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The output gap is a measure of the difference between actual GDP and potential GDP. Consider the following figure. Potential GDP is depicted by the blue line, and actual GDP is depicted by the red dashed line. It shows something similar to what has happened to the UK following the financial crisis. The recession caused actual GDP fall below its potential, generating a negative output gap. Often after recessions, during the recovery phase, the economy experiences a short period of high growth in which the output gap is eliminated and the growth path returns to its potential. The figure also shows this occurring. However, whether or not the economy returns to its long term potential growth path is difficult to determine. Following severe or prolonged recessions, economies are sometimes left facing a lower long term potential GDP path.

Output gaps can be both positive (actual > potential) and negative (actual < potential).

How big is the UK output gap?

According to Oxford Economics in 2014, the UK’s output gap is around 4.5%.

Yet on the 12^th of February 2014, Mark Carney, the current Governor of The Bank of England said;

‘The Committee’s (MPC) overall assessment is that spare capacity of 1 – 1½ % of GDP remains concentrated in the labour market.’

This is very interesting; it could suggest that the Bank of England holds the position that the UK economy has experienced a reduction in its long term growth potential.

The following figure depicts this. The most likely case is that the large and persistent output gap the economy has experienced in the last 5-6 years has inflicted upon the economy a phenomenon known as hysteresis. Effectively, the impact of workers and capital remaining idle for long stretches as the economy operates below capacity has caused long-lasting damage.

Policy Implications?

The Governor’s speech highlighted the labour markets as a candidate for the structural change and this could be a cause for concern for HM Treasury if this translates to a prolonged higher rate of unmeasured unemployment – due to workers permanently exiting the labour force. Naturally, this would lead to forgone tax revenues and a higher spending requirement on unemployment assistance.

However, the official inflation document did shed some light on the Bank of England’s view, which suggests the issues likely lie not with the quantity of labour, but the quality;

‘The recent weakness in productivity growth has nevertheless caused the Committee to revise down its judgement of the likely strength of the response of productivity to higher demand’

‘The precise timing and extent of the recovery in productivity is highly uncertain, and this uncertainty inevitably carries over into the outlook for policy. If the recovery in productivity is more (less) rapid than expected, Bank Rate could rise more (less) slowly’

‘Labour productivity growth has been unusually weak since the 2008/09 recession, such that productivity in 2013 Q3 was around 16% below the level implied by an extrapolation of its pre-crisis trend’

The final point about the extrapolation of its pre-crisis trend is key. The 16% productivity gap would imply a much larger output gap than the 1.5% that the Governor announced. The Bank does not indicate that this productivity differential will be recovered anytime soon, although in 2015Q3 there was at last signs of productivity improvement of 1%.

Therefore, two conclusions can be drawn. First, it is likely that the output gap has in fact been revised from around 4-5% to 1-1.5% implying that The Bank of England does in fact hold the view that the long run potential of the economy has been reduced by the recession. And second, that this revision is driven by a belief that a negative productivity shock has occurred.

Although a shock to productivity can be extremely damaging, and has widespread implications for the economy (particularly as it is the key determinant of real wage growth), history tells us that the loss can be clawed back. Take the example of the railways in Victorian Britain, or more recently, computerisation, and consider the direct growth in productivity and the spill-over effects that came as a result. It is likely that some positive technological shock will occur in the future which will lead to an increase in productivity and indeed even raise the long-term potential beyond that implied by the pre-2008 counterfactual.

– See more at: http://www.constructionproducts.org.uk/blog/v/view/uk-economyunderstanding-the-output-gap-and-its-impact/#sthash.uwu8yifD.dpuf