In this article, we examine the most recent economic data and analysis to provide a comprehensive overview of the economy to explore “Does Potential GDP and Output Gap matter”.
Does Potential GDP and Output Gap matter?
The terms Potential GDP and Output Gap appear frequently in many of the articles. They would say that Potential GDP has increased or the output gap has widened, but they would not specify what the Potential GDP or Output Gap is.
What Is Potential Output?
Potential output is an estimate of the maximum amount of goods and services that an economy can produce if it operates at full capacity (or when it is more efficient).
Potential output serves as a standard against which actual output can be measured or compared. Inflation, production, natural resource availability, and infrastructure all influence potential GDP.
Factors influencing potential GDP include Labor Supply, Human Capital Quality, Capital Stock, Technological Advancements, and Natural Resource availability.
What is the Output Gap?
The output gap is an economic measure that shows the difference between an economy’s actual output and its potential output. Normally, this is expressed as a percentage of potential output.
Output Gap Formula
Output Gap = (Actual Output-Potential Output)/ (Potential Output)×100
When actual output is less than or less than Potential Output, there is a negative output gap. This means that there is more capacity available but it is not being used. In other words, the economy’s resources are under-utilised. This could be due to a lack of demand.
When actual output exceeds potential output, there is a positive output gap – a rare occurrence. At this point, the economy is outperforming its potential. This may be feasible in the short term, but it will not be sustainable over time.
The output gap expresses whether an economy is running at an efficient or inefficient rate, that is, whether it is underutilizing its resources or exceeding its potential.
Unemployment, hiring difficulties, capacity utilization, productivity growth, and inflation are the most common determinants of output gap.
Why Does Potential Output Matter?
When the economy grows faster than potential output (positive output gap), it indicates that demand exceeds potential output and inflationary pressures are present. In contrast, when demand grows slower than potential output, the economy grows slower than its potential output (negative output gap). In the first case (positive output gap), the Central Bank will raise interest rates to counteract inflationary and demand pressures, while in the second case (negative output gap), the Central Bank will lower interest rates to stimulate demand. Though this may appear to be a simple policy adjustment, it is not; policy adjustments are dependent on a variety of factors.
Only up to the limit of its potential output can an economy grow faster. Potential output is analogous to the safest speed limit for economic growth. When the government spends too much, it increases demand more than the economy’s capacity to produce, resulting in inflation.
As a result, it is critical for Federal Reserve policymakers to understand Potential Output in order to make policy adjustments that result in price stability, long-term employment, and economic growth. The Central Bank can forecast the output gap by having nearly accurate or good estimates of potential output. This will assist Congress and the President in anticipating whether an economy requires fiscal stimulus or restraint.
Determinants Potential GDP:
However, in USA, the Potential output mainly depends on the productivity growth (output per hour of work) and the size of labor force, which itself is entirely dependent on the amount of capital investment. Potential output can be increased by entrance of more labor in the labor force and also increase in capital in the economy, it can also be increased by increasing the productivity of the existing labor force and capital stock of the economy
Predicting Potential Output
Projecting potential output is difficult during normal times. In the wake of the pandemic it is very difficult as the pandemic has affected the potential output itself. There are many business which was closed, many workers have left labor force and many firms have fired their employees during this pandemic. Therefore, it will take some time for the economy to come back to its original productive capacity (i.e. to the stage where economy would have been without the pandemic). The decline in investments and also in immigration during the pandemic has affected the labor force and capital stock in the economy. This has lowered potential output of the economy.
The following graph is constructed from the data of the Congressional Budget Office’s (CBO’s) July 2022 report – The 2022 Long-Term Budget outlook.
The Following Video from FRED explains in short whether economic is performing to its Potential?