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5.2: Equilibrium Output and Potential Output

  • Page ID
    11810
  • The distinction between equilibrium output and potential output is very important to our study of the economy. In the short run, AD and AS determine equilibrium output. Potential output is determined by the size of the labour force, the stock of capital, and the state of technology. The general level of prices and short-run aggregate demand and supply conditions do not affect potential output.

    Potential output: the real GDP the economy can produce on a sustained basis with current labour force, capital and technology without generating inflationary pressure on prices.

    Short-run equilibrium real GDP is determined by AD and AS conditions. Fluctuations in real GDP and price are a result of short-run changes in economic conditions. To evaluate the economy’s performance and understand how it behaves over time, we need a benchmark. Potential output is the output the economy can produce on a sustained basis using the current labour force, capital, and technology without putting continuous upward pressure on the price level or the inflation rate.

    In the short run, the labour force, the capital stock, and technology are fixed by assumption. Potential output is the economy’s output based on “full employment” of these inputs, but it is not the maximum output an economy can conceivably make. For short periods of time we could make more by using labour for longer hours and factories for extra production shifts. Just as a marathon runner can sprint from time to time but cannot sustain the sprint over the whole race, the economy can operate for short time periods at levels of output above potential. Potential output is the output the economy can produce on a sustained basis.

    When the economy is at potential output, every worker wanting a job at the equilibrium wage rate can find a job, and every machine that can be profitably used at the equilibrium cost for capital is in use. Thus, potential output includes an allowance for “equilibrium unemployment” or structural unemployment and some excess capacity. Some people, who would work at higher wage rates, do not want to work at the equilibrium wage rate. Moreover, in a constantly changing economy, some people are joining the labour force, others are leaving, and still others are temporarily between jobs. Today, Canadian potential output means an unemployment rate of about 6 to 7 percent. This is usually called the natural unemployment rate.

    Natural unemployment rate: the unemployment rate that corresponds to potential GDP.

    Actual output can also fall below potential output. Workers who want jobs may be unemployed, and producers may have idle plant and equipment or excess capacity. The unemployment rate rises above the 6 percent “full employment” rate.

    A key issue in macroeconomics is the way differences between actual output and potential output affect unemployment rates, wage rates, and inflation rates. These effects are important to how the economy adjusts equilibrium output to potential output, as we will see later in this chapter.

    Figure 5.5 illustrates potential real GDP (YP) with a vertical line. Changes in price from P0 to P1, for example, have no effect on YP. Changes in the supply of labour, the stock of capital, or the state of technology would increase potential output and shift the this vertical YP line to the right or to the left.

    Screenshot 2019-03-04 at 22.39.21.png

    Figure 5.5: Potential GDP
    Potential GDP (YP) is the real GDP the economy could produce on a sus-
    tained basis without putting pressure on costs and prices. YP is independent
    of P.