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Previous Year Question & Answers | UPSC Mains 2020 (GS-III)

Q1. Define potential GDP and explain its determinants. What are the factors that have been inhibiting India from realizing its potential GDP?



Most economists and governments use Gross Domestic Product, also known as GDP, or real GDP. GDP represents the total market value of all the goods and services produced by a state over a given period of time.

Like GDP, potential GDP represents the market value of goods and services, but rather than capturing the current objective state of a nation’s economic activity,  potential GDP attempts to estimate the highest level of output an economy can  sustain over a period of time.

Potential GDP:

  1. It assumes that an economy has achieved full employment and that aggregate demand does not exceed aggregate supply.
  2. Sustainability is the key concept Every economy has certain natural limits, determined by its available labour force, technology, natural resources, and other limitations.
  3. When GDP falls short of that natural limit, it means the country is failing to live up to its economic potential.
  4. When GDP exceeds that natural limit, inflation is likely to follow. This is why potential GDP is sometimes referred to as potential output or natural GDP
    The difference between potential and real GDP is called the output gap.
    1. If real GDP falls short of potential GDP (i.e., if the output gap is negative), it means demand for goods and services is weak. It’s a sign that the economy may not be at full employment.
    2. If the real GDP exceeds potential GDP (i.e., if the output gap is positive), it means the economy is producing above its sustainable limits, and that aggregate demand is outstripping aggregate supply. In this case, inflation and price increases are likely to


    Determinants: Factors affecting potential GDP and real GDP

    1. Aggregate demand
    2. Short-term aggregate supply
    3. Quantity and quality of factors of production


    For aggregate demand, examples of factors are household consumption, business investment, exports, and government spending. In this case, the factors also include monetary policy and fiscal policy.

    Meanwhile, the factors affecting short-run aggregate supply (and real GDP) are the cost of raw materials, energy prices, wages, taxes, and subsidies. They all affect the cost of production in the economy.

    Factors affecting quantity and quality of production factors include: Growth in labour supply, Improvement of workforce quality, Capital stock growth, Technology advances and Increased availability of natural resources.

    Factors inhibiting India from achieving its Potential GDP:
    1. Twin challenge of Banking and corporate balance sheet crisis and consequent reduction in savings and investment
    2. Low skilled labour, high unemployment and Inequality keeps demand low
    3. Agriculture which spurs rural demand is dependent on erratic monsoon
    4. Inadequate Capital expenditure: The capital stock also includes infrastructure such as roads, bridges, and ports in a broader
    5. India lacks Technological advances: Technological advances are essential for increasing the productivity of other production factors, such as machinery and labour. By using more sophisticated machines, we can produce more output, using the same
    6. Inefficient use of natural resources like Iron etc due corruption and malpractices
    Way Forward:
    1. National Infrastructure Pipeline
    2. Skilling Labour
    3. Transparent allocation of natural resources
    4. Incentivizing industries for capital expenditure
    5. Bring FDI, Promoting PPP
    6. Reviving banking sector


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