Politics & Society

Economics 101: What Is Potential GDP and Why Does It Matter in Business and Economics?

Written by MasterClass

May 23, 2019 • 3 min read

How do you gauge the overall health of an economy? Most economists and governments use Gross Domestic Product, also known as GDP, or real GDP. GDP represents the total market value of all the goods and services produced by a state over a given period of time. But if GDP represents the actual health of an economy, how do economists know what to compare it to? Put another way, how do economists determine how much the economy should be producing? To answer this question, economists use a related metric: potential GDP.

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What Is Potential GDP?

Like GDP, potential GDP represents the market value of goods and services, but rather than capturing the current objective state of a nation’s economic activity, potential GDP attempts to estimate the highest level of output an economy can sustain over a period of time.

  • It assumes that an economy has achieved full employment and that aggregate demand does not exceed aggregate supply.
  • Sustainability is the key concept here. Every economy has certain natural limits, determined by its available labor force, technology, natural resources, and other limitations.
  • When GDP falls short of that natural limit, it means the country is failing to live up to its economic potential. When GDP exceeds that natural limit, inflation is likely to follow. This is why potential GDP is sometimes referred to as potential output or natural GDP.

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

Potential GDP provides an important benchmark for regulators and policymakers to rely on when making decisions about monetary policy. In the U.S., the Federal Reserve uses these metrics to guide monetary policy.

Of course, the kinds of policies that may be pursued depend on the difference between potential and real GDP. This is called the output gap.

  • If real GDP falls short of potential GDP (i.e., if the output gap is negative), it means demand for goods and services is weak. It’s a sign that the economy may not be at full employment.
  • If the real GDP exceeds potential GDP (i.e., if the output gap is positive), it means the economy is producing above its sustainable limits, and that aggregate demand is outstripping aggregate supply. In this case, inflation and price increases are likely to follow.
  • If the output gap is negative—meaning that the economy isn’t producing its full potential—then central banks like the Fed may consider lowering interest rates to stimulate the economy.
  • The Fed is guided by what’s called the dual mandate: to keep the U.S. economy at full employment while maintaining price stability.
  • Put another way: the Fed aims to keep real GDP aligned with potential GDP.

What Happens When Real GDP Falls Short of Potential GDP?

A prolonged output gap—as during the Great Recession of the 2000s in the U.S.—can have several negative effects on an economy’s Potential GDP:

  • It can affect the long term prospects of the labor market. The longer a nation’s economy persists with a high rate of unemployment, the greater the likelihood of a permanent shrinkage of the labor market as workers voluntarily exit the labor force permanently, or their skills atrophy and they become permanently unemployable.
  • An economy operating below optimal levels for a long time can have long term negative effects on investments in education, research and development, and other areas, potentially reducing the nation’s potential level of economic growth.
  • A persistent output gap can also cut the amount of money paid into taxes, which affects governments’ ability to spend on essential programs that support the economy. At the same time, public spending on unemployment benefits and other social services rise, potentially exacerbating deficits that can also hurt future GDP growth.

On the other hand, if actual GDP exceeds potential GDP, it’s a signal that aggregate demand is unsustainably high, which could lead to high levels of inflation and increased prices. In that case, the Fed may act to rein in spending by raising interest rates.

How Is Potential GDP Estimated?

Estimating the potential output of an economy is a tricky task, and different economists estimate it differently.

  • The Congressional Budget Office (CBO) uses a combination of growth forecasts and gauges of inflationary pressures for its estimates of potential GDP, but other economists have proposed alternative methods.
  • These disagreements aren’t merely academic. They can have serious implications for what monetary policies the Fed and other central banks pursue.
  • In particular, calculating the natural rate of unemployment is an especially thorny problem, and different economists take different views of the best way to gauge slack in the labor market, which after all makes up a big part of potential GDP.
  • Another consideration when calculating potential output is the natural fluctuations of the business cycle. That’s why many estimations of potential GDP rely on trend lines constructed from historical data that smooth out these fluctuations over many business cycles.

Learn more about economics in Paul Krugman’s MasterClass.