Potential output and trend growth; the output gap as actual output cycling around trend, positive gaps and inflation, negative gaps and spare capacity; the accelerator principle I = vΔY and why investment turns before output; how the OBR estimates the gap and why the estimate keeps moving. Through the October 2026 forecast.
On 28 October 2026 the Office for Budget Responsibility published its Economic and fiscal outlook. Its central estimate was that UK GDP stood just over 1% below its potential level, compared with a positive gap of about 2% at the start of 2022, when the labour market was tight and inflation was taking off. For 2026 and 2027 together it now expected an average gap of −1.1%, against −0.7% in its March forecast, as higher interest-rate expectations and an energy price shock weighed on demand while potential output growth slowed from about 1.5% to about 1%.
The OBR does not measure potential output; nobody can. It runs a range of models, statistical filters on GDP, surveys of capacity utilisation and relationships with inflation, and takes a central view. That view decides how much of the deficit is structural, how much spare capacity the Bank of England can see, and how quickly growth can run before prices respond. This lesson is about the gap, how it opens and closes, and why investment swings so much more than output.
Source: Office for Budget Responsibility, Economic and fiscal outlook, October 2026 (Chapter 2, output gap) and March 2026.
Potential output (trend output) is the level of real GDP the economy can produce when labour and capital are fully employed at a sustainable rate, without inflation accelerating. It grows with the labour force, the capital stock and productivity: trend growth, about 1.5% a year in the UK in the 2010s and in the OBR’s current forecasts. Actual output fluctuates around it with the business cycle.
The output gap is actual output minus potential output, as a percentage of potential. A positive gap means demand has outrun sustainable capacity: overtime, shortages, rising prices. A negative gap means spare capacity: unemployment above its natural rate, idle plant, weak pricing power. The accelerator principle says that firms’ investment depends on the change in output, not its level: to produce more they need more capital, so I = v × ΔY, where v is the capital–output ratio. It explains why investment is the most volatile part of aggregate demand and why booms turn before output falls.
In October 2026 the OBR estimated that UK output was about 1% below its potential, against 2% above it at the start of 2022.
Potential output is what the economy could produce with its labour and capital fully but sustainably employed. Nobody can observe it directly: the OBR runs a swathe of models and takes a central estimate.
If output is 1% below potential, what does that suggest for inflation and policy?
A negative gap means slack: unemployed workers and idle machines. A positive gap means overheating. The OBR’s March 2026 estimate for the same two years was −0.7%; by October it was −1.1%. The number matters for policy and is never quite known.
The grey line is potential output, growing at the trend rate of 2% a year: index 100 in year 0, about 122 in year 10. It is a ceiling only in the sense that output cannot stay above it for long without inflation. It is also unobservable, which matters later. Everything the economy does in the short run is measured against this line.
Check: Potential output grows 2% a year from an index of 100. After 10 years it is about:
Growth compounds. The trend line on the diagram curves very gently upward for this reason, though at 2% a year it looks almost straight.
The dark line is actual output, cycling around trend. In year 2 it is 6% above: a positive output gap. Firms are working overtime, unemployment is below its natural rate, and there are shortages and rising prices. This is the 2022 position, when the OBR put the UK gap at about +2% and inflation went to 11%. A positive gap is an inflationary gap: it cannot last.
Check: In year 2 actual output is 110.3 and potential output is 104.0. The output gap is:
(110.3 − 104.0) ÷ 104.0 = 6.0%. Always divide by potential, not by actual, and give it as a percentage.
By year 6 actual output is 6% below trend: a negative output gap. Output is barely lower than in year 2, which is the point students miss: the economy has stood still while capacity grew. Unemployment rises above its natural rate, firms have idle machines and cut prices to fill them. Policy can expand demand to close the gap without much inflation. This is the OBR’s 2026 reading, at about −1%.
Teacher tip: Ask what the gap was in year 4, where the lines cross. Zero: output at potential, which is where policy aims, not the peak of the boom. Students often treat the top of the cycle as the goal.
Check: In year 6 actual output is 105.9 and potential output is 112.6. The output gap is about:
(105.9 − 112.6) ÷ 112.6 = −6.0%. Output is only a little lower than in year 2, but potential has grown and the economy has fallen behind it.
The accelerator. Output grows by 2, 4, 4, 2, then 0. With a capital–output ratio of 3, firms need 3 of new capital for each 1 of extra output, so induced investment is 6, 12, 12, 6, 0. In year 4 output is still rising, yet investment halves; in year 5 output merely stops growing and investment vanishes. Investment turns down before output does, which is why it leads the cycle.
Check: The capital–output ratio is 3. Output rises by 4 in year 2 and by 2 in year 4. Induced investment:
I = vΔY = 3 × 4 = 12, then 3 × 2 = 6. A slowdown in growth, not a fall in output, is enough to halve investment.
Put the two together. Rising demand induces investment; the multiplier turns that investment into more income; more income induces more investment. The boom ends when growth slows, not when it stops: investment falls, the multiplier works in reverse, and a negative gap opens. That is the shape of the cycle on this diagram, and the reason recessions follow booms rather than arriving from nowhere.
Check: The accelerator and the multiplier together help explain the business cycle because:
The interaction amplifies the cycle in both directions: a slowdown in growth cuts investment, the multiplier cuts income, and the negative gap opens.
Trend output is drawn flat at 100. Potential output grows over time as the labour force, capital stock and productivity grow: about 1.5% a year in the UK. With a flat trend the student would read year 10, where output is 29% above 100, as a huge positive gap, when it is 6%. The gap is measured against a rising ceiling.
Evaluate the usefulness of estimates of the output gap as a guide to macroeconomic policy.
The output gap is actual output minus potential output as a percentage of potential, where potential is the level the economy can sustain with labour and capital fully employed without inflation accelerating. On a diagram actual output cycles around a rising trend line; where it is above, as in 2022 when the OBR put the UK gap at about +2%, demand has outrun capacity and inflation follows; where it is below, as in October 2026 when the OBR estimated about −1%, there is spare capacity and demand can be expanded without much inflation. The gap therefore tells policymakers which way to lean: a negative gap argues for lower interest rates or looser fiscal policy, a positive gap for the reverse. It also separates the structural from the cyclical deficit, so fiscal rules that target the structural balance depend on it directly.
**However,** potential output cannot be observed. The OBR estimates it from a swathe of models, statistical filters, surveys of capacity utilisation and relationships with inflation, and the answers move: its estimate of the average gap over 2026 and 2027 went from −0.7% in March 2026 to −1.1% in October, a revision as large as the gap itself. After 2008 estimates of potential were cut again and again as the lost output proved permanent, so a policymaker reading the early figures would have seen a much larger negative gap than existed and risked inflation by closing it. Supply shocks compound the problem: the 2026 energy price rise lowered potential as well as demand, so part of the fall in output was not a gap at all. The accelerator makes timing harder still, since investment falls when growth merely slows, so a gap can open before the data show it.
On balance the output gap is indispensable and unreliable at once. There is no coherent way to judge whether demand is too high or too low without some estimate of what the economy can supply, and both the Bank of England and the OBR build their forecasts on one. But the estimate should be used as a range rather than a point, checked against observable indicators such as vacancies, wage growth and inflation itself, and revised without embarrassment. The mistake is not using the output gap; it is treating a central estimate as a measurement.
Output gap figures: Office for Budget Responsibility, Economic and fiscal outlook, October 2026 (output gap about −1.0% of potential output at the start of 2026 against +2.1% at the start of 2022; average −1.1% over 2026 and 2027, revised from −0.7% in March 2026; potential output growth about 1.5% in 2026 and about 1% in 2027) and March 2026. The output path and investment figures on the diagrams are invented. Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed.