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Chapter 7 Macroeconomists are concerned with the economy’s long-run growth potential, and with short-run economic fluctuations in growth. Policies that can help us smooth economic fluctuations may prove harmful to long-run growth, and vice versa. The classical model says that, although output may fluctuate around its trend for short periods of time, there are powerful forces at work that drive the economy toward full employment. During the Great Depression, however, output was stuck far below potential for many years, and it seemed that the economy wasn’t working the way the classical model said it should. John Maynard Keynes developed a new model of the economy, arguing that the classical model may explain the economy’s operation in the long run, but that the long run may be very long indeed. By the mid-1960s, the entire profession had been won over to Keynesian economics, and the classical model was removed from virtually all introductory economics textbooks. The classical model is still very useful, however, for two reasons. First, it helps us under-stand the “counter-revolution,” based heavily on classical ideas, against Keynes’s approach. Second, the classical model is very useful in understanding the economy over the long run. A critical assumption in the classical model is that markets clear: The price in any market will adjust until quantity supplied and quantity demanded are equal. This assumption allows us to answer a variety of important questions about the economy in the long run. In the classical view, all production arises from one source: our desires for goods and services. We supply labor and other factors to firms in factor markets in order to earn income so we can buy goods and services. The labor supply curve tells us how many people will want to work at each wage. The labor demand curve shows the number of workers firms will want to hire at any real wage. In the classical view, all markets clear, including the market for labor. As long as we can count on markets (including the labor market) to clear, the economy achieves full employment on its own and government action is not needed. The aggregate production function shows the total output the economy can produce with different quantities of labor, for given amounts of land and capital and a given state of technology. The aggregate production function, together with the labor market, determines the economy’s total output. In the classical, long-run view, the economy reaches its potential output automatically. Say’s law says that in a simple economy with just households and firms in which households spend all of their income, total spending must be equal to total output. The circular flow diagram illustrates this law. In the aggregate, we needn’t worry about there being sufficient total demand for the total output produced, because supply creates its own demand. Leakages (savings and net taxes) and injections (government purchases and planned investment spending) complicate this simple model in the real world, but don’t change its basic conclusion. As long as the loanable funds market clears (and classical theory says that it will), Say’s law holds. Fiscal policy is a change in government purchases or in net taxes designed to change total spending in the economy and thereby influence output and employment. In the classical view, fiscal policy is both ineffective and unnecessary. An increase in 1 government purchases, for example, is ineffective because of the crowding-out effect. An increase in government purchases completely crowds out private sector spending, so total spending remains unchanged. Chapter 8 Economic growth is an important determinant of a nation’s average standard of living. If output grows faster than the population, the average living standard will rise, but if output grows more slowly than the population, the average living standard will fall. A useful way to start thinking about long-run growth is to look at what determines our potential GDP in any given period. Real GDP depends on the amount of output the average worker can produce in an hour, the number of hours the average worker spends at the job, the fraction of the population that wants to work, and the size of the population. Ultimately, growth in real GDP—by itself—does not guarantee a rising standard of living. What matters for the standard of living is real GDP per capita—our total output of goods and services per person. To explain growth in output per person and living standards in the U.S. and other developed nations, economists look at two factors: increases in labor force participation rates and growth in productivity. Over the long run, the labor force participation rate rises when employment grows at a faster rate than the population. Growth in employment occurs when the demand for labor or the supply of labor increases. Government policies can help to increase employment. Income tax rate reductions and reductions in government transfer payments are policies that increase the supply of labor. Policies that help increase the skills of the work force (such as education and training subsidies) and policies that subsidize employment directly (such as wage subsidies) increase the demand for labor. Population growth, growth in average hours, and increases in the labor force participation rate cannot explain growth in total output—and living standards—over the long run. Over the past several decades, and into the near future, virtually all growth in the average standard of living can be attributed to growth in productivity. One key to productivity growth is the nation’s capital stock. If the capital stock grows faster than employment, then capital per worker will rise, and labor productivity will increase. But if the capital stock grows more slowly than employment, then capital per worker will fall, and labor productivity will fall as well. A government seeking to spur investment—and thereby increase the growth rate of the capital stock—can direct its efforts toward businesses, toward the household sector, or toward its own budget. Reducing business taxes or providing specific investment incentives can shift the investment curve rightward. Policies that alter the tax and transfer system can increase incentives for saving. This makes more funds available for investment, speeding growth in the capital stock. Finally, a shrinking deficit tends to reduce interest rates and increase investment, although shrinking the deficit by cutting government investment will not stimulate growth as much as would cutting spending that does not contribute to capital formation. 2 An increase in human capital—like an increase in physical capital—works to increase the average standard of living by shifting the production function upward, raising productivity. Some of the same policies that increase investment in physical capital also work to raise investment in human capital. Additionally, income tax reductions can increase the profitability of human capital to households, and increase the rate of investment in human capital. New technology also shifts the production function upward, since it enables any given number of workers to produce more output. The faster the rate of technological change, the greater the growth rate of productivity, and the faster the rise in living standards. Policies that increase research and development spending (such as patent protection, direct government spending, and tax incentives, as well as policies that stimulate investment spending in general) will increase the rate of technological change. Every measure that promotes economic growth has an opportunity cost. The costs of growth include budgetary costs, consumption costs, the opportunity costs of workers’ time, and the sacrifice of other social goals. Growth, like other desirable goals, involves a policy tradeoff. Some less-developed countries (LDCs) have had great difficulty raising living standards. Much of the explanation for these low growth rates lies with three characteristics that they share: very low current output per capita, high population growth rates, and poor infrastructure. These three characteristics interact to create a vicious circle of continuing poverty. The poorest LDCs are too poor to take advantage of the tradeoff between consumption and capital production in order to increase their living standards. Policies that can help break this circle of poverty include a forced reallocation of resources towards capital production, an increase in sacrificed consumption by the wealthy, an increase in foreign investment or foreign assistance, and a reduction in the population growth rate. Chapter 9 Actual GDP fluctuates above and below the classical model’s predictions. GDP rises in an expansion and falls in a recession. A boom is a period during which GDP exceeds its potential level. A recession is a period during which GDP is falling. The classical model cannot explain why economic fluctuations occur because it assumes that labor markets always clear. Evidence suggests that this assumption is not always valid over short time periods. Booms and recessions are periods during which the economy deviates from the normal, full-employment equilibrium of the classical model. These deviations occur due to spending shocks. A spending shock to the economy is a sudden change in spending that pushes the economy away from equilibrium. An increase in spending trigger booms, while a decrease in spending trigger recessions. Because spending shocks can cause the economy to depart from the classical equilibrium, the next several chapters will focus on the role of spending in the macroeconomy. 3 Chapter 10 The main purpose in building the short-run macro model is to explain fluctuations in real GDP that the long-run, classical model cannot explain. The short-run macro model focuses on the role of spending in explaining economic fluctuations. It explains how shocks that initially affect one sector of the economy quickly influence other sectors, causing changes in total output and employment. In this chapter, spending is the only force that determines how much output the economy will produce. The short-run macro model focuses on spending in markets for currently produced U.S. goods and services—that is, spending on things that are included in U.S. GDP. Spending has four components: (real) consumption spending, (real) investment spending, (real) government purchases, and (real) net exports. Consumption is positively related to real disposable income, real wealth, and expectations of future income, and is negatively related to the interest rate. The consumption function illustrates the relationship between consumption and disposable income. Changes in disposable income lead to movements along the consumption function. The slope of the consumption function is equal to the marginal propensity to consume, that is, the amount by which consumption spending changes when disposable income rises by one dollar. The vertical intercept represents autonomous consumption spending, the combined impact on consumption spending of everything other than disposable income. Changes in wealth, the interest rate, or expectations of future income lead to a change in autonomous consumption spending. These changes are shown graphically as a shift of the consumption schedule. The consumption-income line shows the relationship between real consumption spending and real income, rather than real disposable income. When the government collects a fixed amount of taxes from households, the consumption-income line shifts downward by the amount of the tax times the MPC. The slope of the consumptionincome line, however, is unaffected by taxes, and is equal to the MPC. A change in income causes consumption spending to change and leads to a movement along the consumption-income line, while consumption spending changes that occur for any other reason will cause the consumption-income line to shift. These other changes work by changing autonomous consumption or taxes. In the short-run macro model, (planned) investment spending includes plant and equipment purchases by business firms, and new home construction. Inventory investment is treated as unintentional and undesired, and is therefore excluded from the definition. Government purchases include all of the goods and services that government agencies buy during the year. Net exports equal exports minus imports. Export spending measures production sold to foreigners, while import spending measures our spending on foreign output. Thus, to accurately measure domestic output, we must add U.S. exports and subtract U.S. imports. These two adjustments can be made together by simply including net exports as the foreign sector’s contribution to total spending. Investment spending, government purchases, and net exports are all treated as given values, determined by forces outside of this model. Aggregate expenditure (AE) is the sum of spending by households, businesses, the government, and the foreign sector on final goods and services. Since the relationship 4 between income and spending is circular, when income increases, aggregate expenditure will rise by the MPC times the change in income. When aggregate expenditure is less than GDP, output will decline in the future. Similarly, when aggregate expenditure is greater than GDP, output will tend to rise in the future. Therefore, in the short run, equilibrium GDP is the level of output where output and aggregate expenditure are equal. Output minus aggregate expenditures equals the change in inventories during any period. When output equals aggregate expenditures, then inventory changes will equal zero, so another way to find the equilibrium GDP in the economy is to find the output level where inventory changes are equal to zero. Graphically, equilibrium GDP is found at the intersection of the aggregate expenditure line and the 45 line. At any output level where the aggregate expenditure line lies below the 45 line, aggregate expenditure is less than GDP and inventory accumulation will cause firms to reduce output in the future. At any output level where the aggregate expenditure line lies above the 45 line, aggregate expenditure is greater than GDP and inventory depletion will cause firms to increase output in the future. Operating at equilibrium does not guarantee full employment. If aggregate spending is too high or too low, the aggregate expenditure line will cross the 45 line at some output level other than full employment output, and the economy will remain at a shortrun equilibrium where full employment is not achieved. Spending shocks—changes in investment, government purchases, or autonomous consumption—lead to a multiplier effect on GDP, where the initial shock sets off a chain reaction, leading to successive rounds of changes in spending and income. The expenditure multiplier is the number by which the initial spending change is multiplied to get the change in equilibrium GDP. The formula for the expenditure multiplier is 1/(1 – MPC). Automatic stabilizers reduce the size of the multiplier, and therefore reduce the impact of spending shocks to the economy. They work by shrinking the additional spending that occurs in each round of the multiplier. Some real-world automatic stabilizers are changes in taxes, transfer payments, interest rates, imports, and forwardlooking behavior. Perhaps the most important automatic stabilizer of all is the passage of time—in the long run our multipliers have a value of zero. After any spending shock, output will eventually return to full employment, so the change in equilibrium GDP will be zero. There are several key differences between the long-run classical model and the shortrun macro model. In the classical model the economy automatically operates at potential GDP, while in the short-run macro model booms and recessions can occur. In the long run, an increase in the desire to save leads to faster economic growth and rising living standards, while in the short run it can cause a recession. Finally, fiscal policy is completely ineffective in the long run because an increase in government spending crowds out an equal amount of household spending. However, fiscal policy is effective in changing equilibrium GDP in the short run. This short run result suggests that fiscal policy could play a role in altering the path of the economy, and that such intervention is desirable. Very few economists still believe in this type of intervention, however, both because of the practical difficulties in executing fiscal policy 5 and because of the Federal Reserve’s policy of neutralizing fiscal policy changes before they have an effect on the economy. The recession of 2001 was caused by a spending shock to the economy: a decline in investment. Three reasons for the investment spending shock include an end to the rush by firms to catch up to the Internet boom, pessimism as new businesses failed and stock prices fell, and the terrorist attacks of September 11, 2001. Over time, as the multiplier process took place, the decrease in investment brought down both GDP and employment. There are two appendices to this chapter. The first explains how to use algebraic equations to find equilibrium GDP, while the second explains the special case of the tax multiplier. 6