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Potential GDP and its Determinants and Factors

  • Last Updated : 24 Nov, 2021

Potential gross domestic product (GDP) is the amount of output that an economy can produce at a constant rate of inflation. Rising inflation, on the other hand, may cause an economy to produce more than its potential output for a short period of time. The capital stock, the potential labor force based on demographic factors and participation rates, the non-accelerating inflation rate of unemployment, and the level of labor efficiency are all factors to consider when calculating the output gap.

The global financial crisis, the decline in total factor productivity contribution, capital stock growth declaration, capital allocation distortions across various economic sectors, financial sector mess and constraints, reduction in disposable income levels, depletion of consumption and fixed investment, and other factors are preventing India from realizing its potential GDP. India, on the other hand, could boost potential output by increasing capital formation and redistributing excess capital from over-capitalized to under-capitalized entities.

Determinants of potential GDP  

1. Inflation

Inflation can be defined as an increase in either the money supply or the level of prices. When we hear the term “inflation,” we’re referring to a rise in prices relative to some benchmark. If the money supply is expanded, higher prices are almost always the result—just it’s a matter of time. For the purposes of this discussion, we’ll use the core Consumer Price Index (CPI), which is the standard measure of inflation used in the financial markets in the United States. The measurement of core inflation is more important.

According to studies, every percentage point of annual GDP growth above 2.5 percent has resulted in a 0.5 percent decrease in unemployment over the last 20 years. However, when employment is very low or near full employment, this positive relationship begins to break down. Extremely low unemployment rates have proven to be more costly than beneficial because a near-full employment economy will result in two important outcomes:

  1. Aggregate demand: As aggregate demand for goods and services grows faster than supply, prices will rise.
  2. Labor market: Due to the tight labor market, companies will have to raise wages. As a company seeks to maximize profits, this increase is usually passed on to consumers in the form of higher prices.

2. Recession 

The GDP gap is positive when the economy is in a slump, indicating that it is not performing to its full potential (and less than full employment When the economy is in an inflationary boom, the GDP gap is negative, indicating that the economy is performing better than it could be (and more than full employment).

3. Factory output

The contribution of finished goods from factories to GDP increases. For a high GDP, continuous growth will suffice. Meanwhile, raw material costs, energy prices, wages, taxes, and subsidies all have an impact on short-run aggregate supply (and real GDP). They all have an impact on the economy’s production costs. Household consumption, business investment, exports, and government spending are examples of aggregate demand factors. In this case, monetary and fiscal policies are also important considerations.

Factor inhibiting potential GDP in India

1. Low productivity

Low productivity indicates that resources are not maximizing their skills and competencies, resulting in higher resourcing costs for the company. This could be due to two factors: first, managers may assign low-priority or mundane administrative tasks to highly-skilled employees. Furthermore, spending time and money on resources that aren’t performing well reduces profit margins. This is due to the fact that the production costs are higher than or almost equal to the billing costs. As a result, productivity is a major determining factor in the organization’s profit margins.

2. Currency depreciation 

Currency depreciation is the loss of one currency’s value in relation to another. It refers to currencies with a floating exchange rate, which is a system in which the value of a currency is determined by the forex market based on supply and demand. Currency pairs are always traded, with the value of one quoted against the value of the other. The value of the first listed currency, the base currency, is always one, while the value of the second listed currency, the quote currency, is given in relation to it. As currency values fluctuate, currency depreciation allows forex traders to profit or lose money.

Let’s say a trader decides to short EUR/USD because he believes the euro will fall in value against the dollar. The position would be profitable if the euro fell in value. However, if the euro rose in value instead, they would lose money.

Instead, the trader would have taken a long position in the hope that the euro would appreciate against the dollar. They could close their positions for a profit if the euro rose in value. If the euro falls in value against the dollar, the trader’s long position will lose money because the trade will have to be closed at a lower exchange rate.

3. Decrease of foreign capital

Money entering the country in the form of concessional or non-concessional flows is referred to as foreign capital. Foreign capital flows into India in a variety of ways, including banking and NRI deposits. The various forms of foreign capital flowing into India have aided in the inflow of massive amounts of FDI into the country, which has boosted the Indian economy significantly. Foreign capital not only adds to domestic savings and resources but also to the country’s productive assets. FDI provides the country with foreign currency. It aids in the growth of investment and, as a result, income and employment in the recipient country.

4. Lack of infrastructure

Infrastructure investment can be a powerful tool for achieving macroeconomic stability. Infrastructure investments have a significantly higher output “multiplier” than other financial interventions, according to most estimates. Each $100 billion in infrastructure spending would increase job growth by about 1 million full-time equivalents if monetary policymakers adjusted the fiscal boost of the infrastructure investment (FTEs).

In recent years, productivity growth has slowed dramatically. Much of this slowdown is expected to be temporary, as tighter labor markets push productivity growth back to more historically normal levels. It takes effect right away.

Conclusion

Comparing real potential GDP to real GDP-that is, potential output to actual output-can give insight into how the economy is performing in comparison to its potential. An economy that is underutilizing its resources is said to be operating below its potential: The output gap is negative, and the economy is sluggish. A positive output gap, on the other hand, indicates that the slack has vanished and resources are fully utilized, if not over-utilized. In fact, monetary policymakers rely on the output gap to guide their decisions. As a result, errors in estimating real potential GDP can reduce policy effectiveness.

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