Module 12

Potential Output
Resources are = CAPITAL GOODS + LABOUR
Capital goods are

Land (natural resources)

-

Labour force consist

Capital (man-made assets)

Labour (work able part of population)

Enterprise (managers, investors, entrepreneurs)

In the short run these are fixed so a fixed upper limit of total out exists ->
Productive Potential
Question;

- Will Potential Output = Gross National Product?

-

What combination of potential out to consider?

How are scarce resources best allocated?

Production Possibility Frontier ( assuming full use of resources) sets limit for
various combination of goods.

Different combinations at production frontier can be obtains, increasing out output

at expense of other (opportunity cost) since all resources are being used. Micro
economics explains allocation of resources between competing uses, given the fact
of scarcity.
Any point on the frontier is however preferred to within frontier since it means full
use of resources and no waste and assuming society rationally wants more of the
commodities.
However it also means that if society is at Z it can increase output of one product
without sacrificing other product. Macroeconomics determines whether output is at
potential protein or actually is less.

12.2 Potential Output in the long run.

In short run we assume supply factors and technical knowledge as fixed. Some are
inelastic like land but other supplies are more elastic in long run (population and
extent of its involvement in labour). New investment also adds to capital stock.
Entrepreneurship and technical expertise also increase slowly (except in IT
revolution).

Short run macroeconomics Is actual output = to product frontier given fixed

resources
Long run macroeconomics (production frontier is not fixed -> increased output ->
increased standard of living -> economic growth.) What determines rate of
economic growth through time?
Economic growth would be a rightward shift on production frontier. There is option
of consumption or capital investment (although ultimate objective is
consumption).
Some investments needed to offset depreciation the diminution of productivity
existing stock over time.
Shaded area represents investment to replace depreciation.
However society can also increase further in investment so that there are increased
resources in the future.
Net investments = Total/gross investment --- replacement investment
NI = gross investment RI
GNP = consumption + NI + RI
Therefore future GNP grows

In example below;
Prodigality consumes are resources -> in future there is less resources due to
depreciated
Satiated devotes enough investment to offset deprecation -> equal future output
Thrift land Sufficient capital investment to offset depreciated and add net
investment -> future output is further increases. Economic growth.

Natural disasters can shift frontier to left. Poor nations struggle to remain on
satiated production frontier.

12.3 Measuring Potential Output

Is represented by production frontier. Only when full employment of all factors of
employment. (( although there is provision for temporary unemployment and
temporary reduced capital utilization due to ongoing changes)).
We can only estimate the difference between actual and potential output ( cannot
calculate potential output per se).
The unemployment rate and capacity utilization can be calculate in industry
surveys.

High capacity utilization means low unemployment rates. These are never 100%
and 0%.
Full employment is in fact taken as a target rate of employment and since it is some
of the easiest to measure it is a good indicator of potential output.
Types
Frictional Unemployment
Changing jobs takes time due to imperfect information. Even though same
occupation and area of employment.
It is not caused by lack of jobs, in fact number of unemployed would match
unfulfilled vacancies. But finding the match takes time due to imperfect
information.
Structural Unemployment
Occurs despite available vacancies but there is miss match between required and
available skills. Retraining would be required or change location of work. Can persist
for long time.
Seasonal Unemployment
Production is dictated by weather or calendar. This unemployment has a seasonal
pattern.
Factors determining Unemployment
1)
Level of economic activity high economic activity ( close to frontier) means a
lot of production and high employments. There is high demand for labour so good
flow of information to attract new labour and assistance for relocation.
2)
Transmission of information
3)
Rate of structural change due to different product demands.
4)
Ease of changing occupation and home availability of necessaries in new
location and cost of retraining.
5)
Institutional restrictions ( that restrict efficiency of labour market) e.g.
Minimum wage - unemp . or heavy cost for changing pensions etc.
6)
Dependence on season industries

12.4 The relation between the unemployment rate U, Potential output Q

and actual output Y.
Other category of unemployment - Demand deficient unemployment.
Therefore full employment is considered when vacancies unemployed. I.e.
demand deficient unemployment is zero.
There would still be unemployment for previously stated reasons.
The natural rate of unemployment is varies over time and country. 2-6 or 1-2 .
If full-employment rate of unemployment than actual output Y potential output Q.
If unemployment than there is gap between Q and Y and this is known as out-put
gap.

Okuns Law expresses relation between unemployment and output gap with
equation;

UF is full employment rate of unemployment. Each 1% that U is more than UF will

cause 3% reduction of real output.

12.5 Output and Inflation

Demand determines the output of goods. Therefore aggregate demand will
determine unemployment rate.

If aggregate demand goes beyond D4 thee will be an inflationary gap. Prices will
rise and economy remains at full employment at higher price levels.
At full employment or close there would be inflation.

12.5.1 The Inflation rate

% increase per year in average price.

Price level is the consumer price index i.e. average level of prices of goods and
services consume by typical household. ( basket of goods).
Inflation is the % increase of the price index.
Price index features only household goods and dont reflect gov goods or
investments.
Even though demand curve is a downward slope in reality prices have a fixed price.
Firms set short term prices based on expected costs of production and
expected demand.
Firms form these estimates based on recent experience and interpretation of whole
economy.

Of importance is recent level of aggregate demand

High aggregate demand means both that 1) there will be demand for final
product but also that 2) firm will have to compete for resources.
Average price that will be set in next period depends on (aggregate) demand in
current period.
Therefore given price set in current period and the change in demand for it, will
determine price for next period.
Therefore the higher the aggregate demand in the short run the higher the inflation.
And since aggregate demand included both unemployment rate and inflation
rate there is an implied relation for the last 2,.
High aggregate demand = low unemployment = high inflation.
E.g. It can be extrapolated at any stage e.g. - inflation is high because
there is high demand and because people have more income to spend. Or
if employment is low, unemployment is high , there is less demand and
inflation.
Philips curve Inflation Unemployment curve. each point on curve
reflects aggregate demand

If demand is beyond what is produced at full employment ( as define by full

employment) there can be product produced by e.g. overtime. Such output will
however be more expensive and would cause the highest inflation as show by at B increase in rate of inflation
F is full employment and A is unemployment.
This is short run.
Principles of Philips curve - Same principles as above
low unemployment can only be achieved at trade of of
higher inflation.
At full employment inflation is positive called
inflationary bias of economy one would expect it to
be zero because at overfull emp resources are more
expensive pushing up price of goods resulting in
inflation. At under full employment the resources are
cheaper and this pushed down price of goods,
deflation. Therefore at full emp these would
neutralize. In real world this is not so because the
labour market, being the larges resources, - at any
point there is usually substantial structural
unemployment and imperfect market operations in
that wages dont equate fast enough. Therefore when
there is excess supply the wages dont respond to
downward pressure.

This downward rigidity can be caused by collective bargaining, political

unwillingness to propose wage decrease, employees with seniority ( safer jobs)
unwilling for collective decrease in wage and given welfare unemployment
compensation workers prefer unemployment spells and having higher wages.
So at full employment, and considering the many diff markets, there is still frictional
and structural unemployment. Since employment is full these can be considered
as excess demand. And in those markets labour is hired as high wages so they
inflate prices at next period.. While in the markets with no excess demand the
wages will not fall and so are not able to deflate prices at next period.
The inflationary bias reflects Phillips curve crossing horizontal line only at this very
high unemployment there is actual deflation. Only that level would wages actually
decrease.
2nd Philips curve feature;
It is curved doh. At high unemployment it is relatively flat. So increase in
employment will increase inflation only slightly. At higher level of employment the
proportional change in inflation is higher.
At high unemployment only few marks have excess demand of labour so inflation
is only in few products. Majority of employees would go into other markets that
dont impose increase in wages.
Since Philips curve is sort term it can change from one period to next as society
changes.
Shifts up -> full-employment inflation rate if higher and unemployment rate at
which inflation become 0 is higher. Therefore inflation depends not only on where it
society stand on curve but where curve stand itself.
Since curve can shift with time it is important to analyze the implications at each
current state.
Shift in the Philips curve can result in unemployment and inflation moving in same
direction causing some to doubt its existence.
Suppose Curve shifts upwards and at same time aggregate demand declines and
employment was full, there would still be increase in inflation.
Imp to remember that Philips curve is short term. It indicates what inflation rate
would result for different unemployment rates that might occur within the short run
period. If does not necessarily reflect what would happen if unemployment rate
changed from one period to the next.

The existence of short run Philips curve poses a serious dilemma for govs. Its
aggregate demand policies cannot be used, in the short run, to fight both
unemployment and inflation.
Gov decision depends on where economy lies currently on the Philips curve ( to
decide it to tackle inflation or unemployment).
This also depends on peoples preferences. Which evil society considers more
burdensome. The trade off point depends entirely on opinion of society.
There are many manners who may differ.,
Also the short run policy goal should not be decided without taking into account the
long run effects of that policy. It might be possible that high employment and low
inflation today will permit certain preferred combination tomorrow that would be
impossible otherwise.