This is a very nice summary of how economists measure the economy's maximum sustainable level of output from the author of your text [originally here].
The term "maximum sustainable level of output" is a better description of what we are trying to measure than the more common terms such "potential output" or "full employment." Let me try an example to illustrate. For a graduate student, over the course of an entire quarter, there is a certain maximum sustainable level of effort. It might be, say, 14 hours of class and study per day on average. That is "full employment" or "potential output." But in the short-run it's possible to exceed that level of output. Right before a test students can work 20+ hours a day, more than full employment, but such a level of output is not sustainable over the longer run. People need a minimum level of sleep, time to eat, etc. So, potential output for students is the level of effort that is sustainable day after day after day, not the most that can be accomplished in a given 24 hour time period.
A business can do the same thing. If it has 10% of its trucks off the road for maintenance at any given time (i.e. "sleeping"), it can keep those on the road when demand is really high to deliver a little extra, keep workers overtime, run the production lines 24 hours a day without maintenance, etc. But that kind of effort, though possible in short bursts, is not sustainable over the longer haul (with the existing level of resources). Trucks and production lines have to be taken down for maintenance every so often or there will be big problems down the road, people won't work long days continuously, etc. Here, too, when we talk about potential output we don't mean how much the economy can produce in the short-run when it's overheated (sort of like just before an exam), but rather what it can do on a sustainable basis over time with a given quantity of inputs.
More formally, then, we can define potential output as the level of output the economy would produce if labor and all other resources are fully and efficiently employed, where full employment means the maximum sustainable level of activity.
But how do we actually measure potential output? Here' Frederic Mishkin with the details on three different approaches. It's not easy:
Estimating Potential Output, by Governor Frederic S. Mishkin, Federal Reserve: This conference focuses on measurement issues, and in my remarks I want to focus on one of the most important measurement issues that we at the Federal Reserve and other central banks face: How do we determine whether the economy is operating above or below its maximum sustainable level? That is, how do we estimate the path of potential output?1
The Federal Reserve operates under a dual mandate to achieve both price stability and maximum sustainable employment. In that context, it is natural to think of potential output as the level of output that is consistent with the maximum sustainable level of employment: That is, it is the level of output at which demand and supply in the aggregate economy are balanced so that, all else being equal, inflation tends to gravitate to its long-run expected value.
The combination of the dual mandate and this definition suggests two reasons that estimating the path of potential output is so central to the conduct of monetary policy. First, to evaluate whether our policies will help achieve the maximum sustainable employment objective of the dual mandate, we need know the level of future output that would be consistent with that objective. Second, the level of output relative to potential output, which is referred to as the output gap, plays an important role in the inflation process. When the actual level of output is above potential output--so that the output gap is positive--labor and product markets are excessively tight; then, if things such as expected inflation and temporary supply factors are held constant, inflation will tend to rise. Conversely, when the output gap is negative and labor and product markets are slack, inflation will tend to fall. Estimates of the future path of potential output are therefore needed to assess whether the projected path of output that is implied by current monetary policy will lead inflation to move in a direction that is consistent with price stability.
Because estimates of potential output are an important part of central bankers' toolkits, the Federal Reserve and other central banks devote considerable resources to getting the best measures of potential output possible. In this talk, I want to explore something that Bismarck warned us we shouldn't want to examine: "what goes into the sausage"--or in this case, what goes into central bankers' thinking about how to estimate potential output.
Broadly speaking, there are three basic approaches to estimating potential output: (1) aggregate approaches; (2) production function, or growth-accounting, approaches; and (3) the newest kid on the block, dynamic stochastic general equilibrium (DSGE) approaches. Let's look at each of these in turn, with the major focus on the production function approach, one to which we at the Federal Reserve currently pay a lot of attention.
