The table below shows Solavia's actual real GDP index and its estimated potential (trend) real GDP index for three years (Year 1 =100 for both series). Potential output is the level of real output Solavia's economy could sustainably produce if all its factors of production were…

Answer: ((a)) Actual real GDP growth is +5% from Year 1 to Year 2, and -5% from Year 2 to Year 3 ((b)) The output gap is 105.00-102.00=+3.00 index points in Year 2, a positive output gap, and 99.75-104.04=-4.29 index points in Year 3, a negative output gap ((c)) A negative output gap means Solavia's actual output in Year 3 is below the level it could sustainably produce, so there is spare capacity, meaning some factors of production, including labour, are not fully employed; this is likely to raise cyclical (demand-deficient) unemployme… ((d)) A positive output gap means actual output exceeds the economy's sustainable capacity, so firms are producing beyond normal capacity, for example through overtime or fuller use of ageing equipment, which tends to push up costs and prices, so it is associated with rising demand-pu…. Part (a): Actual real GDP growth rates Percentage change uses the earlier year's index as the base: % Real GDP1→2 = 105.00-100.00/100.00×100 = +5% % Real GDP2→3 = 99.75-105.00/105.00×100 = -5.25/105.00×100 = -5% Solavia's actual real GDP g…

AS Level Economics 9708: Actual vs Potential Growth and the Output Gap

Year	Actual real GDP index	Potential (trend) real GDP index
Year 1	100.00	100.00
Year 2	105.00	102.00
Year 3	99.75	104.04

Year

Actual real GDP index

Potential (trend) real GDP index

Year 1

100.00

Year 2

105.00

102.00

Year 3

99.75

104.04

Part (a): Actual real GDP growth rates

Percentage change uses the earlier year’s index as the base:

$\%\Delta \text{Real GDP}_{1\to2} = \frac{105.00-100.00}{100.00}\times100 = +5\%$

$\%\Delta \text{Real GDP}_{2\to3} = \frac{99.75-105.00}{105.00}\times100 = \frac{-5.25}{105.00}\times100 = -5\%$

Solavia’s actual real GDP grew by $5\%$ from Year 1 to Year 2, then fell by $5\%$ from Year 2 to Year 3.

Part (b): The output gap in Year 2 and Year 3

The output gap is the difference between the actual real GDP index and the potential real GDP index in the same year:

Year 2: $105.00 - 102.00 = +3.00 \text{ index points}$

This is a positive output gap: actual output is above potential (sustainable) output.

Year 3: $99.75 - 104.04 = -4.29 \text{ index points}$

This is a negative output gap: actual output is below potential (sustainable) output.

Part (c): What the negative output gap in Year 3 indicates

A negative output gap means Solavia’s economy is producing less than it is capable of producing on a sustainable basis. This indicates that there is spare capacity in the economy. Some factors of production, including workers and machinery, are not being fully utilised, even though the economy’s underlying productive capacity (shown by the still-rising potential output index) has not itself declined.

For unemployment, this spare capacity is likely to show up as higher cyclical (demand-deficient) unemployment: with actual output falling short of potential, firms require fewer workers than the economy could otherwise support, so workers are laid off or hours are cut back until aggregate demand, and therefore actual output, recovers.

Part (d): Why the positive output gap in Year 2 is unsustainable

In Year 2, actual output ( $105.00$ ) exceeded potential output ( $102.00$ ), meaning the economy was producing more than it can sustainably produce. This can only happen in the short run, for example through workers doing overtime, machinery being run more intensively, or older/less efficient capacity being brought back into use. Because resources are being used beyond their normal, sustainable capacity, firms’ costs of production tend to rise (for example through overtime pay or a need to bid up wages for scarce skilled labour), which pushes up prices. A positive output gap is therefore associated with building demand-pull inflationary pressure. Since factors of production have practical limits, output cannot be held above potential indefinitely without inflation accelerating, so a positive output gap is inherently temporary.

Final answers

(a) Real GDP growth: Year 1–2 $=$ $+5\%$ , Year 2–3 $=$ $-5\%$
(b) Output gap: Year 2 $=$ $+3.00$ (positive), Year 3 $=$ $-4.29$ (negative)
(c) A negative output gap indicates spare capacity, likely raising cyclical unemployment
(d) A positive output gap means output exceeds sustainable capacity, building demand-pull inflationary pressure, so it cannot last indefinitely