The gross domestic product (GDP) is one of the main indicators that economists and policy makers use to measure the economic performance of a country. GDP represents the total monetary value of goods and services a country produces over a year. The value of GDP is equal to the difference between the sum of exports, government, investment and consumer expenditures, and the total value of imports (Taylor, 2011). It is necessary to note that GDP affects virtually everyone within an economy. For instance, a high GDP implies a healthy economy hence low unemployment rates and attractive wages. On the other hand, GDP has various measurements entailing real GDP and potential GDP, whose features are often similar hence it is difficult to point out their differences. This paper presents an analysis of the differences and relationship between real GDP and potential GDP (Bangalore, 2011).
Real GDP is a macroeconomic indicator of the value of a country’s economic production adjusted for price variations, that is, deflation or inflation. This adjustment converts the nominal GDP (money-value measure), into an index for total output’s quantity. Real GDP has other names including inflation-corrected and constant-price GDP, and it reflects the value of output that a country expresses in prices of the base-year (Bangalore, 2011).
The formula for calculating real GDP is:
Real GDP = ∑ pb qt, where p refers to price b base year, q is the quantity, and indicates the current year (Bangalore, 2011).
For instance, suppose in year X a nation produced a total of 10 widgets at $10 each, or $100 total and year Y, it produces the same 10 widgets, but the price increases to $12, or $120 total. Assuming that year X is the base year for calculating real GDP, both nominal and real GDP in X will be $120. In year Y, nominal GDP is $120 while real GDP is only $100 because it is constant and the country produced only $100 in widgets. Through elimination of the price effect, real GDP enables economists to make valuable comparisons of a country’s services and output (Gavin, 2012).
Potential GDP is the amount of output that a country’s economy can generate at a steady inflation rate. However, an economy can momentarily generate more than its potential degree of output, as a result of the rising inflation. Potential production relies on many factors including the degree of labor effectiveness, the capital stock and the non-accelerating rate of unemployment (NAIRU). On the other hand, potential GDP depends on the potential work force, which depends on participation rates and demographic dynamics (DBO, 2004).
Monetary policy makers approximate potential GDP through creating measures of the tendency in the actual GDP that can stabilize business cycle variations. Measuring the past potential, output is comparatively easy because there are reliable techniques to obtain smooth trends from past data. Nevertheless, determining potential output in actual time is relatively complex because by using only past data economists cannot confidently approximate the country’s potential GDP for the year 2012 until some years have passed to observe the evolution of GDP, since their estimate’s accuracy relies on their long-term forecast’s accuracy.
Potential GDP is significant since monetary policy makers utilize differences between potential and actual GDP (the output gap) to establish whether the economy requires less or more monetary stimulus than it currently receives (DBO, 2004). For instance, by observing the recent data from Congressional Budget Office (CBO), it is possible to realize the output gap’s approximates overtime. From the estimates, CBO points out that the actual GDP in the USA was almost 10% less than potential output in the first quarter of 2009. From that period, actual GDP has matched the potential GDP sequence that economists estimated back 2007, but certainly, along a noticeably lower level lane than the estimate (DBO, 2004).
The figure below indicates real GDP’s logged values and two approximates of potential GDP that CBO calculated. It approximated the higher degree potential GDP in 2007 and the lower degree in 2011. In the figure, the decreased 2011 estimator replicates the impact of slothful GDP growth over the last three years.
Note: Real (Actual) and Potential GDP (Calculated in constant dollars). Adapted from “What is potential gdp and why does it matter?” By W.T. Gavin, 2012. Copyright (2012) by Economic Synopses. Adapted with permission.
Differences between Real and Potential GDP
There are many differences between potential and real GDP including the way they treat inflation. While the estimates of a country’s potential GDP rely on constant inflation, real GDP’s estimates can change. On the other hand, a country often resets its potential GDP on a quarterly basis using real GDP, but real GDP illustrates its actual financial position (Gavin, 2012). Potential GDP estimates cannot increase because it relies on constant inflation rate, but real GDP estimates can rise. These two measures of the economy also treat unemployment differently, while potential GDP treats it as a constant, real GDP treats it as a variable.
Real GDP is a more accurate measure of the economy than potential GDP because it portrays how a region or a nation is doing financially. On the other hand, financial policy makers use potential GDP as an estimate to describe how well a region or a nation might perform on a quarterly basis, even though the real dimension might be totally different. Consequently, financial stakeholders often use real GDP to observe how a region or a nation performed during the last quarter, while they use potential GDP as an evaluation tool for the following quarter (Taylor and Weerapana, 2011).
Since potential GDP depends on the projections of the inflation rate, its value cannot increase more than the estimate. Conversely, real GDP can radically vary during the quarter, depending on the amount of production and the rate of inflation. Even though policy makers often use potential GDP to demonstrate the highest GDP value of a region or nation, it can sometimes be lower than real GDP.
Relationship between Real and Potential GDP
Potential GDP is the maximum level of real GDP that a country can sustain over a long period. There is a limit on the level of output because of institutional and natural restrictions. If actual GDP increases and remains above the potential GDP, then in the absence of price and income controls, inflation is likely to rise as demand for factors of production surpasses the supply (Taylor and Weerapana, 2011). This happens as a result of restricted supply of labors and their time, natural resources and capital equipment, together with the limits of the nation’s management skills and technology. On the other hand, if real GDP falls below potential GDP, inflation will slow down because suppliers reduce prices to fill their surplus production capacity.
The difference between potential and actual GDP is called the GDP or output gap. Financial policy makers use the output gap to establish whether the economy requires less or more monetary stimulus than it currently receives. They may also use GDP gap to monitor closely dealings of business capacity industrialization (Gavin, 2012).
Price Level and the Relationship between Real and Potential GDP and the Effect on Each of Them
The aggregate supply and demand models offer a scheme for evaluating variations real and potential GDP and variations in the level of price. The relationship between the price level and the quantity of the real GDP supplied is called aggregate supply. The amount of the real GDP supplied refers to the amount of final commodities and services that all firms in the economy produce.
In considering the relationship of real GDP and the price level, it is essential to distinguish between the short run and the long run periods (Taylor and Weerapana, 2011). The short run is an adequate length duration hence all factors including capital, production and labor rare variable. On the other hand, the short run is a period that some factors are variable when some are fixed.
“The long-run aggregate supply (LAS) curve defines the connection between real GDP supplied and the price level when real GDP is equivalent to potential GDP” (Lecture 15). However, since potential GDP is always fixed, it follows that the LAS curve is always vertical. This means that the real GDP equivalent to the potential GDP does not depend on the price level (Taylor and Weerapana, 2011).
Other relevant parameters are the short-run and long-run macroeconomic equilibrium. The short-run equilibrium happens when the demand of the real GDP is equivalent to the supply of the real GDP at the point of intersection of the SAS and AD curve. If real GDP is beneath equilibrium GDP, companies enhance production and increase price, but if it is above the equilibrium, the companies reduce production and prices (Lecture 15).
In short-run equilibrium, actual GDP can be less or greater than potential GDP. On the other hand, long-run equilibrium happens when real GDP is equivalent to potential GDP
The GDP is a significant indicator that financial policy makers use to evaluate the economic performance of a nation. High GDP implies an economically healthy nation with decent wages and low rates of unemployment. To measure the economic output of the region or a nation, economics may use two aspects of the GDP, real GDP and potential GDP. Real GDP is a macroeconomic indicator of the value of a country’s economic production adjusted for price variations, that is, deflation or inflation. On the other hand, potential GDP is the amount of output that a country’s economy can generate at a steady inflation rate.