Understanding Economic Policymaking: GDP, Business Cycle & Aggregate Supply - Demand I (Part 2)

 Potential GDP as a Reference Point for The Business Cycle

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Now that we understand the sources of GDP, we will later discuss the factors that determine the level of GDP in an economy. First, take a moment to examine what GDP growth looks like, and then establish a reference point. This enables us to evaluate whether GDP growth in a specific country at a given time is excessively high, too low, or just right.  First, Let's take a look at a screen from Google Public Data. This tool is recommended because it allows you to visualize and compare indicators from different countries over time. We will begin by examining the GDP growth rates of a group of countries over time, specifically from 1960 onward. This represents a significant period. We chose several countries. We have China, Mexico, the United States, Japan, Germany, the United Kingdom, and Greece. 

Picture 2

What you see on this screen is the GDP growth rate, which is typically what you will find in news articles discussing GDP trends. They often refer to it simply as the GDP growth rate. This is technically referred to as real GDP growth, a concept you may be familiar with if you have studied economics before. This means that we take the quantity of goods and services produced in, for example, year two, using the prices from year two, and then adjust those prices to reflect the levels from year one. 

This approach allows us to eliminate inflation from our calculations, enabling us to see the actual increase in the quantity of goods and services produced by the economy. Compared to the previous year, picture 2 removes inflation from all these figures, allowing us to see the actual increase in output from one year to the next across all these countries. For example, in The United States, Looking at the GDP growth, you will notice that it fluctuated around 5% for many years in the 1960s, with some instances falling below that level. In the 1970s, you can observe a recession, during which GDP growth is actually negative. In other words, this refers to a situation where the quantity of goods and services available declines. As we move into the 1980s, we observe another recession. Then, you can observe significant growth rates, again reaching around 5%. Later, as we enter the 1990s, you can see growth rates of around 4%, which is quite strong. Next, you can observe the crisis; in 2009, GDP growth was negative. In other words, the United States is experiencing a recession, and if you examine all the countries in this chart, you'll see that they are all affected as well.

Picture 3

The only exception in that year is China, which did not experience a recession according to this data.  It is such an outlier; just look at the remarkable growth that China is experiencing. Do you notice that their growth rates occasionally exceed 15%, and at times even surpass 20%? Examining the period since 1990, you can see that the average growth rate was a little over 10% throughout that entire time. For instance, you could consider Mexico and Japan. You can see that their growth rates differ significantly from those of the United States and China.

Mexico's growth rate is approximately one and a half times faster than that of the United States, while Japan's growth rate is roughly half that of the United States. Next, let's consider a country like Greece, where you can appreciate the depth of the European Union's economic crisis. You can see that they are still in recession in the end. This raises the question: what is the appropriate rate of GDP growth? Should we aim to grow as quickly as possible? Does the United States aspire to achieve growth rates similar to those of China? Is Japan truly facing difficulties because its growth rate is about half that of the United States? How can we make sense of all this data? To do so, we will introduce a new concept that will serve as our reference point for this course. This is known as potential real GDP growth, which will serve as our target and reference point for analyzing the business cycle. 

What exactly is potential GDP growth? What does this target mean for the economy? It is calculated by major think tanks and large institutions using a highly technical approach, summing the total investment in the economy and factoring in the growth of the labor force and aspects such as productivity growth.

These are complex models. However, we can calculate it in a straightforward manner that aligns with our objectives for this course by combining two concepts for which data is relatively easy to obtain. One of these factors is productivity growth. Productivity is defined as GDP divided by the number of workers. It reflects the actual output produced by each worker. We measure the growth in productivity, and factors such as education, technological advancements, and management all influence the productivity of each worker, correct? We combine productivity growth with labor force growth. The labor force consists of individuals who are available for work, including those who are currently employed and those actively seeking employment. If demographic growth is robust—such as when people have many children, there is immigration, or the age distribution of the population is leading more individuals to enter the labor force—then we can expect strong growth in the labor force. Conversely, if our population is aging or there is outward migration, we will experience a decline in the labor force. When you combine productivity growth with labor force growth, you obtain a fairly accurate estimate of the economy's potential GDP growth.

Why is this important to us? The potential growth rate of the economy is the rate at which it can expand over the medium term without resulting in an increase in inflation. In other words, we shouldn't aim to grow as quickly as possible because doing so could lead to an inflation problem. We also don't want to grow too slowly, because, as we all know from experiencing this crisis, it can lead to an unemployment problem. So, what do we aim to achieve? We would like to grow at a rate where inflation remains stable and unemployment is at an acceptable level. What is that rate? It varies significantly between countries.

We presented the two concepts discussed—productivity growth and labor force growth—for the United States over an extended period. By averaging these figures, we derived an estimate of potential GDP growth. You can see that represented by picture 2, which fluctuates but typically remains around 2.5% to 3% per year. That represents the potential growth of the U.S. economy without resulting in an increase in inflation. Maintaining unemployment at a relatively reasonable level over time. Currently, we are working to recover from the unemployment caused by the crisis. However, if we could maintain this growth rate over time, unemployment would decrease to an acceptable level, and inflation would remain stable. This illustrates what potential growth looks like for the United States. 

The same approach has been utilized for the 17 countries in the Eurozone. You can see that their productivity growth is actually lower than that of the United States. You can observe that their labor force growth is higher than that of the United States in some years, while in other years it is lower. On average, surprisingly, their labor force growth is higher than that of the U.S. This provides us with a potential growth rate for the countries in the Eurozone; however, this will obviously vary significantly for Germany. For Spain, the figures can vary significantly, but on average, you can see that their potential growth rate is lower than that of the United States. It is approximately two percent. What does this imply? The United States should aim for faster growth than Europe because it has a larger flow of workers and greater productivity growth, allowing it to expand more rapidly without causing higher inflation. 

Picture 4

Europe should aim for a growth rate that is somewhat lower, as indicated in this chart, around two percent or slightly below. Japan was included here as well to highlight the contrast. As you can see, Japan's labor force growth has been negative almost every year. This will impact their potential GDP growth and, consequently, the targets for economic policy-making. While their productivity growth is relatively high, the negative labor force growth leads to a lower estimate of potential GDP growth. In this chart, the average was calculated over ten years, and you can see that the potential GDP growth for the Japanese economy is only about one percent. Here, we have a reference point: how much should we grow? Ideally, we should aim to grow at or near our potential. This serves as the foundation for our economic policy-making.

Source:

The Circular Flow Diagram

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The stepping-stone image —
aligned with the theme of potential GDP
and purposeful progress:
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🪨 Reflection: Step by Step on the Path of Purpose

This image of concrete stepping stones set in grass is a powerful metaphor for potential GDP and the business cycle in life.

Each stone represents a phase or step — a structured point of progress laid out toward a destination. The ground beneath, imperfect and filled with patches of grass or gaps, reflects the real economy — what is happening now.

In economics, potential GDP is the ideal output an economy can sustain over time without overheating or slowing down. It serves as a reference — a path that, if followed steadily, ensures stability and growth. But the business cycle is not always neat — just like how grass grows unevenly between steps, or how some stones are cracked.

In life, too, we are often presented with a clear path of purpose — a calling, a rhythm, a vision of our "potential." But just like the image, our actual steps may be uneven: we pause, slip, or take detours.

🧠 Reflection questions:

• Am I walking in alignment with the “stepping stones” of my potential, or getting lost in the weeds?

• Which stone am I currently standing on — early stage, in transition, or nearing stability?

• Have I been too focused on “speed” (inflationary gap) or too hesitant (recessionary gap)?

💬 Lesson: The path is laid, but progress requires consistency, awareness, and balance. Your potential is not about speed but sustainability. Trust the path, honor each step, and return to your reference point when lost.

📍 Stay on Your Path

Every step counts. Whether you're navigating growth, a pause, or a pivot — keep walking.

📈 Align with your potential, not just the pressure to perform.
🧭 Let purpose—not speed—guide your next move.

➡️ Reflect. Re-align. Step forward.

Quranic Insight:

"And say, ‘Do [good]; for Allah will see your deeds, and [so will] His Messenger and the believers...’"

— Quran Surah 09 At-Tawbah Ayat105

Just like each stone in a path guides us toward a destination, every deed — even small steps — matter in fulfilling your God-given potential.

🌿 Your journey may not be linear, but it is seen, recorded, and purposeful.
🔄 In the business cycle of life, there are slowdowns and accelerations — but staying the course matters most.