GDP Gap

GDP gap is the forfeited output of a country's economy resulting from the failure to create sufficient jobs for all those willing to work.

A GDP gap denotes the amount of production that is irretrievably lost. The potential for higher production levels is wasted because there aren't enough jobs supplied.

A consistently large GDP gap can cause severe consequences on a country's economy – especially the labor market, long-term economic potential and the country's public finances. And the longer a GDP gap lasts, the longer the labor market will under-perform. The effect was evident in an October 2013 unemployment rate of 7.3 percent, compared with an average annual rate of 4.6 percent in 2007, before the brunt of the recession struck.

Damage inflicted on an economy’s long-term potential happens through what economists term “hysteresis effects.” In essence, idle workers and capital remain so for long stretches due to an economy operating below its capacity. This can cause long-lasting damage to workers, whose skills may atrophy or become obsolete, and thus unemployable, and the broader economy. 

An underperforming economy can result in reduced investments in areas that pay dividends over the long term, such as education, research and development. Such reductions are likely to impair an economy’s long-run potential.

A large GDP gap can lead to a struggling overall economy with a weak labor market and lost tax revenues, as unemployed or underemployed workers pay little or no income taxes, or at least less than they would have if fully employed. Additionally, a higher incidence of unemployment increases public spending on social safety-net programs. Reduced tax revenue and increased public spending both exacerbate budget deficits.

Research has shown that for each dollar U.S. GDP moves away from potential output, the U.S. cyclical budget deficits increases 37 cents. 

Okun's Law can be used to reassert this analysis. Based on regression analysis of U.S. data, it shows a correlation between unemployment and GDP. Okun's law can be stated as: For every 1 percent increase in cyclical unemployment (actual unemployment – natural rate of unemployment), GDP will decrease by β percent.

In other words:

%GDP gap = −β x %Cyclical unemployment

This can also be expressed as:

where:

• Y is actual output
• Y* is potential output
• u is actual unemployment
• ū is the natural rate of unemployment
• β is a constant derived from regression to show the link between deviations from natural output and natural unemployment.