The PPF can be used to illustrate several aspects of macroeconomics: In particular, the level of an economy's output, the growth of national and per capita output over time, and short-run business-cycle fluctuations in national output and employment.
An economy's capacity to produce goods and services depends on its endowment of resources and the productivity of those resources. The two-person, two-product examples in the previous section reflect this.
The productivity of labour, defined as output per worker or per hour, depends on:
- Skill, knowledge and experience of the labour force;
- Capital stock: Buildings, machinery, equipment, and software the labour force has to work with; and
- Current state of technology.
The productivity of labour is the output of goods and services per worker.
An economy's capital stock is the buildings, machinery, equipment and software used in producing goods and services.
The economy's output, which we define by Y, can be defined as the output per worker times the number of workers; hence, we can write:
When the employment of labour corresponds to 'full employment' in the sense that everyone willing to work at current wage rates and normal hours of work is working, the economy's actual output is also its capacity output Yc. We also term this capacity output as full employment output:
Full employment output .
Suppose the economy is operating with full employment of resources producing outputs of two types: Goods and services. In Figure 1.5, shows the different combinations of goods and services the economy can produce in a particular year using all its labour, capital and the best technology available at the time.
An aggregate economy produces a large variety of outputs in two broad categories. Goods are the products of the agriculture, forestry, mining, manufacturing and construction industries. Services are provided by the wholesale and retail trade, transportation, hospitality, finance, health care, education, legal and other service sectors. As in the two-product examples used earlier, the shape of the PPF illustrates the opportunity cost of increasing the output of either product type. We are not concerned with who supplies the products for the moment: It may be the private sector or the government.
Point X0 on PPF0 shows one possible structure of capacity output. This combination may reflect the pattern of demand and hence expenditures in this economy. Output structures differ among economies with different income levels. High-income economies spend more on services than goods and produce higher ratios of services to goods. Middle income countries produce lower ratios of services to goods, and low income countries much lower ratios of services to goods. Different countries also have different PPFs and different output structures, depending on their labour forces, labour productivity and expenditure patterns.
Three things contribute to growth in the economy. The labour supply grows as the population expands; the stock of capital grows as spending by business (and government) on buildings, machinery, information technology and so forth increases; and labour-force productivity grows as a result of experience, the development of scientific knowledge combined with product and process innovations, and advances in the technology of production. Combined, these developments expand capacity output over time. In Figure 1.5 economic growth shifts the PPF out from to .
This basic description covers the key sources of growth in total output. Economies differ in their rates of overall economic growth as a result of different rates of growth in labour force, in capital stock, and improvements in technology. But improvements in standards of living require more than growth in total output. Increases in output per worker and per person are necessary. Sustained increases in living standards require sustained growth in labour productivity, which in turn is based on advances in the technology along with the amount of capital each worker has to work with.
Recessions and booms
A prime objective of economic policy is to ensure that the economy operates on or near the PPF – it should use its resources to capacity and have minimal unemployment. However, economic conditions are seldom tranquil for long periods of time. Unpredictable changes in business expectations of future profits, in consumer confidence, in financial markets, in commodity and energy prices, in the demand conditions in major trading partners, in government policy and many other events disrupt patterns of expenditure and output. Some of these changes disturb the level of total expenditure and thus the demand for total output. Others disturb the conditions of production and thus the economy's production capacity. Whatever the exact cause, the economy may be pushed off its current PPF. If expenditures on goods and services decline, the economy may experience a recession. Output would fall short of capacity output and unemployment would rise. Alternatively, times of rapidly growing expenditure and output may result in an economic boom: Output and employment expand beyond capacity levels.
An economic recession occurs when output falls below the economy's capacity output.
A boom is a period of high growth that raises output above normal capacity output.
Recent history provides examples. Following the financial crisis of 2008-09 that hit the US and many other developed economies, many economies were pushed into recessions. Expenditure on new residential construction collapsed for lack of income and secure financing, as did business investment, consumption spending and exports. Lower expenditures reduced producers' revenues, forcing cuts in output and employment and reducing household incomes. Lower incomes led to further cutbacks in spending. In Canada in 2009 aggregate output declined by 2.9 percent, employment declined by 1.6 percent and the unemployment rate rose from 6.1 percent in 2008 to 8.3 percent by 2010. The world's economies have been slow to recover, and even by 2017 the output in several developed economies was no higher than it was in 2008. Canada's recession was not nearly as severe as the recessions in economies such as Spain and Italy; but output between 2009 and 2017 has been below the potential of the Canadian economy. In mid-2017 the national output was about 1.4 percent below potential and the unemployment rate was 6.7 percent.
An economy in a recession is operating inside its PPF. The fall in output from X to Z in Figure 1.6 illustrates the effect of a recession. Expenditures on goods and services have declined. Output is less than capacity output, unemployment is up and some plant capacity is idle. Labour income and business profits are lower. More people would like to work and business would like to produce and sell more output, but it takes time for interdependent product, labour and financial markets in the economy to adjust and increase employment and output. Monetary and fiscal policy may be productive in specific circumstances, to stimulate demand, increase output and employment and move the economy back to capacity output and full employment. The development and implementation of such policies form the core of macroeconomics.
Alternatively, an unexpected increase in demand for exports would increase output and employment. Higher employment and output would increase incomes and expenditure, and in the process spread the effects of higher output sales to other sectors of the economy. The economy would move outside its PPF, for example to W in Figure 1.6, by using its resources more intensively than normal. Unemployment would fall and overtime work would increase. Extra production shifts would run plant and equipment for longer hours and work days than were planned when it was designed and installed. Output at this level may not be sustainable, because shortages of labour and materials along with excessive rates of equipment wear and tear would push costs and prices up. Again, we will examine how the economy reacts to such a state in our macroeconomic analysis.
Output and employment in the Canadian economy over the past twenty years fluctuated about growth trend in the way Figure 1.6 illustrates. For several years prior to 2008 the Canadian economy operated slightly above its capacity; but once the recession arrived monetary and fiscal policy were used to fight it – to bring the economy back from a point such as Z towards a point such as X on the PPF.
Macroeconomic models and policy
The PPF diagrams illustrate the main dimensions of macroeconomics: Capacity output, growth in capacity output and business cycle fluctuations in actual output relative to capacity. But these diagrams do not offer explanations and analysis of macroeconomic activity. We need a macroeconomic model to understand and evaluate the causes and consequences of business cycle fluctuations. As we shall see, these models are based on explanations of expenditure decisions by households and business, financial market conditions, production costs and producer pricing decisions at different levels of output. Models also capture the objectives of fiscal and monetary policies and provide a framework for policy evaluation. A full macroeconomic model integrates different sector behaviours and the feedbacks across sectors that can moderate or amplify the effects of changes in one sector on national output and employment.