Homework: Output Gap & Declined Demand

This post contains my answer to the following question:

“The immediate problem facing the UK economy is a large output gap and decline in aggregate demand. So - what can be done? ”

If I interpreted the given source correctly, an output gap occurs when the actual output is not equal to the potential output. We speak of a negative output gap if the actual output is bellow the potential output and we speak of a positive output if the actual output is above the potential output. In a production possibility curve, this would be shown as the following:

In this diagram, point C would be indicating a negative output gap and point D would be indicating a positive output gap. It seemed worth mentioning that points A and B are indicating cases of potential output (the line on which they are situated).

Once again, If I interpreted the given source correctly, I don’t see any problems to our economy if there is a negative output gap combined with a decline in aggregate demand. As the aggregate demand declines, people consume less. If that’s the case, there is no need for an optimal efficiency in output. As long as the total output meets the aggregate demand, things are fine!

When a positive output gap occurs in combination with a decline in aggregate demand, we are producing more than we need. This could cause problems. If the producers have a surplus of their product and are not able to sell them (as the aggregate demand goes down) the supply is too big. This could cause major deflation. Unless the economy is operating near full employment (which seems barely plausible when demand is declining), a deflation as result of demand pull goes hand in hand with an decrease in real GDP. This means the economy faces a negative economic growth, if the decrease sustains for two consecutive quarters. There is no need to tell that this is dangerous / bad for an economy.

One of the solutions I’ve come up with is for the government to stimulate the exports of its’ nation. That way, the surplus in products can be resolved, even though it’s combined with a decline in aggregate demand. The government can stimulate exports by giving subsidies on exporting companies, or by reducing taxes on exports. If the government stimulates exports, the problem might be resolved.