Everything about Potential Output totally explained
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 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 seen in introductory economics, 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."
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).
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