What does "output gap" refer to?

The concept of the "output gap" is fundamentally about the difference between what an economy is currently producing and what it has the capacity to produce when operating at full efficiency, known as potential output. This gap can provide significant insights into the health of the economy.

When actual output is below potential output, it suggests that there are idle resources, such as labor and capital, indicating underutilization in the economy. Conversely, if actual output exceeds potential output, it could signal that the economy is overheating, which may lead to inflationary pressures. Thus, the output gap is a crucial indicator used by policymakers to gauge economic performance and steer fiscal and monetary policy accordingly.

Understanding this concept helps in analyzing economic recovery phases, recession signs, or inflation risks, making it a key element in macroeconomic theory. This does not pertain to the short-term vs. long-term economic growth comparison, tools for measuring inflation fluctuations, or gaps between various economic indicators, which are separate concepts.