What is Potential GDP? 

An AS curve's slope changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP, which we define as the amount of real GDP an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions. At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time, or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—while assuming no rise in input prices—can encourage a considerable surge in the quantity of aggregate supply because so many workers and factories are ready to swing into production.

As the GDP increases, however, some firms and industries will start running into limits: perhaps nearly all of the expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will be running at full speed. In the AS curve's intermediate area, a higher price level for outputs continues to encourage a greater quantity of output—but as the increasingly steep upward slope of the aggregate supply curve shows, the increase in real GDP in response to a given rise in the price level will not be as large. (Read the following Clear It Up feature to learn why the AS curve crosses potential GDP.)

At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output, because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed. In this example, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively low—at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP.

Back to:ECONOMIC ANALYSIS & MONETARY POLICY

Related Topics

• Supply-Side Economics
• Say's Law
• Laffer Curve
• Neo-Classical Economics
• New Keynesian Economics
• Classical Economics
• Supply-Side Economics
• Keynesian Economics
• Keynes' Law
• Keynesian Analysis
• Demand Side Theory
• Market Forces
• Aggregate demand
  
• Aggregate Demand Curve (and shifts)
• Aggregate supply
• Aggregate Supply Curve (and Shifts)
• Aggregate Demand / Aggregate Supply Models
• Potential GDP
• Aggregate Supply and Demand Equilibrium
• Aggregate Supply and Aggregate Demand in Macroeconomics and Microeconomics
• Input-Output Model
• Stagflation
• Growth and Recessions in the Aggregate Demand - Aggregate Supply Model
• Unemployment in the Aggregate Demand - Aggregate Supply Model
• Inflation in the Aggregate Demand - Aggregate Supply Model
• Keynesian, Intermediate, and Neoclassical Zones