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Potential GDP & The Natural Unemployment Rate
You have learned to evaluate economic performance based on
output , prices, and labor.
Next we will look at some different schools of thought explaining
economic performance.
Classical macroeconomics(Adam Smith 19th century): Free
markets thrive, and free markets with no government intervention
gives the best macroeconomic performance.
Idea- markets will always return to equilibrium.
Ques: What’s the good thing about market equilibrium?
Economic Schools of Thought
Keynesian macroeconomics(John Keynes 20th
century): Markets are unstable and there is some need for
government intervention.
Here the role of government is to maintain full employment in the
economy. (Recall full employment).
The idea is that in times of recession.
Y= C+I+G+NX .
Consumption, investment , and net export expenditure may be too
low. Increased government spending should be used to increase
output and achieve full employment.
Economic Schools of Thought
Both Schools of thought have inherent flaws.
Classical: Could not explain prolonged recessions. (long periods of
high unemployment)
Ques: How do you think this relates to the classical view?
Keynesian: Increased government spending may increase prices in the
long run, increase the cost of living, and decrease productivity.
New Macroeconomics: macroeconomic performance depends on the
choices of individuals and firms.
POTENTIAL GDP
Defn: Potential GDP is the level of real GDP that the economy
would produce if it were at full employment.
Potential GDP is the level of output when the labor market is in
equilibrium.
Point: The economy is at full employment when the labor market is
in equilibrium.
Production function-
POTENTIAL GDP
The production function
displays diminishing
returns.
What is diminishing returns?
How is it shown?
The Labor Market and Potential GDP
Questions to be answered
1)How is the quantity of labor demanded different from the demand
for labor?
2) i) What is the relationship between the quantity of labor
demanded and wages. ii) What does the wage rate represent to the
firm?
3) What is the relationship between the quantity of labor supplied
and the wage rate. What does the wage rate represent to the
worker?
The quantity of labor supplied increases as the real wage rate
increases for two reasons:
• Hours per person increase as the real wage rate increases.
• The labor force participation rate increases as the real wage
rate increases.
Example
Economy LCG has the capability of production function
Y= 2*L0.5 . Where Y is output , and L represents labor hours worked.
i. If equilibrium labor hours is 100, how many goods are produced.
ii. Is there diminishing marginal returns in LCG? How do you know?
iii. If price in LCG is $10, what is GDP?
i)output= 2*(10)=20
ii) Yes, each additional 100 units of labor gives additional less output.
When L=200, Y=28.28. The output increased by 8.29
An additional 100 units of labor L=300, Y=34.64. An increase of only
6.36.
iii) GDP is the value of ouput= price * quantity = $10*20=$200