ECON1102 MACROECONOMICS 1
Tutorial Test No. 2
Time Allowed: 20 mins
(i) Explain the concept of potential output and why actual output can differ from potential output? (2 marks)
Potential output is not the same as actual output.
Potential output also known as potential GDP or Full Employment output and notated as y*, is the level of GDP an economy can produce using its resources i.e. labour and capital at normal rates and is unsustainable.
Whereas, actual output notated as y, can vary i.e. expand or contract due to changes in potential output. Therefore, in the short-run due to the changes in the utilisation rate of labour and capital, as actual output is ...view middle of the document...
In particular, when a contraction or recession results from slowing growth in potential output, the government’s best response is to try to promote saving, investment, technological innovation, human capital formation and other activities that support growth.
(iii) Explain the concept of Okun’s law. Discuss the implications of Okun’s law for policymakers? (6 marks)
Okun’s law describes the systematic relationship between cyclical unemployment and the output gap. It states that each extra percentage point of cyclical unemployment is associated with about a 1.6 percentage point (for Australia) increase in the output gap, measured in relation to potential output.
This can be represented mathematically using the formula:
Where: u = the unemployment rate
u*= Natural rate of unemployment
Therefore, by definition, cyclical unemployment (u-u*) is positive when the economy has a contractionary gap (y-y* < 0), negative when there is an expansionary gap (y-y* > 0), and zero when there is no output gap.
Under the assumption that the economy’s potential output is constant, changes in economy-wide spending are the primary cause of output gaps, therefore government policies can affect total spending directly simply by changing its own level of purchases.
In the long run, total spending influences only the rate of inflation.
In the short-run, the government will try to enforce policies that influence aggregate spending and may help eliminate output gaps.
(i) 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. (5 marks)
The Keynesian model provides an explanation for how contractions and expansions might evolve over the short run; this is the period of time in which firms adjust their output to match the prevailing level of demand without the price level having changed.
One of the basic implications of the model is that the government policies that affect the level of spending can be used to reduce or eliminate output gaps. These policies are known as stabilization policies.
By treating prices as fixed, the basic Keynesian model presented does not address the determination of inflation. The assumption that firms vary their production in order to meet demand at preset prices implies that fluctuations in spending will have powerful effects on the nation’s real GDP.
Firms do not normally change their prices frequently because it is costly. The costs associated to the change in price are the menu costs.
(ii) Explain the concept of Planned Aggregate Expenditure (PAE). How does PAE differ from Actual Expenditure? (2 marks)
Planned Aggregate Expenditure (PAE) is the total planned spending on final goods and services by taking into account the four types of spending i.e. consumer expenditure, investment expenditure, government expenditure and net...