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What does spare capacity mean? watch

    • Thread Starter

    Is spare capacity good/bad for the economy?

    It can potentially be both but the textbook answer is bad.

    Spare capacity is when there is unused capital eg: A manufacturing firm that is no using all its machines.

    It is bad for an economy because it creates what is called an output gap. This is the difference between what the firm actually produces and what it could of produced at 'full capacity'. This leads to lower output and therefore lower income and expenditure (remember O = E = Y).

    While I wouldn't say spare capacity is good for an economy I would say not having spare capacity can be bad. This is because when the economy is at fully capacity (producing as much as it possibly can) a rise in demand while have an upward inflationary pressure on the price. This is because firms cannot increase output to cope with the increase in demand so they have to raise their prices. This obviously leads to inflation. (This is modelled by the Keynesian Long Run Aggregate Supply Curve)

    If there is spare capacity in the economy it means there are unused resources (labour and capital) so the economy can respond to an increase in aggregate demand without suffering pressure on supply, ie it just starts to use the unused resources, hires unemployed workers, uses unutilised capital. So you can get some growth without price pressures coming in.

    When there is no spare capacity the economy is fully using its resources and so if there is an increase in aggregate demand that will lead to shortages of inputs like labour and capital, driving their prices up and driving up firms costs so leading to inflation.
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