How is output gap defined?

The output gap is defined specifically as the difference between potential GDP and actual GDP. Potential GDP represents the maximum output an economy can achieve when operating at full capacity, reflecting optimal utilization of resources without sparking inflation. Actual GDP, on the other hand, represents the real-time production levels of an economy, which can fluctuate due to various factors like demand shocks, changes in consumer confidence, and economic policies.

When the actual GDP is below potential GDP, the output gap is negative, indicating that the economy is underperforming and not utilizing its resources efficiently. Conversely, if actual GDP exceeds potential GDP, the output gap is positive, suggesting that the economy is operating above its sustainable capacity, which could lead to inflationary pressures.

This definition is crucial in macroeconomic analysis as it helps policymakers identify the state of the economy, guiding decisions on fiscal and monetary policies to steer the economy towards full employment and stable growth.