Define potential GDP and explain its determinants. What are the factors that have been inhibiting India from realizing its potential GDP?. (UPSC IAS Mains 2020 General Studies Paper – 3)
Potential GDP is one of the theoretical aspects of national income accounting which assumes that an economy has achieved full employment and that aggregate demand does not exceed aggregate supply. Like other national income accounting methods, potential GDP also represents the market value of all goods and services but rather than capturing the current objective state of a nation’s economic activity, it attempts to estimate the highest level of output an economy can sustain over a period.
Determinants of Potential GDP
- Capital Stock: In an economy, capitalstock isthe plant, equipment, and other assetsthat help with production. The availability of capital stock determines the extent of economic output and potential GDP.
- Labor Force: At any given moment in time, the quantities of capital, land, etc., are typically fixed, but the quantity of labor employed varies. Therefore, in the short-run, Potential GDP depends on the quantity of labor employed, which depends on demographic factors and on participation rates.
- Non-accelerating Inflation Rate of Unemployment: It is the specific unemployment rate at which the rate of inflation stabilizes – inflation will neither increase nor decrease.
- Other determinants of Potential GDP are the level of labor efficiency, labor market efficiency, production capacity, sufficient liquidity, government fiscal support, etc.
Factors Inhibiting India from Realizing its Potential GDP
- Negative Output Gap: A negative output gap occurs when actual output is less than what an economy could produce at full capacity. A negative gap means that there is spare capacity, or slack, in the economy due to weak demand.
- Fall in Private Consumption: Private consumption is the prime component of India’s GDP as it contributes a significantshare to GDP (More than 55%). Indian economy experienced a sharp decline in private consumption expenditure in the past few quarters. Such decline in private consumption de-incentivizes firms in producing more goods, thereby the economy is left with unutilized resources and labor force.
- Mounting NPAs of Banks: The Indian banking system is under the huge burden of NPAs (Non-Performing Assets), which has tremendously reduced banks’ lending capacity. This has severely affected businesses, production houses and particularly the real estate segment. Such liquidity shortages reduce the productive capacity of the economy.
- Unemployment: Huge unemployment in India is also one of the major factorsthat inhibitsIndia from realizing its Potential GDP.
- Informal Economic Activities: Most of the economic activities in India are informal or unorganized and the size of such unorganized sectors is considerably huge but not accounted for in GDP. Therefore, the value of such an economy is not recorded in the national account book and remained unreleased.
- Other Factors: Weak intellectual property rights, low expenditure on R&D, contract enforcement issues, etc.
Way Forward
- Need to work more on the policy levels to generate employment, efficient and cost-effective resource mobilization, to promote export and innovation and to enhance the scope of Make in India Programme.
- Better wages must be ensured so as to increase private consumption expenditure.
- The negative output gap in GDP needs to be managed and compensated through various fiscal and monetary policy measures keeping inflation in check.
- The government needs to bring policies that catalyse rural economic growth.
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