In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (output) that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints. If actual GDP rises and stays above potential output, then (in the absence of wage and price controls) inflation tends to increase as demand for factors of production exceeds supply. This is because of the limited supply of workers and their time, capital equipment, and natural resources, along with the limits of our technology and our management skills. Graphically, the expansion of output beyond the natural limit can be seen as a shift of production volume above the optimum quantity on the average cost curve. Likewise, if GDP is below natural GDP, inflation will decelerate as suppliers lower prices to fill their excess production capacity.
Potential output in macroeconomics corresponds to one point on the production possibilities frontier (or curve) for a society as a whole, reflecting natural, technological, and institutional constraints.
Potential output has also been called the "natural gross domestic product." If the economy is at potential, the unemployment rate equals the NAIRU or the "natural rate of unemployment." There is great disagreement among economists as to what these rates actually are.
Generally speaking, most central banks and other economic planning agencies attempt to keep GDP at or around the natural GDP level. This can be done in a number of ways: the two most common strategies are expanding or contracting the government budget (fiscal policy), and altering the money supply to change consumption and investment levels (monetary policy).
The difference between potential output and actual output is referred to as the output or GDP gap, which may closely track measures of industrial capacity utilization. Potential output has also been studied in relation Okun's law as to percentage changes in output associated with changes in the output gap and over time. and in decomposition of trend and business cycle in the economy relative to the output gap.
- Roger Betancourt, 2008. "capital utilization," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- Jesús Crespo Cuaresma "Okun's Law," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
- Charles R. Nelson, 2008. "trend/cycle decomposition," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.