Real vs. Potential GDP

December 06, 2012 | Christopher Caparelli, CFA, Partner

Among the many factors the Congressional Budget Office (“CBO”) must estimate in budget projections provided to Congress, GDP is often the most important, as it provides a foundation for most other forecasts. While near term GDP growth can often be estimated with some accuracy based on current trends, longer term forecasts rely upon potential GDP. Utilizing the economic factors of labor input and physical capital, potential GDP is a measure of the maximum sustainable output of the national economy. It is the level that national output should be when the economy is at full employment and full resource utilization.

Going back to the 1950’s, real GDP has often plotted very near the CBO’s potential GDP forecast, often correcting any deviation quickly. Since the sharp economic downturn experienced in 2008, however, real GDP has remained below potential GDP, creating a sizeable output gap. In order to close that output gap, the national economy must grow at a faster rate than it has since 2008.

The various dotted lines on the graph contemplate constant forward growth rates in real GDP from the last recorded observation in the third quarter of 2012. Although it is unrealistic to assume the national economy will grow at a constant rate going forward, the analysis presents a hypothetical best/worst case scenario. If the national economy were to grow at a constant 5% annualized growth rate beginning in the fourth quarter of 2012, it would take the national economy until the third quarter of 2014 to realize its potential output. A 4% growth rate would reach potential GDP in the second quarter of 2015, and a 3% constant growth rate would reach potential GDP in the third quarter of 2020. If the national economy were to grow at a constant 2% rate – not far from the observed growth rates of the previous handful of quarters – the gap between real and potential output will continue to grow.