Okay, I’m trying to work my way through these concepts to REALLY understand them. Regarding aggregate demand and potential GDP… Potential GDP is determined by natural level of unemployment, technology, and capital. So, only increases in those 3 items will increase potential GDP. Why does it feel so odd, intuitively, that an increase in demand in an economy would, in the long run, only result in an increase in price and not an actual increase in potential GDP? I guess the way things really move is that, if this demand increase is sustainable and if firms have the funds, they would actually invest in long term capital and technology to meet this increased demand rather than just increasing output in the short run until the cost of labor increased as well – and this increased in capital and technology would increase potential GDP. Is that how we should consider it?
Because it’s economics and economists are never on the same page. I hate to sound broad here, but economics is really meaningless in the real world. The Phillips curve was disproved in the 70s when we had high unemployment and high inflation, yet it’s still being taught. We were told that budget deficits result in the crowding out effect, but interest have declined since the early 80s. The whole argument behind LRAS, SRAS, potential GDP and unemployment all work when you look at the graphs. And, the dirty secret is, that’s really how you respond to econ test questions: just draw the graph. Supply side economics, according to our text book, doesn’t work, yet we have seen economic booms occur subsequent to the tax cuts in the early 20s, 80s, and even with the late 90s cap gains cut. Intuitively you’re right. But academically, just go by what the book says.
mcf, You are arguing your point on the basis of real GDP not potential GDP, potential GDP is the max that the economy can produce at the current level of technology and at full employment of labour. If the economy is at full employment an increase in demand can only lead to an increase in prices, simple, in the long run new technology will come in and increase the country’s capacity to produce hence demand goes up and prices down. Remember at a point in time capacity is limited- the economic problem, scarcity against insatiable wants.
gdiddy Wrote: ------------------------------------------------------- > Because it’s economics and economists are never on > the same page. I hate to sound broad here, but > economics is really meaningless in the real world. > The Phillips curve was disproved in the 70s when > we had high unemployment and high inflation, yet > it’s still being taught. We were told that budget > deficits result in the crowding out effect, but > interest have declined since the early 80s. > > The whole argument behind LRAS, SRAS, potential > GDP and unemployment all work when you look at the > graphs. And, the dirty secret is, that’s really > how you respond to econ test questions: just draw > the graph. > > Supply side economics, according to our text book, > doesn’t work, yet we have seen economic booms > occur subsequent to the tax cuts in the early 20s, > 80s, and even with the late 90s cap gains cut. > > Intuitively you’re right. But academically, just > go by what the book says. That’s what I hate about macro. Micro is so much more civilized!
giving a person higher wages won’t make him work faster than his maximum productivity
mcf, you answered yourself brother. In your “intuitive” reasoning you conclude that if demand increase is sustainable AND IF FIRMS HAVE THE FUNDS… well funds are just another word for capital, and if it is available potential GDP will increase, but only in the long run. On the other hand, if the capital and productivity stay the same - only prices increase.
I minored in Econ back in college. In all the courses I took, I never learned about “potential GDP.” I’ve read books by Mankiw, McEachern, and others, but this concept it seems is specific to Michael Parkins’ work. In fact, I have a Macro textbook of his that was published in 2002 and that was the only other time I saw a discussion of “Potential GDP.”
Think of GDP as a function is price and output. When the price goes up, the employers employ more people at higher wages initially and this increased production costs result lower output.
kochunni69 Wrote: ------------------------------------------------------- > Think of GDP as a function is price and output. > When the price goes up, the employers employ more > people at higher wages initially and this > increased production costs result lower output. I actually disagree with this. As price goes up, the employer initially pays the same wage. Over time, wages rise causing him to reduce production to a lower output.
Well… at pottential GDP, you are aready operating at full employment and inorder to increase the production to take advantage of the increased price level, an employer has to pay more. So he makes more and prices keep going and there will be some FEd/Govt intervention to control the inflation by reducting the money supply. That’s when the aggregate demand demand going back to normal, production is reduced to normal levels, but at higher price levels. I agree with you on the overall concept.