Welcome Back to Basics. 

What Is Potential Output?

Potential Output is an estimate which shows the maximum amount of goods and services and economy can produce at its full capacity (or when it is more efficient).

Potential output is a benchmark for the level of output against which actual output can be compared.

The potential GDP are determined by Inflation, Production, Availability of Natural resources, and Infrastructure.

Factors affecting potential GDP are Supply of Labour, Quality of Human Capital, Capital Stock, Technological Advancements, and Availability of Natural resources.

What is Output Gap?

The Output Gap is an economic measure which shows the difference between actual output of an economy and its potential Output. This is normally expressed in terms of percentage of potential output.

Output Gap = (Actual Output-Potential Output)/(Potential Output)  ×100

A negative output gap occurs when actual output is less than or below Potential Output. This means that there is more capacity to utilise and it is not utilising it. In other words, there is underutilisation of resources in the economy. This may be due to weak demand.

When actual output is higher than the potential output then there is a positive output gap – though it is a rare case. At this stage the economy is overachieving than its potential. This may be feasible in short run but not sustainable over time.

Whether an economy is running at an efficient or inefficient rate – in other words whether it is underutilising its resources or overachieving its potential – is expressed in terms of output gap.

The determinants of output gap are unemployment, difficulties in hiring, capacity utilisation, productivity growth, and inflation.

The output gap is one of the indicators policymakers look at while making policies (esp. Monetary Policy).

Why potential output matters?

When economy is growing faster than potential output (positive output gap) then it means that demand is above the potential output and there is inflationary pressure. Whereas, when the demand is growing slower than the potential output, then economy is growing slower than its potential output (negative output gap). In the first case (i.e. positive output gap), the Central Bank will increase interest rates to moderate inflationary and demand pressures and in the latter case (i.e. negative output gap), the Central bank will reduce interest rates to stimulate demand. Though this may sound very easy policy adjustments in reality it is not so; as the policy adjustments are dependent on various factors.

It is important for Central Bank policymakers to understand Potential Output for their policy adjustments, so that they can deliver price stability, sustainable employment and growth for an economy. By having an almost accurate or good estimates of potential output, the Central Bank can project the output gap. This will help the fiscal policymakers to anticipate the need of fiscal stimulus or restrain for an economy.   

An economy can grow faster only to the limit of its potential output grows. Potential Output is a like safest speed limit for economic growth. When there is too much of Government spending then it increase demand more than economies capacity to produce, this will result in inflation

Though the concept of potential output seems to be simple, it is not possible to observe potential output rather it can only be inferred or estimated from economic data/information available. It requires valuable judgement to observe the path of potential output and cyclical fluctuations.