Theoretically, the concept of potential output is used to describe the "full-employment" GDP or the level of real GDP attainable when the economy is operating at a higher level of resource use. In other words, measurement of potential growth requires estimation of an economy wide indicator of productive capacity.
A more precise definition, however, requires elaboration as it is viewed differently by different analysts. For instance, fiscal analysts may be interested in separating the structural and cyclical components of the government's fiscal deficit, which requires the concept of output that links output to fiscal policy. Similarly, other analysts may be interested in knowing the potential level of output, which could have been produced if a different set of policies under a different set of social institutions prevailed. The relevant concept of potential output for monetary policy could be the one, which is directly linked with the dynamics of wage and price inflation. Although potential output measures the
productive capacity of the economy, it is not a technical ceiling on output that cannot be exceeded. In fact, for monetary policy purposes, it is a measure of sustainable output, in which the intensity of resource use is neither adding to nor subtracting from inflationary pressure. If actual output exceeds its potential level, then constraints on capacity may begin to bind, restraining further growth and perhaps contributing to inflationary pressure. If output tends to fall below potential, then resources could be lying idle and inflation could trend downward.
The fact remains that assessing current economic conditions, gauging inflationary pressures, and projecting long-term economic growth are central to any economic policy making process.
Measures of potential GDP were initially devised to guide decisions regarding monetary and fiscal policy generally for a one- to two year horizon. If the growth rate in the economy were...