Jennah,

Various methodologies are used to estimate potential output, but they all assume that output can be divided into a trend and a cyclical component. One simple way to construct a potential GDP estimate is by fitting a trend line through actual GDP.The trend is interpreted as a measure of the economy's potential output and the cycle as a measure of the output gap. The trick to estimating potential output, therefore, is to estimate trendsthat is, to remove the cyclical changes. Another method of measuring potential output is the application of statistical techniques that differentiate between the short-term ups and downs and the long-term trend. The Hodrick-Prescott filter is one popular technique for separating the short from the long term.

Another method of estimating the potential output is to calculate changes in the production function. In this methoda mathematical equation is used tocalculate output based on an economy's inputs, such as labor and capital.

One simple way to construct potential GDP is by fitting a trend line through actual GDP.

Q.Measuring the output gap is no easy task, however. Unlike actual GDP, the level of potential output and, hence, the output gap cannot be observed directly. Potential output and the output gap can only be estimated. What makes it even more difficult is that the economy goes changes by way of its business cycle. For example, when the economy is emerging from a deep recession there may be much more spare capacity than estimated. Where do you think this extra spare capacity might come from that the economists might overlook? Thanks. G