Potential output

• 1. Introduction

  ›

  Potential output goes by a revealing nickname in economics: "natural gross domestic product." Every economy has a ceiling on what it can sustainably produce over the long run. That ceiling is not fixed by decree. Various forces conspire to keep it in place. Economists have organized those forces into categories that help explain why no economy can grow without limit forever. Knowing where that ceiling sits shapes decisions made by central banks and finance ministries alike. The distance between potential and actual output turns out to carry signals that ripple through prices, employment, and the rhythm of the business cycle.

• 2. What Sets the Ceiling

  ›

  Workers and their time, capital equipment, natural resources, technology, and management skill all impose hard limits on what any economy can produce. These limits fall into two broad categories. Natural constraints are rooted in the physical world. Institutional constraints stem from the rules and arrangements through which a society organizes its economic life. Both types combine to define how much an economy can sustainably deliver.

  Economists map this boundary using the production-possibility curve. That curve represents every combination of goods a society could produce if all its resources were fully and efficiently employed. Potential output corresponds to exactly one point on that curve. It marks the highest level an economy can maintain without overstraining the resources that keep it going. When demand for those very resources begins to press against the limits of available supply, the pressure has to register somewhere.

• 3. Inflation and Its Mirror

  ›

  In a free market economy, without wage or price controls, that pressure registers as inflation. As demand for factors of production outstrips their finite supply, prices across the economy tend to climb. The average cost curve captures this dynamic graphically. When production volume moves above the optimum quantity on that curve, the strain shows up in rising costs throughout the system.

  When actual GDP falls and remains below natural GDP, the dynamic reverses. Suppliers sitting on excess production capacity begin cutting prices to attract buyers and put idle resources back to work. Inflation decelerates. In some circumstances, prices may slide toward outright decline.

  The gap between what an economy actually produces and what it could sustain has acquired its own name. The disagreements about how to locate it accurately, and whether the tools used to find it are even valid, make up some of the most contested ground in macroeconomics.

• 4. Measuring the Gap

  ›

  Economists call the difference between potential output and actual output the output gap, also called the GDP gap. Tracking this gap is how economists assess how far an economy is from running at its natural level.

  When an economy runs at potential, its unemployment rate is expected to equal the NAIRU, short for the natural rate of unemployment. Finding the NAIRU in practice has proved harder than naming it. Genuine disagreement persists among economists about what the NAIRU actually is at any given time. Post-Keynesian economists go further still, rejecting the concept of NAIRU altogether as non-valid.

  Okun's law approaches the same question from a different angle. It examines how percentage changes in real output correspond to changes in the output gap over time. Economists also apply the gap to decompose an economy into its long-run trend and the shorter swings of the business cycle. The output gap may closely track lags in industrial capacity utilization. Factory surveys can therefore sometimes deliver an earlier read on economic slack than official GDP figures alone.