If the real GDP declined for several years, what effect would you expect it to have on the capital-to-labor ratio?
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The capital to labor ratio is a measurement that compares the amount of capital present in the economy to the amount of labor. When the amount of capital rises, the value of the ratio rises if the amount of labor does not rise by a similar amount. When the amount of labor rises, the value of the ratio falls if the amount of capital does not rise by a similar amount.
During a deep recession (when real GDP has been declining for several years), the labor force generally becomes smaller. This has certainly been the case (as seen in this link) during the recent “great recession.” If the labor force shrinks, the denominator of the capital to labor ratio gets smaller. If the denominator gets smaller and the numerator (amount of capital) does not fall by a similar amount, the value of the ratio as a whole will increase. During a recession, the amount of capital in the economy does not rise as quickly as it would in good times. However, it should not fall by a tremendous amount because capital does not tend to disappear quickly. Therefore, in a prolonged recession, we should expect to see a gradual decline in capital and a deep decline in labor. This means that the capital to labor ratio will increase in this situation.
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