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What factors help to determine an economy's potential output?

An economys potential output is defined by the amount and kinds of resources that it has available
to it and by the efficiency with which it can use those resources.

Resources can be both human and natural. For example, a country with more educated workers is
likely to have a higher potential output than one whose workers are uneducated. The educated
workers can do work that is more complex and that adds more value to the things that they produce.
This makes the economys potential output higher. As an example of natural resources, a country that
has large deposits of minerals or rivers suitable for hydropower has advantages over those countries
that do not. These things increase the countrys potential.

At the same time, however, efficiency is very important. A country that has a lot of resources will not
be able to produce much if it lacks the technology and the types of business organization that will
allow those resources to be used.

Resources, and the ability to use them efficiently, are the main factors that define an economys
potential outputDeficient demand! How does it produce depression in the economy?

Deficient demand refers to the situation when aggregate demand for goods and services falls short of
aggregate supply of output which is produced by fully employing the given resources of the economy.
This deficient demand leads to the decrease in output, employment and prices in the economy.

The equilibrium at full employment level of national income is achieved when aggregate demand equals
aggregate supply of output given the resources of the economy such as capital and labour. But the
aggregate demand for goods and services of the economy may be less than aggregate supply at full
employment level of resources. This creates the problem of deficient demand in the economy.

The deficiency in aggregate demand leads to wide spread unemployment of labour on the one hand and
under utilization of the capital and other resources of the economy on the other. This state of
unemployment and under utilization of resources due to lack of aggregate demand is called depression.
In such a situation the economy has the adequate capital stock to produce goods and to employ labour
force but it cannot do because there is not enough demand for the goods to be produced by them.

According to Keynesian theory of income, employment and output, equilibrium at the level of full
employment is established when aggregate demand consisting of consumption demand plus investment
demand plus Govt, demand (C+l+G) is equal to the aggregate output at the level of full employment.

This happens when investment and Govt, demand is equal to the saving gap at full-employment level of
aggregate supply of output i.e. when Govt, demand and investment demand is less than saving gap at
full employment level of income, the deficiency of aggregate demand occurs due to which national
output and employment will fall below the full employment level causing unemployment and
depression in the economy.

The concept of deflationary gap is just opposite of the inflationary gap as illustrated by John Maynard
Keynes. The deflationary gap for the economy as a whole may be defined as a shortage of anticipated
expenditure compared with the available output of goods and services at base price.

The deflationary gap is a situation where the anticipated expenditure falls short of available output at
base prices. The deflationary gap is illustrated in the above diagram. The anticipated expenditure or the
aggregate demand function is represented by C+l+G. the 45 line OZ indicates that aggregate demand is
equal to aggregate supply.

That means income is equal to expenditure. The aggregate demand function C+l+G intersects the line OZ
at the point P, This gives us the equilibrium income indicated by OM, Thus OM represents full
employment income at the base price.

The aggregate demand (C+l+G) is P, Mr This P, M, is equivalent to the total output of goods and services
amounting to OM, Since the total money income is equal to the total available output, there is no
question of any shortage of demand arising in the economy, hence there is no possibility of the
emergence of a deflationary gap in the economy. Supposing the aggregate demand expenditure (C+l+G)
is reduced by certain amount of government expenditure and the new expenditure function in the
economy is (C+l+G1).

Since OM, is the national income of the economy at the full employment level it does not decrease with
the reduced Govt, expenditure (G,) amounting to P2N2. This P2N2 represent deflationary gap in the
economy. It lowers down the price level. The price level can remain constant only if the output of goods
and services decreases from OM, to OM2. In other words the output of goods and services must be
reduced by M2M; the deflationary gap of P2N2 can be wiped-out only if the output of goods and
services decreases by M2M.
Brief notes on three major Impacts of deficient demand
SUSHIL SURI


Deficient demand produces adverse effects upon employment, output and the price level in the
following manner.

(a) Impact on employment:

If aggregate demand is less than aggregate supply, entire amount of goods produced in an economy is
not sold. This leads to glut (or over production). Therefore, producers of goods cut production and
reduce investment. Consequently, unemployment problem becomes rampant.

(b) Impact on Output:

When aggregate demand is less than aggregate supply, producers are not able to sell the entire output
produced in the economy during a given period. Therefore, the reduce the volume of production of
output. Thus, deficient demand is responsible for low output in an economy.

(c) Impact on Price Level:

When aggregate demand is less than aggregate supply, price level tends to fall. Unless deflationary gap
is removed, price level continues to decline. Decline in price level leads to a fall in the rate of profit.
Continuous fall in rate of profit leads to a decline in the volume of private investment. Consequently,
problem of unemployment becomes rampant; income and output become low and the country
becomes poorer
Potential gross domestic product, or potential GDP, is a measurement of what a country's gross
domestic product would be if it were operating at full employment and utilizing all of its resources.
This amount is generally higher than the actual gross domestic product, or GDP, of a country. As a
result, the separation between a country's potential GDP and its real GDP is known as the output gap.
The output gap is caused by the fact that most economies suffer from certain inefficiencies, such as
inflation, unemployment, and government regulations, which hamper production levels.

One of the major economic factors which helps to measure economic strength is the gross domestic
product. The GDP totals up the value of all of the goods produced in a specific country over a certain
period of time. Economists watch how the GDP in a specific nation rises and falls, and they also check
how it compares to the GDP levels achieved by other nations. It is important to realize where
production levels are lacking within a country compared to where they could be, which is where the
potential GDP comes into play.

Ad
Basically, the potential GDP is what the gross domestic product would look like if all the disparate
facets of the economy were working on all cylinders for the time period being studied. This would
mean that the full employment force of a country were working at its maximum capacity. It would
also mean that resources are being mined and converted into products without any sort of excess
waste in the process.

Of course, the potential GDP is just an ideal toward which countries may strive but usually never
reach. That is because the necessary circumstances that would cause a country to reach these levels
are unlikely to exist all at once. Unemployment is a big cause of countries' failures to reach potential
production levels. In addition, general inefficiency, whether caused by government interference or
simple business incompetence, can also drag down gross domestic products.


Since there is rarely ever an occasion when a country can reach its potential GDP, economists often
study the lag between what a country can produce and what it actually does produce. This is known
as the output gap. When the gap grown larger, it means that the country is failing to utilize all the
tools it has at its disposal. As a result, economic leaders try to find ways to minimize that gap so that
production output can more closely resemble potential levels.
Productive Capacity

by Tejvan Pettinger on October 22, 2008 in economics
Readers Question: Identify and explain clearly the determinants of a nations productive capacity.
How does the concept of productive capacity differ from a nations actual GDP?

A nations productive capacity reflects potential output of an economy. It depends on:

Quantity of Labour. Size of workforce; in effect people of working age, economically active
Productivity of labour. This is the output per worker and depends on factors such as education, skills,
motivation and ability to use technology.
Capital Stock. This is the amount of capital that can be used in the productive process. It includes
machines, factories e.t.c.
Raw Materials. This is the amount of natural resources such as oil, coal, gas e.t.c
State of Technology. Technological innovations determine the productivity of labour and capital.
Difference between Productive Capacity and Actual GDP.

If an economy is at full employment it will be producing on its production possibility frontier. There
will be no spare capacity and the actual GDP will equal the productive capacity.

However, if the economy is not operating on its production possibility frontier. If the economy has a
degree of spare capacity then actual GDP will be less than potential GDP.

In a recession, there will be a negative output gap as the actual GDP, is less than potential. This can also
be illustrated using a simple AD / AS diagram.




At Y1 actual output is less than potential.

Output Gap Definition


The output gap is a measure of the difference between actual output (Y) and potential output (Yf).

The output gap = Y- Yf

Negative Output Gap

This occurs when actual output is less than potential output gap. This is also called a deflationary (or
recessionary) gap. In this situation the economy is producing less than potential. There will be
unemployment, low growth and / or a fall in output. A negative output gap will typically cause low
inflation or even deflation.

Positive Output Gap

This occurs when actual output is greater than potential output. This will occur when economic growth
is above the long run trend rate (e.g. during an economic boom). It will involve firms asking workers to
overtime.

With a positive output gap, there will be inflationary pressures. It will also tend to cause a bigger current
account deficit as consumers buy more imports due to domestic supply constraints.

Essay: Explain what can cause an increase in the long run trend rate of economic growth. (10)

The Long run trend rate of economic growth measures the average sustainable rate of economic growth
over a period of time.

The Long Run trend rate will depend upon the growth of productive capacity in the economy and
therefore the growth of LRAS. The below diagram shows an increase in LRAS and therefore an increase
in potential growth:

Diagram: Long Run Economic Growth
r





The growth of potential output could increase due to 2 main factors:

1. An increase in resources land, labour and capital
2. An increase in the efficiency of these resources i.e. improved labour or capital productivity.
Firstly if there is improved technology, e.g if robots were used more effectively in factories, this will
enable higher output and lower costs. An important factor is labour productivity; if there is improved
education and training then workers will be more productive and this will increase the LRAS.

If the country had an increase in Raw materials e.g. finding a new source of oil this would increase LRAS.

Also, if there is an increase Capital, such as, investment in new factories and machines LRAS will
increase.

The growth rate could increase if there was an increase in the size of the labour force. This could caused
by higher population growth or an increase in the participation rate.

The Long run trend rate could be increased by successful government supply side policies. Supply side
policies attempt to increase productivity in the economy through greater efficiency and productivity. For
example, in the UK Supply side policies have involved privatisation and reducing the power of trades
unions. Supply side policies can be either, free market, or interventionist. Privatisation is an example of a
free market policy because it increases efficiency by removing the role of government in industries. It is
argued the private sector are more efficient because they have a profit motive. This increased efficiency
can increase long run growth.

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