Economic Growth
Economic Growth
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An economy can grow by using resources that stand idle, or by becoming able to produce more than before.
Elvesta is a middle-income country (neither among the richest nor the poorest) with an open economy (one that trades a lot with other countries). It assembles electronics for export and imports much of its fuel and machinery. In Year 3, some of its factories stand idle and some of its workers cannot find a job. This is spare capacity: resources that could be producing but stand idle.
Because of this spare capacity, Elvesta's real output in Year 3 is $490bn. If its factories ran their usual shifts and its workers had jobs, it could produce $500bn.
Potential output: the real output an economy can produce when all its resources are employed at a normal, sustainable rate.
Put simply, potential output, also called productive capacity, is the most an economy can keep producing year after year: $500bn for Elvesta in Year 3. For a few months, firms can produce more than this, with overtime and extra shifts, but they cannot do this for long.
Growth can mean a rise in either real output or potential output.
Actual economic growth: an increase in real GDP, the real output an economy actually produces.
Potential economic growth: an increase in an economy's potential output, its productive capacity.
Put simply, actual growth is about what IS produced, and potential growth is about what COULD be produced. If Elvesta's idle factories reopen, real GDP rises towards $500bn. That is actual growth, and potential output has not changed. When Elvesta opens a new port, it could produce more than $500bn. That is potential growth.
A production possibility frontier (PPF) shows the combinations of goods an economy can produce when all its resources are employed at a normal, sustainable rate. So it shows potential output, and with it both kinds of growth. On the diagram, A is a point inside the frontier PPF₁, where resources stand idle, and B is a point on PPF₁. Moving from A to B is actual growth. C is a point on PPF₂, the frontier after it shifts outwards, so the economy can now produce more of every good. Moving from B to C is potential growth. A movement along a frontier is neither, because more of one good means less of another.
Real Example: In 2020, lockdowns closed shops and factories, and world output fell by about 3.3%. As they eased, the IMF expected world output to grow by about 6% in 2021, the fastest rate in its records since 1980. Part of this expected rise would be actual growth: shops, factories and workers that had stood idle could go back to work.
A rise in aggregate demand raises real output when firms have idle resources they can use to produce more.
In Year 3, Elvesta has $10bn of spare capacity: it produces $490bn against a potential output of $500bn. Total spending on a country's output is its aggregate demand (AD). It is the sum of consumption (C, spending by households), investment (I, spending by firms on capital goods such as machines) and government spending (G), plus net exports, which are exports (X) minus imports (M): AD = C + I + G + (X − M).
When any component rises, AD rises and firms sell more. The multiplier (the extra income from the first rise is spent again, in further rounds) makes the final rise in AD larger than the first rise in spending. Whether firms can also produce more depends on the spare capacity left. The Keynesian long-run aggregate supply curve shows the real output firms supply at each price level (the average level of prices in the economy). Its three ranges show how spare capacity decides the effect:
So in Year 3, a small rise in household spending, one that Elvesta's $10bn of spare capacity can meet, raises real output with little or no rise in the price level. That rise in real output is actual growth, made by using spare capacity.
If Elvesta were already at potential output, the same rise in spending would raise only the price level.
A country can grow by selling more to the rest of the world, but its growth then depends on foreign buyers.
Elvesta's electronics factories sell most of what they make to buyers abroad. In Year 3, its exports of $180bn are more than a third of its real GDP. Exports are one component of AD, so when foreign orders rise, AD rises. With spare capacity, firms produce more to meet the orders, and real output rises.
Export-led growth: economic growth in which rising exports of goods and services are the main source of the increase in output.
Put simply, the extra spending comes mainly from buyers in other countries. A country's own households can buy only so much, but the world market is far larger.
Trade can also raise Elvesta's potential output, in the years that follow:
Export-led growth has a weakness. The extra spending comes from abroad, so it falls when foreign buyers buy less. If incomes fall in the countries that buy Elvesta's electronics, or those countries put new taxes on imports, Elvesta's exports fall. AD falls with them, and Elvesta's growth slows.
Real Example: In 2023 Samsung, a South Korean firm, exported about $55 billion of goods from its factories in Vietnam, around 16% of the country's exports, by the firm's own estimate. This shows how large a part of Vietnam's exports one foreign firm's factories supply, and so how much those exports depend on buyers abroad. It does not show how much of Vietnam's growth the exports caused.
Potential output grows with more workers or more output per worker, and over many years output per worker usually matters more.
What decides how much Elvesta could produce? Two numbers. The first is its labour force (the people able and willing to work): 25 million in Year 3. The second is how much each worker can produce at a normal, sustainable pace: $20,000 of output a year. This second number is called labour productivity.
Labour productivity: output per worker, or per worker per hour, over a period of time.
Put simply, labour productivity is how much one worker makes in a year or an hour. Better tools, skills and methods raise it.
Multiply the two numbers and you get potential output: potential output = labour force × output per worker.
So potential output grows by about the sum of the two growth rates. It is only about the sum, because the extra workers also produce the higher output per worker, which adds a tiny amount more. Of the 2.5% a year, 2% comes from productivity and 0.5% from the labour force.
Why does productivity usually matter more for the rate of growth over many years? The labour force can grow only as fast as people are born, arrive from abroad or decide to work, and each of these has limits. Output per worker has no fixed limit like these. Better tools and methods can keep raising it, year after year.
Every cause of potential growth works through one of the two numbers. New capital (machines, buildings and tools), better methods and stronger competition can raise output per worker. More people working, born in the country or arriving from abroad, raise the labour force. On a diagram, potential growth shifts the long-run aggregate supply curve to the right.
Real Example: Japan's working-age population, the people aged 15 to 64, peaked around 1995 and has fallen since. With fewer people of working age than in 1995, it is harder for Japan to raise its potential output by adding workers, so raising output per worker matters more for its growth.
Investment adds capital goods, so each worker has more and better tools to produce with.
Picture a worker in an Elvesta garment factory with an old sewing machine. Give her a faster machine, and she can sew more shirts each day. Investment does this across a whole economy.
Investment is spending by firms on capital goods, such as factories, machines and software. Each new capital good adds to the capital stock (all the capital goods an economy has). More and better capital per worker can raise output per worker, so potential output can rise.
Investment affects the economy twice, at different times. When a firm pays to build a factory, the spending is part of AD at once. With spare capacity, that raises real output now: actual growth. When the factory opens, months or years later, it raises potential output: potential growth.
Some investment comes from firms based abroad, which put money into productive assets in Elvesta: assets used to make goods and services, such as factories and machines.
Foreign direct investment (FDI): investment by a firm based in one country in productive assets in another country that it owns and controls.
Put simply, FDI is a foreign firm building or buying a business in Elvesta and running it itself. When the firm builds new factories or installs new machines, it adds capital like any investment, and it often brings two more things:
Not every foreign purchase raises capacity. When a foreign firm buys an existing office tower, only its owner changes. Nothing new is built, so Elvesta cannot produce any more than before.
Real Example: In 1972 Intel, a US chip maker, opened its first factory outside the United States in Penang, Malaysia. Suppliers and related firms followed it there. This shows FDI adding new productive capital: a foreign firm built a new plant, and other firms set up nearby after it.
New ideas raise output when firms put them to use, and a better method can be used again and again.
A factory in Elvesta finds a way to test each circuit board in half the time. It sells nothing new, but each worker now finishes more boards a day. A new idea has been put to use.
Innovation: the commercial use of a new idea, as a new product or a new way of producing.
Put simply, an invention is only an idea. It becomes an innovation when a firm uses it to make or sell something. Innovation comes in two kinds.
Process innovation: a new or improved way of producing a good or delivering a service.
Product innovation: a new or improved good or service brought to the market.
The key difference is what changes. Process innovation changes how a good is made, so output per worker can rise, as with the faster circuit-board test. Product innovation changes what is sold. It creates new markets and new spending, and often new firms to supply them. The new spending gives firms a reason to invest in new capacity, so product innovation can also raise potential output, though less directly than process innovation.
Why can innovation keep raising growth? Give the same workers more and more machines, and each extra machine adds less than the one before, because there are not enough hands to use them all. A better method is different. Once found, it can be used again and again, in every factory, and using it in one factory leaves no less of it for another.
Innovation also needs investment to buy the new equipment, skilled workers to use it, and competition to push firms to adopt it.
Real Example: M-Pesa, launched in Kenya in 2007, lets people send, receive and save money by mobile phone. A 2016 study estimated that it lifted about 194,000 households, around 2% of Kenya's households, out of poverty, partly as women moved from farming into business. M-Pesa is a product innovation, a new service brought to the market. The study measured poverty, not output per worker.
More people able and willing to work can raise the total output an economy can produce.
Each year, more people in Elvesta are able to work. But who exactly counts in the labour force?
Labour force: the people of working age who are in work or actively looking for work.
Put simply, the labour force counts everyone who is working or trying to find work. A full-time student who is not looking for work is not in it. An unemployed welder who is applying for jobs is.
Elvesta's labour force is 25 million in Year 3 and grows by 0.5% a year, which is 125,000 more workers in Year 4. It can grow in three ways. Two come from people already living in the country:
The third way comes from abroad.
Net migration: the number of people who come to live in a country minus the number who leave it to live elsewhere, over a period of time.
Put simply, net migration is arrivals minus departures. Migrants of working age can join the labour force soon after they arrive, without the many years of growing up and schooling a newborn needs first.
More workers can raise total potential output, because potential output = labour force × output per worker. If Elvesta's 125,000 extra workers each produce $20,000 a year, its potential output rises by $2.5bn.
Do people become better off? That depends on output per head (real output divided by the whole population). Extra workers raise output per head when the labour force grows faster than the population, so a larger share of the people are producing, and when the new workers produce about as much as those already in jobs. If the population grows faster than the labour force, the extra output is shared among even more people, so output per head can fall. If the new workers have less capital each, or fewer skills, output per worker falls, and output per head may not rise.
Real Example: In Qatar, people from other countries make up most of the population and over 90% of the workforce. This shows how large a part of a labour force people from other countries can make up. It counts the migrants living there, not net migration, which is the arrivals minus the departures in a year.
When rivals can take their customers, firms have a reason to use their workers and machines better.
In one Elvesta city, a single bus company holds the only licence to run buses. In another, four companies compete for the same passengers. If one of the four wastes fuel or runs half-empty buses, a rival can win its passengers with lower fares. This pressure is called the degree of competition: how strongly rival firms press each firm in a market.
Where competition is weak, a firm can survive while producing inefficiently. The single bus company has no rival to lose passengers to, so it has little reason to spend on better methods. Its workers and buses produce less than they could.
Governments can raise competition by removing barriers to entry (rules or costs that stop new firms joining a market), such as a single licence. They can also remove taxes on imports. Buyers can then switch to foreign goods, so local firms have to match the best producers abroad to keep them.
Real Example: In India's mobile market, private operators compete for customers. Call charges fell from about 16 rupees a minute in 1999 to half a rupee in 2011, the operators' association reports, and subscribers rose from 1.2 million to over 900 million by early 2012. These figures show lower prices and many more users. They do not measure output per worker, so on their own they show the gain to consumers, not the effect on potential growth.
Growth raises output per person only if output outgrows the population, and lowers unemployment only if firms need more extra workers than the labour force adds.
Elvesta's real GDP grows, but so does its population. For each person, what matters is how much output there is to share. Living standards (the goods and services people can enjoy) are measured, on average, by real GDP per head:
real GDP per head = real GDP ÷ population
If real GDP and the population both grow 3%, there is more output but also more people to share it, so real GDP per head does not change. Real GDP per head rises only when real GDP grows faster than the population, and average living standards, measured this way, rise with it. If the population grows faster than real GDP, each person's share of the output is smaller, so real GDP per head falls.
Unemployment is the number of people in the labour force who are looking for work but cannot find a job. Growth can lower it, because firms hire workers when they want to produce more. How many workers they need depends on two more numbers. Output per worker rises each year, so the same output needs fewer workers. And the labour force grows, so more people look for work.
So growth lowers unemployment only when the growth of output is larger than the growth of output per worker plus the growth of the labour force. In Elvesta, that means faster than about 2% + 0.5% = 2.5% a year, the growth rate of its potential output.
Real Example: In 1965, Singapore's GDP per head was about $500. In 2024 it was about $95,000, among the highest in the world (World Bank, each in that year's US dollars). The figures show how far GDP per head rose in current prices. They do not show how much of the rise is real, because part of it is higher prices: real GDP per head removes that part.
Exam Matters: For living standards, write "real GDP per head", not "GDP". "Real" removes the effect of higher prices, and "per head" shares the output among the population. For unemployment, use the figures you are given for output, output per worker and the labour force, and do not assume that any growth lowers unemployment.
When incomes grow, most firms sell more and earn more profit, and many then invest to produce more.
When real GDP grows, households earn and spend more, so most firms sell more. Profit is total revenue minus total costs. More sales raise total revenue. Producing more also raises total costs, but usually by less than revenue, so profit usually rises.
Profit on each unit can rise too. Some costs, such as rent, stay the same when sales rise, so each sale carries less of that cost.
Growth also tends to raise investment, the spending by firms on capital goods such as machines and buildings. A firm invests when it expects to use the new capacity: a factory already at its normal full rate needs a new production line only if orders keep rising. Profit that a firm keeps instead of paying it to its owners, called retained profit, can pay for it without a loan. Higher profits also make lenders more willing to lend, because the firm can more easily pay the loan back.
Investment is a component of AD, so it adds to AD while it is being spent, and it adds to capacity once the new capital is working.
Not every firm gains. If demand grows faster than capacity, firms compete for scarce workers and inputs, so wages and input prices rise, which raises their costs. Growing markets attract new rivals, who take some of an existing firm's customers, so its sales can fall. People also buy less of some goods as they get richer, such as long-distance bus tickets once families own cars, so the firms that sell them lose sales.
Exam Matters: In an Examine answer on the benefits of growth for firms, build the chain from rising real incomes to sales to profit. Then judge it: say which firms may not gain, and why.
When incomes, profits and spending grow, a government collects more tax without charging anyone a higher share.
Elvesta's government taxes incomes, profits and spending, and the money it collects is its tax revenue. Each tax has a tax rate: the share of an income, a profit or a price that is paid in tax. The incomes, profits and spending a tax is charged on are called the tax base.
When the economy grows, people earn more, firms make more profit and households spend more. So the tax base grows. Tax revenue then rises even though no tax rate changes.
Some government spending can fall at the same time. When growth lowers unemployment, fewer people need unemployment support, so the government spends less on it.
The extra revenue can pay for better public services: the schools, hospitals, roads and water systems a government provides. It can also pay for lower tax rates, or for less borrowing (money the government owes and must repay).
This benefit is possible, not automatic. A government can spend the extra revenue badly, or on things that do not improve services. Some government spending, such as pensions (regular payments to retired people), can rise as the population ages, whatever the growth rate, and this can use up part of the extra revenue.
Real Example: In its budget (its plan of spending and taxes) for 2024-25, India's government planned capital spending of about 3.4% of GDP. Capital spending builds assets such as roads, schools and hospitals. The finance minister said this spending had tripled in four years. This shows a government planning more spending on assets such as roads, schools and hospitals. It does not show that the money comes from extra tax revenue, or how much of it is borrowed.
When every resource is in use, producing more machines and factories today means producing fewer goods for households today.
Suppose every worker and factory in Elvesta is already in use. Elvesta now wants more capital goods: machines, factories and roads, which are used to produce other goods. To make them, it must move workers, land and materials away from consumer goods, the goods households buy for their own use. So fewer consumer goods are made today.
The consumer goods given up are the opportunity cost of this growth: the next best alternative given up to get it.
On the diagram, capital goods are on one axis and consumer goods on the other. A is a point on today's frontier with more consumer goods. B is a point on the same frontier with more capital goods. Moving from A to B gives up consumer goods today.
Why accept this cost? The extra capital raises what Elvesta can produce in later years, so its frontier shifts further out than it would have. With a frontier further out, Elvesta can produce more of every good, consumer goods included, so consumption later can then be higher than it would have been. How much consumption to give up now is a judgement, not a calculation.
Growth uses other resources too. Land used for new factories cannot also be used for farms or parks. Output from longer working hours costs leisure (free time), and real GDP does not record that cost.
Real Example: For about twenty years, China has invested over 40% of its GDP each year, against a world average of about 25%. Household consumption has been about 35-40% of GDP. China invests a much larger share of its GDP than the world average, so a smaller share is left for consumer goods today. The figures show that choice, not how much it will raise consumption later.
Exam Matters: Draw two points on one frontier and label them. Then mark the consumer goods given up on the consumer goods axis, with dashed lines from both points.
Producing more can harm the environment, and real GDP does not count that harm.
As Elvesta's output grows, it burns more fuel and uses more materials. This can harm the environment in two ways:
Neither cost is subtracted from real GDP. If a factory's smoke makes people in a nearby town ill, real GDP still counts the factory's whole output and takes nothing off. In the same way, oil sold from a field adds its value to real GDP, and nothing is taken off for the oil that is now gone. So when growth pollutes, real GDP overstates the gain in welfare, how well off people are.
The link between growth and harm is not fixed. Cleaner technology, a move from heavy industry (such as steel and cement) towards services (such as banking and education, which burn far less fuel for each $1 of output), and regulation (rules that limit pollution) can cut the pollution from each unit of output. Then output can rise while pollution falls, if the pollution from each unit falls by more than output rises.
So the cost is possible, not certain. Growth based on heavy industry and fossil fuels (coal, oil and gas) is likely to be costly, but growth based on services and cleaner production need not be.
Real Example: For years, Beijing's air failed China's national air-quality standard. In 2021 it met the standard for the first time, after the city cut coal use, reduced traffic emissions and moved heavy industry out. This shows that cutting coal, cleaning up traffic and moving industry can cut a city's air pollution. Moving industry out can also move some pollution to other regions.
Exam Matters: Name the cost precisely: which pollution, or which resource is used up. Then say why the market price leaves it out.
Fast growth can make a country's imports grow faster than its exports.
In Year 3, Elvesta's exports of goods and services are worth $180bn and its imports $160bn. Its balance of trade, the value of its exports minus the value of its imports, is a surplus of $20bn. Fast growth can turn it into a balance of trade deficit (imports worth more than exports) by three routes:
Exports rose by $10bn but imports by $40bn, four times as much, so the surplus of $20bn became a deficit of $10bn. Imports rose more because they rise with Elvesta's own income, while its exports depend on incomes abroad.
Does it matter? A deficit must be paid for, by borrowing abroad or by selling assets (such as firms, buildings or land) to foreign owners. A deficit that lasts many years builds up debt and foreign ownership. Interest on the debt and the profits of foreign-owned firms then flow abroad every year, which can limit growth. It also depends on the imports: machinery raises later capacity, but consumer goods do not.
Real Example: In 2021-22, Pakistan's real GDP grew by about 6%. Its import bill rose by about 43%, and its trade deficit reached a record $48.7bn, up from $31.0bn the year before. The rise in imports came largely from record prices for oil and other commodities. So the deficit rose in a year of growth, but the figures do not show how much of it came from growth itself.
Exam Matters: Keep the direction of each effect clear: rising incomes raise imports (M up), while diverted output and higher prices lower exports (X down). In an Explain answer, take one route and give every step of it.
Growth can raise most incomes and still widen the gap between high and low incomes.
Growth raises Elvesta's average income, but incomes do not all rise equally. How income is shared between people is called the income distribution. Inequality means the gap between higher and lower incomes. To compare groups, people can be put in order of income and split into five equal groups, called fifths. The poorest fifth are the 20% of people with the lowest incomes, and the richest fifth the 20% with the highest. Inequality can widen in three ways:
In absolute terms (measured on its own), each fifth is better off. In relative terms (compared with others), the poorest fifth has fallen further behind, because its income rose by 5% and the richest fifth's by 20%.
Is this a cost? People judge their living standards partly against others. But the cost is not certain: growth that creates many jobs for lower-paid workers can narrow the gap, and so can spending on education, which helps lower-paid workers gain the skills for better-paid jobs.
Real Example: In China, the gap in income between the coastal and inland provinces (regions) widened over 1991-1999. One study links the gap partly to differences in foreign and private investment between the regions, and partly to transport costs. This is an example of the regional route: the gap between regions widened.
Exam Matters: Name the route that widens the gap (skill, ownership or region), then explain how it widens the gap.
When demand grows faster than an economy's capacity, firms run short of workers and inputs, and prices rise.
From Year 4 to Year 7, Elvesta's real output grows by 3.5% a year. Its potential output, what it can keep producing at a normal, sustainable rate, grows by only 2.5% a year. Spare capacity meets the extra demand only at first:
This is why Elvesta's inflation rises. Inflation is a sustained rise in the general price level, and the inflation rate is how fast the price level rises. Elvesta's rate climbs from 2% in Year 5 to 5% in Year 7. Inflation caused by demand growing faster than potential output is demand-pull inflation. Inflation caused by rising costs of production, such as higher wages and input prices, is cost-push inflation. In Elvesta the rise in demand starts the process, and the higher wages and input prices then add to it.
This inflation can then harm growth. Savings can lose real value, because the same money buys fewer goods, which weakens the reason to save. Elvesta's exports cost more abroad, so foreign buyers may buy fewer of them. Firms unsure of future costs may delay investment. The central bank (the institution that sets the interest rate) may raise the rate. A higher interest rate makes borrowing more expensive, so households and firms borrow and spend less, which slows growth too.
Growth that raises capacity works the other way. If output per worker rises, the same demand meets more capacity, so prices rise more slowly. So the source of growth decides whether inflation is a cost.
Real Example: In late 2022, Türkiye's central bank cut its interest rate to 10.5%, making borrowing cheaper, while prices were already rising fast. Annual inflation reached 85.5% in October 2022, the highest since 1998. A falling currency and higher energy prices were the main causes. Here the central bank did the opposite of slowing demand, and inflation still rose. Because the main causes were the falling currency and energy prices, this is mainly cost-push inflation, not inflation from growth outrunning capacity.
Exam Matters: Name the type of inflation, demand-pull or cost-push, and follow each step from the growth of demand to the price level. "Growth causes inflation" leaves out every reason.
Growth rises and falls from year to year around a long-run average, called the trend rate of growth.
Elvesta's real GDP grows faster in some years than in others: 1.5% a year at first, then 3.5%, then 1.5% again. Its potential output grows by 2.5% every year.
Trend rate of growth: the average rate of economic growth over a long period of time, which reflects the growth of productive capacity.
Put simply, the trend rate is the growth an economy can sustain year after year, because its capacity grows that fast. Elvesta's trend rate is 2.5%.
A growth rate shows how fast real GDP changes, not how much is produced. When growth slows but stays above zero, real GDP still rises, only more slowly.
Elvesta's output against its potential output, year by year, as a percentage of potential output. In Year 1, output equals potential output, so the entry is 0%:
Each row moves by about the difference between that year's growth and 2.5%. In Year 2, output grows 1 point slower than potential output, so it ends about 1% further below it. From Year 4, it grows 1 point faster, so the shortfall closes by about 1% a year, and from Year 6 output is above potential. In Years 8 and 9, growth is again 1 point below 2.5%, so the excess above potential output shrinks by about 1% a year, from +2% to 0%. Each year's change adds to the last. Over Years 2 to 9, growth is 1.5% in four years and 3.5% in four years, an average of 2.5%, the trend rate, so in Year 9 output is back on potential output, as in Year 1.
Real Example: In 2015 the IMF estimated that the potential growth of advanced economies had fallen from slightly less than 2% a year in 2006-07 to about 1.5% in 2013-14. So, by the IMF's estimate, growth of about 1.5% a year was close to how fast their capacity grew in 2013-14, but below how fast it grew in 2006-07.
Output can sit below or above potential output, and the difference between them is called the output gap.
In Year 3, Elvesta's actual output, the real GDP it produces, is $490bn, but its potential output is $500bn. In Year 7, after four years of growth above the trend rate, it produces more than its potential output. Both situations are measured in the same way.
Output gap: the difference between actual output and potential output, usually given as a percentage of potential output.
Put simply, the output gap tells you how far actual output is from the output the economy can sustain, and in which direction.
Negative output gap: when actual output is less than potential output.
Positive output gap: when actual output is greater than potential output.
Put simply, the sign shows the direction. A minus sign means idle resources: spare capacity. A plus sign means resources are used faster than is sustainable.
How can output be above potential output? Potential output is what the economy produces with its resources employed at a normal, sustainable rate. For a while, firms can go beyond that rate: workers do overtime, factories add extra shifts, and machines run without their usual maintenance. Workers tire and machines break down, so output cannot stay above potential output for long.
The sign of the gap and the growth rate are different things. In Year 3, Elvesta's gap is negative, yet its real GDP grows by 1.5%. So a negative output gap does not mean a recession (real GDP falling for two quarters in a row): output can be rising. If it rises more slowly than potential output, as in Year 3, the gap widens. If it rises faster, as in Year 4, the gap narrows.
Real Example: The IMF's World Economic Outlook publishes estimated output gaps, as a percentage of potential GDP, for major advanced economies such as Japan, Germany and Canada. Each figure carries a sign: minus for output below potential, plus for output above it. Each is an estimate, because potential GDP cannot be observed.
Exam Matters: State the gap with its sign and what it is a percentage of: "actual output is 2% below potential output" is complete, while "the output gap is 2%" leaves out the direction.
Each kind of output gap leaves its own signs in jobs, prices, factories and trade.
Picture two economies. In the first, firms cannot find enough workers, factories work night shifts and prices rise faster each month. In the second, half the factories stand idle, many people look for work, and shops cut prices to sell their stock. The first has a positive output gap; the second has a negative output gap.
Each sign comes from demand compared with capacity. When output is below potential output, firms need fewer workers than the labour force could supply, so unemployment is high. Firms with spare capacity compete for sales, not for workers and inputs, so wages and input prices rise little, and shops may cut prices to sell their stock: this is why inflation is low. When output is above potential, firms compete for scarce workers and inputs, so wages, input prices and then prices rise. With spare capacity, firms can use idle workers and machines, so output can rise without inflation.
A positive gap cannot last for long. Postponed maintenance and tired workers reduce output later. Rising inflation can also lead the central bank to raise interest rates, which makes borrowing more expensive and slows the growth of AD.
A negative gap has a different cost: output that is lost for good. Elvesta's $10bn shortfall in Year 3 is goods and services that were never produced. A long negative gap can also lower potential output, as unemployed workers lose skills and firms cancel investment. Yet it leaves room: while spare capacity remains, AD can grow faster than potential output without much inflation. This is what happened in Elvesta in Years 4 and 5, when output grew 3.5% a year against 2.5% for potential output, and inflation was 2% in Year 5. Inflation climbed once output passed potential output, reaching 5% in Year 7.
Real Example: As Singapore reopened after the pandemic, job vacancies reached a record 128,100 in the first quarter of 2022, according to its Ministry of Manpower. Record vacancies mean firms had many jobs to fill. That can be a labour shortage, one sign of demand pressing against capacity. A record number of vacancies alone does not prove a positive output gap; it is read together with inflation and the use of capacity.
Exam Matters: When data give you signs, not a gap figure, read two or three signs together before you name the gap: one sign alone can have another cause.
Actual output can be measured, but potential output can only be estimated, so every output gap is an estimate.
Actual output is real GDP, which is measured. Potential output is what the economy could produce, so nobody can observe it. It can only be estimated (worked out from evidence and assumptions). Four things make the output gap hard to measure:
Actual output is the same in all three cases. Only the estimate of potential output differs, yet it changes the advice.
Real Example: In a study published by the US Federal Reserve, two economists, Orphanides and van Norden, compared output gap estimates for the United States made at the time with later estimates. The later revisions were of a similar size to the gaps themselves. Most of the error came from the estimate of the trend, not from revised GDP data.
Exam Matters: When you evaluate, name one difficulty and say what it does to a policy decision: a gap wrongly estimated as negative can lead a government to raise demand in an economy already at potential output.
An economy can grow by using resources that stand idle, or by becoming able to produce more than before.
A rise in aggregate demand raises real output when firms have idle resources they can use to produce more.