For example, economist Athanasios Orphanides in 8 and 9 argued that during the s the Federal Reserve believed that potential output was higher than it actually was—and therefore that the output gap was more negative than it really was—and took overly simulative actions that contributed to the increased inflation of the s.
The green line shows the most recent real GDP data. To account for changes in the economy that impact potential output, the CBO updates its projections on a regular basis. Comparing real potential GDP to real GDP—that is, potential output to actual output—can provide useful information for how the economy is performing relative to its potential. Operating below potential indicates that an economy is underutilizing its resources: The output gap is negative and there is "slack" in the economy.
On the other end, a positive output gap means that the slack has disappeared and resources are fully employed, or perhaps overutilized. In fact, monetary policymakers use the output gap to inform policy. As such, errors in the estimation of real potential GDP can reduce the effectiveness of policy.
The views expressed are those of the author s and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System. Business cycle: The fluctuating levels of economic activity in an economy over a period of time measured from the beginning of one recession to the beginning of the next.
Federal funds rate: The interest rate at which a depository institution lends funds that are immediately available to another depository institution overnight.
Nonvoting Reserve Bank presidents also participate in Committee deliberations and discussion. Full employment: The lowest possible unemployment rate in a growing economy with all factors of production used as efficiently as possible. Inflation: A general, sustained upward movement of prices for goods and services in an economy.
Potential output: The real output GDP an economy can produce when it fully employs its available resources. Real gross domestic product GDP : The total market value of all final goods and services produced in an economy in a given year calculated by using a base year's price for goods and services; nominal gross domestic product GDP adjusted for inflation. Stimulus: Actions taken by a government or a central bank that are intended to encourage economic activity and growth.
The green line in Figure 2 shows the real-time estimates of potential output for each quarter over the past decade. Nearly all the revisions are downward relative to the real-time estimates, and the magnitude of the revisions are very large. These changes reflect the surprising slowdown in underlying trends in productivity and labor force growth that have occurred over the past decade Fernald et al.
Large downward revisions are also seen in the Laubach-Williams LW estimates. The solid blue line in Figure 3 shows the current LW estimates for potential output, the dashed red lines show the model forecast from early , and the green line shows the real-time estimates.
Like the CBO estimates, the current LW estimates of potential output in —before the recession—are below the real-time estimates. And, like the CBO estimates, the current LW estimates are mostly lower than the real-time estimates, although the magnitude of the LW revisions since are relatively small compared with the CBO revisions. Although the two sets of current estimates share the same general upward trend over that time, at any point in time the two estimates differ by up to 4.
As of the second quarter of , the two estimates differ by only 1 percentage point, but this serendipity may not persist. Moreover, other estimates differ from the two described here, with some suggesting that potential output is much higher today than the CBO and LW estimates. This reinforces the message that it is inherently difficult to pinpoint potential output and that estimates are sensitive to assumptions and methodology.
Given the difficulty in estimating potential output even with modern, sophisticated methods, what is the alternative? One approach is to rely on other indicators that appear to be more stable over time. In particular, the unemployment rate is often used as a key indicator of the cyclical state of the economy Fleischman and Roberts , Fernald et al.
One can then derive the level of potential output based on the difference between the unemployment rate and its long-term trend. This approach has the advantage of reducing the problem of estimating the supply side of the economy, as in the CBO and LW approaches, but it presents its own challenges, too.
For one, the structure of the labor market evolves over time, and with it the full-employment level of the unemployment rate.
In practice, measuring the full-employment level of unemployment has proven nearly as difficult as measuring potential output Orphanides and Williams , Second, there are numerous indicators of the strength of the labor market besides the unemployment rate, which may at any point in time give a different reading of labor market slack, and choosing between them can give a different answer about potential output Weidner and Williams In light of the reality that measuring potential output is very difficult despite the best efforts, it pays to avoid overreliance on these estimates when possible.
In particular, there has been considerable research on the problem of conducting monetary policy with imperfect estimates of potential output or the full-employment level of unemployment Williams In a nutshell, the big advantage of the price-level targeting approach is that swings in the inflation rate need to be made up in the future.
This assures that, over the medium term, inflation stays on track, even if policymakers have a very imperfect understanding of the levels of potential output or other structural changes affecting the economy.
In sum, past experience teaches us that the measurement of potential output is a perennial problem that is unlikely to vanish in the foreseeable future. Monetary policymakers are well advised to take this uncertainty into account in devising and carrying out their policy strategies. Views expressed are not necessarily those of the St.
Louis Fed or Federal Reserve System. Open Vault Blog. August 04, By Doreen Fagan. The economy is performing below potential. A positive output gap means any slack has evaporated and resources are being fully employed, maybe even to the point of overcapacity. In this case, the economy is performing above potential.
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Economics Macroeconomics. Table of Contents Expand. What Is an Output Gap? How an Output Gap Works. Positive and Negative Gaps. Pros and Cons of the Output Gap. Real-World Example.
Potential Output FAQs. Key Takeaways An output gap is a difference between an economy's actual output and its maximum potential output expressed as a percentage of gross domestic product. A positive or negative output gap is an unfavorable indicator of an economy's efficiency.
Policymakers often use the output gap to determine inflationary pressure so they can make policy decisions. Although it's an important economic indicator, the output gap isn't always reliable because the potential output must be estimated. Because potential output isn't observable, it's often determined using historical data. Pros It provides a picture of how the economy is doing. Policymakers are able to use output gap to help make decisions. Consumers and investors can make informed decisions about their finances and investments.
Cons Output gap is hard to measure because we can't observe potential output. There is no uniform way to measure potential output. Potential output relies heavily on relationships that are intertwined in the economy.
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