Potential output

Potential output

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In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, potential output (also referred to as "natural gross domestic product") refers to the highest level of real Gross Domestic Product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

 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
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 tends to increase as demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...

 exceeds supply
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

. This is because of the limited supply of workers and their time, capital equipment, and natural resources, along with the limits of our technology
Technology
Technology is the making, usage, and knowledge of tools, machines, techniques, crafts, systems or methods of organization in order to solve a problem or perform a specific function. It can also refer to the collection of such tools, machinery, and procedures. The word technology comes ;...

 and our management
Management
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...

 skills. Graphicaly, 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
Average cost
In economics, average cost or unit cost is equal to total cost divided by the number of goods produced . It is also equal to the sum of average variable costs plus average fixed costs...

 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
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 rate equals the NAIRU
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...

 or the "natural rate of unemployment
Natural rate of unemployment
The natural rate of unemployment is a concept of economic activity developed in particular by Milton Friedman and Edmund Phelps in the 1960s, both recipients of the Nobel prize in economics...

." 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
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

), and altering the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 to change consumption and investment levels (monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

).

The difference between potential output and actual output is referred to as the output or GDP gap
GDP gap
The GDP gap or the output gap is the difference between potential GDP and actual GDP or actual output. The calculation for the output gap is Y*–Y where Y* is actual output and Y is potential output...

, which may closely track measures of industrial capacity utilization
Capacity utilization
Capacity utilization is a concept in economics and managerial accounting which refers to the extent to which an enterprise or a nation actually uses its installed productive capacity...

. Potential output has also been studied in relation Okun's law
Okun's law
In economics, Okun's law is an empirically observed relationship relating unemployment to losses in a country's production first quantified by Arthur M. Okun. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be at an additional roughly 2% lower...

 as to percentage changes in output associated with changes in the output gap and over time. and in decomposition of trend and business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

in the economy relative to the output gap.