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Why CBO Projects That Actual Output Will Be Below Potential Output on Average 1 (February 10, 2015)

handle is hein.congrec/cbo2074 and id is 1 raw text is: FEBRUARY 2015 Why CBO Projects That Actual Output Will Be Below Potential Output on Average Overall economic activity often is measured as the market value of the economy's total output of goods and see- vices-the nation's gross domestic product (GDP). For many reasons, GDP rises in some periods and falls in oth- ers, but those fluctuations occur around a rising path that is determined by growth in three particular factors in the economy: labor, capital, and productivity. The maximum sustainable output of the economy given those factors is defined by the Congressional Budget Office as potential output, or potential GDP. (Analyses of potential output, including CBO's, focus on the quantity of output, adjusted to remove the effects of inflation.) Potential GDP is not the nation's productive maximum, as would occur if all factors in the economy were employed to their fullest extent, but rather it is the maximum output that can be achieved over a prolonged period without strain- ing productive capacity and thus increasing the risk that inflation will rise above the Federal Reserve's goal. GDP has never equaled potential output for a sustained period. Instead, there usually is a gap (expressed as a percentage of GDP) between the economy's actual and potential output. Typically, that gap is negative during economic recessions and early in subsequent recoveries, when actual output is less than potential (see Figure 1). The gap has been positive, however-and in some cases substantially so-during later phases of eco- nomic expansions. CBO's estimate of the output gap pro- vides a measure of the slack or the overheating in the economy, and that assessment in turn can provide useful information to policymakers as they consider the economic consequences of various actions. CBO's projections of potential output guide its projec- tions of actual output. For roughly the first half of its 10-year projection period (which currently runs through 2025), CBO projects the growth of actual output by esti- mating both the potential and the cyclical components of economic activity. For the latter part of the projection period, however, CBO does not estimate cyclical compo- nents. Instead, it projects that actual output will grow at the same rate as potential output but remain about one- half of one percent below potential, on average. Accord- ing to CBO's analysis, from 1961 to 2009, the nation's actual output was below its potential by about that amount, on average, and below its potential, on average, during each of the past five complete business cycles (since 1975).' 1. The term business cycle describes fluctuations in overall economic activity that are accompanied by fluctuations in the unemploy- ment rate, investment, interest rates, income, and other variables. Over a complete cycle, real (inflation-adjusted) activity rises to a peak and then falls until it reaches a trough, and then starts to rise again-defining a new cycle. Business cycles are irregular, varying in frequency, magnitude, and duration, but despite those variations, actual GDP tends to fall below potential GDP during recessions and tends to exceed it during the later stages of each business cycle, indicating that the economy may be overheating. By convention, business cycle peaks and troughs are identified after the fact bv the National Bureau of Economic Research. Notes: All years are calendar years. Some values are expressed as fractions to indicate numbers rounded to amounts greater than one tenth of a percentage point. The vertical bars in figures indicate the duration of recessions, which extend from the peak of a business cycle to its trough. Supplemental data for this analysis are available on CBO's website (www.cbo.gov/publication/49890).

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