Explain the Concept of Potential Output and Why actual Output can Differ From Potential Output

Saturday December 11, 2021

Explain the concept of potential output and why actual output can differ from potential output? (2 marks) Potential output is the amount of output that an economy can produce when using its resources such as capital and labour, at normal rates. Potential output is not a fixed number but grows over time, reflecting increases in both the amounts of available capital and labour and their productivity. As capital and labour can be utilised at greater than normal rates, at least for a time, a country’s actual output can exceed its potential output. Identify two factors that might cause a change in the level of potential output. For each factor briefly explain why they can affect potential output. (2 marks) Unfavourable weather conditions, such as severe drought, could reduce potential output growth in an economy such as Australia’s, or a decline in technological innovation might also reduce potential output. This would affect potential output as it reduces the availability of resources such as capital and labour. Under the assumption that the country is using its resources at normal rates, so that actual output equals potential output, a significant fall in potential output growth would tend to result in recession. Similarly, new technologies, increased capital investment, or a surge in immigration that swells the labour force could produce unusually brisk growth in potential output, and hence an economic expansion or even a boom. This is so as availability of resources has increased. – Growth in potential output itself may slow down or speed up, reflecting changes in the growth rates of available capital and labour and in the pace of technological progress. Identify and briefly explain the main features of the business cycle. (2 marks) usiness cycles are usually thought of as being characterised by periods of transition from peak to trough (a contraction) and then from trough to peak (an expansion) draw diagram peak: the beginning of a contraction, the high point of economic activity prior to downturn trough: the end of a contraction, the low point of economic activity prior to a recovery Explain the concepts of (a) potential output and (b) the output gap. (3 marks) a) Potential output: the amount of output (real GDP) that an economy can produce when using its resources such as capital and labour, at normal rates. Potential output is not a fixed number but grows over time, reflecting increases in both the amounts of available capital and labour and their productivity. b) Output gap: the difference between the economy’s potential output and its actual output at a point in time. Positive output gap, when actual output is above potential and resources are being utilised at above normal rates is called an expansionary gap. A negative output gap, when actual output is below potential, and resources are not being utilised is referred to as a contractionary gap. Whenever an output gap exists, whether it is contractionary or expansionary, policy-makers have an incentive to try to eliminate the gap by returning actual output to potential. Explain the concept of Okun’s law. Discuss the implications of Okun’s law for policymakers? (5 marks) Okun’s law describes a systematic relationship between cyclical unemployment and the output gap. According to this law, an additional percentage point of cyclical unemployment is associated with some constant (noted by B) percentage point decline in the output gap. For Australia B is estimated to be about 1. 5. IMPLICATIONS Explain the concept of Planned Aggregate Expenditure (PAE). How does PAE differ from Actual Expenditure? (2 marks) Planned aggregate expenditure is the total planned spending on final goods and services. This involves consumer expenditure, investment, government purchases and net exports. PAE and AE differ when a firm sells either less or more of its product than expected. As a result the planned investment I(p) and actual investment I values vary, resulting in different PAE and AE. ADD EXAMPLE Explain why the following two conditions are equivalent ways of describing equilibrium in the Keynesian aggregate expenditure model. • Y =PAE • INJ(p)=WD (3 marks) For the keynesian model, it was assumed that in the short run, producers leave prices at preset levels and simply meet the demand that is forthcoming at those prices, and thus in the short run, firms produce an amount that is equal to planned aggregate expenditure, i. e. when Y=PAE. Equilibrium can also be defined as a situation in which planned injections of expenditure are enough to exactly offset any withdrawals, i. . INJ(p)=WD. Using the two-sector model, this description of equilibrium is the same as Y=PAE. PAE can also be written as C + I(p). In equilibrium, it must therefore be the case that Y=C+I(p) and hence Y-C=I(p). Also, as aggregate output, is equivalent to aggregate income. Savings is equal to investments. As savings are the only withdrawals while investment expenditure the only injection in this model it can be seen that the two conditions are indeed equivalent in describing equilibrium in the Keynesian aggregate expenditure model. Discuss the role played by fixed (or sticky) prices in the Keynesian model of income determination. Briefly explain what would happen if prices were fully flexible in the short-run. (2 marks) Use the Keynesian aggregate expenditure model and appropriate diagrams to explain the following: •


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