Split (1)

train · 11.7k rows

text stringlengths 204 3.13k
Problems in Macroeconomics The Problems of Fixed Weights MyLab Economics Concept Check To see why the BEA switched to the new procedure, let us consider a number of problems using fixed-price weights to compute real GDP. First, 1987 price weights, the last price weights the BEA used before it changed procedures, are not likely to be accurate for, say, 2014. Many structural changes took place in the U.S. economy between 1987 and 2014, and it seems unlikely that 1987 prices are good weights to use for this much later period. Another problem is that the use of fixed-price weights does not account for the responses in the economy to supply shifts. Perhaps bad weather leads to a lower production of oranges in year 2. In a simple supply-and-demand diagram for oranges, this corresponds to a shift of the supply curve to the left, which leads to an increase in the price of oranges and a decrease in the quantity demanded. As consumers move up the demand curve, they are substituting away from oranges. If technical advances in year 2 result in cheaper ways of producing computers, the result is a shift of the computer supply curve to the right, which leads to a decrease in the price of computers and an increase in the quantity demanded. Consumers are substituting toward computers. (You should be able to draw supply-and-demand diagrams for both cases.) Table 6.6 shows this tendency. The quantity of good A rose between years 1 and 2 and the price decreased (the computer case), whereas the quantity of good B fell and the price increased (the orange case). The computer supply curve has been shifting to the right over time, primarily because of technical advances. The result has been large decreases in the price of computers and large increases in the quantity demanded. To see why these responses pose a problem for the use of fixed-price weights, consider the data in Table 6.6. Because the price of good A was higher in year 1, the increase in production of good A is weighted more if we use year 1 as the base year than if we used year 2 as the base year. Also, because the price of good B was lower in year 1, the decrease in production of good B is weighted less if we use year 1 as the base year. These effects make the overall change in real GDP larger if we use year 1 price weights than if we use year 2 price weights. Using year 1 price weights ignores the kinds of substitution responses discussed in the previous paragraph and leads to what many believe are
too-large estimates of real GDP changes. In the past, the BEA tended to move the base year forward about every 5 years, resulting in the past estimates of real GDP growth being revised downward. It is undesirable to have past growth estimates change simply because of the change to a new base year. The new BEA procedure avoids many of these fixed-weight problems. Similar problems arise when using fixed-quantity weights to compute price indexes. For example, the fixed-weight procedure ignores the substitution away from goods whose prices are increasing and toward goods whose prices are decreasing or increasing less rapidly. The procedure tends to overestimate the increase in the overall price level. As discussed in the next chapter, there are still a number of price indexes that are computed using fixed weights. The GDP deflator differs because it does not use fixed weights. It is also a price index for all the goods and services produced in the economy. Other price indexes cover fewer domestically produced goods and services but also include some imported (foreign-produced) goods and services. It should finally be stressed that there is no “right” way of computing real GDP. The economy consists of many goods, each with its own price, and there is no exact way of adding together the production of the different goods. We can say that the BEA’s new procedure for computing real GDP avoids the problems associated with the use of fixed weights, and it seems to be an improvement over the old procedure. We will see in the next chapter, however, that the consumer price index (CPI)—a widely used price index—is still computed using fixed weights. 6.4 LEARNING OBJECTIVE Discuss the limitations of using GDP to measure well-being. Limitations of the GDP Concept We generally think of increases in GDP as good. Increasing GDP (or preventing its decrease) is usually considered one of the chief goals of the government’s macroeconomic policy. But there are some limitations to the use of GDP as a measure of welfare. GDP and Social Welfare MyLab Economics Concept Check If crime levels went down, society would be better off, but a decrease in crime is not an increase in output and is not reflected in GDP. Neither is an increase in leisure time. Yet to the extent that households want extra leisure time (instead of having it forced on them by a lack of jobs M06_CASE3826_13_GE_C06.indd 144 17/04/19 12:16 AM CHAPTER 6 Me
asuring National Output and National Income 145 in the economy), an increase in leisure is also an increase in social welfare. Furthermore, some increases in social welfare are associated with a decrease in GDP. An increase in leisure during a time of full employment, for example, leads to a decrease in GDP because less time is spent on producing output. Most nonmarket and domestic activities, such as housework and child care, are not counted in GDP even though they amount to real production. However, if I decide to send my children to day care or hire someone to clean my house or drive my car for me, GDP increases. The salaries of day care staff, cleaning people, and chauffeurs are counted in GDP, but the time I spend doing the same things is not counted. A mere change of institutional arrangements, even though no more output is being produced, can show up as a change in GDP. Furthermore, GDP seldom reflects losses or social ills. GDP accounting rules do not adjust for production that pollutes the environment. The more production there is, the larger the GDP, regardless of how much pollution results in the process. GDP also has nothing to say about the distribution of output among individuals in a society. It does not distinguish, for example, between the case in which most output goes to a few people and the case in which output is evenly divided among all people. The Informal Economy MyLab Economics Concept Check Many transactions are missed in the calculation of GDP even though, in principle, they should be counted. Most illegal transactions are missed unless they are “laundered” into legitimate business. Income that is earned but not reported as income for tax purposes is usually missed, although some adjustments are made in the GDP calculations to take misreported income into account. The part of the economy that should be counted in GDP but is not is sometimes called the informal economy. informal economy The part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP An Alternative to GDP: The Human Development Index GDP and GNI are often used as indicators of economic welfare. However, there is some dissatisfaction with both as measures of a nation’s overall well-being. During the second half of the 20th century, debates about the various dimensions of economic development led to the creation, in 1990, of a new indicator—the Human Development Index (HDI). First introduced by the United Nations Development Program, an international development agency, it is now widely used to compare well
-being across nations. Comparing country classifications based on GNI per capita and HDI yields interesting results. While the two are strongly correlated, since the HDI already incorporates the GNI, some high-income countries exhibit lower HDI scores than lower-income countries. Norway, a small high-income country, has consistently topped the HDI chart while having a lower gross national income than other countries such as Singapore or Kuwait. However, it neglects important aspects of a country’s well-being, such as human rights or political participation. It also provides only aggregate country-level measures and not the distribution of wellbeing within countries, leading some economists to propose alternatives like a “household-based HDI.”1 CRITICAL THINKING 1. What are the other aspects of a nation’s well-being you think are missing from both HDI and GDP (or GNI) measures? 1Kenneth Harttgen and Stephan Klasen, “A Household-Based Human Development Index,” Proceedings of the German Development Economics Conference, Hannover 2010, No. 30. M06_CASE3826_13_GE_C06.indd 145 17/04/19 12:16 AM 146 PART II Concepts and Problems in Macroeconomics Tax evasion is usually thought to be one of the major incentives for people in developed countries to participate in the informal economy. Studies estimate the size of the U.S. informal economy at about 10 percent, whereas Europe is closer to 20 percent. In the developing world, for a range of reasons, the informal economy is much larger, particularly for women workers. In Latin America and Africa, it is estimated that the informal economy comprises well more than a third of GDP in many nations.5 Why should we care about the informal economy? To the extent that GDP reflects only a part of economic activity instead of a complete measure of what the economy produces, it is misleading. Unemployment rates, for example, may be lower than officially measured if people work in the informal economy without reporting this fact to the government. Also, if the size of the informal economy varies among countries—as it does—we can be misled when we compare GDP among countries. For example, Italy’s GDP would be much higher if we considered its informal sector as part of the economy, and Switzerland’s GDP would change very little. Gross National Income per Capita MyLab Economics Concept Check Making comparisons across countries is difficult because such comparisons
need to be made in a single currency, generally U.S. dollars. Converting GNP numbers for Japan into dollars requires converting from yen into dollars. Because exchange rates can change quite dramatically in short periods of time, such conversions are tricky. Recently, the World Bank adopted a new measuring system for international comparisons. The concept of gross national income (GNI) is GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. Figure 6.1 lists the gross national income per capita (GNI divided by population) for various countries in 2016. Of the countries in the figure, Switzerland had the highest per capita GNI, followed by Norway, the United States, and Ireland. Ethiopia was estimated to have per capita GNI of only $1,730 in 2016. This compares to $63,810 for Switzerland. gross national income (GNI) GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. $70,000 $60,000 $50,000 $40,000 $30,000 20,000 $10,000 MyLab Economics Real-time data ▴ FIGURE 6.1 Per Capita Gross National Income for Selected Countries, 2016 Source: Data from GNI per capita, PPP (current international $), The World Bank Group, Retrieved from http://data.worldbank.org/indicator/ NY.GNP.PCAP.PP.CD 5Jacques Chermes, “The Informal Economy,” Journal of Applied Economic Research, 2012. M06_CASE3826_13_GE_C06.indd 146 17/04/19 12:16 AM CHAPTER 6 Measuring National Output and National Income 147 Looking Ahead This chapter has introduced many key variables in which macroeconomists are interested, including GDP and its components. There is much more to be learned about the data that macroeconomists use. In the next chapter, we will discuss the data on employment, unemployment, and the labor force. In Chapter 10, we will discuss the data on money and interest rates. Finally, in Chapter 19, we will discuss in more detail the data on the relationship between the United States and the rest of the world. S U M M A R Y 1. One source of data on the key variables in the macro- 8. Government consumption and gross investment (G) include economy is the national income and product accounts. These accounts provide a conceptual framework
that macroeconomists use to think about how the pieces of the economy fit together. 6.1 GROSS DOMESTIC PRODUCT p. 132 2. Gross domestic product (GDP) is the key concept in national income accounting. GDP is the total market value of all final goods and services produced within a given period by factors of production located within a country. GDP excludes intermediate goods. To include goods when they are purchased as inputs and when they are sold as final products would be double counting and would result in an overstatement of the value of production. 3. GDP excludes all transactions in which money or goods change hands but in which no new goods and services are produced. GDP includes the income of foreigners working in the United States and the profits that foreign companies earn in the United States. GDP excludes the income of U.S. citizens working abroad and profits earned by U.S. companies in foreign countries. 4. Gross national product (GNP) is the market value of all final goods and services produced during a given period by factors of production owned by a country’s citizens. 6.2 CALCULATING GDP p. 134 5. The expenditure approach to GDP adds up the amount spent on all final goods and services during a given period. The four main categories of expenditures are personal consumption expenditures (C), gross private domestic investment (I), government consumption and gross investment (G), and net exports (EX - IM). The sum of these categories equals GDP. 6. The three main components of personal consumption expendi- tures (C) are durable goods, nondurable goods, and services. 7. Gross private domestic investment (I) is the total investment made by the private sector in a given period. There are three kinds of investment: nonresidential investment, residential investment, and changes in business inventories. Gross investment does not take depreciation—the decrease in the value of assets—into account. Net investment is equal to gross investment minus depreciation. expenditures by state, federal, and local governments for final goods and services. The value of net exports (EX - IM) equals the differences between exports (sales to foreigners of U.S.-produced goods and services) and imports (U.S. purchases of goods and services from abroad). 9. Because every payment (expenditure) by a buyer is a receipt (income) for the seller, GDP can be computed in terms of who receives it as income—the income approach to calculating gross domestic product. 10. GNP minus depreciation
is net national product (NNP). National income is the total amount earned by the factors of production in the economy. It is equal to NNP except for a statistical discrepancy. Personal income is the total income of households. Disposable personal income is what households have to spend or save after paying their taxes. The personal saving rate is the percentage of disposable personal income saved instead of spent. 6.3 NOMINAL VERSUS REAL GDP p. 140 11. GDP measured in current dollars (the current prices that one pays for goods) is nominal GDP. If we use nominal GDP to measure growth, we can be misled into thinking that production has grown when all that has happened is a rise in the price level, or inflation. A better measure of production is real GDP, which is nominal GDP adjusted for price changes. 12. The GDP deflator is a measure of the overall price level. 6.4 LIMITATIONS OF THE GDP CONCEPT p. 144 13. We generally think of increases in GDP as good, but some problems arise when we try to use GDP as a measure of happiness or well-being. The peculiarities of GDP accounting mean that institutional changes can change the value of GDP even if real production has not changed. GDP ignores most social ills, such as pollution. Furthermore, GDP tells us nothing about what kinds of goods are being produced or how income is distributed across the population. GDP also ignores many transactions of the informal economy. 14. The concept of gross national income (GNI) is GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M06_CASE3826_13_GE_C06.indd 147 17/04/19 12:16 AM 148 PART II Concepts and Problems in Macroeconomics base year, p. 142 change in business inventories, p. 135 compensation of employees, p. 138 corporate profits, p. 138 current dollars, p. 140 depreciation, p. 136 disposable personal income, or after-tax income, p. 140 durable goods, p. 134 expenditure approach, p. 134 final goods and services, p. 132 fixed-weight procedure, p. 142 government consumption and gross investment (G), p. 137 gross domestic product (GDP), p. 132 gross investment
, p. 136 gross national income (GNI), p. 146 gross national product (GNP), p. 133 gross private domestic investment (Ia), p. 135 income approach, p. 134 indirect taxes minus subsidies, p. 138 informal economy, p. 145 intermediate goods, p. 132 national income, p. 138 national income and product accounts, p. 131 net business transfer payments, p. 138 net exports (EX - IM), p. 137 net interest, p. 138 net investment, p. 136 net national product (NNP), p. 139 nominal GDP, p. 140 nondurable goods, p. 134 nonresidential investment, p. 135 personal consumption expenditures, p. 134 personal income, p. 139 personal saving, p. 140 personal saving rate, p. 140 proprietors’ income, p. 138 rental income, p. 138 residential investment, p. 135 services, p. 134 statistical discrepancy, p. 139 surplus of government enterprises, p. 138 value added, p. 132 weight, p. 140 Equations: Expenditure approach to GDP: GDP = C + I a + G + (EX - IM), p. 134 GDP = Final sales + Change in business inventories, p. 136 capitalend of period = capitalbeginning of period + net investment, p. 137 P R O B L E M S All problems are available on MyLab Economics. 6.1 GROSS DOMESTIC PRODUCT a. A transportation company acquires a fleet of second-hand LEARNING OBJECTIVE: Describe GDP fundamentals and differentiate between GDP and GNP. 1.1 [Related to the Economics in Practice on p. 135] Which of the following transactions or activities would be counted in your country’s GDP? Explain your answers. a. A transportation company acquires a fleet of second-hand vehicles. b. The same transportation company acquires 1,000 gallons of gas from a foreign company. c. You buy 10 short-term government bonds. d. A mining company acquires new government licenses to drill in the land that the company already owns. e. You pay for a new haircut at your local hairdresser. f. Foreign residents buy a bundle of your country’s food spe- cialties on an online retail site. g. Your parents spend a whole day cooking for the underprivileged. h. The local government acquires furniture for newly built schools. i. Two telecommunications companies merge. j. A
nonprofit organization buys an apartment to use as its headquarters. k. You receive a large sum of money as bequest from a dead relative. 1.2 [Related to the Economics in Practice on p. 135] Which of the following transactions or activities would be counted in your country’s GDP? Explain your answers. vehicles. b. The same transportation company acquires 1,000 gallons of gas from a foreign company. c. You buy 10 short-term government bonds. d. A mining company acquires new government licenses to drill in the land that the company already owns. e. You pay for a new haircut at your local hairdresser. f. Foreign residents buy a bundle of your country’s food spe- cialties on an online retail site. g. Your parents spend a whole day cooking for the underprivileged. h. The local government acquires furniture for newly built schools. i. Two telecommunications companies merge. j. A nonprofit organization buys an apartment to use as its headquarters. k. You receive a large sum of money as bequest from a dead relative. 1.3 Jacques, a resident of France, goes to Germany to buy a brand new car for €15,600. He then brings the car back to France and sells it to another resident for €17,500. Which parts of this transaction will be included in each country’s GDP, deducted from the net export component of GDP? 1.4 Anissa makes custom bird houses in her garage and she buys all her supplies from a local lumber yard. Last year she purchased $3,500 worth of supplies and produced 250 bird houses. She sold all 250 bird houses to a local craft store for $25 each. The craft store sold all the bird MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M06_CASE3826_13_GE_C06.indd 148 17/04/19 12:16 AM houses to customers for $55 each. For the total bird house production, calculate the value added of Anissa and of the craft store. 6.2 CALCULATING GDP LEARNING OBJECTIVE: Explain two methods for calculating GDP. 2.1 [Related to the Economics in Practice on p. 135] In a simple economy, suppose that all income is either compensation of employees or profits. Suppose also that
there are no indirect taxes. Calculate gross domestic product from the following set of numbers. Show that the expenditure approach and the income approach add up to the same figure. Consumption Investment Depreciation Profits Exports Compensation of employees Government purchases Direct taxes Saving Imports $9,500 3,000 1,750 2,400 850 11,500 3,200 1,200 1,600 900 2.2 How do we know that calculating GDP by the expenditure approach yields the same answer as calculating GDP by the income approach? 2.3 From July 2017 to July 2018, real GDP in Germany rose about 2.1 percent. During the same period, retail sales in Germany fell 1.6 percent in real terms. 2.4 If you buy a new car, the entire purchase is counted as consumption in the year in which you make the transaction. Explain briefly why this is in one sense an “error” in national income accounting. (Hint: How is the purchase of a car different from the purchase of a pizza?) How might you correct this error? How is housing treated in the National Income and Product Accounts? Specifically how does owner- occupied housing enter into the accounts? (Hint: Do some Web searching on “imputed rent on owner-occupied housing.”) 2.5 Explain why imports are subtracted in the expenditure ap- proach to calculating GDP. 2.6 Go to www.bea.gov/national and look at the GDP-by- industry data for the United States, which assesses added value. Between 2005 and 2017, what are the sectors in which you can see the impact of the global financial crisis more vividly? Which sectors were left relatively alone and did not suffer a major decline? By what time did the various sectors reach their pre-crisis levels of growth? 2.7 [Related to the Economics in Practice on p. 137] Depreciation, or the amount by which an asset’s value falls in a given period, is a term primarily used for tangible assets, such as computers. For intangible assets, the term amortization is used. Computer software is generally considered an intangible asset, and its value can be amortized over time. The tax treatment of computer software, however, can be confusing because its amortization schedule is based on how it was acquired. If software is acquired as a CHAPTER 6 Measuring National Output and National Income 149 part of the acquisition of a business, it must be amortized over 15
years. If software is purchased separately, it can be amortized over 36 months. Bundled software that is included in computer hardware is not amortized, but rather the entire value of the computer, including the bundled software, is depreciated over the life of the hardware, which is normally set at 5 years. Therefore, identical software is treated differently in terms of loss of value over time depending on how it is acquired. How might these different time periods for amortization and depreciation affect the government’s ability to estimate GDP? How does the amortization of software affect the measure of real production in an economy as measured by GDP? Suggest a better way to amortize computer software. Do you think there is a more logical, standardized length of time for amortization, regardless of how it was acquired? Briefly explain. 6.3 NOMINAL VERSUS REAL GDP LEARNING OBJECTIVE: Discuss the difference between real GDP and nominal GDP. 3.1 The following table shows World Bank estimates for world GDP from 2005 to 2014, both in nominal and real terms (real GDP is calculated using a fixed weights method, using 2005 as a base year). How do you explain the discrepancy between nominal and real GDP in 2014? How do you explain the evolution of world’s real GDP growth rate from 2005 to 2014? 2005 Constant World GDP (Trillions, US$) Current World GDP (Trillions, US$) Real GDP (% Change) Nominal GDP (% Change) 47.033 48.971 50.899 51.652 50.582 52.646 54.142 55.351 56.652 58.054 47.033 50.971 57.452 62.982 59.704 65.489 72.572 74.041 76.123 77.868 4.1% 3.9% 1.5% −2.1% 4.1% 2.8% 2.2% 2.4% 2.5% 8.4% 12.7% 9.6% −5.2% 9.7% 10.8% 2.0% 2.8% 2.3% Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 3.2 In 2014, New Zealand changed its method of calculating real GDP growth rate, substituting fixed weights with chain weights. What might explain such a change in method? Are the differences between the two methods significant? 3.3 The following table gives some
figures from forecasts of real GDP (in 2009 dollars) and population done in 2018 According to the forecasts, approximately how much real growth will there be between 2022 and 2023? What is the per-capita real GDP projected to be in 2022 and in 2023? Compute the forecast rate of change in real GDP and percapita real GDP between 2022 and 2023. Real GDP 2022 (billions) Real GDP 2023 (billions) Population 2022 (millions) Population 2023 (millions) $18,965 $19,269 338.2 340.5 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M06_CASE3826_13_GE_C06.indd 149 17/04/19 12:16 AM 150 PART II Concepts and Problems in Macroeconomics 3.4 Look at a recent edition of The Economist. Go to the section on economic indicators. Go down the list of countries and make a list of the ones with the fastest and slowest GDP growth. Look also at the forecast rates of GDP growth. Go back to the table of contents at the beginning of the journal to see if there are articles about any of these countries. Write a paragraph or two describing the events or the economic conditions in one of the countries. Explain why they are growing or not growing rapidly. 3.5 In 2017, the average real GDP growth rate of the European Union was 2.4 percent. Apart from a few outliers, the Western European member states achieved lower growth rates compared to members states in Eastern Europe. Go to www.ec.europa.eu/eurostat.com and look at real GDP growth rates for the EU. What do you see in the data? Can you tell by reading newspapers or watching the news why there are differences in growth rates of member states? Do you think this means that members states in Eastern Europe are catching up to those in Western Europe in terms of living standards? 3.6 Gorgonzola is a small island nation with a simple economy that produces only six goods: sugar cane, yo-yos, rum, peanuts, harmonicas, and peanut butter. Assume that one-quarter of all the sugar cane is used to produce rum and one-half of all the peanuts are used to produce peanut butter. a. Use the production and price information in the table to
calculate nominal GDP for 2018. b. Use the production and price information in the table to calculate real GDP for 2016, 2017, and 2018 using 2016 as the base year. What is the growth rate of real GDP from 2016 to 2017 and from 2017 to 2018? c. Use the production and price information in the table to calculate real GDP for 2016, 2017, and 2018 using 2017 as the base year. What is the growth rate of real GDP from 2016 to 2017 and from 2017 to 2018? 2016 2017 2018 Product Quantity Price Quantity Price Quantity Price Sugar cane Yo-yos Rum Peanuts Harmonicas Peanut butter 240 600 150 500 75 100 $0.80 2.50 10.00 2.00 25.00 4.50 240 700 160 450 75 85 $1.00 3.00 12.00 2.50 30.00 4.50 300 750 180 450 85 85 $1.15 4.00 15.00 2.50 30.00 5.00 3.7 The following table contains nominal per capita GDP data, in US dollars, and implicit price deflator from the years between the years 2000 and 2016 for India from the United Nations. Fill in the column for the real GDP for each year. Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Nominal per cap GDP GDP Deflator Real GDP 430.7277284 437.0571735 449.2611259 517.4687782 616.0236666 709.7680483 790.9944417 991.3467178 1048.161005 1068.62321 1340.910324 1500.853109 1473.301818 1499.382472 1576.058753 1629.233446 1706.457685 57.36678064 56.29168237 56.71696401 61.28959225 68.47409723 73.34417561 75.97529403 88.04073962 90.92663843 86.677581 100 106.3463115 100.2490858 97.037604 96.05228642 93.00899416 92.00380372 3.8 Evaluate the following statement: Even if the prices of a large number of goods and services in the economy increase dramatically, the real GDP for the economy can still fall, but if the prices of a large number of goods and services in
the economy decrease dramatically, the real GDP for the economy cannot rise. 6.4 LIMITATIONS OF THE GDP CONCEPT LEARNING OBJECTIVE: Discuss the limitations of using GDP to measure well-being. 4.1 GDP calculations do not directly include the economic costs of environmental damage—for example, global warming and acid rain. Do you think these costs should be included in GDP? Why or why not? How could GDP be amended to include environmental damage costs? 4.2 [Related to the Economics in Practice on p. 145] A World Bank brief entitled Natural Capital Accounting contains the following statement: “(A) major limitation of GDP is the limited representation of natural capital. The full contribution of natural capital like forests, wetlands, and agricultural land does not show up.” Identify some additional examples of natural capital and explain how limited representation of these types of natural capital could affect the measurement of gross domestic product. Source: Natural Capital Accounting, World Bank brief, May 20, 2015 QUESTION 1 Goods and services that are produced and consumed within the same household are not included in GDP calculations. Economists refer to the production of these goods and services as “household production.” Does the existence of household production lead GDP to understate or overstate the true value of production in the economy? QUESTION 2 GDP calculations do not include the production of illegal drugs. Why is their production not included? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M06_CASE3826_13_GE_C06.indd 150 17/04/19 12:16 AM Unemployment, Inflation, and Long-Run Growth 7 CHAPTER OUTLINE AND LEARNING OBJECTIV ES 7.1 Unemployment p. 152 Explain how unemployment is measured. 7.2 Inflation and Deflation p. 157 Describe the tools used to measure inflation and discuss the costs and effects of inflation. 7.3 Long-Run Growth p. 162 Discuss the components and implications of long-run growth. Looking Ahead p. 164 151 Each month the U.S. Bureau of Labor Statistics (BLS) announces the value of the unemployment rate for the previous month. For example, on March 9, 2018, it announced that the unemployment rate for February 2018 was 4.1 percent. The unemployment rate is a key measure of how the economy is
doing and helps to determine the direction of government policy on spending, taxes and interest rates. This announcement is widely watched, and if the announced unemployment rate is different from what the financial markets expect, there can be large movements in those markets. It is thus important to know how the BLS computes the unemployment rate. The first part of this chapter describes how the unemployment rate is computed and discusses its various components. Inflation is another key macroeconomic variable. The previous chapter discussed how the GDP deflator, the price deflator for the entire economy, is computed. The percentage change in the GDP deflator is a measure of inflation. There are, however, other measures of inflation, each pertaining to some part of the economy. The most widely followed price index is the consumer price index (CPI), and its measurement is discussed in this chapter. The CPI is also announced monthly by the BLS, and this announcement is widely followed by the financial markets as well. For example, on March 13, 2018, the BLS announced that the percentage change in the CPI for February 2018 was 0.2 percent for the month. After discussing the measurement of the CPI, this chapter discusses various costs of inflation as well as the concerns policy makers might have when there is deflation (a fall in the price level). M07_CASE3826_13_GE_C07.indd 151 17/04/19 4:13 AM 152 PART II Concepts and Problems in Macroeconomics The last topic considered in this chapter is long-run growth. Although much of macroeconomics is concerned with explaining business cycles, long-run growth is also a major concern. The average yearly growth rate of U.S. real GDP depicted in Figure 5.2 in Chapter 5 is 3.2 percent. Although there were many ups and downs during the 118 years depicted in Figure 5.2, on average, the economy was growing at an annual 3.2 percent rate. In the last part of this chapter, we discuss the sources of this growth. Keep in mind that this chapter is still descriptive. We begin our analysis of how the economy works in the next chapter. 7.1 LEARNING OBJECTIVE Explain how unemployment is measured. Unemployment We begin our discussion of unemployment with its measurement. Measuring Unemployment MyLab Economics Concept Check The unemployment data released each month by the BLS are based on a survey of 60,000 households. Each interviewed household answers questions concerning the work activity of household members 16 years of age or older during
the calendar week that contains the 12th of the month. (The survey is conducted in the week that contains the 19th of the month.) If a household member 16 years of age or older worked 1 hour or more as a paid employee, either for someone else or in his or her own business or farm, the person is classified as employed. A household member is also considered employed if he or she worked 15 hours or more without pay in a family enterprise. Finally, a household member is counted as employed if the person held a job from which he or she was temporarily absent because of illness, bad weather, vacation, labor-management disputes, or personal reasons, regardless of whether he or she was paid. Those who are not employed fall into one of two categories: (1) unemployed or (2) not in the labor force. To be considered unemployed, a person must be 16 years old or older, available for work, and have made specific efforts to find work during the previous 4 weeks. A person not looking for work because he or she does not want a job or has given up looking is classified as not in the labor force. People not in the labor force include full-time students, retirees, individuals in institutions, those staying home to take care of children, and discouraged job seekers. The total labor force in the economy is the number of people employed plus the number of unemployed: labor force = employed + unemployed The total population 16 years of age or older is equal to the number of people in the labor force plus the number not in the labor force: population = labor force + not in labor force With these numbers, several ratios can be calculated. The unemployment rate is the ratio of the number of people unemployed to the total number of people in the labor force: unemployment rate = unemployed employed + unemployed In February 2018, the labor force contained 161,921 million people, 155,215 million of whom were employed and 6,706 million of whom were unemployed and looking for work. The unemployment rate was 4.1 percent: 6,706 155,215 + 6,706 = 4.1, The ratio of the labor force to the population 16 years old or over is called the labor force participation rate: labor force participation rate = labor force population 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. 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. 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. unemployment rate The ratio of the number of people unemployed to the total number of people in the labor force. labor force participation rate The ratio of the labor force to the total population 16 years old or older. M07_CASE3826_13_GE_C07.indd 152 17/04/19 4:13 AM Time Use for the Unemployed in a Recession CHAPTER 7 Unemployment, Inflation, and Long-Run Growth 153 During the recession of 2008–2009, aggregate market work hours in the United States decreased substantially. A recent paper uses interesting new survey data to explore what the unemployed population did with these hours lost to the formal market.1 What would an economist expect to see change in time use for someone newly unemployed in a recession? First, we might expect people to spend some time looking for new jobs. Aguiar and his co-authors find that between 2 percent and 6 percent of the lost market hours go to job search. But clearly there are diminishing returns to job search, especially in a recession when new job opportunities are limited. What else did the survey reveal about time allocation? Twelve percent of the newly opened time went to activities tied to longer-run job placement, increased education, civic involvement, and health care. Other time, 35 percent of the hours lost, went to nonmarket work, cleaning, home maintenance, and child care. Clearly here the unemployed were substituting their own work for services they used to buy in the marketplace. For the unemployed worker, the opportunity cost of producing one’s own home services is lower, so this change makes good economic sense. The remaining time, just under half the hours lost to the market, went to leisure activities, including sleeping. CRITICAL THINKING 1. How would you expect the time use of the unem- ployed to differ in a boom time? 1Mark Aguiar, Erik Hurst, Louokas Karabarbounis, “Time Use During the Great Recession,” American Economic Review 2016, 1664–1696.
In February 2018, the population of 16 years old or older was 256,934 million. So the labor force participation rate was.60 (=155,215/256,934). Table 7.1 shows values of these variables for selected years since 1950. Although the unemployment rate has gone up and down over this period, the labor force participation rate grew steadily from 1950 until 2000, with declines thereafter. Much of the increase in the early period was the result of the growth in the participation rate of women between the ages of 25 and 54. This rate also declined slightly in the more recent period. Column 3 in Table 7.1 shows how many new workers the U.S. economy has absorbed since 1950. The number of employed workers increased by 40.4 million between 1950 and 1980 and by 54.0 million between 1980 and 2017. TABLE 7.1 Employed, Unemployed, and the Labor Force, 1950–2017 (1) (2) (3) (4) Population 16 Years Old or Over (Millions) Labor Force (Millions) Employed (Millions) Unemployed (Millions) (5) Labor Force Participation Rate (Percentage Points) (6) Unemployment Rate (Percentage Points) 1950 1960 1970 1980 1990 2000 2010 2017 105.0 117.2 137.1 167.7 189.2 212.6 237.8 255.1 62.2 69.6 82.8 106.9 125.8 142.6 153.9 160.3 58.9 65.8 78.7 99.3 118.8 136.9 139.1 153.3 3.3 3.9 4.1 7.6 7.0 5.7 14.8 7.0 59.2 59.4 60.4 63.8 66.5 67.1 64.7 62.9 5.3 5.5 4.9 7.1 5.6 4.0 9.6 4.4 Note: Figures are civilian only (military excluded). Source: Economic Report of the President, 2018 and U.S. Bureau of Labor Statistics. MyLab Economics Real-time data M07_CASE3826_13_GE_C07.indd 153 17/04/19 4:13 AM 154 PART II Concepts and Problems in Macroeconomics Components of the Unemployment Rate MyLab Economics Concept Check To get a better picture of unemployment in the United States, it is useful to look at unemployment rates across groups of people. Unemployment
Rates for Different Demographic Groups There are large differences in rates of unemployment across demographic groups. Table 7.2 shows the unemployment rate for November 1982—the worst month of the recession in 1982—and for February 2018—a month of low unemployment—broken down by race, sex, and age. In February 2018, when the overall unemployment rate was 4.1 percent, the rate for whites was 3.7 percent, whereas the rate for African Americans was higher at 6.9 percent. During the recession of 1982, men fared worse than women. For African Americans, 19.3 percent of men 20 years and older and 16.5 percent of women 20 years and older were unemployed. Teenagers between 16 and 19 years of age fared worst. African Americans between 16 and 19 experienced an unemployment rate of 49.5 percent in November 1982. For whites between 16 and 19, the unemployment rate was 21.3 percent. The unemployment rate for teenagers was also high in February 2018, and African American men and women continue to have unemployment rates higher than their white counterparts. Discouraged-Worker Effects Many people believe that the unemployment rate underestimates the fraction of people who are involuntarily out of work. People who stop looking for work are classified as having dropped out of the labor force instead of being unemployed. During recessions, people may become discouraged about finding a job and stop looking. This lowers the unemployment rate as calculated by the BLS because those no longer looking for work are no longer counted as unemployed. discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find work grow discouraged and stop looking, thus dropping out of the ranks of the unemployed and the labor force. To demonstrate how this discouraged-worker effect lowers the unemployment rate, suppose there are 10 million unemployed out of a labor force of 100 million. This means an unemployment 100 =.10, or 10 percent. If 1 million of these 10 million unemployed people stopped rate of 10 looking for work and dropped out of the labor force, 9 million would be unemployed out of a labor force of 99 million. The unemployment rate would then drop to 9 99 =.091, or 9.1 percent. > The BLS survey provides some evidence on the size of the discouraged-worker effect. Respondents who indicate that they have stopped searching for work are asked why they stopped. If the respondent cites inability to find employment as the sole reason for not searching, that person might be classified as a discouraged worker. > The number
of discouraged workers seems to hover around 1 percent of the size of the labor force in normal times. During the 1980–1982 recession, the number of discouraged workers increased steadily to a peak of 1.5 percent. In February 2018, discouraged workers were estimated to comprise about 0.23 percent of the size of the labor force. Some economists argue that adding the number of discouraged workers to the number who are now classified as unemployed gives a better picture of the unemployment situation. The Duration of Unemployment The unemployment rate measures unemployment at a given point in time. It tells us nothing about how long the average unemployed worker is out of work. With a labor force of 1,000 people and an annual unemployment rate of 10 percent, we TABLE 7.2 Unemployment Rates by Demographic Group, 1982 and 2018 Years November 1982 February 2018 Total White Men Women Both sexes African American Men Women Both sexes 20 + 20 + 16–19 20 + 20 + 16–19 10.8 9.6 9.0 8.1 21.3 20.2 19.3 16.5 49.5 4.1 3.7 3.4 3.3 12.6 6.9 5.9 6.2 27.2 Source: U.S. Bureau of Labor Statistics. Data are seasonally adjusted. MyLab Economics Real-time data M07_CASE3826_13_GE_C07.indd 154 17/04/19 4:13 AM Female Labor Force Participation and Economic Development CHAPTER 7 Unemployment, Inflation, and Long-Run Growth 155 It is a fact generally accepted that the labor force participation rate of women is a crucial factor in the economic development of any country. Higher female participation means a larger labor force and, therefore, an increase in the productive output of the economy. Though a direct causality between female labor force participation and economic growth is not easy to determine, there is, nonetheless, evidence of positive correlations between increased presence of women in labor markets and accelerated economic growth. Such a correlation can be found, for instance, in the decades following World War II in Western Europe and Northern America. Boosting the integration of women into labor markets is an important policy objective for governments desirous of sustaining domestic economic development, besides other equally important objectives related to gender equality. To do so, it is important to consider factors like economic growth, rising wages, decline in fertility, and improvement in health, which help increase female labor force participation. However, a recent study1 shows that despite the incidence of all
these factors, female labor participation has stagnated in urban India over the past 30 years. The authors of the study, Stephan Klasen and Janneke Pieters, attribute this stagnation to a combination of supply and demand effects. On the demand side, they point out the stagnation of sectors traditionally hiring more women. On the supply side, female labor market participation has been hampered by rising household income, which makes the addition of another breadwinner, besides men, less necessary, along with the mixed effects of education. The latter discovery can appear counter-intuitive given the usually positive correlation one assumes between education and labor market participation: higher education levels usually help prospective workers improve their chance of getting a job and therefore indicate a willingness to integrate the labor market or, as some economists call it, improve “labor market returns.” In India, however, as the study showed higher education did not lead to increased female labor market participation. The authors find that at least some of the expansion in female education in urban India was driven by expected “marriage market returns”; in other words, some families invested in their daughters’ education so as to improve their marriage prospects. This example effectively highlights some of the challenges associated with efforts to boost female labor force participation rate. 1Stephan Klasen and Janneke Pieters, “What Explains the Stagnation of Female Labor Force Participation In Urban India?” World Bank Policy Research Working Paper, March 2013. know that at any moment 100 people are unemployed. But a different picture emerges if it turns out that the same 100 people are unemployed all year, as opposed to a situation in which each of the 1,000 people has a brief spell of unemployment of a few weeks during the year. The duration statistics give us information on this feature of unemployment. Table 7.3 shows that during recessionary periods, the average duration of unemployment rises. Between 1979 and 1983, the average duration of unemployment rose from 10.8 weeks to 20.0 weeks. The slow growth following the 1990–1991 recession resulted in an increase in duration of unemployment to 17.7 weeks in 1992 and to 18.8 weeks in 1994. In 2000, average duration was down to 12.6 weeks, which then rose to 19.6 weeks in 2004. Between 2007 and 2009 average duration rose sharply from 16.8 weeks to 24.4 weeks. Following the recession it rose even more—to 39.4 weeks in 2012. This reflects the slow overall recovery from the recession.
Average duration then fell to 25.0 weeks by 2017. The Costs of Unemployment MyLab Economics Concept Check In the Employment Act of 1946, Congress declared that it was the continuing policy and responsibility of the federal government to use all practicable means to promote maximum employment, production, and purchasing power. In the years since, full employment has remained an important target of federal policy. Why should full employment be a policy objective of the federal government? What costs does unemployment impose on society? M07_CASE3826_13_GE_C07.indd 155 17/04/19 4:13 AM 156 PART II Concepts and Problems in Macroeconomics The Consequences of Unemployment Persist Throughout the recession of 2008–2009 and the slow recovery afterward, many young college graduates found themselves unemployed, many for a number of months. As painful as that experience was, economists had more bad news for them. The negative effect of early unemployment on your career lasts for many years! Lisa Kahn, a labor economist, followed graduates of colleges from the period 1979–1989 over the subsequent 17 years.1 You know from Chapter 5 that within this overall period there was one recession in 1980–1982. Kahn finds that even 15 years later, wage rates of those with post-college unemployment lagged substantially. Not only did low wages persist, but fewer graduates in recessionary periods were able to enter high prestige jobs, even when the economy recovered. CRITICAL THINKING 1. Describe a mechanism that might help explain the persistence of wage-effects from a recession. 1Lisa Kahn, “The Long-Term Labor Consequences of Graduating from College in a Bad Economy,” Labour Economics, April 2010. Frictional, Structural, and Cyclical Unemployment When we consider the various costs of unemployment, it is useful to categorize unemployment into three types: ■■ Frictional unemployment ■■ Structural unemployment ■■ Cyclical unemployment TABLE 7.3 Average Duration of Unemployment, 1970–2017 Weeks Weeks Weeks 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 8.6 11.3 12.0 10.0 9.8 14.2 15.8 14.3 11.9 10.8 11.9 13.7 15.6 20.0 18.2 15.6 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 15.0 14.5 13.5 11.9 12.0 13.7 17.7 18.0
18.8 16.6 16.7 15.8 14.5 13.4 12.6 13.1 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 16.6 19.2 19.6 18.4 16.8 16.8 17.9 24.4 33.0 39.3 39.4 36.5 33.7 29.2 27.5 25.0 Source: U.S. Bureau of Labor Statistics. MyLab Economics Real-time data M07_CASE3826_13_GE_C07.indd 156 17/04/19 4:14 AM CHAPTER 7 Unemployment, Inflation, and Long-Run Growth 157 In thinking about the social costs of unemployment, all unemployment is not created equal! When the BLS does its survey about work activity for the week containing the 12th of each month, it interviews many people who are involved in the normal search for work. Some are either newly entering the labor force, while others are switching jobs. This unemployment is both natural and beneficial for the economy. The portion of unemployment resulting from the normal turnover in the labor market is called frictional unemployment. As long as job search takes some time, the frictional unemployment rate will not be zero. The industrial structure of the U.S. economy is continually changing. Manufacturing, for instance, has yielded part of its share of total employment to services and to finance, insurance, and real estate. Within the manufacturing sector, the steel and textile industries have contracted sharply, whereas high-technology sectors have expanded. The unemployment that arises from such structural shifts is usually called structural unemployment. Thus, the term frictional unemployment is used to denote short-run job/skill-matching problems, problems that last a few weeks, and structural unemployment denotes longer-run adjustment problems—those that tend to last for years. Although structural unemployment is an indication of a dynamic economy, it also brings with it cost to those who lose their jobs because their skills are obsolete. Economists sometimes use the term natural rate of unemployment to refer to the unemployment rate that occurs in a normal functioning economy, subject to some frictional and structural unemployment. Estimates of the natural rate vary from 4 percent to 6 percent. Between 2007 and 2009 the actual unemployment rate rose from 4.6 percent to 9.3 percent, and it seems unlikely that all of this rise was simply because of a rise in frictional and structural unemployment. Any unemployment that is above frictional plus structural
is called cyclical unemployment. It seems likely that much of the unemployment in 2009, during the 2008–2009 recession, and during earlier recessions, was cyclical unemployment. Social Consequences The costs of unemployment are neither evenly distributed across the population nor easily quantified. The social consequences of the Depression of the 1930s are perhaps the hardest to comprehend. Few emerged from this period unscathed. At the bottom were the poor and the fully unemployed, about 25 percent of the labor force. Even those who kept their jobs found themselves working part-time. Many people lost all or part of their savings as the stock market crashed and thousands of banks failed. Re-reading the excerpt from John Steinbeck’s The Grapes of Wrath in Chapter 5 will give you a flavor for the social costs of the unemployment of that period. Many of you may also have seen friends or families lose valued jobs in the more recent recession of 2008–2009. Inflation and Deflation In a market economy like the U.S. economy, prices of individual goods continually change as supply and demand shift. Indeed, a major concern of microeconomics is understanding the way in which relative prices change—why, for example, have computers become less expensive over time and dental services more expensive? In macroeconomics, we are concerned not with relative price changes, but with changes in the overall price level of goods and services. Inflation is defined as an increase in the overall price level, whereas deflation is a decrease in the overall price level. The fact that all prices for the multitude of goods and services in our economy do not rise and fall together at the same rate makes measurement of inflation difficult. We have already explored measurement issues in Chapter 6 in defining the GDP deflator, which measures the price level for all goods and services in an economy. We turn now to look at a second, commonly used measure of the price level, the consumer price index. 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 a result of changes in the structure of the economy that result in a significant loss of jobs in certain industries. natural rate of unemployment The unemployment rate that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of the frictional unemployment rate and the structural unemployment rate. cyclical unemployment Unemployment that is above frictional plus structural unemployment. 7.2 LEARNING OB
JECTIVE Describe the tools used to measure inflation and discuss the costs and effects of inflation. The Consumer Price Index MyLab Economics Concept Check The consumer price index (CPI) is the most widely followed price index. Unlike the GDP deflator, it is a fixed-weight index. It was first constructed during World War I as a basis for adjusting shipbuilders’ wages, which the government controlled during the war. Currently, the CPI consumer price index (CPI) A price index computed each month by the Bureau of Labor Statistics using a bundle that is meant to represent the “market basket” purchased monthly by the typical urban consumer. M07_CASE3826_13_GE_C07.indd 157 17/04/19 4:14 AM 158 PART II Concepts and Problems in Macroeconomics is computed by the BLS each month using a bundle of goods meant to represent the “market basket” purchased monthly by the typical urban consumer. The quantities of each good in the bundle that are used for the weights are based on extensive surveys of consumers. In fact, the BLS collects prices each month for about 71,000 goods and services from about 22,000 outlets in 44 geographic areas. For example, the cost of housing is included in the data collection by surveying about 5,000 renters and 1,000 homeowners each month. Figure 7.1 shows the CPI market basket for December 2007. Table 7.4 shows values of the CPI since 1950. The base period for this index is 1982–1984, which means that the index is constructed to have a value of 100.0 when averaged across these three years. The percentage change for a given year in the table is a measure of inflation in that year. For example, from 1970 to 1971, the CPI increased from 38.8 to 40.5, a percentage change of 4.4 percent. [The percentage change is 38.8 times 100.] The table shows the high inflation rates in the 1970s and early 1980s and the fairly low inflation rates since 1992. 40.5 - 38.8 1 2 > Because the CPI is a fixed-weight price index (with the current base period 1982–1984), it suffers from the substitution problem discussed in the last chapter. With fixed weights, it does not account for consumers’ substitution away from high-priced goods. The CPI thus has a tendency to overestimate the rate of inflation. This problem has important policy implications because government transfers, such as Social Security payments
, are tied to the CPI. If inflation as measured by percentage changes in the CPI is biased upward, Social Security payments will grow more rapidly than they would with a better measure: The government is spending more than it otherwise would. In response to the fixed-weight problem, in August 2002, the BLS began publishing a version of the CPI called the Chained Consumer Price Index, which uses changing weights. Although this version is not yet the main version, it may be that within a few years the BLS will completely move away from the fixed-weight version of the CPI. Remember, however, that even if this happens, the CPI will still differ in important ways from the GDP deflator, discussed in the last chapter. The CPI covers only consumer goods and services—those listed in Figure 7.1—whereas the GDP deflator covers all goods and services produced in the economy. Also, the CPI includes prices of imported goods, which the GDP deflator does not. 6.2% Medical Care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services) 5.6% Recreation (televisions, cable television, pets and pet products, sports equipment, admissions) 17.7% Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance) 3.7% Apparel (men’s shirts and sweaters, women’s dresses, jewelry) 6.1% Education and Communication (college tuition, postage, telephone services, computer software and accessories) 3.3% Other Goods and Services (tobacco and smoking products, haircuts and other personal services, funeral expenses) 14.9% Food and Beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals and snacks) 42.4% Housing (rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture) MyLab Economics Concept Check ▴▴ FIGURE 7.1 The CPI Market Basket 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. M07_CASE3826_13_GE_C07.indd 158 17/04/19 4:14 AM CHAPTER 7 Unemployment, Inflation, and Long-Run Growth 159 TABLE 7.4 The CPI, 1950–2017 Percentage Change in CPI 1950 1951 1952 1953 1954 1955 1956 1957
1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1.3 7.9 1.9 0.8 0.7 -0.4 1.5 3.3 2.8 0.7 1.7 1.0 1.0 1.3 1.3 1.6 2.9 3.1 4.2 5.5 5.7 4.4 3.2 6.2 11.0 9.1 5.8 6.5 7.6 11.3 13.5 10.3 6.2 3.2 CPI 24.1 26.0 26.5 26.7 26.9 26.8 27.2 28.1 28.9 29.1 29.6 29.9 30.2 30.6 31.0 31.5 32.4 33.4 34.8 36.7 38.8 40.5 41.8 44.4 49.3 53.8 56.9 60.6 65.2 72.6 82.4 90.9 96.5 99.6 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Percentage Change in CPI 4.3 3.6 1.9 3.6 4.1 4.8 5.4 4.2 3.0 3.0 2.6 2.8 3.0 2.3 1.6 2.2 3.4 2.8 1.6 2.3 2.7 3.4 3.2 2.8 3.9 -0.4 1.7 3.1 2.1 1.5 1.6 1.3 1.3 2.1 CPI 103.9 107.6 109.6 113.6 118.3 124.0 130.7 136.2 140.3 144.5 148.2 152.4 156.9 160.5 163.0 166.6 172.2 177.1 179.9 184.0 188.9 195.3 201.6 207.3 215.3 214.5 218.1 224.9 229.6 233.0 236.7 237.0 240.0 245.1 Sources: U.S. Bureau of Labor Statistics. MyLab Economics Real-time data Other popular price indexes are producer price indexes (PPIs), once called wholesale price indexes
. These are indexes of prices that producers receive for products at various stages in the production process, not just the final stage. The indexes are calculated separately for various stages in the production process. The three main categories are finished goods, intermediate materials, and crude materials, although there are subcategories within each of these categories. One advantage of some of the PPIs is that they detect price increases early in the production process. Because their movements sometimes foreshadow future changes in consumer prices, they are considered to be leading indicators of future consumer prices. producer price indexes (PPIs) Measures of prices that producers receive for products at various stages in the production process. The Costs of Inflation MyLab Economics Concept Check If you asked most people why inflation is bad, they would tell you that it lowers the overall standard of living by making goods and services more expensive. That is, it cuts into people’s purchasing power. People are fond of recalling the days when a bottle of Coca-Cola cost a dime and a hamburger cost a quarter. Just think what we could buy today if prices had not changed. What people usually do not think about is what their incomes were in the “good old days.” The fact that the cost of a Coke has increased from 10 cents to a dollar does not mean anything in real terms if people who once earned $5,000 now earn $50,000. During inflations, most prices—including M07_CASE3826_13_GE_C07.indd 159 17/04/19 4:14 AM 160 PART II Concepts and Problems in Macroeconomics input prices like wages—tend to rise together, and input prices determine both the incomes of workers and the incomes of owners of capital and land. So inflation by itself does not necessarily reduce one’s purchasing power. Inflation May Change the Distribution of Income Whether you gain or lose during a period of inflation depends on whether your income rises faster or slower than the prices of the things you buy. The group most often mentioned when the impact of inflation is discussed is people living on fixed incomes. If your income is fixed and prices rise, your ability to purchase goods and services falls proportionately. Although the elderly are often thought of as living on fixed incomes, many pension plans pay benefits that are indexed to inflation, as we describe in the Economics in Practice on the next page. The benefits these plans provide automatically increase when the general price level rises. If prices rise 10 percent, benefits also rise 10 percent
. The biggest source of income for many elderly people is Social Security. These benefits are fully indexed; when prices rise—that is, when the CPI rises—by 5 percent, Social Security benefits also increase by 5 percent. Wages are also sometimes indexed to inflation through cost-of-living adjustments (COLAs) written into labor contracts. These contracts usually say the wage rate will be increased with the inflation rate. If wages are fully indexed, workers do not suffer a fall in real income when inflation rises, although wages are not always fully indexed. One way of thinking about the effects of inflation on the distribution of income is to distinguish between anticipated and unanticipated inflation. If inflation is anticipated and contracts are made and agreements written with the anticipated value of inflation in mind, there need not be any effects of inflation on income distribution. Consider an individual who is thinking about retiring and has a pension that is not indexed to the CPI. If she knew what inflation was going to be for the next 20 or 30 years of her retirement, there would be no problem. She would just wait to retire until she had enough money to pay for her anticipated growing expenses. The problem occurs if, after she has retired, inflation is higher than she expected. At that point, she may face the prospect of having to return to work. Similarly, if I as a landlord expect inflation to be 2 percent per year over the next 3 years and offer my tenants a 3-year lease with a 2 percent rent increase each year, I will be in bad shape if inflation turns out to be 10 percent per year and causes all my costs to rise by 10 percent per year. For another example, consider debtors versus creditors. It is commonly believed that debtors benefit at the expense of creditors during an inflation because with inflation they pay back less in the future in real terms than they borrowed. But this is not the case if the inflation is anticipated and the loan contract is written with this in mind. Suppose that you want to borrow $100 from me to be paid back in a year and that we both agree that if there is no inflation, the appropriate interest rate is 5 percent. Suppose also that we both anticipate that the inflation rate will be 10 percent. In this case we will agree on a 15 percent interest rate—you will pay me back $115 at the end of the year. By charging you 15 percent I have taken into account the fact that you will be paying me back with dollars worth 10 percent less in real terms than when you borrowed them.
I am then not hurt by inflation and you are not helped if the actual inflation rate turns out to equal our anticipated rate. I am earning a 5 percent real interest rate—the difference between the interest rate on a loan and the inflation rate. Unanticipated inflation, on the other hand, is a different story. If the actual inflation rate during the year turns out to be 20 percent, I as a creditor will be hurt. I charged you 15 percent interest, expecting to get a 5 percent real rate of return, when I needed to charge you 25 percent to get the same 5 percent real rate of return. Because inflation was higher than anticipated, I got a negative real return of 5 percent. Inflation that is higher than anticipated benefits debtors; inflation that is lower than anticipated benefits creditors. To summarize, the effects of anticipated inflation on the distribution of income are likely to be fairly small because people and institutions will adjust to the anticipated inflation. Unanticipated inflation, on the other hand, may have large effects, depending, among other things, on how much indexing to inflation there is. If many contracts are not indexed and are based on anticipated inflation rates that turn out to be wrong, there can be big winners and real interest rate The difference between the interest rate on a loan and the inflation rate. M07_CASE3826_13_GE_C07.indd 160 17/04/19 4:14 AM CHAPTER 7 Unemployment, Inflation, and Long-Run Growth 161 losers. In general, there is more uncertainty and risk when inflation is unanticipated. This uncertainty may prevent people from signing long-run contracts that would otherwise be beneficial for both parties. Administrative Costs and Inefficiencies There may be costs associated even with anticipated inflation. One is the administrative cost associated with simply keeping up. During the rapid inflation in Israel in the early 1980s, a telephone hotline was set up to give the hourly price index. In Zimbabwe, where the inflation rate in June 2008 was estimated by some to be more than 1 million percent at an annual rate, the government was forced to print ever-increasing denominations of money. In 2009, Zimbabwe abandoned its currency and started using the U.S. dollar and the South African Rand to conduct business. In 2018 the Venezuelan government was increasing the total currency in circulation by more than 50 percent per month to avoid the cash shortages coming from its hyperinflation. What about Deflation? MyLab Economics Concept Check In 2017 most of the developed world experienced very little inflation. Indeed
, the United States has not seen high inflation since the 1970s. Instead, governments in a number of countries have begun to worry about deflation hitting their economies. Why might we worry about price declines? Part of the answer, of course, parallels the discussion of price increases. If prices fall and the fall is unanticipated, borrowers will gain at the expense of lenders, whereas those on fixed pensions will gain at the expense of the governments and firms paying those pensions. But deflation also brings with it another worry. It may be a signal that aggregate demand is too low to support full employment. We will have much to say about aggregate demand in future chapters Chain-Linked Consumer Price Index in the News The calculations described in Chapter 6 on how to construct a chain-linked price index may seem complicated and a bit arcane to you. But throughout the last months of 2012 and into early 2016, as Republicans and Democrats argued over the federal budget, chain linking became a hot topic. As we know from the discussion of fixed weights in Chapter 6, chain linking a price index accounts for product substitution that people make in response to relative price changes. Fixed-weight price indices, which do not take into account this substitution, tend to overestimate inflation. There are two versions of the consumer price index (CPI), one using fixed weights and one using chain linking. The fixedweight version is the one that is used to adjust Social Security benefits and veteran benefits to price changes. If, say, the CPI increases by 2 percent in a year, benefits are increased by 2 percent. If the chain-linked CPI were used instead, benefits would tend to increase more slowly because in general the chain-linked CPI increases less than does the fixed-weight CPI (because of product substitution). You may see where this is going. One way to decrease expenditures on social security and veteran benefits in the future would be to use the chain-linked CPI rather than the fixed-weight CPI. The nonpartisan Congressional Budget Office estimated that if the chain-linked CPI were adopted, it would save the federal government about $145 billion over a 10-year period from the lower benefits. CRITICAL THINKING 1. Tax brackets are also tied to the fixed-weight CPI. How would tax revenue be affected if the chain-linked CPI were used instead? M07_CASE3826_13_GE_C07.indd 161 17/04/19 4:14 AM 162 PART II Concepts and Problems in Macroeconomics 7.3 LEARNING OBJECT
IVE Discuss the components and implications of long-run growth. output growth The growth rate of the output of the entire economy. per-capita output growth The growth rate of output per person in the economy. productivity growth The growth rate of output per worker. Long-Run Growth In discussing long-run growth, it will be useful to begin with a few definitions. Output growth is the growth rate of the output of the entire economy. Per-capita output growth is the growth rate of output per person in the economy. If the population of a country is growing at the same rate as output, then per-capita output is not growing: Output growth is simply keeping up with population growth. Not everyone in a country works, and so output per worker is not the same as output per person. Output per worker is larger than output per person, and it is a measure of productivity. Productivity growth is thus the growth rate of output per worker. One measure of the economic welfare of a country is its per-capita output. Per-capita output can increase because each worker now produces more than he or she did previously, or because there are more workers relative to nonworkers in the population. In the United States, both forces have been at work in increasing per-capita output. Output and Productivity Growth MyLab Economics Concept Check We have pointed out that aggregate output in the United States has grown at an annual rate of 3.2 percent since 1900, with year-to-year fluctuations. An area of economics called growth theory is concerned with the question of what determines this rate. Why 3.2 percent and not 2 percent or 4 percent? We take up this question in Chapter 16, but a few points are useful to make now. In a simplified economy, machines (capital) and workers (labor) are needed to produce output. How can output increase in this economy? There are a number of ways. One way is to add more workers. With more workers, more output can be produced per machine per hour. Another way is to add more machines, so that each worker has more capital to work with. A third way is to increase the length of the work week. With workers and machines working more hours, more output can be produced. Output can thus increase if labor or capital increases or if the amount of time that labor and capital are working per week increases. Another way for output to increase in our economy is for the quality of the workers to increase, perhaps through education, experience, or
even better health. If workers become more physically fit by exercising more and eating less fat and more whole grains and fresh fruits and vegetables, their greater fitness may increase their output on the machines. People are sometimes said to be adding to their human capital when they increase their mental or physical skills. The quality of the machines used in the workplace may also increase. In particular, new machines that replace old machines may allow more output to be produced per hour with the same number of workers. An obvious example is the replacement of an old computer with a new, faster one that allows more to be done per minute of work on the computer. To summarize, output can increase when there are more workers, more skills per worker, more machines, better machines, or a longer workweek. Output per worker hour is called labor productivity or sometimes just productivity. Output per worker hour is plotted in Figure 7.2 for the 1952 I–2017 IV period. Two features are immediately clear from the figure. First, there is an upward trend in labor productivity. Second, there are fairly sizable short-run fluctuations around the trend. Chapter 16 will discuss these short-run fluctuations, linking them to underutilization of an employed work force. For now, however, our main interest is the long-run trend. To smooth out the short-run fluctuations in Figure 7.2, we have added straight-line segments to the figure, where the segments roughly go through the high values. The slope of each line segment is the growth rate of productivity along the segment. The growth rates are listed in the figure. The different productivity growth rates in the figure tell an interesting story. From the 1950s through the mid-1960s, the growth rate was 3.4 percent. The rate then fell to 2.6 percent in the last half of the 1960s and early 1970s. Between the early 1970s and the early 1990s, the growth rate was much lower at 1.6 percent. Between the early 1990s and 2010 it was 2.0 percent. Since 2010 the growth rate appears to have considerably slowed, to around 1.0 percent. Why are the growth rates positive in Figure 7.2? Why has the amount of output that a worker can produce per hour risen in the last half-century? Part of the answer is that the amount of capital per worker has increased. In Figure 7.3 capital per worker is plotted for the same 1952 I–2017 M07_CASE3826_13_GE_C07.ind
d 162 17/04/19 4:14 AM CHAPTER 7 Unemployment, Inflation, and Long-Run Growth 163 1.0% 2.0% Line segments 1.6% 2.6% Output per worker hour 3.3 ( 71.0 64.0 32.0 16.0 1952 I 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I Quarters 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Real-time data ▴▴ FIGURE 7.2 Output per Worker Hour (Productivity), 1952 I–2017 IV Productivity grew much faster in the 1950s and 1960s than since. IV period. It is clear from the figure that the amount of capital per worker has generally been rising. Therefore, with more capital per worker, more output can be produced per worker. The other part of the answer is that the quality of labor and capital has been increasing. Both the average skill of workers and the average quality of capital have been increasing. This means that more output can be produced per worker for a given quantity of capital because both workers and capital are getting better. A harder question to answer concerning Figure 7.2 is why the growth rate of productivity was much higher in the 1950s and 1960s than it has been since the early 1970s. Again, part of the answer is that the amount of capital per worker rose more rapidly in the 1950s and 1960s than it has since then. This can be seen in Figure 7.3. The other part of the answer is, of course, that the quality of labor and capital must have increased more in the 1950s and 1960s than later, although this is difficult to explain or to get direct evidence on. Interestingly, it has been difficult to find big productivity gains from recent technological innovations in the communications area. 122.0 80. ( 40.0 1952 I1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I Quarters 2010 I 2015 I 2017 IV 2005 I MyLab Economics Concept Check ▴▴ FIGURE 7.3 Capital per Worker, 1952 I–2017 IV Capital per worker grew until about 1980 and then leveled off somewhat. M07_CASE3826_13_GE_C07.indd 163 17/04/19 4:14 AM 164 PART II Concepts and Problems in Macroeconomics Looking Ahead This ends our introduction to the basic concepts and problems of macroeconomics. The first
chapter of this part introduced the field; the second chapter discussed the measurement of national product and national income; and this chapter discussed unemployment, inflation, and long-run growth. We are now ready to begin the analysis of how the macroeconomy works. S U M M A R Y 7.1 UNEMPLOYMENT p. 152 1. The unemployment rate is the ratio of the number of unem- ployed people to the number of people in the labor force. To be considered unemployed and in the labor force, a person must be looking for work. 2. Big differences in rates of unemployment exist across demographic groups, regions, and industries. African Americans, for example, experience much higher unemployment rates than whites. 3. A person who decides to stop looking for work is consid- ered to have dropped out of the labor force and is no longer classified as unemployed. People who stop looking because they are discouraged about finding a job are sometimes called discouraged workers. 4. Some unemployment is inevitable. Because new workers are continually entering the labor force, because industries and firms are continuously expanding and contracting, and because people switch jobs, there is a constant process of job search as workers and firms try to match the best people to the available jobs. This unemployment is both natural and beneficial for the economy. 5. The unemployment that occurs because of short-run job/ skill-matching problems is called frictional unemployment. The unemployment that occurs because of longer-run structural changes in the economy is called structural unemployment. The natural rate of unemployment is the sum of the frictional rate and the structural rate. The increase in unemployment that occurs during recessions and depressions is called cyclical unemployment. 7.2 INFLATION AND DEFLATION p. 157 6. The consumer price index (CPI) is a fixed-weight price index. It represents the “market basket” purchased by the typical urban consumer. 7. Whether people gain or lose during a period of inflation depends on whether their income rises faster or slower than the prices of the things they buy. The elderly are more insulated from inflation than most people think because Social Security benefits and many pensions are indexed to inflation. 8. Inflation is likely to have a larger effect on the distribution of income when it is unanticipated than when it is anticipated. 7.3 LONG-RUN GROWTH p. 162 9. Output growth depends on: (1) the growth rate of the capital stock, (2) the growth rate of output per
unit of the capital stock, (3) the growth rate of labor, and (4) the growth rate of output per unit of labor. 10. Output per worker hour (labor productivity) rose faster in the 1950s and 1960s than it rose from the 1970s to 2017. An interesting question is whether labor productivity will rise faster in the future because of the Internet consumer price index (CPI), p. 157 cyclical unemployment, p. 157 discouraged-worker effect, p. 154 employed, p. 152 frictional unemployment, p. 157 labor force, p. 152 labor force participation rate, p. 152 natural rate of unemployment, p. 157 not in the labor force, p. 152 output growth, p. 162 per-capita output growth, p. 162 producer price indexes (PPIs), p. 159 productivity growth, p. 162 real interest rate, p. 160 structural unemployment, p. 157 unemployed, p. 152 unemployment rate, p. 152 Equations: labor force = employed + unemployed, p. 152 population = labor force + not in labor force, p. 152 unemployment rate = unemployed employed + unemployed, p. 152 labor force participation rate = labor force population, p. 152 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M07_CASE3826_13_GE_C07.indd 164 17/04/19 4:14 AM CHAPTER 7 Unemployment, Inflation, and Long-Run Growth 165 P R O B L E M S All problems are available on MyLab Economics. 7.1 UNEMPLOYMENT LEARNING OBJECTIVE: Explain how unemployment is measured. 1.1 According to the World Bank, unemployment in Australia in 2008 was at an all-time low at 4.23 percent. However, unemployment picked up after 2008, reaching 6.07 percent in 2014, while GDP growth averaged at around a stable 2.2 percent. What is the connection between unemployment and GDP growth? Was Australia in a recession between 2008 and 2014? 1.2 When an inefficient firm or a firm producing a product that people no longer want goes out of business, people are unemployed, but that is part of the normal process of economic growth and development. The unemployment is part of the natural rate and need not concern policy makers. Discuss that statement and its relevance to the economy today.
1.3 What is the unemployment rate in your country today? Compare the national GDP to global GDP during the 2008 financial crisis. Was unemployment in your country significantly affected by the global financial crisis? Do you know or can you determine why? 1.4 [Related to the Economics in Practice on p. 153] For each of the following events, explain what is likely to happen to the labor force participation rate: a. The federal minimum wage is abolished. b. The minimum legal working age is lowered from 16 to 14. c. The economy is in the midst of a prolonged period of economic growth. d. The federal government decreases the duration unemployment benefits from a high of 99 weeks back to a maximum of 26 weeks. e. The federal government lowers the minimum age requirement for collecting Social Security benefits. 1.5 Many European countries, such as Germany, underwent a recession after 2008. Go to the website of the Federal Reserve Bank of St. Louis (www.research.stlouisfed.org) and look up employment data for Germany from 2008. What trends do you observe? In what ways do you think the recession impacted unemployment in the country? 1.6 [Related to the Economics in Practice on p. 155] Go to http://data.worldbank.org/ and look at the data available. What is the female labor force participation rate in your country? How does it compare to the male and female labor force participation rates in the rest of the world? 1.7 Consider the following statements: a. Fewer people are employed in Freedonia now than at any time in the past 75 years. b. The unemployment rate in Freedonia is lower now than it has been in 75 years. Can both of those statements be true at the same time? Explain. 1.8 Suppose the number of employed people in an economy is 312,545,372. The unemployment rate in this economy is 7.4 percent, or 074, and the labor force participation rate is 80 percent, or 80. a. What is the size of the labor force? b. How many people are unemployed? c. What is the size of the working-age population? 1.9 On average, nations in Europe pay higher unemployment benefits for longer periods of time than does the United States. How do you suppose this would impact the unemployment rates in these nations? Explain which type of unemployment you think is most directly affected by the size and duration of unemployment benefits. 1.10 In each of the following cases,
classify the person as cyclically unemployed, structurally unemployed, frictionally unemployed, or not in the labor force. Explain your answers. a. Carl just graduated from college five weeks ago and has been looking for a job. b. Christine lost her job as a biologist at a biotech company due to recession. c. Gerhard got laid off from his job as a taxi driver and gave up looking for a new job three months later. d. Dirk is a craftsman of handmade cotton dolls. Since all kids now want plastic dolls, he has been out of a job for the past two years. e. Aditee quit her job as a hi-tech engineer at a start-up firm in Bangalore. She is scheduled for an interview with a multinational company for a higher-paying job in Pune. f. Lennon got laid off from his job as a public reader as the level of education has risen in his village. 7.2 INFLATION AND DEFLATION LEARNING OBJECTIVE: Describe the tools to measure inflation and discuss the costs and effects of inflation. 2.1 Suppose all wages, salaries, welfare benefits, and other sources of income were indexed to inflation. Would inflation still be considered a problem? Why or why not? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M07_CASE3826_13_GE_C07.indd 165 17/04/19 4:14 AM 166 PART II Concepts and Problems in Macroeconomics 2.2 What do the CPI and PPIs measure? Why do we need both a. The nominal interest rate is 6 percent and the inflation of these types of price indexes? (Think about what purpose you would use each one for.) 2.3 The CPI is a fixed-weight index. It compares the price of a fixed bundle of goods in one year with the price of the same bundle of goods in a base year. Calculate the price of a bundle containing 100 units of food, 40 units of utilities, 200 units of unexpected expenses, and 30 units of leisure activities in 2015, 2016, 2017, and 2018. Convert the results into an index by dividing each bundle price figure by the bundle price in 2015 and multiplying it by 100. Calculate the percentage change in your index between 2015 and 2016, between 2016 and 2017, and again between 2017 and 2018. rate is
3 percent. b. The nominal interest rate is 13 percent and the inflation rate is 11 percent. c. The nominal interest rate is 3 percent and the inflation rate is –1 percent. d. The real interest rate is 8 percent and the inflation rate is 7 percent. e. The real interest rate is 5 percent and the inflation rate is 9 percent. 2.6 The CPI is 120 in year 1 and 150 in year 2. All inflation is anticipated. If the Gringotts Bank charges an interest rate of 30 percent in year 2, what is the bank’s real interest rate? Quantity Consumed 2015 Prices 2016 Prices 2017 Prices 2018 Prices 100 40 200 30 HK$80 HK$85 HK$90 HK$92 50 30 75 60 40 81 61 44 78 65 50 76 Good Food Utilities Unexpected expenses Leisure activities 2.4 [Related to the Economics in Practice on p. 161] Since 2009, the federal minimum wage has been set at $7.25 per hour. In 2018, 29 states and Washington, DC had higher minimum wages than the federal minimum wage, the highest being $12.50 per hour in Washington, DC. In 18 of those states and in Washington, DC, the minimum wage is indexed for inflation and is therefore automatically adjusted each year for price increases. Explain how tying the federal minimum wage to an index like the CPI could impact the economy. Do you suppose the impact would be different if the minimum wage was tied to the chainlinked CPI as opposed to the fixed-weight CPI? Explain. 2.5 Consider the following five situations. In which situa- tion would a borrower be best off and in which situation would a lender be best off? 7.3 LONG-RUN GROWTH LEARNING OBJECTIVE: Discuss the components and implications of long-run growth. 3.1 Policy makers talk about the “capacity” of the economy to grow. What specifically is meant by the “capacity” of the economy? How might capacity be measured? In what ways is capacity limited by labor constraints and by capital constraints? What are the consequences if demand in the economy exceeds capacity? What signs would you look for? 3.2 What was the rate of growth in real GDP during the most recent quarter? You can find the answer in publications such as the Survey of Current Business, The Economist, and Business Week. Has growth been increasing or decreasing? What policies might you suggest for increasing the economy’s potential long-run rate of
growth? 3.3 An article in the Gotham Times states that the stock of capital and the workforce in Gotham are both increasing at an annual rate of 7 percent. The same article states that real output is growing by 11 percent. Explain if this is possible in the short run and in the long run QUESTION 1 During a recession, many workers with part-time jobs want full-time jobs, but cannot find them. These workers are referred to as “underemployed.” Does the existence of underemployment lead the unemployment rate to understate or overstate the problem of joblessness in the economy? QUESTION 2 Suppose that you purchased a new car last year, and that you took out a five-year car loan to pay for it. Would unexpected inflation this year lead you to repay less or more for your car loan? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M07_CASE3826_13_GE_C07.indd 166 17/04/19 4:14 AM PART III The Core of Macroeconomic Theory We now begin our discussion of the theory of how the macroeconomy works. We know how to calculate gross domestic product (GDP), but what factors determine it? We know how to define and measure inflation and unemployment, but what circumstances cause inflation and unemployment? What, if anything, can government do to reduce unemployment and inflation? Analyzing the various components of the macroeconomy is a complex undertaking. The level of GDP, the overall price level, and the level of employment—three chief concerns of macroeconomists—are influenced by events in three broadly defined “markets”: • Goods-and-services market • Financial (money) market • Labor market We will explore each market, as well as the links between them, in our discussion of macroeconomic theory. Figure V.1 presents the plan of the next seven chapters, which form the core of CHAPTER 13 The Labor Market • The supply of labor • The demand for labor • Employment and unemployment CHAPTERS 8–9 CHAPTER 11 The Goods-and-Services Market Full Equilibrium: AS/AD Model • Planned aggregate expenditure Consumption (C) Planned investment (I) Government (G) • Aggregate output (income) (Y) CHAPTERS 10 The Money Market • The supply of money
• The demand for money • Interest rate (r) • Aggregate supply curve • Fed rule • Aggregate demand curve Equilibrium interest rate (r) Equilibrium output (income) (Y) Equilibrium price level (P*) CHAPTER 12 Policy and Cost Effects in the AS/AD model ▴ FIGURE V.1 The Core of Macroeconomic Theory We build up the macroeconomy slowly. In Chapters 8 and 9, we examine the market for goods and services. In Chapter 10, we examine the money market. Chapter 11 introduces the aggregate supply (AS) curve and the Fed rule and derives the aggregate demand (AD) curve. Chapter 12 uses the AS/AD model to examine policy and cost effects, and Chapter 13 discusses the labor market. 167 M08_CASE3826_13_GE_C08.indd 167 17/04/19 12:07 PM macroeconomic theory. In Chapters 8 and 9, we describe the market for goods and services, often called the goods market. In Chapter 8, we explain several basic concepts and show how the equilibrium level of output is determined in a simple economy with no government and no imports or exports. In Chapter 9, we add the government to the economy. In Chapter 10 we introduce the money market and discuss the way the U.S. central bank (the Federal Reserve) controls the interest rate. Chapter 11 introduces the aggregate supply (AS) curve. It also discusses the behavior of the Federal Reserve regarding its interest rate decision, which is approximated by a “Fed rule.” The Fed rule is then added to the analysis of the goods market to derive the aggregate demand (AD) curve. The resulting model, the “AS/AD” model, determines the equilibrium values of the interest rate (r), aggregate output (income) (Y), and the price level (P). Chapter 12 uses the AS/AD model to analyze policy and cost effects. Finally, Chapter 13 discusses the supply of and demand for labor and the functioning of the labor market in the macroeconomy. This material is essential to understanding how modern, developed economies function. 168 M08_CASE3826_13_GE_C08.indd 168 17/04/19 12:07 PM Aggregate Expenditure and Equilibrium Output 8 CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 8.1 The Keynesian Theory of Consumption p. 170 Explain the principles of the Keynesian theory of consumption. 8
.2 Planned Investment (I) versus Actual Investment p. 175 Explain the difference between planned investment and actual investment. 8.3 Planned Investment and the Interest Rate (r) p. 175 Understand how planned investment is affected by the interest rate. 8.4 The Determination of Equilibrium Output (Income) p. 176 Explain how equilibrium output is determined. 8.5 The Multiplier p. 180 Describe the multiplier process and use the multiplier equation to calculate changes in equilibrium. Looking Ahead p. 185 Appendix: Deriving the Multiplier Algebraically p. 189 Show that the multiplier is one divided by one minus the MPC. 169 In the last several chapters we described a number of features of the U.S. economy, including real GDP, inflation, and unemployment, and we talked about how they are measured. Now we begin the analytical part of macroeconomics: How do the different parts of the economy interact to produce the time-profile of the U.S. economy that we described in the last few chapters? We begin with the simplest case, focusing on households and firms, we ask what happens to the economy as a whole when investment increases. If suddenly all the managers of firms in the economy decided to expand their plants, how would that affect households and aggregate output? Once we understand how households and firms interact at the aggregate level, we will introduce government in Chapter 9. In subsequent chapters, we will make our simple economic model both more realistic, and as a result more complex, but the basic intuitions of these early chapters will remain. As we work through our model of the economy, we focus, at least initially, on understanding movements in real gross domestic product (GDP), one of the measures of macroeconomic activity. We focus on real, rather than nominal, output because we are interested in tracking real changes in the level of economic activity. So, although we will typically use dollars to measure GDP, you should think about this as dollars corrected for price level changes. M08_CASE3826_13_GE_C08.indd 169 17/04/19 12:07 PM 170 PART III The Core of Macroeconomic Theory aggregate output The total quantity of goods and services produced in an economy in a given period. aggregate income The total income received by all factors of production in a given period. aggregate output (income) (Y) A combined term used to remind you of the exact equality between aggregate output and aggregate income. 8.1 LEARNING OBJECT
IVE Explain the principles of the Keynesian theory of consumption. consumption function The relationship between consumption and income. We saw previously that GDP can be calculated in terms of either income or expenditures. We will use the variable Y to refer to both aggregate output and aggregate income. In any given period, there is an exact equality between aggregate output (production) and aggregate income. You should be reminded of this fact whenever you encounter the combined term aggregate output (income) (Y). Aggregate output can also be considered the aggregate quantity supplied because it is the amount that firms are supplying (producing) during a period. In the discussions that follow, we use the term aggregate output (income) instead of aggregate quantity supplied, but keep in mind that the two are equivalent. Also remember that aggregate output means “real GDP.” For ease of discussion we will sometimes refer to aggregate output (income) as simply “output” or “income.” From the outset, you must think in “real terms.” For example, when we talk about output (Y), we mean real output, not nominal output. In the current chapter and the next, we will assume the overall price level (P) is fixed, so those nominal and real outputs are the same. Nevertheless, because eventually we will introduce the possibility of a changing price level, it is useful now to begin thinking of output (Y) as being in real terms. The Keynesian Theory of Consumption In 2016, the average U.S. family spent about $1,800 on clothing. For high-income families earning more than $150,000, the amount spent on clothing was higher, at about $5,500. We all recognize that for consumption as a whole, as well as for consumption of most specific categories of goods and services, consumption rises with income. This relationship between consumption and income is central to Keynes’s model of the economy. Although Keynes recognized that many factors, including wealth and interest rates, play a role in determining consumption levels in the economy, in his classic The General Theory of Employment, Interest, and Money, current income played the key role: The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men [and women, too] are disposed, as a rule and on average, to increase their consumption as their incomes increase, but not by as much as the increase in their income.1
Keynes is telling us two things in this quote. First, if you find your income going up, you will spend more than you did before. Keynes is also saying something about how much more you will spend: he predicts—based on his looking at the data and his understanding of people—that the rise in consumption will be less than the full rise in income. This simple observation plays a large role in helping us understand the workings of the aggregate economy. The relationship between consumption and income is called a consumption function. Figure 8.1 shows a hypothetical consumption function for an individual household. The curve is labeled c(y), which is read “c is a function of y,” or “consumption is a function of income.” Note that we have drawn the line with an upward slope, showing that consumption increases with income. To reflect Keynes’s view that consumption increases less than one for one with income, we have drawn the consumption function with a slope of less than 1. The consumption function in Figure 8.1 is a straight line, telling us that an increase in income of $1 leads to the same increase in consumption regardless of the initial value of income. In practice, the consumption function may be curved, with the slope decreasing as income increases. This would tell us that the typical consumer spends less of the incremental income received as his or her income rises. The consumption function in Figure 8.1 represents an individual household. In macroeconomics, however, we are interested in the behavior of the economy as a whole, the aggregate 1 John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), First Harbinger Ed. (New York: Harcourt Brace Jovanovich, 1964), p. 96. M08_CASE3826_13_GE_C08.indd 170 17/04/19 12:07 PM CHAPTER 8 Aggregate Expenditure and Equilibrium Output 171 c(y) ◂ FIGURE 8.1 A Consumption Function for a Household A consumption function for an individual household shows the level of consumption at each level of household income Household income, y MyLab Economics Concept Check consumption of all households in the economy in relation to aggregate income. Figure 8.2 shows this aggregate consumption function, again using a straight line, or constant slope, for simplicity. With a straight-line consumption curve, we can use the following equation to describe the curve: C = a + bY Y is aggregate output (income),
C is aggregate consumption, and a is the point at which the consumption function intersects the vertical axis—a constant. The letter b is the slope of the line, in this case ∆C ∆Y [because consumption (C) is measured on the vertical axis and income (Y) is measured on the horizontal axis].2 Every time income increases (say by ∆Y), consumption increases by b times ∆Y. Thus, ∆C = b * ∆Y and ∆C ∆Y = b. Suppose, for example, that the slope of the line in Figure 8.2 is 0.75 (that is, b =.75). An increase in income (∆Y) of $1,000 would then increase consumption by b∆Y = 0.75 * +1,000, or +750. > > The marginal propensity to consume (MPC) is the fraction of a change in income that is consumed, or spent. In the consumption function here, b is the MPC. An MPC of.75 means consumption changes by $0.75 for every $1.00 increase in income. The slope of the consumption function is the MPC. An MPC less than 1 tells us that individuals spend less than 100 percent of their additional income, just as Keynes suggested. marginal propensity to consume (MPC) The fraction of a change in income that is consumed, or spent. C = a + bY ¢C ¢Y Slope = ¢C ¢Y = b ◂ FIGURE 8.2 An Aggregate Consumption Function The aggregate consumption function shows the level of aggregate consumption at each level of aggregate income. The upward slope indicates that higher levels of income lead to higher levels of consumption spending Aggregate income, Y MyLab Economics Concept Check 2 The Greek letter ∆ (delta) means “change in.” For example, ∆Y (read “delta Y”) means the “change in income.” If income (Y) in 2012 is $100 and income in 2013 is $110, then ∆Y for this period is +110 - +100 = +10. For a review of the concept of slope, see Appendix, Chapter 1. M08_CASE3826_13_GE_C08.indd 171 17/04/19 12:07 PM 172 PART III The Core of Macroeconomic Theory aggregate saving (S) The part of
aggregate income that is not consumed. identity Something that is always true by definition. marginal propensity to save (MPS) That fraction of a change in income that is saved. marginal propensity to consume K slope of consumption function K ∆C ∆Y Aggregate saving (S) in the economy, denoted S, is the difference between aggregate income and aggregate consumption: S K Y - C The triple equal sign means that this equation is an identity, or something that is always true by definition. This equation simply says that income that is not consumed must be saved. If $0.75 of a $1.00 increase in income goes to consumption, $0.25 must go to saving. If income decreases by $1.00, consumption will decrease by $0.75 and saving will decrease by $0.25. The marginal propensity to save (MPS) is the fraction of a change in income that is saved: ∆S ∆Y, where ∆S is the change in saving. Everything not consumed is saved, so the MPC and the MPS must add up to 1. MPC + MPS K 1 The MPC and the MPS are important concepts, as such it may help to review their definitions. The marginal propensity to consume (MPC) is the fraction of an increase in income that is consumed (or the fraction of a decrease in income that comes out of consumption). > The marginal propensity to save (MPS) is the fraction of an increase in income that is saved (or the fraction of a decrease in income that comes out of saving). The numerical examples used in the rest of this chapter are based on the following con- sumption function: C = 100 + 0.75 Y " ()* a b This equation is simply an extension of the generic C = a + bY consumption function we have been discussing, where a is 100 and b is 0.75. This function is graphed in Figure 8.3. ▸ FIGURE 8.3 The Aggregate Consumption Function Derived from the Equation C = 100 + 0.75Y In this simple consumption function, consumption is 100 at an income of zero. As income rises, so does consumption. For every 100 increase in income, consumption rises by 75. The slope of the line is 0.75 800 700 600 500 400 300 200 100 C = 100 + 0.75Y ¢C = 75 ¢Y = 100 Slope = ¢C ¢Y
= 75 100 = 0.75 0 100 MyLab Economics Concept Check 200 300 400 500 600 700 800 900 1000 Aggregate income, Y Aggregate Income, Y Aggregate Consumption, C 0 80 100 200 400 600 800 1,000 100 160 175 250 400 550 700 850 M08_CASE3826_13_GE_C08.indd 172 17/04/19 12:07 PM CHAPTER 8 Aggregate Expenditure and Equilibrium Output 173 Because saving and consumption by definition add up to income, we can use the consumption curve to tell us about both consumption and saving. We do this in Figure 8.4. In this figure, we have drawn a 45-degree line from the origin. Everywhere along this line aggregate consumption is equal to aggregate income. Therefore, saving is zero. Where the consumption curve is above the 45-degree line, consumption exceeds income and saving is negative, that is, people borrow. Where the consumption function crosses the 45-degree line, consumption is equal to income and saving is zero. Where the consumption function is below the 45-degree line, consumption is less than income and saving is positive. Note that the slope of the saving function is ∆S ∆Y, which is equal to the marginal propensity to save (MPS). The consumption function and the saving function are mirror images of each other. No information appears in one that does not appear in the other. These functions tell us how households in the aggregate will divide income between consumption spending and saving at every possible income level. In other words, they embody aggregate household behavior. > C = 100 + 0.75Y 800 700 400 250 200 100 +50 0 –50 –100 45º 0 200 400 800 Y Aggregate income, Y S K Y – C 200 400 800 Aggregate income, Y MyLab Economics Concept Check Y 2 C 5 S Aggregate Income Aggregate Consumption Aggregate Saving 0 80 100 200 400 600 800 1,000 100 160 175 250 400 550 700 850 2100 280 275 250 0 50 100 150 ◂ FIGURE 8.4 Deriving the Saving Function from the Consumption Function in Figure 8.3 Because S K Y - C, it is easy to derive the saving function from the consumption function. A 45-degree line drawn from the origin can be used as a convenient tool to compare consumption and income graphically. At Y = 200, consumption is 250. The 45-degree line shows us that consumption is larger than income by 50. Thus S K Y - C =
-50. At Y = 800, consumption is less than income by 100. Thus S = 100 when Y = 800. M08_CASE3826_13_GE_C08.indd 173 17/04/19 12:07 PM 174 PART III The Core of Macroeconomic Theory Behavioral Biases in Saving Behavior This chapter has described how saving is related to income. Economists have generally assumed that people make their saving decisions rationally, just as they make other decisions about choices in consumption and the labor market. Saving decisions involve thinking about trade-offs between present and future consumption. Recent work in behavioral economics has highlighted the role of psychological biases in saving behavior and has demonstrated that seemingly small changes in the way saving programs are designed can result in big behavioral changes. Many retirement plans are designed with an opt-in feature. That is, you need to take some action to enroll. Typically, when you begin a job, you need to check “yes” on the retirement plan enrollment form. Recent work in economics by James Choi of Yale University, Brigitte Madrian of Harvard, and Dennis Shea, head of executive compensation at Aetna, suggests that simply changing the enrollment process from the opt-in structure just described to an opt-out system in which people are automatically enrolled unless they check the “no” box dramatically increases enrollment in retirement pension plans. In one study, the change from an opt-in to an opt-out system increased pension plan enrollment after three months of work from 65 percent to 98 percent of workers. Behavioral economists have administered a number of surveys suggesting that people, on average, think they save too little of their income for retirement. Shlomo Benartzi, from the University of California, Los Angeles, and Richard Thaler, recent Nobel prize winner from the University of Chicago, devised a retirement program to try to increase saving rates. Under this plan, called Save More Tomorrow, employees are offered a program that allows them to precommit to save more whenever they get a pay raise. Behavioral economists argue that people find this option attractive because it is easier for them to commit to making sacrifices tomorrow than it is for them to make those sacrifices today. (This is why many people resolve to diet sometime in the future but continue to overeat today.) The Save More Tomorrow retirement plans have been put in place in a number of companies, including Vanguard, T. Rowe Price, and TIAA-CREF. Early results suggest dramatic increases in the saving rates of those enrolled
, with saving rates quadrupling after four years and four pay raises. CRITICAL THINKING 1. The Save More Tomorrow Plans encourage people to save more by committing themselves to future action. Can you think of examples in your own life of similar commitment devices you use? Other Determinants of Consumption MyLab Economics Concept Check The assumption that consumption depends only on income is obviously a simplification. In practice, the decisions of households on how much to consume in a given period are also affected by their wealth, by the interest rate, and by their expectations of the future. Households with higher wealth are likely to spend more, other things being equal, than households with less wealth, even at the same income level. As we will see, these other factors shift the consumption function. The boom in the U.S. stock market in the last half of the 1990s and the boom in housing prices between 2003 and 2005, both of which increased household wealth substantially, led households to consume more than they otherwise would have in these periods. In 2009–2010, after a fall in housing prices and the stock market, consumption was less than it otherwise would have been. For many households, interest rates also figure in to consumption and saving decisions. Lower interest rates reduce the cost of borrowing, so lower interest rates are likely to stimulate spending. (Conversely, higher interest rates increase the cost of borrowing and are likely to decrease spending.) Finally, as households think about what fraction of incremental income to M08_CASE3826_13_GE_C08.indd 174 17/04/19 12:07 PM CHAPTER 8 Aggregate Expenditure and Equilibrium Output 175 consume versus save, their expectations about the future may also play a role. If households are optimistic and expect to do better in the future, they may spend more at present than if they think the future will be bleak. Household expectations are also important regarding households’ responses to changes in their income. If, for example, the government announces a tax cut, which increases aftertax income, households’ responses to the tax cut will likely depend on whether the tax cut is expected to be temporary or permanent. If households expect that the tax cut will be in effect for only two years, their responses are likely to be smaller than if they expect the tax cut to be permanent. We examine these issues in Chapter 15, where we take a closer look at household behavior regarding both consumption and labor supply. But for now, we will focus only on income, given
that it is the most important determinant of consumption. Planned Investment (I) versus Actual Investment The output of an economy consists not only of goods consumed by households, but investments made by firms. Some firms’ investments are in the form of plant and equipment. These investments in many ways look like some consumption expenditures of households. In a given period, a firm might buy $500,000 of new machinery, which would be part of aggregate output for the period, as would the purchase of automobiles by households. In Chapter 6, you learned that firms’ investments also include inventories. Understanding how firms invest in inventories is a little more complicated, but it is important for understanding the way the macroeconomy works. A firm’s inventory is the stock of goods that it has awaiting sale. For many reasons, most firms want to hold some inventory. It is hard to predict exactly when consumers will want to purchase a new refrigerator, and most customers are not patient. Sometimes it is cheaper to produce goods in larger volumes than current demand requires, which leads firms to produce more than they need this period to hold for sale in a later period. From a macroeconomic perspective, however, inventory differs from other capital investments in one important way: although purchases by firms of machinery and equipment are always deliberate, sometimes inventories build up (or decline) without any deliberate plan by firms. For this reason, there can be a difference between planned investment, which consists of the investments firms plan to make, and actual investment, which consists of all of firms’ investments, including their unplanned changes in inventories. Remember that in Chapter 6 we used Ia to denote actual investment. We will always use I to denote planned investment. Why are inventories sometimes different from what was planned? Recall that firms hold planned inventories in anticipation of sales, recognizing that the exact timing of sales may be uncertain. If a firm overestimates how much it will sell in a period, it will end up with more in inventory than it planned to have. On other occasions, inventories may be lower than planned when sales are stronger than expected. As we will see shortly, the economy is in equilibrium only when planned investment and actual investment are equal. Planned Investment and the Interest Rate (r) We have seen that there is an important difference between planned investment and actual investment, and this distinction will play a key role in the discussion of equilibrium in this chapter. But another important question is what determines planned investment in the first place? In practice,
planned investment depends on many factors, as you would expect, but here we focus on just one: the interest rate. Recall that investment includes a firm’s purchase of new capital—new machines and plants. Whether a firm decides to invest in new capital depends on whether the expected profits from that machinery and those plants justify their costs. One cost of an investment project is the interest cost. When a manufacturing firm builds a new plant, the contractor must be paid at the time the plant is built. The money needed to carry out such projects is generally borrowed and 8.2 LEARNING OBJECTIVE Explain the difference between planned investment and actual investment. planned investment (I) Those additions to capital stock and inventory that are planned by firms. actual investment (Ia) The actual amount of investment that takes place; it includes items such as unplanned changes in inventories. 8.3 LEARNING OBJECTIVE Understand how planned investment is affected by the interest rate. M08_CASE3826_13_GE_C08.indd 175 17/04/19 12:07 PM 176 PART III The Core of Macroeconomic Theory ▸ FIGURE 8.5 Planned Investment Schedule 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 I2 I1 Planned investment, I I0 MyLab Economics Concept Check paid back over an extended period. The real cost of an investment project thus depends in part on the interest rate—the cost of borrowing. When the interest rate rises, it becomes more expensive to borrow and fewer projects are likely to be undertaken; increasing the interest rate, ceteris paribus, is likely to reduce the level of planned investment spending. When the interest rate falls, it becomes less costly to borrow and more investment projects are likely to be undertaken; reducing the interest rate, ceteris paribus, is likely to increase the level of planned investment spending. The relationship between the interest rate and planned investment is illustrated by the downward-sloping demand curve in Figure 8.5. The higher the interest rate, the lower the level of planned investment. At an interest rate of 3 percent, planned investment is I0. When the interest rate rises from 3 to 6 percent, planned investment falls from I0 to I1. As the interest rate falls, however, more projects become profitable, so more investment is undertaken. The curve in Figure 8.5 is sometimes called the �
�marginal efficiency of investment” curve. Other Determinants of Planned Investment MyLab Economics Concept Check 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. If a firm expects that its sales will increase in the future, it may begin to build up its capital stock—that is, to invest—now so that it will be able to produce more in the future to meet the increased level of 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 significantly. We will come back to this issue in Chapter 15, where we will take a closer look at firm behavior (and household behavior), but until then to complete our simple model we will assume that planned investment depends only on the interest rate. 8.4 LEARNING OBJECTIVE Explain how equilibrium output is determined. The Determination of Equilibrium Output (Income) Thus far, we have described the behavior of firms and households. In this simple setting, how does the economy achieve equilibrium and what does that equilibrium look like? M08_CASE3826_13_GE_C08.indd 176 17/04/19 12:07 PM CHAPTER 8 Aggregate Expenditure and Equilibrium Output 177 A number of definitions of equilibrium are used in economics but all use the idea that at equilibrium, there is no tendency for change. In microeconomics, equilibrium is said to exist in a particular market (for example, the market for bananas) at the price for which the quantity demanded is equal to the quantity supplied. At this point, both suppliers and demanders are satisfied. The equilibrium price of a good is the price at which suppliers want to furnish the amount that demanders want to buy. In the macroeconomic goods market, we will use a similar definition of equilibrium focused on a match between what is planned and what actually happens. To define equilibrium for the macroeconomy, we start with a new variable, planned aggregate expenditure (AE). Planned aggregate expenditure is, by definition, consumption plus planned investment: AE K C + I Note that I is planned investment spending only. It does not include any unplanned increases or decreases in inventory. Note
also that this is a definition. Aggregate expenditure is always equal to C + I, and we write it with the triple equal sign. The economy is defined to be in equilibrium when aggregate output (Y) is equal to planned aggregate expenditure (AE). equilibrium The condition that exists when quantity supplied and quantity demanded are equal. At equilibrium, there is no tendency for price to change. planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. Equal to consumption plus planned investment: AE K C + I Equilibrium : Y = AE Because AE is, by definition, C + I, equilibrium can also be written: Equilibrium : Y = C + I It will help in understanding the equilibrium concept to consider what happens if the economy is out of equilibrium. First, suppose aggregate output is greater than planned aggregate expenditure: Y 7 C + I aggregate output 7 planned aggregate expenditure When output is greater than planned spending, there is unplanned inventory investment. For some reason, consumers bought fewer goods than firms anticipated, and the unsold goods turned up in the form of unplanned inventory. Suppose instead that planned aggregate expenditure is greater than aggregate output: C + I 7 Y planned aggregate expenditure 7 aggregate output When planned spending exceeds output, firms have sold more than they planned to. Consumers have bought more than was expected, and firms are left with lower inventory levels than they planned. Planned and actual investment are not equal. Only when output is exactly matched by planned spending will there be no unplanned inventory investment. If there is unplanned inventory investment, this will be a state of disequilibrium. The mechanism by which the economy returns to equilibrium will be discussed later. Equilibrium in the goods market is achieved only when aggregate output (Y) and planned aggregate expenditure are equal, or when actual and planned investment are equal. C + I Table 8.1 derives a planned aggregate expenditure schedule and shows the point of equilibrium for our numerical example. I is assumed to be fixed and equal to 25 for these calculations. Remember that I depends on the interest rate, but the interest rate is fixed for purposes of this chapter. Remember also that all our calculations are based on C = 100 + 0.75Y. To determine planned aggregate expenditure, we add consumption spending (C) to planned investment spending (I) at every level of income. Glancing down columns (1) and (4), we see one and only one level at which aggregate output and planned aggregate expenditure are equal: Y = 500. 1 2 Figure 8
.6 illustrates the same equilibrium graphically. Figure 8.6a adds planned investment, fixed at 25, to consumption at every level of income. Because planned investment is a constant, the planned aggregate expenditure function is simply the consumption function displaced vertically by that constant amount. Figure 8.6b shows the planned aggregate expenditure M08_CASE3826_13_GE_C08.indd 177 17/04/19 12:07 PM 178 PART III The Core of Macroeconomic Theory ▸ FIGURE 8.6 Equilibrium Aggregate Output Equilibrium occurs when planned aggregate expenditure and aggregate output are equal. Planned aggregate expenditure is the sum of consumption spending and planned investment spending. TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium.* (1) (2) (3) (4) (5) (6) Aggregate Output (Income) (Y) Aggregate Consumption (C) Planned Investment (I) Planned Aggregate Expenditure (AE) C + I Unplanned Inventory Change Y - (C + I) Equilibrium? (Y - AE?) 100 200 400 500 600 800 1,000 175 250 400 475 550 700 850 25 25 25 25 25 25 25 200 275 425 500 575 725 875 *The figures in column (2) are based on the equation C = 100 + 0.75Y. -100 -75 -25 0 +25 +75 +125 No No No Yes No No No function with the 45-degree line. The 45-degree line represents all points on the graph where the variables on the horizontal and vertical axes are equal. Any point on the 45-degree line is a potential equilibrium point. The planned aggregate expenditure function crosses the 45-degree line at a single point, where Y = 500. (The point at which the two lines cross is sometimes called the Keynesian cross.) At that point, Y = C + I. a. 800 500 125 100 25 0 b. 800 725 600 500 275 200 125 = 100 + 0.75 Y 200 500 800 I = 25 Planned aggregate expenditure: (AE K C + I) Unplanned rise in inventory: output falls Equilibrium point: Y = C + I Unplanned fall in inventory: output rises 45º 0 200 500 800 Aggregate output, Y MyLab Economics Concept Check M08_CASE3826_13_GE_C08.indd 178 17/04/19 12:07 PM CHAPTER 8 Agg
regate Expenditure and Equilibrium Output 179 Now let us look at some other levels of aggregate output (income). First, consider Y = 800. Is this an equilibrium output? Clearly, it is not. At Y = 800, consumers are only interested in buying 700 worth of goods, which when added to planned inventory gives us planned aggregate expenditure levels of 725 (see Table 8.1). This amount is less than aggregate output, which is 800. Output is greater than planned spending, so the difference ends up in inventory as unplanned inventory investment. In this case, unplanned inventory investment is 75. In the aggregate, firms have more inventory than desired. As a result, firms have an incentive to change their production plans going forward. In this sense, the economy will not be in equilibrium. Next, consider Y = 200. Is this an equilibrium output? No. At Y = 200, planned aggregate expenditure is 275. Planned spending (AE) is greater than output (Y), and there is an unplanned fall in inventory investment of 75. Again, firms in the aggregate will experience a different result from what they expected. At Y = 200 and Y = 800, planned investment and actual investment are unequal. There is unplanned investment, and the system is out of balance. Only at Y = 500, where planned aggregate expenditure and aggregate output are equal, will planned investment equal actual investment. Finally, let us find the equilibrium level of output (income) algebraically. Recall that we know the following: Y = C + I C = 100 + 0.75Y I = 25 1 equilbrium consumption function planned investment 1 2 2 By substituting the second and third equations into the first, we get: 1 2 Y = 100 + 0.75 Y + 25. " 3 C I There is only one value of Y for which this statement is true, and we can find it by rearranging terms: Y - 0.75Y = 100 + 25 0.25Y = 125 125 0.25 Y = = 500 The equilibrium level of output is 500, as shown in Table 8.1 and Figure 8.6. The Saving/Investment Approach to Equilibrium MyLab Economics Concept Check Aggregate income must be saved or spent, by definition, Y K C + S, which is an identity. The equilibrium condition is Y = C + I, but this is not an identity because it does not hold when we are out of equilibrium.3 By substituting C + S for Y in the equilibrium
condition, we can write: C + S = C + I We can subtract C from both sides of this equation and we are left with: S = I Thus, only when planned investment equals saving will there be equilibrium. Figure 8.7 reproduces the saving schedule derived in Figure 8.4 and the horizontal investment function from Figure 8.6. Notice that S = I at one and only one level of aggregate output, Y = 500. At Y = 500, C = 475 and I = 25. At this level of Y, saving equals 25 and so S = I and we are at an equilibrium. 3It would be an identity if I included unplanned inventory accumulations—in other words, if I were actual investment instead of planned investment. M08_CASE3826_13_GE_C08.indd 179 17/04/19 12:07 PM 180 PART III The Core of Macroeconomic Theory ▸ FIGURE 8.7 The S = I Approach to Equilibrium Aggregate output is equal to planned aggregate expenditure only when saving equals planned investment (S = I). Saving and planned investment are equal at Y = 500 100 25 0 –100 S I 100 200 300 400 500 600 Aggregate output, Y MyLab Economics Concept Check Adjustment to Equilibrium MyLab Economics Concept Check We have defined equilibrium and learned how to find it, but we have said nothing about how firms might react to disequilibrium. Let us consider the actions firms might take when planned aggregate expenditure exceeds aggregate output (income). We already know the only way firms can sell more than they produce is by selling some inventory. This means that when planned aggregate expenditure exceeds aggregate output, unplanned inventory reductions have occurred. Firms have sold more than they planned. It seems reasonable to assume that firms will respond to unplanned inventory reductions by increasing output. If firms increase output, income must also increase. (Output and income are two ways of measuring the same thing.) As GM builds more cars, it hires more workers (or pays its existing workforce for working more hours), buys more steel, uses more electricity, and so on. These purchases by GM represent income for the producers of labor, steel, electricity, and so on. When firms try to keep their inventories stable by increasing production, this will generate more income in the economy as a whole. This will lead to more consumption. Remember, when income rises, so does consumption, albeit not one for one. The adjustment process will continue as long as output (income)
is below planned aggregate expenditure. If firms react to unplanned inventory reductions by increasing output, an economy with planned spending greater than output will adjust to equilibrium, with Y being higher than before. If planned spending is less than output, there will be unplanned increases in inventories. In this case, firms will respond by reducing output. As output falls, income falls, consumption falls because consumption depends on income, output falls even more, and so on, until equilibrium is restored, with Y being lower than before. As Figure 8.6 shows, at any level of output above Y = 500, such as Y = 800, output will fall until it reaches equilibrium at Y = 500, and at any level of output below Y = 500, such as Y = 200, output will rise until it reaches equilibrium at Y = 500.4 8.5 LEARNING OBJECTIVE Describe the multiplier process and use the multiplier equation to calculate changes in equilibrium. The Multiplier We are now ready to answer the question posed at the beginning of this chapter: what happens to the level of real output if all of the managers in the economy suddenly decide to increase planned investment from, say, 25 to 50? It may surprise you to learn that the change in equilibrium output will be greater than the initial change in planned investment. In fact, output will change by a multiple of the change in planned investment. 4In discussing simple supply and demand equilibrium in Chapters 3 and 4, we saw that when quantity supplied exceeds quantity demanded, the price falls and the quantity supplied declines. Similarly, when quantity demanded exceeds quantity supplied, the price rises and the quantity supplied increases. In the analysis here, we are ignoring potential changes in prices or in the price level and focusing on changes in the level of real output (income). Later, after we have introduced the price level into the analysis, prices will be important. At this stage, however, only aggregate output (income) (Y) adjusts when aggregate expenditure exceeds aggregate output (with inventory falling) or when aggregate output exceeds aggregate expenditure (with inventory rising). M08_CASE3826_13_GE_C08.indd 180 17/04/19 12:07 PM CHAPTER 8 Aggregate Expenditure and Equilibrium Output 181 The Rise and Fall of Nokia As we will see, an unplanned increase in inventory is likely to reduce output by a larger proportion than the reduction in investment expenditure. This can have pronounced effects on the overall level of output, especially for large industries that have a
significant contribution to their country’s GDP. Let us take the example of the Finnish company Nokia. Up until 2007, the mogul mobile phone producer supplied nearly 48 percent of the world's mobile phones. At the national level, it accounted for 4 percent of Finland’s GDP, 21 percent of total exports, and 14 percent of corporate tax revenues.1 However, Nokia’s fortune reversed in 2007 with the advent of Apple’s iPhone and other Android devices. The decrease in global demand resulted in a disequilibrium due to the accumulation of unplanned inventory. Nokia responded by massive production cutbacks and several rounds of immense layoffs. This decline in production slashed its global market share from 46.7 percent in 2007 to a mere 1 percent in 2017. Further, its share of market capital in Helsinki's stock exchange plunged from 70 percent to 13 percent during the same period. As for backward linkages, since many industries, such as electronics manufacturing, research and development, software, wholesalers, and retailers, depended on Nokia, the impact on the Finnish economy was immense. Studies show that at least 20 percent of the reduction of total employment between 2008 and 2016 is attributed to the “Nokia effect,” while the rest is due to the Global Financial Crisis of 2008. The prolonged structural unemployment and collapsing household incomes that followed caused an economic slowdown. By 2016, Nokia was contributing to less than 0.4 percent of Finland’s gross GDP.2 The takeaway from this case is that a nation’s dependence on a single company or industry can be quite risky because, in the event of corporate mismanagement or market failure, it can cause severe macroeconomic damage. Therefore, diversification is key in a nation’s industrial policy to protect the economy from shifts in technology, swings in consumer behavior, changes in competitive advantage, or economic meltdowns. CRITICAL THINKING 1. Do you think that during its golden years from 1998 to 2007, Nokia had unplanned inventory levels? How would this have impacted the overall level of Finland’s GDP? 1Boston Consulting Group, 2017. “Nokia: Reprogramming for Growth,” The Comeback Kids: Lessons from Successful Turnarounds, November 13. 2Paavo Suni and Vesa Vihriälä, 2016. “Finland and Its Northern Peers in the Great Recession.” ETLA Reports No. 49, The Research Institute of the Finnish Economy–
ELTA, January 15. The multiplier is defined as the ratio of the change in the equilibrium level of output to a change in some exogenous variable. An exogenous variable is a variable that does not depend on the state of the economy—that is, a variable is exogenous if it does not change in response to changes in the economy. In this chapter, we treat planned investment as exogenous. This simplifies our analysis and provides a foundation for later discussions. With planned investment exogenous, we can ask how much the equilibrium level of output changes when planned investment changes. Remember that we are not trying to explain why planned investment changes; we are simply asking how much the equilibrium level of output changes when (for whatever reason) planned investment changes. (Beginning in Chapter 11, we will no longer take planned investment as a given and will explain how planned investment is determined.) Consider a sustained increase in planned investment of 25—that is, suppose I increases from 25 to 50 and stays at 50. If equilibrium existed at I = 25, an increase in planned investment of 25 will cause a disequilibrium, with planned aggregate expenditure greater than aggregate output by 25. Firms immediately see unplanned reductions in their inventories. As a result, firms begin to increase output. Let us say the increase in planned investment comes from an anticipated increase in world travel that comes, for example, from a decision by a major world power to lift restrictions on its multiplier The ratio of the change in the equilibrium level of output to a change in some exogenous variable. exogenous variable A variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes. M08_CASE3826_13_GE_C08.indd 181 17/04/19 12:07 PM 182 PART III The Core of Macroeconomic Theory citizens’ ability to travel. This increase in expected travel demand leads airlines to purchase more airplanes, car rental companies to increase purchases of automobiles, and bus companies to purchase more buses (all capital goods). The firms experiencing unplanned inventory declines will be automobile manufacturers, bus producers, and aircraft producers—GM, Ford, Boeing, and so on. In response to declining inventories of planes, buses, and cars, these firms will increase output. Now suppose these firms raise output by the full 25 increase in planned investment. Does this restore equilibrium? No, it does not because when output goes up, people earn more income and a part of that income will
be spent. This increases planned aggregate expenditure even further. In other words, an increase in I also leads indirectly to an increase in C. To produce more airplanes, Boeing has to hire more workers or ask its existing employees to work more hours. It also must buy more engines from General Electric, more tires from Goodyear, and so on. Owners of these firms will earn more profits, produce more, hire more workers, and pay out more in wages and salaries. This added income does not vanish into thin air. It is paid to households that spend some of it and save the rest. The added production leads to added income, which leads to added consumption spending. If planned investment (I) goes up by 25 initially and is sustained at this higher level, an increase of output of 25 will not restore equilibrium because it generates even more consumption spending (C). People buy more consumer goods. There are unplanned reductions of inventories of basic consumption items—washing machines, food, clothing, and so on—and this prompts other firms to increase output. The cycle starts all over again. Output and income can rise significantly more than the initial increase in planned investment, but how much and how large is the multiplier? This is answered graphically in Figure 8.8. Assume that the economy is in equilibrium at point A, where equilibrium output is 500. The increase in I of 25 shifts the AE K C + I curve up by 25 because I is higher by 25 at every level of income. The new equilibrium occurs at point B, where the equilibrium level of output is 600. Like point A, point B is on the 45-degree line and is an equilibrium value. Output (Y) has increased by 100 (600–500), or four times the initial increase in planned investment of 25, between point A and point B. The multiplier in this example is 4. At point B, aggregate spending is also higher by 100. If 25 of this additional 100 is investment (I), as we know it is, the remaining 75 is added consumption (C). From point A to point B then, ∆Y = 100, ∆I = 25, and ∆C = 75. AE 2 K C + I + ¢I B AE1 K C + I ¢I = 25 ¢C = 75 ¢AE = 100 A ▸ FIGURE 8.8 The Multiplier as Seen in the Planned Aggregate Expenditure Diagram At point A, the economy is in equilibrium at Y = 500
. When I increases by 25, planned aggregate expenditure is initially greater than aggregate output. As output rises in response, additional consumption is generated, pushing equilibrium output up by a multiple of the initial increase in I. The new equilibrium is found at point B, where Y = 600. Equilibrium output has increased by 100, 600 - 500 or four times the amount of the 2 increase in planned investment 600 575 500 400 300 ¢I = 25 200 150 125 100 45º 0 100 200 300 400 500 600 700 800 ¢Y = 100 Aggregate output, Y MyLab Economics Concept Check M08_CASE3826_13_GE_C08.indd 182 17/04/19 12:07 PM Why doesn’t the multiplier process go on forever? The answer is that only a fraction of the increase in income is consumed in each round. Successive increases in income become smaller and smaller in each round of the multiplier process because of leakage, such as saving, until equilibrium is restored. CHAPTER 8 Aggregate Expenditure and Equilibrium Output 183 The size of the multiplier depends on the slope of the planned aggregate expenditure line. The steeper the slope of this line is, the greater the change in output for a given change in investment. When planned investment is fixed, as in our example, the slope of the AE K C + I line. The greater the MPC is, the greater the ∆C is just the marginal propensity to consume multiplier. This should not be surprising. A large MPC means that consumption increases a great deal when income increases. ∆Y 2 1 > The Multiplier Equation MyLab Economics Concept Check Is there a way to determine the size of the multiplier without using graphic analysis? Yes, there is. Assume that the market is in equilibrium at an income level of Y = 500. Now suppose planned investment (I)—thus, planned aggregate expenditure (AE)—increases and remains higher by 25. Planned aggregate expenditure is greater than output, there is an unplanned inventory reduction, and firms respond by increasing output (income) (Y). This leads to a second round of increases, and so on. What will restore equilibrium? Look at Figure 8.7 and recall: planned aggregate expenditure (AE K C + I) is not equal to aggregate output (Y) unless S = I; the leakage of saving must exactly match the injection of planned investment spending for the economy to be in equilibrium. Recall also that we assumed that planned investment jumps to a
new, higher level and stays there; it is a sustained increase of 25 in planned investment spending. As income rises, consumption rises and so does saving. Our S = I approach to equilibrium leads us to conclude that equilibrium will be restored only when saving has increased by exactly the amount of the initial increase in I. Otherwise, I will continue to be greater than S and C + I will continue to be greater than Y. (The S = I approach to equilibrium leads to an interesting paradox in the macro-economy. See the Economics in Practice, “The Paradox of Thrift” on the next page.) It is possible to figure how much Y must increase in response to the additional planned investment before equilibrium will be restored. Y will rise, pulling S up with it until the change in saving is exactly equal to the change in planned investment—that is, until S is again equal to I at its new higher level. Because added saving is a fraction of added income (the MPS), the increase in income required to restore equilibrium must be a multiple of the increase in planned investment. Recall that the marginal propensity to save (MPS) is the fraction of a change in income that is saved. It is defined as the change in S (∆S) over the change in income (∆Y): MPS = ∆S ∆Y Because ∆S must be equal to ∆ I for equilibrium to be restored, we can substitute ∆ I for ∆ S and solve: Therefore, MPS = ∆I ∆Y ∆Y = ∆I * 1 MPS As you can see, the change in equilibrium income (∆Y) is equal to the initial change in planned investment (∆I) times 1 MPS. The multiplier is 1 MPS: > > multiplier K 1 MPS M08_CASE3826_13_GE_C08.indd 183 17/04/19 12:07 PM 184 PART III The Core of Macroeconomic Theory The Paradox of Thrift An interesting paradox can arise when households attempt to increase their saving. What happens if households become concerned about the future and want to save more today to be prepared for hard times tomorrow? If households increase their planned saving, the saving schedule in the graph below shifts upward from S0 to S1. The plan to save more is a plan to consume less, and the resulting drop in spending leads to a drop in income. Income drops by a multiple of the initial shift
in the saving schedule. Before the increase in saving, equilibrium exists at point A, where S0 = I and Y = 500. Increased saving shifts the equilibrium to point B, the point at which S1 = I. New equilibrium output is 300—a decrease of 200 (∆Y ) from the initial equilibrium. By consuming less, households have actually caused the hard times about which they were apprehensive. Worse, the new equilibrium finds saving at the same level as it was before consumption dropped (25). In their attempt to save more, households have caused a contraction in output, and thus in income. They end up consuming less, but they have not saved any more. It should be clear why saving at the new equilibrium is equal to saving at the old equilibrium. Equilibrium requires 200 100 50 25 0 –50 –100 –200 that saving equals planned investment, and because planned investment is unchanged, saving must remain unchanged for equilibrium to exist. This paradox shows that the interactions among sectors in the economy can be of crucial importance. The paradox of thrift is “paradoxical” because it contradicts the widely held belief that “a penny saved is a penny earned.” This may be true for an individual, but when society as a whole saves more, the result is a drop in income, but no increased saving. Does the paradox of thrift always hold? Recall our assumption that the interest rate is fixed. If the extra saving that the households want to do to ward off hard times leads to a fall in the interest rate, this will increase planned investment and thus shift up the I schedule in the figure. The paradox might then be avoided. Planned investment could increase enough so that the new equilibrium occurs at a higher level of income (and saving). CRITICAL THINKING 1. Draw a consumption function corresponding to S0 and S1 and describe what is happening. B A S1 S0 I 100 200 300 500 400 ¢Y MyLab Economics Concept Check Aggregate output, Y The Paradox of Thrift An increase in planned saving from S0 to S1 causes equilibrium output to decrease from 500 to 300. The decreased consumption that accompanies increased saving leads to a contraction of the economy and to a reduction of income, B=but at the new equilibrium, saving is the same as it was at the initial equilibrium. Increased efforts to save have caused a drop in income, but no overall change in saving. M08_CASE3826_13_GE_C08.ind
d 184 17/04/19 12:07 PM Because MPS + MPC K 1, MPS K 1 - MPC. It follows that the multiplier is also equal to CHAPTER 8 Aggregate Expenditure and Equilibrium Output 185 multiplier K 1 1 - MPC In our example, the MPC is.75; so the MPS must equal 1 – 0.75, or 0.25. Thus, the multiplier is 1 divided by.25, or 4. The change in the equilibrium level of Y is 4 * 25, or 100.5 Also note that the same analysis holds when planned investment falls. If planned investment falls by a certain amount and is sustained at this lower level, output will fall by a multiple of the reduction in I. As the initial shock is felt and firms cut output, they lay people off. The result is income, and subsequently consumption, fall. The Size of the Multiplier in the Real World MyLab Economics Concept Check In considering the size of the multiplier, it is important to realize that the multiplier we derived in this chapter is based on a very simplified picture of the economy. First, we have assumed that planned investment is exogenous and does not respond to changes in the economy. Second, we have thus far ignored the role of government, financial markets, and the rest of the world in the macroeconomy. For these reasons, it would be a mistake to move on from this chapter thinking that national income can be increased by $100 billion simply by increasing planned investment spending by $25 billion. Nevertheless, even this simple model should give you some intuition as to why and how national income responds to increases in planned investment. As we relax these assumptions in the following chapters, you will see that most of what we add to make our analysis more realistic has the effect of reducing the size of the multiplier. For example: 1. The Appendix to Chapter 9 shows that when tax payments depend on income (as they do in the real world), the size of the multiplier is reduced. As the economy expands, tax payments increase and act as a drag on the economy. The multiplier effect is smaller. 2. We will see in Chapter 11 that adding Fed behavior regarding the interest rate has the effect of reducing the size of the multiplier. 3. We will also see in Chapter 11 that adding the price level to the analysis reduces the size of the multiplier. We will see that part of an expansion of the economy is likely to take the form of an increase in the price level instead of
an increase in real output. When this happens, the size of the multiplier is reduced. 4. The multiplier is also reduced when imports are introduced (in Chapter 19) because some domestic spending leaks into foreign markets. These juicy tidbits give you something to look forward to as you proceed through the rest of this book. For now, however, it is enough to point out that in reality the size of the multiplier is probably about two. This is much lower than the value of four that we used in this chapter, but still tells us that an increase in planned investment has more of an effect than you might have expected before beginning this chapter! Looking Ahead In this chapter, we took the first step toward understanding how the economy works. We assumed that consumption depends on income, that planned investment is fixed, and that there is equilibrium. We discussed how the economy might adjust back to equilibrium when it is out of equilibrium. We also discussed the effects on equilibrium output from a change in planned investment and derived the multiplier. In the next chapter, we retain these assumptions and add the government to the economy. 5 The multiplier can also be derived algebraically, as the Appendix to this chapter demonstrates. M08_CASE3826_13_GE_C08.indd 185 17/04/19 12:07 PM 186 PART III The Core of Macroeconomic Theory S U M M A R Y 8.1 THE KEYNESIAN THEORY OF CONSUMPTION p. 170 1. Aggregate consumption is assumed to be a function of ag- gregate income. 2. The marginal propensity to consume (MPC) is the fraction of a change in income that is consumed, or spent. The marginal propensity to save (MPS) is the fraction of a change in income that is saved and because all income must be saved or spent, MPS + MPC K 1. 8.2 PLANNED INVESTMENT (I) VERSUS ACTUAL INVESTMENT p. 175 3. Planned investment may differ from actual investment be- cause of unanticipated changes in inventories. 8.3 PLANNED INVESTMENT AND THE INTEREST RATE (r) p. 175 4. Planned investment depends on the interest rate, which is assumed to be fixed for this chapter. 8.4 THE DETERMINATION OF EQUILIBRIUM OUTPUT (INCOME) p. 176 5. Planned aggregate expenditure (AE) equals consumption plus planned investment: AE K C + I. Equilibrium in the
goods market is achieved when planned aggregate expenditure equals aggregate output: C + I = Y. This holds if and only if planned investment and actual investment are equal. 6. Because aggregate income must be saved or spent, the equilibrium condition Y = C + I can be rewritten as C + S = C + I, or S = I. Only when planned investment equals saving will there be equilibrium. This approach to equilibrium is the saving/investment approach to equilibrium. 7. When planned aggregate expenditure exceeds aggregate output (income), there is an unplanned fall in inventories. Firms will increase output. This increased output leads to increased income and even more consumption. This process will continue as long as output (income) is below planned aggregate expenditure. If firms react to unplanned inventory reductions by increasing output, an economy with planned spending greater than output will adjust to an equilibrium, with Y higher than before. THE MULTIPLIER p. 180 8. Equilibrium output changes by a multiple of the change in planned investment or any other exogenous variable. The multiplier is equal to 1/MPS. 9. When households increase their planned saving, income decreases and saving does not change. Saving does not increase because in equilibrium, saving must equal planned investment and planned investment is fixed. If planned investment also increased, this paradox of thrift could be averted and a new equilibrium could be achieved at a higher level of saving and income. This result depends on the existence of a channel through which additional household saving finances additional investment actual investment p. 175 aggregate income p. 170 aggregate output p. 170 aggregate output (income) (Y), p. 170 aggregate saving (S), p. 172 consumption function p. 170 equilibrium p. 177 exogenous variable p. 181 identity p. 172 marginal propensity to consume (MPC), p. 171 marginal propensity to save (MPS), p. 172 multiplier p. 181 planned aggregate expenditure (AE), p. 172 planned investment p. 175 Equations: S K Y - C, p. 172 MPC K slope of consumption ∆C ∆Y function K, p. 172 MPC + MPS K 1, p. 172 AE K C + I, p. 177 Equilibrium condition: Y = AE or Y = C + I, p. 177 Saving/investment approach to equilibrium: S = I, p. 179 Multiplier K 1 MPS K 1 1 - MPC, p. 185 P R O B L E M S All problems are available
on MyLab Economics. 8.1 THE KEYNESIAN THEORY OF CONSUMPTION LEARNING OBJECTIVE: Explain the principles of the Keynesian theory of consumption. 1.1 Briefly define the following terms and explain the rela- tionship between MPC and MPS and the relationship between aggregate output and aggregate income. a. MPC b. MPS c. Aggregate output d. Aggregate income 1.2 Fill in the aggregate saving column in the following table. Use the data in the table to calculate the consumption function and the saving function, and plot these functions MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M08_CASE3826_13_GE_C08.indd 186 17/04/19 12:07 PM CHAPTER 8 Aggregate Expenditure and Equilibrium Output 187 as well as the 45-degree line on a graph. What are the values for the MPC and the MPS? 8.3 PLANNED INVESTMENT AND THE INTEREST RATE (r) Aggregate Income, Y Aggregate Consumption, C Aggregate Saving, S LEARNING OBJECTIVE: Understand how planned investment is affected by the interest rate. $ 0 100 200 300 400 500 600 $200 250 300 350 400 450 500 1.3 [Related to the Economics in Practice on p. 174] The Economics in Practice describes some of the difficulties that households have with regard to decisions involving tradeoffs between the present and the future. Explain briefly how the problem of global warming and the problem of adequate household saving are similar. Describe ways in which the concept of opportunity cost can be used to frame these two problems. What barriers might prevent households or societies from achieving satisfactory outcomes? 1.4 Assume in country X the average marginal propensity to save is 0.2 when the aggregate income equals zero and consumption is 50. Derive the saving function and consumption function. What happens to consumption when the marginal propensity to save decreases to 0.1? Explain your answer and show this on a graph. 8.2 PLANNED INVESTMENT (I) VERSUS ACTUAL INVESTMENT LEARNING OBJECTIVE: Explain the difference between planned investment and actual investment. 2.1 Explain the difference between actual investment and planned investment. When are actual investment and planned investment equal? When is actual
investment greater than planned investment? When is actual investment less than planned investment? 2.2 Suppose that AhoySales, Inc., a large multinational shipping company, has decided to spend €10 million on a new storage space in Munich, €45 million on new aircraft, and €5 million on additional acquisition of kerosene. Further assume that in addition to these expenses the company is planning to produce 5 million parcels, which have been selling at a price of €5 each. Now suppose that AhoySales plans to keep a tenth of that production in inventory. Over time, the company’s parcels have met with increasing demand, but the inventory has only increased by €1 million. a. How much was AhoySales’ total planned investment? b. How much did AhoySales actually invest? c. What is the difference between the actual and the planned investment? Should AhoySales produce fewer or more parcels? Why? 3.1 Explain whether you agree or disagree with the following statement: “All else equal, businesses will generally plan more investment projects when interest rates rise, because higher interest rates mean businesses will earn more on those investments.” 8.4 THE DETERMINATION OF EQUILIBRIUM OUTPUT (INCOME) LEARNING OBJECTIVE: Explain how equilibrium output is determined. 4.1 The following data are estimates for the nation of Teleria. Real GNP = 700,000 telers Investment = 150,000 telers Savings are 20 percent of income because Telerians like to enjoy life and consume most of their income. Annual investment is kept constant at 150,000 telers. The commodities the country primarily produces are wheat, wine, and meat. Governmental expenditure is zero because the citizens self-govern themselves for free. They also do not trade. You are asked by the business editor of the Telerian Gazette, the national newspaper, to predict the economic events of the next few months. By using the data given, can you make a forecast? What is likely to happen to the level of real GDP? What will happen to inventory levels? When will things stop changing? 4.2 Go to www.oecd.org and look through their report on the latest GDP release. What are the main components of Australia’s GDP for the last quarter for which data is available? How does it compare to New Zealand’s GDP? 4.3 The following questions refer to this table: Aggregate Output/Income Consumption Planned
Investment 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 1,500 1,875 2,250 2,625 3,000 3,375 3,750 4,125 250 250 250 250 250 250 250 250 a. At each level of output, calculate saving. At each level of output, calculate unplanned investment (inventory change). What is likely to happen to aggregate output if the economy produces at each of the levels indicated? What is the equilibrium level of output? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M08_CASE3826_13_GE_C08.indd 187 17/04/19 12:07 PM 188 PART III The Core of Macroeconomic Theory b. Over each range of income (1,000 to 1,500, 1,500 to 2,000, and so on), calculate the marginal propensity to consume. Calculate the marginal propensity to save. What is the multiplier? c. By assuming there is no change in the level of the MPC and the MPS and planned investment jumps by 125 and is sustained at that higher level, recompute the table. What is the new equilibrium level of Y? Is this consistent with what you compute using the multiplier? 4.4 This chapter argues that saving and spending behavior depend in part on wealth (accumulated savings and inheritance), but our simple model does not incorporate this effect. Consider the following model of a simple economy: C = 50 + 0.8Y + 0.1W I = 200 W = 500 If you assume that wealth (W) and investment (I) remain constant (we are ignoring the fact that saving adds to the stock of wealth), what are the equilibrium levels of GDP (Y), consumption (C), and saving (S)? Now suppose that wealth increases by 100 percent to 1,000. Recalculate the equilibrium levels of Y, C, and S. What impact does wealth accumulation have on GDP? Many were concerned with the large increase in stock values in 2016 and 2017. Does this present a problem for the economy? Explain. 4.5 You are given the following data concerning Kadwan, a country located in the mountains. (1) Consumption function: C = 150 + 0.7Y (2) Investment function: I = 75 (3)
AE K C + I (4) AE = Y a. What is the marginal propensity to consume in Kadwan, and what is the marginal propensity to save? b. Graph equations (1) to (4) and solve for equilibrium income. the unplanned inventory if the economy experiences a larger-than-expected expansion? Construct a graph that shows planned aggregate expenditure and aggregate output and identify each of these situations on the graph. What needs to happen to output in each situation to reach equilibrium? 8.5 THE MULTIPLIER LEARNING OBJECTIVE: Describe the multiplier process and use the multiplier equation to calculate changes in equilibrium. 5.1 Explain the multiplier intuitively. Why is it that an increase in planned investment of $100 raises equilibrium output by more than $100? Why is the effect on equilibrium output finite? How do we know that the multiplier is 1/MPS? 5.2 [Related to the Economics in Practice on p. 184] If households decide to save more, saving in the aggregate may fall. Explain this in words. 45° AE = 1200 450 0 300 900 1,300 Aggregate output, Y c. Suppose equation (2) is changed to (2’) I = 90. 5.3 Use the graph to answer the questions that follow. What is the new equilibrium level of income? By how much does the 15-currency unit increase in planned investment change equilibrium income? What is the value of the multiplier? a. What is the value of the MPC? b. What is the value of the MPS? c. What is the value of the multiplier? d. What is the amount of unplanned investment at aggregate d. Calculate the saving function for Kadwan. Plot outputs of 300, 900, and 1,300? this saving function on a graph with equation (2). Explain why the equilibrium income in this graph must be the same as in part b. 4.6 [Related to the Economics in Practice on p. 181] Suppose the economy enters an unexpected recession. What would happen to the unplanned inventory of a company like General Motors? What would happen to 5.4 According to OECD data, in 2015, household saving as a fraction of disposable income in Germany was 10.1 percent, while in Brazil it was 14.2 percent. All else equal, what does this difference tell us about the MPC, MPS, and multipliers of the two economies? How would an increase in investment of the same amount
impact the aggregate output in each economy? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M08_CASE3826_13_GE_C08.indd 188 17/04/19 12:07 PM LEARNING OBJECTIVE Show that the multiplier is one divided by one minus the MPC. the unplanned inventory if the economy experiences a larger-than-expected expansion? Construct a graph that shows planned aggregate expenditure and aggregate output and identify each of these situations on the graph. What needs to happen to output in each situation to reach equilibrium? 8.5 THE MULTIPLIER LEARNING OBJECTIVE: Describe the multiplier process and use the multiplier equation to calculate changes in equilibrium. 5.1 Explain the multiplier intuitively. Why is it that an increase in planned investment of $100 raises equilib- rium output by more than $100? Why is the effect on equilibrium output finite? How do we know that the multiplier is 1/MPS? 5.2 [Related to the Economics in Practice on p. 184] If households decide to save more, saving in the aggregate may fall. Explain this in words. 5.3 Use the graph to answer the questions that follow. a. What is the value of the MPC? b. What is the value of the MPS? c. What is the value of the multiplier? d. What is the amount of unplanned investment at aggregate outputs of 300, 900, and 1,300? 5.4 According to OECD data, in 2015, household saving as a fraction of disposable income in Germany was 10.1 percent, while in Brazil it was 14.2 percent. All else equal, what does this difference tell us about the MPC, MPS, and multipliers of the two economies? How would an increase in investment of the same amount impact the aggregate output in each economy CHAPTER 8 Aggregate Expenditure and Equilibrium Output 189 QUESTION 1 The marginal propensity to consume is not equal across all members of society. The marginal propensity to consume for individuals in the lowest quintile of the U.S. income distribution is markedly different from the marginal propensity to consume for individuals in the highest quintile. Which of these groups likely has a larger marginal propensity to consume? QUESTION 2 When homeowners watch the values of their homes rise quickly in a booming
real estate market, they often choose to save a smaller fraction of their income. How would this behavior affect the marginal propensity to consume? CHAPTER 8 APPENDIX: Deriving the Multiplier Algebraically In addition to deriving the multiplier using the simple substitution we used in the chapter, we can also derive the formula for the multiplier by using simple algebra. Recall that our consumption function is: C = a + bY where b is the marginal propensity to consume. In equilibrium: Y = C + I Now we solve these two equations for Y in terms of I. By substituting the first equation into the second, we get: LEARNING OBJECTIVE Show that the multiplier is one divided by one minus the MPC. ()* Y = a + bY + I C This equation can be rearranged to yield: Y - bY = We can then solve for Y in terms of I by dividing through by Now look carefully at this expression and think about increasing I by some amount, ∆I, with a held constant. If I increases by ∆I, income will increase by 1 2a b ∆Y = ∆I * 1 1 - b Because b K MPC, the expression becomes The multiplier is ∆Y = ∆I * 1 1 - MPC 1 1 - MPC Finally, because MPS + MPC K 1, MPS is equal to 1 - MPC, making the alternative expression for the multiplier 1/MPS, just as we saw in this chapter. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M08_CASE3826_13_GE_C08.indd 189 17/04/19 12:07 PM 9 The Government and Fiscal Policy CHAPTER OUTLINE AND LEARNING OBJECTIVES 9.1 Government in the Economy p. 191 Discuss the influence of fiscal policies on the economy. 9.2 Fiscal Policy at Work: Multiplier Effects p. 195 Describe the effects of three fiscal policy multipliers. 9.3 The Federal Budget p. 201 Compare and contrast the federal budgets of three U.S. government administrations. 9.4 The Economy’s Influence on the Government Budget p. 206 Explain the influence of the economy on the federal government budget. Looking Ahead p. 207 Appendix A: Deriving the Fiscal Policy Multipliers p
. 211 Show that the government spending multiplier is one divided by one minus the MPC. Appendix B: The Case in Which Tax Revenues Depend on Income p. 212 Explain why the multiplier falls when taxes depend on income. 190190 There is considerable debate over what the government can and should do in managing the macroeconomy. At one end of the spectrum are the Keynesians and their intellectual descendants who believe that the macroeconomy is likely to fluctuate too much if left on its own and that the government should smooth out fluctuations in the business cycle. These ideas can be traced to Keynes’s analysis in The General Theory, which suggests that governments can use their taxing and spending powers to increase aggregate expenditure (and thereby stimulate aggregate output) in recessions or depressions. At the other end of the spectrum are those who claim that government spending is incapable of stabilizing the economy, or worse, is destabilizing and harmful. In this chapter, we turn to this set of questions. The government has a variety of powers—including regulating firms’ entry into and exit from an industry, setting standards for product quality, setting minimum wage levels, and regulating the disclosure of information—but in macroeconomics, we focus on two policy instruments: fiscal policy and monetary policy. Fiscal policy, the focus of this chapter, refers to the government’s spending and taxing behavior—in other words, its budget policy. (The word fiscal comes from the root fisc, which refers to the “treasury” of a government.) Fiscal policy is generally divided into three categories: (1) policies concerning government purchases of goods and services, (2) policies concerning taxes, and (3) policies concerning transfer payments (such as unemployment compensation, Social Security benefits, welfare payments, and M09_CASE3826_13_GE_C09.indd 190 17/04/19 4:16 AM veterans’ benefits) to households. Monetary policy, which we consider in the next chapter, refers to the behavior of the nation’s central bank, the Federal Reserve, with respect to the interest rate. fiscal policy The government’s spending and taxing policies. CHAPTER 9 The Government and Fiscal Policy 191 9.1 LEARNING OBJECTIVE Discuss the influence of fiscal policies on the economy. monetary policy The tools used by the Federal Reserve to control the short-term interest rate. discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy. net
taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government. disposable, or after-tax, income (Yd) Total income minus net taxes: Y – T. Government in the Economy Local, state, and federal governments have in some areas considerable control. In many cases, however, the effect of government decisions on the economy depends not only on the decision itself, but also on the state of the economy. It is important to understand the limits of government control as well as its power. Taxes provide a good example. Tax rates are controlled by the government. By law, Congress has the authority to decide who and what should be taxed and at what rate. Tax revenue, on the other hand, is not subject to complete control by the government. Revenue from the personal income tax system depends on personal tax rates (which Congress sets) and on the income of the household sector (which depends on many factors not under direct government control, such as how much households decide to work). Revenue from the corporate profits tax depends on both corporate profits tax rates and the size of corporate profits. The government controls corporate tax rates, but not the size of corporate profits. Some government spending also depends on government decisions and on the state of the economy. In the United States, the unemployment insurance program pays benefits to unemployed people. When the economy goes into a recession, the number of unemployed workers increases and so does the level of government unemployment insurance payments. This occurs not because of a change in government decisions, but because of the interaction between existing policies and the economy itself. Taxes and spending often go up or down in response to changes in the economy instead of as the result of deliberate decisions by policy makers. As such we will occasionally use discretionary fiscal policy to refer to changes in taxes or spending that are the result of deliberate changes in government policy. Government Purchases (G), Net Taxes (T), and Disposable Income (Yd) MyLab Economics Concept Check We now add the government to the simple economy in Chapter 6. To keep things simple, we will combine two government activities—the collection of taxes and the payment of transfer payments—into a category we call net taxes (T). Specifically, net taxes are equal to the tax payments made to the government by firms and households minus transfer payments made to households by the government. The other variable we will consider is government purchases of goods and services (G). Our previous discussions of household consumption did not take taxes into account. We assumed that all the
income generated in the economy was spent or saved by households. When we take into account the role of government, as Figure 9.1 does, we see that as income (Y) flows toward households, the government takes income from households in the form of net taxes (T). The income that ultimately gets to households is called disposable, or after-tax, income (Yd): disposable income K total income - net taxes Yd K Y - T Yd excludes taxes paid by households and includes transfer payments made to households by the government. For now, we are assuming that T does not depend on Y—that is, net taxes do not depend on income. This assumption is relaxed in Appendix B to this chapter. Taxes that do not depend on income are sometimes called lump-sum taxes. As Figure 9.1 shows, the disposable income (Yd) of households must end up as either con- sumption (C) or saving (S). Thus, This equation is an identity—something that is always true. Yd K C + S M09_CASE3826_13_GE_C09.indd 191 17/04/19 4:16 AM 192 PART III The Core of Macroeconomic Theory ▸▸ FIGURE 9.1 Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income Firms MyLab Economics Concept Check Government Households Because disposable income is aggregate income (Y) minus net taxes (T), we can write another identity: By adding T to both sides This identity says that aggregate income gets cut into three pieces. Government takes a slice (net taxes, T), and then households divide the rest between consumption (C) and saving (S). We need to expand our definition of planned aggregate expenditure because governments spend money on goods and services,. Planned aggregate expenditure (AE) is the sum of consumption spending by households (C), planned investment by business firms (I), and government purchases of goods and services (G). AE K C + I + G A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period: budget deficit K G - T If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills (more on this later). In this case, a part of household saving (S) goes to the government. The dashed lines in Figure 9.1 mean
that some household saving goes to firms to finance investment projects and some goes to the government to finance its deficit. If G is less than T, which means that the government is spending less than it is collecting in taxes, the government is running a surplus. In this case it is retiring debt. budget deficit The difference between what a government spends and what it collects in taxes in a given period: G – T. M09_CASE3826_13_GE_C09.indd 192 17/04/19 4:16 AM CHAPTER 9 The Government and Fiscal Policy 193 Adding Taxes to the Consumption Function In Chapter 8, we assumed that aggregate consumption (C) depends on aggregate income (Y), and for the sake of illustration, we used a specific linear consumption function: C = a + bY where b is the marginal propensity to consume. We need to modify this consumption function because we have added government to the economy. With taxes a part of the picture, it makes sense to assume that disposable income (Yd), instead of before-tax income (Y), determines consumption behavior. If you earn a million dollars, but have to pay $950,000 in taxes, you have no more disposable income than someone who earns only $50,000, but pays no taxes. What you have available for spending on current consumption is your disposable income, not your beforetax income. To modify our aggregate consumption function to incorporate disposable income instead of before-tax income, instead of C = a + bY, we write or C = a + bYd C = a + b(Y - T) Our consumption function now has consumption depending on disposable income instead of before-tax income. Planned Investment What about planned investment? The government can affect investment behavior through its tax treatment of depreciation and other tax policies. Also, planned investment depends on the interest rate, as discussed in the previous chapter. For purposes of this chapter, we continue to assume that the interest rate is fixed. We will ignore any tax effects on planned investment and thus continue to assume that it is fixed (because the interest rate is fixed). The Determination of Equilibrium Output (Income) MyLab Economics Concept Check We know from Chapter 8 that equilibrium occurs where Y = AE —that is, where aggregate output equals planned aggregate expenditure. Remember that planned aggregate expenditure in an economy with a government is AE K C + I + G, so equilibrium is Y = C + I + G The equilibrium analysis in Chapter 8 applies here also. If output
(Y) exceeds planned aggregate expenditure (C + I + G), there will be an unplanned increase in inventories—actual investment will exceed planned investment. Conversely, if C + I + G exceeds Y, there will be an unplanned decrease in inventories. An example will illustrate the government’s effect on the macroeconomy and the equilibrium condition. First, our consumption function, C = 100 + 0.75Y before we introduced the government sector, now becomes or C = 100 + 0.75Yd C = 100 + 0.75(Y - T) Second, we assume that G is 100 and T is 100.1 In other words, the government is running a balanced budget, financing all of its spending with taxes. Third, we assume that planned investment (I) is 100. 1As we pointed out previously, the government does not have complete control over tax revenues and transfer payments. We ignore this problem here, however, and set T, tax revenues minus transfers, at a fixed amount. Things will become more realistic later in this chapter and in Appendix B. M09_CASE3826_13_GE_C09.indd 193 17/04/19 4:16 AM 194 PART III The Core of Macroeconomic Theory TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100 (1) (2) (3) (4) (5) (7) Consumption Spending C = 100 + 0.75 Yd Saving S Yd - C (6) Planned Investment Spending I Government Purchases G (8) Planned Aggregate Expenditure C + I + G Output (Income) Y Net Taxes T 300 500 700 900 1,100 1,300 1,500 100 100 100 100 100 100 100 Disposable Income Yd K Y - T 200 400 600 800 1,000 1,200 1,400 250 400 550 700 850 1,000 1,150 -50 0 50 100 150 200 250 100 100 100 100 100 100 100 100 100 100 100 100 100 100 450 600 750 900 1,050 1,200 1,350 (9) Unplanned Inventory Change Y - (C + I + G) (10) Adjustment to Disequilibrium -150 -100 -50 0 +50 +100 + 150 Output c Output c Output c Equilibrium Output T Output T Output T Table 9.1 calculates planned aggregate expenditure at several levels of disposable income. For example, at Y = 500,
disposable income is Y - T, or 400. Therefore, C = 100 + 0.75(400) = 400. Assuming that I is fixed at 100 and assuming that G is fixed at 100, planned aggregate expenditure is 600 (C + I + G = 400 + 100 + 100). Because output (Y) is only 500, planned spending is greater than output by 100. As a result, there is an unplanned inventory decrease of 100, giving firms an incentive to raise output. Thus, output of 500 is below equilibrium. If Y = 1,300, then Yd = 1,200, C = 1,000, and planned aggregate expenditure is 1,200. Here planned spending is less than output, there will be an unplanned inventory increase of 100, and firms have an incentive to cut back output. Thus, output of 1,300 is above equilibrium. Only when output is 900 are output and planned aggregate expenditure equal, and only at Y = 900 does equilibrium exist. In Figure 9.2, we derive the same equilibrium level of output graphically. First, the consumption function is drawn, taking into account net taxes of 100. The old function was C = 100 + 0.75Y. The new function is C = 100 + 0.75 (Y - T) or C = 100 + 0.75(Y - 100), rewritten as C = 100 + 0.75Y - 75, or C = 25 + 0.75Y. For example, consumption at an income of zero is 25 (C = 25 + 0.75Y = 25 + 0.75(0) = 25). The marginal propensity to consume has not changed—we assume that it remains 0.75. Note that the consumption function in Figure 9.2 plots the points in columns (1) and (4) of Table 9.1. Planned aggregate expenditure, recall, adds planned investment to consumption. Now in addition to 100 in investment, we have government purchases of 100. I and G are constant at 100 each at all levels of income, so we add I + G = 200 to consumption at every level of income. The result is the new AE curve. This curve is just a plot of the points in columns (1) and (8) of Table 9.1. The 45-degree line helps us find the equilibrium level of real output, which, we already know, is 900. If you examine any level of output above or below 900, you will find disequilibrium. At Y
= 500, for example, people want to consume 400, which with planned investment of 100 and government purchases of 100, gives planned aggregate expenditure of 600. Output is, however, only 500. Inventories will fall below what was planned, and firms will have an incentive to increase output. The Saving/Investment Approach to Equilibrium As in the last chapter, we can also examine equilibrium using the saving/investment approach. Look at the circular flow of income in Figure 9.1. The government takes out net taxes (T) from the flow of income—a leakage— and households save (S) some of their income—also a leakage from the flow of income. The planned spending injections are government purchases (G) and planned investment (I). If leakages (S + T) equal planned injections (I + G), there is equilibrium: saving investment approach to equilibrium : S + T = I + G > M09_CASE3826_13_GE_C09.indd 194 17/04/19 4:16 AM,300 1,200 1,100 1,000 900 800 700 600 500 400 300 225 200 100 25 0 CHAPTER 9 The Government and Fiscal Policy 195 AE K C + I + G Equilibrium point = 200 C = 100 +.75(Y – T) ▸◂ 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. 45° 100 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300 1,400 Aggregate output (income), Y MyLab Economics Concept Check To derive this, we know that in equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE). By definition, AE equals C + I + G, and by definition, Y equals C + S + T. Therefore, at equilibrium Subtracting C from both sides leaves Note that equilibrium does not require that G = T (a balanced government budget) or that S = I. It is only necessary that the sum of S and T equals the sum of I and G. Column (5) of Table 9.1 calculates aggregate saving by subtracting consumption from disposal income at every level of disposable income(S K Yd - C). I and G are fixed, so I +
G equals 200 at every level of income. Using the table to add saving and taxes (S + T), we see that S + T equals 200 only at Y = 900. Thus, the equilibrium level of output (income) is 900, the same answer we arrived at through numerical and graphic analysis. Fiscal Policy at Work: Multiplier Effects You can see from Figure 9.2 that if the government were able to change the levels of either G or T, it would be able to change the equilibrium level of output (income). At this point, we are assuming that the government controls G and T. In this section, we will review three multipliers: 9.2 LEARNING OBJECTIVE Describe the effects of three fiscal policy multipliers. ■■ Government spending multiplier ■■ Tax multiplier ■■ Balanced-budget multiplier The Government Spending Multiplier MyLab Economics Concept Check Suppose you are the chief economic adviser to the president and the economy is sitting at the equilibrium output pictured in Figure 9.2. Output and income are 900, and the government is currently buying 100 worth of goods and services each year and is financing them with 100 in taxes. The budget is balanced. In addition, firms are investing (producing capital goods) 100. The M09_CASE3826_13_GE_C09.indd 195 17/04/19 4:16 AM 196 PART III The Core of Macroeconomic Theory president calls you into the Oval Office and says, “Unemployment is too high. We need to lower unemployment by increasing output and income.” After some research, you determine that an acceptable unemployment rate can be achieved only if aggregate output increases to 1,100. You now need to determine how the government can use taxing and spending policy— fiscal policy—to increase the equilibrium level of national output by 200. Suppose the president has let it be known that taxes must remain at present levels—Congress just passed a major tax reform package—so adjusting T is out of the question for several years. That leaves you with G. Your only option is to increase government spending while holding taxes constant. To increase spending without raising taxes (which provides the government with revenue to spend), the government must borrow. When G is bigger than T, the government runs a deficit and the difference between G and T must be borrowed. For the moment, we will ignore the possible effect of the deficit and focus only on the effect of a higher G with T constant. Meanwhile, the president is awaiting your answer
. How much of an increase in spending would be required to generate an increase of 200 in the equilibrium level of output, pushing it from 900 to 1,100 and reducing unemployment to the president’s acceptable level? You might be tempted to say that because we need to increase income by 200 (1,100 - 900), we should increase government spending by the same amount, but what will happen if we raise G by 200? The increased government spending will throw the economy out of equilibrium because G is a component of aggregate spending, planned aggregate expenditure will increase by 200. Planned spending will be greater than output, inventories will be lower than planned, and firms will have an incentive to increase output. Suppose output rises by the desired 200. You might think, “We increased spending by 200 and output by 200, so equilibrium is restored.” There is more to the story than this. The moment output rises, the economy is generating more income. This was the desired effect: the creation of more employment. The newly employed workers are also consumers, and some of their income gets spent. With higher consumption spending, planned spending will be greater than output, inventories will be lower than planned, and firms will raise output (and thus raise income) again. This time firms are responding to the new consumption spending. Already, total income is over 1,100. This story should sound familiar. It is the multiplier in action. Although this time it is government spending (G) that is changed rather than planned investment (I), the effect is the same as the multiplier effect we described in Chapter 8. An increase in government spending has the same impact on the equilibrium level of output and income as an increase in planned investment. A dollar of extra spending from either G or I is identical with respect to its impact on equilibrium output. The equation for the government spending multiplier is the same as the equation for the multiplier for a change in planned investment. government spending multiplier K 1 MPS K 1 1 - MPC We derive the government spending multiplier algebraically in Appendix A to this chapter. Formally, the government spending multiplier is defined as the ratio of the change in the equilibrium level of output to a change in government spending. This is the same definition we used in the previous chapter, but now the exogenous variable is government spending instead of planned investment. Remember that we were thinking of increasing government spending (G) by 200. We can use the multiplier analysis to see what the new equilibrium level of Y would be for an increase in G
of 200. The multiplier in our example is 4. (Because b—the MPC—is.75, the MPS must be 0.25 = 4.) Thus, Y will increase by 800 (4 * 200). Because the initial 1 - 0.75 = 0.25; and 1 level of Y was 900, the new equilibrium level of Y is 900 + 800 = 1,700 when G is increased by 200. > government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending. The level of 1,700 is much larger than the level of 1,100 that we calculated as being necessary to lower unemployment to the desired level. Let us back up then. If we want Y to increase by 200 and if the multiplier is 4, we need G to increase by only 200 4 = 50. If G increases by 50, the equilibrium level of Y will change by 200 and the new value of Y will be 1,100 (900 + 200), as desired. Looking at Table 9.2, we can check our answer to make sure it is an equilibrium. Look first at the old equilibrium of 900. When government purchases (G) were 100, aggregate output (income) was equal to planned aggregate expenditure (AE K C + I + G) at Y = 900. > M09_CASE3826_13_GE_C09.indd 196 17/04/19 4:16 AM TABLE 9.2 Finding Equilibrium after a Government Spending Increase of 50* CHAPTER 9 The Government and Fiscal Policy 197 (1) (2) (3) (4) (5) Output (Income) Y Net Taxes T Disposable Income Yd K Y - T Consumption Spending C = 100 +.75 Yd Saving S Yd - C (6) Planned Investment Spending I (7) Government Purchases G (8) Planned Aggregate Expenditure C + I + G 300 500 700 900 1,100 1,300 100 100 100 100 100 100 200 400 600 800 1,000 1,200 250 400 550 700 850 1,000 *G has increased from 100 in Table 9.1 to 150 here. -50 0 50 100 150 200 100 100 100 100 100 100 150 150 150 150 150 150 500 650 800 950 1,100 1,250 (9) Unplanned Inventory Change Y - (C + I + G) (10) Adjustment to Disequilibrium - 200 - 150 - 100 - 50 0
+ 50 Output c Output c Output c Output c Equilibrium Output T Now G has increased to 150. At Y = 900, (C + I + G)is greater than Y, there is an unplanned fall in inventories, and output will rise, but by how much? The multiplier told us that equilibrium income would rise by four times the 50 change in G. Y should rise by 4 * 50 = 200, from 900 to 1,100, before equilibrium is restored. Let us check. If Y = 1,100, consumption is C = 100 + 0.75Yd = 100 + 0.75(1,000) = 850. Because I equals 100 and G now equals 100 (the original level of G) + 50 (the additional G brought about by the fiscal policy change) = 150, C + I + G = 850 + 100 + 150 = 1,100. Y = AE, and the economy is in equilibrium. The graphic solution to the president’s problem is presented in Figure 9.3. An increase of 50 in G shifts the planned aggregate expenditure function up by 50. The new equilibrium income occurs where the new AE line (AE2) crosses the 45-degree line, at Y = 1,100. Make sure you understand the economics underlying the numerical analysis here. When the government injects money into the economy through new purchases of goods and services, those new purchases create income for newly hired workers. That income stimulates the newly hired workers to spend more, which in turn stimulates the economy more, providing further new jobs and more income. The final result is that the stimulus effect is multiplied and the economy increases by more than the original government spending. C + I + G2 K AE2 C + I + G1 K AE1 ¢G = 50 ▸◂ FIGURE 9.3 The Government Spending 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. 1,300 1,100 900 700 500 300 275 225 100 458 0 100 300 500 700 900 1,100 1,300 Y Aggregate output (income), Y MyLab Economics Concept Check ¢Y M09_CASE3826_13_GE_C09.indd 197 17/04/19 4:16 AM 198 PART III The Core of Macroeconomic Theory tax multiplier The ratio of change in the equilibrium
level of output to a change in taxes. The Tax Multiplier MyLab Economics Concept Check Remember that fiscal policy includes both spending and taxing policies. To see what effect a change in tax policy has on the economy, imagine the following. You are still chief economic adviser to the president, but now you are instructed to devise a plan to reduce unemployment to an acceptable level without increasing the level of government spending. In your plan, instead of increasing government spending (G), you decide to cut taxes and maintain the current level of spending. A tax cut increases disposable income, which is likely to lead to added consumption spending. (Remember our general rule that increased income leads to increased consumption.) Would a decrease in taxes affect aggregate output (income) the same as an equal increase in G? A decrease in taxes would certainly increase aggregate output. The government spends no less than it did before the tax cut, and households find that they have a larger after-tax (or disposable) income than they had before. This leads to an increase in consumption. Planned aggregate expenditure will increase, which will lead to inventories being lower than planned, which will lead to more workers being hired to increase output. With more workers employed, more income will be generated, causing a second-round increase in consumption, and so on. Thus, income will increase by a multiple of the decrease in taxes, just as there was in the case of government spending, but there is a “wrinkle.” The multiplier for a change in taxes is not the same as the multiplier for a change in government spending. Why does the tax multiplier—the ratio of change in the equilibrium level of output to a change in taxes—differ from the spending multiplier? To answer that question, we need to compare the ways in which a tax cut and a spending increase work their way through the economy. Look at Figure 9.1. When the government increases spending, there is an immediate and direct impact on the economy’s total spending. An increase in G leads to a dollar-for-dollar increase in planned aggregate expenditure because G is a component of planned aggregate expenditure. When taxes are cut, there is no direct impact on spending. Taxes enter the picture only because they have an effect on the household’s disposable income, which influences household’s consumption (which is part of total spending). As Figure 9.1 shows, the tax cut flows through households before affecting aggregate expenditure. Let us assume that the government decides to cut taxes by $1.
By how much would spending increase? We already know the answer. The marginal propensity to consume (MPC) tells us how much consumption spending changes when disposable income changes. In the example running through this chapter, the marginal propensity to consume out of disposable income is 0.75. This means that if households’ after-tax incomes rise by $1.00, they will increase their consumption not by the full $1.00, but by only $0.75.2 In summary, when government spending increases by $1, planned aggregate expenditure increases initially by the full amount of the rise in G, or $1. When taxes are cut, however, the initial increase in planned aggregate expenditure is only the MPC times the change in taxes. The final effect on the equilibrium level of income will be smaller because the initial increase in planned aggregate expenditure is smaller for a tax cut than for a government spending increase. The size of the tax multiplier is calculated in the same way we derived the multiplier for an increase in investment and an increase in government purchases. The final change in the equilibrium level of output (income) (Y) is ∆Y = (initial increase in aggregate expenditure) * 1 MPS Because the initial change in aggregate expenditure caused by a tax change of ΔT is ( - ∆T * MPC), we can solve for the tax multiplier by substitution: a b ∆Y = ( - ∆T * MPC) * 1 MPS a b = - ∆T * MPC MPS a b 2What happens to the other $0.25? Remember that whatever households do not consume is, by definition, saved. The other $0.25 thus gets allocated to saving. M09_CASE3826_13_GE_C09.indd 198 17/04/19 4:16 AM A tax cut will cause an increase in consumption expenditures and output and a tax increase will cause a reduction in consumption expenditures and output so the tax multiplier is a negative multiplier: CHAPTER 9 The Government and Fiscal Policy 199 tax multiplier K - MPC MPS a b We derive the tax multiplier algebraically in Appendix A to this chapter. If the MPC is.75, as in our example, the multiplier is -0.75 0.25 = -3. Notice the multiplier is negative as an increase in taxes takes money out of the household sector and reduces consumption and conversely for a tax cut. A tax cut of 100 will increase the equilibrium level of output by
-100 * -3 = 300. This is different from the effect of our government spending multiplier of 4. Under those same conditions, a 50 increase in G will increase the equilibrium level of output by 200 (50 × 4). If we wanted to increase output by 200, we would need a tax cut of 200/3 or 66.67. > The Balanced-Budget Multiplier MyLab Economics Concept Check We have now discussed (1) changing government spending with no change in taxes and (2) changing taxes with no change in government spending. What if government spending and taxes are increased by the same amount? That is, what if the government decides to pay for its extra spending by increasing taxes by the same amount? The government’s budget deficit would not change because the increase in expenditures would be matched by an increase in tax income. You might think in this case that equal increases in government spending and taxes have no effect on equilibrium income. After all, the extra government spending equals the extra amount of tax revenues collected by the government. This is not so. Take, for example, a government spending increase of $40 billion. We know from the preceding analysis that an increase in G of 40, with taxes (T) held constant, should increase the equilibrium level of income by 40 * the government spending multiplier. The multiplier is 1/MPS or 1 0.25 = 4. The equilibrium level of income should rise by 160 (40 * 4). Now suppose that instead of keeping tax revenues constant, we finance the 40 increase in government spending with an equal increase in taxes so as to maintain a balanced budget. What happens to aggregate spending as a result of the rise in G and the rise in T? There are two initial effects. First, government spending rises by 40. This effect is direct, immediate, and positive. Now the government also collects 40 more in taxes. The tax increase has a negative impact on overall spending in the economy, but it does not fully offset the increase in government spending. > The final impact of a tax increase on aggregate expenditure depends on how households respond to it. The only thing we know about household behavior so far is that households spend 75 percent of their added income and save 25 percent. We know that when disposable income falls, both consumption and saving are reduced. A tax increase of 40 reduces disposable income by 40, and that means consumption falls by 40 * MPC and because MPC = 0.75, consumption falls by 30 (40 * 0.75). The net result
in the beginning is that government spending rises by 40 and consumption spending falls by 30. Aggregate expenditure increases by 10 right after the simultaneous balanced-budget increases in G and T. So a balanced-budget increase in G and T will raise output, but by how much? How large is this balanced-budget multiplier? The answer may surprise you: balanced - budget multiplier K 1 Let us combine what we know about the tax multiplier and the government spending multiplier to explain this. To find the final effect of a simultaneous increase in government spending and increase in net taxes, we need to add the multiplier effects of the two. The government spending multiplier is 1/MPS. The tax multiplier is -MPC MPS. Their sum is MPS. Because MPC + MPS K 1, 1 - MPC K MPS. (1 MPS K 1. (We also derive the balanced-budget multiThis means that (1 - MPC) > plier in Appendix A to this chapter.) > MPS) K (1 - MPC) MPS K MPS MPS) + ( -MPC > > > > balanced-budget multiplier The ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit. The balanced-budget multiplier is equal to one: the change in Y resulting from the change in G and the equal change in T is exactly the same size as the initial change in G or T. M09_CASE3826_13_GE_C09.indd 199 17/04/19 4:16 AM 200 PART III The Core of Macroeconomic Theory TABLE 9.3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each* (1) (2) (3) (4) (5) (6) (7) (8) (9) Output (Income) Y Net Taxes T Disposable Income Yd = Y - T Consumption Spending C = 100 + 0.75Yd Planned Investment Spending I Government Purchases G Planned Aggregate Expenditure C + I + G Unplanned Inventory Change C + I + G Y - Adjustment to Disequilibrium 500 700 900 1,100 1,300 1,500 300 300 300 300 300 300 200 400 600 800 1,000 1,200 250 400 550 700 850 1,000 *Both G and T have increased from 100 in Table 9.1
to 300 here. 100 100 100 100 100 100 300 300 300 300 300 300 650 800 950 1,100 1,250 1,400 1 -150 -100 -50 0 +50 +100 2 Output c Output c Output c Equilibrium Output T Output T Returning to our example, recall that by using the government spending multiplier, a 40 increase in G would raise output at equilibrium by 160 (40 * the government spending multiplier of 4). By using the tax multiplier, we know that a tax hike of 40 will reduce the equilibrium level of output by 120 (40 * the tax multiplier, -3). The net effect is 160 minus 120, or 40. It should be clear then that the effect on equilibrium Y is equal to the balanced increase in G and T. In other words, the net increase in the equilibrium level of Y resulting from the change in G and the change in T are exactly the size of the initial change in G or T. If the president wanted to raise Y by 200 without increasing the deficit, a simultaneous increase in G and T of 200 would do it. To see why, look at the numbers in Table 9.3. In Table 9.1, we saw an equilibrium level of output at 900. With both G and T up by 200, the new equilibrium is 1,100—higher by 200. At no other level of Y do we find (C + I + G) = Y. An increase in government spending has a direct initial effect on planned aggregate expenditure, a tax increase does not. The initial effect of the tax increase is that households cut consumption by the MPC times the change in taxes. This change in consumption is less than the change in taxes because the MPC is less than one. The positive stimulus from the government spending increase is thus greater than the negative stimulus from the tax increase. The net effect is that the balanced- budget multiplier is one. Table 9.4 summarizes everything we have said about fiscal policy multipliers. A Warning Although we have added government, the story told about the multiplier is still incomplete and oversimplified. For example, we have been treating net taxes (T) as a lump-sum, fixed amount, whereas in practice, taxes depend on income. Appendix B to this chapter shows that the size of the multiplier is reduced when we make the more realistic assumption that taxes depend on income. We continue to add more realism and difficulty to our analysis in the chapters that follow. TABLE 9.4 Summary of Fiscal Policy Multipliers Policy Stim
ulus Multiplier Government spending multiplier Tax multiplier Balanced-budget multiplier Increase or decrease in the level of government purchases: ∆ G Increase or decrease in the level of net taxes: ∆ T Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: ∆G = ∆T 1 MPS -MPC MPS 1 Final Impact on Equilibrium Y 1 MPS - MPC MPS ∆G * ∆T * ∆G M09_CASE3826_13_GE_C09.indd 200 17/04/19 4:16 AM CHAPTER 9 The Government and Fiscal Policy 201 The Federal Budget The federal budget lists in detail all the things the government plans to spend money on and all the sources of government revenues for the coming year. It therefore describes the government’s fiscal policy in granular detail. Of course, the budget is not simply an economic document but is the product of a complex interplay of social, political, and economic forces. 9.3 LEARNING OBJECTIVE Compare and contrast the federal budgets of three U.S. government administrations. federal budget The budget of the federal government. federal surplus (+) or (−) deficit Federal government receipts minus expenditures. The Budget in 2017 MyLab Economics Concept Check A highly aggregated version of the federal budget is shown in Table 9.5. In 2017, the government had total receipts of $3,587.4 billion, largely from personal income taxes ($1,603.5 billion) and contributions for social insurance ($1,287.3 billion). (Contributions for social insurance are employer and employee Social Security taxes.) Receipts from corporate income taxes accounted for $401.3 billion, or only 11.2 percent of total receipts. Not everyone is aware of the fact that corporate income taxes as a percentage of government receipts are quite small relative to personal income taxes and Social Security taxes. With the tax reform of 2017, corporate taxes as a share of government receipts are likely to fall further. The federal government also spent $4,252.5 billion in expenditures in 2017. Of this, $2,074.5 billion represented transfer payments to persons (Social Security benefits, military retirement benefits, and unemployment compensation).3 Consumption ($977.8 billion) was the next- largest component, followed by grants-in-aid given to state and local governments by the federal government ($559.6 billion), and interest payments on the federal debt ($504.
9 billion). The difference between the federal government’s receipts and its expenditures is the federal surplus ( + ) or deficit ( − ), which is federal government saving. Table 9.5 shows that the federal government spent much more than it took in during 2017, resulting in a deficit of $665.1 billion. TABLE 9.5 Federal Government Receipts and Expenditures, 2017 Current receipts Personal income taxes Excise taxes and customs duties Corporate income taxes Taxes from the rest of the world Contributions for social insurance Interest receipts and rents and royalties Current transfer receipts from business and persons Current surplus of government enterprises Total Current expenditures Consumption expenditures Transfer payments to persons Transfer payments to the rest of the world Grants-in-aid to state and local governments Interest payments Subsidies Total Net federal government saving–surplus (+) or deficit (−) (Total current receipts - Total current expenditures) Amount (Billions, $) Percentage of Total (%) 44.7 3.7 11.2 0.6 35.9 1.6 2.4 -0.1 100.0 23.0 48.8 1.8 13.2 11.9 1.4 100.0 1,605.3 132.3 401.3 22.4 1,287.3 58.5 86.5 -3.5 3,587.4 977.8 2,074.5 74.9 559.6 504.9 60.8 4,252.5 -665.1 Note: Numbers may not add exactly because of rounding. Source: U.S. Bureau of Economic Analysis, March 28, 2018. MyLab Economics Real-time data 3Remember that there is an important difference between transfer payments and government purchases of goods and services (consumption expenditures). Much of the government budget goes for things that an economist would classify as transfers (payments that are grants or gifts) instead of purchases of goods and services. Only the latter are included in our variable G. Transfers are counted as part of net taxes. M09_CASE3826_13_GE_C09.indd 201 17/04/19 4:16 AM 202 PART III The Core of Macroeconomic Theory Fiscal Policy since 1993: The Clinton, Bush, Obama, and Trump Administrations MyLab Economics Concept Check Between 1993 and the current edition of this text, the United States has had four different presidents, two Democrats and two Republicans. The fiscal policy implemented by each president reflects both the political philosophy of the administration and the
differing economic conditions each faced. Figures 9.4, 9.5, and 9.6 trace the fiscal policies of the Clinton (1993–2000), Bush (2001–2008), and Obama administrations (2009–2016), and first year of the Trump administration (2017). Figure 9.4 plots total federal personal income taxes as a percentage of total taxable income. This is a graph of the average personal income tax rate. As the figure shows, the average tax rate increased substantially during the Clinton administrations. Much of this increase was the result of a tax bill that was passed in 1993 during the first Clinton administration. The figure then shows the dramatic effects of the tax cuts during the first Bush administration. The large fall in the average tax rate in 2001 III was because of a tax rebate passed after the 9/11 terrorist attacks. Although the average tax rate went back up in 2001 IV, it then fell substantially as the Bush tax cuts began to be felt. The average tax rate remained low during the beginning of the first Obama administration. This was in part due to the large ($787 billion) stimulus bill that was passed in February 2009. The bill consisted of tax cuts and government spending increases, mostly for the 2009–2010 period enacted in response to the recession. In 2011–2012 the average tax rate was somewhat higher than it was in 2009–2010 because of the winding down of the stimulus bill. The average tax rate generally rose from 2010 to 2015 and then leveled out. In December of 2017 a significant tax act was passed by Congress and signed by President Trump, to go into effect beginning in 2018. The act included large cuts in corporate taxes, but also some cuts in personal income taxes. When data are available for 2018 and beyond, the line in Figure 9.4 is likely to turn down. To summarize, the overall tax policy of the federal government is fairly clear from Figure 9.4. The average tax rate rose sharply under President Clinton, fell sharply under President Bush, and remained low initially under President Obama before beginning to rise. It is likely to fall in 2018 and beyond under President Trump. Table 9.5 shows that the three most important spending variables of the federal government are consumption expenditures, transfer payments to persons, and grants-in-aid to state and local governments. Consumption expenditures, which are government expenditures on goods and services, are part of GDP. Transfer payments and grants-in-aid are not spending on current output (GDP), but just transfers from the federal government to people and state and local governments. Figure
9.5 plots two spending ratios. One is federal government consumption expenditures as a percentage of GDP, and the other is transfer payments to persons plus grants-in-aid to state and local governments as a percentage of GDP. The figure shows that consumption expenditures as a percentage of GDP generally fell during the Clinton administrations, Clinton administrations Bush administrations Obama administrations 14 13 12 11 10 1993 I 1994 I 1995 I 1996 I 1997 I 1998 I 1999 I 2000 I 2001 I 2002 I 2003 I 2004 I 2005 I 2006 I 2007 I 2008 I 2009 I 2010 I 2011 I 2012 I 2013 I 2014 I 2015 I 2016 I 2017 I 2017 IV MyLab Economics Real-time data ▸▴ FIGURE 9.4 Federal Personal Income Taxes as a Percentage of Taxable Income, 1993 I–2017 IV Quarters M09_CASE3826_13_GE_C09.indd 202 17/04/19 4:16 AM CHAPTER 9 The Government and Fiscal Policy 203 Clinton administrations Bush administrations Obama administrations 9.0 8.5 8.0 7.5 7.0 6. Expenditures (left scale) Transfers (right scale 16.0 15.0 14.0 13.0 12.0 11.0 10..0 1993 I 1994 I 1995 I 1996 I 1997 I 1998 I 1999 I 2000 I 2001 I 2002 I 2003 I 2004 I 2005 I 2006 I 2007 I 2008 I 2009 I 2010 I 2011 I 2012 I 2013 I 2014 I 2015 I 2016 I 2017 I 9.0 2017 IV Quarters MyLab Economics Real-time data ▸▴ FIGURE 9.5 Federal Government Consumption Expenditures as a Percentage of GDP and Federal Transfer Payments and Grants-in-Aid as a Percentage of GDP, 1993 I–2017 IV generally rose during the Bush administrations, and was quite high during the first Obama administration. The increase during the Bush administrations reflects primarily the spending on the Iraq war. The initial increase during the Obama administration reflects the effects of the stimulus bill and increased spending for the Afghanistan war. Expenditures as a fraction of GDP fell considerably during the second Obama administration. The fraction was essentially unchanged during the first year of the Trump administration. In early 2018 U.S. budget bills were passed that will lead to increased government spending in 2018 and beyond. The expenditure line in Figure 9.5 is thus likely to rise when extended into 2018 and beyond. Figure 9.5 also shows that transfer payments as a percentage of GDP generally rose during the Bush administrations especially near the end, and remained high
in the Obama administrations and into the Trump administration. The percent was flat or slightly falling during the Clinton administrations. Some of the fall between 1996 and 2000 was because of President Clinton’s welfare reform legislation. Some of the rise from 2001 on is as a result of increased Clinton administrations Bush administrations Obama administrations 2 -4 -6 -10 1993 I 1994 I 1995 I 1996 I 1997 I 1998 I 1999 I 2000 I 2001 I 2002 I 2003 I 2004 I 2005 I 2006 I 2007 I 2008 I 2009 I 2010 I 2011 I 2012 I 2013 I 2014 I 2015 I 2016 I 2017 I MyLab Economics Real-time data ▸▴ FIGURE 9.6 The Federal Government Surplus (+) or Deficit (−) as a Percentage of GDP, 1993 I–2017 IV Quarters 2017 IV M09_CASE3826_13_GE_C09.indd 203 17/04/19 4:16 AM 204 PART III The Core of Macroeconomic Theory Medicare payments. The high initial values in the Obama administration again reflect the effects of the stimulus bill and various extensions. Figure 9.6 plots the federal government surplus ( + ) or deficit ( -1) as a percentage of GDP. The figure shows that during the Clinton administrations the federal budget moved from substantial deficit to noticeable surplus. This, of course, should not be surprising because the average tax rate generally rose during this period and spending as a percentage of GDP generally fell. Figure 9.6 then shows that the surplus turned into a substantial deficit during the first Bush administration. This also should not be surprising since the average tax rate generally fell during this period and spending as a percentage of GDP generally rose. The deficit rose sharply in the beginning of the Obama administration—to 9.3 percent of GDP by the second quarter of 2009. Again, this is not a surprise. The average tax rate remained low and spending increased substantially. The deficit-to-GDP ratio was roughly constant at about 3.5 percent during the second Obama administration and the first year of the Trump administration. Given the tax cuts that were passed at the end of 2017 and the spending increases that were passed at the beginning of 2018, the deficit-to-GDP ratio is likely to rise substantially from 2018 on. The Economics in Practice box discusses Spain’s regional budget constraints. As you look at the differences in the three figures, you should remember that the decisions that governments make about levels of spending and taxes reflect not only macroeconomic Regional Autonomy and Government Budgeting
in Spain To avoid cessation aspirations by Catalonia and the Basque, Spain has undergone massive political and fiscal decentralization over the last three decades. However, the Catalonian independence referendum of October 2017 demonstrates that the autonomy granted to regional governments was not sufficient. Aside from a strong ethnic identity and cultural pride, the main grievance of the Catalonians is that Spain’s fiscal expenditure is far from equitable. Spanish regions administer most taxes in their jurisdiction and are required to contribute an annual sum to the central government. The Spanish fiscal equalization program aims to reduce regional inequalities by increasing welfare expenditure in deprived regions regardless of their tax capacity. While its population makes up only 16 percent of the total population of Spain, Catalonia’s GDP comprises 20 percent of national GDP. Yet, it receives only 11 percent of national expenditure. During the European Sovereign Debt crisis of 2011–2015, severe austerity measures obliged regional governments to borrow in order to cover their public expenditures. Paying €10 billion more than what reached their region, the Catalonian public debt to GDP ratio in 2017 stood at 35.3 percent, compared to Spain’s average of 24.2 percent in the same year. Fiscal revenue and expenditure autonomy are requisites of regional political autonomy. To avoid future disputes, Spain may need to impose harder regional budget constraints and match spending needs with tax capacities for each of its jurisdictions. CRITICAL THINKING 1. How do you the think the European Debt Crisis has contributed to the fiscal problem in Spain and Catalonia? How can this be avoided in the future? M09_CASE3826_13_GE_C09.indd 204 17/04/19 4:16 AM CHAPTER 9 The Government and Fiscal Policy 205 Clinton administrations Bush administrations Obama administrations 70 65 60 55 50 45 40 1993 I 1994 I 1995 I 1996 I 1997 I 1998 I 1999 I 2000 I 2001 I 2002 I 2003 I 2004 I 2005 I 2006 I 2007 I 2008 I 2009 I 2010 I 2011 I 2012 I 2013 I 2014 I 2015 I 2016 I 2017 I 2017 IV MyLab Economics Real-time data ▸▴ FIGURE 9.7 The Federal Government Debt as a Percentage of GDP, 1993 I–2017 IV Quarters concerns, but also microeconomic issues and political philosophy. President Clinton’s welfare reform program resulted in a decrease in government transfer payments but was motivated in part by interest in improving market incentives. President Bush’s early tax cuts were based less on macroeconomic concerns than on political philosophy, while the increased spending
came from developments in international relations. President Obama’s fiscal policy, on the other hand, was motivated by macroeconomic concerns. The stimulus bill was designed to mitigate the effects of the recession that began in 2008. Whether tax and spending policies are motivated by macroeconomic concerns or not, they have macroeconomic consequences. The Federal Government Debt MyLab Economics Concept Check When the government runs a deficit, it must borrow to finance it. To borrow, the federal government sells government securities to the public, which it pays interest on. In return, it receives funds from the buyers of the securities and uses these funds to pay its bills. This borrowing increases the federal debt, the total amount owed by the federal government. The federal debt is the total of all accumulated deficits minus surpluses over time. Conversely, if the government runs a surplus, the federal debt falls. Some of the securities that the government issues end up being held by the federal government at the Federal Reserve or in government trust funds, the largest of which is Social Security. The term privately held federal debt refers to the non-government-owned debt of the U.S. government. The privately held federal government debt as a percentage of GDP is plotted in Figure 9.7 for the 1993 I–2017 IV period. The percentage fell during the second Clinton administration, when the budget was in surplus, and it mostly rose during the Bush administrations, when the budget was in deficit. The rise during the first Obama administration was dramatic, reaching 70 percent at the end of 2012. The debt to GDP ratio remained high during the second Obama administration and into the first year of the Trump administration. With higher deficits projected from 2018 on, the ratio is likely to rise substantially from 2018 on. 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. M09_CASE3826_13_GE_C09.indd 205 17/04/19 4:16 AM 206 PART III The Core of Macroeconomic Theory 9.4 LEARNING OBJECTIVE Explain the influence of the economy on the federal government budget. 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. automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to destabilize GDP. 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. The Economy’s Influence on the Government Budget We have just seen that an administration’s fiscal policy is sometimes affected by the state of the economy. The Obama administration, for example, increased government spending and lowered taxes in response to the recession of 2008–2009. It is also the case, however, that the economy affects the federal government budget even if there are no explicit fiscal policy changes. There are effects that the government has no direct control over. They can be lumped under the general heading of “automatic stabilizers and destabilizers.” Automatic Stabilizers and Destabilizers MyLab Economics Concept Check Most of the tax revenues of the government result from applying a tax rate decided by the government to a base that reflects the underlying activity of the economy. The corporate profits tax, for example, comes from applying a rate (say 20 percent) to the profits earned by firms. Income taxes come from applying rates shown in tax tables to income earned by individuals. Tax revenues thus depend on the state of the economy even when the government does not change tax rates. When the economy goes into a recession, tax revenues will fall, even if rates remain constant, and when the economy picks up, so will tax revenues. As a result, deficits fall in expansions and rise in recessions, other things being equal. Some items on the expenditure side of the government budget also automatically change as the economy changes. If the economy declines, unemployment increases, which leads to an increase in unemployment benefits. General assistance to the needy, food stamp allotments, and similar transfer payments also increase in recessions and decrease in expansions. These automatic changes in government revenues and expenditures are called automatic stabilizers. They help stabilize the economy. In recessions, taxes fall and expenditures rise, which creates positive effects on the economy, and in expansions, the opposite happens. The government does not have to change any laws for this to happen. Another reason that government spending is not completely controllable is that inflation often picks up in an expansion. We saw in Chapter 7 that some government transfer payments are tied to the rate of inflation (changes in the CPI); so these transfer payments increase as inflation increases. Some medical care transfer payments also increase as the prices of medical care rise, and these prices may be affected by the overall rate of inflation. To the extent that inflation is more likely to increase in an expansion than in a recession, inflation can be considered to be an automatic
destabilizer. Government spending increases as inflation increases, which further fuels the expansion, which is destabilizing. If inflation decreases in a recession, there is an automatic decrease in government spending, which makes the recession worse. We will see in later chapters that interest rates tend to rise in expansions and fall in recessions. When interest rates rise, government interest payments to households and firms increase (because households and firms hold much of the government debt), which is interest income to the households and firms. Government spending on interest payments thus tends to rise in expansions and fall in contractions, which, other things being equal, is destabilizing. We will see in later chapters that a rise in interest rates can also lead for other reasons to a decrease in consumption (and investment), which, other things being equal, is stabilizing. The net effect of interest rate changes is generally stabilizing, but this is getting ahead of our story. Since 1982 personal income tax brackets have been tied to the overall price level. Prior to this they were not, which led to what was called fiscal drag. If tax brackets are not tied to the price level, then as the price level rises and thus people’s nominal incomes rise, people move into higher brackets; so the average tax rates that they pay increase. This is a “drag” on the economy, hence the name fiscal drag. In 1982, the United States instituted an alternative Minimum Tax (AMT), directed at higher income individuals who had a number of special tax deductions. These individuals were subject to an alternative calculation of their income taxes, which essentially eliminated some deductions and imposed a (lower) flat tax. In contrast to the standard tax tables, the income level at which the AMT would kick in remained constant over the subsequent 30 years until finally indexed to inflation in 2013. For this period, the AMT tax created fiscal drag. It is interesting to note that fiscal drag is actually an automatic stabilizer in that the number of people moving into higher tax brackets increases in expansions and falls in contractions. By indexing the tax brackets to the overall price level, the legislation in 1982 eliminated the fiscal drag M09_CASE3826_13_GE_C09.indd 206 17/04/19 4:16 AM CHAPTER 9 The Government and Fiscal Policy 207 caused by inflation from taxes other than the AMT. If incomes rise only because of inflation, there is no change in average tax rates because the brackets are changed each year. The inflation part of the automatic
stabilizer has been eliminated. Full-Employment Budget MyLab Economics Concept Check We have seen that the state of the economy has a big effect on the budget deficit. When the economy turns down, automatic stabilizers act to increase the deficit; the government may also take further actions intended to pull the economy out of a slump. Under these conditions, running a deficit may seem like a good idea. When the economy is thriving, however, deficits may be more problematic. In particular, if the government runs deficits in good times as well as bad, the overall debt is surely going to rise, which may be unsustainable in the long run. Instead of looking simply at the size of the surplus or deficit, economists have developed an alternative way to calibrate deficits. By examining what the budget would be like if the economy were producing at the full-employment level of output—the so-called full-employment budget —we can establish a benchmark for evaluating fiscal policy. The distinction between the actual and full-employment budget is important. Suppose the economy is in a slump and the deficit is $250 billion. Also suppose that if there were full employment, the deficit would fall to $75 billion. The $75 billion deficit that would remain even with full employment would be because of the structure of tax and spending programs instead of the state of the economy. This deficit—the deficit that remains at full employment—is sometimes called the structural deficit. The $175 billion ($250 billion − $75 billion) part of the deficit caused by the fact the economy is in a slump is known as the cyclical deficit. The existence of the cyclical deficit depends on where the economy is in the business cycle, and it ceases to exist when full employment is reached. By definition, the cyclical deficit of the full-employment budget is zero. Table 9.5 shows that the federal government deficit in 2014 was $582.3 billion. How much of this was cyclical and how much was structural? The U.S. economy was still not quite at full employment in 2014, and so some of the deficit was cyclical. Looking Ahead We have now seen how households, firms, and the government interact in the goods market, how equilibrium output (income) is determined, and how the government uses fiscal policy to influence the economy. In the next chapter we analyze the money market and monetary policy—the government’s other major tool for influencing the economy. S U M M A R Y full-employment budget What the federal budget would be if the
economy were producing at the full- employment level of output. structural deficit The deficit that remains at full employment. cyclical deficit The deficit that occurs because of a downturn in the business cycle. 1. The government can affect the macroeconomy through two specific policy channels. Fiscal policy refers to the government’s taxing and spending behavior. Discretionary fiscal policy refers to changes in taxes or spending that are the result of deliberate changes in government policy. Monetary policy refers to the behavior of the Federal Reserve concerning the interest rate. 9.1 GOVERNMENT IN THE ECONOMY p. 191 2. The government does not have complete control over tax revenues and certain expenditures, which are partially dictated by the state of the economy. 3. As a participant in the economy, the government makes purchases of goods and services (G), collects taxes, and makes transfer payments to households. Net taxes (T) is equal to the tax payments made to the government by firms and households minus transfer payments made to households by the government. 4. Disposable, or after-tax, income (Yd) is equal to the amount of income received by households after taxes: Yd K Y - T. After-tax income determines households’ consumption behavior. 5. The budget deficit is equal to the difference between what the government spends and what it collects in taxes: G - T. When G exceeds T, the government must borrow from the public to finance its deficit. 6. In an economy in which government is a participant, planned aggregate expenditure equals consumption spending by households (C) plus planned investment spending by firms (I) plus government spending on goods and services (G): AE K C + I + G. Because the condition Y = AE is necessary for the economy to be in equilibrium, it follows that Y = C + I + G is the macroeconomic equilibrium condition. The economy is also in equilibrium when leakages out of the system equal injections into the system. This occurs when MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 207 17/04/19 4:16 AM 208 PART III The Core of Macroeconomic Theory saving and net taxes (the leakages) equal planned investment and government purchases (the injections): S + T = I + G. 9.2 FISC
AL POLICY AT WORK: MULTIPLIER EFFECTS p. 195 7. Fiscal policy has a multiplier effect on the economy. A change in government spending gives rise to a multiplier equal to 1 plier equal to - MPC > or decrease in government spending and taxes has a multiplier effect of one. MPS. A change in taxation brings about a multiMPS. A simultaneous equal increase > 9.3 THE FEDERAL BUDGET p. 201 8. During the two Clinton administrations, the federal budget went from being in deficit to being in surplus. This was reversed during the two Bush administrations, driven by tax rate decreases and government spending increases. The deficit increased further during the first Obama administration. The deficit to GDP ratio was roughly constant during the second Obama administration and the first year of the Trump administration, but it is projected to increase substantially from 2018 on. The same is true of the debt to GDP ratio. 9.4 THE ECONOMY’S INFLUENCE ON THE GOVERNMENT BUDGET p. 206 9. Automatic stabilizers are revenue and expenditure items in the federal budget that automatically change with the state of the economy and that tend to stabilize GDP. For example, during expansions, the government automatically takes in more revenue because people are making more money that is taxed. 10. The full-employment budget is an economist’s construc- tion of what the federal budget would be if the economy were producing at a full-employment level of output. The structural deficit is the federal deficit that remains even at full employment. The cyclical deficit is that part of the total deficit caused by the economy operating at less than full employment automatic destabilizer, p. 206 automatic stabilizers, p. 206 fiscal policy, p. 190 full-employment budget, p. 207 balanced-budget multiplier, p. 199 government spending multiplier, p. 196 budget deficit, p. 192 cyclical deficit, p. 207 monetary policy, p. 191 net taxes (T), p. 191 discretionary fiscal policy, p. 191 privately held federal debt, p. 205 disposable, or after-tax, income (Yd), p. 191 structural deficit, p. 207 federal budget, p. 201 federal debt, p. 205 federal surplus ( + ) or deficit ( -), p. 201 fiscal drag, p. 206 tax multiplier, p. 198 Equations: Disposable income: Yd K Y - T, p. 191 AE K C + I

Subsets and Splits

No community queries yet

The top public SQL queries from the community will appear here once available.