Business cycles and the production possibilities curve | APⓇ Macroeconomics | Khan Academy

What we have here are two different visualizations of a country's output at different points in time. You might recognize that here on the left, we have a production possibilities curve for this country. It's a very simple country that either produces forks and/or spoons.

So, 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. All the combinations of forks and spoons that it would produce efficiently at its potential, well, that's what defines this production possibilities curve.

On the right here, we have this country's real GDP versus time. 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.

What we have here is thinking about three different scenarios at three different times for this country. We're going to connect the dots between the visualization on the left, the production possibilities curve, and the visualization on the right. We're also going to think about other economic indicators other than real GDP and how those might play out.

So let's start off at time t sub 1, 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.

But 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, in your personal life, you're pulling all-nighters in order to study for a test. That is not a sustainable situation.

At t sub 1, when you're operating above your potential, it is associated with low unemployment. Many would argue unsustainably low unemployment. Because there's so much demand for labor, there's so much demand for utilization of other resources, that could increase price pressure. So, it's also associated with higher inflation.

Now, what would time t sub 1 look like on this graph? Well, I already depicted it. It could be this point right over here, where real GDP is above this horizontal red line, which you could view as our potential GDP, our full employment GDP, our full employment output.

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 above our potential, as being associated with an expansion versus a recession. It is indeed the case that this t sub 1 is happening during an expansion.

An expansion is a situation where the GDP is growing. This is an expansion here, and then if we go from the next trough to the next peak, this is an expansion here. The opposite of an expansion is a recession. So, this is a recession; we're going from a peak to a trough. 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. So, 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 2. Now, we are actually operating at potential; we are at our production possibilities curve.

What point could that be on this graph? Well, we have it depicted right here. At time t sub 2, the country is operating exactly at its potential. The country is operating efficiently in a sustainable way. Then we go to time t sub 3.

At time t sub 3, 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. If you think about the economic indicators other than real GDP, what would 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.

Because both 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. In extreme cases, you could even have negative inflation, which we would call deflation.

Now, 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.

To 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 suddenly have more factors of production, better resources, better technology, or the population has increased.

So, economic growth would be associated with pushing out the actual PPC. This would, if they somehow had more technology or more people now, push out the PPC. Economic growth, for example, if this red line, which is the country's potential, were to increase like this, that would be economic growth.

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