Aggregate Demand and Aggregate Supply

Potential (Full-Employment) GDP

Potential GDP corresponds with full employment and represents the greatest quantity of productive output that can be sustainably produced on an ongoing basis.
Potential GDP is the maximum sustainable level of production in an economy, given constraints such as the available supply of labor and material resources. Calculations of potential GDP rely on the assumption of full employment or the natural rate of unemployment, which is the state in the economy when all eligible people who want to work can find employment at prevailing wage rates. Any remaining unemployment is considered to be frictional, structural, seasonal, or voluntary. It is also assumed that all the material and capital resources in an economy are fully available to be utilized for the production of goods and services.

It is possible for an economy to temporarily produce an output of goods and services at a higher level than potential GDP, but that will inevitably result in rising inflation, which is why that situation is known as an inflationary gap. Conversely, if an economy is producing goods and services at a lower level than potential GDP, that represents what is called a recessionary gap, when industrial and commercial activity is declining. These output gaps result from various inefficiencies found in particular economies, including inadequate or insufficient information possessed by economic actors, price gouging, out-of-control inflation, high unemployment, material waste, inefficient production technologies, poor business decisions, and government interference through regulation. All of these can affect production levels and push them higher or lower than their optimum potential. Price gouging, or charging an unreasonably high price for a product (often utilized during a shortage), can cause a gap in GDP because it is increasing the price of a product, thus fewer people are able to buy it. Material waste also causes output gaps. Companies working in technology or manufacturing often have material waste they must dispose of. For example, some by-products of manufacturing processes, such as a chemicals, are costly to dispose of.

In every real-world situation, there is bound to be some level of output gap. Economies tend toward equilibrium in the long run, but some inefficiencies will always remain. However, studying the quantity and nature of the output gaps in an economy and comparing them with potential GDP can provide economic policymakers with important information to use in crafting regulations and other incentives intended to narrow the gap. Some economists caution against eliminating the output gap completely, though, even if it were possible. Stopping short of potential employment allows an economy to respond more flexibly to changing market conditions and new regulation. Most economists agree that some level of unemployment (creating risk on the part of employers and labor alike) is desirable so that all parties are motivated to better their circumstances, leading to overall economic growth.