Potential GDP & The Natural Unemployment Rate You have learned to evaluate economic performance based on output, prices, and labor. Next we will look at some different schools of thought explaining economic performance. Classical macroeconomics(Adam Smith 19 th century): Free markets thrive, and free markets with no government intervention gives the best macroeconomic performance. Idea- markets will always return to equilibrium. Ques: What’s the good thing about market equilibrium?

Keynesian macroeconomics(John Keynes 20 th century): Markets are unstable and there is some need for government intervention. Here the role of government is to maintain full employment in the economy. (Recall full employment). The idea is that in times of recession. Y= C+I+G+NX. Consumption, investment, and net export expenditure may be too low. Increased government spending should be used to increase output and achieve full employment. Economic Schools of Thought

Both Schools of thought have inherent flaws. Classical: Could not explain prolonged recessions. (long periods of high unemployment) Ques: How do you think this relates to the classical view? Keynesian: Increased government spending may increase prices in the long run, increase the cost of living, and decrease productivity. New Macroeconomics: macroeconomic performance depends on the choices of individuals and firms.

POTENTIAL GDP Defn: Potential GDP is the level of real GDP that the economy would produce if it were at full employment. Potential GDP is the level of output when the labor market is in equilibrium. Point: The economy is at full employment when the labor market is in equilibrium. Production function-

POTENTIAL GDP The production function displays diminishing returns. What is diminishing returns? How is it shown?

The Labor Market and Potential GDP Questions to be answered 1)How is the quantity of labor demanded different from the demand for labor? 2) i) What is the relationship between the quantity of labor demanded and wages. ii) What does the wage rate represent to the firm? 3) What is the relationship between the quantity of labor supplied and the wage rate. What does the wage rate represent to the worker? The quantity of labor supplied increases as the real wage rate increases for two reasons: Hours per person increase as the real wage rate increases. The labor force participation rate increases as the real wage rate increases.

Example Economy LCG has the capability of production function Y= 2*L 0.5. Where Y is output, and L represents labor hours worked. i. If equilibrium labor hours is 100, how many goods are produced. ii. Is there diminishing marginal returns in LCG? How do you know? iii. If price in LCG is $10, what is GDP? i)output= 2*(10)=20 ii) Yes, each additional 100 units of labor gives additional less output. When L=200, Y= The output increased by 8.29 An additional 100 units of labor L=300, Y= An increase of only iii) GDP is the value of ouput= price * quantity = $10*20=$200