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Flashcards in Module 12 – Potential Output Deck (70):
1

Classify Capital goods and Labour force

Capital goods

Land – all natural resources including agricultural land, rivers, forests, climate and mineral deposits

Capital – all factories, offices, warehouses, shops, houses, machinery, roads, harbours, airports, schools, colleges, …

Labour force

Labour – proportion of population able and willing to work; quality dependent on age, effort, education, aptitudes…

Enterprise – individual with organisational and managerial ability or financial skills, taking risks in starting new companies and launching innovative products

1

A shifting Phillips Curve over time can have inflation rates and unemployment rates moving in the ___, whereas a movement along a Phillips Curve shows ___.

The curvature of the Phillips Curve suggests the short-run inflation–unemployment trade-off is not___ but varies depending upon where an ___.

same direction; higher inflation rates associated with lower unemployment rates

 constant;

economy actually is on the curve

2

Define Consumer Price Index

CPI - Consumer Price Index - most common; measures average level of goods/services consumed by typically households

  • Most market it is calucated monthly
  • Typical household does not purchase average selection of goods that make up total output / GNP
    - E.g. Government and investment goods make up 35-45%
     

3

Define Replacement investment 

Resources purchased to maintain productive capacity

- Training to keep labour force current
- Diversion from consumption

3

Define inflation

Inflation rate is the percentage increase per year in the average price level from one time period to another.

Thus if Pt is the average price level in period t and if Pt+1
is the average price level in period t + 1, then the inflation rate in time period t is defined by

INFt = Pt + 1 - Pt

                  Pt

Expressed alternatively, the price level in period t + 1 is:
Pt+1 = Pt(1 + INFt)

 

3

Define GNP deflator.

 GNP deflator is similar to CPI but measures all goods

4

Discuss Structural unemployment.

o Unemployment matches unfilled job vacancies but
o Mismatch between locations/characteristics of vacancies
o Require retraining, location change or both
o Can persist for long periods

4

Discuss demand-deicient unemplyment.

  • Demand-deficient unemployment
    • Arises through insufficient demand for labour
    • Policy-makers more confident about eradicating than frictional, structural and seasonal unemployment

5

Discuss Frictional unemployment.

- People are always changing jobs; search takes time because information is imperfect

 - Amount depends on:
 Number of persons changing jobs
 Average length of job search

- Unemployment is matched by unfilled job vacancies in the same occupations and same locations

5

Discuss Seasonal unemployment.

o Any activity where level of production is dictated by weather or by calendar
o E.g. farming, fishing, forestry, food processing, construction, tourism
o Characterised by periods of high employment with overtime working alternating with lower employment, short-time working, unemployment

5

Discuss full employment.

V (unfilled job vacancies) >= U (unemployed)

Most countries have no vacancy data at all therefore:

- Full employment usually taken as some target rate of unemployment: Essentially the sum of frictional, structural and seasonal unemployment

- During full employment:  Y=Q  (actual equals potential output)

6

Discuss the factors determining unemployment

Level of economic activity: Decrease/ increase frictional and structural unemployment, depending on output 

Transmission of information: Job advertisement through Internet, newspapers, radio, TV…

Rate of structural change: Require redistribution of skills and location of workforce

Ease of changing occupation and home: Availability and cost of retraining programmes, cost of travel and moving, suitable schools, hospitals…

Institutional restrictions: Minimum wage, restrictions on job entry, local favouritism in allocating houses, union restrictions

Dependence on seasonal industries: Economies depending on i.e. farming.

6

Discuss the Phillips Curve.

Phillips Curve plots unemployment versus inflation

- Short-run relationship
- Trade-off between unemployment and inflation
- Inflationary bias – positive inflation at full employment
o Reflected in curve crossing horizontal axis at unemployment rate to right of natural rate of unemployment

7

Which of the following is correct? The economy is capable of producing the combination of guns and butter represented by points

A. Z only
B. W and Y only
C. W, Y and Z only
D. W, X, Y and Z

The correct answer is C. An economy has the resources to produce all combinations of guns and butter which lie on the production possibilities frontier, by definition, or within the frontier. Thus points W, Y, and Z qualify but not X since X lies outside the frontier.

8

Which of the following is correct?

If during the course of a year actual output and the unemployment rate both increase it follows that

A. potential output increased at a faster rate than actual output
B. the Phillips Curve shifted towards the origin
C. the inflation rate decreased
D. frictional and structural unemployment rates decreased

The correct answer is A. The unemployment rate is determined by the difference between actual and potential output. Thus if potential output and the unemployment rate both increase the potential output rate must, by definition, have increased at a faster rate than actual output.

9

Which of the four points W, X, Y and Z represents the combination of guns and butter that society would prefer?

A. X only
B. Y only
C. W or Y only
D. Z only

The correct answer is A. The more goods and services a nation has the better off it is. Point X represents:

more guns and butter than Z

more guns and the same amount of butter as point Y

more butter and the same amount of guns as point W

Therefore X is the most preferred point in the diagram even though it cannot be reached with existing resources.

10

Point Z in the diagram indicates:

I. an unattainable output combination of guns and butter
II. unemployed, or inefficiently employed, factors of production

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is B. Any point on or within the production possibilities frontier indicates attainable outputs; thus outputs represented by W, Y and Z are all feasible. Thus I is incorrect. An economy can move from a point within the frontier (Z) to a point on the frontier by efficient use of all of its production resources. Thus II is correct.

12

If an economy were operating within the production frontier, it would be possible to produce:

I. more guns without the sacrifice of some butter
II. more guns and more butter

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is C. Point Z is a point within the ppf. In moving to point W on the frontier gun production increases from g1 to g2 while butter production remains at b1. Thus I is correct. In moving to any point on the frontier between W and Y from point Z more of both guns and butter is produced. Thus II is correct.

13

For a society to increase its stock of human and physical capital net investment must be positive.

Which of the following is correct?

Net investment equals:

A. potential output minus actual output
B. actual output minus potential output
C. gross investment minus replacement investment
D. replacement investment minus gross investment

The correct answer is C. Part of the productive capacity of an economy wears out with use and with the passage of time e.g. ships, aircraft, trucks depreciate with time. To maintain the capital stock, i.e. replace that part which wears out, requires investment – replacement investment. To add to the capital stock requires gross investment to exceed replacement investment, i.e. there must be positive net investment. Total investment (gross investment) equals replacement investment plus net investment.

14

Demand deficient unemployment is caused by:

I. structural change in the economy
II. time required to leave one job and seek alternative employment
III. fluctuations in economic activity caused by seasonal nature of some jobs

Which of the following is correct?

A. I only
B. II and III only
C. I, II and III
D. Not I, not II, not III

The correct answer is D. Demand deficient unemployment arises because of insufficient demand for labour and occurs when society demands less than the economy is capable of producing, i.e. occurs when actual output is less than potential output. Thus I, II and III are incorrect each referring to respectively structural, frictional and seasonal unemployment.

15

According to Okun’s Law a 1% unemployment rate above the full employment unemployment rate, or above the natural rate of unemployment, is associated with

I. a 1% reduction in real output
II. a 1% reduction in the inflation rate

Which of the following is correct?

A. I only
B. II only
C. I and II
D. Neither I nor II

The correct answer is D. Okun’s Law, based on empirical data, associated a 1% unemployment rate (above the full employment unemployment rate) with a 3% reduction in real output. Thus I is incorrect. Okun’s Law stated nothing about the relationship between unemployment and inflation. Thus II is incorrect.

16

In official statistics it was noted that the consumer price index (CPI) was:

Which of the following is correct?


These data indicate an annual increase in the average level of prices paid by consumers of

A. 6% in year t + 1 then less than 6% in subsequent years
B. a constant 6% in each year
C. 6% in year t + 1 and a doubling in year t + 2
D. 6% in year t + 1, 12% in year t + 2, 18% in year t + 3

17

In the Phillips Curve depicted above in which

In the Phillips Curve depicted above in which

I. the inflationary bias of the economy is demonstrated
II. a low unemployment rate is associated with a high inflation rate
III. the lower the rate of unemployment the higher the rate of increase of the inflation rate

Which of the following is correct?

A. I and II only
B. II and III only
C. III only
D. I, II and III

The correct answer is D. Since U2=full employment and U2 is associated with the inflation rate I2 then inflation exists when the economy is at full employment; this is known as the inflationary bias; thus I is correct. Because the curve slopes downwards from left to right there is an inverse relationship between inflation and unemployment rates; thus II is correct. Because of the curvature of the Phillips Curve – relatively flat at high unemployment rates and relatively steep at low rates the lower the rate of unemployment the higher will be the rate of increase of inflation, e.g. compare U3U2 and I2I1 with U2U1 and I3I2. Thus III is correct.

17

Which of the following is correct?

Downward real/nominal wage rigidity means
A. the inflation rate sets the minimum rate of increase of wages
B. in labour markets where there is excess supply of workers wage rates do not fall to clear the market
C. every increase in the unemployment rate is associated with a downward movement of wages
D. workers’ wages never decrease as the economy grows

The correct answer is B. In a perfectly competitive labour market wages would fall if the supply of labour exceeded the demand for labour. For a variety of reasons in many labour markets this does not occur, e.g. collective bargaining agreements, employers wishing to retain employee goodwill and it is said ‘wages are sticky downwards’, i.e. downward wage rigidity. Statements A, C and D are false.

18

The curved shape of the production possibilities frontier indicates that:

I. the more butter being produced the greater the amount of resources required to produce one more kilo of butter
II. the greater the number of guns being produced the greater the amount of resources required to pro-duced one additional gun


Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is C. Were the production possibilities frontier linear the opportunity cost of producing guns, in terms of butter, would be constant and vice versa. The curved shape of the production possibilities frontier indicates that the closer society is to either point A (all guns) or point B (all butter) the greater is the amount of resources required to produce one additional unit of the commodity in ‘short’ supply. This is because society will utilise first the resources most suitable for producing any good. Imagine a farmer whose land includes a fertile valley and a rugged rocky hillside. He grows wheat in the valley and raises sheep on the hillside. To produce more wheat and have fewer sheep means planting wheat on the hillside; for each additional bushel of wheat he plants on the hillside he will need more and more resources as the land becomes increasingly difficult to cultivate. Thus both statements are correct.

19

If actual output increased at a faster rate than potential output which of the following could NOT occur?

A. The unemployment rate could not increase
B. The unemployment rate could not decrease
C. The inflation rate could not decrease
D. The inflation rate could not increase

The correct answer is A. The unemployment rate is determined by the difference between actual and potential output. If the former increases faster than the latter then the unemployment rate must decrease. Thus A is correct and B incorrect. Many factors determine the inflation rate in the short-run. It could increase, decrease or remain unchanged. Thus C and D are incorrect.

20

Which of the following is correct? The opportunity cost of b1b2 of butter is:

A. 0b1 of butter
B. g1g2 of guns
C. 0g2 of guns
D. 0b2 of butter

The correct answer is B. In moving from W (0b1 of butter and 0g2 of guns) to Y (0b2 of butter and 0g1 of guns) on the production possibilities frontier the economy sacrifices g1g2 of guns to obtain b1b2 of butter.

21

Economic growth is made possible by:

I. increases in the supply of factors of production
II. increase in factor productivity
III. technological change

Which of the following is correct?

A. I and II only
B. II and III only
C. III only
D. I, II and III

The correct answer is D. The larger the stock of resources the larger is potential output. Growth in potential output therefore and consequently economic growth are made possible by increases in the supply of factor inputs. Similarly increases in factor productivity, i.e. more output from given factor inputs e.g. discovering that milk output increased when music was played during milking, and technological change e.g. adoption of new production technologies, inventions, innovations etc. make output of goods and services higher than they otherwise would have been, i.e. make possible economic growth.

21

If a society year after year were to allocate all of its resources to the production of consumption goods living standards would decline because

I. the capital stock would diminish
II. output of consumption goods would decline
III. potential output would be greater than actual output

Which of the following is correct?
A. I only
B. I and II only
C. III only
D. I, II and III

The correct answer is B. With all resources allocated to the production of consumption goods replacement investment would be zero, the capital stock would decline as would the amount of consumption goods which could be produced. Thus I and II are correct. This resource allocation would not cause actual output to be less than potential output.

22

Which of the following is correct?

I. When potential output exceeds actual output only demand deficient unemployment exists
II. When potential output equals actual output the economy is operating at full employment
III. Actual output, by definition, cannot exceed potential output

A. I and II only
B. II only
C. III only
D. I, II and III

The correct answer is B. The nature of labour markets means that a market economy experiences continuous frictional, structural and seasonal unemployment. Thus I is incorrect. Only when actual is less than potential output does demand deficient unemployment exist; when equal the economy is said to be at full employment. Thus II is correct. Potential output is defined to be that output that would be produced when all resources were fully employed at their normal levels of utilisation. When aggregate demand exceeds potential output above normal levels of utilisation occur, e.g. overtime and as a consequence actual can exceed potential output in the short-term. Thus III is incorrect.

24

The differences between the Consumer Price Index (CPI) and the Gross National Product (GNP) deflator are

I. the price index for the base period is 100 in the CPI and between 135 and 145 in the GNP deflator
II. the CPI does not include investment expenditure and government purchases of goods and services

Which of the following is correct?
A. I only
B. II only
C. I and II
D. Neither I nor II

The correct answer is B. The importance of each item in any price index is determined by its weight in total expenditure and is calculated by the number of units purchased times the price of each unit. To compare changes each year (or time period) a starting year (or time period t) is determined and the index set equal to 100, i.e.

Thus I is incorrect. The CPI includes consumption goods and services purchased by the average household but does not include investment expenditure and government purchases of goods and services. The GNP deflator includes all goods and services. Thus II is correct.

25

Assuming a shifting Phillips Curve when

I. aggregate demand is high the unemployment rate will not always be low
II. the unemployment rate is low the inflation rate will not always be high

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is B. The Phillips Curve shows a relationship between unemployment rates and inflation rates for a given level of aggregate demand. The inverse relationship observed between inflation and unemployment rates (the trade off) is in one sense like the inverse relationship between prices and quantities on a demand curve; for a given income, on a demand curve, i.e. if income were to increase dramatically a ‘large’ quantity might be purchased at a high price, i.e. large compared to what was purchased previously at a low income. Thus if aggregate demand were to change dramatically (a shifting Phillips Curve) relationship between low unemployment and high inflation may not be observed empirically. Thus II is correct. Implicitly, high aggregate demand means a low unemployment rate; the ‘high’ in aggregate demand refers to actual GNP being close to, equal to or greater than potential output which by definition means almost full employment, full employment or excess demand for labour. Thus I is incorrect.

25

Discuss Okun’s Law

One third of output gap is due to unemployment (beyond natural rate Uf)

where UF = full-employment rate of unemployment. In words Okun’s Law states that for each one per cent by which actual output falls short of potential output, the unemployment rate will exceed its full-employment rate of unemployment by one-third of one per cent. Thus if Y is 6 per cent below Q, then U will be 2 per cent above UF. Expressed alternatively, Okun’s Law suggests that each percentage point increase in the unemployment rate above UF is associated with a 3 per cent reduction in real output.

26

Let Q = potential output and Y = actual output and assume the natural rate of unemployment (UF) = 5%.

I. If Y = Q, UF = 0.
II. when U = 5% demand deficient unemployment = 0

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

The correct answer is B. When Y = Q the economy is defined to be operating at full employment which means the only unemployment which exists is composed of frictional and structural elements; thus demand deficient unemployment = 0. U is composed of frictional structure and demand deficient elements. U=UF on when frictional and structural elements are present. Therefore I is incorrect and II is correct.

27

Foregoing analysis suggests that the average price level that will be set at the ___ will depend on the level of ___

beginning of the next period;

aggregate demand in the current period

 

28

Government dilemma.  Aggregate demand policies cannot simultaneously address both ___ and ___ .

unemployment and inflation

29

Historically the production frontier has shifted upwards at different rates for different economies and different periods. Discuss.

- Most economies experience some growth over time
- Occasional leftward shifts are rare – usually due to war or natural disaster
- Very poor nations lie very close to the “satiated” line

30

In short run, production possibility frontier taken as fixed, the only question is whether ___

 society attains the frontier

31

In the long run the production possibility frontier is not fixed, explain.

  • What determines the rate of growth of potential output
  • Economic growth depicted graphically as shift to right of production possibility frontier

32

Microe-conomics is concerned with explaining how a society determines the ___ between competing uses, given the ___.

allocation of resources;

fact of scarcity

33

Name types of unemployment:

  • Frictional 
  • Structural
  • Seasonal

34

Net investment equals ___ minus ___ and GNP growth is attributable to ___

gross investment; replacement investment; net investment

35

Potential Output = 

Q

36

Production frontier sets limits to ___ that can be produced

combinations of goods

For any point within the frontier there is a preferred point on the frontier

38

The average well-being of people in a nation is determined by

I. the quantity and quality of resources under the nation’s command.

II. how fully the nation utilises these resources in producing goods and services.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is C. The quantity and quality of resources in a nation together set an upper limit on what a nation can produce; together they determine potential output. The extent to which resources are utilised determines what is actually produced, i.e. actual output. Average well-being, which is total output divided by the number of people in a nation, depends therefore on both its stock of resources and how fully they are utilised.

40

Which of the following is correct? In practice, the potential output of the economy is calculated as the level of output

A. that would be achieved when demand-deficient unemployment was zero.

B. at which all unemployment would be demand-deficient unemployment.

C. at which the number of people seeking work exceeds job vacancies.

D. achieved in the current period.

The correct answer is A. Potential output is the level of output that would be achieved at full capacity utilisation, i.e. it is the level of output that would be achieved if all factors of production were fully and efficiently employed. In practice, unemployment cannot be zero because there is always some frictional or structural unemployment arising from the fact that the economy is always undergoing change. Change involves some period of unemployment as workers move from one job to another in the same industry or from one industry to another. At full capacity output, therefore, there will be some frictional and structural unemployment, but there will be no unemployment due to deficient demand. Where demand-deficient unemployment exists, it indicates that the level of demand is not sufficient to provide jobs for all people willing and able to work at going wage rates and condi- tions of employment, so that full capacity utilisation is not achieved. Potential output can differ from actual output, which is the level of output achieved in the current period.

41

Which of the following is correct? Actual output of an economy is the output

A. that would be produced if all resources were fully employed.
B. produced by currently employed labour and capital.
C. produced in the consumption goods sector.
D. produced in the capital goods sector.

The correct answer is B. Actual output is the level of output realised in a given period by currently employed labour and capital, and includes both consumption goods and capital goods. The output that would be realised if all resources were fully employed is the potential output of the economy. Only at full employment is actual output equal to potential output. At all levels of employment below full employ- ment, actual output is less than potential output.

42

Which of the following is correct? The higher the actual level of output in the economy in a given year,

A. the higher will be potential output.
B. the lower will be potential output.
C. the higher will be the unemployment rate.
D. the lower will be the unemployment rate.

The correct answer is D. Actual output is the level of output realised in the current period. Potential output is the level of output that would be realised if all factors of production were fully and efficiently employed. A higher level of actual output can be achieved without any increase in potential output, provided that potential output is greater than actual output initially. This occurs whenever there are unemployed factors of production in the economy. Given the level of potential output, the higher is actual output the more fully are the factors of production utilised and, therefore, the lower is the unemployment rate.

43

If potential output in an economy exceeds actual output,

I. some labour must be unemployed.

II. some capital must be underutilised. Which of the following is correct?

A. I only.
B. II only.
C. I or II or both I and II.
D. Neither I nor II.

The correct answer is C. Actual output is the level of output realised; potential output is the level of output that would be realised if all resources were fully employed. Classifying all resources under the headings capital and labour, it follows that if potential output exceeds actual output, at least one of these two sets of resources is not fully employed.

45

If, in an economy, actual output equals potential output, the following types of unemployment cannot exist:

I. demand-deficient unemployment;

II. frictional unemployment;

III. structural unemployment.

Which of the following is correct?

A. I only.
B. II only.
C. II and III only.
D. III only.

The correct answer is A. When potential and actual output are equal, all resources are fully employed. Full employment of labour, however, is defined to exclude that unemployment occurring as people change jobs, as old industries close and new industries begin, and as industry relocates. Unemployment associated with such changes is known as frictional and structural; it is never zero, and is an integral part of the market system. People willing and able to work at going wage rates and conditions for whom no jobs exist are unemployed because of demand deficiency. When such unemployment appears, actual will be less than potential output.

46

In an economy, potential output has increased and this is accompanied by an increase in
the unemployment rate.

This could be due to

I. actual output increasing more slowly than potential output.
II. an increase in the number of married women wishing to work.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is C. The unemployment rate is determined by the gap between potential and actual output. Thus, if both potential output and the unemployment rate increase, actual output is growing more slowly than potential output. One possible cause of this growing gap is that certain groups of the population, such as married women, are joining the labour force (and increasing potential output) faster than they are being employed.

47

Which of the following is an example of structural unemployment?

A. A building worker leaving one company and seeking employment from other
builders in the local community.

B. A credit squeeze reducing the demand for all goods and hence employment.

C. Cheap oil from the North Sea reducing the demand for coalminers.

D. A bricklayer retiring because he can no longer face the demands of his job.

The correct answer is C. Structural unemployment occurs as an economy’s infrastructure changes, i.e. as some industries decline and new ones emerge; this is a continuous process and thus structural unemployment is always present in a market economy. The substitution of oil for coal, which increases employment opportuni- ties in the oil industry but decreases those in the coal industry, causes structural unemployment. The building worker seeking employment with another company comes under the classification ‘frictional unemployment’. Unemployment caused by lack of demand through a credit squeeze would be ‘demand-deficient’ unemploy- ment. The bricklayer who retired would not be considered a member of the labour force.

48

The level of frictional unemployment in an economy

A. is determined solely by macroeconomic policy.
B. depends on the nature and extent of job search.
C. results from obsolete industries closing down.
D. can be eliminated by lowering real wages.

The correct answer is B. Frictional unemployment arises when an individual is not working because he/she is in the process of changing jobs within the same geo-graphical region, occupation and industry. Such a process normally takes time because of imperfect information on the part of both employers and employees. Structural unemployment can be conceived as frictional unemployment with a long time lag, but job changing in this case requires some change of region and/or occupation, and/or industry. Demand-deficient unemployment arises because of insufficient demand for labour and could be attributable to macroeconomic policy or inflexible market wages.

49

Assume an economy moved from a state of high unemployment at the beginning of the year to full employment by the end of the year. Assume also no change in the capital stock or labour force (employed + unemployed). It can be concluded that I. the flow of goods and services at the beginning of the year was below the economy’s potential output. II. average output per worker employed was higher at the end than at the beginning of
the year. Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is A. The presence of high unemployment in an economy means that actual output is below potential output. Average output per worker employed equals total output divided by the number of workers actually employed. At the end of the year, total output was higher but so was the number of workers employed. Insufficient information is given to determine whether average output per worker employed increased, remained constant, or decreased. If the least productive workers are hired last, then average output per worker would fall as full employment was approached.

50

The following data refer to the output of guns and butter (both standard quality) in three economies in different years:

In which of the economies did economic growth occur?


A. Z only.
B. X and Z only.
C. X, Y and Z.
D. Not X, not Y, and not Z.

The correct answer is A. In economy Z, more guns and more butter were produced in t + 1 compared with Year t; therefore economic growth occurred. In economy Y, the output of guns remained constant and the output of butter fell; thus there was a decline in total output. In economy X, the output of guns declined and the output of butter rose; however, since no information is given about the relative worth of guns in relation to butter (e.g. their prices), no conclusions can be drawn about total output because the units (number of guns and tons of butter) are not additive.

52

Which of the following is correct? A production possibilities frontier illustrates that:

A. an economy’s capacity to produce increases in proportion with population.

B. if all the resources of an economy are employed efficiently, more of one good can be produced only if less of another good is produced.

C. an economy automatically adjusts to that level of output at which all of itsresources are employed efficiently.

D. various combinations of output can maximise the welfare of society.

The correct answer is B. When an economy is operating at any point on its production possibilities frontier, it is producing maximum output from its factors of production. It follows that producing more of any good necessitates withdrawing some resources from the production of other goods. The production possibilities frontier implies nothing about the effects of population growth on productive capacity, nor does it imply that an economy will automatically produce on the frontier. Finally, the production possibilities frontier says nothing about the optimal combination of outputs, which is dependent on people’s preferences.

54

The following data in index form refer to a hypothetical economy:

From the data it can be concluded that

I. per capita GNP did not increase between Year t and Year t + 2.
II. the labour force did not increase between Year t and Year t + 2.
III. technological progress did not occur between Year t and Year t + 2.

Which of the following is correct?

A. I and II only.
B. I and III only.
C. II and III only.
D. Not I nor II nor III.

The correct answer is D. Since actual GNP increased from 100 to 150 between time periods t and t + 2, and since population remained constant, GNP per capita increased. Thus I is incorrect. Increases in potential GNP come about from a net increase in technological change, the labour force and the capital stock. Thus either or both of the labour force and technological change could have increased between t and t + 1 but could have been offset by a reduction in the capital stock, resulting in a constant potential GNP – for example, the labour force could have increased due to a rise in the participation rate of teenagers, but potential output could have remained constant due to declining technology and/or a decrease in the capital stock. Thus neither II nor III must be correct.

55

The government is considering which policies to adopt and is using the Phillips Curve in Figure 12.13 in its deliberations. It has decided that

I. Policy A will result in a 10 per cent inflation rate and a 3 per cent unemployment
rate.

II. Policy B will result in a zero inflation rate and an 8 per cent unemployment rate.

III. Policy C will result in a −2 per cent inflation rate (i.e. a 2 per cent deflation rate) and a 10 per cent unemployment rate. Which of the following is correct?

A. The best policy is A because it yields the lowest unemployment rate.

B. The best policy is B because it yields the lowest inflation rate.

C. The best policy is C because it will lower inflationary expectations.

D. The best policy is dependent entirely on the subjective opinions of the popula-tion of the economy.

The correct answer is D. The most appropriate policy depends upon the opinion of the people it affects. Whether the government should emphasise lowering the inflation rate or lowering the unemployment rate will depend upon which evil – inflation or unemployment – society considers to be more burdensome. Similarly, if society places a high value on low inflation rates in the future and believes that this can be attained by suffering high unemployment today, III might be chosen as the best short-run policy. Thus the most appropriate policy depends entirely on the subjective opinions of society.

57

If the Phillips Curve in Figure 12.13 were to shift to the left, the following would occur in the economy:

I. the unemployment rate would decrease.
II. the inflation rate would decrease.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is D. A shift to the left of the Phillips Curve indicates only a more favourable trade-off between inflation and unemployment; it does not indicate where the economy will be on the shifted Phillips Curve.

For example, the economy might originally be at point B in Figure 12.13 (zero inflation and an eight per cent unemployment rate); policies might take the economy to a position of say, a one per cent inflation rate and a five per cent unemployment rate on the shifted Phillips Curve; thus the inflation rate will have risen despite the shift on the curve.

Similarly, if the economy had started out at point A, policies could have led to an increase in the unemployment rate on the shifted curve. Thus, neither I nor II is necessarily true.

58

For an economy operating on the production possibilities frontier CA in Figure 12.12, which of the following correctly describes the combination of capital and consumer goods indicated by point L? It

A. would entail substantial unemployment.
B. would entail an inefficient use of society’s resources.
C. is beyond the productive capacity of the economy.
D. suggests the productive capacity of the economy is declining.

The correct answer is C. Point L lies beyond the production possibilities frontier CA shown in Figure 12.12. It therefore represents a level of output that is unattainable given the current stock of factors of production and the current state of technical knowledge. A point such as L may be achieved at some period in the future given an increase in the supply of the factors of production (land, labour, capital, and enterprise) and/or an increase in technical knowledge, but is beyond the current productive capacity of the economy. Points within the frontier would indicate unemployment and an inefficient use of resources. A leftward-shifting frontier would indicate declining productive capacity.

59

Which of the following is correct? The choice of point P on production possibilities frontier CA in Figure 12.12 will

A. result in a faster rate of economic growth than would the choice of point N.
B. result in a slower rate of economic growth than would the choice of point N.
C. result in the same rate of growth as would the choice of point N. D. be unattainable because P exceeds productive capacity.

The correct answer is A. At point P in Figure 12.12, more resources are allocated to the production of capital goods than at point N; consequently potential output will be higher in the following year, which would allow the economy to achieve a higher growth rate in actual output. Point P is feasible because it lies on the production frontier.

60

Which of the following is correct? A shift of the production possibilities frontier in Figure 12.12 from CA to CB indicates

A. a movement from unemployment to full employment.

B. an improvement in capital goods technology but not in consumption goods
technology.

C. an improvement in consumption goods technology but not in capital goods
technology.

D. a decline in the total output of the economy.

The correct answer is B. The shift in the production possibilities frontier from CA to CB shown in Figure 12.12 denotes increased productive potential, which may be due to an increase in the supply of the factors of production and/or improved technical knowledge. In the example illustrated, the economy’s productive potential to manufacture capital goods has improved but its productive potential to manufac- ture consumption goods has remained unchanged. This suggests an improvement in capital goods technology but not in consumption goods technology.

61

After the production possibilities frontier in Figure 12.12 has shifted from CA to CB, the economy has moved from N to P. The result is

I. an increase in unemployment.
II. an increase in output.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is A. Since point N lies on the production possibilities frontier CA in Figure 12.12, no unemployment exists while CA is the production possibili- ties frontier. However, when CB becomes the production possibilities frontier, unemployment exists when the economy is operating at any point within the frontier, e.g. at point P. The shift in the production possibilities frontier from CA to CB increases the economy’s potential output. The movement from point N to point P increases output of capital goods at the expense of consumption goods; actual output does not increase.

62

Assuming all resources in an economy are fully employed, which of the following would make potential GNP in that economy lower in the future than it otherwise would have
been?

A. An increase in output of consumption goods and a decrease in output of capital goods.
B. An increase in output of capital goods and a decrease in output of consumption goods.
C. Technological progress that reduces capital inputs per unit of output.
D. Technological progress that reduces labour inputs per unit of output.

The correct answer is A. Potential output can increase if any of the following occur: an increase in labour, an increase in capital, or technological progress. However, if in any year there is a reallocation of resources to the production of consumption goods away from capital goods, potential output will be lower in the future than it other- wise would have been.

63

In advising the government on economic policy, the economist’s role is

I. to outline the likely consequences of alternative policies.

II. to determine society’s goals and the policies for achieving these goals.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is A. When acting in an advisory capacity to government, an economist’s role is to give professional opinions about the expected outcomes of a policy or policies. Such information is crucial to rational policy-making. For example, a tax cut plus an increase in the money supply may lower the unemploy- ment rate, lower interest rates, and increase investment expenditure; but an advising economist can point out that the tax cut may only have little effect on the unem- ployment rate but may increase interest rates and hence may reduce investment expenditure. Most, if not all, economists have opinions about what society’s goals should be but those are value judgements and should not influence the economist in his advisory capacity on the consequences of alternative policies.

64

Which of the following would increase the potential GNP of an economy?

A. An increase in government expenditure on government employees’ pay.

B. An increase in the proportion of the population that is available for employ-ment.

C. A decrease in the rate of unemployment.

D. A decrease in output per worker.

The correct answer is B. The potential GNP of an economy will rise if the supply of any factor of production increases or if there is an advance in technical knowledge. When the proportion of the population available for employment increases, the labour supply increases (for instance an increase in the number of married women looking for work) and potential GNP increases.

A decrease in the rate of unem- ployment would imply an increase in actual GNP but not an increase in potential GNP because the supply of labour available for employment has not changed; the only change is in the utilisation of the given labour force.

A decrease in output per worker would not increase potential GNP. Although increased government ex- penditure on civil servants’ pay would result in an increase in measured GNP, potential GNP would not have changed. For potential GNP to increase, the productivity of civil servants would need to rise.

66

The production possibilities frontier can be used to illustrate the microeconomic question of ___

 what should be produced

67

The higher the level of aggregate demand in any short-run period, the higher will be the ___ .

Since, in any short-run period, aggregate demand will influence both the ___ and the ___, there will be an implied relationship between ___.

rate of inflation during that period.

 

unem-ployment rate;

inflation rate ;  

unemployment and inflation

68

To measure potential output some measure of utilisation of factors of production is necessary.

  • Unemployment rate – number of unemployed as percentage of labour force seeking work
  • Capacity utilisation measured in industry surveys
  • Clear relation between the two: As the degree of capacity utilisation increases, the rate of unemployment falls
  • Unemployment is important for economic, social and political  reasons and data is more easily collected

69

What is the “Productive potential” of the economy?

With sufficient time, energy and resources all human and non-human resources could be increased and enhanced

But in short run, we assume they are fixed

Therefore there is a fixed upper limit to the total output producible