An economy is most efficient when it is at full employment; otherwise, it has an inflationary or recessionary gap.
An economy is said to be at a state of full employment when actual output is equal to potential output or full capacity. An output gap is the difference between the maximum theoretical output of an economy and that economy's actual output. It occurs when actual output is either greater than or less than potential output, which corresponds to the natural rate of unemployment. A recessionary gap is the difference between real GDP and the potential GDP that would exist in a condition of full employment, when real GDP is lower than potential GDP. When an economy is in a recessionary gap actual output is below potential output. In the aggregate demand/aggregate supply (AD/AS) framework, a recessionary gap occurs when the actual level of output in the economy is below potential or full capacity output. In the Phillips curve model, a recessionary gap is depicted as a point along the short-run Phillips curve to the right of the long-run Phillips curve. Unused capacity for production in the economy corresponds to high rates of unemployment and lower rates of inflation.
An inflationary gap is the difference between real GDP and the potential GDP that would exist in a condition of full employment, when real GDP is higher than potential GDP. In an inflationary gap, actual output is above potential output. In the AD/AS framework an inflationary gap occurs when the actual level of output in the economy is greater than potential or full capacity output. In the Phillips curve model, an inflationary gap is depicted as a point along the short-run Phillips curve to the left of the long-run Phillips curve. Exceeding the economy’s capacity for production corresponds to low rates of unemployment and higher rates of inflation.
Governments try to use fiscal and monetary policies to maintain full employment and therefore avoid output gaps. To address a recessionary gap, the government may increase government spending and lower taxes. This results in a decrease in unemployment which, according to the short-run Phillips curve, should then increase inflation. On the other hand, decreasing government spending and increasing taxes can be used in the case of an inflationary gap. This will increase unemployment and should, therefore, reduce inflation.