Review of Macroeconomics. 2 of 38 THE ROOTS OF MACROECONOMICS Great Depression The period of severe economic contraction and high unemployment that began

Review of Macroeconomics

2 of 38

THE ROOTS OF MACROECONOMICS

Great Depression The period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.

THE GREAT DEPRESSION

3 of 38


Classical Models

Classical economists applied microeconomic models, or “market clearing” models, to economy-wide problems.

Simple classical models failed to explain the prolonged existence of high unemployment during the Great Depression. This provided the impetus for the development of macroeconomics.

4 of 38


The Keynesian Revolution

In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money.

Much of macroeconomics has roots in Keynes’s work. According to Keynes, it is not prices and wages that determine the level of employment, as classical models had suggested, but instead the level of aggregate demand for goods and services.

5 of 38

MACROECONOMIC CONCERNS

Three of the major concerns of macroeconomics are:

■ Inflation

■ Output growth

■ Unemployment

6 of 38


INFLATION AND DEFLATION

inflation An increase in the overall price level.

hyperinflation A period of very rapid increases in the overall price level.

deflation A decrease in the overall price level.

7 of 38


OUTPUT GROWTH: SHORT RUN AND LONG RUN

business cycle The cycle of short-term ups and downs in the economy.

aggregate output The total quantity of goods and services produced in an economy in a given period.

8 of 38


depression A prolonged and deep recession.

recession A period during which aggregate output declines. Conventionally, a period in which aggregate output declines for twoconsecutive quarters.

9 of 38


unemployment rate The percentage of the labor force that is unemployed.

UNEMPLOYMENT

10 of 38

GOVERNMENT IN THE MACROECONOMY

There are three kinds of policy that the government has used to influence the macroeconomy:

1. Fiscal policy

2. Monetary policy

3. Growth or supply-side policies

11 of 38


fiscal policy Government policies concerning taxes and expenditures (spending).

FISCAL POLICY

12 of 38


monetary policy The tools used by the Federal Reserve to control the quantity of money in the economy.

MONETARY POLICY

13 of 38


supply-side policies Government policies that focus on stimulating aggregate supply instead of aggregate demand.

GROWTH POLICIES

14 of 38

THE COMPONENTS OF THE MACROECONOMY

Macroeconomics focuses on four groups:

(1) households and(2) firms, which together compose the

private sector,(3) the government (the public sector), and(4) the rest of the world (the international

sector).

15 of 38

THE U.S. ECONOMY SINCE 1900:TRENDS AND CYCLES

FIGURE 5.3 A Typical Business Cycle

EXPANSION AND CONTRACTION: THE BUSINESS CYCLE

16 of 38


expansion or boom The period in the business cycle from a trough up to a peak, during which output and employment rise.

contraction, recession, or slump The period in the business cycle from a peak down to a trough, during which output and employment fall.

17 of 38


FIGURE 5.4 Real GDP, 1900–2004

18 of 38


FIGURE 5.5 Real GDP, 1970 I–2005 II

THE U.S. ECONOMY SINCE 1970

19 of 38


FIGURE 5.6 Unemployment Rate, 1970 I–2005 II

20 of 36

GROSS DOMESTIC PRODUCT

gross domestic product (GDP) The total market value of all final goods and services produced within a given period by factors of production located within acountry.

GDP is the total market value of a country’s output. It is the market value of all final goods and services produced within a given period of time by factors of production located within a country.

21 of 36


final goods and services Goods and services produced for final use.

FINAL GOODS AND SERVICES

intermediate goods Goods that are produced by one firm for use in further processing by another firm.

value added The difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage.

22 of 36


In calculating GDP, we can either sum up the value added at each stage of production or we can take the value of final sales. We do not use the value of total sales in an economy to measure how much output has been produced.

TABLE 6.1 Value Added in the Production of a Gallon of Gasoline (Hypothetical Numbers)

STAGE OF PRODUCTION VALUE OF SALES VALUE ADDED

(1) Oil drilling $ 1.00 $1.00

(2) Refining 1.30 0.30

(3) Shipping 1.60 0.30

(4) Retail sale 2.00 0.40

Total value added $2.00

23 of 36


GDP ignores all transactions in which money or goods change hands but in which no new goods and services are produced.

EXCLUSION OF USED GOODS AND PAPER TRANSACTIONS

GDP is concerned only with new, or current, production.

24 of 36

CALCULATING GDP

THE EXPENDITURE APPROACH

There are four main categories of expenditure:

Expenditure Categories:■ Personal consumption expenditures (C):

household spending on consumer goods■ Gross private domestic investment (I):

spending by firms and households on new capital, i.e., plant, equipment, inventory, and new residential structures

■ Government consumption and gross investment (G)

■ Net exports (EX - IM): net spending by the rest of the world, or exports (EX) minus imports (IM)

GDP = C + I + G + (EX - IM)

25 of 36

CALCULATING GDP

personal consumption expenditures (C) A major component of GDP: expenditures by consumers on goods and services.

Personal Consumption Expenditures (C)

There are three main categories of consumer expenditures: durable goods, nondurable goods, and services.

26 of 36

CALCULATING GDP

durable goods Goods that last a relatively long time, such as cars and household appliances.

nondurable goods Goods that are used up fairly quickly, such as food and clothing.

services The things we buy that do not involve the production of physical things,such as legal and medical services and education.

27 of 36

CALCULATING GDP

gross private domestic investment (I) Total investment in capital—that is,the purchase of new housing, plants, equipment, and inventory by the private (or nongovernment) sector.

Gross Private Domestic Investment (I)

nonresidential investment Expenditures by firms for machines, tools, plants, and so on.

28 of 36

CALCULATING GDP

residential investment Expenditures by households and firms on new houses and apartment buildings.

change in business inventories The amount by which firms’ inventories change during a period. Inventories arethe goods that firms produce now but intend to sell later.

Change in Business Inventories

GDP = final sales + change in business inventories

29 of 36

CALCULATING GDP

depreciation The amount by which an asset’s value falls in a given period.

Gross Investment versus Net Investment

gross investment The total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period.

net investment Gross investment minus depreciation.

capitalend of period = capitalbeginning of period + net investment

30 of 36

CALCULATING GDP

government consumption and grossinvestment (G) Expenditures by federal, state, and local governments for final goods and services.

Government Consumption and Gross Investment (G)

31 of 36

CALCULATING GDP

net exports (EX - IM) The difference between exports (sales to foreigners of U.S.- produced goods and services) and imports (U.S. purchases of goods and services from abroad). The figure can be positive or negative.

Net Exports (EX - IM)

32 of 36

NOMINAL VERSUS REAL GDP

current dollars The current prices that one pays for goods and services.

nominal GDP Gross domestic product measured in current dollars.

weight The importance attached to an item within a group of items.

33 of 36


TABLE 6.6 A Three-Good Economy(1) (2) (3) (4) (5) (6) (7) (8)

GDP IN GDP IN GDP IN GDP INYEAR 1 YEAR 2 YEAR 1 YEAR 2

IN IN IN INPRODUCTION PRICE PER UNIT YEAR 1 YEAR 1 YEAR 2 YEAR 2

YEAR 1 YEAR 2 YEAR 1 YEAR 2 PRICES PRICES PRICES PRICESQ1 Q2 P1 P2 P1 x Q1 P1 x Q2 P2 x Q1 P2 X Q2

Good A 6 11 $.50 $ .40 $3.00 $5.50 $2.40 $4.40

Good B 7 4 .30 1.00 2.10 1.20 7.00 4.00

Good C 10 12 .70 .90 7.00 8.40 9.00 10.80

Total $12.10 $15.10 $18.40 $19.20

Nominal GDPin year 1

Nominal GDPin year 2

CALCULATING REAL GDP

34 of 36


base year The year chosen for the weights in a fixed-weight procedure.

fixed-weight procedure A procedure that uses weights from a given base year.

35 of 36


CALCULATING THE GDP DEFLATOR

The GDP deflator is one measure of the overall price level. The GDP deflator is computed by the Bureau of Economic Analysis (BEA).

Overall price increases can be sensitive to the choice of the base year. For this reason, using fixed-price weights to compute real GDP has some problems.

36 of 36


THE PROBLEMS OF FIXED WEIGHTS

The use of fixed-price weights to estimate real GDP leads to problems because it ignores:

• Structural changes in the economy.

• Supply shifts, which cause large decreases in price and large increases in quantity supplied.

• The substitution effect of price increases.

37 of 36

LIMITATIONS OF THE GDP CONCEPT

GDP AND SOCIAL WELFARE

Society is better off when crime decreases; however, a decrease in crime is not reflected in GDP.

An increase in leisure is an increase in social welfare, but not counted in GDP.

Nonmarket and household activities are not counted in GDP even though they amount to real production.

38 of 25

Unemployment

employed Any person 16 years old or older (1) who works for pay, either for someone else or in his or her own business for 1 or more hours per week, (2) who works without pay for 15 or more hours per week in a family enterprise, or (3) who has a job but has been temporarily absent with or without pay.

Measuring Unemployment

unemployed A person 16 years old or older who is not working, is available for work, and has made specific efforts to find work during the previous 4 weeks.

39 of 25

Unemployment

not in the labor force A person who is not looking for work because he or she does not want a job or has given up looking.


labor force The number of people employed plus the number of unemployed.

labor force = employed + unemployed

population = labor force + not in labor force

40 of 25

Unemployment

unemployment rate The ratio of the number of people unemployed to the total number of people in the labor force.


unemployedunemployment rate =

employed + unemployed

labor force participation rate The ratio of the labor force to the total population 16 years old or older.

labor forcelabor force participation rate =

population

41 of 25

Unemployment


TABLE 7.1 Employed, Unemployed, and the Labor Force, 1953–2007

(1) (2) (3) (4) (5) (6)

Population16 Years

Old Or Over(Millions)

LaborForce

(Millions)Employed(Millions)

Unemployed(Millions)

Labor ForceParticipation

Rate(Percentage

Points)

UnemploymentRate

(PercentagePoints)

1953 107.1 63.0 61.2 1.8 58.9 2.9

1960 117.2 69.6 65.8 3.9 59.4 5.5

1970 137.1 82.8 78.7 4.1 60.4 4.9

1980 167.7 106.9 99.3 7.6 63.8 7.1

1982 172.3 110.2 99.5 10.7 64.0 9.7

1990 189.2 125.8 118.8 7.0 66.5 5.6

2000 212.6 142.6 136.9 5.7 67.1 4.0

2007 231.9 153.1 146.0 7.1 66.0 4.6

Note: Figures are civilian only (military excluded).Source: Economic Report of the President, 2008, Table B-35.

42 of 25

Unemployment

Components of the Unemployment Rate

Discouraged-Worker Effects

discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find jobs grow discouraged and stop looking, thus dropping out of the ranks of the unemployed and the labor force.

43 of 25

Unemployment

Components of the Unemployment Rate

The Duration of Unemployment

TABLE 7.4 Average Duration of Unemployment, 1979–2007

Weeks Weeks

1979 10.8 1993 18.0

1980 11.9 1994 18.8

1981 13.7 1995 16.6

1982 15.6 1996 16.7

1983 20.0 1997 15.8

1984 18.2 1998 14.5

1985 15.6 1999 13.4

1986 15.0 2000 12.6

1987 14.5 2001 13.1

1988 13.5 2002 16.6

1989 11.9 2003 19.2

1990 12.0 2004 19.6

1991 13.7 2005 18.4

1992 17.7 2006 16.8

2007 16.8Sources: U.S. Department of Labor, Bureau of Labor Statistics.

44 of 25

Unemployment

The Costs of Unemployment

Some Unemployment Is Inevitable

When we consider the various costs of unemployment, it is useful to categorize unemployment into three types:

Frictional unemployment

Structural unemployment

Cyclical unemployment

45 of 25

Unemployment


Frictional, Structural, and Cyclical Unemployment

frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems.

structural unemployment The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries.

46 of 25

Unemployment


Frictional, Structural, and Cyclical Unemployment

natural rate of unemployment The unemployment that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment.

cyclical unemployment The increase in unemployment that occurs during recessions and depressions.

47 of 25

Unemployment


Social Consequences

In addition to economic hardship, prolonged unemployment may also bring with it social and personal ills: anxiety, depression, deterioration of physical and psychological health, drug abuse (including alcoholism), and suicide.

THE CONSUMER PRICE INDEX

The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.

The Bureau of Labor Statistics reports the CPI each month.

It is used to monitor changes in the cost of living over time.

How the Consumer Price Index Is Calculated

1. Fix the basket. Determine what prices are most important to the typical consumer.a. The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. b. The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

2. Find the prices. Find the prices of each of the goods and services in the basket for each point in time.3. Compute the basket’s cost. Use the data on prices to calculate the cost of the basket of goods and services at different times.4. Choose a base year and compute the index.

a. Designate one year as the base year, making it the benchmark against which other years are compared. b. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

100Year Basein basket ofCost

YearCurrent in basket ofCost index priceConsumer

How the Consumer Price Index Is Calculated

5. Compute the inflation rate. The inflation rate is the percentage change in the price index from the preceding period.The inflation rate is calculated as follows:

CPI in Year 2 CPI in Year 1Inflation Rate in Year 2= 100

CPI in Year 1

51 of 25

Inflation

The Consumer Price Index

The CPI market basket shows how a typical consumer divides his or her money among various goods and services. Most of a consumer’s money goes toward housing, transportation, and food and beverages.Source: The Bureau of Labor Statistics

FIGURE 7.1 The CPI Market Basket

52 of 25

Inflation

The Costs of Inflation

real interest rate The difference between the interest rate on a loan and the inflation rate.

Real Interest Rate = Nominal Interest Rate – Inflation Rate

Inflation May Change the Distribution of Income

53 of 39

Government in the Economy

The Determination of Equilibrium Output (Income)

Y = Planned AE= C + I + G

TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Output(Income)

Y

NetTaxes

T

DisposableIncome

Yd / Y T

ConsumptionSpending

(C = 100 + .75 Yd)

SavingS

(Yd – C)

PlannedInvestmentSpending

I

GovernmentPurchases

G

PlannedAggregate

Expenditure C + I + G

UnplannedInventoryChange

Y (C + I + G)

Adjustmentto Disequi-

librium

300 100 200 250 50 100 100 450 150 Output8500 100 400 400 0 100 100 600 100 Output8700 100 600 550 50 100 100 750 50 Output8900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output91,300 100 1,200 1,000 200 100 100 1,200 + 100 Output91,500 100 1,400 1,150 250 100 100 1,350 + 150 Output9

54 of 39

Government in the Economy

The Determination of Equilibrium Output (Income) FIGURE 9.2 Finding Equilibrium Output/Income Graphically

Because G and I are both fixed at 100, the aggregate expenditure function is the new consumption function displaced upward by I + G = 200. Equilibrium occurs at Y = C + I + G = 900.

55 of 39

Fiscal Policy at Work: Multiplier Effects

The Government Spending Multiplier

1government spending multiplier

MPS

government spending multiplier The ratio of thechange in the equilibrium level of output to a change in government spending.

56 of 39



TABLE 9.2 Finding Equilibrium After a Government Spending Increase of 50 (G Has Increased from 100 in Table 9.1 to 150 Here)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Output(Income)

Y

NetTaxes

T

DisposableIncome

Yd / Y T

ConsumptionSpending

(C = 100 + .75 Yd)

SavingS

(Yd – C)

PlannedInvestmentSpending

I

GovernmentPurchases

G

PlannedAggregate

Expenditure C + I + G

UnplannedInventoryChange

Y (C + I + G)

AdjustmentTo

Disequilibrium

300 100 200 250 50 100 150 500 200 Output8

500 100 400 400 0 100 150 650 150 Output8

700 100 600 550 50 100 150 800 100 Output8

900 100 800 700 100 100 150 950 50 Output8

1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium

1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output

57 of 39



FIGURE 9.3 The GovernmentSpending Multiplier

Increasing government spending by 50 shifts the AE function up by 50. As Y rises in response, additional consumption is generated. Overall, the equilibrium level of Y increases by 200, from 900 to 1,100.

58 of 39


The Tax Multiplier

tax multiplier The ratio of change in the equilibrium level of output to a change in taxes.

tax multiplier MPC

MPS

YM PS

( in itia l in c rease in ag g reg a te ex p en d itu re )

1

1( )

MPCY T MPC T

MPS MPS

59 of 39

The Federal Budget

federal budget The budget of the federal government.

The “budget” is really three different budgets.

First, it is a political document that dispenses favors to certain groups or regions and places burdens on others.

Second, it is a reflection of goals the government wants to achieve.

Third, the budget may be an embodiment of some beliefs about how (if at all) the government should manage the macroeconomy.

60 of 39

The Federal Budget

The Budget in 2007

TABLE 9.5 Federal Government Receipts and Expenditures, 2007 (Billions of Dollars)Amount Percentage Of Total

ReceiptsPersonal income taxes 1,162.1 43.5Excise taxes and customs duties 99.9 3.7Corporate income taxes 380.8 14.3Taxes from the rest of the world 13.4 0.5Contributions for social insurance 953.0 35.7Interest receipts and rents and royalties 25.1 0.9Current transfer receipts from business and persons 39.4 1.5Current surplus of government enterprises − 2.3 − 0.0

Total 2,671.4 100.0Current Expenditures

Consumption expenditures 856.0 29.6Transfer payments to persons 1,270.7 43.9Transfer payments to the rest of the world 38.6 1.3Grants-in-aid to state and local governments 377.5 13.1Interest payments 302.4 10.5Subsidies 46.7 1.6

Total 2,892.0 100.0Net federal government saving—surplus (+) or deficit (−)

(Total current receipts − Total current expenditures) − 220.6Source: U.S. Department of Commerce, Bureau of Economic Analysis.

61 of 39

The Federal Budget

The Budget in 2007

federal surplus (+) or deficit () Federal government receipts minus expenditures.

62 of 39

The Federal Budget

The Federal Government Debt

federal debt The total amount owed by the federal government.

privately held federal debt The privately held(non-government-owned) debt of the U.S. government.

63 of 39

The Federal Budget

The Federal Government Debt

FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2007 IV

64 of 39

The Economy’s Influence on the Government Budget

Tax Revenues Depend on the State of the Economy

Tax revenue, on the other hand, depends on taxable income, and income depends on the state of the economy, which the government does not completely control.

Some Government Expenditures Depend on the State of the Economy

Transfer payments tend to go down automatically during an expansion.

Inflation often picks up when the economy is expanding. This can lead the government to spend more than it had planned to spend.

Any change in the interest rate changes government interest payments.

65 of 39

The Economy’s Influence on the Government Budget

Automatic Stabilizers

automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP.

Fiscal Drag

fiscal drag The negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

Automatic De-Stabilizers: Any Thoughts?

66 of 31

An Overview of Money

What Is Money?

store of value An asset that can be used to transport purchasing power from one time period to another.

A Store of Value

liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods.

unit of account A standard unit that provides a consistent way of quoting prices.

A Unit of Account

67 of 31


Commodity and Fiat Monies

commodity monies Items used as money that also have intrinsic value in some other use.

fiat, or token, money Items designated as money that are intrinsically worthless.

legal tender Money that a government has required to be accepted in settlement of debts.

currency debasement The decrease in the value of money that occurs when its supply is increased rapidly.

68 of 31


Measuring the Supply of Money in the United States

M1, or transactions money Money that can bedirectly used for transactions.

M1: Transactions Money

M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

69 of 31


Measuring the Supply of Money in the United States

near monies Close substitutes for transactions money, such as savings accounts and money market accounts.

M2: Broad Money

M2, or broad money M1 plus savings accounts, money market accounts, and other near monies.

M2 ≡ M1 + Savings accounts + Money market accounts + Other near monies

70 of 31

How Banks Create Money

The Money Multiplier

An increase in bank reserves leads to a greater than one-for-one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier.

money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio.

ratio reserve required

1 multiplier money

71 of 31

How the Federal Reserve Controls the Money Supply

If the Fed wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves.

Three tools are available to the Fed for changing the money supply:

(1) changing the required reserve ratio,

(2) changing the discount rate, and

(3) engaging in open market operations.

72 of 31


The Required Reserve Ratio

Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency + deposits) increases. The reverse is also true: If the Fed wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply.

73 of 31


The Discount Rate

discount rate The interest rate that banks pay to the Fed to borrow from it.

moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed.

74 of 31


Open Market Operations

open market operations The purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

75 of 31


Open Market Operations

Two Branches of Government Deal in Government Securities

The Treasury Department is responsible for collecting taxes and paying the federal government’s bills.

The Fed is not the Treasury. Instead, it is a quasi-independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market.

76 of 23

The Demand for Money

transaction motive The main reason that people hold money—to buy things.

The Transaction Motive

When we speak of the demand for money, we are concerned with how much of your financial assets you want to hold in the form of money, which does not earn interest, versus how much you want to hold in interest-bearing securities, such as bonds.

77 of 23


nonsynchronization of income and spending The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.


78 of 23



The quantity of money demanded (the amount of money households and firms want to hold) is a function of the interest rate. Because the interest rate is the opportunity cost of holding money balances, increases in the interest rate reduce the quantity of money that firms and households want to hold and decreases in the interest rate increase the quantity of money that firms and households want to hold.

FIGURE 11.4 The Demand Curve for Money Balances

79 of 23


The Speculation Motive

speculation motive One reason for holding bonds instead of money: Because the market price of interest-bearing bonds is inversely related to the interest rate, investors may want to hold bonds when interest rates are high with the hope of selling them when interest rates fall.

80 of 23


The Total Demand for Money

The total quantity of money demanded in the economy is the sum of the demand for checking account balances and cash by both households and firms.

At any given moment, there is a demand for money—for cash and checking account balances. Although households and firms need to hold balances for everyday transactions, their demand has a limit. For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.

81 of 23


The Effects of Income and the Price Level on the Demand for Money

TABLE 11.1 Determinants of Money Demand

1. The interest rate: r (The quantity of money demanded is a negative function of the interest rate.)

2. The dollar volume of transactions

a. Aggregate output (income): Y (An increase in Y shifts the money demand curve to the right.)

b. The price level: P (An increase in P shifts the money demand curve to the right.)

The amount of money needed by firms and households to facilitate their day-to-day transactions also depends on the average dollar amount of each transaction. In turn, the average amount of each transaction depends on prices, or instead, on the price level.

82 of 23

The Equilibrium Interest Rate

We are now in a position to consider one of the key questions in macroeconomics :

How is the interest rate determined in the economy?

The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

83 of 23


Supply and Demand in the Money Market

Equilibrium exists in the money market when the supply of money is equal to the demand for money and thus when the supply of bonds is equal to the demand for bonds.At r0 the price of bonds would be bid up (and thus the interest rate down), and at r1 the price of bonds would be bid down (and thus the interest rate up).

FIGURE 11.6 Adjustments in the Money Market

84 of 23


Changing the Money Supply to Affect the Interest Rate

FIGURE 11.7 The Effect of an Increase in the Supply of Money on the Interest Rate

An increase in the supply of money from to lowers the rate of interest from 7 percent to 4 percent.

85 of 23


Increases in Y and Shifts in the Money Demand Curve

FIGURE 11.8 The Effect of an Increase in Income on the Interest Rate

An increase in aggregate output (income) shifts the money demand curve from to , which raises the equilibrium interest rate from 4 percent to 7 percent.

86 of 23

Looking Ahead: The Federal Reserve and Monetary Policy

tight monetary policy Fed policies that contract the money supply and thus raise interest rates in an effort to restrain the economy.

easy monetary policy Fed policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy.

87 of 37

Aggregate Demand in the Goods and Money Markets

goods market The market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined.

money market The market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.

88 of 37

Planned Investment and the Interest Rate

Planned investment spending is a negative function of the interest rate. An increase in the interest rate from 3 percent to 6 percent reduces planned investment from I0 to I1.

FIGURE 12.1 Planned Investment Schedule

89 of 37


Other Determinants of Planned Investment

The assumption that planned investment depends only on the interest rate is obviously a simplification, just as is the assumption that consumption depends only on income. In practice, the decision of a firm on how much to invest depends on, among other things, its expectation of future sales.

The optimism or pessimism of entrepreneurs about the future course of the economy can have an important effect on current planned investment. Keynes used the phrase animal spirits to describe the feelings of entrepreneurs, and he argued that these feelings affect investment decisions.

90 of 37


Planned Aggregate Expenditure and the Interest Rate

We can use the fact that planned investment depends on the interest rate to consider how planned aggregate expenditure (AE) depends on the interest rate.

Recall that planned aggregate expenditure is the sum of consumption, planned investment, and government purchases.

AE ≡ C + I + G

91 of 37



An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium income from Y0 to Y1.

FIGURE 12.2 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure

92 of 37



The effects of a change in the interest rate include:

A high interest rate (r) discourages planned investment (I).

Planned investment is a part of planned aggregate expenditure (AE).

Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of income falls.

Finally, a decrease in planned aggregate expenditure lowers equilibrium output (income) (Y) by a multiple of the initial decrease in planned investment.

93 of 37



Using a convenient shorthand:

r I AE Y

r I AE Y

94 of 37

Equilibrium in Both the Goods and Money Markets

An increase in the interest rate (r) decreases output (Y) in the goods market because an increase in r lowers planned investment.

When income (Y) increase, this shifts the money demand curve to the right, which increases the interest rate (r) with a fixed money supply. We can thus write:

rMY

rMYd

d

95 of 37

Equilibrium in Both the Goods and Money Markets

Planned investment depends on the interest rate, and money demand depends on aggregate output.

FIGURE 12.3 Links Between the Goods Market and the Money Market

96 of 37

Policy Effects in the Goods and Money Markets

Expansionary Policy Effects

expansionary fiscal policy An increase ingovernment spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y).

expansionary monetary policy An increase in the money supply aimed at increasing aggregate output (income) (Y).

97 of 37



crowding-out effect The tendency for increases in government spending to cause reductions in private investment spending.

Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T)

98 of 37




An increase in government spending G from G0 to G1 shifts the planned aggregate expenditure schedule from 1 to 2. The crowding-out effect of the decrease in planned investment (brought about by the increased interest rate) then shifts the planned aggregate expenditure schedule from 2 to 3.

FIGURE 12.4 The Crowding-Out Effect

99 of 37




interest sensitivity or insensitivity of planned investment The responsiveness of planned investment spending to changes in the interest rate. Interest sensitivity means that planned investment spending changes a great deal in response to changes in the interest rate; interest insensitivity means little or no change in planned investment as a result of changes in the interest rate.

Effects of an expansionary fiscal policy:

increase not did if than less increases rY

IrMYG d

100 of 37



Expansionary Monetary Policy: An Increase in the Money Supply

Effects of an expansionary monetary policy:

increase not did if than less decreases d

Mr

ds MYIrM

101 of 37


Contractionary Policy Effects

Contractionary Fiscal Policy: A Decrease in Government Spending (G) or an Increase in Net Taxes (T)

contractionary fiscal policy A decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y).

Effects of a contractionary fiscal policy:

decrease not did if than less decreases

or

rY

IrMYTG d

102 of 37


The Macroeconomic Policy Mix

policy mix The combination of monetary and fiscal policies in use at a given time.

TABLE 12.1 The Effects of the Macroeconomic Policy Mix

Fiscal Policy

MonetaryPolicy

)or (

ryExpansiona

TG )or (

naryContractio

TG

)(

ryExpansionasM

)(

naryContractiosM

CIrY ?,?,, ?,,?, CIrY

?,,?, CIrY CIrY ?,?,,

moves. variable the way which specify

cannot we n,informatio additional Without .directions different in variable the push Forces :?

decreases. Variable :

increases. Variable

:Key

:

103 of 37

The Aggregate Demand (AD) Curve

aggregate demand The total demand for goods and services in the economy.

aggregate demand (AD) curve A curve that shows the negative relationship between aggregate output (income) and the price level. Each point on the AD curve is a point at which both the goods market and the money market are in equilibrium.

104 of 37


This figure shows that when P increases, Y decreases.

FIGURE 12.5 The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and Ms

105 of 37


At all points along the AD curve, both the goods market and the money market are in equilibrium. The policy variables G, T, and Ms are fixed.

FIGURE 12.6 The Aggregate Demand (AD) Curve

106 of 37


The Aggregate Demand Curve: A Warning

It is important that you realize what the aggregate demand curve represents.

The aggregate demand curve is more complex than a simple individual or market demand curve. The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy.

To understand what the aggregate demand curve represents, you must understand the interaction between the goods market and the money markets.

107 of 37


Other Reasons for a Downward-Sloping Aggregate Demand Curve

The Consumption Link

The consumption link provides another reason for the AD curve’s downward slope.

An increase in the price level increases the demand for money, which leads to an increase in the interest rate, which leads to a decrease in consumption (as well as planned investment), which leads to a decrease in aggregate output (income).

108 of 37



The Consumption Link

The initial decrease in consumption (brought about by the increase in the interest rate) contributes to the overall decrease in output.

Planned investment does not bear all the burden of providing the link from a higher interest rate to a lower level of aggregate output.

Decreased consumption brought about by a higher interest rate also contributes to this effect.

109 of 37



The Real Wealth Effect

real wealth, or real balance, effect The change in consumption brought about by a change in real wealth that results from a change in the price level.

110 of 37


Aggregate Expenditure and Aggregate Demand

At equilibrium, planned aggregate expenditure (AE ≡ C + I + G) and aggregate output (Y) are equal:

equilibrium condition: C + I + G = Y

111 of 37


Shifts of the Aggregate Demand Curve

An increase in the money supply (Ms) causes the aggregate demand curve to shift to the right, from AD0

to AD1. This shift occurs because the increase in Ms lowers the interest rate, which increases planned investment (and thus planned aggregate expenditure). The final result is an increase in output at each possible price level.

FIGURE 12.7 The Effect of an Increase in Money Supply on the AD Curve

112 of 37



An increase in government purchases (G) or a decrease in net taxes (T) causes the aggregate demand curve to shift to the right, from AD0 to AD1. The increase in G increases planned aggregate expenditure, which leads to an increase in output at each possible price level. A decrease in T causes consumption to rise. The higher consumption then increases planned aggregate expenditure, which leads to an increase in output at each possible price level.

FIGURE 12.8 The Effect of an Increase in Government Purchases or a Decrease in Net Taxes on the AD Curve

113 of 37



FIGURE 12.9 Factors That Shift the Aggregate Demand Curve

114 of 37

THE IS-LM DIAGRAM

A P P E N D I X A

THE IS-LM DIAGRAM

•The IS-LM diagram is a way of depicting graphically the determination of aggregate output (income) and the interest rate in the goods and money markets.

The point at which the IS and LM curves intersect corresponds to the point at which both the goods market and the money market are in equilibrium. The equilibrium values of aggregate output and the interest rate are Y0 and r0.

FIGURE 12A.3 The IS-LM Diagram

115 of 37

THE IS-LM DIAGRAM

A P P E N D I X A

THE IS-LM DIAGRAM

When G increases, the IS curve shifts to the right. This increases the equilibrium value of both Y and r.

FIGURE 12A.4 An Increase in Government Purchases (G)

116 of 37

THE IS-LM DIAGRAM

A P P E N D I X A

THE IS-LM DIAGRAM

When Ms increases, the LM curve shifts to the right. This increases the equilibrium value of Y and decreases the equilibrium value of r.

FIGURE 12A.5 An Increase in the Money Supply (Ms)

117 of 25

The Aggregate Supply Curve

aggregate supply The total supply of all goods and services in an economy.

aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.

The Aggregate Supply Curve: A Warning

An “aggregate supply curve” in the traditional sense of the word supply does not exist. What does exist is what we might call a “price/output response” curve—a curve that traces out the price decisions and output decisions of all firms in the economy under a given set of circumstances.

118 of 25


Aggregate Supply in the Short Run

In the short run, the aggregate supply curve (the price/output response curve) has a positive slope.At low levels of aggregate output, the curve is fairly flat.As the economy approaches capacity, the curve becomes nearly vertical.At capacity, the curve is vertical.

FIGURE 13.1 The Short-Run Aggregate Supply Curve

119 of 25


Shifts of the Short-Run Aggregate Supply Curve

cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve.

FIGURE 13.2 Shifts of the Short-Run Aggregate Supply Curve

120 of 25

The Equilibrium Price Level

equilibrium price level The price level at which the aggregate demand and aggregate supply curves intersect.

At each point along the AD curve, both the money market and the goods market are in equilibrium. Each point on the AS curve represents the price/ output decisions of all the firms in the economy. P0 and Y0 correspond to equilibrium in the goods market and the money market and to a set of price/output decisions on the part of all the firms in the economy.

FIGURE 13.3 The Equilibrium Price Level

121 of 25

The Long-Run Aggregate Supply Curve

When the AD curve shifts from AD0 to AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1.Wages respond in the longer run, shifting the AS curve from AS0 to AS1.If wages fully adjust, output will be back at Y0. Y0 is sometimes called potential GDP.

FIGURE 13.4 The Long-Run Aggregate Supply Curve

122 of 25


The Simple “Keynesian” Aggregate Supply Curve

One view of the aggregate supply curve, the simple “Keynesian” view, holds that at any given moment, the economy has a clearly defined capacity, or maximum, output.

With planned aggregate expenditure of AE1 and aggregate demand of AD1, equilibrium output is Y1. A shift of planned aggregate expenditure to AE2, corresponding to a shift of the AD curve to AD2, causes output to rise but the price level to remain at P1. If planned aggregate expenditure and aggregate demand exceed YF, however, there is an inflationary gap and the price level rises to P3.

123 of 25


Potential GDP

potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation.

Short-Run Equilibrium Below Potential Output

Although different economists have different opinions on how to determine whether an economy is operating at or above potential output, there is general agreement that there is a maximum level of output (below the vertical portion of the short-run aggregate supply curve) that can be sustained without inflation.

124 of 25

Monetary and Fiscal Policy Effects

Aggregate demand can shift to the right for a number of reasons, including an increase in the money supply, a tax cut, or an increase in government spending. If the shift occurs when the economy is on the nearly flat portion of the AS curve, the result will be an increase in output with little increase in the price level from point A to point A’.

FIGURE 13.5 A Shift of the Aggregate Demand Curve When the Economy Is on the Nearly Flat Part of the AS Curve

125 of 25


If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be an increase in the price level with little increase in output from point B to point B’.

FIGURE 13.6 A Shift of the Aggregate Demand Curve When the Economy Is Operating at or Near Maximum Capacity

126 of 25


Long-Run Aggregate Supply and Policy Effects

It is important to realize that if the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output in the long run.

The conclusion that policy has no effect on aggregate output in the long run is perhaps startling.

127 of 25

Causes of Inflation

Demand-Pull Inflation

demand-pull inflation Inflation that is initiated by an increase in aggregate demand.

128 of 25

Causes of Inflation

Cost-Push, or Supply-Side, Inflation

An increase in costs shifts the AS curve to the left. By assuming the government does not react to this shift, the AD curve does not shift, the price level rises, and output falls.

FIGURE 13.7 Cost-Push, or Supply-Side, Inflation

cost-push, or supply-side, inflation Inflation caused by an increase in costs.

129 of 25

Causes of Inflation

Cost-Push, or Supply-Side, Inflation

A cost shock with no change in monetary or fiscal policy would shift the aggregate supply curve from AS0 to AS1, lower output from Y0 to Y1, and raise the price level from P0 to P1.Monetary or fiscal policy could be changed enough to have the AD curve shift from AD0 to AD1. This policy would raise aggregate output Y again, but it would raise the price level further, to P2.

FIGURE 13.8 Cost Shocks Are Bad News for Policy Makers

stagflation Occurs when output is falling at the same time that prices are rising.

130 of 25

Causes of Inflation

Expectations and Inflation

When firms are making their price/output decisions, their expectations of future prices may affect their current decisions. If a firm expects that its competitors will raise their prices, in anticipation, it may raise its own price.

Given the importance of expectations in inflation, the central banks of many countries survey consumers about their expectations.

131 of 25

Causes of Inflation

Money and Inflation

An increase in G with the money supply constant shifts the AD curve from AD0 to AD1. Although not shown in the figure, this leads to an increase in the interest rate and crowding out of planned investment. If the Fed tries to keep the interest rate unchanged by increasing the money supply, the AD curve will shift farther and farther to the right. The result is a sustained inflation, perhaps even hyperinflation.

FIGURE 13.9 Sustained Inflation From an Initial Increase in G and Fed Accommodation

132 of 25

Causes of Inflation

Sustained Inflation as a Purely Monetary Phenomenon

Virtually all economists agree that an increase in the price level can be caused by anything that causes the AD curve to shift to the right or the AS curve to shift to the left.

It is also generally agreed that for a sustained inflation to occur, the Fed must accommodate it.

In this sense, a sustained inflation can be thought of as a purely monetary phenomenon.

133 of 25

The Behavior of the Fed

FIGURE 13.10 Fed Behavior

134 of 25


Controlling the Interest Rate

The buying and selling of government securities by the Fed has two effects at the same time: It changes the money supply, and it changes the interest rate.

How much the interest rate changes depends on the shape of the money demand curve. The steeper the money demand curve, the larger the change in the interest rate for a given size change in government securities.

If the Fed wants to achieve a particular value of the money supply, it must accept whatever interest rate value is implied by this choice. Conversely, if the Fed wants to achieve a particular value of the interest rate, it must accept whatever money supply value is implied by this.

135 of 25


The Fed’s Response to the State of the Economy

During periods of low output/low inflation, the economy is on the relatively flat portion of the AS curve. In this case, the Fed is likely to lower the interest rate (and thus expand the money supply). This will shift the AD curve to the right, from AD0 to AD1, and lead to an increase in output with very little increase in the price level.

FIGURE 13.11 The Fed’s Response to Low Output/Low Inflation

136 of 25


The Fed’s Response to the State of the Economy

During periods of high output/high inflation, the economy is on the relatively steep portion of the AS curve. In this case, the Fed is likely to increase the interest rate (and thus contract the money supply).This will shift the AD curve to the left, from AD0 to AD1, and lead to a decrease in the price level with very little decrease in output.

FIGURE 13.12 The Fed’s Response to High Output/High Inflation

137 of 25


Fed Behavior Since 1970

The Fed generally had high interest rates in the two inflationary periods and low interest rates from the mid 1980s on. It aggressively lowered interest rates in the 1990 IV–1991 I and 2001 I–2001 III recessions. Output is the percentage deviation of real GDP from its trend. Inflation is the 4-quarter average of the percentage change in the GDP deflator. The interest rate is the 3- month Treasury bill rate.

FIGURE 13.13 Output, Inflation, and the Interest Rate 1970 I–2007 IV

138 of 25


Inflation Targeting

inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon.

Rising Food Prices Worry Central Banks Around the WorldFood Prices Worry Central Bankers

Wall Street Journal

139 of 29

The Labor Market: Basic Concepts

frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems.

structural unemployment The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries.

cyclical unemployment The increase in unemployment that occurs during recessions and depressions.

140 of 29

The Classical View of the Labor Market

labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate.

labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate.

141 of 29


Classical economists believe that the labor market always clears. If the demand for labor shifts from D0 to D1, the equilibrium wage will fall from W0 to W1. Anyone who wants a job at W1 will have one.

FIGURE 14.1 The Classical Labor Market

142 of 29


The Classical Labor Market and the Aggregate Supply Curve

The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. This means that the AS curve is vertical.

When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy.

143 of 29


The Unemployment Rate and the Classical View

The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly.

The measured unemployment rate may sometimes seem high even though the labor market is working well.

144 of 29

Explaining the Existence of Unemployment

Sticky Wages

sticky wages The downward rigidity of wages as an explanation for the existence of unemployment.

If wages “stick” at W0 instead of falling to the new equilibrium wage of W* following a shift of demand from D0 to D1, the result will be unemployment equal to L0 - L1.

FIGURE 14.2 Sticky Wages

145 of 29


Sticky Wages

social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages.

Social, or Implicit, Contracts

relative-wage explanation of unemployment An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts.

146 of 29


Sticky Wages

explicit contracts Employment contracts thatstipulate workers’ wages, usually for a period of 1 to 3 years.

Explicit Contracts

cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised.

147 of 29


Sticky Wages

Explicit Contracts

Graduate School Applications in Recessions

Graduate School Offers Relief During Economic Recession

Oklahoma Daily (U. Oklahoma)

148 of 29


Efficiency Wage Theory

efficiency wage theory An explanation forunemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate.

149 of 29


Imperfect Information

Firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information.

If firms have imperfect or incomplete information, they may set wages wrong—wages that do not clear the labor market.

150 of 29


Minimum Wage Laws

minimum wage laws Laws that set a floor for wage rates—that is, a minimum hourly rate for any kind of labor.

An Open Question

The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment.

151 of 29

The Short-Run Relationship Betweenthe Unemployment Rate and Inflation

The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y).

FIGURE 14.3 The Aggregate Supply Curve

In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related.

152 of 29


This curve shows a negative relationship between the price level (P) and the unemployment rate (U). As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the price level rises more and more.

FIGURE 14.4 The Relationship Between the Price Level and the Unemployment Rate

153 of 29


inflation rate The percentage change in the price level.

Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate.

154 of 29


The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

FIGURE 14.5 The Phillips Curve

155 of 29


During the 1960s, there seemed to be an obvious trade-off between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off.

FIGURE 14.6 Unemployment and Inflation, 1960–1969

The Phillips Curve: A Historical Perspective

156 of 29


From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.

FIGURE 14.7 Unemployment and Inflation, 1970–2007

The Phillips Curve: A Historical Perspective

157 of 29


Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply

158 of 29


Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve

FIGURE 14.9 The Price of Imports, 1960 I–2007 IV

The Role of Import Prices

159 of 29


Expectations and the Phillips Curve

Expectations are self-fulfilling. This means that wage inflation is affected by expectations of future price inflation.

Price expectations that affect wage contracts eventually affect prices themselves.

Inflationary expectations shift the Phillips Curve to the right.

160 of 29


Is There a Short-Run Trade-Off between Inflation and Unemployment?

There is a short-run trade-off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves more than simply choosing a point along a nice smooth curve.

161 of 29

The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment

If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemployment—that is, the unemployment rate that is consistent with the notion of a fixed long-run output at potential output. U* is the natural rate of unemployment.

FIGURE 14.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment

162 of 31

Time Lags Regarding Monetary and Fiscal Policy

stabilization policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible.

time lags Delays in the economy’s response to stabilization policies.

163 of 31


Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A.

FIGURE 15.1 Two Possible Time Paths for GDP

164 of 31


Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. Hence, the policy pushes the economy to points E1, and F1, (instead of points E and F). Income varies more widely than it would have if no policy had been implemented.

FIGURE 15.2 Possible Stabilization Timing Problems

Stabilization

165 of 31


Recognition Lags

recognition lag The time it takes for policy makers to recognize the existence of a boom or a slump.

implementation lag The time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump.

Implementation Lags

166 of 31


Response Lags

response lag The time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself.

167 of 31


Response Lags

Response Lags for Fiscal Policy

Neither individuals nor firms revise their spending plans instantaneously. Until they can make those revisions, extra government spending does not stimulate extra private spending.

Monetary policy works by changing interest rates, which then change planned investment.

The response of consumption and investment to interest rate changes takes time.

Response Lags for Monetary Policy

168 of 31


Response Lags

Summary

Stabilization is not easily achieved. It takes time for policy makers to recognize the existence of a problem, more time for them to implement a solution, and yet more time for firms and households to respond to the stabilization policies taken.

169 of 31

Fiscal Policy: Deficit Targeting

Gramm-Rudman-Hollings Act Passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991.

The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion per year. If the plan had worked, a zero deficit would have been achieved by 1991.

FIGURE 15.3 Deficit Reduction Targets under Gramm-Rudman-Hollings

170 of 31


deficit response index (DRI) The amount by which the deficit changes with a $1 change in GDP.

The Effects of Spending Cuts on the Deficit

A cut in government spending causes the economy to contract. Both the taxable income of households and the profits of firms fall.

The deficit tends to rise when GDP falls, and tends to fall when GDP rises.

171 of 31


The Effects of Spending Cuts on the Deficit

Monetary Policy to the Rescue?

A zero multiplier can come about through renewed optimism on the part of households and firms or through very aggressive behavior on the part of the Fed, but because neither of these situations is very plausible, the multiplier is likely to be greater than zero. Thus, it is likely that to lower the deficit by a certain amount, the cut in government spending must be larger than that amount.

172 of 31


Economic Stability and Deficit Reduction

negative demand shock Something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports.

automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP.

automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP.

173 of 31


Economic Stability and Deficit Reduction

Deficit targeting changes the way the economy responds to negative demand shocks because it does not allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have otherwise occurred.

FIGURE 15.4 Deficit Targeting as an Automatic Destabilizer

174 of 31


Summary

It is clear that the GRH legislation, the balanced-budget amendment, and similar deficit targeting measures have some undesirable macroeconomic consequences.

Locking the economy into spending cuts during periods of negative demand shocks, as deficit-targeting measures do, is not a good way to manage the economy.

175 of 27

Long-Run Growth

economic growth An increase in the total output of an economy.

modern economic growth The period of rapid and sustained increase in output that began in the Western world with the Industrial Revolution.

176 of 27

The Growth Process: From Agriculture to Industry

The production possibility frontier shows all the combinations of output that can be produced if all society’s scarce resources are fully and efficiently employed. Economic growth expands society’s production possibilities, shifting the ppf up and to the right.

FIGURE 17.1 Economic Growth Shifts Society’s Production Possibility Frontier Up and to the Right

177 of 27


Beginning in England around 1750, technical change and capital accumulation increased productivity significantly in two important industries: agriculture and textiles.

More could be produced with fewer resources, leading to new products, more output, and wider choice.

A rural agrarian society was very quickly transformed into an urban industrial society.

From Agriculture to Industry: The Industrial Revolution

178 of 27


Economic growth continues today, and while the underlying process is still the same, the face is different.

Growth comes from a bigger workforce and more productive workers. Higher productivity comes from tools (capital), a better-educated and more highly skilled workforce (human capital), and increasingly from innovation and technical change (new techniques of production) and newly developed products and services.

Growth in Modern Society

179 of 27


Growth Patterns and the Possibility of Catch-Up

TABLE 17.1 Growth of Real GDP: 1999-2007

CountryAverage Growth RatePer Year, 1999-2007

United States 2.7

Japan 1.5

Germany 1.5

France 2.1

United Kingdom 2.7

China 9.6

India 7.0

Africa (continent) 4.5

Republic of South Africa (2002-2007) 3.9

Cameroon (2002-2007) 4.0

Zimbabwe (2007-2007) 1.0Source: Economic Report of the President, 2008.

180 of 27


catch-up The theory stating that the growth rates of less developed countries will exceed the growth rates of developed countries, allowing the less developed countries to catch up.

Growth Patterns and the Possibility of Catch-Up

181 of 27

The Sources of Economic Growth

aggregate production function The mathematical representation of the relationship between inputs and national output, or gross domestic product.

An increase in GDP can come about through

1. An increase in the labor supply.

2. An increase in physical or human capital.

3. An increase in productivity (the amount of product produced by each unit of capital or labor).

182 of 27


An Increase in Labor Supply

labor productivity Output per worker hour; the amount of output produced by an average worker in 1 hour.

TABLE 17.2 Economic Growth from an Increase in Labor—More Output but Diminishing Returns and Lower Labor Productivity

Period

QuantityOf Labor

L(Hours)

QuantityOf Capital

K(Units)

TotalOutput

Y(Units)

MeasuredLabor

ProductivityY/L

1 100 100 300 3.0

2 110 100 320 2.9

3 120 100 339 2.8

4 130 100 357 2.7

183 of 27


An Increase in Labor Supply

TABLE 17.3 Employment, Labor Force, and Population Growth, 1947–2007

CivilianNoninstitutional

PopulationOver 16 Years Old

(Millions)

CivilianLaborForce

Employment(Millions)

Number(Millions)

PercentageOf

Population

1947 101.8 59.4 58.3 57.01960 117.3 69.6 59.3 65.81970 137.1 82.8 60.4 78.71980 167.7 106.9 63.7 99.31990 189.2 125.8 66.5 118.82000 212.6 142.6 67.1 136.92007 231.9 153.1 66.0 146.0Percentage change, 1947–2007 + 127.8% + 157.7% + 156.1%Annual rate + 1.4% +1.6% + 1.6%

Source: Economic Report of the President, 2008, Table B-35.

184 of 27


Increases in Physical Capital

TABLE 17.4 Economic Growth from an Increase in Capital—More Output, Diminishing Returns to Added Capital, Higher Measured Labor Productivity

Period

QuantityOf Labor

L(Hours)

QuantityOf Capital

K(Units)

TotalOutput

Y(Units)

MeasuredLabor

ProductivityY/L

1 100 100 300 3.0

2 100 110 310 3.1

3 100 120 319 3.2

4 100 130 327 3.3

185 of 27



TABLE 17.5 Fixed Private Nonresidential Net Capital Stock, 1960–2006 (Billions of 2000 Dollars)

Equipment Structures

1960 645.7 2,273.3

1970 1,108.5 3,094.8

1980 1,910.0 4,047.7

1990 2,613.3 5,304.5

2000 4,090.5 6,301.6

2006 4,841.8 6,776.9

Percentage change, 1960–2006 +649.9% +198.1%

Annual rate +4.4% + 2.4%

Source: Survey of Current Business, September 2007, Table 15, p. 32 and author’s estimates.

186 of 27



Role of Institutions in Attracting Capital

foreign direct investment (FDI) Investment in enterprises made in a country by residents outside that country.

187 of 27


Increases in Human Capital

TABLE 17.6 Years of School Completed by People Over 25 Years Old, 1940–2006

Percentage With LessThan 5 Years Of

School

Percentage With 4 Years Of High School

Or More

Percentage With 4 Years Of College

Or More

1940 13.7 24.5 4.61950 11.1 34.3 6.2

1960 8.3 41.1 7.71970 5.5 52.3 10.71980 3.6 66.5 16.21990 NA 77.6 21.32000 NA 84.1 25.62006 NA 85.5 28.0

NA = not available.Source: Statistical Abstract of the United States, 1990, Table 215; and 2008, Table 217.

188 of 27


Increases in Productivity

Technological Change

productivity of an input The amount of output produced per unit of an input.

invention An advance in knowledge.

innovation The use of new knowledge to produce a new product or to produce an existing product more efficiently.

189 of 27


Increases in Productivity

Economies of Scale

External economies of scale are cost savings that result from increases in the size of industries.

In addition to technological change, other advances in knowledge, and economies of scale, other forces may affect productivity.

Other Influences on Productivity

190 of 27

Growth and Productivity in the United States

TABLE 17.7 Growth of Real GDP in the United States, 1871–2000

PeriodAverage Growth

Rate Per Year PeriodAverage Growth

Rate Per Year

1871-1889 5.5 1950-1960 3.5

1889-1909 4.0 1960-1970 4.2

1909-1929 2.8 1970-1980 3.2

1929-1940 1.6 1980-1990 3.2

1940-1950 5.6 1990-2000 3.2

Sources: Historical Statistics of the United States: Colonial Times to 1970, Tables F47-70, F98-124; U.S. Department of Commerce, Bureau of Economic Analysis.

191 of 27


Sources of Growth in the U.S. Economy

TABLE 17.8 Sources of Growth in the United States, 1929–1982

Percent Of Growth Attributable To Each Source

1929 – 1982 1929 – 1948 1948 – 1973 1973 – 1979

Increases in inputs 53 49 45 94

Labor 20 26 14 47

Capital 14 3 16 29

Education (human capital)

19 20 15 18

Increases in productivity 47 51 55 6

Advances in knowledge 31 30 39 8

Other factorsa 16 21 16 2

Annual growth rate in 2.8 2.4 3.6 2.6real national income

aEconomies of scale, weather, pollution abatement, worker safety and health, crime, labor disputes, and so forth.Source: Edward Denison, Trends in American Economic Growth, 1929–1982 (Washington: Brookings Institution, 1985). Reprinted with permission of The Brookings Institution.

192 of 27


Sources of Growth in the U.S. Economy

TABLE 17.9 Sources of U.S. Growth, 1995-2004

Percent Contribution 1995-2004

Increases in inputs 71.6

Labor 20.6

Capital 50.7

IT capital 22.8

Non-IT capital 27.9

Increases in productivity 28.4

Source: Information Technology and the American Growth Resurgence. Dale W. Jorgenson, Mun S. Ho and Kevin J. Stiroh (Cambridge, MA: MIT Press, 2005). Data update provided by the authors.

193 of 27

Economic Growth and Public Policy in the United States

Suggested Public Policies

Policies to Improve the Quality of Education

Policies to Increase the Saving Rate

Policies to Stimulate Investment

Policies to Increase Research and Development

Industrial Policy

Can We Really Measure Productivity Changes?One of the leading experts on technology and productivity estimates that we have reasonably good measures of output and productivity in only about 31 percent of the U.S. economy.

194 of 27

Growth and the Environment and Issues of Sustainability

TABLE 17.10 Environmental Scores in the World Bank Country Policy and Institutional Assessment 2005 Scores (min = 1, max = 6)

Albania 3

Angola 2.5

Bhutan 4.5

Cambodia 2.5

Cameroon 4

Gambia 3

Haiti 2.5

Madagascar 4

Mozambique 3

Papua New Guinea 1.5

Sierra Leone 2.5

Sudan 2.5

Tajikistan 2.5

Uganda 4

Vietnam 3.5

Zimbabwe 2.5Source: World Bank, “Policies and Institutions for Environmental Sustainability.”

195 of 27


One measure of air pollution is smoke in cities. The relationship between smoke concentration and per-capita GDP is an inverted U: As countries grow wealthier, smoke increases and then declines.

FIGURE 17.3 The Relationship Between Per-Capita GDP and Urban Air Pollution

196 of 27


Sustainability of Resource Extraction Growth Strategies

Much of Southeast Asia has fueled its growth through export-led manufacturing. For countries that have based their growth on resource extraction, there is another set of potential sustainability issues.

Because extraction can be accomplished without a well-educated labor force, while other forms of development are more dependent on a skilled- labor base, public investment in infrastructure is especially important.

Documents

Review of Macroeconomics. 2 of 38 THE ROOTS OF MACROECONOMICS Great Depression The period of severe economic contraction and high unemployment that began