5. Output Gaps and Economic Cycle Flashcards
When are positive output gaps created on the economic cycle? Why?
When actual growth exceeds trend growth.
Demand is out-stripping supply and so prices rise, fulfilling their rationing function, creating inflationary pressure.
When are negative output gaps created on the economic cycle? Why?
When actual growth is below trend growth.
Demand is below capacity. Firms underuse resources to lower costs and unemployment rises. There is SPARE CAPACITY and thus a NEGATIVE OUTPUT GAP.
What are causes 3 of instability? Define them…
Demand-side shocks: these are related to a rise or decline in spending and confidence abroad.
Supply-side shocks: these affect the price/supply of goods and services.
Financial shocks: financial instability can spread due to the interconnectedness of global finance.
What happens in the short run as a positive output gap occurs? (step-by-step)
1) there is an increase in spending and AD shifts right to AD2
2) Demand moves beyond the capacity of the economy to sustainably produce sufficient goods/services as factors of production are over-employed to increase output
3) prices rise as consumers outbid one another for the limited supply (demand pull inflation)
4) there is inflationary pressure in the economy
Explain why positive output gaps occur in the short run?
Because the economy is producing and consuming beyond capacity. More is being demanded than can be produced at existing prices. Prices in order to fill the ‘rationing function’. The economy therefore experiences inflation and an increase in output in the short run as factors of production are overemployed. (According to classical economists, this is unsustainable in the short run)
What happens in the short run as a negative output gap occurs? (step-by-step)
1) there is a decrease in spending and AD shifts left
2) demand moves below the capacity of the economy to produce goods/services so firms reduce output and the factors of production become unemployed
3) prices fall as firms must discount to sll stuck (reduction of demand pull inflation)
4) there is spare capacity in economy
Explain why negative output gaps occur in the short run?
this is because the economy is producing and consuming below capacity. Less is being demanded than can be produced at existing prices. Prices fall in order to sell stock. The economy experiences less inflation and a decrease in output in the short run as the factors of production are unemployed. This is unsustainable in the long run according to classical economists.
What does the PPF show?
The productive capacity of the economy - what it can produce with all resources fully employed. (same as LRAS or Yfe)
NOTE: PPF CAN’T SHOW POSITIVE OUTPUT GAP
NOTE: PPF CAN’T SHOW POSITIVE OUTPUT GAP
What happens in the long run as a positive output gap occurs? (step-by-step)
1) The factors of production are being overemployed. Labour works extra hours, machines overused, almost to the point of breaking down, efficiency is squeezing out any waste in utilisation etc.
2) eventually the Costs of production, especially wages will rise as the owners of the factors realise they are scarce and being offered too cheaply and worked too hard
3) SRAS will shift left as the cost of the CoP increases
4) Prices rise again as firms pass on the costs to consumers (cost push inflation) from p1 to p2
5) output falls back to the sustainable level of full employment as consumers demand less goods ad services at the new higher prices
What happens in the long run as a negative output gap occurs? (step-by-step)
1) in a negative output gap the factors of production are unemployed. Labour is unemployed, machines are sitting idle, resources are being unused etc.
2) eventually the costs of production - expeciall wages - will fall as the owners of the factors realise they are willing to accept lower wages in order to be employed
3) SRAS will shift right as the cost of the factors of production will fall
4) prices fall as firms pass on the cost of savings from p1 to p2.
5) output returns back to the sustainable level of full employment (Yfe) as consumers demand more goods and services at the new lower prices.
Explain what happens when negative output gaps occur in the long run?
the economy can produce more than is being demanded. Our ability to produce goods and services isn’t the problem, just people don’t want them at current prices because of the unemployment they. According to classical economists, wages will fall as people would rather have a low wage than have no job at all. Meaning the price level falls, returning to full employment.
What do keynesian economists argue about in relation to negative output gaps?
they argue that costs of production (especially wages) are sticky. They don’t go down easily. This could be because of labour contracts but it is largely due to a psychological phenomenon. Labour is the only factor of production that gets upset when price falls. It is this difficulty for people to accept lower wages that makes recessions last a long time and why recovery is slow where a bust is quick.
What did Keynes argue about recessions?
They are a long run phenomenon, they don’t fix themselves. They can become depressions and the only way to fix them is by increase government spending to increase AD and return back to Yfe (full employment)
NOTE: the keynesian curve CANNOT be effectively used to illustrate a positive output gap in the short run, it can only show the long run effect of higher demand on inflation when there is no spare capacity.
NOTE: the keynesian curve CANNOT be effectively used to illustrate a positive output gap in the short run, it can only show the long run effect of higher demand on inflation when there is no spare capacity.
