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i). Potential output is different from maximum output in an engineering sense (and the first will be lower).

ii). The concepts of low inflation and medium term are open to different interpretations.

There are two ways of estimating potential GNP: through the analysis of the past trend of the growth rate or through the production function approach. This second estimate, regularly produced (for example by OECD), is computed as follows:

i)  Separate private from public sector (due to the difficulty of measuring output in the latter, actual government output is assumed to be equal to its potential).

ii) Estimate the growth of productive inputs.

iii) Estimate the utilisation levels consistent with low inflation.

iv) Assess the impact of new technologies and changes in economic policy on economic activity.

v)  Derive the total factor productivity growth.

vi) Combine the previous statistics together in order to obtain an estimate of potential growth for private sector and then re-aggregate the public sector to obtain potential GNP.

Since deviations from potential GNP in either direction can cause problems (inflation if actual exceeds potential GNP and unemployment if the former is far less than the latter), its estimate gives a guidance to economic authorities in the management of monetary, fiscal and industrial policies. Besides, business economists use estimates of potential GNP to estimate future economic growth from which sales forecasts are derived.

Q3.  Discuss reasons why the aggregate supply curve might be vertical. Do you find them convincing?

In the classical model the aggregate supply (AS) curve can be considered a proxy for potential output and represents the possible combinations of real output (y) and the price level (p) consistent with equilibrium in the economy. Under certain assumptions AS is vertical:

i)  Individuals are utility maximising.

ii) Firms are profit maximising.

iii) Markets for factors of production and goods are perfectly competitive (full flexibility of prices and wages).

iv) Existence of rational expectations (absence of money illusion).

The AS curve can be derived as in figure 11.1: the starting point is the equilibrium in the labour market in which demand and supply are functions of the real wage. Given a certain price P0, demand and supply of labour become related to nominal wages as the equilibrium in point A - graph (a) shows. Students should pay attention to the variable plotted on the vertical axis for this demonstration: it is the nominal wage, not the real wage used elsewhere in the textbook.

A rise in the price level from P0 to P1 implies a decrease in the real wage. Because the cost of labour has now fallen, employers demand more labour for the same nominal


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