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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
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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.
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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.
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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
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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
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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.
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