Q2. [Solved] Define potential GDP and explain its determinants. What are the factors that have been inhibiting India from realizing its potential GDP? (UPSC GS-3 Mains 2020)

By | June 11, 2021

Most economists and governments use Gross Domestic Product, also known as potential GDP, or real GDP. GDP represents the total market value of all the goods and services produced by a state over a given period of time.

  • The highest market value of goods and services that can be produced in an economy  over a period of time is known as potential GDP.
  • Unlike normal GDP that estimates during current duration, potential GDP seeks to find the highest value that can be obtained.
  • Like GDP, potential GDP represents the market value of goods and services, but rather than capturing the current objective state of a nation’s economic activity, potential GDP attempts to estimate the highest level of output an economy can sustain over a period of time.

Potential GDP:

  • It assumes that an economy has achieved full employment and that aggregate demand does not exceed aggregate supply
  • Sustainability is the key concept here. Every economy has
  • certain natural limits, determined by its available labour force, technology, natural resources, and other limitations.
  • When GDP falls short of that natural limit, it means the country is failing to live up to its economic potential.
  • When GDP exceeds that natural limit, inflation is likely to follow. This is why potential GDP is sometimes referred to as potential output or natural GDP.

The difference between potential and real GDP is called the output gap.

  • If real GDP falls short of potential GDP (i.e., if the output gap is negative), it means demand for goods and services is weak. It’s a sign that the economy may not be at full employment.
  • If the real GDP exceeds potential GDP (i.e., if the output gap is positive), it means the economy is producing above its sustainable limits, and that aggregate demand is outstripping aggregate supply. In this case, inflation and price increases are likely to follow.

Determinants of potential GDP

Inflation

  • The inflation rate in the country in a year influences the GDP growth. Higher inflation can boost the potential GDP rate.

Recession

  • Recession is the slowdown in growth rate for two consecutive quarters. Recession can significantly reduce the GDP.

Factory output

  • The output of finished goods from factories increases its contribution to GDP. Continuous growth will be suitable for high GDP.
  • For aggregate demand, examples of factors are household consumption, business investment, exports, and government spending. In this case, the factors also include monetary policy and fiscal policy.
  • Meanwhile, the factors affecting short-run aggregate supply (and real GDP) are the cost of raw materials, energy prices, wages, taxes, and subsidies. They all affect the cost of production in the economy.

Factors affecting quantity and quality of production factors include:

Growth in labour supply

Improvement of workforce

  • Twin challenge of Banking and corporate balance sheet crisis and consequent reduction in savings and investment
  • Low skilled labour, high unemployment and Inequality keeps demand low
  • Agriculture which spurs rural demand is dependent on erratic monsoon
  • Inadequate Capital expenditure: The capital stock also includes infrastructure such as roads, bridges, and ports in a broader sense.
  • India lacks Technological advances: Technological advances are essential for increasing the productivity of other production factors, such as machinery and labour. By using more sophisticated machines, we can produce more output, using the same input.
  • Inefficient use of natural resources like coal. Iron etc due corruption and malpractices

Factors inhibiting potential GDP of India

Low productivity

High employment generation in economy will show that potential GDP to be high but it will not be achieved due to low productivity from employment generation.

Currency depreciation

GDP is calculated using American dollars after converting it from Indian rupees. The depreciation of Indian rupees vis a vis American dollars will reduce GDP value.

Decrease in foreign capital

The inflow of foreign capital may decrease over a period of time due to various factors. This will result in economy not being able to emulate the potential numbers.

Lack of Infrastructure

The infrastructure growth in domestic economy may not be in predicted lines. This will hamper the final contribution to GDP output.

Further reading..

  • Potential gross domestic product (GDP) is the level of output that any economy can present at a constant inflation rate.
  • However, the cost of rising inflation could make an economy temporarily produce more than its potential level of output.
  • The capital stock, the latent labor force depending on demographic factors and participation rates, the non-accelerating inflation rate of unemployment, and the level of labor efficiency determine this potential output which is important to calculate the output gap.

The factors restraining India from realizing its potential GDP include the global financial crisis, decline in total factor productivity contribution, capital stocks growth deceleration, capital allocation distortions across various economic sectors, financial sector mess and constraints, reduction in disposable income levels, depletion of consumption and fixed investment and the like. However, India could make potential output accelerate with a higher level of capital formation and by redistributing the excess capital from over-capitalized places to the under-capitalized entities.

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