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The supply curve is drawn as upward sloping, though steep, to reflect studies showing that the quantity of labor supplied at any one time is nearly fixed. Thus, an increase in the real wage induces a relatively small increase in the quantity of labor supplied. The demand curve shows the quantity of labor demanded at each real wage. The lower the real wage, the greater the quantity of labor firms will demand. In the case shown here, the real wage, ωe, equals the equilibrium solution defined by the intersection of the demand curve D1 and the supply curve S1. The quantity of labor demanded, Le, equals the quantity supplied. 5.3 Unemployment 214 Chapter 5 Macroeconomics: The Big Picture The employment level at which the quantity of labor demanded equals the quantity supplied is called the natural level of employment20. It is sometimes referred to as full employment. Figure 5.5 The Natural Level of Employment The employment level at which the quantity of labor demanded equals the quantity supplied is called the natural level of employment. Here, the natural level of employment is Le, which is achieved at a real wage ωe. Even if the economy is operating at its natural level of employment, there will still be some unemployment. The rate of unemployment consistent with the natural level of employment is called the natural rate of unemployment21. Business cycles may generate additional unemployment. We discuss these various sources of unemployment below. 20. The employment level at which the quantity of labor demanded equals the quantity supplied. 21. The rate of unemployment consistent with the natural level of employment. Frictional Unemployment Even when the quantity of labor demanded equals the quantity of labor supplied, not all employers and potential workers have found each other. Some workers are looking for jobs, and some employers are looking for workers. During the time it 5.3 Unemployment 215 Chapter 5 Macroeconomics: The Big Picture takes to match them up, the workers are unemployed. Unemployment that occurs because it takes time for employers and workers to find each other is called frictional unemployment22. The case of college graduates engaged in job searches is a good example of frictional unemployment. Those who did not land a job while still in school will seek work. Most of them will find jobs, but it will take time. During that time, these new graduates will be unemployed. If information about the labor market were costless, firms and potential workers would instantly know everything they needed to know about each other and there would be no need for searches on the part of workers and firms. There would be no fr
ictional unemployment. But information is costly. Job searches are needed to produce this information, and frictional unemployment exists while the searches continue. The government may attempt to reduce frictional unemployment by focusing on its source: information costs. Many state agencies, for example, serve as clearinghouses for job market information. They encourage firms seeking workers and workers seeking jobs to register with them. To the extent that such efforts make labor-market information more readily available, they reduce frictional unemployment. Structural Unemployment Another reason there can be unemployment even if employment equals its natural level stems from potential mismatches between the skills employers seek and the skills potential workers offer. Every worker is different; every job has its special characteristics and requirements. The qualifications of job seekers may not match those that firms require. Even if the number of employees firms demand equals the number of workers available, people whose qualifications do not satisfy what firms are seeking will find themselves without work. Unemployment that results from a mismatch between worker qualifications and the characteristics employers require is called structural unemployment23. 22. Unemployment that occurs because it takes time for employers and workers to find each other. Structural unemployment emerges for several reasons. Technological change may make some skills obsolete or require new ones. The widespread introduction of personal computers since the 1980s, for example, has lowered demand for typists who lacked computer skills. 23. Unemployment that results from a mismatch between worker qualifications and the characteristics employers require. Structural unemployment can occur if too many or too few workers seek training or education that matches job requirements. Students cannot predict precisely how many jobs there will be in a particular category when they graduate, and they are not likely to know how many of their fellow students are training for these jobs. 5.3 Unemployment 216 Chapter 5 Macroeconomics: The Big Picture Structural unemployment can easily occur if students guess wrong about how many workers will be needed or how many will be supplied. Structural unemployment can also result from geographical mismatches. Economic activity may be booming in one region and slumping in another. It will take time for unemployed workers to relocate and find new jobs. And poor or costly transportation may block some urban residents from obtaining jobs only a few miles away. Public policy responses to structural unemployment generally focus on job training and education to equip workers with the skills firms demand. The government publishes regional labor-market information, helping to inform unemployed workers of where jobs can be found. The North American Free Trade Agreement (NAFTA), which created a free trade region encompassing Mexico, the United States, and
Canada, has created some structural unemployment in the three countries. In the United States, the legislation authorizing the pact also provided for job training programs for displaced U.S. workers. Although government programs may reduce frictional and structural unemployment, they cannot eliminate it. Information in the labor market will always have a cost, and that cost creates frictional unemployment. An economy with changing demands for goods and services, changing technology, and changing production costs will always have some sectors expanding and others contracting—structural unemployment is inevitable. An economy at its natural level of employment will therefore have frictional and structural unemployment. Cyclical Unemployment Of course, the economy may not be operating at its natural level of employment, so unemployment may be above or below its natural level. In a later chapter we will explore what happens when the economy generates employment greater or less than the natural level. Cyclical unemployment24 is unemployment in excess of the unemployment that exists at the natural level of employment. Figure 5.6 "Unemployment Rate, 1960–2011" shows the unemployment rate in the United States for the period from 1960 through 2011. We see that it has fluctuated considerably. How much of it corresponds to the natural rate of unemployment varies over time with changing circumstances. For example, in a country with a demographic “bulge” of new entrants into the labor force, frictional unemployment is likely to be high, because it takes the new entrants some time to find their first jobs. This factor alone would raise the natural rate of unemployment. A demographic shift toward more mature workers would lower the natural rate. 24. Unemployment in excess of the unemployment that exists at the natural level of employment. 5.3 Unemployment 217 Chapter 5 Macroeconomics: The Big Picture During recessions, highlighted in Figure 5.6 "Unemployment Rate, 1960–2011", the part of unemployment that is cyclical unemployment grows. The analysis of fluctuations in the unemployment rate, and the government’s responses to them, will occupy center stage in much of the remainder of this book. Figure 5.6 Unemployment Rate, 1960–2011 The chart shows the unemployment rate for each year from 1960 to 2011. Recessions are shown as shaded areas. Source: Economic Report of the President, 2012, Table B-42 • People who are not working but are looking and available for work at any one time are considered unemployed. The unemployment rate is the percentage of the labor force that is unemployed. • When the labor market is in equilibrium, employment is at the natural level and
the unemployment rate equals the natural rate of unemployment. • Even if employment is at the natural level, the economy will experience frictional and structural unemployment. Cyclical unemployment is unemployment in excess of that associated with the natural level of employment. 5.3 Unemployment 218 Chapter 5 Macroeconomics: The Big Picture T R Y I T! Given the data in the table, compute the unemployment rate in Year 1 and in Year 2. Explain why, in this example, both the number of people employed and the unemployment rate increased. Year 1 2 Number employed (in millions) Number unemployed (in millions) 20 21 2 2.4 5.3 Unemployment 219 Chapter 5 Macroeconomics: The Big Picture Case in Point: Might Increased Structural Unemployment Explain the “Jobless Recovery” Following the 2001 Recession? The U.S. 2001 recession was mild by historical standards, but recovery in terms of increased employment seemed painfully slow in coming. Economists Erica Goshen and Simon Potter at the Federal Reserve Bank of New York think the reason for the slow recovery in jobs may have actually reflected structural changes in the U.S. economy. They argue that during the recession permanent rather than temporary layoffs predominated and that it takes longer for firms to hire workers into new positions than to hire them back into former jobs. What is their evidence? When the layoff is temporary, the employer “suspends” the job, due to slack demand, and the employee expects to be recalled once demand picks up. With a permanent layoff, the employer eliminates the job. So, they looked at the contribution of temporary layoffs to the unemployment rate during the recent recession compared to the situation in the four recessions before 1990. In the earlier recessions, unemployment from temporary layoffs rose when the economy was shrinking and fell after the economy began to recover. In both the 1991 and 2001 recessions, temporary layoffs were minor. Then, the authors examined job flows in 70 industries. They classified layoffs in an industry as being cyclical in nature if the job losses during the recession were reversed during the recovery but structural if job losses for the industry continued during the recovery. Their analysis revealed that during the 5.3 Unemployment 220 Chapter 5 Macroeconomics: The Big Picture recession of the early 1980s, job losses were about evenly split between cyclical and structural changes. In the 1991 recession and then more strongly in the 2001 recession, structural changes dominated. “Most of the industries that lost jobs during the [2001] recession—for example, communications, electronic
equipment, and securities and commodities brokers—[were] still losing jobs” in 2003. “The trend revealed... is one in which jobs are relocated from some industries to others, not reclaimed by the same industries that lost them earlier.” The authors suggest three possible reasons for the recent increased role of structural change: (1) The structural decline in some industries could be the result of overexpansion in those industries during the 1990s. The high tech and telecommunications industries in particular could be examples of industries that were overbuilt before the 2001 recession. (2) Improved government policies may have reduced cyclical unemployment. Examination of macroeconomic policy in future chapters will return to this issue. (3) New management strategies to reduce costs may be promoting leaner staffing. For firms adopting such strategies, a recession may provide an opportunity to reorganize the production process permanently and reduce payrolls in the process. Goshen and Potter point out that, for workers, finding new jobs is harder than simply returning to old ones. For firms, making decisions about the nature of new jobs is time consuming at best. The uncertainty created by the war in Iraq and the imposition of new accounting standards following the “Enron”-like scandals may have further prolonged the creation of new jobs. Source: Erica L. Goshen and Simon Potter, “Has Structural Change Contributed to a Jobless Recovery?” Federal Reserve Bank of New York Current Issues in Economics and Finance 9, no. 8 (August 2003): 1–7. 5.3 Unemployment 221 Chapter 5 Macroeconomics: The Big Picture In Year 1 the total labor force includes 22 million workers, and so the unemployment rate is 2/22 = 9.1%. In Year 2 the total labor force numbers 23.4 million workers; therefore the unemployment rate is 2.4/23.4 = 10.3%. In this example, both the number of people employed and the unemployment rate rose, because more people (23.4 − 22 = 1.4 million) entered the labor force, of whom 1 million found jobs and 0.4 million were still looking for jobs. 5.3 Unemployment 222 Chapter 5 Macroeconomics: The Big Picture 5.4 Review and Practice Summary In this chapter we examined growth in real GDP and business cycles, price-level changes, and unemployment. We saw how these phenomena are defined and looked at their consequences. Examining real GDP, rather than nominal GDP, over time tells us whether the economy is expanding
or contracting. Real GDP in the United States shows a long upward trend, but with the economy going through phases of expansion and recession around that trend. These phases make up the business cycle. An expansion reaches a peak, and the economy falls into a recession. The recession reaches a trough and begins an expansion again. Inflation is an increase in the price level and deflation is a decrease in the price level. The rate of inflation or deflation is the percentage rate of change in a price index. We looked at the calculation of the consumer price index (CPI) and the implicit price deflator. The CPI is widely used in the calculation of price-level changes. There are, however, biases in its calculation: the substitution bias, the new-product bias, the quality-change bias, and the outlet bias. Inflation and deflation affect economic activity in several ways. They change the value of money and of claims on money. Unexpected inflation benefits borrowers and hurts lenders. Unexpected deflation benefits lenders and hurts borrowers. Both inflation and deflation create uncertainty and make it difficult for individuals and firms to enter into long-term financial commitments. The unemployment rate is measured as the percentage of the labor force not working but seeking work. Frictional unemployment occurs because information about the labor market is costly; it takes time for firms seeking workers and workers seeking firms to find each other. Structural unemployment occurs when there is a mismatch between the skills offered by potential workers and the skills sought by firms. Both frictional and structural unemployment occur even if employment and the unemployment rate are at their natural levels. Cyclical unemployment is unemployment that is in excess of that associated with the natural level of employment. 223 Chapter 5 Macroeconomics: The Big Picture. Describe the phases of a business cycle. 2. On the basis of recent news reports, what phase of the business cycle do you think the economy is in now? What is the inflation or deflation rate? The unemployment rate? 3. Suppose you compare your income this year and last year and find that your nominal income fell but your real income rose. How could this have happened? 4. Suppose you calculate a grocery price inflation rate. Using the arguments presented in the chapter, explain possible sources of upward bias in the rate you calculate, relative to the actual trend of food prices. 5. Name three items you have purchased during the past year that have increased in quality during the year. What kind of adjustment would you make in assessing their prices for the CPI? 6. Why do some people gain and other
people lose from inflation and deflation? 7. Suppose unemployed people leave a state to obtain jobs in other states. What do you predict will happen to the unemployment rate in the state experiencing the out-migration? What might happen to the unemployment rates in the states experiencing in-migration? 8. Minority teenagers have the highest unemployment rates of any group. One reason for this phenomenon is high transportation costs for many minority teens. What form of unemployment (cyclical, frictional, or structural) do high transportation costs suggest? 9. Welfare reforms enacted in 1996 put more pressure on welfare recipients to look for work. The new law mandated cutting off benefits after a certain length of time. How do you think this provision might affect the unemployment rate? 10. American workers work more hours than their European counterparts. Should Congress legislate a shorter workweek? 5.4 Review and Practice 224 Chapter 5 Macroeconomics: The Big Picture. Plot the quarterly data for real GDP for the last two years. (You can find the data online at http://www.whitehouse.gov/administration/eop/ cea/economic-indicators. Relate recent changes in real GDP to the concept of the phases of the business cycle.) 2. Suppose that in 2013, the items in the market basket for our movie price index cost $53.40. Use the information in the chapter to compute the price index for that year. How does the rate of movie price inflation from 2012 to 2013 compare with the rate from 2011 to 2012? 3. Recompute the movie price indexes for 2011 and 2012 using 2012 as the base year. Now compute the rate of inflation for the 2011–2012 period. Compare your result to the inflation rate calculated for that same period using 2011 as the base year. 4. Here are some statistics for August 2006. Compute the unemployment rate for that month (all figures are in thousands). Population (Civilian, noninstitutional) 229,167 Civilian Labor Force Participation Rate Not in Labor Force Employed Unemployed 151,698 66.2% 77,469 144,579 7,119 5. Suppose an economy has 10,000 people who are not working but looking and available for work and 90,000 people who are working. What is its unemployment rate? Now suppose 4,000 of the people looking for work get discouraged and give up their searches. What happens to the unemployment rate? Would you interpret this as good news for the economy or bad news? Explain. 6. The average price
of going to a baseball game in 2011, based on the observations in the Case in Point, was $197.35. Using this average as the equivalent of a base year, compute fan price indexes for: a. The New York Yankees. b. The Chicago Cubs. c. The Boston Red Sox. 5.4 Review and Practice 225 Chapter 5 Macroeconomics: The Big Picture d. The Tampa Bay Rays. e. The team of your choice. 7. Suppose you are given the following data for a small economy: Number of unemployed workers: 1,000,000. Labor force: 10,000,000. Based on this data, answer the following: a. What is the unemployment rate? b. Can you determine whether the economy is operating at its full employment level? c. Now suppose people who had been seeking jobs become discouraged, and give up their job searches. The labor force shrinks to 900,500 workers, and unemployment falls to 500,000 workers. What is the unemployment rate now? Has the economy improved? 8. Nominal GDP for an economy is $10 trillion. Real GDP is $9 trillion. What is the value of the implicit price deflator? 9. Suppose you are given the following data for an economy: Month Real GDP Employment 10.0 trillion 100 million $10.4 trillion 104 million $10.5 trillion 105 million $10.3 trillion 103 million $10.2 trillion 102 million $10.3 trillion 103 million $10.6 trillion 106 million $10.7 trillion 107 million $10.6 trillion 106 million 5.4 Review and Practice 226 Chapter 5 Macroeconomics: The Big Picture a. Plot the data for real GDP, with the time period on the horizontal axis and real GDP on the vertical axis. b. There are two peaks. When do they occur? c. When does the trough occur? 10. The Consumer Price Index in Period 1 is 107.5. It is 103.8 in Period 2. Is this a situation of inflation or deflation? What is the rate? 5.4 Review and Practice 227 Chapter 6 Measuring Total Output and Income Start Up: The Lockup It is early morning when a half-dozen senior officials enter the room at the Commerce Department in Washington. Once inside, they will have no communication with the outside world until they have completed their work later that day. They will have no telephone, no computer links. They will be able to slip out to an adjoining restroom, but only in pairs.
It is no wonder the room is called “the Lockup.” The Lockup produces one of the most important indicators of economic activity we have: the official estimate of the value of the economy’s total output, known as its gross domestic product (GDP). When the team has finished its computations, the results will be placed in a sealed envelope. A government messenger will hand carry the envelope to the Executive Office Building and deliver it to a senior adviser to the president of the United States. The adviser will examine its contents, then carry it across the street to the White House and give it to the president. The senior officials who meet in secret to compute GDP are not spies; they are economists. The adviser who delivers the estimate to the president is the chairman of the Council of Economic Advisers. The elaborate precautions for secrecy do not end there. At 7:30 the next morning, journalists from all over the world will gather in an electronically sealed auditorium at the Commerce Department. There they will be given the GDP figure and related economic indicators, along with an explanation. The reporters will have an hour to prepare their reports, but they will not be able to communicate with anyone else until an official throws the switch at 8:30. At that instant their computers will connect to their news services, and they will be able to file their reports. These will be major stories on the Internet and in the next editions of the nation’s newspapers; the estimate of the previous quarter’s GDP will be one of the lead items on television and radio news broadcasts that day. The clandestine preparations for the release of quarterly GDP figures reflect the importance of this indicator. The estimate of GDP provides the best available 228 Chapter 6 Measuring Total Output and Income reading of macroeconomic performance. It will affect government policy, and it will influence millions of decisions in the private sector. Prior knowledge of the GDP estimate could be used to anticipate the response in the stock and bond markets, so great care is taken that only a handful of trusted officials have access to the information until it is officially released. The GDP estimate took on huge significance in the fall of 2008 as the United States and much of the rest of the world went through the wrenching experience of the worst financial crisis since the Great Depression of the 1930s. The expectation that the financial crisis would lead to an economic collapse was widespread, and the quarterly announcements of GDP figures were more anxiously awaited than ever. The primary measure of the ups and downs of economic activity—the
business cycle—is real GDP. When an economy’s output is rising, the economy creates more jobs, more income, and more opportunities for people. In the long run, an economy’s output and income, relative to its population, determine the material standard of living of its people. Clearly GDP is an important indicator of macroeconomic performance. It is the topic we will consider in this chapter. We will learn that GDP can be measured either in terms of the total value of output produced or as the total value of income generated in producing that output. We will begin with an examination of measures of GDP in terms of output. Our initial focus will be on nominal GDP: the value of total output measured in current prices. We will turn to real GDP—a measure of output that has been adjusted for price level changes—later in the chapter. We will refer to nominal GDP simply as GDP. When we discuss the real value of the measure, we will call it real GDP. 229 Chapter 6 Measuring Total Output and Income 6.1 Measuring Total Output. Define gross domestic product and its four major spending components and illustrate the various flows using the circular flow model. 2. Distinguish between measuring GDP as the sum of the values of final goods and services and as the sum of values added at each stage of production. 3. Distinguish between gross domestic product and gross national product. An economy produces a mind-boggling array of goods and services every year. For example, Domino’s Pizza produces hundreds of millions of pizzas. The United States Steel Corporation, the nation’s largest steel company, produces tens of millions of tons of steel. A small logging company in Colorado produces a couple million board feet of lumber. A university football team draws more than half a million fans to its home games. A pediatric nurse in Los Angeles delivers hundreds of babies and takes care of several hundred additional patients. A list of all the goods and services an economy produces in any year would be virtually endless. So—what kind of year is the year we are looking at? We would not get very far trying to wade through a list of all the goods and services produced that year. It is helpful to have instead a single number that measures total output in the economy; that number is GDP. The Components of GDP We can divide the goods and services produced during any period into four broad components, based on who buys them. These components of GDP are personal consumption (C), gross private domestic investment
(I), government purchases (G), and net exports (Xn). Thus Equation 6.1 GDP = consumption (C) GDP = C + + private investment (I) or I + + + + net exports (X n), X n government purchases (G) G 230 Chapter 6 Measuring Total Output and Income We will examine each of these components, and we will see how each fits into the pattern of macroeconomic activity. Before we begin, it will be helpful to distinguish between two types of variables: stocks and flows. A flow variable1 is a variable that is measured over a specific period of time. A stock variable2 is a variable that is independent of time. Income is an example of a flow variable. To say one’s income is, for example, $1,000 is meaningless without a time dimension. Is it $1,000 per hour? Per day? Per week? Per month? Until we know the time period, we have no idea what the income figure means. The balance in a checking account is an example of a stock variable. When we learn that the balance in a checking account is $1,000, we know precisely what that means; we do not need a time dimension. We will see that stock and flow variables play very different roles in macroeconomic analysis. Personal Consumption Personal consumption3 is a flow variable that measures the value of goods and services purchased by households during a time period. Purchases by households of groceries, health-care services, clothing, and automobiles—all are counted as consumption. The production of consumer goods and services accounts for about 70% of total output. Because consumption is such a large part of GDP, economists seeking to understand the determinants of GDP must pay special attention to the determinants of consumption. In a later chapter we will explore these determinants and the impact of consumption on economic activity. Personal consumption represents a demand for goods and services placed on firms by households. In the chapter on demand and supply, we saw how this demand could be presented in a circular flow model of the economy. Figure 6.1 "Personal Consumption in the Circular Flow" presents a circular flow model for an economy that produces only personal consumption goods and services. (We will add the other components of GDP to the circular flow as we discuss them.) Spending for these goods flows from households to firms; it is the arrow labeled “Personal consumption.” Firms produce these goods and services using factors of production: labor, capital, and
natural resources. These factors are ultimately owned by households. The production of goods and services thus generates income to households; we see this income as the flow from firms to households labeled “Factor incomes” in the exhibit. 1. A variable that is measured over a specific period of time. 2. A variable that is independent of time. 3. A flow variable that measures the value of goods and services purchased by households during a time period. 6.1 Measuring Total Output 231 Chapter 6 Measuring Total Output and Income In exchange for payments that flow from households to firms, there is a flow of consumer goods and services from firms to households. This flow is shown in Figure 6.1 "Personal Consumption in the Circular Flow" as an arrow going from firms to households. When you buy a soda, for example, your payment to the store is part of the flow of personal consumption; the soda is part of the flow of consumer goods and services that goes from the store to a household—yours. Similarly, the lower arrow in Figure 6.1 "Personal Consumption in the Circular Flow" shows the flow of factors of production—labor, capital, and natural resources—from households to firms. If you work for a firm, your labor is part of this flow. The wages you receive are part of the factor incomes that flow from firms to households. Figure 6.1 Personal Consumption in the Circular Flow Personal consumption spending flows from households to firms. In return, consumer goods and services flow from firms to households. To produce the goods and services households demand, firms employ factors of production owned by households. There is thus a flow of factor services from households to firms, and a flow of payments of factor incomes from firms to households. There is a key difference in our interpretation of the circular flow picture in Figure 6.1 "Personal Consumption in the Circular Flow" from our analysis of the same model in the demand and supply chapter. There, our focus was microeconomics, which examines individual units of the economy. In thinking about the flow of consumption spending from households to firms, we emphasized demand and supply in particular markets—markets for such things as blue jeans, haircuts, and apartments. In thinking about the flow of income payments from firms to households, we focused on the demand and supply for particular factors of production, such as textile workers, barbers, and apartment buildings. Because our focus now is macroeconomics, the study of aggregates of economic activity, we will think in terms of
the total of personal consumption and the total of payments to households. Private Investment Gross private domestic investment4 is the value of all goods produced during a period for use in the production of other goods and services. Like personal consumption, gross private domestic investment is a flow variable. It is often simply referred to as “private investment.” A hammer produced for a carpenter is private investment. A printing press produced for a magazine publisher is private investment, as is a conveyor-belt system produced for a manufacturing firm. Capital includes all the goods that have been produced for use in producing other goods; it 4. The value of all goods produced during a period for use in the production of other goods and services. 6.1 Measuring Total Output 232 Chapter 6 Measuring Total Output and Income is a stock variable. Private investment is a flow variable that adds to the stock of capital during a period. Heads Up! The term “investment” can generate confusion. In everyday conversation, we use the term “investment” to refer to uses of money to earn income. We say we have invested in a stock or invested in a bond. Economists, however, restrict “investment” to activities that increase the economy’s stock of capital. The purchase of a share of stock does not add to the capital stock; it is not investment in the economic meaning of the word. We refer to the exchange of financial assets, such as stocks or bonds, as financial investment to distinguish it from the creation of capital that occurs as the result of investment. Only when new capital is produced does investment occur. Confusing the economic concept of private investment with the concept of financial investment can cause misunderstanding of the way in which key components of the economy relate to one another. Gross private domestic investment includes three flows that add to or maintain the nation’s capital stock: expenditures by business firms on new buildings, plants, tools, equipment, and software that will be used in the production of goods and services; expenditures on new residential housing; and changes in business inventories. Any addition to a firm’s inventories represents an addition to investment; a reduction subtracts from investment. For example, if a clothing store stocks 1,000 pairs of jeans, the jeans represent an addition to inventory and are part of gross private domestic investment. As the jeans are sold, they are subtracted from inventory and thus subtracted from investment. By recording additions to inventories as investment and reductions from inventories as
subtractions from investment, the accounting for GDP records production in the period in which it occurs. Suppose, for example, that Levi Strauss manufactures 1 million pairs of jeans late in 2011 and distributes them to stores at the end of December. The jeans will be added to inventory; they thus count as investment in 2011 and enter GDP for that year. Suppose they are sold in January 2012. They will be counted as consumption in GDP for 2012 but subtracted from inventory, and from investment. Thus, the production of the jeans will add to GDP in 2011, when they were produced. They will not count in 2012, save for any increase in the value of the jeans resulting from the services provided by the retail stores that sold them. 6.1 Measuring Total Output 233 Chapter 6 Measuring Total Output and Income Private investment accounts for about 15% of GDP—but, at times, even less. Despite its relatively small share of total economic activity, private investment plays a crucial role in the macroeconomy for two reasons: 1. Private investment represents a choice to forgo current consumption in order to add to the capital stock of the economy. Private investment therefore adds to the economy’s capacity to produce and shifts its production possibilities curve outward. Investment is thus one determinant of economic growth, which is explored in another chapter. 2. Private investment is a relatively volatile component of GDP; it can change dramatically from one year to the next. Fluctuations in GDP are often driven by fluctuations in private investment. We will examine the determinants of private investment in a chapter devoted to the study of investment. Private investment represents a demand placed on firms for the production of capital goods. While it is a demand placed on firms, it flows from firms. In the circular flow model in Figure 6.2 "Private Investment in the Circular Flow", we see a flow of investment going from firms to firms. The production of goods and services for consumption generates factor incomes to households; the production of capital goods for investment generates income to households as well. Figure 6.2 "Private Investment in the Circular Flow" shows only spending flows and omits the physical flows represented by the arrows in Figure 6.1 "Personal Consumption in the Circular Flow". This simplification will make our analysis of the circular flow model easier. It will also focus our attention on spending flows, which are the flows we will be studying. Government Purchases Government agencies at all levels purchase goods and services from firms. They purchase office equipment, vehicles, buildings, jan
itorial services, and so on. Many government agencies also produce goods and services. Police departments produce police protection. Public schools produce education. The National Aeronautics and Space Administration (NASA) produces space exploration. Figure 6.2 Private Investment in the Circular Flow Private investment constitutes a demand placed on firms by other firms. It also generates factor incomes for households. To simplify the diagram, only the spending flows are shown—the corresponding flows of goods and services have been omitted. 6.1 Measuring Total Output 234 Chapter 6 Measuring Total Output and Income Government purchases5 are the sum of purchases of goods and services from firms by government agencies plus the total value of output produced by government agencies themselves during a time period. Government purchases make up about 20% of GDP. Government purchases are not the same thing as government spending. Much government spending takes the form of transfer payments6, which are payments that do not require the recipient to produce a good or service in order to receive them. Transfer payments include Social Security and other types of assistance to retired people, welfare payments to poor people, and unemployment compensation to people who have lost their jobs. Transfer payments are certainly significant—they account for roughly half of all federal government spending in the United States. They do not count in a nation’s GDP, because they do not reflect the production of a good or service. Government purchases represent a demand placed on firms, represented by the flow shown in Figure 6.3 "Government Purchases in the Circular Flow". Like all the components of GDP, the production of goods and services for government agencies creates factor incomes for households. Net Exports Sales of a country’s goods and services to buyers in the rest of the world during a particular time period represent its exports7. A purchase by a Japanese buyer of a Ford Taurus produced in the United States is a U.S. export. Exports also include such transactions as the purchase of accounting services from a New York accounting firm by a shipping line based in Hong Kong or the purchase of a ticket to Disney World by a tourist from Argentina. Imports8 are purchases of foreignproduced goods and services by a country’s residents during a period. United States imports include such transactions as the purchase by Americans of cars produced in Japan or tomatoes grown in Mexico or a stay in a French hotel by a tourist from the United States. Subtracting imports from exports yields net exports9. Figure 6.3 Government Purchases in the Circular Flow Purchases of goods and
services by government agencies create demands on firms. As firms produce these goods and services, they create factor incomes for households. Equation 6.2 Exports (X) − imports (M) = net exports (Xn ) 5. The sum of purchases of goods and services from firms by government agencies plus the total value of output produced by government agencies themselves during a time period. 6. Payments that do not require the recipient to produce a good or service in order to receive them. 7. Sales of a country’s goods and services to buyers in the rest of the world during a particular time period. 8. Purchases of foreign-produced goods and services by a country’s residents during a period. 9. Exports minus imports. 6.1 Measuring Total Output 235 Chapter 6 Measuring Total Output and Income In 2011, foreign buyers purchased $2,087.5 billion worth of goods and services from the United States. In the same year, U.S. residents, firms, and government agencies purchased $2,664.4 billion worth of goods and services from foreign countries. The difference between these two figures, −$576.9 billion, represented the net exports of the U.S. economy in 2011. Net exports were negative because imports exceeded exports. Negative net exports constitute a trade deficit10. The amount of the deficit is the amount by which imports exceed exports. When exports exceed imports there is a trade surplus11. The magnitude of the surplus is the amount by which exports exceed imports. The United States has recorded more deficits than surpluses since World War II, but the amounts have typically been relatively small, only a few billion dollars. The trade deficit began to soar, however, in the 1980s and again in the 2000s. We will examine the reasons for persistent trade deficits in another chapter. The rest of the world plays a key role in the domestic economy and, as we will see later in the book, there is nothing particularly good or bad about trade surpluses or deficits. Goods and services produced for export represent roughly 14% of GDP, and the goods and services the United States imports add significantly to our standard of living. In the circular flow diagram in Figure 6.4 "Net Exports in the Circular Flow", net exports are shown with an arrow connecting firms to the rest of the world. The balance between the flows of exports and imports is net exports. When there is a trade surplus, net exports are positive and add spending to the circular
flow. A trade deficit implies negative net exports; spending flows from firms to the rest of the world. The production of goods and services for personal consumption, private investment, government purchases, and net exports makes up a nation’s GDP. Firms produce these goods and services in response to demands from households (personal consumption), from other firms (private investment), from government agencies (government purchases), and from the rest of the world (net exports). All of this production creates factor income for households. Figure 6.5 "Spending in the Circular Flow Model" shows the circular flow model for all the spending flows we have discussed. Each flow is numbered for use in the exercise at the end of this section. Figure 6.4 Net Exports in the Circular Flow Net exports represent the balance between exports and imports. Net exports can be positive or negative. If they are 10. Negative net exports. 11. Positive net exports. 6.1 Measuring Total Output 236 Chapter 6 Measuring Total Output and Income The circular flow model identifies some of the forces at work in the economy, forces that we will be studying in later chapters. For example, an increase in any of the flows that place demands on firms (personal consumption, private investment, government purchases, and exports) will induce firms to expand their production. This effect is characteristic of the expansion phase of the business cycle. An increase in production will require firms to employ more factors of production, which will create more income for households. Households are likely to respond with more consumption, which will induce still more production, more income, and still more consumption. Similarly, a reduction in any of the demands placed on firms will lead to a reduction in output, a reduction in firms’ use of factors of production, a reduction in household incomes, a reduction in income, and so on. This sequence of events is characteristic of the contraction phase of the business cycle. Much of our work in macroeconomics will involve an analysis of the forces that prompt such changes in demand and an examination of the economy’s response to them. Figure 6.6 "Components of GDP, 2011 in Billions of Dollars" shows the size of the components of GDP in 2011. We see that the production of goods and services for personal consumption accounted for about 70% of GDP. Imports exceeded exports, so net exports were negative. positive, net export spending flows from the rest of the world to firms. If they are negative, spending flows from firms to the rest of the
world. Figure 6.5 Spending in the Circular Flow Model GDP equals the sum of production by firms of goods and services for personal consumption (1), private investment (2), government purchases (3), and net exports (4). The circular flow model shows these flows and shows that the production of goods and services generates factor incomes (5) to households. 6.1 Measuring Total Output 237 Chapter 6 Measuring Total Output and Income Figure 6.6 Components of GDP, 2011 in Billions of Dollars Consumption makes up the largest share of GDP. Net exports were negative in 2011. Total GDP—the sum of personal consumption, private investment, government purchases, and net exports—equaled $15,094.4 billion in 2011. Source: Bureau of Economic Analysis, National Income and Product Accounts, Table 1.1.5 (revised February 29, 2012) Final Goods and Value Added GDP is the total value of all final goods and services produced during a particular period valued at prices in that period. That is not the same as the total value of all goods and services produced during a period. This distinction gives us another method of estimating GDP in terms of output. Suppose, for example, that a logger cuts some trees and sells the logs to a sawmill. The mill makes lumber and sells it to a construction firm, which builds a house. The market price for the lumber includes the value of the logs; the price of the house includes the value of the lumber. If we try to estimate GDP by adding the value of the logs, the lumber, and the house, we would be counting the lumber twice and the logs three times. This problem is called “double counting,” and the economists who compute GDP seek to avoid it. In the case of logs used for lumber and lumber produced for a house, GDP would include the value of the house. The lumber and the logs would not be counted as 6.1 Measuring Total Output 238 Chapter 6 Measuring Total Output and Income additional production because they are intermediate goods that were produced for use in building the house. Another approach to estimating the value of final production is to estimate for each stage of production the value added12, the amount by which the value of a firm’s output exceeds the value of the goods and services the firm purchases from other firms. Table 6.1 "Final Value and Value Added" illustrates the use of value added in the production of a house. Table 6.1 Final Value and Value Added Good Produced by Purch
ased by Price Value Added Logs Logger Sawmill $12,000 $12,000 Lumber Sawmill Construction firm $25,000 $13,000 House Construction firm Household $125,000 $100,000 Final Value $125,000 Sum of Values Added $125,000 If we sum the value added at each stage of the production of a good or service, we get the final value of the item. The example shown here involves the construction of a house, which is produced from lumber that is, in turn, produced from logs. Suppose the logs produced by the logger are sold for $12,000 to a mill, and that the mill sells the lumber it produces from these logs for $25,000 to a construction firm. The construction firm uses the lumber to build a house, which it sells to a household for $125,000. (To simplify the example, we will ignore inputs other than lumber that are used to build the house.) The value of the final product, the house, is $125,000. The value added at each stage of production is estimated as follows: a. The logger adds $12,000 by cutting the logs. b. The mill adds $13,000 ($25,000 − $12,000) by cutting the logs into lumber. c. The construction firm adds $100,000 ($125,000 − $25,000) by using the lumber to build a house. 12. The amount by which the value of a firm’s output exceeds the value of the goods and services the firm purchases from other firms. The sum of values added at each stage ($12,000 + $13,000 + $100,000) equals the final value of the house, $125,000. 6.1 Measuring Total Output 239 Chapter 6 Measuring Total Output and Income The value of an economy’s output in any period can thus be estimated in either of two ways. The values of final goods and services produced can be added directly, or the values added at each stage in the production process can be added. The Commerce Department uses both approaches in its estimate of the nation’s GDP. GNP: An Alternative Measure of Output While GDP represents the most commonly used measure of an economy’s output, economists sometimes use an alternative measure. Gross national product (GNP)13 is the total value of final goods and services produced during a particular period with factors of production owned by the residents of a particular country. The
difference between GDP and GNP is a subtle one. The GDP of a country equals the value of final output produced within the borders of that country; the GNP of a country equals the value of final output produced using factors owned by residents of the country. Most production in a country employs factors of production owned by residents of that country, so the two measures overlap. Differences between the two measures emerge when production in one country employs factors of production owned by residents of other countries. Suppose, for example, that a resident of Bellingham, Washington, owns and operates a watch repair shop across the Canadian–U.S. border in Victoria, British Columbia. The value of watch repair services produced at the shop would be counted as part of Canada’s GDP because they are produced in Canada. That value would not, however, be part of U.S. GDP. But, because the watch repair services were produced using capital and labor provided by a resident of the United States, they would be counted as part of GNP in the United States and not as part of GNP in Canada. Because most production fits in both a country’s GDP as well as its GNP, there is seldom much difference between the two measures. The relationship between GDP and GNP is given by Equation 6.3 GDP + net income received from abroad by residents of a nation = GNP 13. The total value of final goods and services produced during a particular period with factors of production owned by the residents of a particular country. In the third quarter of 2011, for example, GDP equaled $15,176.1 billion. We add income receipts of $792.2 billion earned by residents of the United States from the rest of the world and then subtract income payments of $524.9 billion that went from the United States to the rest of the world to get GNP of $15,443.4 billion for the 6.1 Measuring Total Output 240 Chapter 6 Measuring Total Output and Income third quarter of 2011. GNP is often used in international comparisons of income; we shall examine those later in this chapter • GDP is the sum of final goods and services produced for consumption (C), private investment (I), government purchases (G), and net exports (Xn). Thus GDP = C + I + G + Xn. • GDP can be viewed in the context of the circular flow model. Consumption goods and services are produced in response to demands from households; investment goods are produced in response to demands for new
capital by firms; government purchases include goods and services purchased by government agencies; and net exports equal exports less imports. • Total output can be measured two ways: as the sum of the values of final goods and services produced and as the sum of values added at each stage of production. • GDP plus net income received from other countries equals GNP. GNP is the measure of output typically used to compare incomes generated by different economies. 6.1 Measuring Total Output 241 Chapter 6 Measuring Total Output and Income T R Y I T! Here is a two-part exercise. 1. Suppose you are given the following data for an economy: Personal consumption $1,000 Home construction Increase in inventories Equipment purchases by firms Government purchases 100 40 60 100 Social Security payments to households 40 Government welfare payments Exports Imports 100 50 150 Identify the number of the flow in Figure 6.5 "Spending in the Circular Flow Model" to which each of these items corresponds. What is the economy’s GDP? 2. Suppose a dairy farm produces raw milk, which it sells for $1,000 to a dairy. The dairy produces cream, which it sells for $3,000 to an ice cream manufacturer. The ice cream manufacturer uses the cream to make ice cream, which it sells for $7,000 to a grocery store. The grocery store sells the ice cream to consumers for $10,000. Compute the value added at each stage of production, and compare this figure to the final value of the product produced. Report your results in a table similar to that given in Table 6.1 "Final Value and Value Added". 6.1 Measuring Total Output 242 Chapter 6 Measuring Total Output and Income Case in Point: The Spread of the Value Added Tax Outside the United States, the value added tax (VAT) has become commonplace. Governments of more than 120 countries use it as their primary means of raising revenue. While the concept of the VAT originated in France in the 1920s, no country adopted it until after World War II. In 1948, France became the first country in the world to use the VAT. In 1967, Brazil became the first country in the Western Hemisphere to do so. The VAT spread to other western European and Latin American countries in the 1970s and 1980s and then to countries in the Asia/Pacific region, central European and former Soviet Union area, and Africa in the 1990s and early 2000s. What is the VAT? It is equivalent to a sales tax on
final goods and services but is collected at each stage of production. Take the example given in Table 6.1 "Final Value and Value Added", which is a simplified illustration of a house built in three stages. If there were a sales tax of 10% on the house, the household buying it would pay $137,500, of which the construction firm would keep $125,000 of the total and turn $12,500 over to the government. With a 10% VAT, the sawmill would pay the logger $13,200, of which the logger would keep $12,000 and turn $1,200 over to the government. The sawmill would sell the lumber to the construction firm for $27,500—keeping $26,200, which is the $25,000 for the lumber itself and $1,200 it already paid in tax. The government at this stage would get $1,300, the difference between the $2,500 the construction firm collected as tax and the $1,200 the sawmill already paid in tax to the logger at the previous stage. The household would pay the construction firm $137,500. Of that total, the construction firm would turn over to the government $10,000, which is the difference between the $12,500 it 6.1 Measuring Total Output 243 Chapter 6 Measuring Total Output and Income collected for the government in tax from the household and the $2,500 in tax that it already paid when it bought the lumber from the sawmill. The table below shows that in the end, the tax revenue generated by a 10% VAT is the same as that generated by a 10% tax on final sales. Why bother to tax in stages instead of just on final sales? One reason is simply record keeping, since it may be difficult to determine in practice if any particular sale is the final one. In the example, the construction firm does not need to know if it is selling the house to a household or to some intermediary business. Also, the VAT may lead to higher revenue collected. For example, even if somehow the household buying the house avoided paying the tax, the government would still have collected some tax revenue at earlier stages of production. With a tax on retail sales, it would have collected nothing. The VAT has another advantage from the point of view of government agencies. It has the appearance at each stage of taking a smaller share. The individual amounts collected are not as obvious to taxpayers as a sales tax might be. Good Price Value Added
Tax Collected − Tax Already Paid = Value Added Tax Logs $12,000 $12,000 $1,200 − $0 = $1,200 Lumber $25,000 $13,000 $2,500 − $1,200 = $1,300 House $125,000 $100,000 $12,500 − $2,500 = $10,000 Total $16,200 −$3,700 = $12,500 6.1 Measuring Total Output 244 Chapter 6 Measuring Total Output and Income. GDP equals $1,200 and is computed as follows (the numbers in parentheses correspond to the flows in Figure 6.5 "Spending in the Circular Flow Model"): Personal consumption (1) $1,000 Private investment (2) Housing Equipment and software Inventory change 200 100 60 40 Government purchases (3) 100 Net exports (4) GDP −100 $1,200 Notice that neither welfare payments nor Social Security payments to households are included. These are transfer payments, which are not part of the government purchases component of GDP. 2. Here is the table of value added. Good Produced by Purchased by Price Value Added Raw milk Dairy farm Dairy $1,000 $1,000 Cream Dairy Ice cream maker 3,000 2,000 Ice cream Ice cream manufacturer Grocery store 7,000 4,000 Retail ice cream Grocery store Consumer 10,000 3,000 Final Value $10,000 6.1 Measuring Total Output 245 Chapter 6 Measuring Total Output and Income Good Produced by Purchased by Price Sum of Values Added Value Added $10,000 6.1 Measuring Total Output 246 Chapter 6 Measuring Total Output and Income 6.2 Measuring Total Income. Define gross domestic income and explain its relationship to gross domestic product. 2. Discuss the components of gross domestic income. 3. Define disposable personal income and explain how to calculate it from GDP. We saw in the last section that the production of goods and services generates factor incomes to households. The production of a given value of goods and services generates an equal value of total income. Gross domestic income (GDI)14 equals the total income generated in an economy by the production of final goods and services during a particular period. It is a flow variable. Because an economy’s total output equals the total income generated in producing that output, GDP = GDI. We can estimate GDP either by measuring total output or by measuring total income. Consider a $
4 box of Cheerios. It is part of total output and thus is part of GDP. Who gets the $4? Part of the answer to that question can be found by looking at the cereal box. Cheerios are made from oat flour, wheat starch, sugar, salt, and a variety of vitamins and minerals. Therefore, part of the $4 goes to the farmers who grew the oats, the wheat, and the beets or cane from which the sugar was extracted. Workers and machines at General Mills combined the ingredients, crafted all those little O’s, toasted them, and put them in a box. The workers were paid part of the $4 as wages. The owners of General Mills and the capital it used received part of the $4 as profit. The box containing the Cheerios was made from a tree, so a lumber company somewhere received part of the $4. The truck driver who brought the box of cereal to the grocery store got part of the $4, as did the owner of the truck itself and the owner of the oil that fueled the truck. The clerk who rang up the sale at the grocery store was paid part of the $4. And so on. How much of the $4 was income generated in the production of the Cheerios? The answer is simple: all of it. Some of the money went to workers as wages. Some went to owners of the capital and natural resources used to produce it. Profits generated along the way went to the owners of the firms involved. All these items represent costs of producing the Cheerios and also represent income to households. 247 14. The total income generated in an economy by the production of final goods and services during a particular period. Chapter 6 Measuring Total Output and Income Part of the $4 cost of the Cheerios, while it makes up a portion of GDI, does not represent ordinary income actually earned by households. That part results from two other production costs: depreciation and taxes related to the production of the Cheerios. Nevertheless, they are treated as a kind of income; we will examine their role in GDI below. As it is with Cheerios, so it is with everything else. The value of output equals the income generated as the output is produced. The Components of GDI Employee compensation is the largest among the components of factor income. Factor income also includes profit, rent, and interest. In addition, GDI includes charges for depreciation and taxes associated with production.
Depreciation and production-related taxes, such as sales taxes, make up part of the cost of producing goods and services and must be accounted for in estimating GDI. We will discuss each of these components of GDI next. Employee Compensation Compensation of employees in the form of wages, salaries, and benefits makes up the largest single component of income generated in the production of GDP. In the third quarter of 2011, employee compensation represented 55% of GDI. The structure of employee compensation has changed dramatically in the last several decades. In 1950, virtually all employee compensation—95% of it—came in the form of wages and salaries. The remainder, about 5%, came in the form of additional benefits such as employer contributions to retirement programs and health insurance. In 2011, the share of benefits was nearly 20% of total employee compensation. Profits The profit component of income earned by households equals total revenues of firms less costs as measured by conventional accounting. Profits amounted to about 17% of GDI in 2011, down sharply from five decades earlier, when profits represented about 25% of the income generated in GDI.Although reported separately by the Department of Commerce, we have combined proprietors’ income (typically independent business owners and farmers) with corporate profits to simplify the discussion. 6.2 Measuring Total Income 248 Chapter 6 Measuring Total Output and Income Profits are the reward the owners of firms receive for being in business. The opportunity to earn profits is the driving force behind production in a market economy. Rental Income Rental income, such as the income earned by owners of rental housing or payments for the rent of natural resources, is the smallest component of GDI (less than 3%); it is the smallest of the income flows to households. The meaning of rent in the computation of GDI is the same as its meaning in conventional usage; it is a charge for the temporary use of some capital asset or natural resource.If you have studied microeconomics, you know that the term “rent” in economics has a quite different meaning. The national income and product accounts use the accounting, not the economic, meaning of “rent.” Net Interest Businesses both receive and pay interest. GDI includes net interest, which equals interest paid less interest received by domestic businesses, plus interest received from foreigners less interest paid to foreigners. Interest payments on mortgage and home improvement loans are counted as interest paid by businesses, because homeowners are treated as businesses in the income accounts. In 2011, net interest accounted for
about 5% of GDI. Depreciation Over time the machinery and buildings that are used to produce goods and services wear out or become obsolete. A farmer’s tractor, for example, wears out as it is used. A technological change may make some equipment obsolete. The introduction of personal computers, for example, made the electric typewriters used by many firms obsolete. Depreciation15 is a measure of the amount of capital that wears out or becomes obsolete during a period. Depreciation is referred to in official reports as the consumption of fixed capital. Depreciation is a cost of production, so it represents part of the price charged for goods and services. It is therefore counted as part of the income generated in the production of those goods and services. Depreciation represented about 13% of GDI in 2011. 15. A measure of the amount of capital that wears out or becomes obsolete during a period. 6.2 Measuring Total Income 249 Chapter 6 Measuring Total Output and Income Indirect Taxes The final component of the income measure of GDI is indirect business taxes.The adjustment for indirect business taxes includes two other minor elements: transfer payments made by business firms and surpluses or deficits of government enterprises. Indirect taxes16 are taxes imposed on the production or sale of goods and services or on other business activity. (By contrast, a direct tax17 is a tax imposed directly on income; the personal income and corporate income taxes are direct taxes.) Indirect taxes, which include sales and excise taxes and property taxes, make up part of the cost to firms of producing goods and services. Like depreciation, they are part of the price of those goods and services and are therefore treated as part of the income generated in their production. Indirect business taxes amounted to nearly 8% of GDI in 2011. Table 6.2 "GDP and GDI, 2011" shows the components of GDI in the third quarter of 2011. Employee compensation represented the largest share of GDI. The exhibit also shows the components of GDP for the same year. In principle, GDP and GDI should be equal, but their estimated values never are, because the data come from different sources. Output data from a sample of firms are used to estimate GDP, while income data from a sample of households are used to estimate GDI. The difference is the statistical discrepancy shown in the righthand column of Table 6.2 "GDP and GDI, 2011". Some of the difficulties with these data are examined in the Case in Point feature on
discrepancies between GDP and GDI. Table 6.2 GDP and GDI, 2011 Gross domestic product Personal consumption expenditures Gross private domestic investment Government consumption expenditures $15,176.1 Gross domestic income $15,214.8 $10,784.5 Compensation of employees $1,906.6 ProfitsProfit is corporate profit ($1,519.3) plus proprietors’ income ($1,113.7), both with inventory valuation and capital consumption adjustment. $3,047.3 Rental income of persons 8,347.3 2,633.0 406.3 250 16. Taxes imposed on the production or sale of goods and services or on other business activity. 17. Taxes imposed directly on income. 6.2 Measuring Total Income Chapter 6 Measuring Total Output and Income and gross investment Net exports of goods and services −$562.3 Net interest 710.3 Taxes on production and importsIndirect taxes include taxes on production and imports of $1,100.0 plus business transfer payments ($133.7) less subsidies ($64.2) and current surplus of government enterprise ($14.5). Prior to the 2003 National Income and Product Accounts (NIPA) revisions, the category “taxes on production and imports” was, with some technical and other minor adjustments, referred to as “indirect business taxes.” See Brent R. Moulton and Eugene P. Seskin, “Preview of the 2003 Comprehensive Revision of the National Income and Product Accounts,” Bureau of Economic Analysis, Survey of Current Business, June 2003, pp. 17–34. Consumption of fixed capital (depreciation) Statistical discrepancy 1,155.1 1,962.8 −38.7 The table shows the composition of GDP and GDI in the third quarter of 2011 (in billions of dollars at an annual rate). Notice the rough equality of the two measures. (They are not quite equal because of measurement errors; the difference is due to a statistical discrepancy and is reduced significantly over time as the data are revised.) Source: Bureau of Economic Analysis, National Income and Product Accounts, Tables 1.10 and 1.1.5 (revised February 29, 2012). Tracing Income from the Economy to Households We have seen that the production of goods and services generates income for households. Thus, the value of total output equals the value of total income in an economy. But we have also seen that our measure of total income,
GDI, includes such things as depreciation and indirect business taxes that are not actually received by households. Households also receive some income, such as transfer payments, that does not count as part of GDP or GDI. Because the income households actually receive plays an important role in determining their consumption, it is useful to examine the relationship between a nation’s total output and the income households actually receive. 6.2 Measuring Total Income 251 Chapter 6 Measuring Total Output and Income Table 6.3 "From GDP to Disposable Personal Income" traces the path we take in going from GDP to disposable personal income18, which equals the income households have available to spend on goods and services. We first convert GDP to GNP and then subtract elements of GNP that do not represent income received by households and add payments such as transfer payments that households receive but do not earn in the production of GNP. Disposable personal income is either spent for personal consumption or saved by households. Table 6.3 From GDP to Disposable Personal Income GDP + net factor earnings from abroad = gross national product (GNP) GNP − depreciation (consumption of fixed capital) = net national product (NNP) NNP − statistical discrepancy = national income (NI) NI − income earned but not received [e.g., taxes on production and imports, social security payroll taxes, corporate profit taxes, and retained earnings] + transfer payments and other income received but not earned in the production of GNP = personal income (PI) PI − personal income taxes = disposable personal income (DPI) GDP, a measure of total output, equals GDI, the total income generated in the production of goods and services in an economy. The chart traces the path from GDP to disposable personal income, which equals the income households actually receive. We first convert GDP to GNP. Then, we subtract depreciation to obtain net national product and subtract the statistical discrepancy to arrive at national income (i.e., gross national income [GNI] net of depreciation and the statistical discrepancy). Next, we subtract components of GNP and GNI that do not represent income actually received by households, such as taxes on production and imports, corporate profit and payroll taxes (contributions to social insurance), and corporate retained earnings. We add items such as transfer payments that are income to households but are not part of GNP and GNI. The adjustments shown are the most important adjustments in going from GNP and GNI to disposable personal income; several smaller adjustments
(e.g., subsidies, business current transfer payments [net], and current surplus of government enterprises) have been omitted. 18. The income households have available to spend on goods and services. 6.2 Measuring Total Income 252 Chapter 6 Measuring Total Output and Income • Gross domestic product, GDP, equals gross domestic income, GDI, which includes compensation, profits, rental income, indirect taxes, and depreciation. • We can use GDP, a measure of total output, to compute disposable personal income, a measure of income received by households and available for them to spend. T R Y I T! The following income data refer to the same economy for which you had output data in the first part of the previous Try It! Compute GDI from the data below and confirm that your result equals the GDP figure you computed in the previous Try It! Assume that GDP = GNP for this problem (that is, assume all factor incomes are earned and paid in the domestic economy). Employee compensation $700 Social Security payments to households 40 Welfare payments Profits Rental income Net interest Depreciation Indirect taxes 100 200 50 25 50 175 6.2 Measuring Total Income 253 Chapter 6 Measuring Total Output and Income Case in Point: The GDP–GDI Gap GDP equals GDI; at least, that is the way it is supposed to work. But in an enormously complex economy, the measurement of these two variables inevitably goes awry. Estimates of the two are never quite equal. In recent years, the absolute value of the gap has been quite sizable, while in other years, it has been quite small. For example, for the years 2006 through 2010, GDI has differed from GDP by −242.3, −12.0, −2.4, 77.4, and 0.8 billion per year, respectively. Although the gap seems large at times, it represents a remarkably small fraction of measured activity—around 1% or less. Of course, 1% of a big number is still a big number. But it is important to remember that, relative to the size of the economy, the gap between GDI and GDP is not large. The gap is listed as a “statistical discrepancy” in the Department of Commerce reporting of the two numbers. Why does the gap exist? From an accounting point of view, it should not. The total value of final goods and services produced must be equal to the total value of income generated in that production. But output is measured from sales and inventory
figures collected from just 10% of commercial establishments. Preliminary income figures are obtained from household surveys, but these represent a tiny fraction of households. More complete income data are provided by income tax returns, but these are available to the economists who estimate GDI only after a two- to four-year delay. The Department of Commerce issues revisions of its GDP and GDI estimates as more complete data become available. With each revision, the gap between GDP and GDI estimates is significantly reduced. 6.2 Measuring Total Income 254 Chapter 6 Measuring Total Output and Income While GDP and GDI figures cannot provide precise measures of economic activity, they come remarkably close. Indeed, given that the numbers come from entirely different sources, the fact that they come as close as they do provides an impressive check of the accuracy of the department’s estimates of GDP and GDI GDI equals $1,200. Note that this value equals the value for GDP obtained from the estimate of output in the first part of the previous Try It! Here is the computation: Employee compensation $700 Profits Rental income Net interest Depreciation Indirect taxes 200 50 25 50 175 GDI $1,200 Once again, note that Social Security and welfare payments to households are transfer payments. They do not represent payments to household factors of production for current output of goods and services, and therefore are not included in GDI. 6.2 Measuring Total Income 255 Chapter 6 Measuring Total Output and Income 6.3 GDP and Economic Well-Being. Discuss and give examples of measurement and conceptual problems in using real GDP as a measure of economic performance and of economic well-being. 2. Explain the use of per capita real GNP or GDP to compare economic performance across countries and discuss its limitations. GDP is the measure most often used to assess the economic well-being of a country. Besides measuring the pulse of a country, it is the figure used to compare living standards in different countries. Of course, to use GDP as an indicator of overall economic performance, we must convert nominal GDP to real GDP, since nominal values can rise or fall simply as a result of changes in the price level. For example, the movie Avatar, released in 2009, brought in $761 million—the highest amount to date in gross box office receipts, while Gone with the Wind, released in 1939, earned only $199 million and ranks 117th in terms of nominal receipts. But does that mean that Avatar actually did better than Gone with the Wind? After all, the
average price of a movie ticket in 1939 was about 25 cents. At the time of Avatar, the average ticket price was about $7.50. A better way to compare these two movies in terms of popularity is to control for the price of movie tickets—the same strategy that economists use with real GDP in order to determine whether output is rising or falling. Adjusting the nominal boxoffice receipts using 2012 movie prices to obtain real revenue reveals that in real terms Gone with the Wind continues to be the top real grosser of all time with real box-office receipts of about $1.6 billion. Avatar’s real box-office receipts amounted to a mere $776 million.Based on estimates at “Domestic Grosses Adjusted for Ticket Price Inflation,” Box Office Mojo, accessed April 10, 2012, http://boxofficemojo.com/alltime/adjusted.htm. As illustrated by this example on revenues from popular movies, we might draw erroneous conclusions about performance if we base them on nominal values instead of on real values. In contrast, real GDP, despite the problems with price indexes that were explained in another chapter, provides a reasonable measure of the total output of an economy, and changes in real GDP provide an indication of the direction of movement in total output. 256 Chapter 6 Measuring Total Output and Income We begin this section by noting some of the drawbacks of using real GDP as a measure of the economic welfare of a country. Despite these shortcomings, we will see that it probably remains our best single indicator of macroeconomic performance. Measurement Problems in Real GDP There are two measurement problems, other than those associated with adjusting for price level changes, in using real GDP to assess domestic economic performance. Revisions The first estimate of real GDP for a calendar quarter is called the advance estimate. It is issued about a month after the quarter ends. To produce a measure so quickly, officials at the Department of Commerce must rely on information from relatively few firms and households. One month later, it issues a revised estimate, and a month after that it issues its final estimate. Often the advance estimate of GDP and the final estimate do not correspond. The recession of 2001, for example, began in March of that year. But the first estimates of real GDP for the second and third quarters of 2001 showed output continuing to rise. It was not until later revisions that it became clear that a recession had been under way. But the revision story does not end there. Every summer, the Commerce Department issues revised
figures for the previous two or three years. Once every five years, the department conducts an extensive analysis that traces flows of inputs and outputs throughout the economy. It focuses on the outputs of some firms that are inputs to other firms. In the process of conducting this analysis, the department revises real GDP estimates for the previous five years. Sometimes the revisions can paint a picture of economic activity that is quite different from the one given even by the revised estimates of GDP. For example, revisions of the data for the 1990–1991 recession issued several years later showed that the recession had been much more serious than had previously been apparent, and the recovery was more pronounced. Concerning the most recent recession, the first estimates of fourth quarter 2008 GDP showed that the U.S. economy shrank by 3.8%. The first revision, however, showed a drop of 6.8%, and the second revision showed a drop of 8.9%! The Service Sector Another problem lies in estimating production in the service sector. The output of goods in an economy is relatively easy to compute. There are so many bushels of corn, so many pounds of beef. But what is the output of a bank? Of a hospital? It is 6.3 GDP and Economic Well-Being 257 Chapter 6 Measuring Total Output and Income easy to record the dollar value of output to enter in nominal GDP, but estimating the quantity of output to use in real GDP is quite another matter. In some cases, the Department of Commerce estimates service sector output based on the quantity of labor used. For example, if this technique were used in the banking industry and banking used 10% more labor, the department would report that production has risen 10%. If the number of employees remains unchanged, reported output remains unchanged. In effect, this approach assumes that output per worker—productivity—in those sectors remains constant when studies have indicated that productivity has increased greatly in the service sector. Since 1990 progress has been made in measurement in this area, which allows in particular for better estimation of productivity changes and price indexes for different service sector industries, but more remains to be done in this large sector of the U.S. economy.Jack E. Triplett and Barry P. Bosworth, “The State of Data for Services Productivity Measurement in the United States,” International Productivity Monitor 16 (Spring 2008): 53–70. Conceptual Problems with Real GDP A second set of limitations of real GDP stems from problems inherent in the indicator itself. Real GDP measures market
activity. Goods and services that are produced and exchanged in a market are counted; goods and services that are produced but that are not exchanged in markets are not.There are two exceptions to this rule. The value of food produced and consumed by farm households is counted in GDP. More important, an estimate of the rental values of owneroccupied homes is included. If a family rents a house, the rental payments are included in GDP. If a family lives in a house it owns, the Department of Commerce estimates what the house would rent for and then includes that rent in the GDP estimate, even though the house’s services were not exchanged in the marketplace. Household Production Suppose you are considering whether to eat at home for dinner tonight or to eat out. You could cook dinner for yourself at a cost of $5 for the ingredients plus an hour or so of your time. Alternatively, you could buy an equivalent meal at a restaurant for perhaps $15. Your decision to eat out rather than cook would add $10 to the GDP. But that $10 addition would be misleading. After all, if you had stayed home you might have produced an equivalent meal. The only difference is that the value of your time would not have been counted. But surely your time is not worthless; it is just not counted. Similarly, GDP does not count the value of your efforts to clean your own house, to wash your own car, or to grow your own vegetables. In general, 6.3 GDP and Economic Well-Being 258 Chapter 6 Measuring Total Output and Income GDP omits the entire value added by members of a household who do household work themselves. There is reason to believe this omission is serious. Economists J. Steven Landefeld and Stephanie H. McCulla of the U.S. Bureau of Economic Analysis estimated in a 2000 paper the value of household output from 1946 to 1997. Their estimate of household output in 1946 was 50% of reported GDP. Since then, that percentage has fallen, because more women have entered the workforce, so that more production that once took place in households now occurs in the market. Households now eat out more, purchase more prepared foods at the grocery store, hire out child-care services they once performed themselves, and so on. Their estimate for 1997, for example, suggests that household production amounted to 36% of reported GDP.J. Steven Landefeld and Stephanie H. McCulla, “Accounting for Nonmarket Household Production within a National Accounts Framework,” Review of Income &
Wealth 46, no. 3 (September 2000): 289–307. This problem is especially significant when GDP is used to make comparisons across countries. In low-income countries, a much greater share of goods and services is not exchanged in a market. Estimates of GDP in such countries are adjusted to reflect nonmarket production, but these adjustments are inevitably imprecise. Underground and Illegal Production Some production goes unreported in order to evade taxes or the law. It is not likely to be counted in GDP. Legal production for which income is unreported in order to evade taxes generally takes place in what is known as the “underground economy.” For example, a carpenter might build a small addition to a dentist’s house in exchange for orthodontic work for the carpenter’s children. Although income has been earned and output generated in this example of bartering, the transaction is unlikely to be reported for income tax or other purposes and thus is not counted in GDP. Illegal activities are not reported for income taxes for obvious reasons and are thus difficult to include in GDP. Leisure Leisure is an economic good. All other things being equal, more leisure is better than less leisure. But all other things are not likely to be equal when it comes to consuming leisure. Consuming more leisure means supplying less work effort. And that means producing less GDP. If everyone decided to work 10% fewer hours, GDP would fall. But that would not mean that people were worse off. In fact, their choice of more 6.3 GDP and Economic Well-Being 259 Chapter 6 Measuring Total Output and Income leisure would suggest they prefer the extra leisure to the goods and services they give up by consuming it. Consequently, a reduction in GDP would be accompanied by an increase in satisfaction, not a reduction. The GDP Accounts Ignore “Bads” Suppose a wave of burglaries were to break out across the United States. One would expect people to respond by buying more and louder burglar alarms, better locks, fiercer German shepherds, and more guard services than they had before. To the extent that they pay for these by dipping into savings rather than replacing other consumption, GDP increases. An epidemic might have much the same effect on GDP by driving up health-care spending. But that does not mean that crime and disease are good things; it means only that crime and disease may force an increase in the production of goods and services counted in the GDP. Similarly, the GDP accounts ignore the impact
of pollution on the environment. We might produce an additional $200 billion in goods and services but create pollution that makes us feel worse off by, say, $300 billion. The GDP accounts simply report the $200 billion in increased production. Indeed, some of the environmental degradation might itself boost GDP. Dirtier air may force us to wash clothes more often, to paint buildings more often, and to see the doctor more often, all of which will tend to increase GDP! Conclusion: GDP and Human Happiness More GDP cannot necessarily be equated with more human happiness. But more GDP does mean more of the goods and services we measure. It means more jobs. It means more income. And most people seem to place a high value on these things. For all its faults, GDP does measure the production of most goods and services. And goods and services get produced, for the most part, because we want them. We might thus be safe in giving two cheers for GDP—and holding back the third in recognition of the conceptual difficulties that are inherent in using a single number to summarize the output of an entire economy. International Comparisons of Real GDP and GNP Real GDP or GNP estimates are often used in comparing economic performance among countries. In making such comparisons, it is important to keep in mind the general limitations to these measures of economic performance that we noted earlier. Further, countries use different methodologies for collecting and compiling data. 6.3 GDP and Economic Well-Being 260 Chapter 6 Measuring Total Output and Income Three other issues are important in comparing real GDP or GNP for different countries: the adjustment of these figures for population, adjusting to a common currency, and the incorporation of nonmarket production. In international comparisons of real GNP or real GDP, economists generally make comparisons not of real GNP or GDP but of per capita real GNP or GDP19, which equals a country’s real GNP or GDP divided by its population. For example, suppose Country A has a real GDP of about $4,000 billion and Country B has a real GDP of about $40 billion. We can conclude that Country A produced 100 times more goods and services than did Country B. But if Country A has 200 times as many people as Country B (for example, 200 million people in Country A and 1 million in Country B), then Country A’s per capita output will be half that of Country B ($20,000 versus $40,000 in this example). Figure 6.7 "Comparing Per Capita
Real GNP, 2010" compares per capita real GNP for 11 countries in 2010. It is based on data that uses a measure called “international dollars” in order to correct for differences in the purchasing power of $1 across countries. The data also attempt to adjust for nonmarket production (such as that of rural families that grow their own food, make their own clothing, and produce other household goods and services themselves). Figure 6.7 Comparing Per Capita Real GNP, 2010 There is a huge gap between per capita income in one of the poorest countries in the world, the Democratic Republic of Congo, and wealthier nations such as the United States and Luxembourg. Source: World Bank, World Development Indicators Online 19. A country’s real GNP or GDP divided by its population. 6.3 GDP and Economic Well-Being 261 Chapter 6 Measuring Total Output and Income The disparities in income are striking; Luxembourg, the country with the highest per capita real GNP, had an income level nearly 200 times greater than the Democratic Republic of Congo, the country with the lowest per capita real GNP. What can we conclude about international comparisons in levels of GDP and GNP? Certainly we must be cautious. There are enormous difficulties in estimating any country’s total output. Comparing one country’s output to another presents additional challenges. But the fact that a task is difficult does not mean it is impossible. When the data suggest huge disparities in levels of GNP per capita, for example, we observe real differences in living standards • Real GDP or real GNP is often used as an indicator of the economic well- being of a country. • Problems in the measurement of real GDP, in addition to problems encountered in converting from nominal to real GDP, stem from revisions in the data and the difficulty of measuring output in some sectors, particularly the service sector. • Conceptual problems in the use of real GDP as a measure of economic well-being include the facts that it does not include nonmarket production and that it does not properly adjust for “bads” produced in the economy. • Per capita real GDP or GNP can be used to compare economic performance in different countries. T R Y I T! What impact would each of the following have on real GDP? Would economic well-being increase or decrease as a result? 1. On average, people in a country decide to increase the number of hours they work by 5%. 2. Spending on homeland security increases in response to a
terrorist attack. 3. The price level and nominal GDP increase by 10%. 6.3 GDP and Economic Well-Being 262 Chapter 6 Measuring Total Output and Income Case in Point: Per Capita Real GDP and Olympic Medal Counts In the popular lore, the Olympics provide an opportunity for the finest athletes in the world to compete with each other head-to-head on the basis of raw talent and hard work. And yet, contenders from Laos tend to finish last or close to it in almost any event in which they compete. One Laotian athlete garnered the unenviable record of having been the slowest entrant in the nearly halfcentury long history of the 20-kilometer walk. In contrast, U.S. athletes won 103 medals at the 2004 Athens Olympics and 110 medals at the 2008 Beijing Olympics. Why do Laotians fare so poorly and Americans so well, with athletes from other countries falling in between? Economists Daniel K. N. Johnson and Ayfer Ali have been able to predict with astonishing accuracy the number of medals different countries will win on the basis of a handful of factors, including population, climate, political structure, and real per capita GDP. For example, they predicted that the United States would win 103 medals in Athens and that is precisely how many the United States won. They predicted 103 medals for the United States in Beijing; 110 were won. They did not expect the Laotians to win any medals in either Athens or Beijing, and that was indeed the outcome. Johnson and Ali estimated that summer game participant nations average one more medal per additional $1,000 of per capita real GDP. With per capita real GDP in Laos less than the equivalent of $500 compared to per capita real GDP in the United States of about $38,000, the results for these two nations could be considered a foregone conclusion. According to Johnson and Ali, “High productive capacity or income per person displays an ability to pay the costs necessary to send athletes to the Games, and may also be associated with a higher quality of training and better equipment.” For example, a Laotian swimmer at Athens, Vilayphone Vongphachanh, had never practiced in an 6.3 GDP and Economic Well-Being 263 Chapter 6 Measuring Total Output and Income Olympic-size pool, and a runner, Sirivanh Ketavong, had worn the same running shoes for four years. The good news is that as the per capita real GDP in some relatively poor countries has risen
, the improved living standards have led to increased Olympic medal counts. China, for instance, won 28 medals in 1988 and 63 in 2004. As the host for the 2008 games, it won an impressive total of 100 medals. While not a perfect measure of the well-being of people in a country, per capita real GDP does tell us about the opportunities available to the average citizen in a country. Americans would surely find it hard to imagine living at the level of consumption of the average Laotian. In The Progress Paradox: How Life Gets Better While People Feel Worse, essayist Gregg Easterbrook notes that a higher material standard of living is not associated with higher reported happiness. But, he concludes, the problems of prosperity seem less serious than those of poverty, and prosperity gives people and nations the means to address problems. The Olympic medal count for each nation strongly reflects its average standard of living and hence the opportunities available to its citizens. Sources: Gregg Easterbrook, The Progress Paradox: How Life Gets Better While People Feel Worse (New York: Random House, 2003); Daniel K. N. Johnson and Ayfer Ali, “A Tale of Two Seasons: Participation and Medal Counts at the Summer and Winter Olympic Games,” Social Science Quarterly 84, no. 4 (December 2004): 974–93; David Wallechinsky, “Why I’ll Cheer for Laos,” Parade Magazine, August 8, 2004, p. 8. Real GDP would increase. Assuming the people chose to increase their work effort and forgo the extra leisure, economic well-being would increase as well. 2. Real GDP would increase, but the extra expenditure in the economy was due to an increase in something “bad,” so economic well-being would likely be lower. 3. No change in real GDP. For some people, economic well-being might increase and for others it might decrease, since inflation does not affect each person in the same way. 6.3 GDP and Economic Well-Being 264 Chapter 6 Measuring Total Output and Income 6.4 Review and Practice Summary This chapter focused on the measurement of GDP. The total value of output (GDP) equals the total value of income generated in producing that output (GDI). We can illustrate the flows of spending and income through the economy with the circular flow model. Firms produce goods and services in response to demands from households (personal consumption), other firms (private investment), government agencies (government purchases), and the rest of the
world (net exports). This production, in turn, creates a flow of factor incomes to households. Thus, GDP can be estimated using two types of data: (1) data that show the total value of output and (2) data that show the total value of income generated by that output. In looking at GDP as a measure of output, we divide it into four components: consumption, investment, government purchases, and net exports. GDP equals the sum of final values produced in each of these areas. It can also be measured as the sum of values added at each stage of production. The components of GDP measured in terms of income (GDI) are employee compensation, profits, rental income, net interest, depreciation, and indirect taxes. We also explained other measures of income such as GNP and disposable personal income. Disposable personal income is an important economic indicator, because it is closely related to personal consumption, the largest component of GDP. GDP is often used as an indicator of how well off a country is. Of course, to use it for this purpose, we must be careful to use real GDP rather than nominal GDP. Still, there are problems with our estimate of real GDP. Problems encountered in converting nominal GDP to real GDP were discussed in the previous chapter. In this chapter we looked at additional measurement problems and conceptual problems. Frequent revisions in the data sometimes change our picture of the economy considerably. Accounting for the service sector is quite difficult. Conceptual problems include the omission of nonmarket production and of underground and illegal production. GDP ignores the value of leisure and includes certain “bads.” We cannot assert with confidence that more GDP is a good thing and that less is bad. However, real GDP remains our best single indicator of economic performance. It is used not only to indicate how any one economy is performing over time but also to compare the economic performance of different countries. 265 Chapter 6 Measuring Total Output and Income. GDP is used as a measure of macroeconomic performance. What, precisely, does it measure? 2. Many economists have attempted to create a set of social accounts that would come closer to measuring the economic well-being of the society than does GDP. What modifications of the current approach would you recommend to them? 3. Every good produced creates income for the owners of the factors of production that created the product or service. For a recent purchase you made, try to list all the types of factors of production involved in making the product available, and try to determine who received income
as a result of your purchase. 4. Explain how the sale of used textbooks in your campus bookstore affects the GDP calculation. 5. Look again at the circular flow diagram in Figure 6.5 "Spending in the Circular Flow Model" and assume it is drawn for the United States. State the flows in which each of the following transactions would be entered. a. A consumer purchases fresh fish at a local fish market. b. A grocery store acquires 1,000 rolls of paper towels for later resale. c. NASA purchases a new Saturn rocket. d. People in France flock to see the latest Brad Pitt movie. e. A construction firm builds a new house. f. A couple from Seattle visits Guadalajara and stays in a hotel there. g. The city of Dallas purchases computer paper from a local firm. 6. Suggest an argument for and an argument against counting in GDP all household-produced goods and services that are not sold, such as the value of child care or home-cooked meals. 7. Suppose a nation’s firms make heavy use of factors of production owned by residents of foreign countries, while foreign firms make relatively little use of factors owned by residents of that nation. How does the nation’s GDP compare to its GNP? 8. Suppose Country A has the same GDP as Country B, and that neither nation’s residents own factors of production used by foreign firms, nor do either nation’s firms use factors of production owned by foreign residents. Suppose that, relative to Country B, depreciation, indirect 6.4 Review and Practice 266 Chapter 6 Measuring Total Output and Income business taxes, and personal income taxes in Country A are high, while welfare and Social Security payments to households in Country A are relatively low. Which country has the higher disposable personal income? Why? 9. Suppose that virtually everyone in the United States decides to take life a little easier, and the length of the average workweek falls by 25%. How will that affect GDP? Per capita GDP? How will it affect economic welfare? 10. Comment on the following statement: “It does not matter that the value of the labor people devote to producing things for themselves is not counted in GDP; because we make the same ‘mistake’ every year, relative values are unaffected.” 11. Name some of the services, if any, you produced at home that do get counted in GDP. Are there any goods you produce that are not counted? 12. Marijuana is
sometimes estimated to be California’s largest cash crop. It is not included in estimates of GDP. Should it be? 6.4 Review and Practice 267 Chapter 6 Measuring Total Output and Income. Given the following nominal data, compute GDP. Assume net factor incomes from abroad = 0 (that is, GDP = GNP). Nominal Data for GDP and NNP $ Billions Consumption Depreciation Exports 2,799.8 481.6 376.2 Gross private domestic investment 671.0 Indirect taxes Government purchases Government transfer payments Imports 331.4 869.7 947.8 481.7 2. Find data for each of the following countries on real GDP and population. Use the data to calculate the GDP per capita for each of the following countries: a. Mozambique b. India c. Pakistan d. United States e. Canada f. Russia g. Brazil h. Iran i. Colombia 3. Now construct a bar graph showing your results in the previous problem, organizing the countries from the highest to the lowest GNP per capita, with countries on the horizontal axis and GNP per capita on the vertical axis. 4. Suppose Country A has a GDP of $4 trillion. Residents of this country earn $500 million from assets they own in foreign countries. Residents of foreign countries earn $300 million from assets they own in Country A. Compute: 6.4 Review and Practice 268 Chapter 6 Measuring Total Output and Income a. Country A’s net foreign income. b. Country A’s GNP. 5. Suppose a country’s GDP equals $500 billion for a particular year. Economists in the country estimate that household production equals 40% of GDP. a. What is the value of the country’s household production for that year? b. Counting both GDP and household production, what is the country’s total output for the year? 6. A miner extracts iron from the earth. A steel mill converts the iron to steel beams for use in construction. A construction company uses the steel beams to make a building. Assume that the total product of these firms represents the only components of the building and that they will have no other uses. Complete the following table: Company Product Total Sales Value Added Acme Mining iron ore $100,000 Fuller Mill steel beams $175,000 Crane Construction building $1,100,000 Total Value Added???? 7. You are given the data below for 2008 for the
imaginary country of Amagre, whose currency is the G. Consumption Transfer payments Investment Government purchases Exports Imports Bond purchases 350 billion G 100 billion G 100 billion G 200 billion G 50 billion G 150 billion G 200 billion G 6.4 Review and Practice 269 Chapter 6 Measuring Total Output and Income Earnings on foreign investments 75 billion G Foreign earnings on Amagre investment 25 billion G a. Compute net foreign investment. b. Compute net exports. c. Compute GDP. d. Compute GNP. 6.4 Review and Practice 270 Chapter 7 Aggregate Demand and Aggregate Supply Start Up: The Great Warning The first warning came from the Harvard Economic Society, an association of Harvard economics professors, early in 1929. The society predicted in its weekly newsletter that the seven-year-old expansion was coming to an end. Recession was ahead. Almost no one took the warning seriously. The economy, fueled by soaring investment, had experienced stunning growth. The 1920s had seen the emergence of many entirely new industries—automobiles, public power, home appliances, synthetic fabrics, radio, and motion pictures. The decade seemed to have acquired a momentum all its own. Prosperity was not about to end, no matter what a few economists might say. Summer came, and no recession was apparent. The Harvard economists withdrew their forecast. As it turned out, they lost their nerve too soon. Indeed, industrial production had already begun to fall. The worst downturn in our history, the Great Depression, had begun. The collapse was swift. The stock market crashed in October 1929. Real GDP plunged nearly 10% by 1930. By the time the economy hit bottom in 1933, real GDP had fallen 30%, unemployment had increased from 3.2% in 1929 to 25% in 1933, and prices, measured by the implicit price deflator, had plunged 23% from their 1929 level. The depression held the economy in its cruel grip for more than a decade; it was not until World War II that full employment was restored. In this chapter we go beyond explanations of the main macroeconomic variables to introduce a model of macroeconomic activity that we can use to analyze problems such as fluctuations in gross domestic product (real GDP), the price level, and employment: the model of aggregate demand and aggregate supply. We will use this model throughout our exploration of macroeconomics. In this chapter we will present the broad outlines of the model; greater detail, more examples, and more thorough explanations will follow in subsequent chapters. We will examine
the concepts of the aggregate demand curve and the short- and long-run aggregate supply curves. We will identify conditions under which an 271 Chapter 7 Aggregate Demand and Aggregate Supply economy achieves an equilibrium level of real GDP that is consistent with full employment of labor. Potential output1 is the level of output an economy can achieve when labor is employed at its natural level. Potential output is also called the natural level of real GDP. When an economy fails to produce at its potential, there may be actions that the government or the central bank can take to push the economy toward it, and in this chapter we will begin to consider the pros and cons of doing so. 1. The level of output an economy can achieve when labor is employed at its natural level. 272 Chapter 7 Aggregate Demand and Aggregate Supply 7.1 Aggregate Demand. Define potential output, also called the natural level of GDP. 2. Define aggregate demand, represent it using a hypothetical aggregate demand curve, and identify and explain the three effects that cause this curve to slope downward. 3. Distinguish between a change in the aggregate quantity of goods and services demanded and a change in aggregate demand. 4. Use examples to explain how each component of aggregate demand can be a possible aggregate demand shifter. 5. Explain what a multiplier is and tell how to calculate it. Firms face four sources of demand: households (personal consumption), other firms (investment), government agencies (government purchases), and foreign markets (net exports). Aggregate demand2 is the relationship between the total quantity of goods and services demanded (from all the four sources of demand) and the price level, all other determinants of spending unchanged. The aggregate demand curve3 is a graphical representation of aggregate demand. The Slope of the Aggregate Demand Curve We will use the implicit price deflator as our measure of the price level; the aggregate quantity of goods and services demanded is measured as real GDP. The table in Figure 7.1 "Aggregate Demand" gives values for each component of aggregate demand at each price level for a hypothetical economy. Various points on the aggregate demand curve are found by adding the values of these components at different price levels. The aggregate demand curve for the data given in the table is plotted on the graph in Figure 7.1 "Aggregate Demand". At point A, at a price level of 1.18, $11,800 billion worth of goods and services will be demanded; at point C, a reduction in the price level to 1.
14 increases the quantity of goods and services demanded to $12,000 billion; and at point E, at a price level of 1.10, $12,200 billion will be demanded. 273 2. The relationship between the total quantity of goods and services demanded (from all the four sources of demand) and the price level, all other determinants of spending unchanged. 3. A graphical representation of aggregate demand. Chapter 7 Aggregate Demand and Aggregate Supply Figure 7.1 Aggregate Demand An aggregate demand curve (AD) shows the relationship between the total quantity of output demanded (measured as real GDP) and the price level (measured as the implicit price deflator). At each price level, the total quantity of goods and services demanded is the sum of the components of real GDP, as shown in the table. There is a negative relationship between the price level and the total quantity of goods and services demanded, all other things unchanged. The negative slope of the aggregate demand curve suggests that it behaves in the same manner as an ordinary demand curve. But we cannot apply the reasoning we use to explain downward-sloping demand curves in individual markets to explain the downward-sloping aggregate demand curve. There are two reasons for a negative relationship between price and quantity demanded in individual markets. First, a lower price induces people to substitute more of the good whose price has fallen for other goods, increasing the quantity demanded. Second, the lower price creates a higher real income. This normally increases quantity demanded further. Neither of these effects is relevant to a change in prices in the aggregate. When we are dealing with the average of all prices—the price level—we can no longer say that a fall in prices will induce a change in relative prices that will lead consumers to buy more of the goods and services whose prices have fallen and less of the goods 7.1 Aggregate Demand 274 Chapter 7 Aggregate Demand and Aggregate Supply and services whose prices have not fallen. The price of corn may have fallen, but the prices of wheat, sugar, tractors, steel, and most other goods or services produced in the economy are likely to have fallen as well. Furthermore, a reduction in the price level means that it is not just the prices consumers pay that are falling. It means the prices people receive—their wages, the rents they may charge as landlords, the interest rates they earn—are likely to be falling as well. A falling price level means that goods and services are cheaper, but incomes are lower, too. There is no
reason to expect that a change in real income will boost the quantity of goods and services demanded—indeed, no change in real income would occur. If nominal incomes and prices all fall by 10%, for example, real incomes do not change. Why, then, does the aggregate demand curve slope downward? One reason for the downward slope of the aggregate demand curve lies in the relationship between real wealth (the stocks, bonds, and other assets that people have accumulated) and consumption (one of the four components of aggregate demand). When the price level falls, the real value of wealth increases—it packs more purchasing power. For example, if the price level falls by 25%, then $10,000 of wealth could purchase more goods and services than it would have if the price level had not fallen. An increase in wealth will induce people to increase their consumption. The consumption component of aggregate demand will thus be greater at lower price levels than at higher price levels. The tendency for a change in the price level to affect real wealth and thus alter consumption is called the wealth effect4; it suggests a negative relationship between the price level and the real value of consumption spending. A second reason the aggregate demand curve slopes downward lies in the relationship between interest rates and investment. A lower price level lowers the demand for money, because less money is required to buy a given quantity of goods. What economists mean by money demand will be explained in more detail in a later chapter. But, as we learned in studying demand and supply, a reduction in the demand for something, all other things unchanged, lowers its price. In this case, the “something” is money and its price is the interest rate. A lower price level thus reduces interest rates. Lower interest rates make borrowing by firms to build factories or buy equipment and other capital more attractive. A lower interest rate means lower mortgage payments, which tends to increase investment in residential houses. Investment thus rises when the price level falls. The tendency for a change in the price level to affect the interest rate and thus to affect the quantity of investment demanded is called the interest rate effect5. John Maynard Keynes, a British economist whose analysis of the Great Depression and what to do about it led to the birth of modern macroeconomics, emphasized this effect. For this reason, the interest rate effect is sometimes called the Keynes effect. 4. The tendency for a change in the price level to affect real wealth and thus alter consumption. 5. The tendency for a change in the price level to affect the interest rate
and thus to affect the quantity of investment demanded. 7.1 Aggregate Demand 275 Chapter 7 Aggregate Demand and Aggregate Supply A third reason for the rise in the total quantity of goods and services demanded as the price level falls can be found in changes in the net export component of aggregate demand. All other things unchanged, a lower price level in an economy reduces the prices of its goods and services relative to foreign-produced goods and services. A lower price level makes that economy’s goods more attractive to foreign buyers, increasing exports. It will also make foreign-produced goods and services less attractive to the economy’s buyers, reducing imports. The result is an increase in net exports. The international trade effect6 is the tendency for a change in the price level to affect net exports. Taken together, then, a fall in the price level means that the quantities of consumption, investment, and net export components of aggregate demand may all rise. Since government purchases are determined through a political process, we assume there is no causal link between the price level and the real volume of government purchases. Therefore, this component of GDP does not contribute to the downward slope of the curve. In general, a change in the price level, with all other determinants of aggregate demand unchanged, causes a movement along the aggregate demand curve. A movement along an aggregate demand curve is a change in the aggregate quantity of goods and services demanded7. A movement from point A to point B on the aggregate demand curve in Figure 7.1 "Aggregate Demand" is an example. Such a change is a response to a change in the price level. Notice that the axes of the aggregate demand curve graph are drawn with a break near the origin to remind us that the plotted values reflect a relatively narrow range of changes in real GDP and the price level. We do not know what might happen if the price level or output for an entire economy approached zero. Such a phenomenon has never been observed. Changes in Aggregate Demand Aggregate demand changes in response to a change in any of its components. An increase in the total quantity of consumer goods and services demanded at every price level, for example, would shift the aggregate demand curve to the right. A change in the aggregate quantity of goods and services demanded at every price level is a change in aggregate demand8, which shifts the aggregate demand curve. Increases and decreases in aggregate demand are shown in Figure 7.2 "Changes in Aggregate Demand". 6. The tendency for a change in the price level to affect net
exports. 7. Movement along an aggregate demand curve. 8. Change in the aggregate quantity of goods and services demanded at every price level. 7.1 Aggregate Demand 276 Chapter 7 Aggregate Demand and Aggregate Supply Figure 7.2 Changes in Aggregate Demand An increase in consumption, investment, government purchases, or net exports shifts the aggregate demand curve AD1 to the right as shown in Panel (a). A reduction in one of the components of aggregate demand shifts the curve to the left, as shown in Panel (b). What factors might cause the aggregate demand curve to shift? Each of the components of aggregate demand is a possible aggregate demand shifter. We shall look at some of the events that can trigger changes in the components of aggregate demand and thus shift the aggregate demand curve. Changes in Consumption Several events could change the quantity of consumption at each price level and thus shift aggregate demand. One determinant of consumption is consumer confidence. If consumers expect good economic conditions and are optimistic about their economic prospects, they are more likely to buy major items such as cars or furniture. The result would be an increase in the real value of consumption at each price level and an increase in aggregate demand. In the second half of the 1990s, sustained economic growth and low unemployment fueled high expectations and consumer optimism. Surveys revealed consumer confidence to be very high. That consumer confidence translated into increased consumption and increased aggregate demand. In contrast, a decrease in consumption would accompany diminished consumer expectations and a decrease in consumer confidence, as happened after the stock market crash of 1929. The same problem has plagued the economies of most Western nations in 2008 as declining consumer confidence has tended to reduce consumption. A survey by the Conference Board in September of 7.1 Aggregate Demand 277 Chapter 7 Aggregate Demand and Aggregate Supply 2008 showed that just 13.5% of consumers surveyed expected economic conditions in the United States to improve in the next six months. Similarly pessimistic views prevailed in the previous two months. That contributed to the decline in consumption that occurred in the third quarter of the year. Another factor that can change consumption and shift aggregate demand is tax policy. A cut in personal income taxes leaves people with more after-tax income, which may induce them to increase their consumption. The federal government in the United States cut taxes in 1964, 1981, 1986, 1997, and 2003; each of those tax cuts tended to increase consumption and aggregate demand at each price level. In the United States, another government policy aimed at increasing consumption and thus aggregate demand has been the
use of rebates in which taxpayers are simply sent checks in hopes that those checks will be used for consumption. Rebates have been used in 1975, 2001, and 2008. In each case the rebate was a one-time payment. Careful studies by economists of the 1975 and 2001 rebates showed little impact on consumption. Final evidence on the impact of the 2008 rebates is not yet in, but early results suggest a similar outcome. In a subsequent chapter, we will investigate arguments about whether temporary increases in income produced by rebates are likely to have a significant impact on consumption. Transfer payments such as welfare and Social Security also affect the income people have available to spend. At any given price level, an increase in transfer payments raises consumption and aggregate demand, and a reduction lowers consumption and aggregate demand. Changes in Investment Investment is the production of new capital that will be used for future production of goods and services. Firms make investment choices based on what they think they will be producing in the future. The expectations of firms thus play a critical role in determining investment. If firms expect their sales to go up, they are likely to increase their investment so that they can increase production and meet consumer demand. Such an increase in investment raises the aggregate quantity of goods and services demanded at each price level; it increases aggregate demand. Changes in interest rates also affect investment and thus affect aggregate demand. We must be careful to distinguish such changes from the interest rate effect, which causes a movement along the aggregate demand curve. A change in interest rates that results from a change in the price level affects investment in a way that is already captured in the downward slope of the aggregate demand curve; it causes a 7.1 Aggregate Demand 278 Chapter 7 Aggregate Demand and Aggregate Supply movement along the curve. A change in interest rates for some other reason shifts the curve. We examine reasons interest rates might change in another chapter. Investment can also be affected by tax policy. One provision of the Job and Growth Tax Relief Reconciliation Act of 2003 was a reduction in the tax rate on certain capital gains. Capital gains result when the owner of an asset, such as a house or a factory, sells the asset for more than its purchase price (less any depreciation claimed in earlier years). The lower capital gains tax could stimulate investment, because the owners of such assets know that they will lose less to taxes when they sell those assets, thus making assets subject to the tax more attractive. Changes in Government Purchases Any change in government purchases, all other things unchanged, will
affect aggregate demand. An increase in government purchases increases aggregate demand; a decrease in government purchases decreases aggregate demand. Many economists argued that reductions in defense spending in the wake of the collapse of the Soviet Union in 1991 tended to reduce aggregate demand. Similarly, increased defense spending for the wars in Afghanistan and Iraq increased aggregate demand. Dramatic increases in defense spending to fight World War II accounted in large part for the rapid recovery from the Great Depression. Changes in Net Exports A change in the value of net exports at each price level shifts the aggregate demand curve. A major determinant of net exports is foreign demand for a country’s goods and services; that demand will vary with foreign incomes. An increase in foreign incomes increases a country’s net exports and aggregate demand; a slump in foreign incomes reduces net exports and aggregate demand. For example, several major U.S. trading partners in Asia suffered recessions in 1997 and 1998. Lower real incomes in those countries reduced U.S. exports and tended to reduce aggregate demand. Exchange rates also influence net exports, all other things unchanged. A country’s exchange rate9 is the price of its currency in terms of another currency or currencies. A rise in the U.S. exchange rate means that it takes more Japanese yen, for example, to purchase one dollar. That also means that U.S. traders get more yen per dollar. Since prices of goods produced in Japan are given in yen and prices of goods produced in the United States are given in dollars, a rise in the U.S. exchange rate increases the price to foreigners for goods and services produced in the United States, thus reducing U.S. exports; it reduces the price of foreign-produced goods 9. The price of a currency in terms of another currency or currencies. 7.1 Aggregate Demand 279 Chapter 7 Aggregate Demand and Aggregate Supply and services for U.S. consumers, thus increasing imports to the United States. A higher exchange rate tends to reduce net exports, reducing aggregate demand. A lower exchange rate tends to increase net exports, increasing aggregate demand. Foreign price levels can affect aggregate demand in the same way as exchange rates. For example, when foreign price levels fall relative to the price level in the United States, U.S. goods and services become relatively more expensive, reducing exports and boosting imports in the United States. Such a reduction in net exports reduces aggregate demand. An increase in foreign prices relative to U.S. prices has the opposite effect. The trade
policies of various countries can also affect net exports. A policy by Japan to increase its imports of goods and services from India, for example, would increase net exports in India. The Multiplier A change in any component of aggregate demand shifts the aggregate demand curve. Generally, the aggregate demand curve shifts by more than the amount by which the component initially causing it to shift changes. Suppose that net exports increase due to an increase in foreign incomes. As foreign demand for domestically made products rises, a country’s firms will hire additional workers or perhaps increase the average number of hours that their employees work. In either case, incomes will rise, and higher incomes will lead to an increase in consumption. Taking into account these other increases in the components of aggregate demand, the aggregate demand curve will shift by more than the initial shift caused by the initial increase in net exports. The multiplier10 is the ratio of the change in the quantity of real GDP demanded at each price level to the initial change in one or more components of aggregate demand that produced it: Equation 7.1 10. The ratio of the change in the quantity of real GDP demanded at each price level to the initial change in one or more components of aggregate demand that produced it. Multiplier = Δ (real GDP demanded at each price level) initial Δ (component of AD ) We use the capital Greek letter delta (Δ) to mean “change in.” In the aggregate demand–aggregate supply model presented in this chapter, it is the number by which we multiply an initial change in aggregate demand to obtain the amount by 7.1 Aggregate Demand 280 Chapter 7 Aggregate Demand and Aggregate Supply which the aggregate demand curve shifts as a result of the initial change. In other words, we can use Equation 7.1 to solve for the change in real GDP demanded at each price level: Equation 7.2 Δ (real GDP demanded at each price level) = multiplier × initial Δ (component of AD ) Suppose that the initial increase in net exports is $100 billion and that the initial $100-billion increase generates additional consumption of $100 billion at each price level. In Panel (a) of Figure 7.3 "The Multiplier", the aggregate demand curve shifts to the right by $200 billion—the amount of the initial increase in net exports times the multiplier of 2. We obtained the value for the multiplier in this example by plugging $200 billion (the initial $100-billion increase in net exports plus the $
100-billion increase that it generated in consumption) into the numerator of Equation 7.1 and $100 billion into the denominator. Similarly, a decrease in net exports of $100 billion leads to a decrease in aggregate demand of $200 billion at each price level, as shown in Panel (b). Figure 7.3 The Multiplier A change in one component of aggregate demand shifts the aggregate demand curve by more than the initial change. In Panel (a), an initial increase of $100 billion of net exports shifts the aggregate demand curve to the right by $200 billion at each price level. In Panel (b), a decrease of net exports of $100 billion shifts the aggregate demand curve to the left by $200 billion. In this example, the multiplier is 2. 7.1 Aggregate Demand 281 Chapter 7 Aggregate Demand and Aggregate Supply • Potential output is the level of output an economy can achieve when labor is employed at its natural level. When an economy fails to produce at its potential, the government or the central bank may try to push the economy toward its potential. • The aggregate demand curve represents the total of consumption, investment, government purchases, and net exports at each price level in any period. It slopes downward because of the wealth effect on consumption, the interest rate effect on investment, and the international trade effect on net exports. • The aggregate demand curve shifts when the quantity of real GDP demanded at each price level changes. • The multiplier is the number by which we multiply an initial change in aggregate demand to obtain the amount by which the aggregate demand curve shifts at each price level as a result of the initial change. T R Y I T! Explain the effect of each of the following on the aggregate demand curve for the United States: 1. A decrease in consumer optimism 2. An increase in real GDP in the countries that buy U.S. exports 3. An increase in the price level 4. An increase in government spending on highways 7.1 Aggregate Demand 282 Chapter 7 Aggregate Demand and Aggregate Supply Case in Point: The Multiplied Economic Impact of SARS on China’s Economy Severe Acute Respiratory Syndrome (SARS), an atypical pneumonia-like disease, broke onto the world scene in late 2002. In March 2003, the World Health Organization (WHO) issued its first worldwide alert and a month later its first travel advisory, which recommended that travelers avoid Hong Kong and the southern province of China, Guangdong. Over the next
few months, additional travel advisories were issued for other parts of China, Taiwan, and briefly for Toronto, Canada. By the end of June, all WHO travel advisories had been removed. To estimate the overall impact of SARS on the Chinese economy in 2003, economists Wen Hai, Zhong Zhao, and Jian Want of Peking University’s China Center for Economic Research conducted a survey of Beijing’s tourism industry in April 2003. Based on findings from the Beijing area, they projected the tourism sector of China as a whole would lose $16.8 billion—of which $10.8 billion came from an approximate 50% reduction in foreign tourist revenue and $6 billion from curtailed domestic tourism, as holiday celebrations were cancelled and domestic travel restrictions imposed. To figure out the total impact of SARS on China’s economy, they argued that the multiplier for tourism revenue in China is between 2 and 3. Since the SARS outbreak only began to have a major economic impact after March, they assumed a smaller multiplier of 1.5 for all of 2003. They thus predicted that the Chinese economy would be $25.3 billion smaller in 2003 as a result of SARS. Source: Wen Hai, Zhong Zhao, and Jian Wan, “The Short-Term Impact of SARS on the Chinese Economy,” Asian Economic Papers 3, no. 1 (Winter 2004): 57–61. 7.1 Aggregate Demand 283 Chapter 7 Aggregate Demand and Aggregate Supply. A decline in consumer optimism would cause the aggregate demand curve to shift to the left. If consumers are more pessimistic about the future, they are likely to cut purchases, especially of major items. 2. An increase in the real GDP of other countries would increase the demand for U.S. exports and cause the aggregate demand curve to shift to the right. Higher incomes in other countries will make consumers in those countries more willing and able to buy U.S. goods. 3. An increase in the price level corresponds to a movement up along the unchanged aggregate demand curve. At the higher price level, the consumption, investment, and net export components of aggregate demand will all fall; that is, there will be a reduction in the total quantity of goods and services demanded, but not a shift of the aggregate demand curve itself. 4. An increase in government spending on highways means an increase in government purchases. The aggregate demand curve would shift to the right. 7.1 Aggregate Demand 284 Chapter 7 Aggregate Demand and Aggregate
Supply 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run. Distinguish between the short run and the long run, as these terms are used in macroeconomics. 2. Draw a hypothetical long-run aggregate supply curve and explain what it shows about the natural levels of employment and output at various price levels, given changes in aggregate demand. 3. Draw a hypothetical short-run aggregate supply curve, explain why it slopes upward, and explain why it may shift; that is, distinguish between a change in the aggregate quantity of goods and services supplied and a change in short-run aggregate supply. 4. Discuss various explanations for wage and price stickiness. 5. Explain and illustrate what is meant by equilibrium in the short run and relate the equilibrium to potential output. In macroeconomics, we seek to understand two types of equilibria, one corresponding to the short run and the other corresponding to the long run. The short run11 in macroeconomic analysis is a period in which wages and some other prices do not respond to changes in economic conditions. In certain markets, as economic conditions change, prices (including wages) may not adjust quickly enough to maintain equilibrium in these markets. A sticky price12 is a price that is slow to adjust to its equilibrium level, creating sustained periods of shortage or surplus. Wage and price stickiness prevent the economy from achieving its natural level of employment and its potential output. In contrast, the long run13 in macroeconomic analysis is a period in which wages and prices are flexible. In the long run, employment will move to its natural level and real GDP to potential. We begin with a discussion of long-run macroeconomic equilibrium, because this type of equilibrium allows us to see the macroeconomy after full market adjustment has been achieved. In contrast, in the short run, price or wage stickiness is an obstacle to full adjustment. Why these deviations from the potential level of output occur and what the implications are for the macroeconomy will be discussed in the section on short-run macroeconomic equilibrium. 285 11. In macroeconomic analysis, a period in which wages and some other prices are sticky and do not respond to changes in economic conditions. 12. A price that is slow to adjust to its equilibrium level, creating sustained periods of shortage or surplus. 13. In macroeconomic analysis, a period in which wages and prices are flexible. Chapter 7 Aggregate Demand and Aggregate Supply The Long Run As we saw in a previous chapter, the natural level of
employment occurs where the real wage adjusts so that the quantity of labor demanded equals the quantity of labor supplied. When the economy achieves its natural level of employment, it achieves its potential level of output. We will see that real GDP eventually moves to potential, because all wages and prices are assumed to be flexible in the long run. Long-Run Aggregate Supply The long-run aggregate supply (LRAS) curve14 relates the level of output produced by firms to the price level in the long run. In Panel (b) of Figure 7.4 "Natural Employment and Long-Run Aggregate Supply", the long-run aggregate supply curve is a vertical line at the economy’s potential level of output. There is a single real wage at which employment reaches its natural level. In Panel (a) of Figure 7.4 "Natural Employment and Long-Run Aggregate Supply", only a real wage of ωe generates natural employment Le. The economy could, however, achieve this real wage with any of an infinitely large set of nominal wage and price-level combinations. Suppose, for example, that the equilibrium real wage (the ratio of wages to the price level) is 1.5. We could have that with a nominal wage level of 1.5 and a price level of 1.0, a nominal wage level of 1.65 and a price level of 1.1, a nominal wage level of 3.0 and a price level of 2.0, and so on. Figure 7.4 Natural Employment and Long-Run Aggregate Supply 14. A graphical representation that relates the level of output produced by firms to the price level in the long run. When the economy achieves its natural level of employment, as shown in Panel (a) at the intersection of the demand and supply curves for labor, it achieves its potential output, as shown in Panel (b) by the vertical long-run aggregate supply curve LRAS at YP. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 286 Chapter 7 Aggregate Demand and Aggregate Supply In Panel (b) we see price levels ranging from P1 to P4. Higher price levels would require higher nominal wages to create a real wage of ωe, and flexible nominal wages would achieve that in the long run. In the long run, then, the economy can achieve its natural level of employment and potential output at any price level. This conclusion gives us our long-run aggregate supply curve. With only one level of
output at any price level, the long-run aggregate supply curve is a vertical line at the economy’s potential level of output of YP. Equilibrium Levels of Price and Output in the Long Run The intersection of the economy’s aggregate demand curve and the long-run aggregate supply curve determines its equilibrium real GDP and price level in the long run. Figure 7.5 "Long-Run Equilibrium" depicts an economy in long-run equilibrium. With aggregate demand at AD1 and the long-run aggregate supply curve as shown, real GDP is $12,000 billion per year and the price level is 1.14. If aggregate demand increases to AD2, long-run equilibrium will be reestablished at real GDP of $12,000 billion per year, but at a higher price level of 1.18. If aggregate demand decreases to AD3, long-run equilibrium will still be at real GDP of $12,000 billion per year, but with the now lower price level of 1.10. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 287 Chapter 7 Aggregate Demand and Aggregate Supply Figure 7.5 Long-Run Equilibrium Long-run equilibrium occurs at the intersection of the aggregate demand curve and the long-run aggregate supply curve. For the three aggregate demand curves shown, long-run equilibrium occurs at three different price levels, but always at an output level of $12,000 billion per year, which corresponds to potential output. The Short Run Analysis of the macroeconomy in the short run—a period in which stickiness of wages and prices may prevent the economy from operating at potential output—helps explain how deviations of real GDP from potential output can and do occur. We will explore the effects of changes in aggregate demand and in short-run aggregate supply in this section. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 288 Chapter 7 Aggregate Demand and Aggregate Supply Short-Run Aggregate Supply The model of aggregate demand and long-run aggregate supply predicts that the economy will eventually move toward its potential output. To see how nominal wage and price stickiness can cause real GDP to be either above or below potential in the short run, consider the response of the economy to a change in aggregate demand. Figure 7.6 "Deriving the Short-Run Aggregate Supply Curve" shows an economy that has been operating at potential output of $12,000 billion and a price level of 1
.14. This occurs at the intersection of AD1 with the long-run aggregate supply curve at point B. Now suppose that the aggregate demand curve shifts to the right (to AD2). This could occur as a result of an increase in exports. (The shift from AD1 to AD2 includes the multiplied effect of the increase in exports.) At the price level of 1.14, there is now excess demand and pressure on prices to rise. If all prices in the economy adjusted quickly, the economy would quickly settle at potential output of $12,000 billion, but at a higher price level (1.18 in this case). Figure 7.6 Deriving the Short-Run Aggregate Supply Curve The economy shown here is in long-run equilibrium at the intersection of AD1 with the longrun aggregate supply curve. If aggregate demand increases to AD2, in the short run, both real GDP and the price level rise. If aggregate demand decreases to AD3, in the short run, both real GDP and the price level fall. A line drawn through points A, B, and C traces out the short-run aggregate supply curve SRAS. Is it possible to expand output above potential? Yes. It may be the case, for example, that some people who were in the labor force but were frictionally or structurally unemployed find work because of the ease of getting jobs at the going nominal wage in such an environment. The result is an economy operating at point A in Figure 7.6 "Deriving the Short-Run Aggregate Supply Curve" at a higher price level and with output temporarily above potential. Consider next the effect of a reduction in aggregate demand (to AD3), possibly due to a reduction in investment. As the price level starts to fall, output also falls. The economy finds itself at a price level–output combination at which real GDP is below potential, at point C. Again, price stickiness is to blame. The prices firms receive are falling with the reduction in demand. Without corresponding reductions in nominal wages, there will be an increase in the real wage. Firms will employ less labor and produce less output. By examining what happens as aggregate demand shifts over a period when price adjustment is incomplete, we can trace out the short-run aggregate supply curve by 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 289 Chapter 7 Aggregate Demand and Aggregate Supply drawing a line through points A, B, and C. The short-run aggregate supply (
SRAS) curve15 is a graphical representation of the relationship between production and the price level in the short run. Among the factors held constant in drawing a shortrun aggregate supply curve are the capital stock, the stock of natural resources, the level of technology, and the prices of factors of production. A change in the price level produces a change in the aggregate quantity of goods and services supplied16 and is illustrated by the movement along the short-run aggregate supply curve. This occurs between points A, B, and C in Figure 7.6 "Deriving the Short-Run Aggregate Supply Curve". A change in the quantity of goods and services supplied at every price level in the short run is a change in short-run aggregate supply17. Changes in the factors held constant in drawing the short-run aggregate supply curve shift the curve. (These factors may also shift the long-run aggregate supply curve; we will discuss them along with other determinants of long-run aggregate supply in the next chapter.) One type of event that would shift the short-run aggregate supply curve is an increase in the price of a natural resource such as oil. An increase in the price of natural resources or any other factor of production, all other things unchanged, raises the cost of production and leads to a reduction in short-run aggregate supply. In Panel (a) of Figure 7.7 "Changes in Short-Run Aggregate Supply", SRAS1 shifts leftward to SRAS2. A decrease in the price of a natural resource would lower the cost of production and, other things unchanged, would allow greater production from the economy’s stock of resources and would shift the short-run aggregate supply curve to the right; such a shift is shown in Panel (b) by a shift from SRAS1 to SRAS3. Figure 7.7 Changes in Short-Run Aggregate Supply 15. A graphical representation of the relationship between production and the price level in the short run. 16. Movement along the short-run aggregate supply curve. 17. A change in the aggregate quantity of goods and services supplied at every price level in the short run. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 290 Chapter 7 Aggregate Demand and Aggregate Supply A reduction in short-run aggregate supply shifts the curve from SRAS1 to SRAS2 in Panel (a). An increase shifts it to the right to SRAS3, as shown in Panel (b). Reasons for Wage and Price Stick
iness Wage or price stickiness means that the economy may not always be operating at potential. Rather, the economy may operate either above or below potential output in the short run. Correspondingly, the overall unemployment rate will be below or above the natural level. Many prices observed throughout the economy do adjust quickly to changes in market conditions so that equilibrium, once lost, is quickly regained. Prices for fresh food and shares of common stock are two such examples. Other prices, though, adjust more slowly. Nominal wages, the price of labor, adjust very slowly. We will first look at why nominal wages are sticky, due to their association with the unemployment rate, a variable of great interest in macroeconomics, and then at other prices that may be sticky. Wage Stickiness Wage contracts fix nominal wages for the life of the contract. The length of wage contracts varies from one week or one month for temporary employees, to one year (teachers and professors often have such contracts), to three years (for most union workers employed under major collective bargaining agreements). The existence of such explicit contracts means that both workers and firms accept some wage at the time of negotiating, even though economic conditions could change while the agreement is still in force. Think about your own job or a job you once had. Chances are you go to work each day knowing what your wage will be. Your wage does not fluctuate from one day to the next with changes in demand or supply. You may have a formal contract with your employer that specifies what your wage will be over some period. Or you may have an informal understanding that sets your wage. Whatever the nature of your agreement, your wage is “stuck” over the period of the agreement. Your wage is an example of a sticky price. One reason workers and firms may be willing to accept long-term nominal wage contracts is that negotiating a contract is a costly process. Both parties must keep themselves adequately informed about market conditions. Where unions are 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 291 Chapter 7 Aggregate Demand and Aggregate Supply involved, wage negotiations raise the possibility of a labor strike, an eventuality that firms may prepare for by accumulating additional inventories, also a costly process. Even when unions are not involved, time and energy spent discussing wages takes away from time and energy spent producing goods and services. In addition, workers may simply prefer knowing that their nominal wage will be fixed for some period of time. Some contracts do attempt to take into account
changing economic conditions, such as inflation, through cost-of-living adjustments, but even these relatively simple contingencies are not as widespread as one might think. One reason might be that a firm is concerned that while the aggregate price level is rising, the prices for the goods and services it sells might not be moving at the same rate. Also, costof-living or other contingencies add complexity to contracts that both sides may want to avoid. Even markets where workers are not employed under explicit contracts seem to behave as if such contracts existed. In these cases, wage stickiness may stem from a desire to avoid the same uncertainty and adjustment costs that explicit contracts avert. Finally, minimum wage laws prevent wages from falling below a legal minimum, even if unemployment is rising. Unskilled workers are particularly vulnerable to shifts in aggregate demand. Price Stickiness Rigidity of other prices becomes easier to explain in light of the arguments about nominal wage stickiness. Since wages are a major component of the overall cost of doing business, wage stickiness may lead to output price stickiness. With nominal wages stable, at least some firms can adopt a “wait and see” attitude before adjusting their prices. During this time, they can evaluate information about why sales are rising or falling (Is the change in demand temporary or permanent?) and try to assess likely reactions by consumers or competing firms in the industry to any price changes they might make (Will consumers be angered by a price increase, for example? Will competing firms match price changes?). In the meantime, firms may prefer to adjust output and employment in response to changing market conditions, leaving product price alone. Quantity adjustments have costs, but firms may assume that the associated risks are smaller than those associated with price adjustments. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 292 Chapter 7 Aggregate Demand and Aggregate Supply Another possible explanation for price stickiness is the notion that there are adjustment costs associated with changing prices. In some cases, firms must print new price lists and catalogs, and notify customers of price changes. Doing this too often could jeopardize customer relations. Yet another explanation of price stickiness is that firms may have explicit longterm contracts to sell their products to other firms at specified prices. For example, electric utilities often buy their inputs of coal or oil under long-term contracts. Taken together, these reasons for wage and price stickiness explain why aggregate price adjustment may be incomplete in the sense that the change in the price level is insufficient to maintain
real GDP at its potential level. These reasons do not lead to the conclusion that no price adjustments occur. But the adjustments require some time. During this time, the economy may remain above or below its potential level of output. Equilibrium Levels of Price and Output in the Short Run To illustrate how we will use the model of aggregate demand and aggregate supply, let us examine the impact of two events: an increase in the cost of health care and an increase in government purchases. The first reduces short-run aggregate supply; the second increases aggregate demand. Both events change equilibrium real GDP and the price level in the short run. A Change in the Cost of Health Care In the United States, most people receive health insurance for themselves and their families through their employers. In fact, it is quite common for employers to pay a large percentage of employees’ health insurance premiums, and this benefit is often written into labor contracts. As the cost of health care has gone up over time, firms have had to pay higher and higher health insurance premiums. With nominal wages fixed in the short run, an increase in health insurance premiums paid by firms raises the cost of employing each worker. It affects the cost of production in the same way that higher wages would. The result of higher health insurance premiums is that firms will choose to employ fewer workers. Suppose the economy is operating initially at the short-run equilibrium at the intersection of AD1 and SRAS1, with a real GDP of Y1 and a price level of P1, as shown in Figure 7.8 "An Increase in Health Insurance Premiums Paid by Firms". This is the initial equilibrium price and output in the short run. The increase in labor cost 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 293 Chapter 7 Aggregate Demand and Aggregate Supply shifts the short-run aggregate supply curve to SRAS2. The price level rises to P2 and real GDP falls to Y2. Figure 7.8 An Increase in Health Insurance Premiums Paid by Firms An increase in health insurance premiums paid by firms increases labor costs, reducing short-run aggregate supply from SRAS1 to SRAS2. The price level rises from P1 to P2 and output falls from Y1 to Y2. A reduction in health insurance premiums would have the opposite effect. There would be a shift to the right in the short-run aggregate supply curve with pressure on the price level to fall and real GDP to rise. A Change in Government Purchases Suppose the
federal government increases its spending for highway construction. This circumstance leads to an increase in U.S. government purchases and an increase in aggregate demand. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 294 Chapter 7 Aggregate Demand and Aggregate Supply Assuming no other changes affect aggregate demand, the increase in government purchases shifts the aggregate demand curve by a multiplied amount of the initial increase in government purchases to AD2 in Figure 7.9 "An Increase in Government Purchases". Real GDP rises from Y1 to Y2, while the price level rises from P1 to P2. Notice that the increase in real GDP is less than it would have been if the price level had not risen. Figure 7.9 An Increase in Government Purchases An increase in government purchases boosts aggregate demand from AD1 to AD2. Short-run equilibrium is at the intersection of AD2 and the short-run aggregate supply curve SRAS1. The price level rises to P2 and real GDP rises to Y2. In contrast, a reduction in government purchases would reduce aggregate demand. The aggregate demand curve shifts to the left, putting pressure on both the price level and real GDP to fall. In the short run, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. Recall, however, that the short run is a period in which sticky prices may prevent the economy from 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 295 Chapter 7 Aggregate Demand and Aggregate Supply reaching its natural level of employment and potential output. In the next section, we will see how the model adjusts to move the economy to long-run equilibrium and what, if anything, can be done to steer the economy toward the natural level of employment and potential output • The short run in macroeconomics is a period in which wages and some other prices are sticky. The long run is a period in which full wage and price flexibility, and market adjustment, has been achieved, so that the economy is at the natural level of employment and potential output. • The long-run aggregate supply curve is a vertical line at the potential level of output. The intersection of the economy’s aggregate demand and long-run aggregate supply curves determines its equilibrium real GDP and price level in the long run. • The short-run aggregate supply curve is an upward-sloping curve that shows the quantity of total output that will be produced at each price level in
the short run. Wage and price stickiness account for the shortrun aggregate supply curve’s upward slope. • Changes in prices of factors of production shift the short-run aggregate • supply curve. In addition, changes in the capital stock, the stock of natural resources, and the level of technology can also cause the shortrun aggregate supply curve to shift. In the short run, the equilibrium price level and the equilibrium level of total output are determined by the intersection of the aggregate demand and the short-run aggregate supply curves. In the short run, output can be either below or above potential output. T R Y I T! The tools we have covered in this section can be used to understand the Great Depression of the 1930s. We know that investment and consumption began falling in late 1929. The reductions were reinforced by plunges in net exports and government purchases over the next four years. In addition, nominal wages plunged 26% between 1929 and 1933. We also know that real GDP in 1933 was 30% below real GDP in 1929. Use the tools of aggregate demand and short-run aggregate supply to graph and explain what happened to the economy between 1929 and 1933. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 296 Chapter 7 Aggregate Demand and Aggregate Supply Case in Point: The U.S. Recession of 2001 What were the causes of the U.S. recession of 2001? Economist Kevin Kliesen of the Federal Reserve Bank of St. Louis points to four factors that, taken together, shifted the aggregate demand curve to the left and kept it there for a long enough period to keep real GDP falling for about nine months. They were the fall in stock market prices, the decrease in business investment both for computers and software and in structures, the decline in the real value of exports, and the aftermath of 9/11. Notable exceptions to this list of culprits were the behavior of consumer spending during the period and new residential housing, which falls into the investment category. During the expansion in the late 1990s, a surging stock market probably made it easier for firms to raise funding for investment in both structures and information technology. Even though the stock market bubble burst well before the actual recession, the continuation of projects already underway delayed the decline in the investment component of GDP. Also, spending for information technology was probably prolonged as firms dealt with Y2K computing issues, that is, computer problems associated with the change in the date from 1999 to 2000. Most computers used only two
digits to indicate the year, and when the year changed from ’99 to ’00, computers did not know how to interpret the change, and extensive reprogramming of computers was required. Real exports fell during the recession because (1) the dollar was strong during the period and (2) real GDP growth in the rest of the world fell almost 5% from 2000 to 2001. Then, the terrorist attacks of 9/11, which literally shut down transportation and financial markets for several days, may have prolonged these negative tendencies just long enough to turn what might otherwise have been a mild decline into enough of a downtown to qualify the period as a recession. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 297 Chapter 7 Aggregate Demand and Aggregate Supply During this period the measured price level was essentially stable—with the implicit price deflator rising by less than 1%. Thus, while the aggregate demand curve shifted left as a result of all the reasons given above, there was also a leftward shift in the short-run aggregate supply curve. Source: Kevin L. Kliesen, “The 2001 Recession: How Was It Different and What Developments May Have Caused It?,” The Federal Reserve Bank of St. Louis Review, September/October 2003, 23–37 All components of aggregate demand (consumption, investment, government purchases, and net exports) declined between 1929 and 1933. Thus the aggregate demand curve shifted markedly to the left, moving from AD1929 to AD1933. The reduction in nominal wages corresponds to an increase in short-run aggregate supply from SRAS1929 to SRAS1933. Since real GDP in 1933 was less than real GDP in 1929, we know that the movement in the aggregate demand curve was greater than that of the short-run aggregate supply curve. 7.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run 298 Chapter 7 Aggregate Demand and Aggregate Supply 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium. Explain and illustrate graphically recessionary and inflationary gaps and 2. relate these gaps to what is happening in the labor market. Identify the various policy choices available when an economy experiences an inflationary or recessionary gap and discuss some of the pros and cons that make these choices controversial. The intersection of the economy’s aggregate demand and short-run aggregate supply curves determines equilibrium real GDP and price level in the short run
. The intersection of aggregate demand and long-run aggregate supply determines its long-run equilibrium. In this section we will examine the process through which an economy moves from equilibrium in the short run to equilibrium in the long run. The long run puts a nation’s macroeconomic house in order: only frictional and structural unemployment remain, and the price level is stabilized. In the short run, stickiness of nominal wages and other prices can prevent the economy from achieving its potential output. Actual output may exceed or fall short of potential output. In such a situation the economy operates with a gap. When output is above potential, employment is above the natural level of employment. When output is below potential, employment is below the natural level. Recessionary and Inflationary Gaps At any time, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. If employment is below the natural level of employment, real GDP will be below potential. The aggregate demand and short-run aggregate supply curves will intersect to the left of the longrun aggregate supply curve. Suppose an economy’s natural level of employment is Le, shown in Panel (a) of Figure 7.10 "A Recessionary Gap". This level of employment is achieved at a real wage of ωe. Suppose, however, that the initial real wage ω1 exceeds this equilibrium value. Employment at L1 falls short of the natural level. A lower level of employment produces a lower level of output; the aggregate demand and short-run 299 Chapter 7 Aggregate Demand and Aggregate Supply aggregate supply curves, AD and SRAS, intersect to the left of the long-run aggregate supply curve LRAS in Panel (b). The gap between the level of real GDP and potential output, when real GDP is less than potential, is called a recessionary gap18. Figure 7.10 A Recessionary Gap If employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b) shows the recessionary gap YP − Y1, which occurs when the aggregate demand curve AD and the short-run aggregate supply curve SRAS intersect to the left of the long-run aggregate supply curve LRAS. Just as employment can fall short of its natural level, it can also exceed it. If employment is greater than its natural level, real GDP will also be greater than its potential level. Figure 7.11 "An Inflationary Gap" shows an economy with
a natural level of employment of Le in Panel (a) and potential output of YP in Panel (b). If the real wage ω1 is less than the equilibrium real wage ωe, then employment L1 will exceed the natural level. As a result, real GDP, Y1, exceeds potential. The gap between the level of real GDP and potential output, when real GDP is greater than potential, is called an inflationary gap19. In Panel (b), the inflationary gap equals Y1 − YP. 18. The gap between the level of real GDP and potential output, when real GDP is less than potential. 19. The gap between the level of real GDP and potential output, when real GDP is greater than potential. 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 300 Chapter 7 Aggregate Demand and Aggregate Supply Figure 7.11 An Inflationary Gap Panel (a) shows that if employment is above the natural level, then output must be above potential. The inflationary gap, shown in Panel (b), equals Y1 − YP. The aggregate demand curve AD and the short-run aggregate supply curve SRAS intersect to the right of the long-run aggregate supply curve LRAS. Restoring Long-Run Macroeconomic Equilibrium We have already seen that the aggregate demand curve shifts in response to a change in consumption, investment, government purchases, or net exports. The short-run aggregate supply curve shifts in response to changes in the prices of factors of production, the quantities of factors of production available, or technology. Now we will see how the economy responds to a shift in aggregate demand or short-run aggregate supply using two examples presented earlier: a change in government purchases and a change in health-care costs. By returning to these examples, we will be able to distinguish the long-run response from the shortrun response. A Shift in Aggregate Demand: An Increase in Government Purchases Suppose an economy is initially in equilibrium at potential output YP as in Figure 7.12 "Long-Run Adjustment to an Inflationary Gap". Because the economy is operating at its potential, the labor market must be in equilibrium; the quantities of labor demanded and supplied are equal. 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 301 Chapter 7 Aggregate Demand and Aggregate Supply Now suppose aggregate demand increases because one or more of its components (consumption, investment, government purchases, and
net exports) has increased at each price level. For example, suppose government purchases increase. The aggregate demand curve shifts from AD1 to AD2 in Figure 7.12 "Long-Run Adjustment to an Inflationary Gap". That will increase real GDP to Y2 and force the price level up to P2 in the short run. The higher price level, combined with a fixed nominal wage, results in a lower real wage. Firms employ more workers to supply the increased output. Figure 7.12 Long-Run Adjustment to an Inflationary Gap The economy’s new production level Y2 exceeds potential output. Employment exceeds its natural level. The economy with output of Y2 and price level of P2 is only in short-run equilibrium; there is an inflationary gap equal to the difference between Y2 and YP. Because real GDP is above potential, there will be pressure on prices to rise further. An increase in aggregate demand to AD2 boosts real GDP to Y2 and the price level to P2, creating an inflationary gap of Y2 − YP. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS2. Real GDP returns to potential. Ultimately, the nominal wage will rise as workers seek to restore their lost purchasing power. As the nominal wage rises, the short-run aggregate supply curve will begin shifting to the left. It will continue to shift as long as the nominal wage rises, and the nominal wage will rise as long as there is an inflationary gap. These shifts in short-run aggregate supply, however, will reduce real GDP and thus begin to close this gap. When the short-run aggregate supply curve reaches SRAS2, the economy will have returned to its potential output, and employment will have returned to its natural level. These adjustments will close the inflationary gap. A Shift in Short-Run Aggregate Supply: An Increase in the Cost of Health Care Again suppose, with an aggregate demand curve at AD1 and a short-run aggregate supply at SRAS1, an economy is initially in equilibrium at its potential output YP, at a price level of P1, as shown in Figure 7.13 "Long-Run Adjustment to a Recessionary Gap". Now suppose that the short-run aggregate supply curve shifts owing to a rise in the cost of health care. As we explained earlier, because health insurance premiums are paid primarily by firms for their workers, an increase in premiums raises
the cost of production and causes a reduction in the short-run aggregate supply curve from SRAS1 to SRAS2. 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 302 Chapter 7 Aggregate Demand and Aggregate Supply As a result, the price level rises to P2 and real GDP falls to Y2. The economy now has a recessionary gap equal to the difference between YP and Y2. Notice that this situation is particularly disagreeable, because both unemployment and the price level rose. Figure 7.13 Long-Run Adjustment to a Recessionary Gap With real GDP below potential, though, there will eventually be pressure on the price level to fall. Increased unemployment also puts pressure on nominal wages to fall. In the long run, the short-run aggregate supply curve shifts back to SRAS1. In this case, real GDP returns to potential at YP, the price level falls back to P1, and employment returns to its natural level. These adjustments will close the recessionary gap. How sticky prices and nominal wages are will determine the time it takes for the economy to return to potential. People often expect the government or the central bank to respond in some way to try to close gaps. This issue is addressed next. Gaps and Public Policy If the economy faces a gap, how do we get from that situation to potential output? A decrease in aggregate supply from SRAS1 to SRAS2 reduces real GDP to Y2 and raises the price level to P2, creating a recessionary gap of YP − Y2. In the long run, as prices and nominal wages decrease, the short-run aggregate supply curve moves back to SRAS1 and real GDP returns to potential. Gaps present us with two alternatives. First, we can do nothing. In the long run, real wages will adjust to the equilibrium level, employment will move to its natural level, and real GDP will move to its potential. Second, we can do something. Faced with a recessionary or an inflationary gap, policy makers can undertake policies aimed at shifting the aggregate demand or short-run aggregate supply curves in a way that moves the economy to its potential. A policy choice to take no action to try to close a recessionary or an inflationary gap, but to allow the economy to adjust on its own to its potential output, is a nonintervention policy20. A policy in which the government or central bank acts to move the economy to its potential
output is called a stabilization policy21. Nonintervention or Expansionary Policy? Figure 7.14 "Alternatives in Closing a Recessionary Gap" illustrates the alternatives for closing a recessionary gap. In both panels, the economy starts with a real GDP of 20. A policy choice to take no action to try to close a recessionary or an inflationary gap, but to allow the economy to adjust on its own to its potential output. 21. A policy in which the government or central bank acts to move the economy to its potential output. 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 303 Chapter 7 Aggregate Demand and Aggregate Supply Y1 and a price level of P1. There is a recessionary gap equal to YP − Y1. In Panel (a), the economy closes the gap through a process of self-correction. Real and nominal wages will fall as long as employment remains below the natural level. Lower nominal wages shift the short-run aggregate supply curve. The process is a gradual one, however, given the stickiness of nominal wages, but after a series of shifts in the short-run aggregate supply curve, the economy moves toward equilibrium at a price level of P2 and its potential output of YP. Figure 7.14 Alternatives in Closing a Recessionary Gap Panel (a) illustrates a gradual closing of a recessionary gap. Under a nonintervention policy, short-run aggregate supply shifts from SRAS1 to SRAS2. Panel (b) shows the effects of expansionary policy acting on aggregate demand to close the gap. Panel (b) illustrates the stabilization alternative. Faced with an economy operating below its potential, public officials act to stimulate aggregate demand. For example, the government can increase government purchases of goods and services or cut taxes. Tax cuts leave people with more after-tax income to spend, boost their consumption, and increase aggregate demand. As AD1 shifts to AD2 in Panel (b) of Figure 7.14 "Alternatives in Closing a Recessionary Gap", the economy achieves output of YP, but at a higher price level, P3. A stabilization policy designed to increase real GDP is known as an expansionary policy22. Nonintervention or Contractionary Policy? 22. A stabilization policy designed to increase real GDP. Figure 7.15 "Alternatives in Closing an Inflationary Gap" illustrates the alternatives for closing an inflationary gap. Employment in an economy with an inflationary
gap 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 304 Chapter 7 Aggregate Demand and Aggregate Supply exceeds its natural level—the quantity of labor demanded exceeds the long-run supply of labor. A nonintervention policy would rely on nominal wages to rise in response to the shortage of labor. As nominal wages rise, the short-run aggregate supply curve begins to shift, as shown in Panel (a), bringing the economy to its potential output when it reaches SRAS2 and P2. Figure 7.15 Alternatives in Closing an Inflationary Gap Panel (a) illustrates a gradual closing of an inflationary gap. Under a nonintervention policy, short-run aggregate supply shifts from SRAS1 to SRAS2. Panel (b) shows the effects of contractionary policy to reduce aggregate demand from AD1 to AD2 in order to close the gap. A stabilization policy that reduces the level of GDP is a contractionary policy23. Such a policy would aim at shifting the aggregate demand curve from AD1 to AD2 to close the gap, as shown in Panel (b). A policy to shift the aggregate demand curve to the left would return real GDP to its potential at a price level of P3. For both kinds of gaps, a combination of letting market forces in the economy close part of the gap and of using stabilization policy to close the rest of the gap is also an option. Later chapters will explain stabilization policies in more detail, but there are essentially two types of stabilization policy: fiscal policy and monetary policy. Fiscal policy24 is the use of government purchases, transfer payments, and taxes to influence the level of economic activity. Monetary policy25 is the use of central bank policies to influence the level of economic activity. 23. A stabilization policy designed to reduce real GDP. 24. The use of government purchases, transfer payments, and taxes to influence the level of economic activity. 25. The use of central bank policies to influence the level of economic activity. 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 305 Chapter 7 Aggregate Demand and Aggregate Supply To Intervene or Not to Intervene: An Introduction to the Controversy How large are inflationary and recessionary gaps? Panel (a) of Figure 7.16 "Real GDP and Potential Output" shows potential output versus the actual level of real GDP in the United States since 1960. Real GDP appears to follow potential output quite closely, although you
see some periods where there have been inflationary or recessionary gaps. Panel (b) shows the sizes of these gaps expressed as percentages of potential output. The percentage gap is positive during periods of inflationary gaps and negative during periods of recessionary gaps. Over the last 50 years, the economy has seldom departed by more than 5% from its potential output. So the size and duration of the recessionary gap from 2009 to 2011 certainly stand out. Figure 7.16 Real GDP and Potential Output Panel (a) shows potential output (the blue line) and actual real GDP (the purple line) since 1960. Panel (b) shows the gap between potential and actual real GDP expressed as a percentage of potential output. Inflationary gaps are shown in green and recessionary gaps are shown in yellow. Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012). Real Gross Domestic Product, Chained Dollars [Billions of chained (2005) dollars]. Seasonally adjusted at annual rates; Congressional Budget Office, The Budget and Economic Outlook: An Update, August 2011. 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 306 Chapter 7 Aggregate Demand and Aggregate Supply Panel (a) gives a long-run perspective on the economy. It suggests that the economy generally operates at about potential output. In Panel (a), the gaps seem minor. Panel (b) gives a short-run perspective; the view it gives emphasizes the gaps. Both of these perspectives are important. While it is reassuring to see that the economy is often close to potential, the years in which there are substantial gaps have real effects: Inflation or unemployment can harm people. Some economists argue that stabilization policy can and should be used when recessionary or inflationary gaps exist. Others urge reliance on the economy’s own ability to correct itself. They sometimes argue that the tools available to the public sector to influence aggregate demand are not likely to shift the curve, or they argue that the tools would shift the curve in a way that could do more harm than good. Economists who advocate stabilization policies argue that prices are sufficiently sticky that the economy’s own adjustment to its potential will be a slow process—and a painful one. For an economy with a recessionary gap, unacceptably high levels of unemployment will persist for too long a time. For an economy with an inflationary gap, the increased prices that occur as the short-run aggregate supply curve
shifts upward impose too high an inflation rate in the short run. These economists believe it is far preferable to use stabilization policy to shift the aggregate demand curve in an effort to shorten the time the economy is subject to a gap. Economists who favor a nonintervention approach accept the notion that stabilization policy can shift the aggregate demand curve. They argue, however, that such efforts are not nearly as simple in the real world as they may appear on paper. For example, policies to change real GDP may not affect the economy for months or even years. By the time the impact of the stabilization policy occurs, the state of the economy might have changed. Policy makers might choose an expansionary policy when a contractionary one is needed or vice versa. Other economists who favor nonintervention also question how sticky prices really are and if gaps even exist. The debate over how policy makers should respond to recessionary and inflationary gaps is an ongoing one. These issues of nonintervention versus stabilization policies lie at the heart of the macroeconomic policy debate. We will return to them as we continue our analysis of the determination of output and the price level. 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 307 Chapter 7 Aggregate Demand and Aggregate Supply • When the aggregate demand and short-run aggregate supply curves • intersect below potential output, the economy has a recessionary gap. When they intersect above potential output, the economy has an inflationary gap. Inflationary and recessionary gaps are closed as the real wage returns to equilibrium, where the quantity of labor demanded equals the quantity supplied. Because of nominal wage and price stickiness, however, such an adjustment takes time. • When the economy has a gap, policy makers can choose to do nothing and let the economy return to potential output and the natural level of employment on its own. A policy to take no action to try to close a gap is a nonintervention policy. • Alternatively, policy makers can choose to try to close a gap by using stabilization policy. Stabilization policy designed to increase real GDP is called expansionary policy. Stabilization policy designed to decrease real GDP is called contractionary policy. T R Y I T! Using the scenario of the Great Depression of the 1930s, as analyzed in the previous Try It!, tell what kind of gap the U.S. economy faced in 1933, assuming the economy had been at potential output in 1929. Do you think the unemployment rate was above or below the natural
rate of unemployment? How could the economy have been brought back to its potential output? 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 308 Chapter 7 Aggregate Demand and Aggregate Supply Case in Point: This Time Is Different, Or Is It? In an analysis that spans 66 countries over nearly eight centuries, economists Carmen Reinhart and Kenneth Rogoff investigate hundreds of financial crises and the economic busts each leaves in its wake. With a database that includes crisis episodes that go back as far as 12th-century China and medieval Europe and continue until the financial crisis of 2007–2008, the authors look at the patterns of economic behavior that characterize the periods leading up to financial crises and the patterns that characterize the recoveries. They argue that looking over a long period of history is necessary because financial crises are “rare” events. Financial crises occur at varying intervals, and researchers studying a period of 25 years or so may not encounter the equivalent of a 100-year, category 5 hurricane that hits a major, low-lying city with a faulty levee system. In general, such crises follow periods of relative economic calm. For example, the period in the United States from the mid-1980s until 2007 was often referred to as the Great Moderation. During such periods, inflationary and recessionary gaps may occur, but they are relatively small and short-lived. Societies begin to feel that they have tamed the business cycle, that policy makers have gotten smarter, and that moderation will continue. But then it happens. The accumulation of too much debt by governments, businesses, or consumers leads to a financial meltdown. As housing prices are run up, for example, people tend to find ways to justify their heavy borrowing and to rationalize the ascent in prices: Demographics have changed; mortgage terms have improved; the regulation we have put in place is better this time; it’s better to buy now, before prices go up even more; housing prices won’t fall. Memories of the last crisis fade. “This time is different,” they argue. 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 309 Chapter 7 Aggregate Demand and Aggregate Supply But Reinhart and Rogoff provide convincing evidence that “this time” is usually not different. Large-scale debt buildups lead to crises of confidence, and a financial crisis ensues. The aftermath is typically a severe and prolonged recessionary
gap. On average, they find the following to be true: 1. The collapse in asset market prices is large and long-lasting. Housing prices decline an average of 35% over 6 years, and stock prices decline an average of 56% over 3.5 years. 2. Peak-to-trough GDP falls 9% on average, and the recession averages 2 years in length. 3. The unemployment rate rises 7 percentage points over a 4-year period. 4. Government debt swells due to bailout costs and, more importantly, because tax revenues fall off due to lower GDP. 5. V-shaped recoveries in stock prices are more common than V- shaped recoveries in housing prices or employment. To what extent is the financial crisis of the late 2000s likely to follow this typical pattern? The authors argue that experience with expansionary fiscal policy in such circumstances is actually quite limited. Most often, governments are shut out of borrowing markets when crises hit. Japan’s government explicitly tried to implement fiscal stimulus, but the authors warn against drawing conclusions from one such example. The authors caution that governments should weigh any potential benefit of fiscal stimulus against the problem of higher public debt. They also note that central banks in 2007–2008 acted quickly and aggressively with expansionary monetary policies. But, they caution against “push[ing] too far the conceit that we are smarter than our predecessors” (p. 238). The global nature of the current situation only adds to the difficulty of recovering fully. There was a company failure around 15 years ago that looked like a big deal at the time, but now seems like little more than a blip. The authors quote a trader who, during this event, presciently remarked, “More money has been lost because of four words than at the point of a gun. Those words are ‘This time is different.’” Source: Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press, 2009). 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 310 Chapter 7 Aggregate Demand and Aggregate Supply To the graph in the previous Try It! problem we add the long-run aggregate supply curve to show that, with output below potential, the U.S. economy in 1933 was in a recessionary gap. The unemployment rate was above the natural rate of unemployment. Indeed, real GDP in 1933
was about 30% below what it had been in 1929, and the unemployment rate had increased from 3% to 25%. Note that during the period of the Great Depression, wages did fall. The notion of nominal wage and other price stickiness discussed in this section should not be construed to mean complete wage and price inflexibility. Rather, during this period, nominal wages and other prices were not flexible enough to restore the economy to the potential level of output. There are two basic choices on how to close recessionary gaps. Nonintervention would mean waiting for wages to fall further. As wages fall, the short-run aggregate supply curve would continue to shift to the right. The alternative would be to use some type of expansionary policy. This would shift the aggregate demand curve to the right. These two options were illustrated in Figure 7.15 "Alternatives in Closing an Inflationary Gap". 7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium 311 Chapter 7 Aggregate Demand and Aggregate Supply 7.4 Review and Practice Summary In this chapter, we outlined the model of aggregate demand and aggregate supply. We saw that the aggregate demand curve slopes downward, reflecting the tendency for the aggregate quantity of goods and services demanded to rise as the price level falls and to fall as the price level rises. The negative relationship between the price level and the quantity of goods and services demanded results from the wealth effect for consumption, the interest rate effect for investment, and the international trade effect for net exports. We examined the factors that can shift the aggregate demand curve as well. Generally, the aggregate demand curve shifts by a multiple of the initial amount by which the component causing it to shift changes. We distinguished between two types of equilibria in macroeconomics—one corresponding to the short run, a period of analysis in which nominal wages and some prices are sticky, and the other corresponding to the long run, a period in which full wage and price flexibility, and hence market adjustment, have been achieved. Longrun equilibrium occurs at the intersection of the aggregate demand curve with the long-run aggregate supply curve. The long-run aggregate supply curve is a vertical line at the economy’s potential level of output. Shortrun equilibrium occurs at the intersection of the aggregate demand curve with the short-run aggregate supply curve. The short-run aggregate supply curve relates the quantity of total output produced to the price level in the short run. It is upward sloping because of wage and price stickiness. In
short-run equilibrium, output can be below or above potential. If an economy is initially operating at its potential output, then a change in aggregate demand or short-run aggregate supply will induce a recessionary or inflationary gap. Such a gap will be closed in the long run by changes in the nominal wage, which will shift the short-run aggregate supply curve to the left (to close an inflationary gap) or to the right (to close a recessionary gap). Policy makers might respond to a recessionary or inflationary gap with a nonintervention policy, or they could use stabilization policy. 312 Chapter 7 Aggregate Demand and Aggregate Supply. Explain how the following changes in aggregate demand or short-run aggregate supply, other things held unchanged, are likely to affect the level of total output and the price level in the short run. a. An increase in aggregate demand b. A decrease in aggregate demand c. An increase in short-run aggregate supply d. A reduction in short-run aggregate supply 2. Explain why a change in one component of aggregate demand will cause the aggregate demand curve to shift by a multiple of the initial change. 3. Use the model of aggregate demand and short-run aggregate supply to explain how each of the following would affect real GDP and the price level in the short run. a. An increase in government purchases b. A reduction in nominal wages c. A major improvement in technology d. A reduction in net exports 4. How would an increase in the supply of labor affect the natural level of employment and potential output? How would it affect the real wage, the level of real GDP, and the price level in the short run? How would it affect long-run aggregate supply? What kind of gaps would be created? 5. Give three reasons for the downward slope of the aggregate demand curve. 6. “When the price level falls, people’s wealth increases. When wealth increases, the real volume of consumption increases. Therefore, a decrease in the price level will cause the aggregate demand curve to shift to the right.” Do you agree? Explain. 7. Suppose the economy has a recessionary gap. We know that if we do nothing, the economy will close the gap on its own. Alternatively, we could arrange for an increase in aggregate demand (say, by increasing government spending) to close the gap. How would your views about the degree of price stickiness in the economy influence your views on whether such a policy would be desirable? 8. The
cost of hiring workers includes not only payments made directly to workers, that is, wages, but payments made on behalf of workers as well, such as contributions by employers to pension plans and to health-care 7.4 Review and Practice 313 Chapter 7 Aggregate Demand and Aggregate Supply insurance for employees. How would a decrease in the cost of employerprovided health insurance affect the economy? Using Figure 7.8 "An Increase in Health Insurance Premiums Paid by Firms" as a guide, draw a graph to illustrate your answer. 9. Suppose nominal wages never changed. What would be the significance of such a characteristic? 10. Suppose the minimum wage were increased sharply. How would this affect the equilibrium price level and output level in the model of aggregate demand and aggregate supply in the short run? In the long run? 11. Explain the short-run impact of each of the following. a. A discovery that makes cold fusion a reality, greatly reducing the cost of producing energy b. An increase in the payroll tax 7.4 Review and Practice 314 Chapter 7 Aggregate Demand and Aggregate Supply. Suppose the aggregate demand and short-run aggregate supply schedules for an economy whose potential output equals $2,700 are given by the table. Aggregate Quantity of Goods and Services Price Level Demanded Supplied 0.50 0.75 1.00 1.25 1.50 $3,500 3,000 2,500 2,000 1,500 $1,000 2,000 2,500 2,700 2,800 a. Draw the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves. b. State the short-run equilibrium level of real GDP and the price level. c. Characterize the current economic situation. Is there an inflationary or a recessionary gap? If so, how large is it? d. Now suppose aggregate demand increases by $700 at each price level; for example, the aggregate quantity of goods and services demanded at a price level of 0.50 now equals $4,200. Show the new aggregate demand curve, state the new shortrun equilibrium price level and real GDP, and state whether there is an inflationary or a recessionary gap and give its size. 2. An economy is characterized by the values in the table for aggregate demand and short-run aggregate supply. Its potential output is $1,500. Aggregate Quantity of Goods and Services Price Level Demanded Supplied 0.50 0.75 $2,500 2,000
$1,500 2,000 7.4 Review and Practice 315 Chapter 7 Aggregate Demand and Aggregate Supply Aggregate Quantity of Goods and Services 1.00 1.25 1.50 1,500 1,000 500 2,300 2,500 2,600 a. Draw the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves. b. State the equilibrium level of real GDP and the price level. c. Characterize the current economic situation. Is there an inflationary or a recessionary gap? If so, how large is it? d. Now suppose that nominal wages rise and that the price level required to induce a particular level of total output rises by 0.50. For example, a price level of 1.00 is now required to induce producers to produce a real GDP of $1,500. Show the new short-run aggregate supply curve, state the new equilibrium price level and real GDP, and state whether there is an inflationary or a recessionary gap and give its size. Why might such a change occur? 3. Suppose the price level in a particular economy equals 1.3 and that the quantity of real GDP demanded at that price level is $1,200. An increase of 0.1 point in the price level reduces the quantity of real GDP demanded by $220, and a reduction of 0.1 point would produce an increase in the quantity of real GDP demanded of $220. Draw the aggregate demand curve and show the price level and quantity of real GDP demanded at three points. 4. Suppose an economy is described by the following aggregate demand and short-run aggregate supply curves. The potential level of output is $10 trillion. Aggregate Quantity of Goods and Services Price Level Demanded Supplied 3.0 3.4 3.8 4.2 $11.0 trillion $9.0 trillion $10.8 trillion $9.2 trillion $10.6 trillion $9.4 trillion $10.4 trillion $9.6 trillion 7.4 Review and Practice 316 Chapter 7 Aggregate Demand and Aggregate Supply Aggregate Quantity of Goods and Services 4.6 5.0 5.4 5.8 6.2 6.6 7.0 $10.2 trillion $9.8 trillion $10.0 trillion $10.0 trillion $9.8 trillion $10.2 trillion $9.6 trillion $10.4 trillion $9.4 trillion $10.6 trillion $9.2 trillion $10
.8 trillion $9.0 trillion $11.0 trillion a. Draw the aggregate demand and short-run aggregate supply curves. b. What is the initial real GDP? c. What is the initial price level? d. What kind of gap, if any, exists? e. After the increase in health-care costs, each level of real GDP requires an increase in the price level of 0.8. For example, producing $9.0 trillion worth of goods and services now requires a price level of 3.8. What is the short-run equilibrium level of real GDP? f. After the health-care cost increase, what is the new equilibrium price level in the short run? g. What sort of gap, if any, now exists? 5. According to Alaskan state economist Mark Edwards, the multiplier effect of Alaska’s trade with Japan is such that for every $1 billion exported from Alaska to Japan another $600 million is added to the state’s economy.Matt Volz, “Trade Officials Hopeful for Japanese Recovery,” Associated Press and Local Wire, June 22, 2004, BC cycle. Calculate the size of the export multiplier. 6. The Nottinghamshire Research Observatory in England calculated that students who attend Nottingham Technical University spend about £2,760 each in the local economy for a total of £50.45 million. In total, the impact of their spending on the local economy is £63 million.“University Brings in £250m to Economy,” Nottingham Evening Post, November 4, 2004, p. 37. Calculate the size of the student spending multiplier. In Goa, India, the multiplier effect of iron ore exports is calculated to be 1.62.Vidyut Kumar Ta, “Iron Ore Mining Gives Impetus to Goa’s 7. 7.4 Review and Practice 317 Chapter 7 Aggregate Demand and Aggregate Supply Economy,” Times of India, April 30, 2003. Calculate the impact of an additional 1,000 rupees of iron ore exports on the economy of Goa. 7.4 Review and Practice 318 Chapter 8 Economic Growth Start Up: How Important Is Economic Growth? How important is economic growth? The best way to answer that question is to imagine life without growth—to imagine that we did not have the gains growth brings. For starters, divide your family’s current income by six and imagine what your life would be like. Think about the
kind of housing your family could afford, the size of your entertainment budget, whether you could still attend school. That will give you an idea of life a century ago in the United States, when average household incomes, adjusted for inflation, were about one-sixth what they are today. People had far smaller homes, they rarely had electricity in their homes, and only a tiny percentage of the population could even consider a college education. To get a more recent perspective, consider how growth has changed living standards over the past half century or so. In 1950, the United States was the world’s richest nation. But if households were rich then, subsequent economic growth has made them far richer. Average per capita real income has tripled since then. Indeed, the average household income in 1950, which must have seemed lofty then, was below what we now define as the poverty line for a household of four, even after adjusting for inflation. Economic growth during the last 60-plus years has dramatically boosted our standard of living—and our standard of what it takes to get by. One gauge of rising living standards is housing. A half century ago, most families did not own homes. Today, about two-thirds do. Those homes have gotten a lot bigger: new homes built today are more than twice the size of new homes built 50 years ago. Some household appliances, such as telephones or washing machines, that we now consider basic, were luxuries a half century ago. In 1950, less than twothirds of housing units had complete plumbing facilities. Today, over 99% do. Economic growth has brought gains in other areas as well. For one thing, we are able to afford more schooling. In 1950, the median number of years of school completed by adults age 25 or over was 6.8. Today, about 87% have completed 12 319 Chapter 8 Economic Growth years of schooling and about 30% have completed 4 years of college. We also live longer. A baby born in 1950 had a life expectancy of 68 years. A baby born in 2008 had an expected life of nearly 10 years longer. Of course, while economic growth can improve our material well-being, it is no panacea. Americans today worry about the level of violence in society, environmental degradation, and what seems to be a loss of basic values. But while it is easy to be dismayed about many challenges of modern life, we can surely be grateful for our material wealth. Our affluence gives us the opportunity to grapple with some of our most difficult
problems and to enjoy a range of choices that people only a few decades ago could not have imagined. We learned a great deal about economic growth in the context of the production possibilities curve. Our purpose in this chapter is to relate the concept of economic growth to the model of aggregate demand and aggregate supply that we developed in the previous chapter and will use throughout our exploration of macroeconomics. We will review the forces that determine a nation’s economic growth rate and examine the prospects for growth in the future. We begin by looking at the significance of growth to the overall well-being of society. 320 Chapter 8 Economic Growth 8.1 The Significance of Economic Growth. Define economic growth and explain it using the production possibilities model and the concept of potential output. 2. State the rule of 72 and use it to show how even small differences in growth rates can have major effects on a country’s potential output over time. 3. Calculate the percentage rate of growth of output per capita. To demonstrate the impact of economic growth on living standards of a nation, we must start with a clear definition of economic growth and then study its impact over time. We will also see how population growth affects the relationship between economic growth and the standard of living an economy is able to achieve. Defining Economic Growth Economic growth is a long-run process that occurs as an economy’s potential output increases. Changes in real GDP from quarter to quarter or even from year to year are short-run fluctuations that occur as aggregate demand and short-run aggregate supply change. Regardless of media reports stating that the economy grew at a certain rate in the last quarter or that it is expected to grow at a particular rate during the next year, short-run changes in real GDP say little about economic growth. In the long run, economic activity moves toward its level of potential output. Increases in potential constitute economic growth. Earlier we defined economic growth as the process through which an economy achieves an outward shift in its production possibilities curve. How does a shift in the production possibilities curve relate to a change in potential output? To produce its potential level of output, an economy must operate on its production possibilities curve. An increase in potential output thus implies an outward shift in the production possibilities curve. In the framework of the macroeconomic model of aggregate demand and aggregate supply, we show economic growth as a shift to the right in the long-run aggregate supply curve. There are three key points about economic growth to keep in mind: 321 Chapter 8 Economic
Growth 1. Growth is a process. It is not a single event; rather, it is an unfolding series of events. 2. We define growth in terms of the economy’s ability to produce goods and services, as indicated by its level of potential output. 3. Growth suggests that the economy’s ability to produce goods and services is rising. A discussion of economic growth is thus a discussion of the series of events that increase the economy’s ability to produce goods and services. Figure 8.1 "A Century of Economic Growth" shows the record of economic growth for the U.S. economy over the past century. The graph shows annual levels of actual real GDP and of potential output. We see that the economy has experienced dramatic growth over the past century; potential output has soared nearly 20-fold. The figure also reminds us of a central theme of our analysis of macroeconomics: real GDP fluctuates about potential output. Real GDP sagged well below its potential (initially more than 40% below and then remaining at about 20% below for most of the decade) during the Great Depression of the 1930s and rose well above its potential (about 30% above) as the nation mobilized its resources to fight World War II. With the exception of these two periods, real GDP has remained fairly close to the economy’s potential output. In the recession of 1981, real GDP was about 6.5% below its potential, and during the recession that began at the end of 2007, real GDP fell nearly 8% below its potential. In 2011, the economy was still about 6.8% below its potential. Nonetheless, since 1950, the actual level of real GDP has deviated from potential output by an average of less than 2%. 8.1 The Significance of Economic Growth 322 Chapter 8 Economic Growth Figure 8.1 A Century of Economic Growth At the start of the 21st century, the level of potential output reached a level nearly 20 times its level a century earlier. Over the years, actual real GDP fluctuated about a rising level of potential output. Sources: 1910–1949 data from Christina D. Romer, “World War I and the Postwar Depression: A Reinterpretation Based on Alternative Estimates of GNP,” Journal of Monetary Economics 22 (1988): 91–115; data for 1950–2010 from Congressional Budget Office, The Budget and Economic Outlook: An Update, August 2011 and from Bureau of Economic Analysis, NIPA Table 1.1
.6. We urge you to take some time with Figure 8.1 "A Century of Economic Growth". Over the course of the last century, it is economic growth that has taken center stage. Certainly, the fluctuations about potential output have been important. The recessionary gaps—periods when real GDP slipped below its potential—were often wrenching experiences in which millions of people endured great hardship. The inflationary gaps—periods when real GDP rose above its potential level—often produced dramatic increases in price levels. Those fluctuations mattered. It was the unemployment and/or the inflation that came with them that made headlines. But it was the quiet process of economic growth that pushed living standards ever higher. We must understand growth if we are to understand how we got where we are, and where we are likely to be going during the 21st century. 8.1 The Significance of Economic Growth 323 Chapter 8 Economic Growth Figure 8.2 "Cyclical Change Versus Growth" tells us why we use changes in potential output, rather than actual real GDP, as our measure of economic growth. Actual values of real GDP are affected not just by changes in the potential level of output, but also by the cyclical fluctuations about that level of output. Given our definition of economic growth, we would say that the hypothetical economy depicted in Figure 8.2 "Cyclical Change Versus Growth" grew at a 2.5% annual rate throughout the period. If we used actual values of real GDP, however, we would obtain quite different interpretations. Consider, for example, the first decade of this period: it began with a real GDP of $900 billion and a recessionary gap, and it ended in year 10 with a real GDP of $1,408 billion and an inflationary gap. If we record growth as the annual rate of change between these levels, we find an annual rate of growth of 4.6%—a rather impressive performance. Now consider the second decade shown in Figure 8.2 "Cyclical Change Versus Growth". It began in year 10, and it ended in year 20 with a recessionary gap. If we measure the growth rate over that period by looking at beginning and ending values of actual real GDP, we compute an annual growth rate of 0.5%. Viewed in this way, performance in the first decade is spectacular while performance in the second is rather lackluster. But these figures depend on the starting and ending points we select; the growth rate of potential output was 2.5% throughout the period
. By measuring economic growth as the rate of increase in potential output, we avoid such problems. One way to do this is to select years in which the economy was operating at the natural level of employment and then to compute the annual rate of change between those years. The result is an estimate of the rate at which potential output increased over the period in question. For the economy shown in Figure 8.2 "Cyclical Change Versus Growth", for example, we see that real GDP equaled its potential in years 5 and 15. Real GDP in year 5 was $1,131, and real GDP in year 15 was $1,448. The annual rate of change between these two years was 2.5%. If we have estimates of potential output, of course, we can simply compute annual rates of change between any two years. Figure 8.2 Cyclical Change Versus Growth The use of actual values of real GDP to measure growth can give misleading results. Here, an economy’s potential output (shown in green) grows at a steady rate of 2.5% per year, with actual values of real GDP fluctuating about that trend. If we measure growth in the first 10 years as the annual rate of change between beginning and 8.1 The Significance of Economic Growth 324 Chapter 8 Economic Growth The Rule of 72 and Differences in Growth Rates ending values of real GDP, we get a growth rate of 4.6%. The rate for the second decade is 0.5%. Growth estimates based on changes in real GDP are affected by cyclical changes that do not represent economic growth. The Case in Point on presidents and growth at the end of this section suggests a startling fact: the U.S. growth rate began slowing in the 1970s, did not recover until the mid-1990s, only to slow down again in the 2000s. The question we address here is: does it matter? Does a percentage point drop in the growth rate make much difference? It does. To see why, let us investigate what happens when a variable grows at a particular percentage rate. Suppose two economies with equal populations start out at the same level of real GDP but grow at different rates. Economy A grows at a rate of 3.5%, and Economy B grows at a rate of 2.4%. After a year, the difference in real GDP will hardly be noticeable. After a decade, however, real GDP in Economy A will be 11% greater than in Economy B. Over longer periods, the difference will be more dramatic.
After 100 years, for example, income in Economy A will be nearly three times as great as in Economy B. If population growth in the two countries has been the same, the people of Economy A will have a far higher standard of living than those in Economy B. The difference in real GDP per person will be roughly equivalent to the difference that exists today between Great Britain and Mexico. Over time, small differences in growth rates create large differences in incomes. An economy growing at a 3.5% rate increases by 3.5% of its initial value in the first year. In the second year, the economy increases by 3.5% of that new, higher value. In the third year, it increases by 3.5% of a still higher value. When a quantity grows at a given percentage rate, it experiences exponential growth1. A variable that grows exponentially follows a path such as those shown for potential output in Figure 8.1 "A Century of Economic Growth" and Figure 8.2 "Cyclical Change Versus Growth". These curves become steeper over time because the growth rate is applied to an ever-larger base. A variable growing at some exponential rate doubles over fixed intervals of time. The doubling time is given by the rule of 722, which states that a variable’s approximate doubling time equals 72 divided by the growth rate, stated as a whole number. If the level of income were increasing at a 9% rate, for example, its doubling time would be roughly 72/9, or 8 years.Notice the use of the words roughly and approximately. The actual value of an income of $1,000 growing at rate r for a period of n years is $1,000 × (1 + r)n. After 8 years of growth at a 9% rate, income would thus be $1,000 (1 + 0.09)8 = $1,992.56. The rule of 72 predicts that its value will 1. When a quantity grows at a given percentage rate. 2. A variable’s approximate doubling time equals 72 divided by the growth rate, stated as a whole number. 8.1 The Significance of Economic Growth 325 Chapter 8 Economic Growth be $2,000. The rule of 72 gives an approximation, not an exact measure, of the impact of exponential growth. Let us apply this concept of a doubling time to the reduction in the U.S. growth rate. Had the U.S. economy continued to grow at a 3
.5% rate after 1970, then its potential output would have doubled roughly every 20 years (72/3.5 = 20). That means potential output would have doubled by 1990, would double again by 2010, and would double again by 2030. Real GDP in 2030 would thus be eight times as great as its 1970 level. Growing at a 2.4% rate, however, potential output doubles only every 30 years (72/2.4 = 30). It would take until 2000 to double once from its 1970 level, and it would double once more by 2030. Potential output in 2030 would thus be four times its 1970 level if the economy grew at a 2.4% rate (versus eight times its 1970 level if it grew at a 3.5% rate). The 1.1% difference in growth rates produces a 100% difference in potential output by 2030. The different growth paths implied by these growth rates are illustrated in Figure 8.3 "Differences in Growth Rates". Figure 8.3 Differences in Growth Rates The chart suggests the significance in the long run of a small difference in the growth rate of real GDP. We begin in 1970, when real GDP equaled $2,873.9 billion. If real GDP grew at an annual rate of 3.5% from that year, it would double roughly every 20 years: in 1990, 2010, and 2030. Growth at a 2.4% rate, however, implies doubling every 30 years: in 2000 and 2030. By 2030, the 3.5% growth rate leaves real GDP at twice the level that would be achieved by 2.4% growth. 8.1 The Significance of Economic Growth 326 Chapter 8 Economic Growth Growth in Output per Capita Of course, it is not just how fast potential output grows that determines how fast the average person’s material standard of living rises. For that purpose, we examine economic growth on a per capita basis. An economy’s output per capita3 equals real GDP per person. If we let N equal population, then Equation 8.1 Output per capita = real GDP N In the United States in the third quarter of 2010, for example, real GDP was $13,277.4 billion (annual rate). The U.S. population was 311.0 million. Real U.S. output per capita thus equaled $42,693. We use output per capita as a gauge of an economy’s material standard of living. If the economy’s
population is growing, then output must rise as rapidly as the population if output per capita is to remain unchanged. If, for example, population increases by 2%, then real GDP would have to rise by 2% to maintain the current level of output per capita. If real GDP rises by less than 2%, output per capita will fall. If real GDP rises by more than 2%, output per capita will rise. More generally, we can write: Equation 8.2 % rate of growth of output per capita ≅ % rate of growth of output − % rate of growth of population For economic growth to translate into a higher standard of living on average, economic growth must exceed population growth. From 1970 to 2004, for example, Sierra Leone’s population grew at an annual rate of 2.1% per year, while its real GDP grew at an annual rate of 1.4%; its output per capita thus fell at a rate of 0.7% per year. Over the same period, Singapore’s population grew at an annual rate of 2.1% per year, while its real GDP grew 7.4% per year. The resultant 5.3% annual growth in output per capita transformed Singapore from a relatively poor country to a country with the one of the highest per capita incomes in the world. 3. Real GDP per person. 8.1 The Significance of Economic Growth 327 Chapter 8 Economic Growth • Economic growth is the process through which an economy’s production possibilities curve shifts outward. We measure it as the rate at which the economy’s potential level of output increases. • Measuring economic growth as the rate of increase of the actual level of real GDP can lead to misleading results due to the business cycle. • Growth of a quantity at a particular percentage rate implies exponential growth. When something grows exponentially, it doubles over fixed intervals of time; these intervals may be computed using the rule of 72. • Small differences in rates of economic growth can lead to large differences in levels of potential output over long periods of time. • To assess changes in average standards of living, we subtract the percentage rate of growth of population from the percentage rate of growth of output to get the percentage rate of growth of output per capita. T R Y I T! Suppose an economy’s potential output and real GDP is $5 million in 2000 and its rate of economic growth is 3% per year. Also suppose that its population is 5,000 in 2000, and that its population grows at a rate of
1% per year. Compute GDP per capita in 2000. Now estimate GDP and GDP per capita in 2072, using the rule of 72. At what rate does GDP per capita grow? What is its doubling time? Is this result consistent with your findings for GDP per capita in 2000 and in 2072? 8.1 The Significance of Economic Growth 328 Chapter 8 Economic Growth Case in Point: Presidents and Economic Growth President Annual Increase in Real GDP (%) Growth Rate (%) Truman 1949–1952 Eisenhower 1953–1960 Kennedy-Johnson 1961–1968 Nixon-Ford 1969–1976 Carter 1977–1980 Reagan 1981–1988 G. H. W. Bush 1989–1992 Clinton 1993–2000 G. W. Bush 2001–2008 5.4 2.5 5.1 2.8 3.2 3.5 2.1 3.8 1.6 4.4 3.3 4.4 3.4 3.1 3.1 2.9 3.3 2.6 Presidents are often judged by the rate at which the economy grew while they were in office. This test is unfair on two counts. First, a president has little to do with the forces that determine growth. And second, such tests simply compute the annual rate of growth in real GDP over the course of a presidential term, which we know can be affected by cyclical factors. A president who takes office when the economy is down and goes out with the economy up will look like an economic star; a president with the bad luck to have reverse circumstances will seem like a dud. Here are annual rates of change in real GDP for each of the postwar presidents, together with rates of economic growth, measured as the annual rate of change in potential output. The presidents’ economic records are clearly affected by luck. Presidents Truman, Kennedy, Reagan, and Clinton, for example, began their terms when the economy had a recessionary gap and ended them with an inflationary gap or at about potential output. Real GDP thus rose faster than potential output 8.1 The Significance of Economic Growth 329 Chapter 8 Economic Growth during their presidencies. The Eisenhower, Nixon-Ford, G. H. W. Bush, and G. W. Bush administrations each started with an inflationary gap or at about potential and ended with a recessionary gap, thus recording rates of real GDP increase below the rate of gain in potential. Only Jimmy Carter, who came to office and left it with recessionary gaps, presided over a relatively equivalent rate of increase in
actual GDP versus potential output. How did Barack Obama fare? As this case was written after he was in office for less than a full term, you will have to check for yourself GDP per capita in 2000 equals $1,000 ($5,000,000/5,000). If GDP rises 3% per year, it doubles every 24 years (= 72/3). Thus, GDP will be $10,000,000 in 2024, $20,000,000 in 2048, and $40,000,000 in 2072. Growing at a rate of 1% per year, population will have doubled once by 2072 to 10,000. GDP per capita will thus be $4,000 (= $40,000,000/10,000). Notice that GDP rises by eight times its original level, while the increase in GDP per capita is fourfold. The latter value represents a growth rate in output per capita of 2% per year, which implies a doubling time of 36 years. That gives two doublings in GDP per capita between 2000 and 2072 and confirms a fourfold increase. 8.1 The Significance of Economic Growth 330 Chapter 8 Economic Growth 8.2 Growth and the Long-Run Aggregate Supply Curve. Explain and illustrate graphically the concept of the aggregate production function. Explain how its shape relates to the concept of diminishing marginal returns. 2. Derive the long-run aggregate supply curve from the model of the labor market and the aggregate production function. 3. Explain how the long-run aggregate supply curve shifts in responses to shifts in the aggregate production function or to shifts in the demand for or supply of labor. Economic growth means the economy’s potential output is rising. Because the longrun aggregate supply curve is a vertical line at the economy’s potential, we can depict the process of economic growth as one in which the long-run aggregate supply curve shifts to the right. Figure 8.4 "Economic Growth and the Long-Run Aggregate Supply Curve" illustrates the process of economic growth. If the economy begins at potential output of Y1, growth increases this potential. The figure shows a succession of increases in potential to Y2, then Y3, and Y4. If the economy is growing at a particular percentage rate, and if the levels shown represent successive years, then the size of the increases will become larger and larger, as indicated in the figure. Figure 8.4 Economic Growth and the Long-Run Aggregate Supply Curve Because economic growth can
be considered as a process in which the long-run aggregate supply curve shifts to the right, and because output tends to remain close to this curve, it is important to gain a deeper understanding of what determines long-run aggregate supply (LRAS). We shall examine the derivation of LRAS and then see what factors shift the curve. We shall begin our work by defining an aggregate production function. Because economic growth is the process through which the economy’s potential output is increased, we can depict it as a series of rightward shifts in the long-run aggregate supply curve. Notice that with exponential growth, each successive shift in LRAS is larger and larger. 331 The Aggregate Production Function An aggregate production function4 relates the total output of an economy to the total amount of labor employed in the economy, all other determinants of production (that is, capital, natural resources, and technology) being unchanged. An economy operating on its aggregate production function is producing its potential level of output. Figure 8.5 "The Aggregate Production Function" shows an aggregate production function (PF). It shows output levels for a range of employment between 120 million and 140 million workers. When the level of employment is 120 million, the economy produces a real GDP of $11,500 billion (point A). A level of employment of 130 million produces a real GDP of $12,000 billion (point B), and when 140 million workers are employed, a real GDP of $12,300 billion is produced (point C). In drawing the aggregate production function, the amount of labor varies, but everything else that could affect output, specifically the quantities of other factors of production and technology, is fixed. The shape of the aggregate production function shows that as employment increases, output increases, but at a decreasing rate. Increasing employment from 120 million to 130 million, for example, increases output by $500 billion to $12,000 billion at point B. The next 10 million workers increase production by $300 billion to $12,300 billion at point C. This example illustrates diminishing marginal returns. Diminishing marginal returns5 occur when additional units of a variable factor add less and less to total output, given constant quantities of other factors. Chapter 8 Economic Growth 4. Function that relates the total output of an economy to the total amount of labor employed in the economy, all other determinants of production (capital, natural resources, and technology) being unchanged. 5. Situation that occurs when additional units of a variable factor add less and less to total output
, given constant quantities of other factors. 8.2 Growth and the Long-Run Aggregate Supply Curve 332 Chapter 8 Economic Growth Figure 8.5 The Aggregate Production Function An aggregate production function (PF) relates total output to total employment, assuming all other factors of production and technology are fixed. It shows that increases in employment lead to increases in output but at a decreasing rate. It is easy to picture the problem of diminishing marginal returns in the context of a single firm. The firm is able to increase output by adding workers. But because the firm’s plant size and stock of equipment are fixed, the firm’s capital per worker falls as it takes on more workers. Each additional worker adds less to output than the worker before. The firm, like the economy, experiences diminishing marginal returns. The Aggregate Production Function, the Market for Labor, and Long-Run Aggregate Supply To derive the long-run aggregate supply curve, we bring together the model of the labor market, introduced in the first macro chapter and the aggregate production function. 8.2 Growth and the Long-Run Aggregate Supply Curve 333 Chapter 8 Economic Growth As we learned, the labor market is in equilibrium at the natural level of employment. The demand and supply curves for labor intersect at the real wage at which the economy achieves its natural level of employment. We see in Panel (a) of Figure 8.6 "Deriving the Long-Run Aggregate Supply Curve" that the equilibrium real wage is ω1 and the natural level of employment is L1. Panel (b) shows that with employment of L1, the economy can produce a real GDP of YP. That output equals the economy’s potential output. It is that level of potential output that determines the position of the long-run aggregate supply curve in Panel (c). Figure 8.6 Deriving the Long-Run Aggregate Supply Curve Panel (a) shows that the equilibrium real wage is ω1, and the natural level of employment is L1. Panel (b) shows that with employment of L1, the economy can produce a real GDP of YP. That output equals the economy’s potential output. It is at that level of potential output that we draw the long-run aggregate supply curve in Panel (c). Changes in Long-Run Aggregate Supply The position of the long-run aggregate supply curve is determined by the aggregate production function and the demand and supply curves for labor. A change in any of these will shift the
long-run aggregate supply curve. Figure 8.7 "Shift in the Aggregate Production Function and the Long-Run Aggregate Supply Curve" shows one possible shifter of long-run aggregate supply: a change in the production function. Suppose, for example, that an improvement in technology shifts the aggregate production function in Panel (b) from PF1 to PF2. Other developments that could produce an upward shift in the curve include an increase in the capital stock or in the availability of natural resources. 8.2 Growth and the Long-Run Aggregate Supply Curve 334 Chapter 8 Economic Growth Figure 8.7 Shift in the Aggregate Production Function and the Long-Run Aggregate Supply Curve An improvement in technology shifts the aggregate production function upward in Panel (b). Because labor is more productive, the demand for labor shifts to the right in Panel (a), and the natural level of employment increases to L2. In Panel (c) the long-run aggregate supply curve shifts to the right to Y2. The shift in the production function to PF2 means that labor is now more productive than before. This will affect the demand for labor in Panel (a). Before the technological change, firms employed L1 workers at a real wage ω1. If workers are more productive, firms will find it profitable to hire more of them at ω1. The demand curve for labor thus shifts to D2 in Panel (a). The real wage rises to ω2, and the natural level of employment rises to L2. The increase in the real wage reflects labor’s enhanced productivity6, the amount of output per worker. To see how potential output changes, we see in Panel (b) how much output can be produced given the new natural level of employment and the new aggregate production function. The real GDP that the economy is capable of producing rises from Y1 to Y2. The higher output is a reflection of a higher natural level of employment, along with the fact that labor has become more productive as a result of the technological advance. In Panel (c) the long-run aggregate supply curve shifts to the right to the vertical line at Y2. This analysis dispels a common misconception about the impact of improvements in technology or increases in the capital stock on employment. Some people believe that technological gains or increases in the stock of capital reduce the demand for labor, reduce employment, and reduce real wages. Certainly the experience of the United States and most other countries belies that notion. Between 1990 and 2007, for
example, the U.S. capital stock and the level of technology increased dramatically. During the same period, employment and real wages rose, suggesting that the demand for labor increased by more than the supply of labor. As some firms add capital or incorporate new technologies, some workers at those firms may 6. The amount of output per worker. 8.2 Growth and the Long-Run Aggregate Supply Curve 335 Chapter 8 Economic Growth lose their jobs. But for the economy as a whole, new jobs become available and they generally offer higher wages. The demand for labor rises. Another event that can shift the long-run aggregate supply curve is an increase in the supply of labor, as shown in Figure 8.8 "Increase in the Supply of Labor and the Long-Run Aggregate Supply Curve". An increased supply of labor could result from immigration, an increase in the population, or increased participation in the labor force by the adult population. Increased participation by women in the labor force, for example, has tended to increase the supply curve for labor during the past several decades. Figure 8.8 Increase in the Supply of Labor and the Long-Run Aggregate Supply Curve An increase in the supply of labor shifts the supply curve in Panel (a) to S2, and the natural level of employment rises to L2. The real wage falls to ω2. With increased labor, the aggregate production function in Panel (b) shows that the economy is now capable of producing real GDP at Y2. The long-run aggregate supply curve in Panel (c) shifts to LRAS2. In Panel (a), an increase in the labor supply shifts the supply curve to S2. The increase in the supply of labor does not change the stock of capital or natural resources, nor does it change technology—it therefore does not shift the aggregate production function. Because there is no change in the production function, there is no shift in the demand for labor. The real wage falls from ω1 to ω2 in Panel (a), and the natural level of employment rises from L1 to L2. To see the impact on potential output, Panel (b) shows that employment of L2 can produce real GDP of Y2. The long-run aggregate supply curve in Panel (c) thus shifts to LRAS2. Notice, however, that this shift in the long-run aggregate supply curve to the right is associated with a reduction in the real wage to ω2. 8.2 Growth and the Long-Run
Aggregate Supply Curve 336 Chapter 8 Economic Growth Of course, the aggregate production function and the supply curve of labor can shift together, producing higher real wages at the same time population rises. That has been the experience of most industrialized nations. The increase in real wages in the United States between 1990 and 2007, for example, came during a period in which an increasing population increased the supply of labor. The demand for labor increased by more than the supply, pushing the real wage up. The accompanying Case in Point looks at gains in real wages in the face of technological change, an increase in the stock of capital, and rapid population growth in the United States during the 19th century. Our model of long-run aggregate supply tells us that in the long run, real GDP, the natural level of employment, and the real wage are determined by the economy’s production function and by the demand and supply curves for labor. Unless an event shifts the aggregate production function, the demand curve for labor, or the supply curve for labor, it affects neither the natural level of employment nor potential output. Economic growth occurs only if an event shifts the economy’s production function or if there is an increase in the demand for or the supply of labor • The aggregate production function relates the level of employment to the level of real GDP produced per period. • The real wage and the natural level of employment are determined by the intersection of the demand and supply curves for labor. Potential output is given by the point on the aggregate production function corresponding to the natural level of employment. This output level is the same as that shown by the long-run aggregate supply curve. • Economic growth can be shown as a series of shifts to the right in LRAS. Such shifts require either upward shifts in the production function or increases in demand for or supply of labor. 8.2 Growth and the Long-Run Aggregate Supply Curve 337 Chapter 8 Economic Growth T R Y I T! Suppose that the quantity of labor supplied is 50 million workers when the real wage is $20,000 per year and that potential output is $2,000 billion per year. Draw a three-panel graph similar to the one presented in Figure 8.8 "Increase in the Supply of Labor and the Long-Run Aggregate Supply Curve" to show the economy’s long-run equilibrium. Panel (a) of your graph should show the demand and supply curves for labor, Panel (b) should show the aggregate production function, and Panel (c) should show the long-
run aggregate supply curve. Now suppose a technological change increases the economy’s output with the same quantity of labor as before to $2,200 billion, and the real wage rises to $21,500. In response, the quantity of labor supplied increases to 51 million workers. In the same three panels you have already drawn, sketch the new curves that result from this change. Explain what happens to the level of employment, the level of potential output, and the long-run aggregate supply curve. (Hint: you have information for only one point on each of the curves you draw—two for the supply of labor; simply draw curves of the appropriate shape. Do not worry about getting the scale correct.) 8.2 Growth and the Long-Run Aggregate Supply Curve 338 Chapter 8 Economic Growth Case in Point: Technological Change, Employment, and Real Wages During the Industrial Revolution Technological change and the capital investment that typically comes with it are often criticized because they replace labor with machines, reducing employment. Such changes, critics argue, hurt workers. Using the model of aggregate demand and aggregate supply, however, we arrive at a quite different conclusion. The model predicts that improved technology will increase the demand for labor and boost real wages. The period of industrialization, generally taken to be the time between the Civil War and World War I, was a good test of these competing ideas. Technological changes were dramatic as firms shifted toward mass production and automation. Capital investment soared. Immigration increased the supply of labor. What happened to workers? Employment more than doubled during this period, consistent with the prediction of our model. It is harder to predict, from a theoretical point of view, the consequences for real wages. The latter third of the 19th century was a period of massive immigration to the United States. Between 1865 and 1880, more than 5 million people came to the United States from abroad; most were of working age. The pace accelerated between 1880 and 1923, when more than 23 million people moved to the United States from other countries. Immigration increased the supply of labor, which should reduce the real wage. There were thus two competing forces at work: Technological change and capital investment tended to increase real wages, while immigration tended to reduce them by increasing the supply of labor. The evidence suggests that the forces of technological change and capital investment proved far more powerful than increases in labor supply. Real 8.2 Growth and the Long-Run Aggregate Supply Curve 339 Chapter 8 Economic Growth wages soared 60% between 1860 and 1890. They
continued to increase after that. Real wages in manufacturing, for example, rose 37% from 1890 to 1914. Technological change and capital investment displace workers in some industries. But for the economy as a whole, they increase worker productivity, increase the demand for labor, and increase real wages. Sources: Wage data taken from Clarence D. Long, Wages and Earnings in the United States, 1860–1990 (Princeton, NJ: Princeton University Press, 1960), p. 109, and from Albert Rees, Wages in Manufacturing, 1890–1914 (Princeton, NJ: Princeton University Press, 1961), pp. 3–5. Immigration figures taken from Gary M. Walton and Hugh Rockoff, History of the American Economy, 6th ed. (New York: Harcourt Brace Jovanovich, 1990), p. 371 The production function in Panel (b) shifts up to PF2. Because it reflects greater productivity of labor, firms will increase their demand for labor, and the demand curve for labor shifts to D2 in Panel (a). LRAS1 shifts to LRAS2 in Panel (c). Employment and potential output rise. Potential output will be greater than $2,200 billion. 8.2 Growth and the Long-Run Aggregate Supply Curve 340 Chapter 8 Economic Growth 8.3 Determinants of Economic Growth. Discuss the sources of economic growth. 2. Discuss possible reasons why countries grow at different rates. In this section, we review the main determinants of economic growth. We also examine the reasons for the widening disparities in economic growth rates among countries in recent years. The Sources of Economic Growth As we have learned, there are two ways to model economic growth: (1) as an outward shift in an economy’s production possibilities curve, and (2) as a shift to the right in its long-run aggregate supply curve. In drawing either one at a point in time, we assume that the economy’s factors of production and its technology are unchanged. Changing these will shift both curves. Therefore, anything that increases the quantity or quality of factors of production or that improves the technology available to the economy contributes to economic growth. The sources of growth for the U.S. economy in the 20th century were presented in the chapter on choices in production. There we learned that the main sources of growth for the United States from 1960 to 2007 were divided between increases in the quantities of labor and of physical capital (about 65%) and in improvements in the qualities of
the factors of production and technology (about 35%). Since 2000, however, the contributions from improvements in factor quality and technology have accounted for about half the economic growth in the United States. In order to devote resources to increasing physical and human capital and to improving technology—activities that will enhance future production—society must forgo using them now to produce consumer goods. Even though the people in the economy would enjoy a higher standard of living today without this sacrifice, they are willing to reduce present consumption in order to have more goods and services available for the future. As a college student, you personally made such a choice. You decided to devote time to study that you could have spent earning income. With the higher income, you 341 Chapter 8 Economic Growth could enjoy greater consumption today. You made this choice because you expect to earn higher income in the future and thus to enjoy greater consumption in the future. Because many other people in the society also choose to acquire more education, society allocates resources to produce education. The education produced today will enhance the society’s human capital and thus its economic growth. All other things equal, higher saving allows more resources to be devoted to increases in physical and human capital and technological improvement. In other words, saving, which is income not spent on consumption, promotes economic growth by making available resources that can be channeled into growthenhancing uses. Explaining Recent Disparities in Growth Rates Toward the end of the 20th century, it appeared that some of the world’s more affluent countries were growing robustly while others were growing more slowly or even stagnating. This observation was confirmed in a major study by the Organisation for Economic Co-operation and Development (OECD),The material in this section is based on Organisation for Economic Co-operation and Development, The Sources of Economic Growth in OECD Countries, 2003. whose members are listed in Table 8.1 "Growing Disparities in Rates of Economic Growth". The table shows that for the OECD countries as a whole, economic growth per capita fell from an average of 2.2% per year in the 1980s to an average of 1.9% per year in the 1990s. The higher standard deviation in the latter period confirms an increased disparity of growth rates in the more recent period. Moreover, the data on individual countries show that per capita growth in some countries (specifically, the United States, Canada, Ireland, Netherlands, Norway, and Spain) picked up, especially in the latter half of the 1990s,
while it decelerated in most of the countries of continental Europe and Japan. Table 8.1 Growing Disparities in Rates of Economic Growth Trend Growth of GDP per Capita Country 1980–1990 1990–2000 1996–2000 United States Japan Germany 2.1 3.3 1.9 2.3 1.4 1.2 2.8 0.9 1.7 Excludes Czech Republic, Hungary, Korea, Mexico, Poland, and Slovak Republic 8.3 Determinants of Economic Growth 342 Chapter 8 Economic Growth Trend Growth of GDP per Capita Country 1980–1990 1990–2000 1996–2000 France Italy United Kingdom Canada Austria Belgium Denmark Finland Greece Iceland Ireland Luxembourg Netherlands Portugal Spain Sweden Switzerland Turkey Australia New Zealand Mexico Korea Hungary Poland Czech Republic OECD24 Standard Deviation of OECD24 1.6 2.3 2.2 1.4 2.1 2.0 1.9 2.2 0.5 1.7 3.0 4.0 1.6 3.1 2.3 1.7 1.4 2.1 1.6 1.4 0.0 7.2 — — — 2.2 0.74 1.5 1.5 2.1 1.7 1.9 1.9 1.9 2.1 1.8 1.5 6.4 4.5 2.4 2.8 2.7 1.5 0.4 2.1 2.4 1.2 1.6 5.1 2.3 4.2 1.7 1.9 1.9 1.7 2.3 2.6 2.3 2.3 2.3 3.9 2.7 2.6 7.9 4.6 2.7 2.7 3.2 2.6 1.1 1.9 2.8 1.8 2.7 4.2 3.5 4.8 1.4 2.2 1.17 1.37 *Excludes Czech Republic, Hungary, Korea, Mexico, Poland, and Slovak Republic 8.3 Determinants of Economic Growth 343 Chapter 8 Economic Growth Variation in the growth in real GDP per capita has widened among the world’s leading industrialized economies. Source: Excerpted from Table 1.1 Organisation for Economic Co-operation and Development, Sources of Economic Growth in OECD Countries, 2003: p. 32–33. The study goes on to try to explain the reasons for the divergent growth trends. The main findings were:
• In general, countries with accelerating per capita growth rates also experienced significant increases in employment, while those with stagnant or declining employment generally experienced reductions in per capita growth rates. • • Enhancements in human capital contributed to labor productivity and economic growth, but in slower growing countries such improvements were not enough to offset the impact of reduced or stagnant labor utilization. Information and communication technology has contributed to economic growth both through rapid technological progress within the information and communication technology industry itself as well as, more recently, through the use of information and communication technology equipment in other industries. This has made an important contribution to growth in several of the faster growing countries. • Other factors associated with more growth include: investments in physical and human capital, sound macroeconomic policies (especially low inflation), private sector research and development, trade exposure, and better developed financial markets. Results concerning the impact of the size of the government and of public sector research and development on growth were more difficult to interpret. • With qualifications, the study found that strict regulation of product markets (for example, regulations that reduce competition) and strict employment protection legislation (for example, laws that make hiring and firing of workers more difficult) had negative effects on growth. • All countries show a large number of firms entering and exiting markets. But, a key difference between the United States and Europe is that new firms in the United States start out smaller and less productive than those of Europe but grow faster when they are successful. The report hypothesizes that lower start-up costs and less strict labor market regulations may encourage U.S. entrepreneurs to enter a market and then to expand, if warranted. European entrepreneurs may be less willing to experiment in a market in the first place. 8.3 Determinants of Economic Growth 344 Chapter 8 Economic Growth The general concern in the second half of the 1970s and the 1980s was that economic growth was slowing down and that it might not be possible to reverse this pattern. The 1990s and early 2000s, in which growth picked up in some countries but not in others, suggested that the problem was not universal and led to a search for the reasons for the disparities in growth rates that emerged. The OECD study described above gives some possible explanations. The findings of that study practically beg countries to examine closely their economic policies at a variety of levels and to consider changes that may add flexibility to their economies. To spur this process, in 2005, the OECD started a new annual publication called Going for Growth. The inaugural edition identified five priority structural policy areas specific to each OECD country
. The policies were categorized as either improving labor utilization or improving productivity. Suggestions for improved labor utilization ranged from changing tax policies to improving incentives for females to enter, and for older people to remain in, the workforce. Suggestions for improved productivity ranged from education reform to privatization of stateowned industries. As an example, the priorities proposed for the United States in 2005 included (1) limiting increases in labor costs by reforming Medicare to restrain health care costs, (2) encouraging private saving by shifting the burden of taxation toward consumption, (3) improving primary and secondary education, (4) reducing trade-distorting agricultural price supports, and (5) promoting transparency and accountability of corporate governance.Organisation for Economic Co-operation and Development, Economic Policy Reforms: Going for Growth 2005, available at http://www.OECD.org/economics/goingforgrowth. The 2010 edition of Going for GrowthOrganisation for Economic Co-operation and Development, Economic Policy Reforms: Going for Growth 2010, available at http://www.OECD.org/economics/goingforgrowth. took stock of the progress made over the five-year period leading up to 2010. While two-thirds of the OECD countries took some legislative action in at least one priority area, the scope and depth of this progress varied immensely across countries. Figure 8.9 " of " summarizes this progress using two alternative measures. Panel (a) shows a responsiveness rate, which measures significant actions taken, and Panel (b) shows a follow-through rate, which measures whether priorities could be dropped due to reform implementation. As we can see, the responsiveness and follow-through rates vary widely. Turkey and the Czech Republic stand out as the countries having undertaken substantial reform. The United States stands out as the country having shown neither responsiveness nor follow-through. While the relatively strong performance of the United States at the end of the 20th century, as shown in Table 8.1 "Growing 8.3 Determinants of Economic Growth 345 Chapter 8 Economic Growth Disparities in Rates of Economic Growth", could indicate relatively less need for growth-enhancing reforms, the comparative lack of progress since 2005 raises doubt concerning the ability to maintain strong economic growth going forward. Figure 8.9 of Going for Growth Recommendations across Countries since 2005 Panel (a) measures the 2005 to 2009 rate of responsiveness to the reform priorities given to each country in 2005. Panel (b) shows the reform follow-through rates. Growth-enhancing policy reforms across countries varied
widely during this period. Source: Organisation for Economic Co-operation and Development, Going for Growth 2010, Figure 2.6, p. 75. In closing, it is worth reiterating that economic freedom and higher incomes tend to go together. Countries could not have attained high levels of income if they had not maintained the economic freedom that contributed to high incomes in the first place. Thus, it is also likely that rates of economic growth in the future will be related to the amount of economic freedom countries choose. We shall see in later chapters that monetary and fiscal policies that are used to stabilize the economy in the short run can also have an impact on long-run economic growth. 8.3 Determinants of Economic Growth 346 Chapter 8 Economic Growth • The main sources of growth for the United States from 1948 to 2007 were divided between increases in the quantities of labor and of physical capital (about 65%) and in improvements in the qualities of the factors of production and technology (about 35%). Since 2000, however, improvements in factor quality and technology have contributed to about half the economic growth in the United States. • There has been a growing disparity in the rates of economic growth in industrialized countries in recent decades, which may reflect various differences in economic structures and policies. T R Y I T! All other things unchanged, compare the position of a country’s expected production possibility curve and the expected position of its long-run aggregate supply curve if: 1. 2. 3. 4. Its labor force increases in size by 3% per year compared to 2% per year. Its saving rate falls from 15% to 10%. It passes a law making it more difficult to fire workers. Its level of education rises more quickly than it has in the past. 8.3 Determinants of Economic Growth 347 Chapter 8 Economic Growth Case in Point: Economic Growth in Poor Countries … or Lack Thereof Economist William Easterly in his aptly named book The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics admits that after 50 years of searching for the magic formula for turning poor countries into rich ones, the quest remains elusive. Poor countries just need more physical capital, you say? Easterly points out that between 1960 and 1985, the capital stock per worker in both Gambia and Japan rose by over 500%. The result? In Gambia, output per worker over the 25-year period rose 2%; in Japan, output per worker rose 260%. So, it must be that poor countries need more

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