The Multiplier, Growth and Money and Banking: Question 3

Worked solution

Part (a): Calculating the output gap

The output gap measures how far actual output is from potential output, expressed as a percentage of potential output:

$\text{Output gap} = \frac{\text{Actual GDP} - \text{Potential GDP}}{\text{Potential GDP}} \times 100$

So the output gap is $+2\%$, $+8\%$, $-1\%$ and $-4\%$ in Years 1 to 4 respectively.

Part (b): The first negative output gap

Norvale’s output gap turns negative in Year 3 ($-1\%$), having been positive in Years 1 and 2.

A negative output gap means actual real GDP has fallen below potential real GDP. The level of output the economy could produce if all its resources (labour, capital and land) were being used at their normal, sustainable level. This shows that Norvale is not making full use of its productive resources: there is spare capacity in the economy, which typically shows up as unemployed workers, under-used machinery, and slower growth in actual output than the economy is capable of.

Part (c): Identifying phases of the business cycle

The business (trade) cycle describes fluctuations of actual output around its long-run potential (trend) path, moving through boom, downturn, recession and recovery.

• Year 2 has the largest positive output gap ($+8\%$): actual output is well above potential output, meaning the economy is producing beyond its normal sustainable capacity. This is characteristic of a boom, often accompanied by demand-pull inflationary pressure as resources are stretched.
• Year 4 has a negative output gap that has widened from $-1\%$ in Year 3 to $-4\%$: actual output is persistently, and increasingly, below potential. This is characteristic of a recession, with continuing spare capacity and rising unemployment as the downturn deepens.

Part (d): How an automatic stabiliser cushions the fall in real GDP

An automatic stabiliser is a mechanism built into the structure of government spending or taxation that reduces fluctuations in national income without any new decision being taken by the government.

Between Year 3 and Year 4, Norvale’s actual real GDP falls further below potential, and unemployment is likely to rise as firms cut back production. Unemployment benefits are an automatic stabiliser: as more workers lose their jobs during this downturn, total spending on unemployment benefits rises automatically (because more people qualify for them), without the government having to pass any new legislation. This extra benefit income partially replaces the wages lost by newly unemployed workers, sustaining part of their consumption spending. Because consumption falls by less than it otherwise would, Aggregate Demand, and so actual real GDP, falls by less between Year 3 and Year 4 than it would in the absence of this automatic stabiliser.

(A progressive income tax system works the same way: as incomes fall in the downturn, tax revenue falls proportionately more than income, automatically leaving households with relatively more disposable income to cushion the fall in spending.)

Final answers

• (a) Output gap $=$ $+2\%$ (Year 1), $+8\%$ (Year 2), $-1\%$ (Year 3), $-4\%$ (Year 4)
• (b) First negative output gap in Year 3; it shows Norvale’s resources are not being fully used (spare capacity)
• (c) Year 2 $=$ boom (largest positive output gap); Year 4 $=$ recession (negative, widening output gap)
• (d) Unemployment benefits (or a progressive tax system) rise automatically as real GDP falls, cushioning the fall in Aggregate Demand and real GDP without any new government decision