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Gross domestic product (GDP) has many different measurements, including real GDP and potential GDP, but those numbers are often so similar that it can be difficult to know the differences. Real GDP and potential GDP treat inflation differently, because potential GDP is based on a constant inflation while real GDP can change. Potential GDP is an estimate that is often reset each quarter by real GDP, while real GDP describes the actual financial status of a country or region. It is based on a constant inflation rate, so potential GDP cannot rise any higher, but real GDP can go up. As with the inflation rate, these GDP measurements treat unemployment either as a constant or as a variable.
Inflation, whether positive or negative, is a factor that constantly affects a country or region. While this is true, real GDP and potential GDP treat inflation differently, which often results in differences ranging from slight to major. With potential GDP, inflation is treated as a constant, so the rate never changes. When calculating real GDP, the actual inflation rate — which is prone to changing — is used. Potential GDP’s inflation rate is usually reset each quarter to the inflation rate that occurred with the real GDP.
Real GDP is the more accurate of the real GDP and potential GDP measurements, because it describes how a country or region is actually doing financially. Potential GDP is used as an estimate that describes how well a country or region might do during a quarter, but the real measurement may be completely different. This means real GDP is often used to see how a country or region did last quarter, while potential GDP is used as a measuring tool for the next quarter.
It is based on an estimated inflation rate, so potential GDP cannot rise any higher than its estimated value. Real GDP can drastically alter during the quarter, based on production amounts and inflation. While potential GDP is often thought of as a tool to show a country’s or region’s highest GDP value, real GDP can sometimes be higher than potential GDP.
Unemployment is a factor that can affect production, inflation rates and the general worth of a country or region. Much like with inflation rates, potential GDP treats unemployment as a constant while real GDP measures the actual unemployment rate. The unemployment rate typically does not alter as much as inflation rates, so this tends to have less of an affect on the GDP value.
@simrin-- I wish I had seen this article last week, before my econ test! I had several questions about real and potential GDP on my economy test last week. I got one wrong.
The question was a true or false. It asked: "If the economy is in equilibrium, it means that it must be functioning at potential GDP." I answered true and got it wrong. I thought that for the economy to be at equilibrium, it must have reached full employment and potential GDP.
But apparently, it doesn't have to be so. My instructor said that the economy can be functioning at less than full employment and still be at equilibrium.
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