Business cycles and the production possibilities curve

0:00- [Instructor] What we have here are two different visualizations of a country's output at different points in time. You might recognize here on the left we have our production possibilities curve for this country. And it's a very simple country that either produces forks and/or spoons.

0:16So if it could produce all forks efficiently it would be right here, that many forks. If it could produce all spoons efficiently it would be right here. And all the combinations of forks and spoons that it would produce efficiently at its potential, well that's what defines this production possibilities curve.

0:33On the right here we have this country's real GDP versus time. And so you could view their real GDP as some way of computing their aggregate production of spoons and forks. Now we know that real economies do a lot more than just produce two goods. They produce millions of goods and services, but then you would need a graph that would have millions of dimensions which is very hard for most of our brains to understand.

1:00But what we have here is, thinking about three different scenarios at three different times for this country. Now we're gonna connect the dots between the visualization on the left, the production possibilities curve, and the visualization on the right. And we're also gonna think about other economic indicators other than real GDP and how those might play out.

1:20So let's start off at time T sub one right over here. From what we know of production possibility curves, what is going on in the economy? Pause this video and try to think about that. Well we know that if you're on your production possibilities curve, you're operating at your potential.

1:38But here we have a situation where we are operating beyond our potential. This is not a sustainable situation. This is a situation where some people would argue the economy is overheating. This is like if on your personal life if you're pulling all nighters in order to study for a test, that is not a sustainable situation.

1:58But at T sub one when you're operating above your potential, it is associated with low unemployment and many would argue unsustainably low unemployment. And because there's so much demand for labor, There's so much demand for utilization of other resources that that could increase price pressure.

2:21So it's also associated with higher inflation. Now what would time T sub one, what could that be on this graph here? Well I already depicted it. It could be this point right over here, where our real GDP is above this horizontal red line which you could view as our potential GDP, our full employment GDP, our full employment output.

2:44And so this shows that we have a positive output gap just as when we're above or beyond our PPC that is also a positive output gap. Now sometimes we associate this positive output gap being performing beyond the potential as being associated with an expansion versus a recession.

3:04And it is indeed the case that this T sub one is happening during an expansion. An expansion is a situation where the GDP is growing. So this is an expansion here. And then if we go from the next trough to the next peak, this is an expansion here. And the opposite of an expansion is a recession, so this is a recession where we're going from a peak to a trough.

3:28And if we go from the next peak to the next trough that also would be a recession. So this positive output gap is happening during an expansion. But you could have a situation where you're right here where you have a positive output gap, where you're operating beyond your potential, but the economy has started to shrink.

3:48So it's not always the case. Even though positive output gaps get associated with expansions, it's not always during an expansion. But anyway, let's move forward in time. Let's say for various reasons our economy slows down a bit and we go to time T sub two. Now we are actually operating at potential.

4:05We are at our productions possibility curve. And so at what point could that be on this graph? Well we have it depicted right here at time T sub two. The country is operating exactly at its potential. The country is operating efficiently in a sustainable way. And then we go to time T sub three.

4:26So at time T sub three it's clear that we have a negative output gap and you can see it over here as well. We have a negative output gap. And if you think about the economic indicators other than real GDP what will they be doing? This is a situation where an economy is operating below full employment where the unemployment rate could be elevated, or it's typically elevated when you have this negative output gap.

4:51And because both the labor and oftentimes other resources aren't being fully utilized, there might not be a lot of price pressure. So in this situation inflation would be lower. And in extreme cases you could even have negative inflation, which we would call deflation.

5:07Now associated with all of these ideas is the idea of economic growth. So in everyday language when people talk about economic growth, they're usually talking about expansions. They're talking about situations where real GDP is growing. But economists, when they talk about economic growth do not mean that.

5:26To an economist, economic growth is when the potential of an economy increases. And we know that the only way that the potential of an economy increases is if they all of a sudden have more factors of production, better resources, better technology, the population has increased.

5:42So economic growth would be associated with pushing out the actual PPC. So this would, if you saw now they had more technology or more people now, so now that would push out the PBC. And economic growth, for example, if this red line, which is the country's potential, were to increase like this, that would be economic growth.

6:02The actual real GDP at any given time would likely cycle around that.