Explain the main problems for an economy of having a large positive output gap.

June 2022 15 Mark Model Answer

A positive output gap is when the actual rate of economic growth is greater than the trend rate of economic growth, which relates to the capacity of the economy. Economic growth is when there is an increase in real GDP. A positive output gap would mean there is high inflation.

One problem with high inflation is a wage price spiral. Inflation is when average price level is rising, and this usually happens whilst wages stay low and stable. If this happens, people have lower disposable incomes so they may as for higher wages. If they do not get higher wages, then living standards and welfare would fall, and so would confidence. If firms accept to pay higher wages, they may raise prices further or they may lay off workers, which causes more problems.

Another problem with high inflation is that it would worsen the balance of payments on the current account. If prices are rising rapidly in the UK, whilst staying low and stable in other countries, then UK consumers and firms would stop spending money in the UK where possible and import goods and services instead. Similarly, consumers in other countries would stop buying goods and services from the UK, which is getting expensive, so UK exports would fall. The trade balance is made up of the value of exports minus the value of imports, and this would worsen. Maintaining a balance of payments on the current account is one of the main four macroeconomic objectives.