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Chapter 11
MACROECONOMIC ISSUES:
ECONOMIC GROWTH AND
THE BUSINESS CYCLE
1. The Ideal
Macroeconomic World
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The description of the ideal macroeconomic
world shows that macroeconomics focuses on
two main topics—economic growth and the
business cycle.
Economic growth is the expansion of the
economy’s output over the long run.
The business cycle measures the short-run
fluctuations around the economy’s expansion
of output.
2. Economic Growth
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Economic growth occurs when the production
possibilities frontier (PPF) expands outward to
the right.
There are two basic sources of economic
growth—that is, of outward shifts in the
economy’s PPF: The sources are increases in
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productive resources and
technological progress.
2.1 Capital Accumulation
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Investment is addition to stock of
capital.
The rate at which society expands its
capital depends on the amount of
investment
Society must choose between capital
goods (plant, equipment) and consumer
goods.
2.3 Technological Progress
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Technological progress causes the PPF to shift
out. More outputs is produced from the same inputs.
The sources of technological progress range from
advances in science (the application of computer
technology to word processing and hotel and airline
reservations) to improvements in management
methods (streamlined management structures).
The high living standards in the US, Europe, and
Japan are the products of more than a century of
economic growth.
2.3 Extensive and Intensive Growth:
Production Functions
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The more effective use of inputs shows up as
increases in output per unit of input—that is, as
increases in factor productivity.
Production functions show the relationship
between inputs and output. They show how much
output can be produced from different amounts of
labor and capital with a given state of technology.
The total output of technology (Y) depends on the
amount of labor and capital inputs used by the
economy and on the state of technology.
Y = ƒ (K, L,T)
2.3 Extensive and Intensive Growth:
Production Functions -cont.
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Extensive growth is economic growth that
results from the expansion of factor inputs (K
and L).
To expand:
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labor inputs (L), we must sacrifice leisure or
household production;
capital inputs (K) we must sacrifice current
consumption for future consumption.
Intensive growth is growth that results
from increases in output per unit of factor
input.
2.3 Extensive and Intensive Growth:
Production Functions -cont.
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The major source of productivity improvements is
technological change (T).
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Scientist and engineers discover improved technologies
Agronomists develop drought-resistant grains.
New modes of communication—fax, e-mail, networks,
Production function in terms of annual growth rates:
Ẏ = 0.67L + 0.33K + Ṫ
The sources of economic growth explain the
relative contribution of labor, capital, and technology
to growth.
2.4 Diminishing returns versus
Technological Improvements
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Production function can be expressed as:
Y/L = ƒ(K/L,T).
The output per worker (a measure of average living
standards) increases when there is more capital per
worker and when technology improves.
The law of diminishing returns states that as
more and more capital is combined with the same
amount of labor, eventually its returns will diminish in
the form of smaller and smaller increases in output
per worker.
The process of economic growth can be viewed as a
battle between technological progress and
diminishing returns.
2.5 Growth Policy
For the advanced industrialized economies,
the major source of economic growth has
been intensive (technology) rather than
extensive (labor and capital) growth.
Technological Progress: Moore’s Law Example
 Economies are in a position to affect their
growth through increases either in efficiency
or in inputs.
 The experiences of the four Asian “Tiger”
economies show that countries can pursue
policies that create rapid economic growth.
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2.6 Business Cycles
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The American economy today produces a
volume of output more than 20 times greater
than a century ago.
The growth of economic output is not
smooth; during some periods, growth is well
above the long-run trend; in other periods,
growth is below the trend.
A business cycle is the pattern of upward and
downward movement in the general level of
real business activity.
2.7 Phases of the Business
Cycle
Recession (downturn) output declines for six or more
months. Unemployment rises, corporate profits fall, and
economy activity declines (Prolong = depression)
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Trough occurs when output stops falling. The economy has
reached a low point from which recovery begins.
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Recovery (expansion) is characterized by rising output,
falling unemployment, rising profits, and increasing economic
activity.
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Peak is the final stage and precedes recession. Output
growth ceases after the peak is reached.
U.S. Business Cycles Example
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2.8 The Impact of the
Business Cycle
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The great Depression of 1930
Deep recession of 1970-1980
Longest uninterrupted period of
prosperity was the decade of 1990’s.
Why does business cycles determine
presidential elections?
3. Macroeconomic Variables: Output,
Prices and Employment
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Macroeconomics is particularly interested in
the total output of the economy, called gross
domestic product (GDP).
Macroeconomics studies the price level of the
economy as a whole and its rate of change,
called inflation.
Macroeconomics examines employment and
unemployment for the economy as a whole.
3.1 Measuring Real
Output: GDP
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Gross domestic product (GDP) is the
market value of all final goods and services
produced by the factors of production located
in the country in one year’s time.
The circular-flow-diagram (chapter 2) shows
that the final goods and services flow from
the business sector to households. GDP
includes only final goods.
3.1 Measuring Real Output: GDP
3.1.1 Four Expenditures Categories
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Personal Consumption Expenditure (C)
Goods and services purchased by
households for consumption purposes.
For example food and cars
Government Expenditures for Goods and
Services (G)
Government goods are hired civil servants,
school teachers, judges, etc.
Government services are not sold thus no
established market price.
3.1 Measuring Real Output: GDP
3.1.1 Four Expenditures Categories - cont
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3.
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Transfer payments are payments to recipients
who have not supplied goods or services in return.
They are simply transfers of income from one person
or organization to another.
Investment (I)
Investment is defined as expenditures that add to
the economy’s stock of capital (plants, equipment,
structures, and inventories)
Depreciation is the value of the existing capital
stock that has been consumed or used up in the
process of producing output.
3.1 Measuring Real Output: GDP
3.1.1 Four Expenditures Categories - cont
4.
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Net Exports of Goods and Services (X-M)
The sum of all expenditures by households,
businesses, and government would not
equal the total output of the economy.
Imported products (M) must be subtracted
from total purchases to obtain domestic
production figures.
Exported products (X) does not show up in
domestic consumption figures.
GDP = C + I + G + X – M
3.1.2 Real GDP
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Macroeconomics focuses its attention on the
volume of “real” goods and services produced
because that determines economic welfare
and employment opportunities.
Real GDP measures the volume of real
goods and services produced by the economy
by removing the effects of rising prices on
nominal GDP.
Nominal GDP is the value of final goods and
services for a given year expressed in that
year’s prices.
3.1.3 The Equality of Output
and Income
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The circular-flow diagram shows that firms
pay income to the factors of production to
produce output.
For every dollar of final output produced, the
economy produces a dollar’s worth of factor
income in the form of wages, rent, interest,
and profit.
GDP can also be calculated by adding up the
sum of all incomes earned in the economy.
GDP = consumption (C) + saving (S) +
payroll taxes (T)
3.2 From Gross National Product
to Personal Income
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Gross national product (GNP) measures the
production of the factors of production supplied by
residents of the country, whether that production
took at place at home or abroad.
National income equals GNP minus depreciation
and indirect business (sales) taxes. National income
equals the sum of factor payments made to the
factors of production in the economy.
Personal income equals the sum of all income
received by persons—national income minus retained
corporate profits, corporate income taxes, and social
security contributions plus transfer payments
received by individuals.
3.2.1 The Equality of Investing
and Saving
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Because GDP equals the uses of total
income, we have:
C+I+G=C+S+T
Which reduces to: I = S + G - T
The natural level of real GDP is that
level of output the economy produces
when it is at the natural rate of
unemployment.
3.3 The Natural Level of
Output
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At the natural rate of unemployment: the number of
qualified job seekers equals the number of available
jobs.
The natural level of real GDP is that level of output
the economy produces when it is at the natural rate
of unemployment.
There is also an association between the natural rate
of unemployment and wages. (Too few people and
too many jobs, or too many people and too few jobs)
When the labor market is in balance at the natural
rate, inflationary pressures should be constant.