1 Potential output calculation In class, we considered the model of production Yt = At (utKt) L 1 t (1) where all variables and parameters are as in the standard model of production and ut is capital utilization. We assumed that ut = 1 corresponds to capital utilization that firms would choose if the economy was neither in a recession nor in an expansion.

Question 1.1 Explain why in an expansion, firms would choose ut > 1 and why this would not sustainable in the long run.

Question 1.2 The potential output of the economy is defined as output that the economy would achieve if it was neither in an expansion nor in a recession. Use this definition of potential output to decompose actual output Yt in equation (1) into potential output Y t and the business cycle component Y t (also called the output gap)

Question 1.3 Can we measure potential output directly? Can we use the model to provide an estimate of the potential output? Consider an alternative model of production Yt = AtK t (etLt) 1 where et is the effort workers exert when working. Instead of utilizing capital more intensively during an expansion, in this model the firm asks the workers to work harder.

Question 1.4 Assuming that the normal, long-term level of effort is et = 1, decompose actual output into the potential output and the output gap.

Question 1.5 Why may it be even more difficult in this case to estimate potential output than in the case of variable capital utilization?