Potential GDP

Updated on April 11, 2024
Article byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What is Potential GDP?

The Potential GDP is a measure of the economy’s sustainable output where inflationary pressure is neither increases nor decreases by the intensity of resource usage. Even though one can calculate the economy’s productive potential in various ways, some approaches only use statistical methodologies.

The techniques can vary from trend-based and time-series data analysis to intricate calculations based on the production function and structural equations. It can also consider a moving average of actual output. This GDP estimation is frequently useful for macroeconomic modeling, policy analysis, determining fiscal sustainability, and calculating the structural budget balance.

Key Takeaways

  • Potential GDP refers to the level or measure of output that an economy can produce at a constant inflation rate. Potential output is estimated by estimating potential gross domestic product.
  • Capital accumulation, or stock, labor growth, market efficiency, liquidity, and government policies influence it. 
  • The value of the output produced over a given period—a quarter or a year—is known as real GDP. It is also the actual GDP. In comparison, potential Gross Domestic Product refers to the amount of output a country’s economy may create at a given inflation rate.

 

Potential GDP Explained

Features-of-Potential-GDP

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The Potential GDP definition states that it is the level of GDP that is possible or attainable while the economy is operating at a maximum resource usage rate over a period. It represents full employment GDP and gauges the economy’s productive capability, especially at a constant inflation rate. It plays a significant role in policymaking, but assessment cannot be termed uniform. Therefore, potential GDP is not viewable and can only be the positive, non-recessionary long term trend of GDP.

Actual GDP levels would vary slightly from potential levels. When there is a recession, it would be below the potential level, creating an “output gap,” When there is an expansion, it would be over the potential level, creating an “inflationary gap.” The trend-cycle decomposition models produce an “attainable” potential GDP growth where it is possible to achieve short-term GDP growth above the healthy condition.

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Capital accumulation and potential GDP

Capital accumulation is a key factor in estimating Potential Gross Domestic Product and a significant source of production and potential GDP growth. Although capital growth is typically smooth from a short-term viewpoint, the long-term growth rate might vary significantly for various reasons. For instance, residential assets have historically experienced rapid expansion and significantly contributed to total assets before the Great Recession. However, the housing crash has considerably reduced the real estate sector’s assets and overall capital growth rates. The growth of the workforce is another significant factor in determining sustainable Potential Gross Domestic Product growth. The phenomenon where specific unemployment rate when inflation stabilization, where it will neither rise nor fall. It also serves as one of the factors affecting potential GDP growth. The degrees of labor market efficiency, production capacity, adequate liquidity, government fiscal assistance, etc., are additional factors that affect it.

Potential GDP is not the most useful tool for forecasting or guiding policy because it is unpredictable and varies greatly in value, especially in recent years. Many opine that the value of Potential Gross Domestic Product is not just dependent on short-term current fiscal and monetary policy. The idea of potential output, which a growth model can determine, helps assess the economy’s productive capacity and provides the best basis for estimating Gross Domestic Product over a decade required by the budgeting process. Potential GDP, when carefully calculated, can give the economy a fair idea of the economy’s growth potential.

GDP vs GNP Explanation in Video

Formula of Potentical GDP

Calculation of potential gross domestic product is the labor productivity-growth accounting method. The formula for estimation is:

The growth rate in potential Gross domestic product= Long term growth rate of labor force+ long term growth rate in labor productivity.

Whereas under the growth accounting equation, the growth rate of output is as follows:

The growth rate (of output) = Rate of technological changes + growth rate of capital + growth rate of labor. 

Potential GDP vs. Real GDP

Real GDP is the value of the output during a period; it may be one quarter or one year. It is otherwise referred to as actual GDP, whereas; potential GDP refers to the level of output that a nation’s economy can produce at a constant inflation rate. The ratio between the two, and the level of economic slowdown, is a major factor influencing fixed-income returns over the short run. The disparity between actual and potential gross domestic product is the output gap.

When a negative output gap indicates real GDP is below potential GDP, a sluggish economy. It suggests that there may not be full employment in the economy and the existence of weak demand for goods and services. To stimulate the economy, central banks like the Fed (U.S.) may explore cutting interest rates indicating that the economy is not operating at full capacity.

If the output gap is positive real GDP is higher than potential GDP, meaning that aggregate demand is higher than aggregate supply. Here, the economy is creating more than it can maintain. As a result, price hikes and inflation may follow in this situation. 

 Frequently Asked Questions (FAQs)

How to calculate potential GDP?

Intricate calculations based on the production function and structural equations can be executed, as well as through trend-based and time-series data analysis.

What determines potential GDP?

The major determinants of the potential gross domestic product are:
Capital stock: plants, equipment, and other assets that help production.
The labor force: varies, and in the short run, especially the potential gross domestic product is impacted. The unemployment rate at which the rate of inflation is stabilized.

When does potential GDP increase?

If more people join the labor force, more capital is added to the economy, or the present labor force and the capital stock become more productive, it could increase.

What are actual GDP and potential GDP?

An economy’s potential Gross Domestic Product is its maximum, ideal output while sustaining high employment levels across all sectors and preserving goods’ price and currency stability. At the same time, a nation’s measurable output at any time is represented by its actual GDP.

This has been a guide to Potential GDP and its definition. We explain its formula, difference between potential gross domestic product and real GDP along with detail explanation. You may learn more from the following articles –

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