Actual Growth, Potential Growth & Output Gaps (Cambridge (CIE) A Level Economics): Revision Note

Actual growth, potential growth and output gaps

• The previous sub-topic, introduced the distinction between the equilibrium level of national income and the full employment level, and used inflationary and deflationary gaps to measure the divergence between them at a single point in time

• This topic extends that idea across time: as the economy grows year on year, actual output may grow faster or slower than the economy's potential output, and the resulting divergence is measured as a positive or negative output gap.

Actual growth versus potential growth

• The two concepts capture different things and can move independently of one another

  • Actual growth is the observed change in real GDP from one period to the next - the year-on-year rate of growth reported in official statistics

  • Potential growth is the change in the economy's productive capacity - the rate at which the economy could grow if all its resources were fully and efficiently employed

1. Actual growth

Diagram analysis

• Actual growth is driven primarily by changes in AD in the short run - firms raise output in response to higher demand.

  • An increase in consumption, investment, government spending or net exports has caused a shift in AD from AD→AD₁

  • The current real output has increased from Y1→Y2, which represents an increase in real GDP

    • An increase in real GDP = economic growth

• This short-run growth has led to an increase in average prices from AP₁→AP₂

Determinants of actual growth (in the short run)

• Changes in consumer spending, investment, government spending and net exports

• Monetary and fiscal policy decisions

• Exchange rate movements

• Consumer and business confidence

2. Potential growth

• Potential growth is shown by a rightward shift of LRAS - the economy's capacity expands from Y_FE to Y_FE'

Diagram analysis

• A change to the quantity/quality of the factors of production has increased potential output of the economy from Y_FE→Y_FE1

  • E.g. More rigorous competition policy creates a higher number of firms in each industry, leading to greater aggregate supply in the economy

    • This shifts the long-run aggregate supply curve to the right LRAS1→LRAS2, resulting in economic growth

• The final impact on price levels depends on the shape of the long-run aggregate supply curve (Keynesian or Classical)

Determinants of potential growth (in the long run)

• Quantity of factors - net investment, labour force growth, discovery of new resources

• Quality of factors - education and training raising human capital, R&D improving technology

• Efficiency - reforms that improve productivity and reduce frictions

• Institutional environment - stable rules, secure property rights, effective competition policy

Positive and negative output gaps

• The output gap is the difference between actual real GDP and the economy's potential real GDP at a given point in time

  • It is the direct expression of divergence between actual and potential growth

    • Positive output gap - actual real GDP is above potential real GDP. The economy is producing more than its sustainable capacity in the short run

    • Negative output gap - actual real GDP is below potential real GDP. The economy has spare capacity and unemployed resources

• A positive output gap is not "good news" in a simple sense

  • It reflects overheating and typically generates inflationary pressure

• A negative output gap is not purely "bad news" either

  • It reflects spare capacity that can be brought back into use without inflationary consequences.

• For the AD/AS diagrammatic treatment of positive and negative output gaps, including the equivalence with inflationary and deflationary gaps on the Keynesian 45° model, see the notes on 9.1.3

Indicators of output gaps in practice

• The output gap cannot be measured directly because potential real GDP cannot be observed

  • Policymakers infer the gap from multiple indicators:

• No single indicator is decisive - rising inflation, for example, may reflect either demand-side overheating or a supply-side shock

  • Policymakers typically rely on a basket of measures to form a judgement

Difficulties in measurement

• The measurement problem has real policy consequences:

  • Potential output is not directly observable - it must be estimated, and those estimates are revised regularly

  • Revisions can be large - what looked like a positive output gap at the time may be revised away months later as data are updated

  • Structural changes (technological shifts, labour force participation changes, long recessions) can alter the path of potential growth itself, making historical comparisons unreliable

  • Getting the diagnosis wrong is costly: tightening policy into a negative output gap deepens recession; loosening into a positive output gap fuels inflation

Link to the business cycle

• Output gaps open and close in a repeating pattern over time

• The phases of that pattern, its causes, and the automatic stabilisers that dampen it are covered in 9.2.3.