Study Notes:

If all the productive resources - labour, land, capital - are being fully utilised in production then we say that the economy is operating at full capacity or at its potential. The difference between actual real GDP level in any period and Potential GDP level is the output gap, which is the percentage deviation of actual output from potential.

The output gap is an important concept for several reasons. First, it is used to assess whether the economy has cyclical or demand deficient unemployment, which arises when there is a shortage of jobs overall relative to the willing supply of labour resources (persons and hours) at the current wage levels. This unemployment arises because there is a deficiency of overall spending relative to that required to reach full capacity output (and employment). Cyclical unemployment is intrinsically related to the output gap, because when the economy has a high output gap, increases in total spending will generally result in an expansion of output and employment without any price increases occurring.

The presence of an output gap thus indicates that there is cyclical unemployment, which means after the non-government spending decisions have been executed, the government deficit is too low (or the surplus is too high). One objective of fiscal policy should be to eliminate cyclical unemployment.

The output gap is thus commonly used to assess the appropriateness of the current fiscal policy stance. For given spending and tax policy settings, the fiscal balance between spending and tax revenue will take a particular value at full employment or Potential GDP. This is because tax revenue is dependent on economic activity (rising in a boom) and welfare spending falls when the economy is strong. The estimated fiscal balance that would occur at full capacity is the benchmark against which we assess other fiscal positions away from full employment.

Assume that the economy requires a small fiscal deficit to ensure total spending is commensurate with full capacity output. If the economy goes into recession, the fiscal deficit would be larger than it would be at potential output because tax revenues would be lower and welfare payments higher. The adjustments would work in reverse should the economy be operating above full capacity. Given we would observe a government deficit that is higher than the deficit that would coincide with Potential GDP when the output gap was zero, we would conclude that there is scope for increasing the government deficit to reduce unemployment and move the economy back towards full employment. As economic activity improved the deficit would decline automatically (tax revenue rises, welfare spending falls) back to the benchmark level.

The output gap is a summary measure which informs that assessment.

While that might seem to be straightforward, the problem is that estimation of the output gaps is sensitive to our estimate of Potential GDP, which, in turn, is sensitive to what we consider to be full employment.

Organisations such as the OECD (Organisation for Economic Co-operation and Development) and the IMF (International Monetary Fund) regularly publish estimates of the output gaps for different countries, which understate the gaps because they assume that full employment occurs when the unemployment rate is higher, than say, the rate that an MMT economist would use as the full employment benchmark. This leads these organisations to conclude that fiscal policy is too expansionary, and they use that assessment to argue for austerity measures, despite the on-going presence of cyclical unemployment in reality.

This is very important because the political pressures may then lead to discretionary cutbacks to 'rein in the deficit' even though it is highly possible that, at that point in time, the fiscal position was too contractionary and constraining growth.

The lesson to be drawn from this is that while concepts such as output gaps appear to be technical in nature, the estimates of them are susceptible to ideological assumptions that bias the outcomes and interpretations.