highlights some of the policy measures that can be used in addressing the problems revealed in
section four.
2. MEASURING POTENTIAL OUTPUT AND CAPACITY
The concept of “potential output” is not well defined in the literature and different applications
exist in production analyses. Does “potential” refer to the maximum attainable level of
production such as has been demonstrated at peak periods in the past, or does it refer to a
sustainable level of production in the sense that production can continue at this level without
major constraints emerging?
Furthermore, the methodologies employed in measuring potential output and its deviation from
actual output (i.e. the output gap) also differ.
Two important and commonly used measures can be identified. First, structural production
function techniques, where measures of potential output that are structural and depend on a
production function framework, incorporating information concerning the capital stock, working
population, trend participation rates, structural unemployment and factor productivity
developments. Specific attention may also be given to the sustainability of non-inflationary
growth associated with the labour market, in which case information about both actual rates and
underlying natural rates of unemployment is utilised (i.e. the non-accelerating wage rate of
unemployment, or NAWRU).
A second set of measures is derived by applying time-series (mostly smoothing) techniques to
actual developments in real GDP. The most commonly used time-series technique is the
Hodrick-Prescott (1997) filter. Though parsimonious in their use of information, these methods
are mechanical and have difficulty in dealing with frequent structural changes. They therefore