Potential GDP and Output Gaps in GDP – a primer
(Sources – IMF and Economic survey of India, 2016)

Potential output refers to the highest level of output that can be sustained over the long term. It is assumed that the existence of a limit of output is due to natural and institutional constraints. If actual GDP rises and stays above potential output, then (in the absence of wage and price controls) inflation tends to increase as demand exceeds supply. Likewise, if output is below potential level, inflation will decelerate as suppliers lower prices to fill their excess production capacity. The issue of estimating potential output is, therefore, critically important in understanding the overall Inflationary dynamics of the economy.

The overall stance of monetary and credit policy in India is to provide adequate liquidity to meet genuine credit requirements and support investment demand in the economy while keeping the price level within limit. One of the major issues in the formulation of the monetary policy is to determine whether the economy is operating above or below its maximum sustainable level. The path of the maximum sustainable level, commonly known as the potential output, indicates that level of output that is consistent with stable price level.

In other words, potential output is the maximum output an economy could produce without putting pressure on price level. It is that level of output at which the aggregate demand and supply in the economy are balanced, so that, inflation tends to its long-run expected value, if other factors remain constant. Once potential (capacity) output is estimated, the capacity utilization rate can be constructed as a ratio of the actual level of output to the potential output. The capacity utilization generally conforms to that of a full input point on a production function with the qualifi cation that capacity represents a realistically sustainable maximum level of output for a given industry, rather than some higher unsustainable short term maximum.

Output gap, which is the discrepancy between the actual output and the potential output, indicates the presence of disequilibrium in the economy. When the actual output exceed the potential output, i.e. the output gap becomes positive, the rising demand leads to an increase in the price level, if temporary supply factors are held constant. Such instances are seen as a source for Inflationary pressures and as a signal for the central bank to tighten monetary policy. In case of a negative output gap, inflation tends to fall. The idea of potential output is, therefore, essential to capture the process of inflation dynamics in the economy. However, potential output cannot be observed directly and needs to be estimated.

Potential Output and inflation : Alternative Views

If the real output grows rapidly in the future, the competition for scarce productive resources could put upward pressure on wages and other production costs and ultimately inflation could be raised. Most economic forecasters believe Inflationary pressures build after potential output rises above a certain level. Some analysts, however, claimed that the historical relationship is no longer valid because the present economies are more open today and hence allowing imported goods to relieve any shortage of domestic capacity. Inflationary pressures typically emerge when the overall demand for goods and services grows faster than the supply, causing a decrease in the amount of unused productive resources, or economic slack mostly captured through unemployment rate, which measures unused resources in the labour market. Inflationary pressures can be judged by comparing the current capacity utilization rate with an estimated stable inflation rate. When capacity utilization is at the stable inflation rate, inflation tends neither to increase nor to decrease. The concept is similar to the natural rate of unemployment, the unemployment rate for which inflation neither increases nor decreases, but uses capacity utilization rather than unemployment as the measure of economic slack.

Some analysts contend that potential output has become a less dependable indicator of Inflationary pressures. Critics of it believe that potential output as an inflation indicator tend to over simplify the description of both monetary policy formulation and the Inflationary process. For example in an article appeared in the Wall Street Journal on February 14, 1995, it is indicated that monetary policy should not be guided by using capacity utilization as an indicator of inflation. It is argued that, in practice, a simple relationship between capacity utilization and the overall inflation rate may not exist. Influences on inflation other than resource utilization routinely appear in economic models. Economic developments abroad and foreign exchange rate swings can effect domestic inflation directly through changes in prices of imports and indirectly through competing goods effects on domestic strategic price setting behavior. Therefore, use of potential output as a variable indicating demand pressures has its own limitations.

Typically, economists measure a country’s potential GDP growth in two ways: first, by extrapolating from past growth; and, second, by projecting the underlying drivers of growth: capital (physical and human), labor, and productivity. Both have limitations and both rely on a variety of assumptions. The first methodology has many variants, including the use of Hodrick-Prescott filters. But they are all essentially

mechanical and are really some weighted average of past growth rates. One disadvantage of this method is that variations in actual growth can induce considerable volatility in estimates of potential growth. But potential growth should be relatively stable unless there are some fundamental shifts in the underlying policy and institutional environment.

Estimating potential GDP by projecting the underlying determinants of growth (as done in Rodrik and

Subramanian, “Why India Can Grow at 7 Per Cent a Year or More”, Economic and Political Weekly (EPW)

[2005]) requires assumptions to be made on total factor productivity growth, which can be arbitrary unless they too are based on past performance which leads to the problems noted above.

A different way of estimating potential GDP growth is to use a deep determinants-cum-convergence framework. There is a well-established literature (North, D, “Institutions”, Journal of Economic Perspectives, [1991], Acemoglu, D and J.A. Robinson, “Why Nations Fail: The Origins of Power, Prosperity and Poverty”, Crown Business [2012]) that suggests that institutions are a key determinant of long run growth. This is summarized below.

The upward-sloping line in the figure reflects a strong relationship (on average) between political institutions and economic development that has been found in empirical research, validating the central argument of the “institutions matter” hypothesis. However, China and India are outliers (they are far away from the line of best fit). And the interesting thing is that each of these countries is an exception, or even a challenge, to the relationship but in opposite ways. India (which is way below the line) is not rich enough given its uncontestably vibrant political institutions. China (which is well above the line) is too rich given its weak democratic institutions.

The assumption is that India and China will mean-revert, that is they will become more typical, and move

towards the line of best fit, over the medium term. Mean reversion can happen in different ways. For China, the assumption is that this process of becoming a “normal” country will happen via a combination of slower growth and faster democratization as shown in next diagram. Indeed, the growth slowdown in China should be seen as a process of normalization after a period of abnormally high growth. For India, normalization should take the form of an acceleration of growth shown in the figure below. India’s potential growth rate can thus be estimated as a reversion to a state of things where its economic

development is consistent with its well-developed political institutions. The question is what is the implied

growth rate that is consistent with this mean reversion.

The basic convergence framework provides a framework for estimating, albeit roughly, India’s potential growth rate during this process of normalization (see Technical Appendix for the simple algebra of this computation). According to convergence theory, India’s per capita GDP growth rate (in PPP terms) between 2015 and 2030 should be some multiple of the difference in the initial level of per capita GDP between the US and India in 2015. That difference is about 2.2 log points. The multiple is called the convergence coefficient—the rate at which India will catch up with the United States. A reasonable parameter from the literature is that this should be about 2 percent per year, at least for countries that are converging. The East Asians converged at a much faster pace but others at a slower pace.

The significance of the figure shown above is that since India has under-achieved so far, it must converge at a faster pace than usual, so that it can revert to the “normal” line. Hence, its convergence coefficient should be substantially better than 2 percent. These PPP-based growth rates need to be converted into market exchange rate growth rates. The resulting estimates are shown in the table below for alternative assumptions about this convergence coefficient.

Based on this analysis, India’s medium term growth potential is somewhere between 8 and 10 percent. Of course, this is an estimate of potential, conveying a sense of opportunity. Hard policy choices and a cooperative external environment will be required to convert opportunity into reality.