Potential Output and Actual Output Can Differ – Macroeconomics

Explain the concept of potential output and why actual output can differ from potential output? (2 marks) Potential output is the amount of output that an economy can produce when using its resources such as capital and labour, at normal rates. Potential output is not a fixed number but grows over time, reflecting increases in both the amounts of available capital and labour and their productivity. As capital and labour can be utilised at greater than normal rates, at least for a time, a country’s actual output can exceed its potential output. Identify two factors that might cause a change in the level of potential output.
For each factor briefly explain why they can affect potential output. (2 marks) Unfavourable weather conditions, such as severe drought, could reduce potential output growth in an economy such as Australia’s, or a decline in technological innovation might also reduce potential output. This would affect potential output as it reduces the availability of resources such as capital and labour. Under the assumption that the country is using its resources at normal rates, so that actual output equals potential output, a significant fall in potential output growth would tend to result in recession.
Similarly, new technologies, increased capital investment, or a surge in immigration that swells the labour force could produce unusually brisk growth in potential output, and hence an economic expansion or even a boom. This is so as availability of resources has increased. – Growth in potential output itself may slow down or speed up, reflecting changes in the growth rates of available capital and labour and in the pace of technological progress. Identify and briefly explain the main features of the business cycle. (2 marks) usiness cycles are usually thought of as being characterised by periods of transition from peak to trough (a contraction) and then from trough to peak (an expansion) draw diagram peak: the beginning of a contraction, the high point of economic activity prior to downturn trough: the end of a contraction, the low point of economic activity prior to a recovery Explain the concepts of (a) potential output and (b) the output gap. (3 marks) a) Potential output: the amount of output (real GDP) that an economy can produce when using its resources such as capital and labour, at normal rates.

Potential output is not a fixed number but grows over time, reflecting increases in both the amounts of available capital and labour and their productivity. b) Output gap: the difference between the economy’s potential output and its actual output at a point in time. Positive output gap, when actual output is above potential and resources are being utilised at above normal rates is called an expansionary gap. A negative output gap, when actual output is below potential, and resources are not being utilised is referred to as a contractionary gap.
Whenever an output gap exists, whether it is contractionary or expansionary, policy-makers have an incentive to try to eliminate the gap by returning actual output to potential. Explain the concept of Okun’s law. Discuss the implications of Okun’s law for policymakers? (5 marks) Okun’s law describes a systematic relationship between cyclical unemployment and the output gap. According to this law, an additional percentage point of cyclical unemployment is associated with some constant (noted by B) percentage point decline in the output gap.
For Australia B is estimated to be about 1. 5. IMPLICATIONS Explain the concept of Planned Aggregate Expenditure (PAE). How does PAE differ from Actual Expenditure? (2 marks) Planned aggregate expenditure is the total planned spending on final goods and services. This involves consumer expenditure, investment, government purchases and net exports. PAE and AE differ when a firm sells either less or more of its product than expected. As a result the planned investment I(p) and actual investment I values vary, resulting in different PAE and AE. ADD EXAMPLE
Explain why the following two conditions are equivalent ways of describing equilibrium in the Keynesian aggregate expenditure model. • Y =PAE • INJ(p)=WD (3 marks) For the keynesian model, it was assumed that in the short run, producers leave prices at preset levels and simply meet the demand that is forthcoming at those prices, and thus in the short run, firms produce an amount that is equal to planned aggregate expenditure, i. e. when Y=PAE. Equilibrium can also be defined as a situation in which planned injections of expenditure are enough to exactly offset any withdrawals, i. . INJ(p)=WD. Using the two-sector model, this description of equilibrium is the same as Y=PAE. PAE can also be written as C + I(p). In equilibrium, it must therefore be the case that Y=C+I(p) and hence Y-C=I(p). Also, as aggregate output, is equivalent to aggregate income. Savings is equal to investments. As savings are the only withdrawals while investment expenditure the only injection in this model it can be seen that the two conditions are indeed equivalent in describing equilibrium in the Keynesian aggregate expenditure model.
Discuss the role played by fixed (or sticky) prices in the Keynesian model of income determination. Briefly explain what would happen if prices were fully flexible in the short-run. (2 marks) Use the Keynesian aggregate expenditure model and appropriate diagrams to explain the following: • The paradox of thrift • The effect on equilibrium GDP of an exogenous increase in exports. (4 marks) The paradox of thrift: an attempt by the community to increase its savings will fail and the economy, overall, will be worse off as a result of that attempt. (Price level and the interest rate, are held constant).
Increased saving, decreases consumption hence drops Y=PAE (C+I(p)) and increases withdrawals and hence saving curve increased. Equilibrium GDP would increase if there were an increase in exports (raises PAE, raising whole line therefore equilibrium point is higher) PAE=C+I(p) +G+X-M Explain what is meant by the multiplier? Why, in general, does a one dollar change in exogenous expenditure produce a larger change in short-run output? (4 marks) EXAMPLE The multiplier, otherwise known as the income-expenditure multiplier, is the effect of a one-unit increase in exogenous expenditure on short-run equilibrium output.
The multiplier arises because a given initial change in spending changes the incomes of producers, which leads them to adjust their spending, changing the incomes and spending of other producers, and so on. Ultimately, these successive rounds of declines in spending and income may lead to a decrease in planned aggregate expenditure, and output that is significantly greater than the change in spending that started the process. Explain the role played by the marginal tax rate in determining the size of the multiplier.
Other things equal, how does a cut in the marginal tax rate affect the size of the multiplier? (2 marks) PAGE 214 If the government sets a high tax rate, a change in domestic income will not flow through the expenditure on domestically produced goods and services to as great an extaent as when the tax is low Use a diagram to illustrate the concept of short-run equilibrium in the Keynesian aggregate expenditure model. Suppose the economy is initially not in equilibrium, explain the process by which the economy adjusts to equilibrium. (4 marks) PAGE 204, 205
Explain the role played by the marginal propensity to import in determining the size of the multiplier. Other things equal, how does an increase in the marginal propensity to import affect the size of the multiplier? (2 marks) The size of the multiplier is largely determined by the coefficient in front of GDP in the economy’s planned aggregate expenditure equation, write equation, representing the proportion of any increase in aggregate income that is spent on domestic goods and services and thus useful in representing the change in equilibrium output.
As this coefficient is (c-m)(1-t), and the multiplier 1/(1-k) an increase in the marginal propensity to import would reduce the size of the multiplier. This is so as, if a significantly large proportion of income is spent on imports, then any change in income earned domestically will have a smaller effect on domestic expenditure compared to the situation in which the marginal propensity to import is small. Explain what is meant by the government budget constraint. Indicate how it can provide a link between fiscal policy and public debt? 3 marks) The government budget constraint is the term given to the concept that government spending in any period has to be financed either by raising taxes or by government borrowing. Briefly explain the main implications of demographic changes (over the next 50 years) for fiscal policy (3 marks) What are the main instruments of fiscal policy? Explain how each might be used to close an expansionary output gap. (4 marks) Explain the difference between discretionary fiscal policy and automatic stabilisers.
Which one of these will be the main influence on the size of the structural budget deficit? Explain. (3 marks) A government is considering its fiscal policy response to a decline in exogenous desired expenditure by households and firms which has produced a large contractionary output gap. Two alternative policies are under consideration: An increase in government spending of $20 billion, or A one-time cash payment to all households, which also has a total value of $20 billion
Use the 4-sector Keynesian aggregate expenditure model to explain which of these policies will have the largest effect on planned aggregate expenditure and on the level of output. (4 marks) Suppose a government is concerned about the size of the budget deficit. It decides to increase government spending by $20 billion, but at the same time to increase exogenous taxes by $20 billion. Will this policy have any effect on the level of output? Explain your answer. (3 marks) Briefly discuss any complications or issues with fiscal policy that are not accounted for by the Keynesian aggregate expenditure model. 3 marks) Money can be defined by its functions. In the following cases explain whether or not something is money, and which of the functions of money that it satisfies. – Credit-card account with a $5,000 limit – A BHP-Billiton share – A Transaction Account with the Commonwealth Bank with a $2000 balance (3 marks) Explain the assumptions and implications of the quantity theory of money. (3 marks) Explain what is meant by open-market-operations. Briefly outline how the RBA uses open-market-operations to influence the cash rate. (4 marks)

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