Potential GDP

Actual GDP fluctuates with the business cycle. Potential GDP represents the economy's underlying productive capacity, which grows over time as the workforce expands, businesses invest and productivity improves.

Potential GDP is not the absolute maximum an economy could produce. It is the level consistent with full employment and stable inflation. An economy can produce above its potential for a while, but this usually leads to rising inflation as labour and resources become scarce.

For example, if an economy's potential GDP is 2,000 but actual output is 1,940, there is spare capacity, and policymakers may support demand to bring output back towards potential.

Potential GDP cannot be observed directly. Economists estimate it using statistical methods and models, and estimates are often revised. This uncertainty makes policy decisions difficult, since central banks and governments rely on estimates of how much spare capacity exists. The gap between actual and potential GDP is called the output gap.