The growth of potential GDP

Modelling with Potential GDP

The following four factor of production is what produces real GDP

1. Labor
2. Capital
3. Land
4. Entrepreneurship

Notice that the quantity of land, the abilities of the entrepreneur, and capital is all fixed. Labor is the only factor of production that can vary!

With that information, we can determine potential GDP with the two following components that is associated with labor:

1. Aggregate Production Function
2. Aggregate Labor Market

Aggregate Production Function & Labor Market

Aggregate Production Function: a function that shows the relationship between how real GDP changes when the quantity of labor varies, and all other effects from production stays the same.



Note: an increase in the quantity of labor increases real GDP.

Money Wage Rate: the number of dollars earned per hour of labor.

Real Wage Rate: the quantity of goods earned per hour of labor. In other words,

Real Wage Rate =$\frac{Money\;Wage\;Rate} {Price\;Level}$

Supply of Labor: the relationship between the quantity of labor supplied (in hours) and real wage rate. Generally, people would want to work more hours if the real wage rate is higher.



Demand of Labor: the relationship between the quantity of labor demanded (in hours) and real wage rate. Generally, firms would demand more labor if the real wage rate is lower.



Labor Market Equilibrium: is the intersection between the labor supply curve and labor demand curve. This gives you the real wage rate and quantity of labor when there is no shortage or surplus of labor.



Since the equilibrium gives us the quantity of labor, we can look at the same quantity of labor at the aggregate production function to find the potential GDP!



The Causes of Increasing Potential GDP

There are two factors that can make potential GDP increase:

1. Growth of labor supply
2. Growth of labor productivity

Growth of Labor Supply

There are a few reasons why labor supply can increase:

1. Average hours per worker
2. Increase in the employment – to – population ratio
3. Increase in the working-age population

The 3^rd reason can positively correlate with population growth. The bigger the population, the higher the total number of hours of labor there will be.

Therefore, the labor supply grows, shifting the labor supply curve to the right. This increases the quantity of labor supplied and demanded, but it decreases the real wage rate.



When the new quantity of labor is plugged into the aggregate production function, we see that the potential GDP has increased.



Growth of Labor Productivity

Labor Productivity: is the quantity of real GDP that is produced from an hour of labor.

Example: If GDP is 1 billion, and labor hours are 100 million, then the labor productivity is 10$ an hour.

If the labor productivity were to increase, then the aggregate production function expands upward.



We see that real GDP increases even when the hours of labor are unchanged. Since real GDP has increase from labor productivity, firms are more willing to pay higher for more hours of labor (higher demand). This shifts the labor demand to the right, thus increasing wage rate and labor.



Thus, this gives a movement along the aggregate production curve and increases real GDP even more.



Why does Labor Productivity Grow?

For labor productivity to grow, we must satisfy a precondition. This precondition is that there must be an incentive system made by economic freedom, property rights, firms, markets and money.

There are three ways in which labor productivity can grow

1. Physical Capital Growth: When the amount of capital per worker increases, labor productivity will increase. This is because if you give workers more tools (like machinery, equipment) instead of having to share the tools, then workers can produce much more than the current output.


2. Human Capital Growth: Human capital is the stock of knowledge, habits, social, and personality attributes. If workers continue completing simple repetitive tasks, then they will eventually complete them faster and faster.


3. Technological Advances: the discovery of new technologies and new goods increase labor productivity. For example, instead of old engine trains, we have sky trains and cars.