GDP Gap

What Is a GDP Gap?

A GDP gap is the difference between the actual gross domestic product (GDP) and the potential GDP of an economy as represented by the long-term trend. A negative GDP gap represents the forfeited output of a country's economy resulting from the failure to create sufficient jobs for all those willing to work. A large positive GDP gap, on the other hand, generally signifies that an economy is overheated and at risk of high inflation.

The difference between real GDP and potential GDP is also known as the output gap.

Understanding a GDP Gap

A GDP gap can be positive or negative and is calculated as:

( A c t u a l G D P − P o t e n t i a l G D P ) / P o t e n t i a l G D P (Actual GDP - Potential GDP)/Potential GDP (ActualGDP−PotentialGDP)/PotentialGDP

From a macroeconomic perspective, you want the smallest possible GDP gap, and preferably no gap at all.

A negative gap shows that an economy is operating at less than its full potential. It's underperforming and essentially leaving money on the table from where it should be trend-wise. Here, production and value are irretrievably lost due to a shortage of employment opportunities.

Negative GDP gaps are common after economic shocks or financial crises. The negative GDP gap, in this case, is mostly a reflection of a hesitant business environment. Companies are unwilling to spend or commit to increased production schedules until stronger signs of a recovery are present. This, in turn, leads to less hiring and perhaps even continued layoffs in all sectors.

That said, a positive GDP gap is also problematic. A large positive GDP gap may be a sign that the economy is overheated and heading toward a correction. The larger the positive GDP gap, the more likely it is that an economy is at risk of a period of high inflation at the very least.

Example of a GDP Gap

According to the Bureau of Economic Analysis (BEA), the actual GDP in the United States for the fourth quarter of 2020 was $20.93 trillion. The Federal Reserve Bank of St. Louis has its own real potential GDP in 2012 dollars. Adjusted to 2020 dollars, it projected a potential GDP of $19.41 trillion.

Running this through the formula — ($20.93-$19.41)/$19.41 — we get a positive GDP gap of about 0.8%. That is near ideal from the perspective of sustainable economic growth. However, this represents just a moment in time. Policymakers watch the GDP gap closely and make adjustments to try and keep growth in line with the long-term trend.

GDP Gaps Between Nations

The term GDP gap is also applied more simply to describe the difference in GDP between two national economies.

In recent years, an increasing amount of attention has been paid to the GDP gap between the United States, the world's largest economy in terms of GDP, and China. In 2020, this GDP gap was estimated to be around $5.9 trillion, which while significant still represents a rapid closing in by China over the last decade.

China has been making up ground since the Great Recession with its huge infrastructure investments and also bounced back quicker than the U.S. from the 2020 economic crisis. Current projections anticipate that China could overtake the U.S. economy in GDP terms by 2028. However, other economists are less convinced, arguing that an aging population and growing debt pile could keep China confined to second place.