Potential GDP and its Determinants and Factors

An economy's maximum output with its current economic resources is potential GDP. It symbolizes the overall long-term supply of an economy.

An economy's maximum output with its current economic resources is potential GDP. It symbolizes the overall long-term supply of an economy. The economy will use its resources and achieve full employment at this output level.

The quantity and quality of production inputs and technologies increase along with potential GDP. Its growth does not cause the economy to experience inflationary pressures. It will therefore result in a vertical line on a graph.

Potential output, total output at capacity, long-run output, or output at full employment are additional terms for potential GDP.

Real GDP versus potential GDP

In light of the available economic resources, potential GDP represents the maximum real GDP value. A period (a quarter or a year) 's worth of output is measured in terms of real GDP, which is the actual value of that output.

Compared to a production machine, the idea is similar but distinct. The highest level of capacity is potential GDP. The actual output generated by machines is what is referred to as real GDP.

The real GDP is mentioned more frequently than the potential GDP. In various news media, the term "real GDP" is used to indicate economic growth because the percentage of real GDP growth over time is, in essence, what defines economic growth. Over time, a rise in output volume is called "economic growth."

Real GDP is preferred by economists over nominal GDP when gauging the expansion of economic output. It is all because price changes, including inflation and deflation, have no impact on real GDP growth. 

Determinants of real GDP and potential GDP

The effects of changes on real GDP change:

  • overall demand
  • Short-term aggregate supply
  • Quantity and quality of factors of production

Household consumption, business investment, exports, and government spending are a few factors affecting aggregate demand. In this instance, the variables also include fiscal and monetary policy.

Factors Influencing potential GDP  


A rise in the quantity of money in circulation or the cost of goods can be considered inflation. A rise in prices relative to a benchmark is what we mean when we use the term "inflation." It only takes time, but higher prices almost always follow when the money supply is increased. In this discussion, we will refer to the core Consumer Price Index (CPI), the accepted gauge of inflation used in American financial markets. It is more significant to measure core inflation.

According to studies, there has been a 0.5 percent decline in unemployment over the past 20 years for every percentage point of annual GDP growth above 2.5 percent. This beneficial relationship, however, starts to deteriorate when employment is extremely low or close to full employment. Due to two crucial consequences of an economy with near-full employment, extremely low unemployment rates are more costly than beneficial.

  1. Demand in aggregate: Prices will increase as demand for goods and services expands more quickly than supply. 
  2. Labor market: Due to the tight labour, businesses will have to increase wages. The increase in profits is typically transferred to customers through higher prices as a company looks to maximize profits.


When the economy is struggling, and there is less than full employment, the GDP gap is positive, indicating that it is not operating at its highest level. The GDP gap is negative during periods of inflationary boom, a sign that the economy is doing better than it could (and is at or above full employment).

Factory output

  • A high GDP can be achieved with continuous growth, which increases the contribution of factory-produced finished goods to the overall economy. 
  • The cost of raw materials, energy, wages, taxes, and subsidies impacts short-term aggregate supply (and real GDP). 
  • Each of them affects how much money is spent on production in the economy. 
  • A few factors that affect aggregate demand are household consumption, business investment, exports, and government spending. 
  • Monetary and fiscal policies are also crucial factors to consider in this situation.

Factor inhibiting potential GDP in India

Low productivity

  • Low productivity indicates that resources need to be using their skills and competencies to the fullest, raising the company's resourcing costs.  
  • Two things could cause this: first, managers might give highly skilled workers mundane administrative tasks that are low priority. 
  • Profit margins are also lowered when time and money are spent on resources that are not performing well. 
  • The production costs are greater than or nearly equal to the billing costs, which is why. Therefore, the company's profit margins are largely determined by productivity.

Currency depreciation 

Currency depreciation is the loss of one currency's value in relation to another. 

In a system where the forex market decides a currency's value based on supply and demand, it refers to currencies with a floating exchange rate. Trading involves holding two different currencies in a pair while comparing their values. 

The value of the second listed currency, the quote currency, is given in relation to the value of the first listed currency, the base currency, which is always valued at one. Depreciating currencies allow forex traders to make or lose money as currency values change.

Consider a trader who decides to short EUR/USD because he thinks the value of the euro will decline relative to the dollar. The position would be profitable if the euro fell in value. However, they would incur a loss if the euro's value increased.

Instead, in the expectation that the euro would strengthen against the dollar, the trader would have taken a long position. If the euro's value increased, they could exit their positions at a profit. As a result of closing the trade at a lower exchange rate, the trader's long position will experience a loss if the value of the euro relative to the dollar decreases.

Decrease in foreign capital

  • Foreign capital is defined as funds that enter the nation either as concessional or non-concessional flows. 
  • There are many ways that foreign money enters India, including banking and NRI deposits. 
  • Massive FDI inflows into India, which have significantly boosted the Indian economy, have been made possible by the various forms of foreign capital flowing into the nation. 
  • Foreign investment increases the nation's productive assets, savings, and home resources. 
  • FDI gives the nation foreign currency and promotes investment growth, which raises income and employment in the recipient nation.

Lack of infrastructure

  • Investing in infrastructure can be a highly effective means of achieving macroeconomic stability. 
  • Most estimates indicate that infrastructure investments significantly outperform other financial interventions in terms of the output "multiplier". 
  • If monetary policymakers adjusted the fiscal boost of the infrastructure investment (FTEs), each $100 billion in infrastructure spending would increase job growth of approximately 1 million full-time equivalents.
  • Productivity growth has drastically decreased over the past few years. Since labor markets are becoming more constrained, a large portion of this slowdown is anticipated to be temporary as productivity growth returns to more historically normal levels. It starts having an impact right away.

















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