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Chapter 19
Study Exercise Q3 on page 492 and Q4 on page493 of Ragan/Lipsey 11 Edition
Question 3
a) The output gap is equal to (Y–Y*). When expressed as a percentage of potential output
we have (Y–Y*)/Y*. The output gaps for the nine years in the table are:
1996:
1997:
1998:
1999:
2000:
2001:
2002:
2003:
2004:
gap = (768–788)/788 = -20/788 = –2.5%
gap = (784–796)/796 = -12/796 = –1.5%
gap = (797–805)/805 = -8/805 = –1.0%
gap = (811–815)/815 = -4/815 = –0.5%
gap = (825–825)/825 = 0/825 = 0.0%
gap = (840–836)/836 = 4/836 = 0.5%
gap = (853–847)/847 = 6/847 = 0.7%
gap = (862–858)/858 = 4/858 = 0.5%
gap = (870–870)/870 = 0/870 = 0.0%
b) Potential GDP is the level of output produced when all factors of production are being
used at their normal rates. Output can exceed potential when labour works overtime or
when capital and land are used more intensively than normal.
c) A recessionary output gap only requires Y to be below Y*. It does not require Y to
actually fall. When Y does fall, we usually say there is a recession. In the data shown, GDP
rises steadily, so there is no recession (but there is a recessionary output gap from 1996
through 1999).
d) The natural rate of unemployment is the unemployment rate that exists when actual GDP
equals potential GDP ─ in other words, when the economy is at “full employment”. GDP
equals potential GDP in two years — 2000 and 2004. In both years the unemployment rate
is 7.6%. So the natural rate of unemployment is 7.6%. When unemployment is at its natural
rate, the only unemployment is frictional and structural. There is no cyclical (or deficient
demand) unemployment.
Question 4
a) The rate of CPI inflation for the current year is equal to the percentage change in the CPI
from the previous year to the current year. The missing data are:
1989:
1990:
1992:
1993:
1996:
1997:
inflation = (89.0 – 84.8)/84.8 = 0.0495 = 4.95%
inflation = (93.3 – 89.0)/89.0 = 0.0483 = 4.83%
inflation = (100.0 – 98.5)/98.5 = 0.0152 = 1.52%
inflation = (101.8 – 100.0)/100.0 = 0.0180 = 1.80%
inflation = (105.9 – 104.2)/104.2 = 0.0163 = 1.63%
inflation = (107.6 – 105.9)/105.9 = 0.0161 = 1.61%
b) The CPI never falls between 1987 and 1998 and thus average prices (as shown) never
fall. Average prices come closest to being stable in the year with the lowest rate of
inflation — from 1993 to 1994 the inflation rate was only 0.2%
c) The rate of inflation is the closest to being stable between 1996 and 1997 — the rate of
inflation is almost the same in these two years.
d) See the diagram below. With the price level on the vertical axis, a stable price level is
shown by a line with zero slope — a horizontal line. A stable rate of inflation, however, is
shown by a line that is not only upward sloping but with ever-increasing slope. This is
because a constant percentage change in the price level means that in each successive year
the price level increases by more and more in absolute terms. For example, with a 10% rate
of inflation, the price level progresses from 100 to 110 to 121 to 133.1 to 146.4 to 161.1 to
177.2 to 194.9 etc.