What’s it: Potential GDP refers to the maximum output an economy can produce using its existing economic resources. It represents an economy’s long-run aggregate supply. At this level of output, the economy will fully utilize all its resources and work full employment.
Potential GDP rises along with the increased quantity quality and improved quality of production factors and technology. Its increase does not result in inflationary pressures in the economy. Therefore, in a graph, it will form a vertical line.
Another term for potential GDP is potential output, total output at full capacity, long-run output, or output at full employment.
Why potential GDP matters
The potential output is an important indicator. It is useful for measuring how much an economy can produce goods and services. By comparing real GDP and potential output, you will know whether production can increase and how this will result in inflationary pressures and unemployment.
During a recession, actual economic output falls below its potential (negative output gap). A negative gap means that there is unused capacity in the economy, usually due to weak demand.
In such conditions, the central bank will usually loosen monetary policy to stimulate economic growth. For one thing, the central bank can lower policy rates. This will increase the money supply and boost aggregate demand.
As an alternative, the government can also use fiscal tools to close the output gap. The government increases its spending or cuts taxes. Higher spending or lower taxes will also increase aggregate demand.
Meanwhile, during an economic boom, actual real GDP rises above its potential level (positive output gap). The economy overheats and usually creates high inflationary pressure. Labor costs and prices of goods increased sharply. If the increase in inflation is higher than the increase in income, it will weaken consumers’ purchasing power.
This situation requires the central bank to cool the economy by raising interest rates.
On the fiscal side, the government can reduce spending or raise tax rates. The policy is to reduce aggregate demand and fight inflation.
Comparing potential GDP vs. real GDP
Potential GDP measures the maximum value of real GDP, considering the current economic resources. Meanwhile, real GDP is the actual value of output produced in a period (one quarter or one year).
The concept is similar (but not the same) as a production machine. Potential GDP is the maximum capacity. Meanwhile, real GDP is the actual output produced by machines.
Perhaps you would hear the real GDP more frequently than potential GDP. Often, you see economic growth figures in various news media. Economic growth is, in essence, the percentage of real GDP growth over time. Economic growth represents an increase in the quantity of output over time.
Economists prefer real GDP over nominal GDP to measure the increase in output in the economy. Real GDP growth is free from the effects of price changes (inflation/deflation).
Factors affecting potential GDP and real GDP
Real GDP changes due to the effects of changes:
- Aggregate demand
- Short-term aggregate supply
- Quantity and quality of factors of production
For aggregate demand, examples of factors are household consumption, business investment, exports, and government spending. In this case, the factors also include monetary policy and fiscal policy.
Meanwhile, the factors affecting short-run aggregate supply (and real GDP) are the cost of raw materials, energy prices, wages, taxes, and subsidies. They all affect the cost of production in the economy.
Furthermore, of the three factors, only the quantity and quality of production factors affect potential GDP. Specifically, they include:
- Growth in labor supply. The more labor, the greater the output can be produced. Labor supply depends on population growth, labor force participation rate, and net immigration (immigration minus emigration).
- Improvement of workforce quality. Specifically, we might call this human capital. Its quality improves due to education and training, making the workforce more productive.
- Capital stock growth. That includes machinery and equipment for production. In this case, the stock of capital depends on the level of capital investment in the economy. The higher the capital investment, the higher the capital stock, and the higher the potential output. The capital stock also includes infrastructure such as roads, bridges, and ports in a broader sense.
- Technology advances. Technological advances are essential for increasing the productivity of other production factors, such as machinery and labor. By using more sophisticated machines, we can produce more output, using the same input.
- Increased availability of natural resources. Apparently, this is the most ambiguous among the other factors of production. Not all countries have abundant natural resources. Many countries lack natural resources (such as Japan and South Korea), but they have developed economies. Why? They invest in human capital, stock capital, and technology in growing the economy.
How can real GDP exceed GDP potential
In the short term, real GDP can be above, at, or below potential GDP. The difference in actual real GDP and potential GDP is what we call the output gap (GDP gap). So, the output gap can be positive, zero, or negative.
If the actual real GDP is above potential GDP, the output gap is positive. It shows you that the economy is producing above its maximum level. We call this an inflationary gap or expansionary gap.
How can real GDP exceed potential GDP?
Yes, it can because the supply basically does not only come from within the country but also abroad (through imports). When the output gap is positive, aggregate demand exceeds aggregate supply. Therefore, some of the aggregate demand will be met from imports.
Take a simple example. Assume the country is like a company. The company has machines with a maximum capacity of 100 units. Currently, the demand for this has jumped to 105.
The company decided not to add a new machine with the same capacity (100). The additional demand of 5 units (105-100) is too small compared to the new machine capacity. If the company buys it, it will only incur higher operational costs.
So, how do you fulfill it? Companies can buy them from other companies and sell them. And in the economy, this purchase refers to imports.
Because aggregate demand is higher than aggregate supply, it produces upward pressure on the price level (inflationary pressure increases). This condition usually occurs during an economic boom.
Meanwhile, if real GDP is below potential GDP, the output gap is negative. We call this the deflationary gap or recessionary gap.
Deflationary gaps generate downward pressure on the price level. Aggregate demand is lower than the aggregate supply.
Such situations usually occur during a contraction or recession. You need to remember. Deflationary gaps do not always result in deflation (negative inflation). It may result in a slower but still positive inflation rate, from 5% to 3% (we call this disinflation).
How potential GDP affects the business cycle
The movement of real GDP from its potential level shapes the business cycle.
As I discussed earlier, when the output gap is positive, the economy is usually expanding. At that time, unemployment was low because the economy was using its resources to the full.
Also, because aggregate demand is higher than aggregate supply, the price level tends to rise. It produces upward pressure on the inflation rate.
During this period, you will see the government enforcing contractionary economic policies. It can be through:
- Raising tax
- Decreasing government spending
- Raising policy rates
- Raising the reserve requirement ratio.
- Selling government securities by central bank
The objective of contractionary economic policies is to reduce aggregate demand. So, it will moderate the inflation rate and avoid hyperinflation.
Conversely, when the output gap is negative, some economic resources are idle. The unemployment rate is high because businesses cut their production and streamline their operations by reducing workers. They do not produce optimally because of weak aggregate demand.
During this period, the price level tends to fall and creates downward pressure on inflation. It may result in disinflation or deflation, depending on the severity of the price decline.
To solve such a problem, the government will adopt an expansionary policy through:
- Cutting tax
- Increasing government spending
- Cutting policy interest rates
- Lowering the reserve requirement ratio
- Purchasing government securities by central bank
How the potential GDP is calculated
Before moving on to the potential GDP formula, I will briefly discuss the Solow growth model. The model shows you that an economy’s output depends on two critical factors: labor and capital.
The formula for the Solow growth model is as follows:
Y = A Kα Lβ … (equation 1)
- Y = potential output
- L = number of workers
- K = number of capital
- A = Total factor productivity (TFP) or technology factor
- α = Output elasticity of capital
- β = Output elasticity of labor
Total factor productivity is a factor other than labor and capital that contributes to increasing output. Economics usually refers to technology, which contributes to increased productivity of labor and capital.
Next, we can rewrite Equation 1 to the growth form as follows:
∆Y/Y = α*∆K/K + β*∆L/L + ∆A/A… (equation 2)
- ∆Y/Y = Growth in potential output
- ∆K/K = Growth rate of capital
- ∆L/L = Growth rate of labor
- ∆A/A = TFP growth
Difficulties arise if we use this approach. Data on TFP and capital quantities are difficult to obtain. As a consequence, it may result in a less accurate calculation of potential output.
Alternatively, economists focus on labor because the data are more readily available. Under this approach, the potential GDP formula is:
Potential output = Aggregate hours × Labor productivity… (Equation 3)
If we rewrite Equation 3 in growth form, we get:
Potential output growth rate = Long-run labor growth rate + Long-run labor productivity growth rate
Suppose if worker productivity is growing at 3% per year and the total workforce is growing at 0.5% per year, then potential real GDP is expected to grow at 3.5% per year.
As a side note
The calculation of potential GDP differs from actual real GDP. The statistical bureau collects data and calculates real GDP using three approaches. For example, in the expenditure approach, real GDP is calculated as follows:
Actual real GDP = Consumption + Investment + Government spending + Net exports
Meanwhile, potential GDP is only an estimate using the above model and based on currently available data.