Output Gap
Data:
Indicators of Capacity and Inflation Pressures
for Canada
THE OUTPUT GAP is the difference between the
economy's actual output and the level of
production it can achieve with existing labour,
capital, and technology without putting
sustained upward pressure on
inflation.
The output gap is also referred to as spare
capacity or excess capacity. The gap is positive
when actual output exceeds the economy's
potential and negative when actual output is
below potential output. A positive output gap is
also referred to as excess demand and a negative
output gap is referred to as excess supply.
Pressure on output must be sustainable
When spending in the economy is high in relation
to capacity, this tends to put upward pressure
on prices. Conversely, a low rate of spending
tends to put downward pressure on prices.
This relationship
can also be expressed in the reverse manner—if
the rate of inflation begins to increase, it is
typically a sign that spending levels are
approaching the economy's level of potential
output and that output growth is not
sustainable. Conversely, if the rate of
inflation is consistently below expectations,
this is a sign of continuing slack in the
economy.
The Bank is
concerned about both too much and too little
demand in the economy when either puts sustained
upward or downward pressure on prices. Thus,
when the output gap is thought to be small and
demand is seen to be increasing faster than
potential output, the Bank of Canada will
typically act to tighten monetary conditions to
curb demand and the inflationary pressures. If
the economy can be kept from overheating, then
it will be less likely that even tighter
monetary conditions will be required later to
control inflation.
Tracking the output gap
It
is obviously an important challenge for the Bank
to determine (as closely as possible) the level
of potential output, the level of actual output
at any given time, and the direction in which
they are heading in order to judge whether the
output gap is closing or growing.
Both the level of
potential output and the output gap are
estimates, and therefore there is major
uncertainty in their calculation.
This uncertainty may
be larger now because the estimated output gap
is relatively small, and the economy seems to
have undergone some significant changes during
the 1990s. As a result, the Bank now places
increased weight on a range of indicators to
assess the degree of pressure on the economy's
production capacity. These include movements in
inflation relative to expectations, the growth
of money and credit, wage pressures, and
evidence of supply bottlenecks.
The increased confidence of Canadians in ongoing
low inflation allows the Bank to gather this
additional information before taking action and
gives
monetary policy somewhat more flexibility to
accommodate demand pressures that test the
limits of the economy's capacity to produce.
January 2000
