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.
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. Since, below potential output, firms happily supply as much output as demanded, the actual quantity of total output is 'demand-determined'. It depends on the level aggregate demand, the total amount that people want to spend on goods and services in the economy as a whole.
Keynesian Cross Diagram
Aggregate Demand/
Planned Expenditure
Demand = Supply
Equilibrium
Potential output
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Output/Income
In this case, equilibrium is below the potential of the economy to produce. However, if output were increased to its potential, there wouldn't be enough demand to compensate for this increase resulting in an increase in excess stock. Aggregate demand can be made up of Consumption, Investment, Government spending and taxation, exports and imports. The formula 'AD = C + I + G + X - Z' defines what makes up aggregate demand. Thus, to increase the demand, one or more of the above will have to be changed. In the absence of the government there are two main sources of demand for goods: consumption demand by households, and investment demand for new machines and buildings by firms.
In practice, consumption purchases account for about 90 per cent of personal disposable income (i.e. the income that households have available for spending or saving). Thus, each household must decide how to divide this income, whether it be saving for a bigger house or spending on the round-the-world trip they have always wanted. Consumption varies on household wealth and the amount of consumer credit available to them. Income is the key determinant of household consumption or spending plans as described by the consumption function. Investment demand consists of firms' desired or planned additions to physical capital (factories and ...
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In practice, consumption purchases account for about 90 per cent of personal disposable income (i.e. the income that households have available for spending or saving). Thus, each household must decide how to divide this income, whether it be saving for a bigger house or spending on the round-the-world trip they have always wanted. Consumption varies on household wealth and the amount of consumer credit available to them. Income is the key determinant of household consumption or spending plans as described by the consumption function. Investment demand consists of firms' desired or planned additions to physical capital (factories and machines) and to their inventories (goods held for future production or sale). This depends chiefly on firms' current guesses about how fast the demand for their output will increase.
Total investment spending comprises investment in fixed capital and investment in working capital. Fixed capital includes factories, houses, plant and machinery, whilst working capital includes stocks or inventories. Firms add to their plant and equipment because they foresee profitable opportunities to expand their output, or because they can reduce costs by moving to more capital-intensive production methods. 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. Since ideas about future profits can sometimes be revised quite drastically, it is possible that the investment demand schedule could shift around a lot.
A fall in interest rates increases the level of investment demand by moving firms down their investment demand schedule whilst at the same time, can increase consumption demand by increasing household wealth and shifting the consumption function upwards. In the second part of the question, the government is taken into consideration and it is asked what they could do to remedy the situation. Government spending on goods and services contributes directly to aggregate demand. The government also withdraws money from the circular flow through indirect taxes on expenditure and through direct taxes on factor incomes. In a recession, when output is low, an increase in government spending helps shift the aggregate demand upwards, creating a new, bigger, equilibrium.
Aggregate demand
AD'
E'
AD
AD' = C+I+G
AD = C+I
E AD shifts up to AD'
New equilibrium is E'
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However, including taxation, this increase is not so big. An increase in taxation causes the consumption function to pivot downwards. Thus, if the equilibrium output of the economy is below the potential output, the government should choose a plan of action that will increase consumer demand so that the equilibrium will be moved upwards, nearer to the potential output acting as a stabilizer (i.e. an expansionary fiscal policy - increase spending, decrease taxation). Despite this increase in income and output through government spending, with an unchanged real money supply, higher income will increase the demand for money and thus raise interest rates. This reduces investment demand and shifts the consumption function downwards. These effects tend to offset the original upward shift in aggregate demand caused by the increase in government spending, though they cannot offset it completely.
Similarly, although a tax cut initially causes an upward rotation of the consumption function plotted against national income, the induced rise in income heightens interest rates, again dampening the final effect of the fiscal stimulus.
If the government were to impose a wage freeze, this would mean that all wages would remain the same. 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.
References.
* D. Begg (2000). Economics. (6th) McGraw-Hill Publishing Company.
* W. Branson (1979). Macroeconomic Theory and Policy (2nd).
* K. Chrystal (1983). Controversies in Macroeconomics (2nd).
* K. Chrystal (1994). Controversies in Macroeconomics (3rd).
* D. Demery et al. (1984). Macroeconomics. Surveys in economics. Longman Group Ltd.
* R. Morley (1988). The Macroeconomics of Open Economics. An Introduction to Aggregate Behaviour and Policy. Camelot Press Ltd.
Sam Griffith
