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LECTURE 8
The Big Ideas in
Macroeconomics
Real GDP U.S.
1992 $$
REAL GDP, 1930 - 1990
8,000
Source: U.S. Department of Commerce
6,000
4,000
2,000
0
1930 1935 194 0 1945 1950 1955 1960 1965 1970 1975 1975 1980 1985 1990
YEAR
U.S. REAL GDP
• The data for real GDP control for changes in
prices and thus capture movements in real output
only
• Real GDP has grown substantially over the period
graphed
• This is what economists term economic growth:
sustained increases in real production of an
economy over a period of time
• Differences in economic growth between
countries and changes in economic growth over
time are among the most important issues of
macroeconomics
GROWTH RATES
• The growth rate of a variable is the
percentage change in the variable from one
period to another
• If GDP was 100 in year 1, and 104 in year 2:
growth rate = percentage change
= change in GDP / initial GDP
= ( GDP year 2 - GDP year 1) / GDP year 1
= ( 104 - 100 ) / 100
= 4 / 100 = .04 = 4%
GROWTH RATES
• May be negative as well as positive;
• If GDP was 104 in year 1, and 100 in year 2:
growth rate = change in GDP / initial GDP
= ( GDP year 2 - GDP year 1) / GDP year 1
= ( 100 - 104 ) / 104
= - 4 / 104 = -0.38 = -3.8%
GROWTH RATES
• If we know the growth rate and the initial
GDP value, we can also calculate the GDP
for the next period
• “g’ is the growth rate,
GDP year 2 = ( 1 + g ) * GDP year 1
• GDP in the second year is 1 plus the
growth rate times GDP in the first year;
• If g = 4% and GDP in year 1 were 100,
GDP year 2 = ( 1 + 0.04) * 100 = 104
GROWTH RATES
• If the economy grew at a rate g for n years,
and the economy started at 100, the
formula for real GDP after n years would be
GDP [n years later] = ( 1 + g ) n * (100)
• If the economy starts at 100 and grows at a
rate of 4% for 10 years
GDP [10 years later] = ( 1 + 0.04 ) 10 * (100)
= 148
• This is nearly 50% higher than in the first
year.
RULE OF 70
• If you knew the constant growth rate of real
GDP but wanted to know how many years
it would take until the level of real GDP
doubled
• years to double = 70 / percentage growth
rate
• If growth rate were 5%
Years to double = 70 / 5 = 14 years
STARTING IN 1960, HOW MANY YEARS IT TOOK
FOR GDP TO DOUBLE
YEARS
25
24.0
20
19.0
17.0
15
14.0
10
8.0
5
Belgium Germany
Japan
United States Canada
GROWTH AND PRODUCTIVITY
• Economic growth in the US has slowed
down:
-- from 1950 to 1973, real GDP grew at an annual rate of
3%
-- from 1974 to 1995, real GDP grew at an annual rate of
1.9%
• The decline in growth rate of real GDP in
the US was also associated with a decline
in the growth of labour productivity.
LABOR PRODUCTIVITY
• The amount of output produced per
worker
• It gives us an idea of how much is
produced by the average worker
• Living standards can rise over time
only if more output is produced by
the average worker
PRODUCTIVITY SLOWDOWN
• Although productivity may continue to
grow during a period, it grows at a slower
rate
• This also means that wages and salaries
have not grown as fast as they had in the
past
P
P
T
T
P: peak of recessions
T: trough of recessions
Source: U.S. Department of Commerce
RECESSION
• A period when economic growth is
negative (real GDP falls) for two
consecutive quarters
• A quarter is three consecutive months
during the year
• A recession is a period when real GDP
falls for at least six months
RECESSION
Peak
• The date at which a recession
starts
Trough
• The date at which output starts
to increase again
Since World War II, the United States has
experienced nine recessions.
NINE POSTWAR RECESSIONS
Peak
Trough
November 1948
July 1953
August 1957
April 1960
December 1969
November 1973
January 1980
July 1981
July 1990
October 1949
May 1954
April 1958
February 1961
November 1970
March 1975
July 1980
November 1982
March 1991
Percent Decline in
real GDP
1.5
3.2
3.3
1.2
1.0
4.9
2.5
3.0
1.4
DEPRESSION
• A common term for a severe recession
• In the United States, the Great Depression refers
to the 1929 - 1933 period, in which real GDP fell
by over 33%
• It created the most severe economic dislocations
that the United States has experienced in the
twentieth century
• Banks closed, businesses failed, and many
people lost their life savings
• Unemployment rose sharply
• In 1933, over 25% of the people looking for work
failed to find jobs
CAUSES OF RECESSION
•
•
•
•
Changes in technology
Disruptions to the financial system
Increases in prices of key commodities
(Deliberate or inadvertent) government
policies
KEYNESIAN ECONOMICS
The study of business
cycles and economic
fluctuations that we
develop.
CLASSICAL ECONOMICS
• The study of how the economy operates at
full employment;
• Based on the principle that prices will
adjust in the long run to bring markets for
goods and labour into equilibrium;
• Classical economists believed that
economic episodes of boom and bust were
transitory and economy would return to full
employment.
SUPPLY-SIDE ECONOMICS
A school of thought that
emphasizes how changes in taxes
affect economic activity.
FULL EMPLOYMENT
• Corresponds to zero cyclical
unemployment;
• When the economy is at full
employment, the only unemployment
is frictional and structural.
AGGREGATE PRODUCTION FUNCTION
Explains the relationship of the total inputs used
throughout the economy to the level of
production in the economy or GDP.
• There are two primary factors of production:
capital and labour;
• the stock of capital comprises all the machines,
equipment and buildings in the entire economy;
• Labour consists of the effort of all workers in the
economy;
Y = F ( K,L )
Y is total output or GDP;
K is the stock of capital;
L is the labour force.
SHORT-RUN PRODUCTION
FUNCTION
Shows the relationship between
the amount of labour used in an
economy and the total level of
output with a fixed stock of capital
( K* ).
RELATIONSHIP BETWEEN LABOUR AND OUTPUT
WITH FIXED CAPITAL
Total Output
(Y)
Y1
L1
Labour Force
RELATIONSHIP BETWEEN LABOUR AND OUTPUT
WITH FIXED CAPITAL
Total Output
(Y)
Y2
Y1
L1
L2
Labour Force
RELATIONSHIP BETWEEN LABOUR AND OUTPUT
WITH FIXED CAPITAL
Total Output
(Y)
Y2
Y1
L1
L2
Labour Force
RELATIONSHIP BETWEEN LABOUR AND OUTPUT
WITH FIXED CAPITAL
Total Output
(Y)
Y2
Y1
L1
L2
Labour Force
With capital fixed, output increases with labour input but at a
decreasing rate.
PRINCIPLE OF DIMINISHING
RETURNS
Suppose output is produced with two or
more inputs and we increase one input
while holding other inputs fixed, beyond
some point -- called the point of diminishing
returns -- output will increase at a
decreasing rate.
OUTPUT AND LABOUR
INPUT
Y ( Output )
10
15
19
22
L ( Labour Input )
3
4
5
6
INCREASE IN THE STOCK OF CAPITAL
Total Output
(Y)
K*
L2
Labour Force
INCREASE IN THE STOCK OF CAPITAL
Total Output
(Y)
K*
L2
Labour Force
INCREASE IN THE STOCK OF CAPITAL
Total Output
(Y)
K*
L2
Labour Force
INCREASE IN THE STOCK OF CAPITAL
K* *
Total Output
(Y)
K*
L2
Labour Force
When capital increases from K* to K* *, the production function
shifts up; at any level of labour input, the level of output increases.
REAL WAGE RATE
The wage rate adjusted
for inflation.
DEMAND FOR LABOUR
• Firms hire labour to produce output
and make profits;
• The amount of labour they hire
depends on the real wage rate;
• Firms use the Marginal Principle in
hiring labour;
THE MARGINAL PRINCIPLE
Increase the level of activity if its
marginal benefit exceeds its marginal
cost, but reduce the level if marginal
cost exceeds the marginal benefit. If
possible, pick the level at which the
marginal benefit equals the marginal
cost.
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE
$$ / HR
REAL WAGE
$$ / HR
REAL WAGE
$$ / HR
LABOUR
LABOUR
LABOUR
Demand for Labour Supply of Labour Demand for and
Supply of Labour
A
B
C
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE
$$ / HR
10
REAL WAGE
$$ / HR
REAL WAGE
$$ / HR
10
100
50
LABOUR
LABOUR
Demand for Labour Supply of Labour
A
B
LABOUR
Demand for and
Supply of Labour
C
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE
$$ / HR
REAL WAGE
$$ / HR
20
20
10
10
REAL WAGE
$$ / HR
50
100
50
100
LABOUR
LABOUR
Demand for Labour Supply of Labour
A
B
LABOUR
Demand for and
Supply of Labour
C
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE
$$ / HR
Labour
Demand
REAL WAGE
$$ / HR
20
20
10
10
REAL WAGE
$$ / HR
Labour
Labour
Demand
Supply
50
100
50
100
LABOUR
LABOUR
Demand for Labour Supply of Labour
A
B
Labour
Supply
LABOUR
Demand for and
Supply of Labour
C
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE
$$ / HR
Labour
Demand
20
REAL WAGE
$$ / HR
REAL WAGE
$$ / HR
Labour
Labour
Demand
Supply
Labour
Supply
20
15
10
10
50
100
50
100
LABOUR
LABOUR
Demand for Labour Supply of Labour
A
B
75
LABOUR
Demand for and
Supply of Labour
C
LABOUR SUPPLY CURVE
• Based on decisions of
workers;
• They must decide how many
hours they wish to work
versus how much leisure
time they wish to enjoy;
SUBSTITUTION EFFECT
• An increase in real wage rate will
make working more attractive and
raise the opportunity cost of not
working;
• It leads to workers wanting to supply
more hours.
INCOME EFFECT
• A higher wage rate raises a worker’s
income for the amount of hours that he or
she is currently working;
• As income rises, a worker may choose to
enjoy more leisure and work fewer hours.
INCOME AND
SUBSTITUTION EFFECTS
• In principle, a higher wage could lead
workers to supply either greater or
fewer hours of work;
• In our analysis, we assume that the
substitution effect dominates:
• A higher wage will lead to increases
in the supply of labour.
SHIFTS IN DEMAND AND SUPPLY
Real Wages
B
A
Real Wages
Labour Supply
Labour
Supply
E
E
Labour
Demand
Labour
Labour Demand
Labour
SHIFTS IN DEMAND AND SUPPLY
Real Wages
B
A
Real Wages
Labour Supply
E
E
Increased Labour
Demand
Original Labour
Demand
Labour
Labour Demand
Labour
SHIFTS IN DEMAND AND SUPPLY
Real Wages
B
A
Real Wages
Labour Supply
E1
E
Original Labour
Supply
E
Increased Labour
Demand
Original Labour
Demand
Labour
Labour Demand
Labour
SHIFTS IN DEMAND AND SUPPLY
Real Wages
B
A
Real Wages
Labour Supply
Labour
Supply
E1
E
E
Increased Labour
Demand
Original Labour
Demand
Labour
If demand for labour increases,
real wages rise and the amount
of labour employed increases
Labour Demand
Labour
SHIFTS IN DEMAND AND SUPPLY
Real Wages
B
A
Real Wages
Labour Supply
E1
E
Increased Labour
Demand
Original Labour
Demand
Labour
If demand for labour increases,
real wages rise and the amount
of labour employed increases
Original Labour
Supply Increased
Labour Supply
E
Labour Demand
Labour
SHIFTS IN DEMAND AND SUPPLY
Real Wages
B
A
Real Wages
Labour Supply
E1
E
Increased Labour
Demand
Original Labour
Demand
Labour
If demand for labour increases,
real wages rise and the amount
of labour employed increases
Original Labour
Supply Increased
Labour Supply
E
E1
Labour Demand
Labour
SHIFTS IN DEMAND AND SUPPLY
Real Wages
B
A
Real Wages
Labour Supply
Original Labour
Supply Increased
Labour Supply
E
E1
E
Increased Labour
Demand
Original Labour
Demand
Labour
If demand for labour increases,
real wages rise and the amount
of labour employed increases
E1
Labour Demand
Labour
If supply of labour increases,
real wages fall but the amount
of labour employed increases
FULL-EMPLOYMENT OUTPUT
• The level of output produced when the
labour market is in equilibrium;
• It is also known as the potential output;
• Measuring full-employment output:
-- estimate unemployment if cyclical
unemployment were zero (i.e., only
frictional and structural factors);
economists have estimated 5 - 6.5% in U.S.
-- estimate how many workers will be employed;
-- apply short-run production function to
determine potential output;
DETERMINING FULL-EMPLOYMENT
OUTPUT
Real
Wage
Labour Supply
Labour
DETERMINING FULL-EMPLOYMENT
OUTPUT
Real
Wage
Labour Supply
Labour Demand
Labour
DETERMINING FULL-EMPLOYMENT
OUTPUT
Real
Wage
Labour Supply
W*
Labour Demand
L*
Labour
DETERMINING FULL-EMPLOYMENT
Output
OUTPUT
Labour
Real
Wage
Labour Supply
W*
Labour Demand
L*
Labour
DETERMINING FULL-EMPLOYMENT
Output
OUTPUT
Y*
Real
Wage
L*
Labour
Labour Supply
W*
Labour Demand
L*
Labour
LAFFER CURVE
• Named after economist Arthur Laffer;
Supply-side economist -- one who emphasizes the
adverse effects of taxation on potential output;
• Laffer curve shows the relationship between the
tax rate that a government levies and total tax
revenue that the government collects;
• The total amount of revenue a government
collects depends on both the tax rate and the
level of economic activity;
• Laffer curve illustrates that high tax rates may not
bring in much revenue if economic activity
decreases.
LAFFER CURVE
Tax Revenues
0%
Tax Rate
At a zero tax rate, the government collects no revenue.
LAFFER CURVE
Tax Revenues
0%
Tax Rate
At a zero tax rate, the government collects no revenue.
As tax rates rise, revenues increase.
LAFFER CURVE
Tax Revenues
0%
Tax Rate
At a zero tax rate, the government collects no revenue.
As tax rates rise, revenues increase.
But at some point, the disincentives from higher taxes cause revenues
to fall.
LAFFER CURVE
Tax Revenues
0%
Tax Rate
100%
At a zero tax rate, the government collects no revenue. As tax rates rise,
revenues increase. But at some point, the disincentives from higher
taxes cause revenues to fall. At a tax rate of 100%, no one will work and
tax revenues will disappear.
EFFECTS OF TAX PAID BY
EMPLOYERS FOR HIRING LABOUR
• A tax on labour makes labour more
expensive and raises marginal cost of
hiring workers;
• Since marginal cost has gone up, but
marginal benefit has not changed,
employers hire fewer workers;
• Shift left of labour demand leads to lower
wage and potentially reduced employment;
EFFECTS OF EMPLOYMENT TAXES
Real
wages
A
Labour
supply
Real
wages
E
Labour demand
before tax
Labour
B
Labour
supply
E
Labour demand
before tax
Labour
EFFECTS OF EMPLOYMENT TAXES
Real
wages
A
Labour
supply
Real
wages
E
Labour demand
before tax
B
Labour
supply
E
Labour demand
before tax
Labour demand
after tax
Labour
Labour demand
after tax
Labour
EFFECTS OF EMPLOYMENT TAXES
Real
wages
A
Labour
supply
Real
wages
B
Labour
supply
E
E
Labour demand
before tax
Labour demand
before tax
E1
Labour demand
after tax
Labour
E1
Labour
Labour demand
after tax
EFFECTS OF EMPLOYMENT TAXES
Real
wages
A
Labour
supply
Real
wages
B
Labour
supply
E
E
Labour demand
before tax
Labour demand
before tax
E1
Labour demand
after tax
Labour
A tax on labour shifts the demand curve
left and leads to lower wages and
reduced employment.
E1
Labour demand
after tax
Labour
If the supply curve for labour is
vertical, wages fall but
employment does not change.