Module 12 – Potential Output Flashcards
Classify Capital goods and Labour force
Capital goods
Land – all natural resources including agricultural land, rivers, forests, climate and mineral deposits
Capital – all factories, offices, warehouses, shops, houses, machinery, roads, harbours, airports, schools, colleges, …
Labour force
Labour – proportion of population able and willing to work; quality dependent on age, effort, education, aptitudes…
Enterprise – individual with organisational and managerial ability or financial skills, taking risks in starting new companies and launching innovative products
A shifting Phillips Curve over time can have inflation rates and unemployment rates moving in the ___, whereas a movement along a Phillips Curve shows ___.
The curvature of the Phillips Curve suggests the short-run inflation–unemployment trade-off is not___ but varies depending upon where an ___.
same direction; higher inflation rates associated with lower unemployment rates
constant;
economy actually is on the curve
Define Consumer Price Index
CPI - Consumer Price Index - most common; measures average level of goods/services consumed by typically households
- Most market it is calucated monthly
- Typical household does not purchase average selection of goods that make up total output / GNP
- E.g. Government and investment goods make up 35-45%
Define Replacement investment
Resources purchased to maintain productive capacity
- Training to keep labour force current
- Diversion from consumption
Define inflation
Inflation rate is the percentage increase per year in the average price level from one time period to another.
Thus if Pt is the average price level in period t and if Pt+1
is the average price level in period t + 1, then the inflation rate in time period t is defined by
INFt = Pt + 1 - Pt
Pt
Expressed alternatively, the price level in period t + 1 is:
Pt+1 = Pt(1 + INFt)
Define GNP deflator.
GNP deflator is similar to CPI but measures all goods
Discuss Structural unemployment.
o Unemployment matches unfilled job vacancies but
o Mismatch between locations/characteristics of vacancies
o Require retraining, location change or both
o Can persist for long periods
Discuss demand-deicient unemplyment.
- Demand-deficient unemployment
- Arises through insufficient demand for labour
- Policy-makers more confident about eradicating than frictional, structural and seasonal unemployment
Discuss Frictional unemployment.
- People are always changing jobs; search takes time because information is imperfect
- Amount depends on:
Number of persons changing jobs
Average length of job search - Unemployment is matched by unfilled job vacancies in the same occupations and same locations
Discuss Seasonal unemployment.
o Any activity where level of production is dictated by weather or by calendar
o E.g. farming, fishing, forestry, food processing, construction, tourism
o Characterised by periods of high employment with overtime working alternating with lower employment, short-time working, unemployment
Discuss full employment.
V (unfilled job vacancies) >= U (unemployed)
Most countries have no vacancy data at all therefore:
- Full employment usually taken as some target rate of unemployment: Essentially the sum of frictional, structural and seasonal unemployment
- During full employment: Y=Q (actual equals potential output)
Discuss the factors determining unemployment
Level of economic activity: Decrease/ increase frictional and structural unemployment, depending on output
Transmission of information: Job advertisement through Internet, newspapers, radio, TV…
Rate of structural change: Require redistribution of skills and location of workforce
Ease of changing occupation and home: Availability and cost of retraining programmes, cost of travel and moving, suitable schools, hospitals…
Institutional restrictions: Minimum wage, restrictions on job entry, local favouritism in allocating houses, union restrictions
Dependence on seasonal industries: Economies depending on i.e. farming.
Discuss the Phillips Curve.
Phillips Curve plots unemployment versus inflation
- Short-run relationship
- Trade-off between unemployment and inflation
- Inflationary bias – positive inflation at full employment
o Reflected in curve crossing horizontal axis at unemployment rate to right of natural rate of unemployment
Which of the following is correct? The economy is capable of producing the combination of guns and butter represented by points
A. Z only
B. W and Y only
C. W, Y and Z only
D. W, X, Y and Z
The correct answer is C. An economy has the resources to produce all combinations of guns and butter which lie on the production possibilities frontier, by definition, or within the frontier. Thus points W, Y, and Z qualify but not X since X lies outside the frontier.
Which of the following is correct?
If during the course of a year actual output and the unemployment rate both increase it follows that
A. potential output increased at a faster rate than actual output
B. the Phillips Curve shifted towards the origin
C. the inflation rate decreased
D. frictional and structural unemployment rates decreased
The correct answer is A. The unemployment rate is determined by the difference between actual and potential output. Thus if potential output and the unemployment rate both increase the potential output rate must, by definition, have increased at a faster rate than actual output.
Which of the four points W, X, Y and Z represents the combination of guns and butter that society would prefer?
A. X only
B. Y only
C. W or Y only
D. Z only
The correct answer is A. The more goods and services a nation has the better off it is. Point X represents:
more guns and butter than Z
more guns and the same amount of butter as point Y
more butter and the same amount of guns as point W
Therefore X is the most preferred point in the diagram even though it cannot be reached with existing resources.
Point Z in the diagram indicates:
I. an unattainable output combination of guns and butter
II. unemployed, or inefficiently employed, factors of production
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is B. Any point on or within the production possibilities frontier indicates attainable outputs; thus outputs represented by W, Y and Z are all feasible. Thus I is incorrect. An economy can move from a point within the frontier (Z) to a point on the frontier by efficient use of all of its production resources. Thus II is correct.
If an economy were operating within the production frontier, it would be possible to produce:
I. more guns without the sacrifice of some butter
II. more guns and more butter
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is C. Point Z is a point within the ppf. In moving to point W on the frontier gun production increases from g1 to g2 while butter production remains at b1. Thus I is correct. In moving to any point on the frontier between W and Y from point Z more of both guns and butter is produced. Thus II is correct.
For a society to increase its stock of human and physical capital net investment must be positive.
Which of the following is correct?
Net investment equals:
A. potential output minus actual output
B. actual output minus potential output
C. gross investment minus replacement investment
D. replacement investment minus gross investment
The correct answer is C. Part of the productive capacity of an economy wears out with use and with the passage of time e.g. ships, aircraft, trucks depreciate with time. To maintain the capital stock, i.e. replace that part which wears out, requires investment – replacement investment. To add to the capital stock requires gross investment to exceed replacement investment, i.e. there must be positive net investment. Total investment (gross investment) equals replacement investment plus net investment.
Demand deficient unemployment is caused by:
I. structural change in the economy
II. time required to leave one job and seek alternative employment
III. fluctuations in economic activity caused by seasonal nature of some jobs
Which of the following is correct?
A. I only
B. II and III only
C. I, II and III
D. Not I, not II, not III
The correct answer is D. Demand deficient unemployment arises because of insufficient demand for labour and occurs when society demands less than the economy is capable of producing, i.e. occurs when actual output is less than potential output. Thus I, II and III are incorrect each referring to respectively structural, frictional and seasonal unemployment.
According to Okun’s Law a 1% unemployment rate above the full employment unemployment rate, or above the natural rate of unemployment, is associated with
I. a 1% reduction in real output
II. a 1% reduction in the inflation rate
Which of the following is correct?
A. I only
B. II only
C. I and II
D. Neither I nor II
The correct answer is D. Okun’s Law, based on empirical data, associated a 1% unemployment rate (above the full employment unemployment rate) with a 3% reduction in real output. Thus I is incorrect. Okun’s Law stated nothing about the relationship between unemployment and inflation. Thus II is incorrect.
In official statistics it was noted that the consumer price index (CPI) was:
Which of the following is correct?
These data indicate an annual increase in the average level of prices paid by consumers of
A. 6% in year t + 1 then less than 6% in subsequent years
B. a constant 6% in each year
C. 6% in year t + 1 and a doubling in year t + 2
D. 6% in year t + 1, 12% in year t + 2, 18% in year t + 3
In the Phillips Curve depicted above in which
In the Phillips Curve depicted above in which
I. the inflationary bias of the economy is demonstrated
II. a low unemployment rate is associated with a high inflation rate
III. the lower the rate of unemployment the higher the rate of increase of the inflation rate
Which of the following is correct?
A. I and II only
B. II and III only
C. III only
D. I, II and III
The correct answer is D. Since U2=full employment and U2 is associated with the inflation rate I2 then inflation exists when the economy is at full employment; this is known as the inflationary bias; thus I is correct. Because the curve slopes downwards from left to right there is an inverse relationship between inflation and unemployment rates; thus II is correct. Because of the curvature of the Phillips Curve – relatively flat at high unemployment rates and relatively steep at low rates the lower the rate of unemployment the higher will be the rate of increase of inflation, e.g. compare U3U2 and I2I1 with U2U1 and I3I2. Thus III is correct.
Which of the following is correct?
Downward real/nominal wage rigidity means
A. the inflation rate sets the minimum rate of increase of wages
B. in labour markets where there is excess supply of workers wage rates do not fall to clear the market
C. every increase in the unemployment rate is associated with a downward movement of wages
D. workers’ wages never decrease as the economy grows
The correct answer is B. In a perfectly competitive labour market wages would fall if the supply of labour exceeded the demand for labour. For a variety of reasons in many labour markets this does not occur, e.g. collective bargaining agreements, employers wishing to retain employee goodwill and it is said ‘wages are sticky downwards’, i.e. downward wage rigidity. Statements A, C and D are false.
The curved shape of the production possibilities frontier indicates that:
I. the more butter being produced the greater the amount of resources required to produce one more kilo of butter
II. the greater the number of guns being produced the greater the amount of resources required to pro-duced one additional gun
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is C. Were the production possibilities frontier linear the opportunity cost of producing guns, in terms of butter, would be constant and vice versa. The curved shape of the production possibilities frontier indicates that the closer society is to either point A (all guns) or point B (all butter) the greater is the amount of resources required to produce one additional unit of the commodity in ‘short’ supply. This is because society will utilise first the resources most suitable for producing any good. Imagine a farmer whose land includes a fertile valley and a rugged rocky hillside. He grows wheat in the valley and raises sheep on the hillside. To produce more wheat and have fewer sheep means planting wheat on the hillside; for each additional bushel of wheat he plants on the hillside he will need more and more resources as the land becomes increasingly difficult to cultivate. Thus both statements are correct.
If actual output increased at a faster rate than potential output which of the following could NOT occur?
A. The unemployment rate could not increase
B. The unemployment rate could not decrease
C. The inflation rate could not decrease
D. The inflation rate could not increase
The correct answer is A. The unemployment rate is determined by the difference between actual and potential output. If the former increases faster than the latter then the unemployment rate must decrease. Thus A is correct and B incorrect. Many factors determine the inflation rate in the short-run. It could increase, decrease or remain unchanged. Thus C and D are incorrect.
Which of the following is correct? The opportunity cost of b1b2 of butter is:
A. 0b1 of butter
B. g1g2 of guns
C. 0g2 of guns
D. 0b2 of butter
The correct answer is B. In moving from W (0b1 of butter and 0g2 of guns) to Y (0b2 of butter and 0g1 of guns) on the production possibilities frontier the economy sacrifices g1g2 of guns to obtain b1b2 of butter.
Economic growth is made possible by:
I. increases in the supply of factors of production
II. increase in factor productivity
III. technological change
Which of the following is correct?
A. I and II only
B. II and III only
C. III only
D. I, II and III
The correct answer is D. The larger the stock of resources the larger is potential output. Growth in potential output therefore and consequently economic growth are made possible by increases in the supply of factor inputs. Similarly increases in factor productivity, i.e. more output from given factor inputs e.g. discovering that milk output increased when music was played during milking, and technological change e.g. adoption of new production technologies, inventions, innovations etc. make output of goods and services higher than they otherwise would have been, i.e. make possible economic growth.
The differences between the Consumer Price Index (CPI) and the Gross National Product (GNP) deflator are
I. the price index for the base period is 100 in the CPI and between 135 and 145 in the GNP deflator
II. the CPI does not include investment expenditure and government purchases of goods and services
Which of the following is correct?
A. I only
B. II only
C. I and II
D. Neither I nor II
The correct answer is B. The importance of each item in any price index is determined by its weight in total expenditure and is calculated by the number of units purchased times the price of each unit. To compare changes each year (or time period) a starting year (or time period t) is determined and the index set equal to 100, i.e.
Thus I is incorrect. T_he CPI includes consumption goods and services purchased by the average household_ but does not include investment expenditure and government purchases of goods and services. The GNP deflator includes all goods and services. Thus II is correct.
Discuss Okun’s Law
One third of output gap is due to unemployment (beyond natural rate Uf)
where UF = full-employment rate of unemployment. In words Okun’s Law states that for each one per cent by which actual output falls short of potential output, the unemployment rate will exceed its full-employment rate of unemployment by one-third of one per cent. Thus if Y is 6 per cent below Q, then U will be 2 per cent above UF. Expressed alternatively, Okun’s Law suggests that each percentage point increase in the unemployment rate above UF is associated with a 3 per cent reduction in real output.
The following data refer to the output of guns and butter (both standard quality) in three economies in different years:
In which of the economies did economic growth occur?
A. Z only.
B. X and Z only.
C. X, Y and Z.
D. Not X, not Y, and not Z.
The correct answer is A. In economy Z, more guns and more butter were produced in t + 1 compared with Year t; therefore economic growth occurred. In economy Y, the output of guns remained constant and the output of butter fell; thus there was a decline in total output. In economy X, the output of guns declined and the output of butter rose; however, since no information is given about the relative worth of guns in relation to butter (e.g. their prices), no conclusions can be drawn about total output because the units (number of guns and tons of butter) are not additive.
The following data in index form refer to a hypothetical economy:
From the data it can be concluded that
I. per capita GNP did not increase between Year t and Year t + 2.
II. the labour force did not increase between Year t and Year t + 2.
III. technological progress did not occur between Year t and Year t + 2.
Which of the following is correct?
A. I and II only.
B. I and III only.
C. II and III only.
D. Not I nor II nor III.
The correct answer is D. Since actual GNP increased from 100 to 150 between time periods t and t + 2, and since population remained constant, GNP per capita increased. Thus I is incorrect. Increases in potential GNP come about from a net increase in technological change, the labour force and the capital stock. Thus either or both of the labour force and technological change could have increased between t and t + 1 but could have been offset by a reduction in the capital stock, resulting in a constant potential GNP – for example, the labour force could have increased due to a rise in the participation rate of teenagers, but potential output could have remained constant due to declining technology and/or a decrease in the capital stock. Thus neither II nor III must be correct.
The government is considering which policies to adopt and is using the Phillips Curve in Figure 12.13 in its deliberations. It has decided that
I. Policy A will result in a 10 per cent inflation rate and a 3 per cent unemployment
rate.
II. Policy B will result in a zero inflation rate and an 8 per cent unemployment rate.
III. Policy C will result in a −2 per cent inflation rate (i.e. a 2 per cent deflation rate) and a 10 per cent unemployment rate. Which of the following is correct?
A. The best policy is A because it yields the lowest unemployment rate.
B. The best policy is B because it yields the lowest inflation rate.
C. The best policy is C because it will lower inflationary expectations.
D. The best policy is dependent entirely on the subjective opinions of the popula-tion of the economy.
The correct answer is D. The most appropriate policy depends upon the opinion of the people it affects. Whether the government should emphasise lowering the inflation rate or lowering the unemployment rate will depend upon which evil – inflation or unemployment – society considers to be more burdensome. Similarly, if society places a high value on low inflation rates in the future and believes that this can be attained by suffering high unemployment today, III might be chosen as the best short-run policy. Thus the most appropriate policy depends entirely on the subjective opinions of society.
If the Phillips Curve in Figure 12.13 were to shift to the left, the following would occur in the economy:
I. the unemployment rate would decrease.
II. the inflation rate would decrease.
Which of the following is correct?
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.
The correct answer is D. A shift to the left of the Phillips Curve indicates only a more favourable trade-off between inflation and unemployment; it does not indicate where the economy will be on the shifted Phillips Curve.
For example, the economy might originally be at point B in Figure 12.13 (zero inflation and an eight per cent unemployment rate); policies might take the economy to a position of say, a one per cent inflation rate and a five per cent unemployment rate on the shifted Phillips Curve; thus the inflation rate will have risen despite the shift on the curve.
Similarly, if the economy had started out at point A, policies could have led to an increase in the unemployment rate on the shifted curve. Thus, neither I nor II is necessarily true.
For an economy operating on the production possibilities frontier CA in Figure 12.12, which of the following correctly describes the combination of capital and consumer goods indicated by point L? It
A. would entail substantial unemployment.
B. would entail an inefficient use of society’s resources.
C. is beyond the productive capacity of the economy.
D. suggests the productive capacity of the economy is declining.
The correct answer is C. Point L lies beyond the production possibilities frontier CA shown in Figure 12.12. It therefore represents a level of output that is unattainable given the current stock of factors of production and the current state of technical knowledge. A point such as L may be achieved at some period in the future given an increase in the supply of the factors of production (land, labour, capital, and enterprise) and/or an increase in technical knowledge, but is beyond the current productive capacity of the economy. Points within the frontier would indicate unemployment and an inefficient use of resources. A leftward-shifting frontier would indicate declining productive capacity.
Which of the following is correct? The choice of point P on production possibilities frontier CA in Figure 12.12 will
A. result in a faster rate of economic growth than would the choice of point N.
B. result in a slower rate of economic growth than would the choice of point N.
C. result in the same rate of growth as would the choice of point N. D. be unattainable because P exceeds productive capacity.
The correct answer is A. At point P in Figure 12.12, more resources are allocated to the production of capital goods than at point N; consequently potential output will be higher in the following year, which would allow the economy to achieve a higher growth rate in actual output. Point P is feasible because it lies on the production frontier.
Which of the following is correct? A shift of the production possibilities frontier in Figure 12.12 from CA to CB indicates
A. a movement from unemployment to full employment.
B. an improvement in capital goods technology but not in consumption goods
technology.
C. an improvement in consumption goods technology but not in capital goods
technology.
D. a decline in the total output of the economy.
The correct answer is B. The shift in the production possibilities frontier from CA to CB shown in Figure 12.12 denotes increased productive potential, which may be due to an increase in the supply of the factors of production and/or improved technical knowledge. In the example illustrated, the economy’s productive potential to manufacture capital goods has improved but its productive potential to manufac- ture consumption goods has remained unchanged. This suggests an improvement in capital goods technology but not in consumption goods technology.
After the production possibilities frontier in Figure 12.12 has shifted from CA to CB, the economy has moved from N to P. The result is
I. an increase in unemployment.
II. an increase in output.
Which of the following is correct?
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.
The correct answer is A. Since point N lies on the production possibilities frontier CA in Figure 12.12, no unemployment exists while CA is the production possibili- ties frontier. However, when CB becomes the production possibilities frontier, unemployment exists when the economy is operating at any point within the frontier, e.g. at point P. The shift in the production possibilities frontier from CA to CB increases the economy’s potential output. The movement from point N to point P increases output of capital goods at the expense of consumption goods; actual output does not increase.
