Potential GDP

Introduction

• Potential GDP is one of the theoretical aspects of national income accounting which assumes that an economy has achieved full employment and that aggregate demand does not exceed aggregate supply. 

• Potential GDP attempts to estimate the highest level of output an economy can sustain over a period of time.

Determinants of Potential GDP

• Capital Stock: In an economy,  capital stock is the plant, equipment, and other assets that help with production. The availability of capital stock determines the extent of economic output and Potential GDP. 

• Labour Force: At any given moment in time, the quantities of capital, land, etc,  are typically fixed, but the quantity of labour employed varies.  Therefore, in the short-run, Potential GDP depends on the quantity of labour employed, which depends on demographic factors and on participation rates.

• Non-accelerating Inflation Rate of Unemployment: It is the specific unemployment rate at which the rate of inflation stabilises – inflation will neither increase nor decrease. It is also one of the determinants of Potential GDP.

• Other determinants of Potential GDP are the level of labour efficiency, labour market efficiency, production capacity, sufficient liquidity, government fiscal support, etc.

Factors that Hinder a Country in Realizing Its Potential GDP

• Negative Output Gap: A negative output gap occurs when actual output is less than what an economy could produce at full capacity. A negative gap means that there is spare capacity, or slack, in the economy due to weak demand.

• Fall In Private Consumption: Private consumption is the prime component of the GDP of many developing economies. Decline in private consumption de-incentivise firms in producing more goods, thereby the economy is left with unutilized resources and labour force.
• Mounting NPAs of Banks: Mounting NPAs of banks reduces banks’ lending capacity which affects businesses, production houses, etc. It ends up with liquidity shortages which reduces the productive capacity of the economy.
• Unemployment:  Huge unemployment is also one of the major factors that inhibit a country from realizing its Potential GDP. 
• Other Factors: Weak intellectual property rights, low expenditure on R&D, contract enforcement issues,  etc.

Output Gap

• The output gap is an economic measure of the difference between the actual output of an economy and its potential output. 

• Potential output is the maximum amount of goods and services an economy can turn out when it is most efficient—that is, at full capacity. Often, potential output is referred to as the production capacity of the economy.­

• The output gap can be positive and negative. 

• A positive output gap occurs when actual output is more than the full-capacity output of an economy. This happens when demand is very high. 
• A negative output gap occurs when actual output is less than what an economy could produce at full capacity. This happens when demand is weak or very low. ­

• An output gap, whether positive or negative, is an unfavourable indicator of an economy’s efficiency. 
• A positive output gap commonly spurs inflation in an economy. Alternatively, a negative output gap is a sign of a sluggish economy and portends a declining GDP growth rate.