What Is the Difference between Real GDP and Potential GDP?

The difference between real GDP and potential GDP is one of the most important economic concepts in macroeconomics. In this post I’ll explain what it is and why it’s important.

What Is the Difference between Real GDP and Potential GDP?

Real gross domestic product (GDP) and potential gross domestic product (GDP) are two of the many distinct measures of gross domestic product (GDP), but the figures are sometimes so close that it may be difficult to distinguish between them. Potential GDP is predicated on continuous inflation, while actual GDP is subject to change.

What Is the Difference between Real GDP and Potential GDP?

Potential GDP is an estimate that is often reset each quarter by real GDP, while real GDP depicts a nation or region’s actual financial standing. Because it is predicated on a constant inflation rate, the potential GDP cannot increase, but the actual GDP may. As with the inflation rate, the unemployment rate is either treated as a constant or a variable in these GDP calculations.

Whether inflation is positive or negative, it is a persistent element affecting a nation or area. While this is true, real GDP and potential GDP address inflation differently, resulting in often-significant disparities.

With potential GDP, inflation is viewed as a constant, hence the rate of inflation never varies. In order to calculate real GDP, the actual inflation rate, which is subject to change, is used. Quarterly, the potential GDP’s inflation rate is typically reset to the actual GDP’s inflation rate.

Real GDP is the more accurate of real GDP and prospective GDP, since it depicts a nation’s or region’s actual financial health. Potential GDP is used as an estimate to indicate how well a nation or area may do during a quarter, although the actual measurement may be much different.

This implies that actual GDP is often used to determine how well a nation or area performed in the previous quarter, but potential GDP is utilized as a measurement tool for the next quarter.

Due to the fact that it is based on an assumed inflation rate, the potential GDP cannot exceed its estimated value. Depending on output levels and inflation, quarterly real GDP might fluctuate significantly.

Real GDP may occasionally be greater than potential GDP, despite the fact that potential GDP is often seen as a measure of a country’s or region’s maximum GDP value.

Unemployment is a factor that may influence a nation or region’s output, inflation rates, and overall value. Similar to inflation rates, potential GDP considers unemployment a constant, but real GDP gauges the actual unemployment rate. The unemployment rate tends to fluctuate less than the inflation rate, and hence has a less effect on the GDP.

What Is Potential GDP?

Potential GDP measures the market value of products and services, but rather than documenting the current objective condition of a nation’s economic activity, it aims to predict the maximum level of production an economy can maintain over time.

What Is the Difference between Real GDP and Potential GDP?

  • 1. Assumes an economy has reached full employment and aggregate demand does not exceed aggregate supply.
  • 2. The primary theme here is sustainability. Every economy is constrained by its available labor force, technology, and natural resources, among other restrictions.
  • 3. When the nation’s GDP falls short of this natural limit, it indicates that the economy is failing to reach its full potential. When the GDP reaches this level, inflation is likely to ensue. For this reason, potential GDP is often referred to as potential production or natural GDP.

What Does Potential GDP Reveal About the Health of the Economy?

When making monetary policy choices, regulators and policymakers depend heavily on the GDP potential as a standard. The Federal Reserve utilizes these variables to influence monetary policy in the United States.

Clearly, the gap between potential and actual GDP influences the kind of policies that may be implemented. It is known as the production gap.

1. If real GDP falls short of potential GDP (i.e., if the output gap is negative), it indicates that consumer demand is weak. It indicates that full employment may not exist in the economy.

2. If the real GDP is greater than the potential GDP (i.e., if the output gap is positive), it indicates that the economy is generating over its sustainable limitations and aggregate demand is exceeding aggregate supply. In this situation, inflation and price hikes are probable.

3. If the output gap is negative, which indicates that the economy is not generating at its full capacity, central banks such as the Federal Reserve may explore cutting interest rates to encourage the economy.

4. The Fed is governed by its twin mission, which is to ensure full employment and price stability in the U.S. economy.

5. In other words, the Fed seeks to maintain a balance between actual and potential GDP.

What Happens When Real GDP Falls Short of Potential GDP?

A lengthy output gap, like in the United States during the Great Recession of the 2000s, may have various negative implications on an economy’s Potential GDP, including:

  • 1. It may influence the long-term outlook of the job market. The longer a nation’s economy maintains a high unemployment rate, the more likely it is that the labor market will shrink permanently as employees leave the labor field permanently or as their abilities deteriorate and they become permanently unemployable.
  • 2. An economy running below ideal levels for an extended period of time may have long-term negative impacts on expenditures in education, research and development, and other sectors, thereby lowering the nation’s economic growth potential.
  • 3. A chronic production gap may also reduce the amount of money paid into taxes, so limiting the capacity of governments to fund vital economic projects. Simultaneously, public expenditure on unemployment compensation and other social services increases, possibly worsening deficits, which might also hinder future GDP growth.

Alternatively, if actual GDP exceeds potential GDP, it indicates that aggregate demand is unsustainable, which might lead to excessive inflation and increasing prices. In such a scenario, the Fed may increase interest rates in an effort to curb expenditure.

How Is Potential GDP Estimated?

Estimating the potential production of an economy is a difficult issue, and many economists arrive at different estimates.

  • 1. For its estimations of potential GDP, the Congressional Budget Office (CBO) employs a mix of growth predictions and inflationary pressures gauges, while other economists have offered other techniques.
  • 2. These differences of opinion are not just intellectual. They may have significant effects on the monetary policies pursued by the Federal Reserve and other central banks.
  • 3. Calculating the natural rate of unemployment is a particularly difficult topic, and economists have differing opinions on the best approach to measure labor market slack, which is a significant contributor to GDP potential.
  • 4. The inherent oscillations of the economic cycle should also be taken into account when determining the potential production. For this reason, many estimates of potential GDP depend on trend lines drawn from historical data that smooth out these swings across several economic cycles.

What the Output Gap Tells Us about Business Cycles

Is it feasible for the actual production of the economy to exceed its potential output? “Although uncommon, it is conceivable for actual production to exceed projected output,” noted Wolla. However, it is far more typical for actual production to be less than potential output.

He stated that fluctuations in actual production compared to potential output produce business cycles, i.e. expansion (when the economy is increasing) or contraction (when the economy is shrinking).

When the economy declines, for example, the production gap tends to widen and becoming negative. In contrast, as the economy grows, the disparity tends to diminish and sometimes becomes positive.

How the Output Gap Helps Inform Monetary Policy

The output gap is one of the economic indicators that policymakers analyze when determining whether the economy needs a boost.

For instance, when the economy faces a negative output gap, the Federal Open Market Committee (FOMC), the primary monetary policymaking body of the Federal Reserve, may decrease the federal funds rate target range.

Reducing interest rates may help people and companies improve their financial situations. “When required, the FOMC might also use unorthodox monetary policy instruments like as large-scale asset purchases,” Wolla remarked. When the production gap is positive, the FOMC may consider countermeasures, such as an increase in interest rates, to calm an economy that is expanding faster than it should.

However, some economists and policymakers are concerned by the potential GDP since it relies on historical data to predict future trends.

Wolla said that if these estimations are inaccurate, then policies based on them may also be faulty. However, he noted, to account for economic developments that impact potential production, the CBO frequently adjusts its predictions.

Output Gap

What Is an Output Gap?

The phrase output gap refers to the difference between the actual production of an economy and its greatest potential output, as a percentage of gross domestic product (GDP). Positive or negative production gaps are possible for a nation.

What Is the Difference between Real GDP and Potential GDP?

A negative output gap indicates that real economic production is below the economy’s full potential for output, while a positive output gap indicates that the economy is surpassing expectations since actual output exceeds the economy’s maximum capacity output.

How an Output Gap Works

The output gap is the difference between current GDP and potential GDP or between production and maximum efficiency output. This is difficult to quantify since it is impossible to determine the ideal degree of operational efficiency for an economy.

There is limited agreement among economists on the optimal method for calculating potential GDP, although the vast majority concur that full employment is a crucial element of maximum output.

One way for estimating potential GDP is to draw a trend line across actual GDP over many decades, or long enough to minimise the influence of short-term peaks and troughs. By following the trend line, it is possible to predict where the GDP now stands or what its value will be at a certain moment in the near future.

Divide the difference between the actual and prospective GDPs by the potential GDP to get the production gap.

Because prospective production is not visible, it is often estimated using past information.

Positive and Negative Output Gaps

Whether positive or negative, the production gap is a negative sign of the efficiency of an economy.

A positive production gap shows a strong demand for products and services, which may be seen as advantageous for an economy. In order to satisfy the amount of demand, however, firms and workers must exceed their maximum efficiency.

Commonly, a positive production gap stimulates inflation in an economy, as both labor costs and prices of products rise in response to rising demand.

A negative output gap, on the other hand, shows a lack of demand for products and services in an economy and may result in businesses and workers performing below their optimal efficiency.

This sort of production gap is indicative of a sluggish economy and portends a slowing GDP growth rate and possible recession, since wages and prices of products often decline when economic demand is low.

Advantages and Disadvantages of the Output Gap

The production gap is an extremely crucial economic metric. While the usage of this measure has a number of unique benefits, it also has a number of downsides. Below are some of the most prevalent advantages and disadvantages of employing the output gap.

Advantages

Because the output gap is calculated using the gross domestic product, it provides insight into the state of the economy. Specifically, it may be used to identify whether the economy is underperforming or expanding at an excessive rate. This is because this gap may assist determine an economy’s inflation rate.

The output gap may assist policymakers in devising remedies to steer the economy in a more positive path. Therefore, it plays a crucial part in their decision-making. on fiscal and monetary policy. As an example, the Federal Reserve will increase interest rates to combat inflation, and vice versa.

Due to the fact that economists and analysts utilize the production gap, the general people may also use it to make educated financial and investment choices. For instance, a homeowner may elect to delay mortgage refinancing if there is a probability that interest rates may rise due to the production gap.

Disadvantages

One of the primary issues with the production gap is that it is difficult to quantify. The degree of real production is straightforward to ascertain since we are aware of what is occurring. However, potential production is difficult to quantify since it cannot be determined. This is a number that can only be guessed or projected.

Measuring the potential output might be tricky. In fact, there is more than one method for doing so. Analysts and economists may use distinct filters or models for this purpose. Some experts may calculate the prospective output as the trend output, but others may consider it the trend growth.

The interconnectedness of links throughout the economy is another constraint on the production gap. For instance, a less active labor force will result in a decline in production. Similarly, troubled small enterprises and corporations, as well as tougher lending rules, may have a substantial influence on the potential production during difficult economic times.

What Is the Difference between Real GDP and Potential GDP?

Pros

  • It gives a snapshot of the state of the economy.
  • Policymakers may utilize output gap to aid in decision-making.
  • Consumers and investors may make financial and investing choices with knowledge.

Cons

  • Potential output cannot be seen, hence it is difficult to calculate the output gap.
  • There is no standard method for measuring potential output.
  • Potential production is strongly reliant on interdependent linkages in the economy.

Real-World Example of an Output Gap

According to the Bureau of Economic Analysis, through the fourth quarter of 2020, the real U.S. GDP was $21.48 trillion. The U.S. had a positive output gap of around 10.7 percent (projected GDP minus actual GDP/projected GDP) in the fourth quarter of 2020, according to the Federal Reserve Bank of St. Louis.

Remember that this computation is only one estimate of the U.S.’s potential GDP. The consensus among observers was that the United States will see a positive production gap in 2020.

Since 2016, the U.S. Federal Reserve Bank has steadily raised interest rates in reaction to the favorable gap, which is not unexpected. In 2016, rates were less than 1 percent and will reach as high as 1.25 percent by early 2020. The global financial crisis, however, compelled the Fed to lower interest rates below 1 percent again by mid-March 2020.

Potential Output FAQs

What Is Potential Output?

Potential output is the amount of GDP an economy is capable of producing at full employment. This is often the greatest level when the economy is flourishing. Potential output, unlike actual production, which is already occurring, cannot be measured and hence depends on estimate.

How Can an Economy’s Output Deviate From Its Potential?

The production gap of an economy might differ from its potential in one of two ways. A positive output shows that the economy is operating much better than anticipated. Because the actual output exceeds the anticipated output. It may also be negative when production falls short of capacity.

What Would Help a Government Reduce an Inflationary Output Gap?

Governments may find that decreasing government expenditure, transfer payments, and bond and security issuance might assist in narrowing an inflationary production gap.

What Happens to the Output Gap When the Economy Is in Recession?

In a recession, the actual production gap is less than the prospective output gap.

What Can the Government Do to Move the Economy Back to Potential GDP?

Governments may return the economy to its potential GDP by a variety of measures, including (but not limited to) reevaluating tax rates and rebates, adjusting interest rates, and reducing or raising government expenditure.

Whether they pick a positive or negative path relies on whether the actual product is positive or negative.

Conclusion

In short, the Difference between Real GDP and Potential GDP that potential GDP is the level of output an economy can produce. Real GDP is the level of output actually produced by an economy. Potential GDP takes into account factors like population growth, technological change and new capital stock. Real GDP excludes these factors.

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Pat Moriarty
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