What it is:
GDP gap refers to the disparity between an economy's actual total output and its possible total output.
How it works/Example:
A country's GDP gap is mathematically expressed in the following way and serves as an indicator of where an economy stands in the business cycle:
Gap = Actual – Potential
Measured as an indication of the number of jobs in an economy (labor productivity) a positive gap value indicates an expansion. This means there is still room for the economy to expand, because demand is growing faster than supply and the economy is overproducing with its current resources. This means full employment is exceeded and there is a demand for more workers. Conversely, a negative gap value indicates that an economy is underproducing with its current resources, and the economy is not at full employment. Therefore, there are recessionary pressures. A gap value of zero indicates that an economy is operating at its full capacity and at its most efficient point.
To illustrate, suppose a country's actual GDP is $1 billion and that its potential GDP is $850 million. The gap of $150 million indicates that the country is likely in a period of expansion and probably has a shortage of workers.
Why it matters:
The GDP gap indicates how efficiently a country is using its productive resources (i.e. aggregate capital assets, raw materials, capital funds, etc.). It also reflects, in terms of expansion, the amount of productive opportunity lost due to employment deficits.
In general central banks and governments try to keep the GDP gap as small as possible, because both positive and negative values indicate inefficiency. Both monetary policy and fiscal policy are used to moderate consumption and investment levels. In macroeconomic theory, positive GDP gaps can indicate inflation and negative gaps can indicate recessions.