Potential GDP Definition, Formula, Determinants, and Vs Real GDP

What is potential GDP?

Potential GDP is the level of gross domestic product (GDP) that the economy able to achieve by operating at a full employment output level. So, potential GDP presents the output level that maximum using the resources within the productive capacity, especially at a constant inflation rate.

GDP (gross domestic product) can be defined as the monetary value of the currently produced (produced within the current period, not in the previous periods), final goods and services (not including the intermediate goods and services) in a specific geographical area (usually within a country or a region).

What are other terms for potential Gross Domestic Product?

Potential GDP is the “growth trend of a business cycle”

The potential GDP level is shown as the “growth trend” of a business cycle. The business cycle goes through four major phases: expansion, peak, contraction, and trough. So, at the points, the actual GDP is equal to the growth trend line, the economy is operating at the potential output level.

The potential GDP level is also called the long-run equilibrium level of an economy.

Long run equilibrium of an economy is the point where aggregate demand, short-run aggregate supply and long-run aggregate supply are equal to each other. This is the full employment output level of the economy. So, there is no inflationary gap or deflationary gap. The long-run equilibrium is changed as a result of changing the long-run aggregate supply.

Potential GDP is the natural gross domestic product

Natural gross domestic product means the output level when an economy’s unemployment rate equals the natural rate of unemployment. In the potential output level, the economy uses all the resources that can be utilized for the production process of goods and services.

Potential GDP vs Real GDP

Potential GDP provides an important benchmark for regulators and policymakers. It is the healthy level of GDP of an economy. But, in the real world, actual (real) GDP can vary from the potential GDP.

When nominal GDP is adjusted for inflation, we call it “real GDP”. Since the real GDP is free from price level changes, it is highly acceptable to measure the economic growth of a country.

Potential GDP is usually used to estimate how well a country or region might do during a quarter. But the actual economic condition may be different from our estimation. In this situation, we need to calculate the real GDP to determine the actual economic performance of the economy. This means potential GDP estimate the GDP of a country or region for the next quarter while real GDP shows how a country or region did last quarter.

Gross domestic product estimation (potential GDP) for a particular period may differ from the actual output (real GDP). The difference between real gross domestic product and potential gross domestic productis called the “output gap”.

There are two major types of output gaps. They are the inflationary gap  and the recessionary gap.

Recessionary Gap (Negative Output Gap)

If the real output level < potential GDP, there is a recessionary gap.

The recessionary gap is the negative gap between the actual GDP level and the potential GDP level of the economy. In other words, the recessionary gap measures the amount of actual GDP less than the potential GDP level of the economy.

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Inflationary Gap (Positive Output Gap)

If real output level > potential GDP, there is an inflationary gap.

The inflationary gap measures the amount of actual GDP exceeding the potential GDP level of the economy. In other words, the inflationary gap is a macroeconomic theory to determine the positive difference between the current level of real gross domestic product (GDP) and the full employment level GDP of the economy.

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Potential GDP Formula

Based on the labor productivity method and growth accounting method, we can calculate the potential gross domestic product of a country. So, following are two potential GDP formulas.

Potential gross domestic product based on labor productivity method

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

Potential gross domestic product based on growth accounting equation

Output growth rate = a × capital stock growth rate + [(1 − a) × labor hours growth rate]+ [(1 − a) × human capital growth rate] + technology growth rate.

In this equation, a is just a number. For example, if a = 1/3, the growth in output is as follows:

Output growth rate = (1/3 × capital stock growth rate) + (2/3 × labor hours growth rate)+ (2/3 × human capital growth rate) + technology growth rate.

Determinants of potential GDP

Capital stock: The availability of physical capital, such as machines and equipment, can also increase the productive capacity of an economy.

Labor force: If a country has high skilled and larger labor force, the productivity of the economy is continuesly increasing. So, the potential GDP level is increasing.

Technology: Sophisticated and effective technologies stimulate the productivity of a country by increasing the potential growth.

Natural resources: When a country abundant with more natural resources, it has more production capacity than other countries. So, the potential GDP of that country is high.