When the output gap in an economy is closing — meaning actual output is approaching or matching the economy’s potential — the room for traditional fiscal and monetary policy to make a meaningful impact begins to shrink. In such a phase of the economic cycle, both policies often lose their effectiveness, not because the tools are flawed, but because the conditions no longer warrant aggressive intervention.

Take monetary policy, for instance. Even when central banks lower interest rates in an attempt to stimulate borrowing and investment, the expected rise in credit offtake doesn’t always materialise. Why? Because when capacity utilisation is already high and demand is stabilising, businesses may see little incentive to expand further. Consumer confidence might also plateau, making households reluctant to take on new debt. Essentially, cheap money doesn’t automatically translate into real economic activity when the output gap is nearly closed.

Fiscal policy too runs into limitations. Increased public spending or tax cuts in a nearly full-capacity economy may not boost output meaningfully — instead, they risk fuelling inflation or widening fiscal deficits without proportional economic gains. Crowding out private investment or creating structural imbalances becomes a real danger at this stage.

This is where the conversation needs to shift. When the traditional levers aren’t yielding the desired outcomes, we must look to alternative strategies that go beyond short-term demand management.

One potential direction is structural reform — investing in productivity enhancements, skilling the workforce, easing regulatory bottlenecks, or improving the ease of doing business. These reforms don’t boost output overnight but can raise the economy’s potential over time, making future growth more sustainable.

Another alternative is targeted sectoral policies. For example, if credit offtake is stagnant despite low interest rates, it might signal a need to strengthen the credit delivery mechanism or improve trust and transparency in financial markets. Incentivising innovation, supporting MSMEs through non-debt instruments, or strengthening green investment frameworks can also provide fresh impetus to growth.

Finally, behavioral and psychological factors cannot be ignored. If businesses and consumers are uncertain about the future — whether due to political instability, global trends, or climate risks — they may remain cautious, regardless of supportive policies. In such cases, the role of policy must also be to build confidence, offer clarity, and create a stable environment for long-term planning.

When actual output approaches potential output, the need for stimulus policies diminishes, and the focus of fiscal and monetary policy shifts from supporting growth to maintaining stability and controlling inflation. Structural reforms then become more appropriate to promote long-term growth.

A zero or even negative output gap does and should not mean the end of fiscal or monetary policy (no policy is even not possible!). Economic policy has much more goals than simply to reach the maximum output or a long-term high growth. The main goal should be to promote a good life for the population.

By the way, I do not think that a high capacity utilization (Dr. Onkarnath's comment) means a low investment incentive. On the contrary, high capacity utilization, in general, is connected with high expected returns to investment. But maybe, that profits are high enough to finance investments without credits ("self-financing").

When both the policies have their limitations and limited role to play. You cannot forcefully expect them to deliver the better policy outcomes. You need to focus of boositng productivity. ( “In the long run, output per worker grows only because of technological progress.”) — Robert M. Solow

This highlights that capital accumulation alone cannot sustain growth; productivity improvements (technology) are key for long-term economic growth.

I would not give to much weight on Solow. His view is mainly based on the highly unrealistic neoclassical production functions, from which mainstream economics suffers since. In fact, production takes place in firms, households and institutions with different production processes with different technologies. Many firms use several technologies. Therefore, it is mostly impossible to identify a production function for a firm. An aggregate function for a whole economy is a neoclassical fantasy. Even when one can find a statistical relation between the total real factors of production and GDP, why should a firm with different relations base its decisions on such a function (which btw it, in general, does not know).

The output gap is mostly calculated by an agregate production function, and is, therefore, a rather "foggy" variable. Even if the gap is zero, and production is satisfying, there remains enough scope for fiscal policy, e.g. invest in infrastructure, education, improve health services etc.

And, what I said in my first commen: It is not possible to make no policy!

I am of the opinion that simply runing behind the both the policies to maximise the growth without taking into account other factors which will be boost your Total Factor Productivity will be like not optimally utilizing naton's resources. You cannnot ignore the importance of "Techonology"( and R. Solow) and its role in boosting the economy's capicity utilization. Focus more on increasing the" Standarad of Living the perople, Health Services, Decent job opportunities and capital utlization. You need to have trageted sectoral development approach towards growth. I don't deny both policies role. but in the above stated situation their role is limited. Govt needs to focus on other factor to support growth.

Capacity utilization (Question: Is the output gap, as it is usually calculated, really a good measure?), productivity and growth are different things. There may be a high/low/negative gap, high/low productivity and high/low/no growth etc. all combinations. Static-oriented economists would mainly look on the gap and recommend expansionary policies, when the gap is high. Those with their main focus on growth would not recommend such policies unless growth is low. We economists have a narrow horizon.

When the output gap is closing, the roles of fiscal and monetary policy should shift from being expansionary to more neutral or even contractionary to prevent overheating; both policies must be recalibrated to maintain stability, control inflation, and support long-term structural growth.

Thank you for the insight

Chuck, that is what i meant by narrow horizon.

As the output gap closes, the need for expansionary fiscal or monetary policy diminishes; instead, policymakers face the challenge of preventing overheating and inflation, making the case for tightening or neutral policies depending on labor market slack, inflation trends, and financial stability risks.

When the output gap is closing, the role of fiscal and monetary policy becomes more delicate; stimulus must be withdrawn cautiously to avoid overheating the economy, suggesting a shift from expansionary to neutral or tightening policies, depending on inflation trends, labor market conditions, and financial stability risks.

As the output gap closes, fiscal and monetary policies must gradually withdraw stimulus to prevent overheating, while focusing on structural reforms to support long-term potential growth.

When the output gap closes, the role of fiscal and monetary policy becomes more complex: excessive stimulus risks inflation, while premature tightening may stifle growth; thus, policymakers must balance stabilization with structural reforms to ensure long-term productivity and resilience.