Features and Determinants of Potential GDP

Features and Determinants of Potential GDP

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A country's Potential Gross Domestic Product (GDP) is the maximum amount of output it could create at a constant inflation rate. On the other side, increasing inflation may cause an economy to temporarily create more than its potential output. When measuring the output gap, one must take into account the capital stock, the potential labour force based on demographics and participation rates, the non-accelerating inflation rate of unemployment, and the degree of labour efficiency.

India is unable to achieve its Potential Gross Domestic Product (GDP) due to a number of factors, including the global financial crisis, a decline in total factor productivity contribution, capital stock growth declaration, capital allocation distortions across various economic sectors, chaos and restrictions in the financial sector, a decline in disposable income levels, a decrease in consumption and fixed investment, and others. On the contrary hand, India might increase its potential output by boosting capital formation and shifting surplus funds from over-capitalized to undercapitalized companies.

Determinants of Potential GDP

1. Inflation - A rise in either the quantity of money in circulation or the cost of goods can be considered inflation. When we speak of "inflation," we mean a rise in prices in comparison to some standard. It's only a matter of time before higher prices materialise as a result of increased money supply. We'll use the core Consumer Price Index (CPI), which is the accepted gauge of inflation used in American financial markets, for the discussion. It is more significant to monitor core inflation. Studies show that over the past 20 years, every percentage point of yearly GDP growth above 2.5 percent has led to a 0.5 percent decline in unemployment. This beneficial link, however, starts to deteriorate when employment is extremely low or close to full employment. Extremely low unemployment rates have shown to be more costly than advantageous because of two key consequences of an economy with nearly full employment:

a) Total Demand: Prices will increase if total demand for products and services increases more quickly than supply.

b) Labor Market: Businesses will have to raise wages as a result of the tight labour market. This rise is typically passed on to customers in the form of higher prices as a business looks to maximise profits.

2. Recession - When the economy is struggling, the GDP gap is positive, suggesting that it is not operating at its potential (and that there is less than full employment). The GDP gap is negative during an inflationary boom, indicating that the economy is doing better than it could be (and more than full employment).

3. Factory Output - The GDP's share of factory-produced finished items rises. Continuous expansion will be sufficient for a high GDP. While wages, taxes, subsidies, raw material costs, energy costs, and prices all have an effect on the short-term aggregate supply (and real GDP). The costs of manufacturing in the economy are affected by each of them. A few elements that affect aggregate demand are household consumption, corporate investment, exports, and government spending. Monetary and fiscal policies are also significant factors in this situation.