Potential GDP

economic-dictionary

Potential GDP is the maximum level of production that an economy can achieve with the labor, capital and technology existing in that economy. And this, without inflationary pressures.

When we talk about a potential client, or a potential user, we are referring to clients and users who, having not made use of our product or service, could buy or use it to suit their needs. In the same way, when we talk about potential GDP, we are talking about that GDP that the country could present with the resources it possesses, but which, for whatever reason, is not recorded.

In other words, we are talking about the maximum level of production that an economy can achieve with the labor, capital and technology existing in that economy. That is, when producers and the rest of the economic agents in an economy produce in a scenario of maximum efficiency. And all this, without this efficiency ending up leading to inflationary pressures.

Since it is not always produced efficiently, there is a clear difference between what a country produces and its potential GDP. This is what we know as the output gap that helps us, among other things, control inflation and make decisions, as we will see below, in fields of such relevance as monetary policy.

In short, we are talking about a magnitude that tries to measure the capacity of an economy, and this with respect to its current performance. This, facilitating in its wake not only the measurement of capacity and production in terms of maximum efficiency, but also control and the ability to keep inflation at bay.

Characteristics of potential GDP

Among the characteristics that best define potential GDP, we can highlight the following:

  • It is a macroeconomic magnitude.
  • It is used to measure the capacity of an economy.
  • In other words, it shows the GDP that such an economy could register if both labor and capital and technology operate in terms of maximum efficiency.
  • It tries to measure the capacity of an economy to operate with given resources. All of this without causing inflationary pressures due to said production.
  • As a general rule, it tends to differ from observed GDP.
  • The difference between potential and observed GDP is called the output gap. If the first exceeds the second, we will say that there is a positive gap, while, if it does not arrive, we will say that there is a negative gap.
  • The output gap is used to measure inflation.

The production gap or «output gap»

Since we have talked about this important concept repeatedly throughout the article, it is worth stopping to see what the output gap is, and what it is for.

Thus, as we said before, the observed GDP usually differs, as a general rule, from the potential GDP. In other words, both GDPs are not at the same level, because it is not common for agents to be operating in maximum efficiency scenarios, or if they do, they are passed. For this reason, there are indicators that allow us to know this difference between levels and to see with what capacity an economy is not using.

The benchmark for measuring this is what the Americans and the British call the "output gap," or what we Hispanics call the output gap. The output gap measures the difference between observed GDP and potential GDP.

In expansionary phases, where the economy grows strongly, economic activity remains above its potential for a period of time, generating a positive output gap, albeit with inflationary pressures. In recessions, as we can guess, the opposite happens. Thus, economic activity falls below its potential and that output gap, unlike the previous case, presents a negative balance. This is a characteristic situation of periods of adjustment in economic activity that generate a downward trend in inflation.

This indicator complements the knowledge of politicians in order to make decisions on economic policy.

Criticism of the concept

In the same way that many economists consider potential GDP as an indispensable tool for making economic policy decisions, others, more critical of it, find nuances to highlight that make it imperfect.

In this sense, the first problem is that potential GDP is not an observable variable, so to estimate it, statistical methods and economic models subject to different hypotheses must be used. This means that the results obtained, due to the fact that the methods are not perfect and that you can choose between several, can be very sensitive depending on the method chosen.

Furthermore, in times of crisis, the slow recovery causes potential GDP to decline and, over a period of time, could offer a misdiagnosis due to this process of reallocation of resources.

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