What does the output gap represent?

The output gap represents the difference between a nation's actual output and its potential output. Actual output refers to what the economy is currently producing, while potential output represents the maximum sustainable level of production achievable at full employment without creating inflationary pressures.

When the economy is performing below its potential, there is a negative output gap, which suggests that resources, such as labor and capital, are underutilized. On the other hand, a positive output gap occurs when actual output exceeds potential output, indicating that the economy may be overheating, potentially leading to inflation.

Understanding the output gap is crucial for policymakers, as it helps them assess economic performance and determine appropriate monetary and fiscal policies to stabilize the economy. By monitoring the output gap, they can make informed decisions to encourage growth during a downturn or moderate activity during periods of excessive inflation.