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What Is the Difference Between Real GDP and Potential GDP?

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  • Written By: Alex Newth
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  • Last Modified Date: 02 August 2014
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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.

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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.

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Discuss this Article

turquoise
Post 3

@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.

SteamLouis
Post 2

@turkay1-- That's right. This quarter's potential GDP is based on the inflation and unemployment rates of the previous quarter.

Real GDP will go over potential GDP if there is an increase in employment during that quarter. Because more employment means more production and higher inflation. It also means that the unemployment rate of that quarter is below the natural unemployment rate.

To understand this, you have to think about real and potential GDP a little bit differently. Remember that potential GDP equals all of the goods and services in the country at full employment. So that means that for every job seeker, there is a job vacancy. This doesn't meant that there are no unemployed individuals. It just means that there is a job vacancy for all unemployed individuals.

And real GDP is aggregate expenditures, so all the goods and services in the country as of right now, at the unemployment rate we currently have. Basically, it's all based on employment. Potential GDP always shows us where we can be in terms of economic growth if we reduce unemployment. Real GDP shows us how many more jobs and how much more production is necessary to get there.

candyquilt
Post 1

Can anyone tell me more about how the inflation and unemployment rate affects real GDP and potential GDP?

I understand that real GDP is variant and potential is constant. Since the constant inflation and unemployment rates used to measure potential GDP are renewed every quarter, does this mean that potential GDP is always based on rates of the previous quarter? Is that why real GDP sometimes goes higher than potential GDP?

Because if real and potential GDP were measured based on the same inflation rates, real GDP could never pass potential GDP, right? And can we say the same thing about the unemployment rate?

If I understood this correctly, that means that only real GDP is accurate. Potential GDP is more of an estimation. But I don't know why economists are not looking for more accurate numbers for potential GDP. After all, the potential is used to determine how much increase in production and employment should take place in order for the economy to function at full potential the following quarter.

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