Measuring productive potential and the deviation between potential and actual output (i.e. the output gap) provides a number of key insights into macroeconomic performance.
Output in general is determined by the quantity and quality of the various factors of production and their productivity. Potential output is an indication of the aggregate supply capabilities of the economy and embodies information about developments in the stock of capital, the labour force and technical change. The actual level of output on the other hand, is also influenced by the demand for goods and services. Deviations between the potential and actual levels of output, designated as the output gap, thus provide a measure of the capacity utilisation of the economy and to the extent that demand factors are incorporated, a measure of relative supply and demand in the economy at a particular time. As such, it contains useful short-term information for the formulation of economic policy, particularly policies aimed at controlling inflation. Over the medium term, the growth rate of potential output provides a useful guide for the assessment of sustainable non-inflationary growth in output and employment. Therefore, in a macro-econometric context, capacity utilisation (or the output gap) serves as a determinant of the behaviour of prices and wages and influences all key macroeconomic variables through a well-developed supply system.
However, modelling the output gap or capacity utilisation is a complicated matter for a number of reasons. First, different concepts of potential output have been proposed in the literature and are used in different models. Second, a wide variety of empirical methods are used to measure potential output, ranging from time-series and trend-type analyses to production function-based methodologies, with the precise results sensitive to the method chosen. Finally, actual output could be determined directly from Keynesian demand analysis or by using a production function (supply) approach.