Minding the Gap: Potential Real GDP vs. Real GDP

I was listening to Tom Keene Friday morning on Bloomberg Surveillance (a great show to listen to, by the way) and Tony Cresczenci was discussing the “output gap” or as I always thought of it, the difference between potential and actual real GDP.  So I made this chart to illustrate how I view it:

The blue line is forecasted potential real GDP while the red line is the actual real GDP.  The black circle represents the output gap and you can see it’s significant.  In fact, you can’t find a much bigger one (at least when you see it visually) since, well, you know when.  So just from a visual standpoint that tells me something.

But what about the sideways purple parabola?  That represents a range of projected paths real GDP can take.  I don’t know what the true shape of that parabola is, it can look the one above or it can look the one below, or anything in between:

Now if we assume potential GDP in the blue line is accurate, or said differently, we have no reason to believe it is inaccurate, recovery is all about seeing the gap between the red and blue lines close.  Hence the v-shaped recovery paradigm.  But what about other scenarios?  Other outcomes?

To answer those questions I went back to some of the earliest posts I wrote and found a few I wrote on Thailand and Japan which took a look at how things have turned out in both of those countries, because they’re the closest experiences we can draw on to compare with our current situation.  So thinking about the purple parabolas, we have four basic scenarios: the red line flattens out, it rises parallel to potential real GDP, the aforementioned v-shape or it falls again (the double dip).  The last two are easy to see and recognize so I’m focusing on the other two.

If the red line flattens, congratulations: we’ve replicated Japan.

If the line continues on a parallel path, we would’ve replicated Thailand post-97:

But I can’t help but bring up unemployment, because discussions of Japan and Thailand that don’t factor in that dimension are incomplete.  Here are the charts I have on that:

On one hand, we see in Japan that fewer people are producing a constant level of output, while in Thailand, more people are producing output but the gaps between the path of GDP in the mid 90s and its current one are widening.

If either scenario happens here, neither one is going to be a positive development.

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2 Comments

Filed under government, macro, Way Forward

2 responses to “Minding the Gap: Potential Real GDP vs. Real GDP

  1. Pingback: Drowning in debt? Call anti-collectors! | Best Debt USA

  2. Manik

    I was reading for my CFA level 1 when I came across this post. Great real life insight to some of the basic concepts I am trying to grasp.
    Thanks a lot.

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