Actual growth and long-run trend growth

Actual growth rate

The actual growth rate is the annual percentage change in real GDP. It shows how the economy is performing right now, so it can rise or fall because of short-run changes in aggregate demand (AD) or short-run supply conditions.

Actual growth is often affected by demand shocks (e.g. a fall in confidence, a boom in credit) + supply shocks (e.g. energy price spikes) . More volatile .

Long-run trend growth rate

The long-run trend growth rate is the average sustainable rate the economy can grow at over time without causing accelerating inflation. It depends on the growth of the economy’s productive capacity, so it is driven by long-run aggregate supply (LRAS) shifting right over time. 

Trend growth is mainly driven by supply-side factors such as productivity improvements ,(technology, better management) ,growth in the labour force and higher capital investment

Using a trend helps smooth out unusual one off years (“outliers”), so you get a clearer view of underlying performance. 

Output gaps

What an output gap is

An output gap is the difference between actual output (real GDP) and potential output (the maximum level of output).

Negative output gap (spare capacity)

A negative output gap happens when actual GDP is below potential GDP (Y < YFE). This means the economy is producing less than it could, so resources are underused (spare capacity) .

What it often looks like in the real world:

• Rising unemployment

• Weak demand and slow growth

• Disinflation (inflation falling) or deflation risk

Negative output gap on the AD/AS diagram

A negative output gap exists when the short-run equilibrium level of output is to the left of full-employment output (Y1 < YFE).

Diagram analysis : 

• The economy is in short-run equilibrium where AD intersects SRAS at Y1 with price level PL1.

• Potential output is shown by YFE (full-employment output).

• The output gap is the horizontal distance YFE − Y1, showing spare capacity (same on the LRAS)
  

Positive output gap (overheating)

A positive output gap happens when actual GDP is above potential GDP (Y1 > YFE). This means the economy is overheating and running above its normal capacity, so inflationary pressure tends to build.

What it often looks like in the real world:

• Rising inflation (especially demand-pull)

• Labour shortages and skills bottlenecks

• Firms using overtime / pushing machines harder (temporary, not sustainable)

Positive output gap on the AD/AS diagram

A positive gap exists when the short-run equilibrium is to the right of full-employment output (Y1 > YFE).

Diagram analysis : 

• Potential output is YFE (full-employment output).

• The economy is in short-run equilibrium where AD intersects SRAS at Y1 with price level PL1.

• The output gap is the horizontal distance Y1 − YFE.

• This can happen because firms temporarily push beyond normal capacity (overtime, intensity of work, short-term utilisation), but it can’t last.
  

Lastly, you can only show a positive output gap on the neoclassical LRAS , you cannot show a positive output gap on a keynesian LRAS .

Why output gaps are difficult to measure

The big issue is that potential output cannot be observed directly. It has to be estimated, so any output gap number is partly a judgement/opinion .  

Common Measurement Problems

• Revisions to GDP Data: Subsequent updates can flip a previously perceived positive output gap to a negative one (or vice versa).

• Structural Change: Shifts in technology, demographics, and labor participation alter potential output .

• Temporary vs. Permanent Effects: It is difficult to distinguish whether a shock has merely lowered demand or caused lasting damage to productive capacity.