5.5: Output gaps and unemployment rates

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Output gaps and unemployment rates are tied together. Output gaps measure the difference between actual real GDP and potential GDP. When the economy is producing potential output, employment is at the 'natural employment' rate. Any output other than potential output therefore involves an employment rate other than the full employment rate and a corresponding level of unemployment that differs from the approximately 6 to 7 percent natural unemployment rate.

Figures 5.5 and 5.6 show the relationship between growth rates in actual and potential GDP and the output gap. Negative growth rates in actual GDP in recessions, while potential GDP continues to grow, create recessionary gaps. Indeed any time growth in actual GDP differs from growth in potential GDP the output gap changes and the unemployment rate changes.

Differences between the rates of growth in actual and potential output explain the persistence of high rates of unemployment in western industrial countries in the years since the 2008 financial crisis. Real GDP and employment in both Canada and the United States have been growing since 2009. However, potential output has been growing at the same time. As a result, growth in actual GDP has not been strong enough to eliminate output gaps and restore full employment.

Figure 5.8 shows the relationship between output gaps and unemployment rates in Canada. Clearly, a rise in the output gap also involves a fall in the unemployment rate, and vice versa. Business cycle fluctuations in actual output result in predictable changes in output gaps and unemployment rates.

Figure 5.8 Output Gaps and Unemployment Rates in Canada, 1997–2016

Source: Bank of Canada, Indicators of Capacity and Inflation Pressures for Canada. Statistics Canada, CANSIM series V2062815 and author's calculations.