What does potential output represent in an economy?

Potential output refers to the level of economic output that an economy can produce when operating at full capacity, utilizing all of its resources efficiently, without leading to inflation. This concept is also known as full-employment output, which is achieved when all willing and able workers are employed, and resources are not underutilized.

The idea is that potential output reflects the economy's long-term productivity capabilities, rather than any short-term fluctuations that might occur due to cyclical trends or recessions. It accounts for the available labor force, capital goods, technology, and the overall efficiency of production processes.

Since potential output represents what can be consistently achieved in the long run, it involves considerations of sustainable growth rather than simply the peak output levels that can be reached temporarily in times of high demand. Thus, the notion of potential output aligns well with the broader understanding of economic health and capacity, making the selection of the maximum amount an economy can output over time a central aspect of economic planning and policy formulation.