medium term, the growth rate of potential output provides a useful guide for the assessment of
sustainable non-inflationary growth in output and employment. Therefore, in a macro-
econometric context, capacity utilisation (or the output gap) serves as a determinant of the
behaviour of prices and wages and influences all key macroeconomic variables through a well-
developed supply system.
If the economy is producing at levels exceeding full capacity, that is, if actual output exceeds the
potential of the economy, the economy is “overheated” and production prices and wages start to
rise. Given this subsequent impact on consumer prices, monetary policy will ultimately have to
intervene to deflate the economy by increasing interest rates.
Therefore, the challenges for policy makers are twofold: (1) to know what the excess or available
production capacity of the economy is and to direct economic policy accordingly; and (2) to
design policy to increase the productive potential of the economy towards sustainable, non-
inflationary growth in output and employment.
However, modelling the output gap or capacity utilisation is a complicated matter for a number
of reasons. First, different concepts of potential output have been proposed in the literature and
are used in different models. Second, a wide variety of empirical methods are used to measure
potential output, ranging from time-series and trend-type analyses to production function-based
methodologies, with the precise results sensitive to the method chosen. Finally, actual output
could be determined directly from Keynesian demand or by using a production function (supply)
approach.
This paper is outlined as follows: in the next section, the theoretical methodologies and concepts
are presented. The different methods of estimating potential output and capacity utilisation are
explained in section three. In section four the empirical results are presented. Lastly, section five