Chapter 7: Potential GDP, Economic Growth, and Business Cycles

Potential GDP

real GDP when all inputs are fully employed — labour, capital, land/resources, entrepreneurship

• short-run goal for economic performance

• outcome if invisible hand works perfectly

• the reference point for a well-functioning, fully employed, economy

Potential GDP Per Person

potential GDP divided by the population

• best represents the highest material standard of living an economy can produce if all existing inputs are fully employed

• a better measure of maximum living standards

Business Cycles

The fluctuation of real GDP per person around potential GDP per person

Economic Growth

Expansion of economy’s capacity to produce products and services

• The increase of potential GDP per person over time

Macro Production Possibilities Frontier (PPF)

Shows maximum combinations of products/services a country can produce when all inputs fully employed

• On macro PPF: all inputs fully employed — producing at potential GDP

• Inside macro PPF: some inputs unemployed — producing below potential GDP

Economic Growth Increases…

Potential GDP per person

• Caused by increases in the quantity and/or quality of a country’s inputs, including technological change

• Shifts macro PPF outward

Contributions to economic growth and potential GDP increase

1. Increase in Labour

2. Increase in Capital

3. Increase in Land and Resources

4. Increase in Entrepreneurship

1. Increase in Labour

Quantity: population growth, immigration, labour force participation rate

Quality: increases in human capital — increased earning from work experience, on the job training, education

2. Increases in Capital

Quantity: more factories and equipment

Quality: technological change — improvements in quality of capital through innovation, research, development

3. Increases in Land and Resources

Quantity: bringing unconnected land/resource into the circular flow

Quality: due to increase in capital used with land

4. Increase in Entrepreneurship

• Quantity and quality interrelated

• Better management techniques, organization, worker/management relations

Economic Growth Rate

Annual percentage change in real GDP per person

Rule of 70

Number of years it takes for initial amount to double = 70 divided by annual percentage growth ate

• Because of compounding, small differences in annual growth rates have large consequences over time

Productivity

Quantity of real GDP produced by an hour of labour

• Increases in productivity can increase living standards

• Reduced amount of work time required to buy products and services

• The most important source of increases in our material standard of living

Creative Destruction

Competitive business innovations generate profits for winners, improving living standards, but destroy less productive or less desirable products and production methods

• Imporves living standards

Language of Business Cycles

Up and down fluctuations of real GDP

• Expansion: period during with real GDP increases — business activity increases

• Peak: highest point of an expansion

• Contraction: period during which real GDP decreases — business activity decreases

• Trough: lowest point during contraction

• Recession: 2+ successive quarters (of a year) contraction of real GDP

Output Gap: real GDP - potential GDP

• Inflationary Gap: real GDP is above potential GDP — gap is a positive number

• Recessionary Gap: real GDP below potential GDP — gap is a negative number

Shocks

Unexpected events that affect an economy

External shocks

• New technologies

• New resource discoveries

• Changing world prices for resources like oil

• Natural Disasters

• Pandemics

• Wars

• Changes in government fiscal or monetary policies

Internal Shocks

• Changing expectations (by consumers, businesses, or investors)

• Disruptions in financial markets (money and banks)

• Connection failures between input and output markets

Positive shocks

Lead to expansion

• Introduction of new technologies

• Government fiscal or monetary policies

Negative shocks

Leads to recession

• Financial crises

• Natural disasters

• Pandemics

• Wars

• Affects of government fiscal or monetary policies