Potential Output can be described as what an economy can produce when all its resources such as workforce, equipment, technology, natural resources and others are fully utilized; or the GDP that the economy can attain upon proper application of its resources. An economy that produces at its potential output can be called as working at full employment. 
Potential Output can also be defined as the level of economic activity at which aggregate demand and aggregate supply are consistent with a stable inflation rate. It is used by policymakers to estimate inflation, and use it as a level of output where any rise or fall in prices becomes unnecessary. One can obtain a measure of the degree of spare capacity in the economy, and the rate at which capacity is expanding by calculating the level and rate of growth of potential output, and comparing the results with observed output trends.
The concept of potential output is also essential to government operations. In the short term, an evaluation of the degree of excess demand or excess supply will have its impact on the fiscal policy. The monetary policy can also have an amplifying effect on the business cycle by posing either an over-expansionary stance when excess demand conditions are evident or an over-constricting stance when the spare resources are abundant.In relation to the labor market policy, measures of potential output are helpful in finding out the factors responsible for unemployment, and aid in preparing the corresponding responses. Additionally, they are also used to derive indicators such as cyclically adjusted government budget balances which are used to assess the fiscal policy stance.
The evolution of potential output is dependent on a lot of underlying factors; at the forefront among all of them is supply conditions such as the endowments of the economy relating to the key inputs of capital and labor and their productivity. Hence, potential output growth reflects developments in these supply-side elements that are consequently linked to various factors such as demographic and labor market trends, variations in investment and technological innovations.
The recent advent of economic crises in multiple countries around the world also brought to attention the effects they have on potential output. A crisis can reduce potential output in the short and medium term through its adverse impact on investment as a result of the ensuing slower capital accumulation combined with acceleration in the aging of some capital vintages due to economic restructuring. Additionally, in the case of a prolonged recession, extended unemployment can have ill effects on human capital, possibly leading to an irreparable increase in the Non-Accelerating Inflation Rate of Unemployment (NAIRU), and further drop in the potential output levels.
Measuring potential output
Multiple methods have been developed to calculate potential output and output gap. However, according to many economists, none of the methods are satisfactory. The problem arises from the fact that neither is directly observable, and has to be inferred from existing data using statistical and econometric methods. The problem is compounded by the fact that there is increasing evidence suggesting output series are best characterized as integrated series. Thus, the presence of stochastic component doesn’t allow potential output to be treated as simply a deterministic component.
- Potential Output: Concepts and Measurement by Darren Gibbs
- European Central Bank – Monthly Bulletin – January 2011
- European Economy – Occasional Papers 49 – June 2009
- Measuring Potential Output and Output Gap and Macroeconomic Policy: The Case of Kenya by Angelica E. Njuguna, Stephen N. Karingi, and Mwangi S. Kimenyi