How is the economy doing? You cannot give a clear answer to my question. Instead, your answer depends on how you measure economic performance and whether your measurement is above or below what you think it should be. You could use real GDP, the main measure of an economy’s performance. It is a measure of the value of production that is constructed not to change due to inflation. So real GDP is a good measure of economic performance, but what value should it have?
This value is derived from the real potential GDP. This is an estimate of real GDP if all inputs into the production process were used at a rate that did not cause unwanted inflation. For example, the calculations assume that all workers willing to work can find a job, but also assume that companies do not get involved in bidding wars in order to attract more workers to the labor market. Such bidding wars would have driven up wages and led to inflation.
The solid line in the attached chart shows real GDP since 1995, while the dashed line shows potential GDP over the same period. The graphic shows four interesting results. First, real GDP is generally quite close to potential GDP. This is evidence of how efficiently the US economy works. Real GDP tends to be around the level that experts would expect if the economy were using its resources to promote the maximum sustainable rate of economic growth.
Second, actual real GDP is more likely to be lower than potential GDP. Or to put it another way, the economy generally has the potential to produce more output without causing higher inflation.
Third, the gap between real GDP and potential GDP widens when a recession occurs. The graphic shows the three most recent recessions with shaded areas. You will notice that during recessions, real GDP falls while potential GDP remains relatively unaffected. This result is not surprising because a recession occurs when real GDP growth is negative or there is a prolonged slowdown in real GDP growth. When the economy goes into recession, fewer workers and fewer other means of production are used. These unused resources have no impact on the calculation of potential GDP, as this measure calculates the output value that would arise if these inputs were fully utilized.
While the widening gap between real and potential GDP during a recession may be an expected outcome, few people have expectations about how quickly this gap will close after the recession ends. The pace varies. In general, the gaps close quickly. An exception is recessions caused by financial crises. The recession that began in the first quarter of 2008, often referred to as the Great Recession, occurred when many investment banks became insolvent. It took about ten years for real GDP to get close to potential GDP again. The Great Depression, not shown in this chart, is the best-known example of a financial crisis that kept real GDP well below potential GDP for an extended period of time.
Fourth, real GDP is currently close to potential GDP. You may have noticed that this observation answers the question I asked at the beginning of this column: How is the economy doing?
The answer is that the economy is doing pretty well – at least if you limit your analysis to one measure of economic performance: real GDP. Inflation is another measure of economic performance to consider, but I have touched on this topic in previous columns.
I should add a major caveat to my analysis. Potential GDP is just an estimate. If the experts who create it miss something, potential GDP may not be the best measure. But even if these experts systematically miss something, they will continue to miss it over short periods of time. Therefore, even erroneous measurements of potential real GDP can detect changes in the output gap and be useful in analyzing fluctuations in real GDP.
Joe McGarrity is Professor of Economics at UCA. He can be reached at [email protected].
Joe McGarrity is Professor of Economics at UCA. He can be reached at [email protected].
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