133 The Neoclassical Perspective and Potential GDP (119/108) -- Macroeconomics

133 The Neoclassical Perspective and Potential GDP Learning Objectives - Explain the importance of potential GDP in the long run to the neoclassical perspective - Explain the shape and reasoning for the pure neoclassical aggregate supply curve The neoclassical perspective on macroeconomics is based on two building blocks (or assumptions): - Since in the long run, the economy will fluctuate around its potential GDP and its natural rate of unemployment, the size of the economy is determined by potential GDP. - wages and prices will adjust in a flexible manner so that disturbances such as recessions will be temporary and the economy will always return to its potential level of output on its own. The key policy implication is this: government should focus more on promoting long-term economic growth and on controlling inflation rather than worrying about recession or cyclical unemployment. This focus on long-run growth instead of short-run fluctuations in the business cycle means that neoclassical economics is more useful for long-run macroeconomic analysis and Keynesian economics is more useful for analyzing the macroeconomic short run. Let’s consider the two neoclassical building blocks in turn, and how they can be embodied in the aggregate demand-aggregate supply model. Try It The Importance of Potential GDP in the Long Run When economists refer to potential GDP, they are referring to that level of output that can be achieved when all resources (land, labor, capital, and entrepreneurial ability) are fully employed. While the measured unemployment rate in labor markets will never be zero, full employment in the labor market occurs when there is no cyclical unemployment. There will still be some frictional or structural unemployment, but when the economy is operating with zero cyclical unemployment, the economy is said to be at the natural rate of unemployment, or at full employment. Figure 1 shows potential and actual real GDP from 1960 to 2017 (the data for potential GDP is estimated by the nonpartisan Congressional Budget Office, while the data for real GDP is from the Bureau of Economic Analysis in the U.S. Department of Commerce). What should be clear is that while actual GDP is sometimes above and sometimes below potential, over the long term it tracks potential quite well. For example from 2008 to 2009, the U.S. economy tumbled into recession and remained below its potential. At other times, like in the late 1990s or late 2017, the economy ran at potential GDP—or even slightly ahead. Most economic recessions and upswings are times when the economy is 1–3% below or above potential GDP in a given year. Clearly, short-run fluctuations around potential GDP do exist, but over the long run, the upward trend of potential GDP determines the size of the economy. The unemployment rate has fluctuated from as low as 3.5% in 1969 to as high as 9.7% in 1982 and 9.6% in 2009. Even as the U.S. unemployment rate rose during recessions and declined during expan