A Summary of Alternative Methods for Estimating Potential GDP

Introduction

Assessing current economic conditions, gauging inflationary pressure, and projecting long-term economic growth are central aspects of producing the Congressional Budget Office's (CBO's) economic forecasts and baseline budget projections. Those tasks require having a summary measure of the economy's productive capacity. That measure—known as potential output—is an estimate of "full-employment" gross domestic product, or the level of GDP attainable when the economy is operating at a high rate of resource use. Although potential output measures the productive capacity of the economy, it is not a technical ceiling on output that cannot be exceeded. Rather, 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 begin to bind, restraining further growth and contributing to inflationary pressure. If output falls below potential, then resources are lying idle and inflation tends to fall. Besides being a measure of aggregate supply in the economy, potential output is also an estimate of trend GDP. The long-term trend in real (inflation-adjusted) GDP is generally upward (see Figure 1) as more resources—primarily labor and capital—become available and as technological change allows more-efficient use of existing resources. Real GDP also displays short-term variation around that long-term trend—largely because of the influence of the business cycle but also because of random shocks whose sources are difficult to pinpoint. Analysts often want to estimate the underlying trend, or general momentum, in GDP by removing such short-term variation. A separate but related objective is to remove the fluctuations that arise solely from the effects of the business cycle. Potential GDP serves both purposes.download