Q. Consider the following statements regarding the “output gap”:
1. It refers to the difference between the actual output of the economy and its maximum potential.
2. It is used by policy makers to gauge inflation.
Which of the statements given above is/are correct?

[A] 1 only

[B] 2 only

[C] Both 1 and 2

[D] Neither 1 nor 2

Answer: C
Notes:

The output gap is an economic measure of the difference between the actual output of an economy and its potential output.  

  • Potential output is the maximum amount of goods and services an economy can turn out when it is most efficient—that is, at full capacity.  
  • Often, potential output is referred to as the production capacity of the economy.­ 
  • Policymakers often use potential output to gauge inflation and typically define it as the level of output consistent with no pressure for prices to rise or fall.  
  • In this context, the output gap is a summary indicator of the relative demand and supply components of economic activity.  
  • As such, the output gap measures the degree of inflation pressure in the economy and is an important link between the real sides of the economy—which produces goods and services—and inflation.  
  • All else equal, if the output gap is positive over time, so that actual output is greater than potential output, prices will begin to rise in response to demand pressure in key markets.  
  • Similarly, if actual output falls below potential output over time, prices will begin to fall to reflect weak demand.­ 

Source: Economic Survey