What does potential output represent in an economy?

Potential output represents the level of GDP that can be achieved when an economy is operating at full employment and optimal capacity. This concept is crucial in macroeconomic analysis as it reflects the economy's ability to produce goods and services without triggering inflation. Potential output is determined by the available resources, technology, and institutional settings, which collectively define the maximum sustainable output of an economy over the long term.

In contrast to the actual GDP, which can fluctuate due to various short-term factors such as demand or economic shocks, potential output provides a benchmark for assessing economic performance. When actual GDP is below potential output, it indicates underutilization of resources, often associated with high unemployment. Conversely, if actual GDP exceeds potential output, it can lead to inflationary pressures as the economy operates beyond its sustainable capacity.

Thus, potential output is a critical concept in macroeconomics for understanding the long-term health and capability of an economy, and option B captures this definition accurately.