GDP is defined as Gross Domestic Product and it is one of the most standard measures of an economies output. It measures “The value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production.” GDP is also equal to the sum of personal consumption expenditures, gross private domestic investment, net exports of goods and services, and government consumption expenditures and gross investment.” Real GDP is the measure of an economies output but it also adjusts for the price changes over the years.
Potential GDP however is the level of output an economy can sustain at a constant level of inflation. Potential GDP is an exceedingly important statistics to compute as it can have many potential policy implications. Potential GDP is used in a variety of equations such as the “Taylor Rule.” When looking at Potential GDP we should recognize that many interpret Potential GDP and the disparity between Potential and Real GDP as an indication of the economy is in a recession or expansionary period.
If Real GDP is below potential, that output is below what it should be and the economy would be assumed to be in a trough. Per the graph above (Graph 1) we can see these expansions and recessions over time. From 1995 to around 2002 output was above potential. However from 2008 to 2015 we can see that we have been in a recessionary period as output is well below potential. In that period (from 2008 to 2015) output was at least a trillion dollars short of potential. Obviously, this can be attributed to the great recession. The failures of major banks, financial firms, and other various firms such as the car industry directly lead to this massive collapse in output. As such Real GDP fell compared to the slope of historical GDP (which once again is potential GDP as usually it is the average of Real GDP over time). When looking at the long-term trend of Potential GDP we can see the slope of the line which can indicate the long-term trend of GDP growth. The graph below (Graph 2) shows past Real GDP over time, along with estimates of future GDP using the Potential GDP line.
Currently we are at approximately 17 trillion dollars of GDP or output. Because Potential GDP uses a line equation to run though historical GDP to show deviations from potential and to make predictions of future GDP we can use this line to estimate GDP in say 2020. Per Graph 2 we can see that Potential GDP places an average growth rate that would lead to about an 1 trillion dollar gain in GDP per year in 2020 compared to 2017. Even though we have been below potential in recent years we can see projections of growth in the future based of the line. That bodes well for the economy and shows promise in future output. Potential GDP is a powerful tool that can estimate future growth, and help determine whether the economy is doing well or not, however there are many shortcoming associated with potential GDP as well. Agreement on what potential GDP is especially problematic. While most Economists use historical GDP to estimate potential, the lien of potential GDP is always changing with new data. If for example in 2017 GDP rises, then so will the line. Because of its ever changing nature potential GDP may not truly show the output gap at the current period in the long term. Ben Bernanke states the difficulty in measuring this output gap (in an article writing against “Rule” based policy) and the necessity to limit data lags and use real time data. Even with real time data however the line is still an average and because we cannot predict the future we cannot truly know what potential GDP is.