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What Is Potential GDP?

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  • Written By: Jim B.
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  • Last Modified Date: 07 October 2014
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Potential gross domestic product, or potential GDP, is a measurement of what a country's gross domestic product would be if it were operating at full employment and utilizing all of its resources. This amount is generally higher than the actual gross domestic product, or GDP, of a country. As a result, the separation between a country's potential GDP and its real GDP is known as the output gap. The output gap is caused by the fact that most economies suffer from certain inefficiencies, such as inflation, unemployment, and government regulations, which hamper production levels.

One of the major economic factors which helps to measure economic strength is the gross domestic product. The GDP totals up the value of all of the goods produced in a specific country over a certain period of time. Economists watch how the GDP in a specific nation rises and falls, and they also check how it compares to the GDP levels achieved by other nations. It is important to realize where production levels are lacking within a country compared to where they could be, which is where the potential GDP comes into play.

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Basically, the potential GDP is what the gross domestic product would look like if all the disparate facets of the economy were working on all cylinders for the time period being studied. This would mean that the full employment force of a country were working at its maximum capacity. It would also mean that resources are being mined and converted into products without any sort of excess waste in the process.

Of course, the potential GDP is just an ideal toward which countries may strive but usually never reach. That is because the necessary circumstances that would cause a country to reach these levels are unlikely to exist all at once. Unemployment is a big cause of countries' failures to reach potential production levels. In addition, general inefficiency, whether caused by government interference or simple business incompetence, can also drag down gross domestic products.

Since there is rarely ever an occasion when a country can reach its potential GDP, economists often study the lag between what a country can produce and what it actually does produce. This is known as the output gap. When the gap grown larger, it means that the country is failing to utilize all the tools it has at its disposal. As a result, economic leaders try to find ways to minimize that gap so that production output can more closely resemble potential levels.

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anon307016
Post 4

If you try to push the real GDP above potential GDP, what will happen and why? Does it make sense to say that unemployment is “too low”?

candyquilt
Post 3

@simrin-- I agree with @alisha.

Even though real GDP might be more accurate, it changes all the time. Because real GDP is based on the actual inflation and unemployment rate which is always changing. Potential GDP, on the other hand, is based on a constant inflation and unemployment rate and stays the same during that quarter.

If we only looked at real GDP, we would be pretty confused. Potential GDP helps us make sense of where we are at the moment.

discographer
Post 2

@simrin-- I see what you mean, but as an economy student, I will argue that potential GDP is an important factor that economists must take into account.

Of course, this whole concept is a part of Keynesian economics, which is just one theory of economics. Neither does the entire economic system rest on this theory alone, nor does it rely only on comparisons of potential and real GDP for estimates on growth.

We need to calculate potential GDP to know what our (economists, government agencies and industries) next step should be. Without this measuring tool, we wouldn't have anything to aim for.

Plus, aside from potential GDP and the GDP gap (recessionary and expansionary gap), economists also look at changes in real / actual GDP and GDP per capita as you also mentioned. GDP per capita for example, is another excellent tool that allows us to compare our growth with other countries'.

SteamLouis
Post 1

If it's so hard to reach potential GDP and the output gap will almost always be there, why do we need to measure potential GDP in the first place? Aren't we setting ourselves up to fail?

I know that potential GDP gives us an idea of how the economy is doing. But I agree with the article that it's an ideal and not at all realistic. No country is ever going to have zero percent unemployment or zero waste of resources.

I think it's a much better idea to look at real GDP and compare this between quarters for a better understand of the economy. It's so simple. If the real GDP is increasing, then the economy is working well. If it's decreasing, changes need to be made. Why do we have to aim for the impossible?

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