Answer to Question #113278 in Macroeconomics for aysu

Question

It is very well known by economists and policymakers that, in practice, potential
output is very hard to measure. In particular, different approaches of measurement
give very different levels of potential output. Does this uncertainty about
the measurement of potential output constitute challenges for economic policy?
Why or why not?

Answer 1

Uncertainties regarding the measurement of potential output constitute economic policy challenges.Consider the reasons.

The potential volume of output is the volume of output that the economy is able to provide with the most efficient use of available resources. The production potential depends on the following two factors: the volume of skilled labor and the average labor productivity of the labor force (output of one employee over a certain period). Productivity itself also depends on the capital intensity of the economy and the capital stock per employee.

Potential GNP is one of the main factors determining the volume of real (actual) output (another is aggregate demand). Provided that the aggregate demand is lower than the volume of potential output, the real GNP is equal to the aggregate demand, and a difference is formed between the real and potential volumes, called the deflationary gap.

On the contrary, if demand is excessively high and prevails over potential GNP, then the potential output will limit the real volume, and an increase in aggregate demand will lead to the formation of an inflationary gap.

Therefore, knowing the level of potential GNP, it is possible to minimize the consequences of deflationary and inflationary gaps, which lead to the fact that resources are not used efficiently or are not used at all.