What does the term "output gap" refer to in economics?

The term "output gap" is defined as the difference between actual GDP and potential GDP. Actual GDP represents the real output of an economy at a given time, reflecting the current level of economic activity. In contrast, potential GDP refers to the maximum level of output the economy can achieve when operating at full efficiency, without causing inflation.

When actual GDP is less than potential GDP, it indicates an economy is underperforming and there are unused resources, such as labor and capital, leading to unemployment and inefficiency. This situation creates a negative output gap. Conversely, when actual GDP exceeds potential GDP, it can lead to overheating in the economy, which often drives inflation as demand exceeds supply. Understanding the output gap helps economists assess economic performance and make policy recommendations aimed at stabilizing the economy.