Understanding the output gap

The output gap is the difference between what an economy actually produces and what it would produce in an ideal world.

What is the output gap?

In an ideal world, the economy would be steady and balanced—not too hot and not too cold, but just right. Businesses would produce enough goods to meet customer demand, employment would be high and inflation low and stable.

In the real world though, the economy typically runs either too hot or too cold to keep things balanced for long. This can make employment fluctuate. Sometimes, producers must work overtime to keep up with demand for their goods. At other times, they produce more goods than people will buy, inventories pile up and factories lie dormant. Neither of these situations is ideal.

The output gap measures how close the real-world economy is to that ideal-world scenario of balanced activity.

Visualizing the output gap

An output gap can be positive or negative.

Positive output gap

If the demand for products is greater than the capacity to supply them for a period of time, there is a positive output gap. A positive output gap usually results in:

• higher inflation
• lower unemployment

Let’s imagine a business during a positive output gap:

1. Demand for its product would be higher than normal.
2. To meet the demand, it might need to hire more staff for its factories or pay overtime. It might even have to build new manufacturing facilities.
3. It would have to buy more materials.
4. The cost of those materials could rise.
   • Because there is greater demand for their materials, suppliers might charge more.
   • A shortage could occur because other factories also need materials, and this shortage would drive prices up.
5. The business might raise the price that consumers pay for its product.

By taking these actions, a business might be able to meet the extra demand for a while. But this wouldn’t be sustainable for long: inflation would start to build across the industry and then throughout the economy.

Negative output gap

When demand is low and a surplus of products is available, there is a negative output gap. A negative output gap usually means:

• lower inflation
• higher unemployment

Let’s imagine that same business during a negative output gap:

1. Demand for its product would decrease.
2. The business might lower its prices—or not raise them as fast—to encourage people to buy its product.
3. It would buy fewer materials.
4. The cost of those materials would drop because suppliers would have excess available.
5. The business would have to lay off staff or reduce hours. It might even have to close some manufacturing facilities.

As more and more businesses take these actions, unemployment would go up and wages wouldn’t rise as fast. Reduced incomes lead to less spending, weaker inflation and slower growth.

How we track potential output

To recap, the output gap is the difference between what businesses actually produce and what they would produce when the economy is in balance. At the Bank of Canada, we need to imagine what the economy looks like in that ideal scenario. But how do we measure the potential output of an economy?

We can’t—at least not directly. We can only estimate the economy’s potential, and we use a variety of economic models to do this. Some of the important factors the models look at include:

• trends in the labour market—such as employment and how many hours people are working
• how much companies invest in new machines and equipment to increase their productivity

At the Bank, we use other information to get different perspectives on the output gap. For example, our Business Outlook Survey gathers opinions from business leaders across the country. This can help us understand how the economy has moved away from a balanced scenario. In other words, we can see the possible causes of an output gap—too many or too few workers or businesses that are producing too little or too much to keep the economy in balance.

How the output gap affects our decisions

At the Bank, we track the output gap because it’s a key indicator of whether inflation is likely to rise or fall.

With a positive output gap, we might raise interest rates to:

• cool down demand
• lower inflation pressures

With a negative output gap, we might lower interest rates to:

• keep inflation from falling
• prevent high unemployment

Setting interest rates to maintain low, stable and predictable inflation promotes steady, long-run economic growth and avoids large swings in unemployment.