The potential output level of an economy in other words natural gross domestic product means the output level when an economy’s unemployment rate equals the natural rate of unemployment. In the potential output level, the economy uses all the resources that can be utilized for the production process of goods and services. Also, economists have defined that the output level which is free from both inflationary and deflationary gap is known as the potential output level.
But most of the time, the actual output level of an economy can differs from the potential output level. Equilibrium output level means the output level where aggregate demand equals aggregate supply. (AD= AS). Also, an economy can achieve its equilibrium output under these situations. They are under the deflationary gap (with unemployment), under the inflationary gap (with excess utilization of the resources), or without both inflationary and deflationary gaps (With full employment).
Suppose that the potential GDP of the United States is $10,000 billion. Then marginal propensity to consume is equal to 0.75. If we assume that both taxes and imports are given then simple expenditure multiplier formula is applied. Suppose that exports will fall by $100 billion. Use the multiplier formula to estimate the change in GDP. Suppose further that for every one percentage point that GDP falls below potential, the unemployment rate will rise by 0.5 percentage point. How much then the unemployment rate rise due to the decrease in exports?
In this particular example, initially economy of the US has reached its equilibrium level of Y=$10,000 billion under full employment condition. So initially economy has been operated without both inflation and deflation (Yf represents that situation).
After that, there is a slowdown in Europe’s economy. So, US exports will be declined from $100 billion. The reason for that is, Europe decrease its imports. The US has to decrease the goods that they export to Europe. Above I mentioned that in the equilibrium AD = AS. Aggregate demand (AD) is comprised of four components. They are private consumption(C), private investment(I), government expenditure(G) and net exports (Nx). Decreasing Nx means decreasing aggregate demand. So, the aggregate demand curve will shift downward and it represents from the E2 curve. After that, the equilibrium output level of the US economy will reduce up to Y2 output. In this example K= 1/(1-mpc)=1/(1-0.75)= 4. Change in Y= Change in E*K = 100*4 = So, Y will decrease from $400 billion. The new equilibrium output level is equal to Y2= $9600 billion.
Because of this, the economy will suffer from deflation. In other words, the economy cannot fully utilize its resources, and the economy in an unemployment situation. According to the example, unemployment will rise from half percent for each one percent of GDP level falls. So, percentage of Y falls= (10000-9600)/10000*100=4%. Unemployment will rise half of the percentage from it. So, unemployment will increase from 2%.