Output Gap is the difference between the actual GDP and the potential output (the maximum GDP that can be obtained by full utilization of all the resources) of an economy. In other words, it is the difference between what the economy is producing and what it can produce.
Output Gap can be both positive and negative. It is positive when the actual output exceeds the full-capacity output. This happens when demand is more than supply, and factories and workers work beyond their potential to bridge the gap. Similarly, it can be negative when the actual output is less than the full-capacity output. A negative gap indicates low demand in the economy. A positive gap can lead to inflation while a negative gap encourages disinflation. 
A stable predictive relationship between inflation and output gap provides the basis for many formulations of countercyclical stabilization policy. Such a relationship, referred to as a Phillips curve, is often seen as a helpful guide for policymakers aiming to maintain low inflation and stable economic growth. However, the exact empirical relationship between the gap and inflation is not deductible, and has to be derived from existing data. Additionally, even if the relationship was identified, the operational usefulness of the output gap will remain limited by the timely and reliable estimates of the identified concept.
Multiple methods have been developed to calculate potential output and output gap. However, according to many economists, none of the methods are satisfactory. The problem arises from the fact that neither is directly observable, and has to be inferred from existing data using statistical and econometric methods. The problem is compounded by the fact that there is increasing evidence suggesting output series are best characterized as integrated series. Thus, the presence of stochastic component doesn’t allow potential output and output gap to be treated as deterministic components.
Output gap provides an indication of potential inflationary pressures within the economy, giving it a potentially important role in the conduct of monetary policy. However, a number of studies have argued that the size of the revisions made to real-time estimates of the output gap are such that direct information about the output gap should be disregarded, with the extent of underlying demand pressures instead being inferred from real or nominal GDP growth, the acceleration in the inflation rate, or the behavior of domestic costs. Such approaches carry the disadvantage that they neglect potentially useful supply-side information that might affect judgments about the current state of the economy and potential developments.
Relationship with crises
Economic crises make significant impressions on output gap. Labor, capital, and resources experience a descent, and thus bring down with them what an ideal application of their combination can produce. Although, potential output takes a dive as well with the actual output, the distance between them is larger than before, resulting in a negative gap. In the recent recession, the output gap has been estimated to have dropped to as low as -6.2%, according to the CBO estimate, despite the fact that no drop in productivity was observed and rather an above-trend rate increase was found.
- The Reliability of Inflation Forecasts Based on Output Gap Estimates in Real Time by Athanasios Orphanides and Simon van Norden
- Measuring Potential Output and Output Gap and Macroeconomic Policy: The Case of Kenya by Angelica E. Njuguna, Stephen N. Karingi, and Mwangi S. Kimenyi
- Orphanides and Williams, 2002; Rudebusch, 2001
- Leitemo and Lønning, 2006
- Horn et al., 2007