Potential GDP

Because economists take a long-run perspective in discussing economic growth, the concept of potential GDP is useful.

Potential GDP is the level of GDP attained when all firms are producing at normal capacity.

Every firm has a certain capacity to produce goods and services. The capacity of a firm is not the maximum output the firm is capable of producing.

A car assembly plant could operate 24 hours per day for 52 weeks per year and would be at its maximum production level.

The plant’s capacity, however, is measured by its production when operating on normal hours, using a normal workforce.

If all firms in the economy were operating at normal capacity, the level of total production of final goods and services would equal potential GDP.

Potential GDP will increase over time as the labor force grows, new factories and office buildings are built, new machinery and equipment are installed and technological change Opens in new window takes place.

Growth in potential GDP is estimated to be about 3.5 percent per year.

In other words, each year the capacity of the economy Opens in new window to produce final goods and services expands by 3.5 percent.

The actual level of real GDP Opens in new window may increase by more or less than 3.5 percent as the economy Opens in new window moves through the business cycle (or suffers an economic shock).

That is, there are short-run variations in the rates of economic growth around the long-run growth path of potential GDP. Figure I shows movements in actual and potential GDP for the years since 1960.

graph showing actual and potential GDP Figure I, Actual and potential GDP, Australia, 1960-2008. Source: Created from Australian Bureau of Statistics (2008).

The smooth red line represents potential GDP and the blue line represents actual real GDP.

Notice that during economic contractions and recessions, actual real GDP falls below potential GDP.

This can be seen for the 1982-1983 recession, the 1990 recession, during the 2007-2008 GFC and the subsequent period of below-trend growth.