Understanding Potential GDP and the Output Gap

Comparing an economy’s actual output with its potential output can provide useful information about the economy’s health.

The difference between actual output and potential output is known as the output gap, as discussed in a recent Page One Economics article by Scott Wolla. This economic measure is expressed as a percentage of potential output, which is estimated using potential gross domestic product (GDP), where:

Output gap = Actual output − Potential output divided by Potential output × 100

• A negative output gap indicates there’s slack in the economy as resources are being underutilized. 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.

Monetary policymakers use the output gap to help inform their policy decisions, noted Wolla, who is an economic education coordinator at the St. Louis Fed. While it’s an important economic measure, the output gap has its drawbacks: Estimates of potential GDP rely on historical data rather than on current observable trends. Wolla pointed out that any errors in these estimates can reduce the effectiveness of policy.

What Is Potential GDP?

GDP is the total market value of all final goods and services produced in an economy in a given year. In other words, GDP measures an economy’s output—and tells us the size of the economy in dollar terms.

While economists look to GDP to help assess the well-being of an economy, they also consider how much the economy could produce. To do this, they compare the economy’s actual output (which GDP gives us) with its potential output (or potential GDP).

“Potential output is an estimate of what an economy could feasibly produce when it fully employs its available economic resources,” Wolla explained.

He noted that the Congressional Budget Office (CBO) estimates potential output by estimating potential GDP, with the latter defined as the economy’s maximum sustainable output.

“The word ‘sustainable’ is important—it doesn’t mean that the entire working-age population is working 18 hours per day or that factories are operating 24/7,” Wolla wrote. “Rather, it means that economic resources are fully employed—at normal levels.”

This FRED chart from Wolla’s article plots real potential GDP and actual real GDP using data from the CBO and Bureau of Economic Analysis. (Real GDP allows for a clearer picture of economic growth by stripping out the effects of inflation.)

What the Output Gap Tells Us about Business Cycles

Is it possible for the economy’s actual output to surpass its potential output? “Although rare, it’s possible for actual output to be higher than potential output,” Wolla wrote. “It is far more common, though, for actual output to be lower than potential output.”

He explained that short-run changes in actual output relative to potential output determine business cycles—i.e., periods of economic expansion (when the economy is growing) or recession (when the economy is shrinking). For instance, the output gap tends to get bigger and become negative when the economy contracts. In contrast, the gap tends to narrow and sometimes becomes positive when the economy expands.

Watch this brief video about using FRED to identify past periods when the economy was performing below or above its potential.

How-to steps from this video:

1. Go to https://fred.stlouisfed.org.
2. Search for “Real Gross Domestic Product.” This measures economic output.
3. Hit the “Edit Graph” button.
4. Under “Edit Lines,” in the Customize data section, type and add “Real Potential Gross Domestic Product.” This measures potential economic output.
5. In the Formula field, apply the formula a-b.
6. Under “Format,” in the Graph type field, select “Area.” The shaded area represents the output gap.

Swings in Negative and Positive Output Gaps

Wolla explained that swings into negative territory can be very disruptive. He pointed to two recessionary periods to illustrate the impact on labor markets.

• The negative output gap around the Great Recession of 2007-09 was associated with a sharp rise in the unemployment rate: from 4.4% in the spring of 2007 to 10% in late 2009.
• The COVID-19 recession, which was much shorter (February to April 2020), saw an even sharper rise in unemployment: from 3.5% to 14.8% over that period.

Conversely, a positive output gap occurs when the economy is outperforming its potential. When this happens, the unemployment rate is typically very low. “While this might be feasible in the short run, it is rare and, ultimately, unsustainable over time,” Wolla explained. He offered the examples of workers taking on extra shifts or production lines and machines running without recommended downtime or maintenance.

How the Output Gap Helps Inform Monetary Policy

The output gap is among the economic indicators that policymakers consider when deciding whether the economy needs some form of stimulus. For instance, when the economy is facing a negative output gap, the Federal Open Market Committee (FOMC)—the Federal Reserve’s main monetary policymaking body—may lower its target range for the federal funds rate. Lowering interest rates can help ease financial conditions for consumers and businesses. “When necessary, the FOMC might also use unconventional monetary policy tools such as large-scale asset purchases,” Wolla noted. When the output gap is positive, the FOMC may consider opposite measures—such as raising interest rates—to cool an economy that’s outpacing its potential.

However, some economists and policymakers have concerns about potential GDP since it uses past data to estimate the future trend. If those estimates are flawed, policy that is based on them can be flawed too, Wolla noted. However, he added, to account for changes in the economy that affect potential output, the CBO updates its projections regularly.