key term - Potential GDP

Definition

Potential GDP, also known as the full-employment level of GDP, represents the maximum sustainable output that an economy can produce when all of its resources, including labor, capital, and technology, are being utilized at their full capacity. It is the level of real GDP that an economy would produce if the unemployment rate was at its natural rate.

5 Must Know Facts For Your Next Test

1. Potential GDP is an important concept in macroeconomic analysis as it helps policymakers assess the economy's productive capacity and identify potential inflationary or recessionary gaps.
2. The difference between actual GDP and potential GDP is known as the output gap, which can be either positive (an inflationary gap) or negative (a recessionary gap).
3. Factors that can influence potential GDP include the size and quality of the labor force, the stock of physical capital, the level of technology, and the efficiency of resource allocation.
4. Shifts in aggregate supply, such as changes in productivity or input prices, can affect the level of potential GDP over time.
5. Fiscal and monetary policies can be used to close the output gap and steer the economy towards its potential GDP level.

Review Questions

• Explain how the concept of potential GDP is related to tracking real GDP over time.
  • Potential GDP is a key reference point for tracking real GDP over time. By comparing actual GDP to potential GDP, economists can identify whether the economy is operating above or below its full-employment level. This allows them to assess the economy's overall performance, identify inflationary or recessionary pressures, and guide policymakers in implementing appropriate fiscal and monetary policies to stabilize the economy and promote sustainable growth.
• Describe how potential GDP is related to changes in unemployment over the long run.
  • Potential GDP is closely linked to the natural rate of unemployment, as it represents the level of output that can be sustained when the unemployment rate is at its equilibrium level. Factors that influence potential GDP, such as the size and quality of the labor force, can also impact the natural rate of unemployment. Policies aimed at increasing potential GDP, such as investments in education and infrastructure, can help lower the natural rate of unemployment over the long run, as they expand the economy's productive capacity and create more job opportunities.
• Analyze how shifts in aggregate supply can affect the level of potential GDP.
  • Shifts in aggregate supply, which can be caused by changes in productivity, input prices, or technology, can directly impact the level of potential GDP. For example, an increase in productivity or technological advancement would shift the aggregate supply curve to the right, raising the economy's potential output level. Conversely, a decrease in the supply of labor or a rise in input prices would shift the aggregate supply curve to the left, reducing the level of potential GDP. Understanding how these supply-side factors influence potential GDP is crucial for policymakers in formulating effective policies to promote long-term economic growth.

Related terms

Natural Rate of Unemployment:

The natural rate of unemployment is the lowest level of unemployment an economy can sustain without causing inflation to accelerate. It represents the equilibrium unemployment rate in the long run.

Aggregate Supply:

Aggregate supply is the total quantity of goods and services that firms are willing to sell at different price levels in an economy.

Aggregate Demand:

Aggregate demand is the total quantity of goods and services demanded in an economy at different price levels.