What is an output gap?

An output gap represents the difference between actual output, which is the level of economic production at a given time, and potential output, which is the maximum sustainable output the economy can achieve when operating at full efficiency. This concept is crucial in macroeconomics as it indicates whether an economy is performing below its capacity (a negative output gap) or above its potential (a positive output gap). A negative output gap suggests that there are unused resources, such as labor and capital, which could be utilized to increase production, while a positive output gap may indicate overheating in the economy, potentially leading to inflationary pressures. Understanding the output gap helps policymakers assess economic performance and determine appropriate monetary and fiscal policies to stabilize the economy.