Download Econ 122a. Fall 2013. Note on definition of potential output Potential

Econ 122a. Fall 2013. Note on definition of potential output
Potential GDP (sometimes called the natural rate of output) represents the
maximum sustainable level of output that the economy can produce. When an economy
is operating at its potential, there are high levels of utilization of the labor force and the
capital stock.
Potential output is determined by the economy’s productive capacity, which
depends upon the inputs available (capital, labor, land, etc.) and the economy’s
technological efficiency. Potential GDP tends to grow steadily because inputs like labor
and capital and the level of technology change quite slowly over time. By contrast,
actual GDP is subject to large business-cycle swings if spending patterns change
sharply.
During business downturns, actual GDP falls below its potential, and
unemployment rises. In 2009, for example, the U.S. economy produced about $1000
billion less than its potential output. Output can be temporarily above potential output
during booms and wartime as capacity limits are strained, but the high utilization rates
may bring rising inflation and are usually brought to an end by monetary or fiscal
policy.
Potential output is not directly observed. The usual definition is that potential
output is the output the economy would produce if the unemployment rate were at the
natural rate of unemployment. The natural rate of unemployment is estimated to be
between 5 and 6%. Actual output is higher (or lower) than potential output if the
unemployment rate is lower (or higher) than the natural rate. Okun’s Law states that
every 1 percentage point difference between the actual and natural unemployment rate
leads to a 2 percent difference between actual and potential output. In a formula:
(Y  Y p ) /Y p  2(u  un )
Here, Y  actual output, Y p = potential output, u = the actual
unemployment rate and un = natural unemployment rate.
For example, if actual output = 1000, actual unemployment rate = .06, the natural
unemployment rate = .05, then potential output is about 1020 (actually 1000/0.98).