Potential GDP is the highest level of gross domestic product that the economy can sustain over the long term. Introduced by Okun (1962), potential GDP refers to an unobservable and abstract concept. The economy is at its potential level when all factors of production are at full employment. In absolute terms, full employment corresponds to a situation where all job providers are working. Theoretically, at the potential level of economic activity, there is a very low level of unemployment qualified as natural unemployment, without inflationary pressure (generalized price increases).
There are two opposing currents of thought on the notion. According to the Keynesian vision, the potential level of GDP is that compatible with an unemployment rate that does not accelerate inflation. But according to the neoclassical view, potential output is a trend concept and is driven by exogenous shocks affecting productivity and, by ricochet, aggregate supply, and "determines the long-term growth path and short-term fluctuations in output" (Abou and Melesse, 2012).
The notion of potential GDP is abstract but very important for economists and policy makers, because all economies aspire to full employment. Knowing therefore the relative position of the economy in relation to the potential level (below or above) is a decision support tool. The difference between potential GDP and realized GDP is called the "output gap".
Different measures are used to capture potential GDP that can be grouped into two categories depending on whether they are based on economic theory: non-structural methods and structural methods. While non-structural methods (e.g. Hodrick-Prescott filter and deterministic trend method) do not borrow anything from economic theory, structural methods for estimating potential output (e.g. structural VAR, DSGE, production function models) use economic theory.
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