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Suppose the economy is in a position where equilibrium output is below the potential of the economy to produce. Discuss the ways this may manifest itself.

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Introduction

Suppose the economy is in a position where equilibrium output is below the potential of the economy to produce. Discuss the ways this may manifest itself. In the simple Keynesian model, suggest a plan of action for the government to remedy the situation. In this simple model, what would be the consequences of a government imposed wage freeze? The primary measure of a nation's overall level of economic activity is the value of its production of goods and services, called the national product/income/output or expenditure. To measure total output, money values of the variety of goods and services are aggregated. There are two different measures of output being 'real' and 'nominal' values, where real national output is the change in national output if prices remain unchanged - that is what we are interested in. Equilibrium output is where supply equals demand, or where planned expenditure equals output. The potential of an economy to produce, i.e. potential output, can be defined as; "the output the economy would produce if all factors of production were fully employed" (Begg 2000). However, potential output is not the maximum output the economy could conceivably produce - if compelled to work 18 hours a day, doubtless we could all produce more. Rather, it is the output that could be sustained if every market in the economy were in long-run equilibrium. ...read more.

Middle

For example, Rover needs new assembly lines because it is substituting robots for workers in car production. In each case, the firm has to weigh the benefits from plant or equipment - the increase in profits - against the cost of investment. But, the benefit occurs only in the future, whereas the costs are incurred immediately as the plant is built or the machinery purchased. Furthermore, the firm has to take interest rates into consideration, as the return on investment will be used to pay back, with interest, the loan used to finance the original investment. Thus, the higher the interest rate, the larger must be the return on a new investment before it will match the opportunity cost of the funds tied up in it. This can be seen in the Investment Demand Schedule. Investment Demand Schedule Interest rates A higher interest rate reduces the number of projects that can provide a return matching the opportunity cost of the funds used. As interest rates rise from ro to ri, desired investment falls from Io to Ii. ri ro Ii Io Interest demand An increase in the cost of capital goods or a reduction in expected future profit opportunities will lead to a downward shift in the investment demand schedule. A decrease in the cost of capital goods or greater optimism about future profits will shift the schedule upwards. ...read more.

Conclusion

By introducing this to our model, there would be no increase in the consumption demand by households. In order to increase aggregate demand, one would have to take a look at the formulae: AD = C + I + G + X - Z A wage freeze could produce an uncertainty about the economy's future, which could thus affect the amount of investment spending by firms. However, by inhibiting the growth in wages, an excess demand for labour occurs as households ration employment. In the long run, wages would have to be increased again as more employment is profitable provided the marginal product of labour exceeds the real wage. In conclusion, since, below potential output, firms happily supply as much output as is demanded, the actual quantity of total output is 'demand-determined'. It depends on the level of aggregate demand which is made up of consumption, investment, government spending and taxation, imports and exports. However, there are also other factors, such as interest rates (as seen), which can affect decisions, especially about consumption and investment spending. It is often easier to leave it up to the government to increase their injections so as to re-boost the economy. However, when a government borrows its own currency from residents, the interest rate rises and investment is reduced. Furthermore, when borrowing from foreigners, the currency appreciates and exports become uncompetitive. There has to be some sort of combined increase along the whole formula under each separate, individual characteristic for there to be a smoother increase in the aggregate demand. ...read more.

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