Output Gaps

This section explains Output Gaps covering, An Introduction to Output Gaps, Understanding the Trade (Business) Cycle, Characteristics of a Boom and Characteristics of a Recession.

Introduction to Output Gaps

An output gap is the difference between the actual output (real GDP) of an economy and its potential output (the level of output that can be produced with full employment of resources, without causing inflation). Understanding output gaps is key to analysing the performance of an economy over time and evaluating the effectiveness of fiscal and monetary policies.

An output gap can either be positive (the economy is producing above its potential) or negative (the economy is underperforming). Both have different implications for economic policy and growth.

This section will focus on the relationship between output gaps and the trade cycle, explaining the characteristics of booms and recessions.

Understanding the Trade (Business) Cycle

The trade cycle, also known as the business cycle, refers to the natural fluctuations in economic activity over time. It is characterised by periods of expansion (growth) and contraction (recession), which occur as the economy moves through different phases.

There are four main phases of the trade cycle:

Expansion (Recovery):

• During this phase, the economy experiences growth in output, employment, and spending. Consumer confidence increases, businesses invest more, and demand for goods and services rises. As a result, GDP increases.

Boom (Peak):

• The economy reaches a peak, where output is at or near its maximum sustainable level. At this point, economic growth is very high, and unemployment is at a low point. However, the economy may become overheated, leading to inflationary pressures.

Recession (Contraction):

• After the boom, the economy starts to slow down. Output decreases, consumer spending declines, businesses cut back on investment, and unemployment rises. A recession occurs when the economy contracts for two consecutive quarters or more.

Trough:

• The trough is the lowest point of the business cycle, where economic activity is at its weakest. This phase marks the end of the recession, and the economy begins to recover, moving towards the expansion phase.

The output gap is an important tool for understanding the business cycle. A positive output gap occurs during the boom phase, while a negative output gap occurs during a recession.

Characteristics of a Boom

A boom refers to the peak phase of the business cycle, where the economy is operating at a high level of activity. This period is characterised by several key features:

High Economic Growth

• During a boom, the economy experiences strong real GDP growth. Output exceeds the economy’s potential, leading to increased levels of national income.

Low Unemployment

• The economy is operating at or near full employment. Job creation is high, and the unemployment rate falls to its lowest level. Even people who might struggle to find jobs in other economic conditions are typically employed during a boom.

Rising Consumer and Business Confidence

• Consumer confidence is high, which leads to increased spending on goods and services. Consumers are more likely to make large purchases (e.g., cars, houses) and take on debt.
• Business confidence is also elevated, leading to greater investment in capital, technology, and labour. Firms expand their operations in anticipation of continued growth.

Inflationary Pressures

• A boom can lead to demand-pull inflation. As demand for goods and services outstrips supply, prices begin to rise. The increased demand leads to shortages, which forces firms to increase prices.
• Wage inflation can also occur as firms compete for workers in a tight labour market.

Higher Interest Rates

• To control inflation and prevent the economy from overheating, the central bank may increase interest rates during a boom. Higher interest rates reduce borrowing and spending, thus helping to cool the economy.

Rising Asset Prices

• Asset prices, such as housing and stock prices, tend to rise during a boom due to higher demand and investor optimism. This can lead to the creation of asset bubbles.

Increasing Fiscal Revenues

• Governments typically experience higher tax revenues during a boom due to increased income and spending. This gives the government greater fiscal flexibility, although it may lead to larger budget surpluses.

Characteristics of a Recession

A recession is a period of economic contraction in which output falls below its potential, typically characterised by two consecutive quarters of declining real GDP. During a recession, an economy experiences significant difficulties, and the key features are as follows:

Negative Economic Growth

• During a recession, the economy experiences negative real GDP growth. This means the economy is producing fewer goods and services than in the previous period, and national income falls.

Rising Unemployment

• As businesses face declining demand and output, they may cut back on production and lay off workers, leading to a rise in unemployment. As firms reduce their workforce, the labour market becomes less competitive, and wages may stagnate or fall.

Falling Consumer and Business Confidence

• Consumer confidence falls during a recession, causing people to spend less. As households become more uncertain about their financial future, they tend to save more and reduce consumption.
• Business confidence also decreases. Firms are less likely to invest in new projects or expand operations, as they anticipate lower demand and slower growth.

Falling Inflation or Deflation

• A recession often leads to falling prices due to a decrease in aggregate demand. This can result in deflation (a sustained decrease in the general price level), which can further exacerbate the economic downturn by reducing consumer and business spending.
• However, inflation can also remain if there are supply-side constraints (e.g., higher raw material prices).

Lower Interest Rates

• To combat the recession, the central bank may lower interest rates to encourage borrowing, spending, and investment. Lower interest rates make loans cheaper and can stimulate economic activity by increasing consumer and business spending.

Falling Asset Prices

• During a recession, asset prices typically fall as people become less willing to invest. Housing prices, stock prices, and other financial assets may experience significant declines, especially if consumers and businesses are uncertain about the economy’s future direction.

Lower Tax Revenues and Increased Government Spending

• During a recession, tax revenues typically fall as income, profits, and consumption decline. Governments often respond by increasing public sector spending to stimulate the economy, such as through welfare benefits, infrastructure projects, or fiscal stimulus packages.

Widening Output Gap

• During a recession, there is typically a negative output gap, meaning the actual output is below the economy’s potential. This indicates that resources (such as labour and capital) are underutilised, and the economy is not operating at full capacity.

Summary

• The trade cycle (or business cycle) describes the fluctuations in economic activity over time, including the phases of expansion, boom, recession, and trough.
• Booms are characterised by high economic growth, low unemployment, rising confidence, inflationary pressures, and increasing asset prices.
• Recessions are marked by negative growth, rising unemployment, declining confidence, falling inflation or deflation, and lower asset prices.
• During a boom, the economy operates above its potential, creating a positive output gap, while during a recession, the economy operates below its potential, creating a negative output gap.

Understanding these phases of the business cycle is essential for policymakers and businesses to manage the economy effectively and mitigate the negative effects of recessions while promoting sustainable growth during booms.

Key Points:

• The trade cycle is a natural part of the economy, reflecting the fluctuations in economic activity over time.
• Booms lead to higher output, lower unemployment, and inflationary pressures, while recessions result in negative growth, rising unemployment, and lower consumer and business confidence.
• The concept of output gaps helps economists and policymakers identify whether the economy is operating above or below its potential, providing crucial insights into economic health and policy responses.