The GDP gap is the difference between potential gross domestic product (GDP) and actual GDP. Potential GDP is defined as the maximum amount an economy could produce while maintaining reasonable price stability; it also is sometimes called the high-employment level of output. Actual GDP is the measure of a country's output at any given time, and it fluctuates with business cycles. The gap between the actual and potential GDP is often thought of as the amount of potential output lost by the economy's failure to provide jobs to all willing workers.
During times of recession, the GDP gap grows and unemployment increases. The productivity of workers willing but unable to find jobs is irrevocably lost to the economy. This loss of output has been used by economists and politicians as a reason to employ Keynesian economic policies.
The term is usually used in economics to refer to the relationship between actual and potential GDP, but it is often blended with recessionary gaps and expansionary gaps. Rather than comparing actual and potential GDP, one could compare actual to natural GDP, or the level of output for which there is zero inflation and zero deflation. If actual GDP is larger than natural GDP, the economy is producing lots of goods and services and employing lots of workers. As a result, the unemployment rate is below the natural rate of unemployment and inflation speeds up. This is known as an expansionary gap.
On the other hand, when actual GDP is smaller than the natural figure, the economy is producing less and employing fewer workers. As a result, the unemployment rate is higher than the natural rate of unemployment and inflation slows down. This is known as a recessionary gap. The term GDP gap can accurately be used to refer to either the gap between actual and potential GDP or the gap between actual and natural GDP.
The relationship between output and unemployment has long been a topic of interest to economists. Economist Arthur Okun introduced a mathematical representation of the relationship between unemployment and GDP that is commonly referred to as "Okun's Law" or "Okun's Rule of Thumb." Based on regression analysis of data from the United States, Okun suggested that a 1-point increase in the unemployment rate is associated with 2 percentage points of negative growth in real GDP. While straightforward and easy to understand, the accuracy of Okun's law has been disputed by other economists.
