OUTPUT GAP: IN economic terms output gap is the difference between actual output of an economy- measured in GDP terms- and its potential output. Before understanding Output gap, lets understand what is Potential Output.
Potential Output:- means production capacity of the economy and some times it is referred to as non-inflationary rate of growth. Simply saying, it is maximum amount of goods and services an economy produces when it is working at its full capacity. It is not real output, it is estimating what an economy can produce.
Coming back to Output Gap:- Output Gap is difference between actual output of an economy and its potential output. The gap is positive when economy is growing at a rate faster than then potential rate. The output gap is negative if economy is growing slower than the potential rate of growth. During the year 2013-14 Indian economy has potential rate of growth of 7% whereas economy is growing nearly 5%, meaning that it was growing with a negative gap of 2%.
NEGATIVE GAP: means economy has potential to produce more goods and services but is producing lower than its potential. It implies that demand is not very high and workers/machines/economy are not working to their full capacity.
POSITIVE GAP: when economy is growing at a rate more than potential rate, implies that demand is higher than production capacity of the economy.
It can be further inferred that if there is inflation alongwith Negative Gap, the inflation is Cost push Inflation. If there is inflation in Positive Gap, it is Demand pull inflation.