Potential Output

Potential output is the overall goods and services an economy can generate without increasing inflation. It is an economic term used to evaluate the output gap in the economy. It is the change in an economy's sustainable production capacity over a period.

In other words, it determines the change in the economy's ability to produce when the employment rate is sustainable. It is an estimated figure and can be reckoned as the gross domestic product (GDP). If potential output is less than actual output, the output gap is considered to be positive, and vice versa.

Potential output is a desired GDP growth, i.e., the production of goods or services over the period, assuming the economy operates sustainably without impacting the inflation rate. It serves as a critical comparative parameter for determining the economic growth of a nation ascertained through the actual output. Thus, if the actual output is below the potential GDP, it signifies a negative output gap; however, if the former is more than the latter, the economy is said to have a positive output gap. The output gap is the divergence of the real GDP from the benchmark GDP, i.e., potential output.

Now, let us understand the three major determinants of the potential GDP computation:

1. Labour Supply: It is the total competent labor force of a nation, i.e., the ones who have the ability and willingness to work, the sustainable number of laborers who can find job opportunities and the sustainable average working hours accepted by those who are employed.
2. Capital Stock: It is the function of previous capital investments in tangible and intangible assets used for production, depreciation, or retirement rate of these investments, as well as the addition of new investments.
3. Total Factor Productivity (TFP): The function that can combine the labor and capital factors effectively, such as expertise, knowledge, and technology, to complete the production process.

However, potential output economics is not the real figure but a mere projection. It fails to account for the various external factors affecting GDP growth, including supply chain disruptions, labor market unrest, political issues, etc.

The potential output is just an estimated figure. It is not based on the actual GDP of the nation; however, it is determined by drawing a trend line across the actual output. Thus, it is efficient to combine the factors of production in a sustainable manner using the production function:

Y = A F(K, L)

Here, Y can denote the potential output;

• A resembles the total factor productivity;
• F is the function of;
• K signifies the capital stock and
• L denotes the labor supply

The potential output economics is used to compute the output gap in the economy. The output gap determines whether the nation produces goods or services at full capacity by analyzing whether the real GDP is underperforming or outperforming the expected GDP growth. It is calculated as:

Output Gap = *100

Now let us move to the examples which represent how the potential output plays a critical role in shaping economic decisions:

Example #1

In an economy, the actual output is $15,750 billion. We need to determine the output gap in the economy. Suppose, using the production function Y = A f(K, L), we get the potential output as $15,980 billion. Let us now calculate the output gap.

Solution:

Output Gap = *100

Output Gap = *100 = -1.44%

Thus, the economy is underperforming as it produces fewer goods and services than the sustainable GDP figures, and economists can take relevant measures to boost economic growth.

Example #2

The paper The Impact of COVID on Potential Output by John Fernald and Huiyu Li unfolds the impact of COVID-19 on the potential output of the US economy. For this purpose, the analysts employed a benchmark growth rate of 1.55% from 2004 to 2018 to compare pre- and post-pandemic outputs. The output declined by 1% in the short term before stabilizing to a post-pandemic condition.

The pandemic adversely affected the labor supply since many parents, particularly working mothers, had to leave their jobs due to school and daycare closures. The further predictions emphasize a potential 0.5% reduction in labor inputs in the long term. Moreover, business shutdowns and early retirements would further reduce the labor input by 0.2% or less in 2021, with a projected 0.1% reduction in 2025-26.

There would be a significant negative impact on business investment, as companies emphasized repurchasing equipment for remote work rather than expanding their operations. Also, the research and development efforts within the nation were diverted towards COVID issues, which could have otherwise been used to explore new markets and growth opportunities. Despite these setbacks, analysts conclude that the pandemic had a less severe impact on the potential output than the Great Recession, and the U.S. economy is expected to grow slowly in the long run.