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July 29, 2016 

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FEDERAL FUNDS MARKET: The market used by banks to borrow and lend bank reserves. In particular, a substantial part of the reserves held by banks are deposits with the Federal Reserve System. On many occasions some banks will have more deposits than they need to meet the Fed's reserve requirements, while other banks find themselves a little short. It's a simple matter then for one bank to lend some of these extra reserves to another--usually for no more than a few days. Working on instructions from the banks, the Fed electronically switches funds from one account to another and a federal funds market loan has been completed. The interest rate tacked on by the lending bank is termed the federal funds rate.

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POTENTIAL REAL GROSS DOMESTIC PRODUCT:

The total real output (real gross domestic product) that the economy can produce if resources are fully employed. In theory this means that the economy is operating ON the production possibilities frontier. Full employment is generally indicated by achieving what is termed the natural unemployment rate. If the economy is at full employment then actual real gross domestic product is equal to potential real gross domestic product and the actual unemployment rate is equal to the natural unemployment rate. The macroeconomy is thus living up to its potential.
Potential real gross domestic product (or potential real GDP) provides a benchmark for identifying phases of the business cycle and as a guide for stabilization policies. A business-cycle contraction, with cyclical unemployment, exists if actual or current real GDP is less than potential real GDP. In contrast, inflation is likely to occur if current real GDP is greater than potential real GDP.

Ideally, current real GDP is equal to potential real GDP. If so, then the economy has full employment with no inflation.

A Sample Calculation

Consider a few hypothetical numbers to illustrate how potential real gross domestic product is calculated. A few valuable tidbits of information are:

  1. The natural unemployment rate is 5%.
  2. The current unemployment rate is 6%.
  3. Current real gross domestic product is $10 trillion.

The first tidbit of information means that potential real gross domestic product is achieved when 95% of the labor force is employed, which is 100% minus the 5% natural unemployment rate. This is can be termed the natural employment rate. The second tidbit of information means that the economy currently has only 94% of the labor force employed, 100% minus the actual unemployment rate of 6%. This can be called the actual employment rate. In this example, the actual employment rate is 1% less than the natural employment rate and full employment.

The 94% of the labor force that is working generates $10 trillion worth of real gross domestic product. The question to answer is this: How much real gross domestic product could the economy produce with 95% of the labor force working, with full employment?

Here is the simple formula that can be used to answer this question:

potential real GDP=natural employment rate
actual employment rate
xactual real GDP

Plugging in the specific numbers generates:

potential real GDP=95%
94%
x$10 trillion

potential real GDP=$10.106 trillion

This means that if the economy lives up to its full potential, production-wise, then it can produce $10.106 trillion worth of real gross domestic product. But it is not. It is only producing $10 trillion. Getting the extra 1% of the labor force working would add over $100 billion worth of wants-and-needs satisfying goods and services.

While $100 billion might not seem like much, in light of a $10 trillion total, for a nation of almost 300 million people (about the size of the United States), this averages about $350 for every man, woman, and child in the country. Few people would mind an extra $350 worth of wants-and-needs satisfying goods and services.

Working the Policies

Policy makers often look to potential real GDP as a guide for appropriate stabilization policies.
  • Expansionary policies are designed to counter a business-cycle contraction and are appropriate if actual real GDP is less than potential real GDP. The two most popular types are expansionary fiscal policy, involving an increase in government spending and/or a reduction in taxes, and expansionary monetary policy, involving an increase in the money supply and/or a decrease in interest rates.

  • Contractionary policies are appropriate when a business-cycle expansion heats up to the point of higher inflation, when actual real GDP is greater than potential real GDP. The two most popular types are contractionary fiscal policy, involving a decrease in government spending and/or an increase in taxes, and contractionary monetary policy, involving a decrease in the money supply and/or an increase in interest rates.

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Recommended Citation:

POTENTIAL REAL GROSS DOMESTIC PRODUCT, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2016. [Accessed: July 29, 2016].


Check Out These Related Terms...

     | business cycles | business cycle phases | expansion | contraction | peak | trough | recession | recovery | long-run trend |


Or For A Little Background...

     | full employment | production possibilities | production possibilities frontier | full employment, production possibilities |


And For Further Study...

     | business cycle indicators | investment business cycles | political business cycles | demand-driven business cycles | supply-driven business cycles | stabilization policies | inflation | unemployment |


Related Websites (Will Open in New Window)...

     | Bureau of Economic Analysis |


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