The Output Gap: Consequential, but Inherently Uncertain
The difference between an economy’s actual and potential output (i.e. were the economy running at full capacity). A measure of economic spare capacity that macroeconomic policy has to work with that can have important implications for fiscal policy settings.
‘New Keynesian’ economic theory identifies a possible ‘output gap’, where market imperfections prevent an economy attaining its trend growth potential. This reinforces the role for macroeconomic economic management to bring output closer to full employment. Managing the level of aggregate demand is an important goal here, with fiscal and monetary policy interventions seeking to stabilise the economy at or around full capacity.
Across a five year OBR forecast horizon, the anticipation that the economy will tend to recover an efficient equilibrium (closing the output gap) remains a default position. This reflects assumptions that the economy that returns to a steady-state.
Different respected forecasters and Economists can gauge the output gap in a variety of ways. ‘Measuring’ such unobservable concepts requires ancillary assumptions (for example about productivity’s evolution), and the selection of techniques from amongst a range. There is not one canonical approach to understanding of assessing the output gap, nor an agreed or unproblematic method. The choice of one or other approach to output gap assessment, is, Economists (including those at the OBR) recognise, somewhat arbitrary. The output gap has taken centre stage in anchoring fiscal rules since the 1990s, yet in this era output gaps have become especially difficult to gauge. The OBR underline the key role for expert judgement in divining the future path of the output gap.