Every few weeks someone describes potential growth as the economy’s speed limit. The metaphor is useful, but it is attached to the wrong thing. The real speed limit is potential output, the level: the amount the economy can produce sustainably with inflation at target. Potential growth is only the rate at which that limit itself moves. The two answer different questions, and mixing them up produces bad readings of the cycle.
This post uses a small model of Australian potential output to make one point. Conventionally, the output gap is the difference between actual and potential output, a difference between two levels. This model goes one step further and splits that observed difference into an inflation-related component and a residual. Potential growth tells you how fast the potential level is moving. It does not tell you the sign of the gap, and neither potential growth nor observed GDP growth on its own tells you where inflationary pressure sits.
Two levels and the distance between them
