falls while the price level rises. Which single shock fits best?
Real-world application
Energy costs and aggregate supply
16 November 2022: ONS reported that gas and electricity prices made the largest upward contribution to the change in UK annual consumer-price inflation between September and October 2022.
Model application: dearer energy can raise firms’ unit costs, shifting SRAS left. It also reduces households’ purchasing power, which can weaken demand. The observation alone does not identify the size of either shift or prove all inflation had one cause.
ONS, Consumer price inflation, UK: October 2022 ↗Historical evidence checked 9 October 2026. The model interpretation is an original teaching application.
What to remember
An output gap compares actual production with sustainable capacity. Diagnose whether demand, supply or both changed before choosing a policy response.
Completion is your own reflection on learning, not a test score. Syllabus references: 3.2.12, 3.2.14, 3.2.17.
Lessons in this section
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