What is Negative Output Gap?

Reserve Bank of India (RBI) governor Mr. Raghuram Rajan cited the negative output gap as one reason for not raising interest rates on Wednesday. ET explains the output gap concept and why its relevant in any decision relating to inflation.

WHAT IS THE OUTPUT GAP...

It's the difference between actual output of an economy measured as GDP (Gross Gomestic Production) and its potential output. This gap is positive when the economy is growing at a rate faster than the potential rate & negative when the opposite happens.

The RBI reckons Indias potential rate of growth has dropped to about 7 % from nearly 8.5 % between 2005-06 & 2007-08. Since the economy is growing at about 5 % right now, thats a negative output gap of about 2 %.

WHAT IS POTENTIAL OUTPUT..

Potential output is also referred to as the production capacity ofthe economy & sometimes as the non-inflationary rate of growth. Put simply, it is the maximum amount of goods and services an economy produces when it is working at full capacity.

Since it is not real output, it can only be estimated, which invariably leads to complexities and differences in methodologies.

WHAT ROLE DOES IT PLAY IN POLICY..

It gives policymakers an idea of how the economy is performing relative to its long-term potential. A significant variation on either side is not good. A positive gap during very high demand, when factories and employees are working overtime.

A negative gap means that demand is not enough to employ full capacity of the economy. This gives bankers an indication of how to tweak interest rates.

HOW IS IT RELEVANT TO INFLATION..

A positive gap would suggest high demand relative to capacity, leading to a tendency for prices to rise, referred to as overheating. If demand is below potential, the higher supply should tend to depress prices.

In most developed markets, central banks (Like our RBI) consider the output gap as the key determinant of inflation & alter interest rates accordingly.

WHY DID RBI NOT RAISE RATES..

In the case of India, high food prices, largely because of supply side reasons, have complicated the picture. Essentially, what Rajan has said is that prices should be falling given the negative output gap, but there is some impact due to food prices & it is best to wait for more data before taking a decision.

ET

Share: