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Friday, 5 August 2011

Production Possibility Frontier and Long Run Aggregate Supply

The PPF shows the combination of capital and consumer goods that can be produced within the economy. The PPF shows what the economy can produce. If the economy is producing inside the PPF, point X, it is in a recession. Unemployment is high and the economy is not producing at it’s full productive capacity.

When the economy is producing on the PPF, point Y, it IS producing at its full productive capacity. It is also producing on the LRAS curve, point V on the supply/demand diagram. Real national output is YFE and the price level is P1. Full employment of resources has been achieved, which means that the labour force is fully employed, see Word of the Day. The only way to increase output is by increasing investment in capital goods (which increases consumer goods) thereby increasing LRAS. If this happens, economic growth is occurring in the long run. See Word of the Day. LRAS1 moves rightward to LRAS2 and thus SRAS1 shifts rightward to SRAS2. Real national output in the economy has increased from YFE to YFE2. Assuming AD remains unchanged, the price level falls from P1 to P2.

Word of the Day

Full Employment

According to Beveridge's definition, which is perfectly acceptable to use in the exam, full employment is when 3% or less of the labour force is unemployed.

According to the free market definition, full employment occurs when ASL = ADL

Full employment also occurs when the economy is producing on the LRAS curve, see PPF and LRAS. This is because when there is no spare capacity, all workers willing and able to work are working.

It does not mean that all members of the working population are in employment, frictional and structural unemployment is always occurring.

Stock Markets take a heavy dip

The FTSE 100 and Dow Jones dropped heavily yesterday (Friday) due to the uncertainty bought about by US economic growth and it's debt ceiling, and Spain and Italy's unmanageable public finances. There are fears that Italy and Spain may need bailouts as well, which is why investors sold these stocks.  Spain has the fourth largest economy in the EU, however its bond yields (interest rates on government bonds) remain high at 6.4% and in Italy, 6.3%. Greece, Ireland and Portugal had levels of above 7% when they desperately seeked bailouts by the IMF and European Union, highlighting the risk that Italy and Spain face. Have a look at this video to learn more.

The FTSE 100 fell by almost 3.5%, it's lowest fall since the collapse of Lehman Brothers in September 2008. The Dow Jones fell by 4.3%, Japan's Nikkei fell by 3.7% and Hong Kong's Hang Seng fell by 5%. 

Only time will tell what will happen, how investors react to markets will influence economies in the way they want because speculation is a powerful tool. If things continue the way they are, the EU may have to start preparing more bailout packages. As for the USA, someone once told me that when America sneezes, the whole world catches a cold.