Overall economic activity often is measured as the market value of the economy’s total output of goods and services—the nation’s gross domestic product (GDP). For many reasons, GDP rises in some periods and falls in others, but those fluctuations occur around a rising path that is determined by growth in three particular factors in the economy: labor, capital, and productivity. The maximum sustainable output of the economy given those factors is defined by CBO as potential output, or potential GDP. (Analyses of potential output, including CBO’s, focus on the quantity of output, adjusted to remove the effects of inflation.) Potential GDP is not the nation’s productive maximum, as would occur if all factors in the economy were employed to their fullest extent, but rather it is the maximum output that can be achieved over a prolonged period without straining productive capacity and thus increasing the risk that inflation will rise above the Federal Reserve’s goal.
GDP has never equaled potential output for a sustained period. Instead, there usually is a gap (expressed as a percentage of GDP) between the economy’s actual and potential output. Typically, that gap is negative during economic recessions and early in subsequent recoveries, when actual output is less than potential (see figure below). The gap has been positive, however—and in some cases substantially so—during later phases of economic expansions. CBO’s estimate of the output gap provides a measure of the slack or the overheating in the economy, and that assessment in turn can provide useful information to policymakers as they consider the economic consequences of various actions.
CBO’s projections of potential output guide its projections of actual output. For roughly the first half of its 10 year projection period (which currently runs through 2025), CBO projects the growth of actual output by estimating both the potential and the cyclical components of economic activity. For the latter part of the projection period, however, CBO does not estimate cyclical components. Instead, it projects that actual output will grow at the same rate as potential output but remain about one-half of one percent below potential, on average. According to CBO’s analysis, from 1961 to 2009, the nation’s actual output was below its potential by about that amount, on average, and below its potential, on average, during each of the past five complete business cycles (since 1975).