Potential output
Potential output is the level of production an economy can sustain when its resources are fully and efficiently employed.
Every economy has a speed limit, the most it can produce without overheating. Economists call it potential output, and finding it is harder than it sounds.
Potential output is the level of goods and services an economy can produce when its resources, labour, capital, and technology, are fully and efficiently employed in a sustainable way, without generating accelerating inflation. It is the economy's underlying capacity, around which actual output fluctuates over the business cycle.
Capacity, not a ceiling for a day
Potential output is not the absolute maximum an economy could squeeze out for a moment, but the level it can sustain. An economy can temporarily exceed it, running factories flat out and labour markets tight, but only at the cost of rising inflation, which signals that the strain is unsustainable. Potential output is therefore best understood as the non-inflationary capacity, the pace the economy can keep up without overheating.
What determines it
Potential output is set by the supply side: the size and skills of the workforce, the stock of capital, the level of technology, and the institutions that determine how efficiently these are used. It grows over time, this growth is what economic growth ultimately measures, through more labour and capital and, above all, rising productivity. Demand can push actual output above or below potential, but it cannot change potential itself, which moves only with the economy's productive capacity.
Why it matters and why it is elusive
Potential output anchors key ideas: the output gap is actual output minus potential, and the natural rate of unemployment corresponds to the economy producing at potential. But because it cannot be directly observed, it must be estimated, and those estimates are uncertain and often revised after the fact. Misjudging potential, thinking the economy can grow faster than it sustainably can, or underestimating its capacity, leads to inflation or to needlessly weak policy.
Potential output is the supply-side foundation beneath the cyclical ups and downs of an economy. It defines what is sustainable, separates demand problems from capacity problems, and, precisely because it cannot be seen directly, sits at the centre of some of the hardest judgements in economic policy.