The Roots of Macroeconomics

THE GREAT DEPRESSION Economic events of the 1930s, the decade of the Great Depression, spurred a great deal of thinking about macroeconomic issues, especially unemployment. he 19!0s had been prosperous years for the ".#. economy. $irtually everyone %ho %anted a &ob could get one, incomes rose substantially, and prices %ere stable. 'eginning in late 19!9, things took a sudden turn for the %orse. (n 19!9, 1.) million people %ere unemployed. 'y 1933, that had increased to 13 million out of a labor force of )1 million. (n 1933, the "nited #tates produced about !* percent fe%er goods and services than it had in 19!9. (n +ctober of 19!9, %hen stock prices collapsed on ,all #treet, billions of dollars of personal %ealth %ere lost. "nemployment remained above 1- percent of the labor force until 19-0. Classical Models 'efore the Great Depression, economists applied microeconomic models, sometimes referred to as .classical. or .market clearing. models, to economy/%ide problems. 0or e1ample, classical supply and demand analysis assumed that an e1cess supply of labor %ould drive do%n %ages to a ne% e2uilibrium level3 as a result, unemployment %ould not persist. (n other %ords, classical economists believed that recessions 4do%nturns in the economy5 %ere self/ correcting. 6s output falls and the demand for labor shifts to the left, the argument %ent, the %age rate %ill decline, thereby raising the 2uantity of labor demanded by firms, %ho %ill %ant to hire more %orkers at the ne% lo%er %age rate. 7o%ever, during the Great Depression unemployment levels remained very high for nearly 10 years. (n large measure, the failure of simple classical models to e1plain the prolonged e1istence of high unemployment provided the impetus for the development of macroeconomics. (t is not surprising that %hat %e no% call macroeconomics %as born in the 1930s. The Keynesian Re ol!tion +ne of the most important %orks in the history of economics, The General Theory of Employment, Interest and Money, by 8ohn 9aynard :eynes, %as published in 193;. 'uilding on %hat %as already understood about markets and their behavior, :eynes set out to construct a theory that %ould e1plain the confusing economic events of his time. 9uch of macroeconomics has roots in :eynes<s %ork. 6ccording to :eynes, it is not prices and %ages that determine the level of employment, as classical models had suggested, but instead the level of aggregate demand for goods and services. :eynes believed governments could intervene in the economy and affect the level of output and employment. he government<s role during periods %hen private demand is lo%, :eynes argued, is to stimulate aggregate demand and, by so doing, to lift the economy out of recession. RECENT MACROECONOMIC HISTOR" IN THE #S$ 6fter ,orld ,ar ((, and especially in the 19)0s, :eynes<s vie%s began to gain increasing influence over both professional economists and government policy makers. Governments came to believe they could intervene in their economies to attain specific employment and output goals. hey began to use their po%ers to ta1 and spend, as %ell as their ability to affect interest rates and the money supply, for the e1plicit purpose of controlling the economy<s ups and do%ns. his vie% of government policy became firmly established in the "nited #tates %ith the passage of the Employment 6ct of 19-;. his act established the =resident<s >ouncil of Economic 6dvisors, a group of economists %ho advise the

president on economic issues. (t also committed the federal government to intervening in the economy to prevent large declines in output and employment. %ine&T!nin' in the ()*+s he notion that the government could, and should, act to stabili?e the macroeconomy reached the height of its popularity in the 19;0s. During these years, ,alter 7eller, the chairman of the >ouncil of Economic 6dvisors under both =resident :ennedy and =resident 8ohnson, alluded to fine/tuning as the government<s role in regulating inflation and unemployment. During the 19;0s, many economists believed the government could use the tools available to manipulate unemployment and inflation levels fairly precisely. Disill!sionment in the (),+s and Early ()-+s (n the 19*0s and early 19@0s, the ".#. economy had %ide fluctuations in employment, output, and inflation. (n 19*-A19*) and again in 19@0A19@!, the "nited #tates e1perienced a severe recession. ,hile not as catastrophic as the Great Depression of the 1930s, these t%o recessions left millions %ithout &obs and resulted in billions of dollars of lost output and income. (n 19*-A19*) and again in 19*9A19@1, the "nited #tates sa% very high rates of inflation. 9oreover, in the 19*0s stagflation 4stagnation B inflation5 %as born. #tagflation occurs %hen the overall price level rises rapidly 4inflation5 during periods of recession or high and persistent unemployment 4stagnation5. "ntil the 19*0s, rapidly rising prices had been observed only in periods %hen the economy %as prospering and unemployment %as lo% 4or at least declining5. he problem of stagflation %as ve1ing, both for macroeconomic theorists and for policy makers concerned %ith the health of the economy. (t %as clear by 19*) that the macroeconomy %as more difficult to control than either 7eller<s %ords or te1tbook theory had led economists to believe. he events of the 19*0s and early 19@0s had an important influence on macroeconomic theory. 9uch of the faith in the simple :eynesian model and the .conventional %isdom. of the 19;0s %as lost. Good Times in the ())+s and a Pa!se in .++( he economy gre% %ell in the 19@0s after the recession of 19@0A19@!. here %as a mild recession in 1990A1991, and then the economy gre% for the rest of the 1990s. Gro%th in 199*A1999 %as particularly strong, fueled in part by the stock market boom than began in 199). Cemarkably, inflation %as not a problem throughout the entire 1990s. he economy entered into a recession in early !001, %hich %as e1acerbated by the terrorist attacks on #eptember 11. he strong economy in the 1990s did not lead to a convergence of vie%s of macroeconomists about ho% the macroeconomy %orks. he discipline of macroeconomics is still in flu1, and many important issues have yet to be resolved. his makes it hard to teach, but e1citing to study.

Macroeconomic Concerns
hree of the ma&or concerns of macroeconomics areD

(nflation +utput gro%th

"nemployment

Government policy makers %ould like to have lo% inflation, high output gro%th, and lo% unemployment. hey may not be able to achieve these goals, but the goals themselves are clear. IN%/ATION (nflation is an increase in the overall price level. :eeping inflation lo% has long been a goal of government policy. Especially problematic are hyperinflations, or periods of very rapid increases in the overall price level. (n some countries at some times people %ere accustomed to prices rising by the day, by the hour, or even by the minute. During the hyperinflation in 'olivia in 19@- and 19@), the price of one egg rose from 3,000 pesos to 10,000 pesos in 1 %eek. (n 19@), three bottles of aspirin sold for the same price as a lu1ury car had sold for in 19@!. 6t the same time, the problem of handling money became a burden. 'anks stopped counting deposits/a E)00 deposit %as e2uivalent to about 3! million pesos, and it &ust did not make sense to count a huge sack full of bills. 'olivia<s currency, printed in ,est Germany and England, %as the country<s third biggest import in 19@-, surpassed only by %heat and mining e2uipment. #kyrocketing prices in 'olivia are a small part of the story. ,hen inflation approaches rates of !,000 percent per year, the economy and the %hole organi?ation of a country begin to break do%n. ,orkers may go on strike to demand %age increases in line %ith the high inflation rate, and firms may find it hard to secure credit. 7yperinflations are rare. Fonetheless, economists have devoted much effort to identifying the costs and conse2uences of even moderate inflation. ,ho gains from inflationG ,ho losesG ,hat costs does inflation impose on societyG 7o% severe are theyG ,hat causes inflationG ,hat is the best %ay to stop itG hese are some of the main concerns of macroeconomists. O#TP#T GRO0TH1 SHORT R#N AND /ONG R#N (nstead of gro%ing at an even rate at all times, economies tend to e1perience short/term ups and do%ns in their performance. he technical name for these ups and do%ns is the business cycle. he main measure of ho% an economy is doing is aggregate output, the total 2uantity of goods and services produced in the economy in a given period. ,hen less is produced 4in other %ords, %hen aggregate output decreases5, there are fe%er goods and services to go around, and the average standard of living declines. ,hen firms cut back on production, they also lay off %orkers, increasing the rate of unemployment. Cecessions are periods during %hich aggregate output declines. (t has become conventional to classify an economic do%nturn as a .recession. %hen aggregate output declines for t%o consecutive 2uarters. 6 prolonged and deep recession is called a depression, although economists do not agree on %hen a recession becomes a depression. here is more to output than its up/and/do%n movements during business cycles. he si?e of the gro%th rate of output over a long period 4longer, say, than the typical length of a business cycle5 is also of concern to macroeconomists and policy makers. (f the gro%th rate of output is greater than the gro%th rate of the population, there is a gro%ing amount of goods and services produced per person. #o, on average, people are becoming better off. =olicy makers are thus concerned not only %ith smoothing fluctuations in output during a business cycle but also %ith policies that might increase the long/run gro%th rate.

#NEMP/O"MENT he unemployment rateAthe percentage of the labor force unemployedAis a key indicator of the economy<s health. 6lthough macroeconomists are interested in learning %hy the unemployment rate has risen or fallen in a given period, they also try to ans%er a more basic 2uestionD ,hy is there any unemployment at allG ,e do not e1pect to see ?ero unemployment. 6t any time, some firms may go bankrupt due to competition from rivals, bad management, or bad luck. Employees of such firms typically are not able to find ne% &obs immediately, and %hile they are looking for %ork, they %ill be unemployed. 6lso, %orkers entering the labor market for the first time may re2uire a fe% %eeks, or months, to find a &ob. (f %e base our analysis on supply and demand, as %e have in all our discussions so far, %e %ould e1pect conditions to change in response to the e1istence of unemployed %orkers. #pecifically, %hen there is unemployment beyond some minimum amount, there is an e1cess supply of %orkers/at the going %age rates, there are people %ho %ant to %ork %ho cannot find %ork. (n microeconomic theory, the response to e1cess supply is a decrease in the price of the commodity in 2uestion and therefore an increase in the 2uantity demanded, a reduction in the 2uantity supplied, and the restoration of e2uilibrium. ,ith the 2uantity supplied e2ual to the 2uantity demanded, the market clears. he e1istence of unemployment seems to imply that the aggregate labor market is not in e2uilibrium/ that something prevents the 2uantity supplied and the 2uantity demanded from e2uating. ,hy do labor markets not clear %hen other markets do, or is it that labor markets are clearing and the unemployment data are reflecting something differentG his is another main concern of macroeconomists.

Go ernment in the Macroeconomy

9uch of our discussion of macroeconomics concerns the potential role of government in influencing the economy. here are three kinds of policy that the government has used to influence the macroeconomyD 1. 0iscal policy !. 9onetary policy 3. Gro%th or supply/side policies %ISCA/ PO/IC" +ne %ay the federal government affects the economy is through its ta1 and e1penditure decisions, or fiscal policy. he federal government collects ta1es from households and firms and spends these funds on items ranging from missiles to parks to social security payments to interstate high%ays. 'oth the magnitude and composition of these ta1es and e1penditures have a ma&or effect on the economy. +ne of :eynes<s main ideas in the 1930s %as that fiscal policy could and should be used to stabili?e the level of output and employment. #pecifically, :eynes believed the government should cut ta1es andHor raise spending/called expansionary fiscal policies/to get the economy out of a slump. >onversely, he held that the government should raise ta1es andHor cut spending/called contractionary fiscal policies/to bring the economy out of an inflation. MONETAR" PO/IC"

a1es and spending are not the only variables the government controls. hrough the 0ederal Ceserve, the nation<s central bank, the government can determine the 2uantity of money in the economy. he effects and proper role of monetary policy are among the most hotly debated sub&ects in macroeconomics. 9ost economists agree that the 2uantity of money supplied affects the overall price level, interest rates and e1change rates, unemployment rate, and level of output. he main controversies arise concerning ho% monetary policy manifests itself and e1actly ho% large its effects are. GRO0TH PO/ICIES 9any economists are skeptical about the government<s ability to regulate the business cycle %ith any degree of precision using monetary and fiscal policy. heir vie% is that the focus of government policy should be to stimulate aggregate supply/to stimulate the potential gro%th of aggregate output and income. 6 host of policies have been aimed at increasing the rate of gro%th. 9any of these are targeted at specific markets and are largely discussed in microeconomics. +ne ma&or %orry of macroeconomists is that government borro%ing to finance e1cesses of spending over ta1 collections 4the .deficit.5 sops up saving that %ould other%ise flo% to businesses to be used for investment in capital. 6nother focus of progro%th government policies has been the ta1 system. 6 ma&or goal of ta1 reforms in 19@1 and 19@; %as to increase the incentive to %ork, save, and invest by lo%ering ta1 rates. (n addition, the a1payer Celief 6ct of 199* included a number of progro%th measures. hese types of policies are sometimes referred to as supply/side policies.

The Com2onents of the Macroeconomy

9acroeconomics focuses on four groupsD households and firms 4the private sector5, the government 4the public sector5, and the rest of the world 4the international sector5. hese four groups interact in a variety of %ays, many involving either the receipt or payment of income. THE CIRC#/AR %/O0 DIAGRAM 6 useful %ay of seeing the economic interactions among the four sectors in the economy is a circular flo% diagram, %hich sho%s the income received and payments made by each.

Figure 5.1

The Circular Flow of Payments

Households receive income from firms and the government, purchase goods and services from firms, and pay taxes to the government. They also purchase foreign-made goods and services (imports). Firms receive payments from households and the government for goods and services; they pay wages, dividends, interest, and rents to households, and taxes to the government. The government receives taxes from oth firms and households, pays oth firms and households for goods and services!including wages to government wor"ers!and pays interest and transfers to households. Finally, people in other countries purchase goods and services produced domestically (exports). Note: Though not shown in this diagram, firms and governments also purchase imports.

Iet us %alk through the circular flo% step by step. 7ouseholds %ork for firms and the government, and they receive %ages for their %ork. +ur diagram sho%s a flo% of %ages into the household sector as payment for those services. 7ouseholds also receive interest on corporate and government bonds and dividends from firms. 9any households receive other payments from the government, such as social security benefits, veterans< benefits, and %elfare payments. Economists call these kinds of payments from the government 4for %hich the recipients do not supply goods, services, or labor5 transfer payments. ogether, all these receipts make up the total income received by the households. 7ouseholds spend by buying goods and services from firms and by paying ta1es to the government. hese items make up the total amount paid out by the households. he difference bet%een the total receipts and the total payments of the households is the amount that the households save or dissave. (f households receive more than they spend, they save during the period. (f they receive less than they spend, they dissave. 6 household can dissave by using up some of its previous savings or by borro%ing. (n the circular flo% diagram, household spending is sho%n as a flo% out of the household sector. #aving by households is sometimes termed a .leakage. from the circular flo% because it %ithdra%s income, or current purchasing po%er, from the system. 0irms sell goods and services to households and the government. hese sales earn revenue, %hich sho%s up in the circular flo% diagram as a flo% into the firm sector. 0irms pay %ages, interest, and

dividends to households, and they pay ta1es to the government. hese payments are sho%n flo%ing out of the firm sector. he government collects ta1es from households and firms. he government also makes payments. (t buys goods and services from firms, pays %ages and interest to households, and makes transfer payments to households. (f the government<s revenue is less than its payments, the government is dissaving. 0inally, households spend some of their income on imports/goods and services produced in the rest of the %orld. #imilarly, people in foreign countries purchase exports/goods and services produced by domestic firms and sold to other countries. +ne lesson of the circular flo% diagram is that everyone<s e1penditure is someone else<s receipt. (f you buy a personal computer from ('9, you make a payment to ('9 and ('9 receives revenue. (f ('9 pays ta1es to the government, it has made a payment and the government has received revenue. Everyone<s e1penditures go some%here. (t is impossible to sell something %ithout there being a buyer, and it is impossible to make a payment %ithout there being a recipient. Every transaction must have t%o sides. THE THREE MARKET ARENAS 6nother %ay of looking at the %ays households, firms, the government, and the rest of the %orld relate to each other is to consider the markets in %hich they interact, as depicted in 0igure ).!. he three market arenas areD 1. Goods/and/services market !. Iabor market 3. 9oney 4financial5 market

Figure 5.2

The Three Basic Markets

Households, firms, the government, and the rest of the world all interact in the goods-and-services, la or, and money mar"ets.

Goods&and&Ser ices Mar3et 7ouseholds and the government purchase goods and services from firms in the goods-and-services market. (n this market, firms also purchase goods and services from each other. 0or e1ample, Ievi #trauss buys denim from other firms to make its blue &eans. (n addition, firms buy capital goods from other firms. (f General 9otors needs ne% robots on its assembly lines, it %ill probably buy them from another firm instead of making them. 0irms supply to the goods/and/services market. 7ouseholds, the government, and firms demand from this market. 0inally, the rest of the %orld both buys from and sells to the goods/and/services market. he "nited #tates imports hundreds of billions of dollars %orth of automobiles, videocassette recorders 4$>Cs5, oil, and other goods. 6t the same time, the "nited #tates e1ports hundreds of billions of dollars %orth of computers, airplanes, and agricultural goods. /a4or Mar3et (nteraction in the la or market takes place %hen firms and the government purchase labor from households. (n this market, households supply labor, and firms and the government demand labor. (n the ".#. economy, firms are the largest demanders of labor, although the government is also a substantial employer. he total supply of labor in the economy depends on the sum of decisions made by households. (ndividuals must decide %hether to enter the labor force 4%hether to look for a &ob at all5 and ho% many hours to %ork. Iabor is also supplied to and demanded from the rest of the %orld. (n recent years, the labor market has become an international market. 0or e1ample, vegetable and fruit farmers in >alifornia %ould find it very difficult to bring their product to market if it %ere not for the labor of migrant farm %orkers from 9e1ico. 0or years, urkey has provided Germany %ith .guest %orkers. %ho are %illing to take lo%/paying &obs that more prosperous German %orkers avoid. Money Mar3et (n the money market/sometimes called the financial market/households purchase stocks and bonds from firms. 7ouseholds supply funds to this market in the e1pectation of earning income in the form of dividends on stocks and interest on bonds. 7ouseholds also demand 4borro%5 funds from this market to finance various purchases. 0irms borro% to build ne% facilities in the hope of earning more in the future. he government borro%s by issuing bonds. he rest of the %orld both borro%s from and lends to the money market3 every morning there are reports on $ and radio about the 8apanese and 'ritish stock markets. 9uch of the borro%ing and lending of households, firms, the government, and the international sector is coordinated by financial institutions/commercial banks, savings and loan associations, insurance companies, and the like. hese institutions take deposits from one group and lend them to others. ,hen a firm, a household, or the government borro%s to finance a purchase, it has an obligation to pay that loan back, usually at some specified time in the future. 9ost loans also involve payment of interest as a fee for the use of the borro%ed funds. ,hen a loan is made, the borro%er nearly al%ays signs a .promise to repay,. or promissory note, and gives it to the lender. ,hen the federal government borro%s, it issues .promises. called reasury bonds, notes, or bills in e1change for money. >orporations issue corporate bonds. 6 corporate bond might state, for e1ample, .General Electric >orporation agrees to pay E),000 to the holder of this bond on 8anuary 1, !001, and interest thereon at @.3 percent annually until that time..

(nstead of issuing bonds to raise funds, firms can also issue shares of stock. 6 share of stock is a financial instrument that gives the holder a share in the firm<s o%nership and therefore the right to share in the firm<s profits. (f the firm does %ell, the value of the stock increases, and the stockholder receives a capital gain on the initial purchase. (n addition, the stock may pay dividends/that is, the firm may return some of its profits directly to its stockholders, instead of retaining them to buy capital. (f the firm does poorly, so does the stockholder. he capital value of the stock may fall, and dividends may not be paid. #tocks and bonds are simply contracts, or agreements, bet%een parties. ( agree to loan you a certain amount, and you agree to repay me this amount plus something e1tra at some future date, or ( agree to buy part o%nership in your firm, and you agree to give me a share of the firm<s future profits. 6 critical variable in the money market is the interest rate. 6lthough %e sometimes talk as if there %ere only one interest rate, there is never &ust one interest rate at any time. (nstead, the interest rate on a given loan reflects the length of the loan and the perceived risk to the lender. 6 business that is &ust getting started %ill have to pay a higher rate than %ill General 9otors. 6 30/year mortgage has a different interest rate than a 90/day loan. Fevertheless, interest rates tend to move up and do%n together, and their movement reflects general conditions in the financial market.

The Methodolo'y of Macroeconomics

9acroeconomists build models based on theories, and they test their models using data. (n this sense, the methodology of macroeconomics is similar to the methodology of microeconomics. CONNECTIONS TO MICROECONOMICS 7o% do macroeconomists try to e1plain aggregate behaviorG +ne %ay assumes that the same factors that affect individual behavior also affect aggregate behavior. 0or e1ample, %e kno% from microeconomics that an individual<s %age rate should affect her consumption habits and the amount of labor she is %illing to supply. (f %e %ere to apply this microeconomic hypothesis to the aggregate data, %e %ould say that the average %age rate in the economy should affect total consumption and total labor supply 4%hich seems to be true5. he reason for looking to microeconomics for help in e1plaining macroeconomic events is simpleD 9acroeconomic behavior is the sum of all the microeconomic decisions made by individual households and firms. (f the movements of macroeconomic aggregates, such as total output or total employment, reflect decisions made by individual firms and households, %e cannot understand the former %ithout some kno%ledge of the factors that influence the latter. >onsider unemployment. he unemployment rate is the number of people unemployed as a fraction of the labor force. o be classified as .in the labor force,. a person must either have a &ob or be seeking one actively. o understand aggregate unemployment, %e need to understand individual household behavior in the labor market. ,hy do people choose to enter the labor forceG "nder %hat circumstances %ill they drop outG ,hy does unemployment e1ist even %hen the economy seems to be doing very %ellG 6 kno%ledge of microeconomic behavior is the logical starting point for macroeconomic analysis. AGGREGATE DEMAND AND AGGREGATE S#PP/"

6 ma&or concern of the ne1t fe% chapters is the behavior of aggregate demand and aggregate supply. 6ggregate demand is the total demand for goods and services. 6ggregate supply is the total supply of goods and services. 0igure ).3 sho%s aggregate demand and aggregate supply curves. 9easured on the hori?ontal a1is is aggregate output. 9easured on the vertical a1is is the overall price level, not the price of a particular good or service. he economy is in e2uilibrium at the point at %hich these curves intersect. 6s you %ill discover, aggregate demand and supply curves are much more complicated than the simple demand and supply curves %e described in >hapters 3 and -. he simple logic of supply, demand, and e2uilibrium in individual markets does not e1plain %hat is depicted in 0igure ).3. (t %ill take the entire ne1t chapter for us to describe %hat is meant by .aggregate output. and the .overall price level.. 0urthermore, although %e %ill look to the behavior of households and firms in individual markets for clues about ho% to analy?e aggregate behavior, there are important differences %hen %e move from the individual to the aggregate level.

Figure 5.3

The Aggregate

eman! an! Aggregate "u##ly Cur$es

# ma$or theme in macroeconomics is the ehavior of aggregate demand and aggregate supply. The logic ehind the aggregate demand and aggregate supply curves is much more complex than the logic underlying the simple demand and supply curves descri ed in %hapters & and '.

>onsider, for e1ample, demand, one of the most important concepts in economics. ,hen the price of a specific good increases, perhaps the most important determinant of consumer response is the availability of other goods that can be substituted for the good %hose price has increased. =art of the reason that an increase in the price of airline tickets causes a decline in the 2uantity of airline tickets demanded is that a higher price relative to other goods means that the opportunity cost of buying a ticket is higherD he sacrifice re2uired in terms of other goods and services has increased. 7o%ever, %hen the overall price level changes, there may be no changes at all in relative prices. ,hen analy?ing the behavior of aggregate demand, the availability of substitutes is irrelevant. 9icroeconomics teaches us that, ceteris pari us, the 2uantity demanded of a good falls %hen its price rises and rises %hen its price falls. 4 his is the microeconomic la% of demand.5 (n other %ords, individual demand curves and market demand curves slope do%n%ard to the right. he reason the aggregate demand curve in 0igure ).3 slopes do%n%ard to the right is comple1. 6s %e %ill see later, the do%n%ard slope of the aggregate demand curve is related to %hat goes on in the money 4financial5 market.

he aggregate supply curve is very different from the supply curve of an individual firm or market. 6 firm<s supply curve is derived under the assumption that all its input prices are fi1ed. (n other %ords, the firm<s input prices are assumed to remain unchanged as the price of the firm<s output changes. ,hen %e derived >larence 'ro%n<s soybean supply schedule in >hapter 3, %e took his input prices as fi1ed. 6 change in an input price leads to a shift in 'ro%n<s supply curve, not a movement along it. (f %e are e1amining changes in the overall price level, ho%ever, all prices are changing 4including input prices5, so the aggregate supply curve cannot be based on the assumption of fi1ed input prices. ,e %ill see that the aggregate supply curve is a source of controversy in macroeconomics.

Gross Domestic Prod!ct

he key concept in the national income and product accounts is gross domestic product 4GD=5. GD= is the total market value of a country<s output. (t is the market value of all final goods and services produced %ithin a given period of time by factors of production located %ithin a country. he centrality of GD= as a %orking concept cannot be overestimated. 8ust as an individual firm needs to evaluate the success or failure of its operations each year, so the economy as a %hole needs to assess itself. GD=, as a measure of the total production of an economy, provides us %ith a country<s economic report card. 'ecause GD= is such an important concept, %e need to take some time to e1plain e1actly %hat its definition means. %INA/ GOODS AND SER5ICES 0irst note that the definition refers to final goods and services. 9any goods produced in the economy are not classified as final goods, but instead as intermediate goods. (ntermediate goods are produced by one firm for use in further processing by another firm. 0or e1ample, tires sold to automobile manufacturers are intermediate goods. he value of intermediate goods is not counted in GD=. ,hy are intermediate goods not counted in GD=G #uppose that in producing a car General 9otors 4G95 pays E100 to Goodyear for tires. G9 uses these tires 4among other components5 to assemble a car, %hich it sells for E1!,000. he value of the car 4including its tires5 is E1!,000, not E1!,000 B E100. he final price of the car already reflects the value of all its components. o count in GD= both the value of the tires sold to the automobile manufacturers and the value of the automobiles sold to the consumers %ould result in double counting. Double counting can also be avoided by counting only the value added to a product by each firm in its production process. he value added during some stage of production is the difference bet%een the value of goods as they leave that stage of production and the cost of the goods as they entered that stage. $alue added is illustrated in able ;.1. he four stages of the production of a gallon of gasoline are 415 oil drilling, 4!5 refining, 435 shipping, and 4-5 retail sale. (n the first stage, value added is the value of sales. (n the second stage, the refiner purchases the oil from the driller, refines it into gasoline, and sells it to the shipper. he refiner pays the driller E.)0 per gallon and charges the shipper E.;). he value added by the refiner is thus E.1) per gallon. he shipper then sells the gasoline to retailers for E.@0. he value added in the third stage of production is E.1). 0inally, the retailer sells the gasoline to consumers for E1.00. he value added at the fourth stage is E.!0, and the total value added in the production process is E1.00, the same as the value of sales at the retail level. 6dding the total values of sales at each stage of production 4E.)0 B E.;) B E.@0 B E1.00 J E!.9)5 %ould significantly overestimate the value of the gallon of gasoline.

Ta%le &.1

'alue A!!e! in the Pro!uction of a (allon of (asoline )*y#othetical +um%ers,

STAGE OF PRODUCTION 415 +il drilling 4!5 Cefining 435 #hipping 4-5 Cetail sale Total value added

VALUE OF SALES E .)0 .;) .@0 1.00

VALUE ADDED E .)0 .1) .1) .!0 $1.00

(n calculating GD=, %e can either sum up the value added at each stage of production or %e can take the value of final sales. ,e do not use the value of total sales in an economy to measure ho% much output has been produced. E6C/#SION O% #SED GOODS AND PAPER TRANSACTIONS GD= is concerned only %ith ne%, or current, production. +ld output is not counted in current GD= because it %as already counted back at the time it %as produced. (t %ould be double counting to count sales of used goods in current GD=. (f someone sells a used car to you, the transaction is not counted in GD=, because no ne% production has taken place. #imilarly, a house is counted in GD= only at the time it is built, not each time it is resold. (n shortD GD= ignores all transactions in %hich money or goods change hands but in %hich no ne% goods and services are produced. #ales of stocks and bonds are not counted in GD=. hese sales are e1changes of paper assets and do not correspond to current production. 7o%ever, %hat if ( sell the stock or bond for more than ( originally paid for itG =rofits from the stock or bond market have nothing to do %ith current production, so they are not counted in GD=. 7o%ever, if ( pay a fee to a broker for selling a stock of mine to someone else, this fee is counted in GD=, because the broker is performing a service for me. his service is part of current production. 'e careful to distinguish bet%een e1changes of stocks and bonds for money 4or for other stocks and bonds5, %hich do not involve current production, and fees for performing such e1changes, %hich do. E6C/#SION O% O#TP#T PROD#CED A7ROAD 7" DOMESTICA//" O0NED %ACTORS O% PROD#CTION GD= is the value of output produced by factors of production located within a country. he three basic factors of production are land, labor, and capital. he labor of ".#. citi?ens counts as a domestically o%ned factor of production for the "nited #tates. he output produced by ".#. citi?ens abroadAfor e1ample, ".#. citi?ens %orking for a foreign companyAis not counted in ".#. GD= because the output is not produced %ithin the "nited #tates. Iike%ise, profits earned abroad by ".#. companies are not counted in ".#. GD=. 7o%ever, the output produced by foreigners %orking in the "nited #tates is counted in ".#. GD= because the output is produced %ithin the "nited #tates. 6lso, profits earned in the "nited #tates by foreign/o%ned companies are counted in ".#. GD=.

(t is sometimes useful to have a measure of the output produced by factors of production o%ned by a country<s citi?ens regardless of %here the output is produced. his measure is called gross national product 4GF=5. 0or most countries, including the "nited #tates, the difference bet%een GD= and GF= is small. (n !001, GF= for the "nited #tates %as E10,19-.) billion, %hich is close to the E10,!0).; billion value for ".#. GD=. he distinction bet%een GD= and GF= can be tricky. >onsider the 7onda plant in 9arysville, +hio. he plant is o%ned by the 7onda >orporation, a 8apanese firm, but most of the %orkers employed at the plant are ".#. %orkers. 6lthough all the output of the plant is included in ".#. GD=, only part of it is included in ".#. GF=. he %ages paid to ".#. %orkers are part of ".#. GF=, %hile the profits from the plant are not. he profits from the plant are counted in 8apanese GF= because this is output produced by 8apanese/o%ned factors of production 48apanese capital in this case5. he profits, ho%ever, are not counted in 8apanese GD= because they %ere not earned in 8apan.

Calc!latin' GDP
GD= can be computed in t%o %ays. +ne is to add up the amount spent on all final goods during a given period. his is the e1penditure approach to calculating GD=. he other is to add up the income A%ages, rents, interest, and profitsAreceived by all factors of production in producing final goods. his is the income approach to calculating GD=. hese t%o methods lead to the same value for GD= for the reason %e discussed in the previous chapterD Every payment !expenditure" y a uyer is at the same time a receipt !income" for the seller. ,e can measure either income received or e1penditures made, and %e %ill end up %ith the same total output. #uppose the economy is made up of &ust one firm and the firm<s total output this year sells for E1 million. 'ecause the total amount spent on output this year is E1 million, this year<s GD= is E1 million. 4CememberD he e1penditure approach calculates GD= on the basis of the total amount spent on final goods and services in the economy.5 7o%ever, every one of the million dollars of GD= is either paid to someone or remains %ith the o%ners of the firm as profit. "sing the income approach, %e add up the %ages paid to employees of the firm, the interest paid to those %ho lent money to the firm, and the rents paid to those %ho leased land, buildings, or e2uipment to the firm. ,hat is left over is profit, %hich is, of course, income to the o%ners of the firm. (f %e add up the incomes of all the factors of production, including profits to the o%ners, %e get a GD= of E1 million. THE E6PENDIT#RE APPROACH Cecall from the previous chapter the four main groups in the economyD households, firms, the government, and the rest of the %orld. here are also four main categories of e1penditureD E1penditure >ategoriesD

=ersonal consumption e1penditures 4#5Ahousehold spending on consumer goods Gross private domestic investment 4I5Aspending by firms and households on ne% capitalD plant, e2uipment, inventory, and ne% residential structures Government consumption and gross investment 4G5 Fet e1ports 4E$ K IM5Anet spending by the rest of the %orld, or e1ports 4E$5 minus imports 4IM5

he e1penditure approach calculates GD= by adding together these four components of spending. (n e2uation formD GD= J # B I B G B 4E$ K IM5 ".#. GD= %as E10,!0).; billion in !001. he four components of the e1penditure approach are sho%n in able ;.!, along %ith their various categories. Personal Cons!m2tion E82endit!res 9C: 6 large part of GD= consists of personal consumption e1penditures 4#5. able ;.! sho%s that in !001 the amount of personal consumption e1penditures accounted for ;9.! percent of GD=. hese are e1penditures by consumers on goods and services.
Ta%le &.2 Com#onents of ( P- 2..1/ The 01#en!iture A##roach

BILLIONS OF DOLLARS Total gross domestic product %ersonal consumption expenditures 4#5 Durable goods Fondurable goods #ervices Gross private domestic investment !I5 Fonresidential Cesidential >hange in business inventories Government consumption and gross investment 4G 5 0ederal #tate and local &et exports 4E$ / IM5 E1ports 4E$5 (mports 4IM5
Note: Numbers may not add exactly because of rounding . Source: (.). *epartment of %ommerce, +ureau of ,conomic #nalysis.

PERCENTAGE OF GDP 100.0 ;9.! @.!0.1 -0.* 1;.0 1!.! -./0.; 1@.0 ;.0 1!.0 /3.! 10.3 13.)

10,!0).; *,0;3.) @)@.! !,0)).0 -,1)0.! 1,;3-.0 1,!-;.; --;.1 /)@.; 1,@39.3 ;1).* 1,!!3.; /331.! 1,0-9.1,3@0.*

here are three main categories of consumer e1pendituresD durable goods, nondurable goods, and services. Durable goods, such as automobiles, furniture, and household appliances, last a relatively long time. Fondurable goods, such as food, clothing, gasoline, and cigarettes, are used up fairly

2uickly. =ayments for servicesAthose things that %e buy that do not involve the production of physical itemsAinclude e1penditures for doctors, la%yers, and educational institutions. Gross Pri ate Domestic In estment 9I: Investment, as %e use the term in economics, refers to the purchase of ne% capitalAhousing, plants, e2uipment, and inventory. he economic use of the term is in contrast to its everyday use, %here investment often refers to purchases of stocks, bonds, or mutual funds. otal investment in capital by the private sector is called gross private domestic investment 4I5. E1penditures by firms for machines, tools, plants, and so forth make up nonresidential investment.1 'ecause these are goods that firms buy for their o%n final use, they are part of .final sales. and counted in GD=. E1penditures for ne% houses and apartment buildings constitute residential investment. he third component of gross private investment, the change in business inventories, is the amount by %hich firms< inventories change during a period. 'usiness inventories can be looked at as the goods that firms produce no% but intend to sell later.

Cha !e " Bu#" e## I ve to$"e#

(t is sometimes confusing to students that inventories are counted as capital and that changes in inventory are counted as investment, but conceptually it makes sense. he inventory a firm o%ns has a value, and it serves a purpose, or provides a service, to the firm. hat it has value is obvious. hink of the inventory of a ne% car dealer or of a clothing store, or stocks of ne%ly produced but unsold computers a%aiting shipment. 6ll these have value. 7o%ever, %hat service does inventory provideG 0irms keep stocks of inventory for a number of reasons. +ne is to meet unforeseen demand. 0irms are never sure ho% much they %ill sell from period to period. #ales go up and do%n. o maintain the good%ill of their customers, firms need to be able to respond to unforeseen increases in sales. he only %ay to do that is %ith inventory. #ome firms use inventory to provide direct services to customersAthe main function of a retail store. 6 grocery store provides a serviceAconvenience. he store itself does not produce any food at all. (t simply assembles a %ide variety of items and puts them on display so consumers %ith varying tastes can come and shop in one place for %hat they %ant. he same is true for a clothing or hard%are store. o provide their services, such stores need light fi1tures, counters, cash registers, buildings, and lots of inventory. >apital stocks are made up of plant, e2uipment, and inventory3 inventory accumulations are part of the change in capital stocks, or investment. Cemember that GD= is not the market value of total final sales during a periodAit is the market value of total production. he relationship bet%een total production and total sales isD GD= J final sales B GD= K change in business inventories otal production 4GD=5 e2uals final sales of domestic goods plus the change in business inventories..

G$o## I ve#t%e t ve$#u# Net I ve#t%e t

During the process of production, capital 4especially machinery and e2uipment5 produced in previous periods gradually %ears out. GD= does not give us a true picture of the real production of an economy. GD= includes ne%ly produced capital goods but does not take account of capital goods .consumed. in the production process. >apital assets decline in value over time. he amount an asset<s value falls each period is called its depreciation.! 6 personal computer purchased by a business today may be e1pected to have a useful life of - years before becoming %orn out or obsolete. +ver that period, the computer steadily depreciates. ,hat is the relationship bet%een gross investment 4I5 and depreciationG Gross investment is the total value of all ne%ly produced capital goods 4plant, e2uipment, housing, and inventory5 produced in a given period. (t takes no account of the fact that some capital %ears out and must be replaced. Fet investment is e2ual to gross investment minus depreciation. Fet investment is a measure of ho% much the stock of capital changes during a period. =ositive net investment means that the amount of ne% capital produced e1ceeds the amount that %ears out, and negative net investment means that the amount of ne% capital produced is less than the amount that %ears out. herefore, if net investment is positive, the capital stock has increased, and if net investment is negative, the capital stock has decreased. =ut another %ay, the capital stock at the end of a period is e2ual to the capital stock that e1isted at the beginning of the period plus net investmentD capitalend of period J capitalbeginning of period B net investment Go ernment Cons!m2tion and Gross In estment 9G: Government consumption and gross investment 4G5 include e1penditures by federal, state, and local governments for final goods 4bombs, pencils, school buildings5 and services 4military salaries, congressional salaries, school teachers< salaries5. #ome of these e1penditures are counted as government consumption and some are counted as government gross investment. Government transfer payments 4#ocial #ecurity benefits, veterans< disability stipends, etc.5 are not included in G because these transfers are not purchases of anything currently produced. he payments are not made in e1change for any goods or services. 'ecause interest payments on the government debt are also counted as transfers, they are also e1cluded from GD= on the grounds that they are not payments for current goods or services. . Net E82orts 9EX ; IM: he value of net e1ports 4E$ K IM5 is the difference bet%een exports 4sales to foreigners of (ndian./ produced goods and services5 and imports 4(ndian purchases of goods and services from abroad5. his figure can be positive or negative. he reason for including net e1ports in the definition of GD= is simple. >onsumption, investment, and government spending 4#, I, and G5 include e1penditures on goods produced both domestically and by foreigners. herefore, # B I B G overstates domestic production because it contains e1penditures on foreign/produced goodsAthat is, imports 4IM5, %hich have to be subtracted out of GD= to obtain the correct figure. 6t the same time, # B IB G understates domestic production because some of %hat a nation produces is sold abroad and therefore not included in #, I, or GAe1ports 4E$5 have to be added

in. (f an (ndian firm produces computers and sells them in Germany, the computers are part of (ndian production and should be counted as part of (ndian GD=.

Ta3e a moment to a22ly <hat yo!= e learned$

THE INCOME APPROACH able ;.3 presents the income approach to calculating GD=, %hich looks at GD= in terms of %ho receives it as income, not %ho purchases it.
Ta%le &.3 Com#onents of ( P- 2..1/ The 2ncome A##roach

BILLIONS OF DOLLARS Gross domestic product Fational income >ompensation of employees =roprietors< income >orporate profits Fet interest Cental income Depreciation (ndirect ta1es minus subsidies Fet factor payments to the rest of the %orld +ther
Source: )ee Ta le -...

PERCENTAGE OF GDP 100.0 @0.3 )@.9 *.3 *.3 ).1.13.! *.! 0.1 /0.9

10,!0).; @,199.9 ;,010.0 9-3.) *-@.9 ))-.@ 1-!.* 1,3)1.3 *39.11.1 /9;.1

he income approach to GD= breaks do%n GD= into four componentsD national income, depreciation, indirect ta1es minus subsidies, and net factor payments to the rest of the %orldD GD= J national income B depreciation B 4indirect ta1es K subsidies5 B net factor payments to the rest of the %orld B other 6s %e e1amine each, keep in mind that total e1penditures al%ays e2ual total income. National Income

Fational income is the total income earned by factors of production o%ned by a country<s citi?ens. able ;.3 sho%s that national income is the sum of five itemsD 415 compensation of employees, 4!5 proprietors< income, 435 corporate profits, 4-5 net interest, and 4)5 rental income. >ompensation of employees, the largest of the five items by far, includes %ages and salaries paid to households by firms and by the government, as %ell as various supplements to %ages and salaries such as contributions that employers make to social insurance and private pension funds. =roprietors< income is the income of unincorporated businesses, and corporate profits are the income of corporate businesses. Fet interest is the interest paid by business. 4(nterest paid by households and by the government is not counted in GD= because it is not assumed to flo% from the production of goods and services.5 Cental income, a minor item, is the income received by property o%ners in the form of rent. De2reciation Cecall from our discussion of net versus gross investment that %hen capital assets %ear out or become obsolete, they decline in value. he measure of that decrease in value is called depreciation. his depreciation is a part of GD= in the income approach. (t may seem odd that %e add depreciation to national income %hen %e calculate GD= by the income approach. o see %hy depreciation is added, let us go back to the e1ample earlier in this chapter in %hich the economy is made up of &ust one firm and total output 4GD=5 for the year is E1 million. 6ssume that after the firm pays %ages, interest, and rent, it has left E100,000. 6ssume also that its capital stock depreciated by E-0,000 during the year. Fational income includes corporate profits, and in calculating corporate profits the E-0,000 depreciation is subtracted from the E100,000, leaving profits of only E;0,000. ,hen %e calculate GD= using the e1penditure approach, depreciation is not subtracted. ,e simply add consumption, investment, government spending, and net e1ports. (n our simple e1ample, this is &ust E1 million. ,hen %e calculate GD= using the income approach, %e must add depreciation because it has been subtracted from the amount that corporations actually receive 4the full E100,0005. his is necessary to balance the income and e1penditure sides. (n other %ords, national income as defined in able ;.3 includes corporate profits after depreciation has been deducted, and so depreciation must be added back. Indirect Ta8es Min!s S!4sidies (n calculating final sales on the e1penditures side, indirect ta1esAsales ta1es, customs duties, and license fees, for e1ampleAare included. 'ecause these ta1es are counted on the e1penditure side, they must also be counted on the income side. o see %hy indirect ta1es are added, let us again go back to the e1ample of the one firm economy, %here total output is E1 million. (f the sales ta1 rate %ere, say, * percent, total sales ta1es %ould be E*0,000. hese ta1es %ould go to the government, and so the firm %ould receive only E930,000, to be allocated to %ages, interest, rent, profits, and depreciation. herefore, to measure total income, %e must add to these items the sales ta1es of E*0,000. #ubsidies are payments made by the government for %hich it receives no goods or services in return. hese subsidies are subtracted from national income to get GD=. 4Cemember, GD= is indirect ta1es minus subsidies.5 0or e1ample, farmers receive substantial subsidies from the government. #ubsidy payments to farmers are income to farm proprietors and are thus part of national income, but they do not come from the sale of agricultural products, so are not part of GD=. o balance the e1penditure side %ith the income side, these subsidies must be subtracted on the income side. Net %actor Payments to the Rest of the 0orld

Fet factor payments to the rest of the %orld e2ual the payments of factor income 4income to the factors of production5 to the rest of the %orld minus the receipts of factor income from the rest of the %orld. his item is added for the follo%ing reason. Fational income is defined as the income of factors of production owned by the country. GD=, ho%ever, is output produced by factors of production located within the country. (n other %ords, national income includes some income that should not be counted in GD=Anamely, the income a country<s citi?ens earn abroadAand this income must be subtracted. (n addition, national income does not include some income that is counted in GD= Anamely, the foreigners< income in the country %hose GD= %e are calculatingAand this income must be added. Other (n able ;.3, .other. includes business transfer payments and the statistical discrepancy. 'usiness transfer payments are deducted from corporate profits and are not included as income else%here. herefore, they need to be included to get total income. he statistical discrepancy ad&usts for errors in the data collection. Gross Domestic Prod!ct 6s you can see in able ;.3, ".#. GD= as calculated by the income approach %as E10,!0).; billion in !001Athe same amount that %e calculated using the e1penditure approach.

%rom GDP to Dis2osa4le Personal Income

6lthough GD= is the most important item in national income accounting, other concepts are also useful to kno%. #ome are presented in able ;.-. he top of the table sho%s ho% GF= is calculated from GD=. Cemember that a country<s GD= is total production by factors of production located %ithin that country, %hile its GF= is total production by factors of production o%ned by that country. (f %e take (ndian GD=, add to it factor income earned by (ndian citi?ens from the rest of the %orld 4receipts of factor income from the rest of the %orld5, and subtract from it factor income earned in (ndia by foreigners 4payments of factor income to the rest of the %orld5, %e get GF=.
Ta%le &.3 ( P- (+P- ++P- +ational 2ncome- Personal 2ncome- an! 2ncome- 2..1 is#osa%le Personal

GD= =lusD receipts of factor income from the rest of the %orld IessD payments of factor income to the rest of the %orld E2ualsD GF= IessD depreciation E2ualsD net national product 4FF=5 IessD indirect ta1es minus subsidies plus other E2ualsD national income IessD corporate profits minus dividends IessD social insurance payments =lusD personal interest income received from the government and consumers =lusD transfer payments to persons E2ualsD personal income IessD personal ta1es

DOLLARS &BILLIONS' 10,!0).; B3-!.1 /3)3.! 10,19-.) /1,3)1.3 @,@-3.! /;-3.3 @,199.9 /33!.; /*31.! B-39.1 1,1-@.* @,*!3.9 /1,30;.!

E2ualsD disposable personal income

Source/ )ee Ta le -...

*,-1*.*

0rom GF=, %e can calculate net national product 4FF=5. Cecall that the e1penditure approach to GD= includes gross investment as one of the components of GD= 4and of GF=5. Gross domestic product does not account for the fact that some of the nation<s capital stock is used up in the process of producing the nation<s product. FF= is GF= minus depreciation. (n a sense, it is a nation<s total product minus 4or .net of.5 %hat is re2uired to maintain the value of its capital stock. 'ecause GD= does not take into account any depreciation of the capital stock that may have occurred, FF= is sometimes a better measure of ho% the economy is doing than is GD=. o calculate national income, %e subtract indirect ta1es minus subsidies from FF= 4subtract indirect business ta1es and add subsidies5. ,e subtract indirect ta1es because they are included in FF= but do not represent payments to factors of production and are not part of national income. ,e add subsidies because they are payments to factors of production but are not included in FF=. =ersonal income is the total income of households. o calculate personal income from national income, t%o items are subtractedD 415 corporate profits minus dividends, and 4!5 social insurance payments. 'oth need e1planation. 0irst, some corporate profits are paid to households in the form of dividends, and dividends are part of personal income. he profits that remain after dividends are paid Acorporate profits minus dividendsAare not paid to households as income. herefore, corporate profits minus dividends must be subtracted from national income %hen computing personal income. #econd, social insurance payments are payments made to the government, some by firms and some by employees. 'ecause these payments are not received by households, they must be subtracted from national income %hen computing personal income. %o items must be added to national income to calculate personal incomeD 415 personal interest income received from the government and consumers, and 4!5 transfer payments to persons. 6s %e have pointed out, interest payments made by the government and consumers 4households5 are not counted in GD= and not reflected in national income figures.3 7o%ever, these payments are income received by households, so they must be added to national income %hen computing personal income. 7ouseholds can pay and receive interest. 6s a group, households receive more interest than they pay. #imilarly, transfer payments to persons are not counted in GD= because they do not represent the production of any goods or services. #ocial #ecurity checks and other cash benefits are income received by households and must also be added to national income %hen computing personal income. =ersonal income is the income received by households before paying personal income ta1es but after paying social insurance contributions. he amount of income that households have to spend or save is called disposable personal income, or after/ta1 income. (t is e2ual to personal income minus personal ta1es. 'ecause disposable personal income is the amount of income that households can spend or save, it is an important income concept. able ;.) sho%s there are three categories of spendingD 415 personal consumption e1penditures, 4!5 interest paid by consumers to business, and 435 personal transfer payments to foreigners. he amount of disposable personal income left after total personal spending is personal saving. (f your monthly disposable income is E)00 and you spend E-)0, you have E)0 left at the end of the month. Lour personal saving is E)0 for the month. Lour personal saving level can be negativeD (f you earn E)00 and spend E;00 during the month, you have dissaved E100. o spend E100 more than you earn, you %ill either have to borro% the E100 from someone, take the E100 from your savings account, or sell an asset you o%n.

Ta%le &.5

is#osa%le Personal 2ncome an! Personal "a$ing- 2..1

DOLLARS &BILLIONS' Disposable personal income IessD =ersonal consumption e1penditures (nterest paid by consumers to business =ersonal transfer payments to foreigners E2ualsD personal saving =ersonal saving as a percentage of disposable personal incomeD
Source: )ee Ta le -...

*,-1*.*

/*,0;3.) /!0-.3 /31.3 11@.; 1.;M

he personal saving rate is the percentage of disposable personal income saved, an important indicator of household behavior. 6 lo% saving rate means households are spending a large amount of their income. 6 high saving rate means households are cautious in their spending. #aving rates tend to rise during recessionary periods, %hen consumers become an1ious about their future, and fall during boom times, as pent/up spending demand gets released.

Nominal 5ers!s Real GDP

#o far, %e have looked at GD= measured in current dollars, or the current prices %e pay for things. ,hen a variable is measured in current dollars, it is described in nominal terms. Fominal GD= is GD= measured in current dollarsAall components of GD= valued at their current prices. (n many applications of macroeconomics, nominal GD= is not a very desirable measure of production. ,hyG 6ssume there is only one goodAsay, pi??a. (n each year 1 and !, 100 units 4slices5 of pi??a %ere produced. =roduction thus remained the same for year 1 and year !. #uppose the price of pi??a increased from E1.00 per slice in year 1 to E1.10 per slice in year !. Fominal GD= in year 1 is E100 4100 units N E1.00 per unit5, and nominal GD= in year ! is E110 4100 units N E1.10 per unit5. Fominal GD= has increased by E10, even though no more slices of pi??a %ere produced. (f %e use nominal GD= to measure gro%th, %e can be misled into thinking production has gro%n %hen all that has really happened is a rise in the price level. (f there %ere only one good in the economyAlike pi??aAit %ould be easy to measure production and compare one year<s value to another<s. ,e %ould add up all the pi??a slices produced each year. (n the e1ample, production is 100 in both years. (f the number of slices had increased to 10) in year !, %e %ould say production increased by five slices bet%een year 1 and year !, %hich is a ) percent increase. 6las, ho%ever, there is more than one good in the economy. he follo%ing is a discussion of ho% the 'E6 ad&usts nominal GD= for price changes. 6s you read the discussion, keep in mind that this ad&ustment is not easy. Even in an economy of &ust apples and oranges, it %ould not be obvious ho% to add up apples and oranges to get an overall measure of output. he 'E6<s task is to add up thousands of goods, each of %hose price is changing over time.

(n the follo%ing, %e %ill use the concept of a %eight, either price %eights or 2uantity %eights. ,hat is a %eightG (t is easiest to define the term by an e1ample. #uppose in your economics course there is a final e1am and t%o other tests. (f the final e1am counts for one/half of the grade and the other t%o tests for one/fourth each, the .%eights. are one/half, one/fourth, and one/fourth. (f instead the final e1am counts for @0 percent of the grade and the other t%o tests for 10 percent each, the %eights are .@, .1, and .1. he more important an item is in a group, the larger its %eight. CA/C#/ATING REA/ GDP Fominal GD= ad&usted for price changes is called real G'%. 6ll the main issues involved in computing real GD= can be discussed using a simple three/good economy and ! years. able ;.; presents all the data that %e %ill need. he table presents price and 2uantity data for ! years and three goods. he goods are labeled (, ), and #, and the years are labeled 1 and !. % denotes price, and * denotes 2uantity.
Ta%le &.& A Three4(oo! 0conomy

&1'

&('

&)'

&*'

&+'

&,'

&-'

&.'

PRODUCTION /EAR 1 Q1 Good ( Good ) Good # Total ; * 10 /EAR ( Q( 11 1!

PRICE PER UNIT /EAR 1 P1 E .)0 .30 .*0

GDP IN GDP IN GDP IN GDP IN /EAR 1 /EAR ( /EAR 1 /EAR ( IN IN IN IN /EAR 1 /EAR 1 /EAR ( /EAR (

/EAR PRICES PRICES PRICES PRICES ( P( E .-0 1.00 .90 P1 N Q1 E3.00 !.10 *.00 $1(.10 Fominal GD= in year 1 P1 N Q( E).)0 1.!0 @.-0 $1+.10 P( N Q1 E!.-0 *.00 9.00 $1..*0 P( N Q( E -.-0 -.00 10.@0 $10.(0 Fominal GD= in year !

he first thing to note from able ;.; is that nominal outputAin current dollarsAin year 1 for good ( is the price of good ( in year 1 4E.)05 times the number of units of good ( produced in year 1 4;5, %hich is E3.00. #imilarly, nominal output in year 1 is * N E.30 J E!.10 for good ) and 10 N E.*0 J E*.00 for good #. he sum of these three amounts, E1!.10 in column ), is nominal GD= in year 1 in this simple economy. Fominal GD= in year !Acalculated by using the year ! 2uantities and the year ! pricesAis E19.!0 4column @5. Fominal GD= has risen from E1!.10 in year 1 to E19.!0 in year !, an increase of )@.* percent.Lou can see that the price of each good changed bet%een year 1 and year !Athe price of good ( fell 4from E.)0 to E.-05 and the prices of goods ) and # rose 4) from E.30 to E1.003 # from E.*0 to E.905. #ome of the change in nominal GD= bet%een years 1 and ! is due to price changes and not production changes. 7o% much can %e attribute to price changes and ho% much to production changesG 7ere, things get tricky. he procedure that the 'E6 used prior to 199; %as to pick a base year and use the prices in that base year as %eights to calculate real GD=. his is a fi1ed/%eight procedure because the

%eights used, %hich are the prices, are the same for all yearsAnamely, the prices that prevailed in the base year. Iet us use the fi1ed/%eight procedure and year 1 as the base year, %hich means using year 1 prices as the %eights. hen in able ;.;, real GD= in year 1 is E1!.10 4column )5, and real GD= in year ! is E1).10 4column ;5. Fote that both columns use year 1 prices, and that nominal and real GD= are the same in year 1 because year 1 is the base year. Ceal GD= has increased from E1!.10 to E1).10, an increase of !-.@ percent. Iet us no% use the fi1ed/%eight procedure and year ! as the base year, %hich means using year ! prices as the %eights. (n able ;.;, real GD= in year 1 is E1@.-0 4column *5, and real GD= in year ! is E19.!0 4column @5. Fote that both columns use year ! prices, and nominal and real GD= are the same in year ! because year ! is the base year. Ceal GD= has increased from E1@.-0 to E19.!0, an increase of -.3 percent. his e1ample sho%s that gro%th rates can be sensitive to the choice of the base yearA!-.@ percent using year 1 prices as %eights and -.3 percent using year ! prices as %eights. he old 'E6 procedure simply picked one year as the base year and did all the calculations using the prices in that year as %eights. he ne% procedure makes t%o important changes. he first 4using the current e1ample5 is to .split the difference. bet%een !-.@ percent and -.3 percent. ,hat does .splitting the difference. meanG +ne %ay %ould be to take the average of the t%o numbers, %hich is 1-.)) percent. ,hat the 'E6 does is to take the geometric average, %hich for the current e1ample is 1-.09 percent.) hese t%o averages 41-.)) percent and 1-.09 percent5 are 2uite close, and the use of either %ould give similar results. he point here is not that the geometric average is used, but that the first change is to split the difference using some average. Fote that this ne% procedure re2uires t%o .base. years, because !-.@ percent %as computed using year 1 prices as %eights and -.3 percent %as computed using year ! prices as %eights. he second 'E6 change is to use years 1 and ! as the base years %hen computing the percentage change bet%een years 1 and !, then use years ! and 3 as the base years %hen computing the percentage change bet%een years ! and 3, and so on. he t%o base years change as the calculations move through time. he series of percentage changes computed in this %ay is taken to be the series of gro%th rates of real GD=, and so in this %ay nominal GD= is ad&usted for price changes. o make sure you understand this, revie% the calculations in able ;.;3 all the data you need to see %hat is going on are in this table.

CA/C#/ATING THE GDP PRICE INDE6 ,e no% s%itch gears from real GD=, a 2uantity measure, to the GD= price inde1, a price measure. +ne of economic policy makers< goals is to keep changes in the overall price level small. 0or this reason policy makers need not only good measures of ho% real output is changing but also good measures of ho% the overall price level is changing. he GD= price inde1 is one measure of the overall price level. ,e can use the data in able ;.; to sho% ho% the GD= price inde1 is computed by the 'E6. (n able ;.;, the price of good ( fell from E.)0 in year 1 to E.-0 in year !3 the price of good ) rose from E.30 to E1.003 and the price of good # rose from E.*0 to E.90. (f %e %ere interested only in ho% individual prices change, this is all the information %e %ould need. 7o%ever, if %e are interested in

ho% the overall price level changes, %e need to %eight the individual prices in some %ay. he obvious %eights to use are the 2uantities produced, but %hich 2uantitiesAthose of year 1 or of year !G he same issues arise here for the 2uantity %eights as for the price %eights in computing real GD=. Iet us first use the fi1ed/%eight procedure and year 1 as the base year, %hich means using year 1 2uantities as the %eights. hen in able ;.;, the .bundle. price in year 1 is E1!.10 4column )5, and the bundle price in year ! is E1@.-0 4column *5. 'oth columns use year 1 2uantities. he bundle price has increased from E1!.10 to E1@.-0, an increase of )!.1 percent. Fe1t use the fi1ed/%eight procedure and year ! as the base year, %hich means using year ! 2uantities as the %eights. hen the bundle price in year 1 is E1).10 4column ;5, and the bundle price in year ! is E19.!0 4column @5. 'oth columns use year ! 2uantities. he bundle price has increased from E1).10 to E19.!0, an increase of !*.! percent. his e1ample sho%s that overall price increases can be sensitive to the choice of the base yearA)!.1 percent using year 1 2uantities as %eights and !*.! percent using year ! 2uantities as %eights. 6gain, the old 'E6 procedure simply picked one year as the base year and did all the calculations using the 2uantities in the base year as %eights. he ne% procedure first splits the difference bet%een )!.1 percent and !*.! percent by taking the geometric average, %hich is 39.1 percent. #econd, it uses years 1 and ! as the base years %hen computing the percentage change bet%een years 1 and !, years ! and 3 as the base years %hen computing the percentage change bet%een years ! and 3, and so on. he series of percentage changes computed in this %ay is taken to be the series of percentage changes in the GD= price inde1, that is, a series of inflation rates of the overall price level.

/imitations of the GDP Conce2t

,e generally think of increases in GD= as good. (ncreasing GD= 4or preventing its decrease5 is usually considered one of the chief goals of the government<s macroeconomic policy. 'ecause some serious problems arise %hen %e try to use GD= as a measure of happiness or %ell/being, %e no% point out some of the limitations of the GD= concept as a measure of %elfare. GDP AND SOCIA/ 0E/%ARE (f crime levels %ent do%n, society %ould be better off, but a decrease in crime is not an increase in output and is not reflected in GD=. Feither is an increase in leisure time. Let, to the e1tent that households desire e1tra leisure time 4instead of having it forced on them by a lack of &obs in the economy5, an increase in leisure is also an increase in social %elfare. 0urthermore, some increases in social %elfare are associated %ith a decrease in GD=. 6n increase in leisure during a time of full employment, for e1ample, leads to a decrease in GD= because less time is spent on producing output. 9ost nonmarket and domestic activities, such as house%ork and child care, are not counted in GD= even though they amount to real production. 7o%ever, if ( decide to send my children to day care or hire someone to clean my house or to drive my car for me, GD= increases. he salaries of day/care staff, cleaning people, and chauffeurs are counted in GD=, but the time ( spend doing the same things is not counted. 6 mere change of institutional arrangements, even though no more output is being produced, can sho% up as a change in GD=. 0urthermore, GD= seldom reflects losses or social ills. GD= accounting rules do not ad&ust for production that pollutes the environment. he more production there is, the larger is GD=, regardless of ho% much pollution results in the process.

GD= also has nothing to say about the distribution of output among individuals in a society. (t does not distinguish, for e1ample, bet%een the case in %hich most output goes to a fe% people and the case in %hich output is evenly divided among all people. ,e cannot use GD= to measure the effects of redistributive policies 4%hich take income from some people and give income to others5. #uch policies have no direct impact on GD=. GD= is also neutral about the kinds of goods an economy produces. #ymphony performances, handguns, cigarettes, professional football games, 'ibles, soda pop, milk, economics te1tbooks, and comic books all get counted. (n spite of these limitations, GD= is a highly useful measure of economic activity and %ell/being. (f you doubt this, ans%er this simple 2uestionD ,ould you rather live in the "nited #tates of !00 years ago, %hen rivers %ere less polluted and crime rates %ere probably lo%er, or in the "nited #tates of todayG 9ost people say they prefer the present. Even %ith all the .negatives,. GD= per person and the average standard of living are much higher today than !00 years ago. THE #NDERGRO#ND ECONOM" 9any transactions are missed in the calculation of GD=, even though in principle they should be counted. 9ost illegal transactions are missed unless they are .laundered. into legitimate business. (ncome that is earned but not reported as income for ta1 purposes is usually missed, although some ad&ustments are made in the GD= calculations to take misreported income into account. he part of the economy that should be counted in GD= but is not is sometimes called the underground economy. a1 evasion is usually thought to be the ma&or incentive for people to participate in the underground economy. #tudies estimate the si?e of the ".#. underground economy ranging from ) percent to 30 percent of GD=,; comparable to the si?e of the underground economy in most European countries and probably much smaller than the si?e of the underground economy in the Eastern European countries. Estimates of (taly<s underground economy range from 10 percent to 3) percent of (talian GD=. 6t the lo%er end of the scale, estimates for #%it?erland range from 3 percent to ) percent. ,hy should %e care about the underground economyG o the e1tent that GD= reflects only a part of economic activity instead of a complete measure of %hat the economy produces, it is misleading. "nemployment rates, for e1ample, may be lo%er than officially measured if people %ork in the underground economy %ithout reporting this fact to the government. 6lso, if the si?e of the underground economy varies bet%een countriesAas it doesA%e can be misled %hen %e compare GD= bet%een countries. 0or e1ample, (taly<s GD= %ould be much higher if %e considered its underground sector as part of the economy, %hile #%it?erland<s GD= %ould change very little. PER CAPITA GDP>GNP GD= and GF= are sometimes measured in per capita terms. =er capita GD= or GF= is a country<s GD= or GF= divided by its population. (t is a better measure of %ell/being for the average person than is total GD= or GF=. able ;.* lists the per capita GF= of various countries for 199@. #%it?erland has the highest per capita GF=, follo%ed by For%ay and Denmark. ".#. per capita GF= %as E!9,3-0. Ethiopia %as estimated to have a per capita GF= of only E100 in 199@.

The A''re'ate Prod!ction %!nction for the Economy

+ne of the most e1tremely simplified assumptions in macroeconomics is the aggregate production function. 6s a reminder, a function is &ust a convenient %ay to describe the relationship bet%een variables. he aggregate production function e1plains the relationship of the total inputs used

throughout the economy to the total level of production in the economy or GD=. ,e assume that there are only t%o factors of productionD capital and labor. he stock of capital comprises all the machines, e2uipment, and buildings in the entire economy. Iabor consists of the efforts of all the %orkers in the economy. ,e %rite the aggregate production function as + J ,4-, .5 %here + is total output, or GD=, - is the stock of capital, and . is the labor force. ,hat the math says in %ords is that total output is produced from both capital and labor. he aggregate production function ,4-,.5 tells us ho% much output is produced from the inputs to production, - and .. 9ore inputs of either capital or labor lead to increased output. he stock of capital that a society has at any point in time is given to us by its past investments in ne% plants and e2uipment. (nvestments taken today %ill have no or little immediate effect on the total stock of machines, e2uipment, and buildings in e1istence today. (t takes time for investment to change the stock of capital. (n this chapter, most of our discussion %ill assume that the stock of capital is fi1ed at a constant level, %hich %e call -O. 'ut there %ill be a fe% places %here %e %ill stray from that assumption to consider %hat happens %hen there are changes in the stock of capital. ,e promise to let you kno% %here %e are straying from the assumption of fi1ed capital. ,ith the stock of capital fi1ed at the constant level -O, only variations in the amount of labor can change the level of output in the economy. 0igure *.1 plots the relationship bet%een the amount of labor used in an economy and the total level of output %ith a fi1ed stock of capital. 'ecause the amount of labor can be changed over a short period, resulting in a corresponding change in output, also %ithin a short time, this diagram is called the short/run production function.

Figure 5.1

6elationshi# Between 7a%or an! 8ut#ut with Fi1e! Ca#ital

0ith capital fixed, output increases with la or input ut at a decreasing rate.

0igure *.1 sho%s that as labor inputs are increased from I1 to I!, output increases from L1 to L!. he relationship bet%een output and labor sho%n here reflects the principle of diminishing returns. =rinciple of Diminishing Ceturns

#uppose that output is produced %ith t%o or more inputs and that %e increase one input %hile holding the other inputs fi1ed. 'eyond some pointAcalled the point of diminishing returnsAoutput %ill increase at a decreasing rate. o e1plain %hat diminishing marginal returns means, look at the data in able *.1 from a typical production function. he table sho%s the amount of output that can be produced from different amounts of labor inputs %hile the stock of capital is held constant at some amount. 4,e donPt care %hat amount, as long as it is constant.5 0irst, notice that as the amount of labor increases, so does the amount of output produced. #econd, as output increases, it increases at a diminishing rate. 0or e1ample, as labor input increases from 3 to - labor units, output increases by ) output units, from 10 to 1) output units. 'ut as labor input increases from - to ) labor units, output only increases by output units, from 1) to 19 output units. he rate of output dropped from ) output units per additional unit of labor input to - output units per additional unit of labor input, and thatPs diminishing returns.
Ta%le 5.1 8ut#ut an! 7a%or 8ut#ut

+ 4+utput5 10 1) 19 !!

. 4Iabor (nput5 3 ) ;

,hat happens if the stock of capital increases, say, from -O to -OOG 0igure *.! sho%s that %hen the stock of capital increases, the entire short/run production function shifts up%ard. 6t any level of labor input, more output can be produced than before the stock of capital %as increased. 6s %e add more capital, %orkers become more productive and can produce more output. hatPs %hy the production function curve is higher for more capital. 0or e1ample, an office has five staff members %ho must share one copier. hey %ill inevitably %aste some time %aiting to use it. 6dding a copier %ill enable the staff to be more productive. he benefit of additional capital is a higher level of output from any level of labor input.

Figure 5.2

2ncrease in the "tock of Ca#ital

0hen capital increases from 12 to 122 the production function shifts up. #t any level of la or input, the level of output increases.

The Demand and S!22ly for /a4or

,ePve &ust seen that %ith the amount of capital fi1ed, the level of output in the economy %ill be determined e1clusively by the amount of labor employed. Fo% %ePll see ho% the amount of employment in an economy is determined by the demand and supply for labor. +n the basis of %hat you already kno% about supply and demand from >hapter -, you should be able to see %hat 0igure *.3 represents %ith respect to the demand and supply for labor for the entire economy. 0irms hire labor to produce output and make profits. he amount of labor they %ill hire depends on the real %ageD the %age rate paid to employees ad&usted for changes in prices. o understand the demand for labor, %e use the marginal principleD 9arginal =rinciple (ncrease the level of an activity if the marginal benefit e1ceeds its marginal cost, but reduce the level if the marginal cost e1ceeds the marginal benefit. (f possible, pick the level at %hich the marginal benefit e2uals the marginal cost.

Figure 5.3

eman! for an! "u##ly of 7a%or

he marginal benefit that a firm receives from hiring an additional %orker is the value of the e1tra output that results %hen that additional %orker is hired. he marginal cost of the %orker is the real %age a firm pays to hire the additional %orker. he firm %ill continue to hire additional %orkers as long as the marginal benefit from an additional %orker e1ceeds the marginal cost of the additional %orker. 0or e1ample, if the real %age is E!0 per hour, a firm %ill continue to hire additional %orkers as long as the marginal benefit from an additional hour of %ork e1ceeds E!0 and %ill continue hiring only until the marginal benefit from an additional hour e2uals E!0. (f the real %age falls, the marginal cost of labor falls. 6s the cost falls, the firm %ill again hire additional laborAagain, only until the marginal benefit again e2uals marginal cost. 0or e1ample, suppose the real %age is E!0 per hour and the marginal benefit from an e1tra hour of %ork is E!0. IetPs say the %age falls E10 per hour. hen, the marginal benefit to the firm %ill e1ceed the %age. he firm %ill respond by hiring more labor until the marginal benefit from hiring an additional %orker e2uals E10.

6s the real %age falls, firms %ill hire more labor. he labor demand curve in 0igure *.3 is therefore do%n%ard sloping. (n panel 6, %e see that as the real %age falls from E!0 to E10 per hour, the firm %ill increase the amount of its labor from )0 to 100 %orkers. he labor supply curve is based on the decisions of %orkers. hey must decide ho% many hours they %ant to %ork and ho% much leisure they %ant to en&oy. >hanges in %ages have t%o different effects on %orkersP decisions about those %ants. 0irst, an increase in the real %age %ill make %orking more attractive and raise the opportunity cost of not %orking. >alled the substitution effect, this increase leads %orkers to supply more hours of labor. his is called the substitution effect because %orkers %ant to substitute %ork for leisure. #econd, a higher %age raises a %orkerPs income for the amount of hours that he or she is currently %orking. 6s income rises, a %orker may choose to en&oy more leisure hours and %ork fe%er hours. his is kno%n as the income effect because as %orkers have more income, they can afford to have more leisure time. he substitution effect and the income effect %ork in opposite directions. (n principle, a higher %age could lead %orkers to supply either more or fe%er hours of %ork. (n our analysis, %e assume that the substitution effect dominates, so a higher %age rate %ill lead to increases in the supply of labor. (n panel ' of 0igure *.3 %e see that )0 people %ould like to %ork at E10 per hour, but E!0 per hour motivates 100 people to %ant to %ork. =anel > puts the demand and supply curves together. 6t a %age of E1) per hour, the amount of labor that firms %ant to hireA*) %orkersA%ill be e2ual to the number %ho %ant to %orkA*) %orkers. his is the labor market e2uilibriumD he 2uantity demanded for labor e2uals the 2uantity supplied. ogether, the demand and supply curves determine the level of employment in the economy and the level of real %ages. ,hen firms increase their capital stock, they find that the marginal benefit from hiring %orkers increases because each %orker becomes more productive %ith the additional capital. 0or e1ample, suppose that the marginal benefit of an additional hour of %ork is initially E1), and an increase in the supply of capital raises it to E!0. 0irms %ill %ant to hire additional %orkers at the e1isting %age until the marginal benefit again e2uals the marginal cost. 'ecause the demand for labor increases at any real %age, the labor demand curve shifts to the right. =anel 6 of 0igure *.- sho%s the effects of an increase in labor demand. he ne% market e2uilibrium moves from E to E<. Ceal %ages increase, and the amount of labor employed in the economy increases as %ell. 7aving more capital in the economy is beneficial for %orkers.

Figure 5.3

"hifts in

eman! an! "u##ly

,e also can analy?e the effect of an increase in the supply of labor that might come, for e1ample, from immigration. (f the population increases, %e %ould e1pect that more people %ould %ant to %ork at any given %age. his means that the labor supply curve %ould shift to the right. =anel ' of 0igure *.- sho%s that %ith an increase in the supply of labor, the labor market e2uilibrium moves from E to E<. Ceal %ages have fallen, and the amount of labor employed has increased. ,orkers %ho %ere employed before the increase in labor supply suffer because real %ages have fallenAall %ages, including theirs. ,e can no% see %hy currently employed %orkers might be reluctant to favor increased immigration. he additional supply of labor %ill tend to decrease real %ages. +ur model also e1plains %hy %orkers %ould like to see increases in the supply of machines and e2uipment as long as full employment can be maintained. he increased supply of capital increases labor demand and leads to higher real %ages.

/a4or Mar3et E?!ili4ri!m and %!ll Em2loyment

,e no% sho% e1actly ho% much output the economy can produce %hen it is operating at full employmentAa big ob&ective of this chapter. ,ePll put the short/run production function in a conte1t %ith the demand and supply for labor. ogether, they %ill give us a model that %ill help us to achieve our ob&ective as %ell as help us to understand ho% ta1es on employers affect the level of output. 0igure *.) brings the model of the labor market together %ith the short/run production function. =anel ' depicts e2uilibrium in the labor market, %hich %e sa% in 0igure *.3. he demand and supply for labor determine the real %age rate /O and identify the level of employment .O. =anel 6 plots the short/ run production function. ,ith the level of employment determined at .O in panel ', %e move up%ard to panel 6 and use that level of employment to determine the level of production is +O. 0ull/ employment output is the level of output that is produced %hen the labor market is in e2uilibrium. (t is also kno%n as potential output because a meaningful measure of an economyPs long/run productive potential %ill need to have the labor market in e2uilibrium. 7o% do economists typically measure the level of full employment output, or potential outputG hey start %ith an estimate of %hat the unemployment rate %ould be if cyclical unemployment %ere ?eroAthat is, if the only unemployment %ere due to frictional or structural factors. (n the "nited #tates, estimates of the natural rate in recent years have varied bet%een -.0M to ).)M. Economists then estimate ho% many %orkers %ill be employed and use the short/run production function to determine potential output.

Figure 5.5

etermining Full 0m#loyment 8ut#ut

3anel + determines the e4uili rium level of employment at L2 and the real wage rate at W2. Full employment output in panel # is Y2.

he level of potential output in an economy increases as the supply of labor increases or the stock of capital increases. 6n increase in the supply of labor, perhaps from more liberal immigration, %ould shift the labor supply curve to the right and lead to a higher level of employment in the economy. ,ith a higher level of employment, the level of full employment output %ill increase. 6n increase in the stock of capital %ill increase the demand for labor. 6s labor demand increases, the result %ill be higher %ages and increased employment. 7igher employment %ill again raise the level of full employment output. =otential output depends on both capital and labor. >onse2uently, differences in the 2uantity of labor supplied to the market %ill affect the level of potential output in a country.

The Classical Model in Historical Pers2ecti e

he term Qclassical modelR %as actually first used by 8ohn 9aynard :eynes in the 1930s to contrast his theory %ith the received %isdom of the time. >lassical economics refers to the body of %ork developed over time starting %ith 6dam #mith. +ther classical economistsA8ean 'aptiste #ay, David Cicardo, 8ohn #tuart 9ill, homas 9althus, and othersAdeveloped their %ork from appro1imately the late eighteenth and nineteenth century. SA"@S /A0

>lassical economics is often associated %ith #ayPs Ia%, the doctrine that Qsupply creates its o%n demand.R o understand #ayPs Ia%, recall from our discussion of GD= accounting in >hapter ) that production in an economy creates an e2uivalent amount of income. 0or e1ample, if GD= is E9 trillion, then production is E9 trillion and generates E9 trillion in income. he classical economists argued that the E9 trillion of production also created E9 trillion in demand for current goods and services. his meant that there could never be a shortage of demand for total goods and services in the economy. Demand %ould al%ays be sufficient to purchase the goods and services producedAthus, there never could be an e1cess supply of output in the economy. 'ut suppose that consumers, %ho earned income, decided to save their income rather than spend it. ,ouldnPt this increase in savings lead to a shortfall in the total demand for goods and servicesG >lassical economists argued that the increase in savings %ould eventually find its %ay to an e2uivalent increase in investment spending by firms. #avings by households gets channeled to investments by firms. he result %ould be that spending on consumption and investment together %ould be sufficient to purchase the goods and services produced in the economy. :eynes argued that there could be situations in %hich total demand fell short of total production in the economyAat least for e1tended periods of time. (n particular, if consumers increased their savings, there %as no guarantee that there %ould be a rise in investment spending to offset the decrease in consumption. 6nd, if total spending did fall short of total demand, the result could be a recession or depression. =roducers %ould find that they could not sell their goods and cut back on production, and output in the economy %ould conse2uently fall. KE"NESIAN AND C/ASSICA/ DE7ATES he debates bet%een :eynesian and classical economists continued for several decades after :eynes developed his theories. =rofessors Don =atinkin and 0ranco 9odigliani clarified the conditions for %hich the classical model %ould be true. (n particular, they studied the conditions under %hich there %ould be sufficient demand for goods and services %hen the economy %as at full employment. 'oth emphasi?ed that one of the necessary conditions for the classical model to be true %as that %ages and prices %ere fully fle1ibleAthat is, they ad&ust rapidly to changes in demand and supply. (f %ages and prices are not fully fle1ible, then :eynesPs vie% that demand could fall short of production is more likely to be true. 6s %e discuss in more detail in later chapters, over short periods of time, %ages and prices are not fully fle1ible, so the insights of :eynes are important. +ver longer periods of time, %ages and prices do ad&ust and the insights of the classical model are restored.

A22lications of the Classical Model

he classical model is used e1tensively in macroeconomics to analy?e a %ide range of issues. 9any politicians and economists have argued that high ta1 rates have hurt the ".#. economy and reduce the level of output and production. ,e %ill use the classical model to e1plore the logic of these claims. ,e %ill also see ho% the classical model can be used to e1plain booms and recessionsAfluctuations in output. his %ill allo% us to understand the fundamental idea of an influential school of economic thoughtD real business cycle theory. TA6ES AND POTENTIA/ O#TP#T

,e use the classical model in 0igure *.; to study the effects of a ta1 paid by employers for hiring labor, such as the ta1es they pay for %orkersP #ocial #ecurity. Economists use similar arguments to study a variety of ta1es, including personal and corporate income ta1es. 6 ta1 on labor %ill make labor more e1pensive and raise the marginal cost of hiring %orkers. 0or e1ample, letPs say that there is no ta1 on labor, and suddenly a 10M ta1 is imposed. 6n employer %ho had been paying E10 an hour for %orkers %ill no% find that labor costs E11 an hour. #ince the marginal cost of hiring %orkers has gone up but the marginal benefit has not changed, employers %ill respond by hiring fe%er %orkers at any given %age. (n panel 6 of 0igure *.;, the labor demand curve shifts to the left, reflecting the ta1 as the increased cost of labor. 6s the demand curve shifts to the left, the market e2uilibrium moves from E to E1. he result is lo%er real %ages and lo%er employment.

Figure 5.&

0ffects of 0m#loyment Ta1es

6s %e have &ust seen, higher ta1es lead to less employment. ,ith reduced employment, potential output in the economy %ill be reduced as the economy moves to a lo%er level of output on the short/ run production function. 7igher ta1es therefore lead to lo%er output. he si?e of the reduction in output depends critically on the slope of the labor supply curve. he slope of the labor supply curve indicates ho% sensitive labor supply is to changes in real %ages. =anel ' in 0igure *.; sho%s the effect of the same ta1 %ith a vertical labor supply curve. 6 vertical labor supply curve means that %orkers %ill supply the same amount of labor regardless of the %age. 0or e1ample, a single parent might %ork a full -0 hours a %eek regardless of the %age. 7is or her supply curve %ill be vertical. (f other %orkers in the economy put in the same hours regardless of the %age, the supply curve for labor in the economy %ill be vertical. (n panel ', %e see that %ith a vertical supply curve, the ta1 %ill reduce %ages but have no effect on employment and therefore no effect on output. his e1ample illustrates that ta1es can affect %ages and output. (n both cases, either output or %ages %ere lo%ered %hen the ta1 %as imposed. 7o%ever, the e1tent of the decline in output depends on the slope of the labor supply curve. o understand the effects of ta1es on output, %e need information about the slope of the labor supply curve. here have been many studies of labor supply. 9ost sho% that full/time %orkers do not change their hours %orked very much %hen %ages change. here is some evidence that part/time %orkers or second earners in a family are more sensitive to changes in %ages and do vary their labor supply %hen %ages change. 'ut the bulk of the evidence suggests that the supply curve for the economy as a %hole is close to vertical. his implies that it is more likely higher ta1es %ill reduce %ages and not have pronounced effects on output.

he entire area of ta1ation and economics is an active branch of economics research. Economists such as 9artin 0eldstein of 7arvard "niversity have studied ho% many different types of ta1es affect employment, savings, and production. Economists use models to try to measure these effects, &ust as %e did for the employment ta1. REA/ 7#SINESS C"C/E THEOR" 0luctuations in economic activity can result from a variety of causes. 7ere are some e1amplesD 6 developing country that is highly dependent on agriculture can lose its cash crop to a prolonged drought. 6ccording to economic historian #tanley Iebergott, the nineteenth century ".#. agricultural/ based economy %as devastated by grasshopper invasions in Forth Dakota in 1@*- to 1@*; and by the boll %eevil migration from 9e1ico to e1as in 1@9!. #harp increases in the price of oil can hurt economies that use oil in production, as %as the case throughout the %orld in both 19*3 and 19*9. ,ars can devastate entire regions of the %orld, and natural disasters, such as earth2uakes or floods, can cause sharp reductions in GD=. 9a&or shifts in technology can also cause economic fluctuations. >onsider some economic developments, starting %ith the early nineteenth century. here %ere large investments in te1tile mills and steam po%er. he birth of the steel industry and railroads dominated the last half of the century. 6t the end of the nineteenth century, ne% industries arose that %ere based on chemical manufacturing, electricity, and the automobile. (t is inconceivable that the vast change in technology that led to the creation of these ne% industries %ould not have profound effects on the economy, particularly because these changes in technology often came in short bursts. Economic fluctuations can also occur because a number of small shocks all hit the economy at the same time. 0or e1ample, a country that primarily produces tea might face a sudden shift of consumer preferences throughout the %orld to coffee. +r a series of small improvements to technology could cause output to rise among %orld%ide producers of tea. +ne school of economic thought, kno%n as real business cycle theory, emphasi?es that shocks to technology can have a big part in causing economic fluctuations. Ied by Ed%ard =rescott of the "niversity of 9innesota, real business cycle economists have developed ne% models that integrate shocks to technology into the classical model %e have been discussing. he idea behind real business cycle theory is simpleD >hanges in technology %ill usually change the level of full employment or potential output. 0or e1ample, if there is a significant technological improvement, it %ill enable the economy to increase the level of both actual and potential output. #imilarly, if there are adverse technological developments 4such as %ould occur if the (nternet %ere to crash, for e1ample5 or adverse shocks to the economy, output and potential output %ill fall. 0igure *.* gives a simple e1ample of ho% the real business cycle theory %orks. #uppose an adverse technological shock occurred, decreasing the demand for labor. he demand curve for labor %ould shift to the left, and the labor market e2uilibrium %ould move from E to E1. he result %ould be a lo%er level of employment and lo%er real %ages. otal GD= %ould fall both because employment %ould be lo% and because the economy %ould be less productive than before from the adverse technological shock.

Figure 5.5

0ffects of an A!$erse Technology "hock

#n adverse shoc" to the economy shifts the la or demand curve to the left and leads to lower wages, reduced employment, and reduced output.

he real business cycle school of thought has been influential %ith some academic economists but is generally vie%ed as controversial. >ritics of the real business cycle theory find it difficult to understand ho% many of the post/,orld ,ar (( recessions could be e1plained by adverse changes in technology. (n addition, it does not provide an e1planation of unemployment. (n the real business cycle model, the labor market is in e2uilibrium and the 2uantity demanded for labor e2uals the 2uantity supplied. 6t the e2uilibrium %age, the 2uantity of labor demanded e2uals the 2uantity of labor supplied, and everyone %ho seeks employment finds employment. =roponents of the real business cycle model counter that other types of economic models can be used to e1plain unemployment, but the real business cycle can still e1plain fluctuations in employment. #o far, real business cycle theory has not had an impact on current macroeconomic policy. 7o%ever, real business cycle theory is an active area of research, and its methods and approach, grounded in classical economics, influence professional research today.

The Di ision of O!t2!t Amon' Com2etin' Demands

+ur model of full employment is based entirely on the supply of factors of production. he demand for and supply of labor determine the real %age and total employment in the economy. ogether, labor and the supply of capital determine the level of output through the production function. 6nd that means that in a full/employment economy, total GD= is determined by the supply of factors of production. 0ull/employment GD= must be divided among competing demands in the economy. 0rom the previous t%o chapters, you kno% that economists think of GD= as being composed of consumption, investment, government purchases, and net e1ports, %hich %e denote as # B I B G B &$. (n this section, %e first discuss ho% different societiesP total GD= is composed. 'ecause governments, for many different reasons, increase their level of spending, %e %ould like to kno% ho% increased government spending %ould affect other types of spending. ,e %ill see ho% increases in government spending must reduce other types of e1penditures %hen the economy is operating at full employment. his phenomenon is called cro%ding out. CRO0DING O#T IN A C/OSED ECONOM"

,e kno% that government spending is part of GD=. IetPs say that GD= is given and government increases its spending. ,hat happens in a country that increases its government purchases %ithin a fi1ed GD=G 'ecause the level of full employment output is given by the supply of factors in the economy, an increase in government spending must come at the e1pense of other uses of GD=. 6nother %ay of looking at thisD (ncreased government spending cro%ds out other demands for GD=. his is an e1ample of the principle of opportunity costD =rinciple of +pportunity >ost he opportunity cost of something is %hat you sacrifice to get it. 6t full employment, the opportunity cost of increased government spending is some other component of GD=. o understand cro%ding out, letPs first consider %hat %ill happen %hen government spending increases in an economy %ithout international trade. 6n economy %ithout international trade is called a closed economy. (n a closed economy, full employment output is divided among &ust 3 different demandsD consumption, investment, and government purchases. ,e can %rite this as output J consumption B investment B government purchases + J # B I B G

'ecause %e are considering an economy at full employment, the supply of output 4 +5 is fi1ed. (ncreases in government spending must reduceAthat is, cro%d outAeither consumption or investment3 in general, both are affected. CRO0DING O#T IN AN OPEN ECONOM" (n an open economy, an economy %ith international trade, full/employment output is divided among usesD consumption, investment, government purchases, and net e1ports 4e1ports K imports5D +0#1I1G1 &$ (n an open economy, increases in government spending need not cro%d out either consumption or investment. (ncreased government spending could lead to reduced e1ports and increased imports. herefore, %hat could instead get cro%ded out is net e1ports. 7ere is ho% this might happenD #uppose the ".#. government began buying domestic goods to use for some governmental purpose. IetPs say these are goods that consumers %ould have purchased but no% cannot. (f consumers %ant to maintain their consumption level despite the goods no longer being available because the governmentPs got them, they could purchase goods previously sold abroad 4e1ports5 and purchase goods sold by foreign countries 4imports5. he result %ould be a decrease in the amount of goods e1ported and an increase in imports, that is, a decrease in net e1ports. (n practice, increases in government spending in an open economy %ould cro%d out consumption, investment, and net e1ports. CRO0DING IN

Governments do not al%ays increase spending. #ometimes, they decrease it. ,hen the government cuts spending and the level of output is fi1ed, some other type of spending %ill be cro%ded in, or increase. (n a closed economy, consumption or investment or both could increase. (n an open economy, net e1ports could increase as %ell. 6s an e1ample, after a %ar, %e might see increases in consumption, investment spending, or net e1ports as they replace military spending. he nature of changes in government spending %ill have some effect on the type of spending that is cro%ded out 4or cro%ded in5. (f the government built more public s%imming pools, households %ould most likely cut back on their o%n spending on backyard pools. (f the government spent less on mail service, businesses and households %ould most likely spend more.

7!siness Cycles and Economic %l!ct!ations

o begin our study of economic fluctuations, letPs look at data on real GD= at the end of the 19@0s and the early 1990s. 0igure 9.1 plots real GD= for the "nited #tates from 19@@ to 199!. Fotice that in mid/1990, real GD= begins to fall. 6 recession is a period %hen real GD= falls for si1 or more consecutive months. Economists talk more in terms of 2uarters of the yearAconsecutive three/month periodsAthan in terms of months. #o they %ould say that %hen real GD= falls for t%o consecutive 2uarters, thatPs a recession. he date at %hich the recession starts, %hen output starts to decline, is called the peak1 and the date at %hich the recession is considered to have begun to end, %hen output starts to increase again, is called the trough. (n 0igure 9.1 %e see the peak and trough of the recession. 6fter a trough, the economy enters a recovery period or period of e1pansion.

Figure 9.1

The 199. 6ecession

Source: (.). *epartment of %ommerce.

Depression is the common term for a severe recession. (n the "nited #tates, the Great Depression refers to 19!9K1933, the period %hen real GD= fell by over 33M. (t created the most severe disruptions to ordinary economic life in the "nited #tates during the t%entieth century. hroughout the country and in much of the %orld, banks closed, businesses failed, and many people lost their &obs

and their life savings. "nemployment rose sharply. (n 1933, over !)M of people %ho %ere looking for %ork failed to find &obs. 6lthough the "nited #tates has not e1perienced a depression since that time, other countries have. During the late 19@0s and 1990s, several 6sian countries and several Iatin 6merican countries suffered severe economic disruptions that %ere true depressions. 6lthough the definition of recessions focuses on the behavior of real GD=, other important economic measures follo% the behavior of output. (n particular, unemployment rises sharply during recessions. 0igure 9.! plots the unemployment rate for 19;) to !000. he periods of recessions are marked on the graph %ith shaded bars. 6s you can see in the graph, unemployment rises sharply during recessions. 0or e1ample, during the 1990 recession, the unemployment rate rose from ).)M to *.)M before beginning to turn do%n%ard.

Figure 9.2

The :nem#loyment 6ate

uring 6ecessions

)haded areas are recessions according to 5+,6 +usiness %ycle reference dates. Source: +ureau of 7a or )tatistics, *epartment of 7a or.

he relationship bet%een changes in real GD= and corresponding changes in unemployment is called +kunPs la%. o understand +kunPs la%, %e first need to remember that potential GD= typically gro%s over time. ,e call the average rate of potential GD= gro%th the trend rate of gro%th. 7ere is +kunPs la%D 0or every percentage point that real GD= gro%s faster than the normal rate of increase in potential output, the unemployment rate falls by 1H! of a percentage point. 0or e1ample, suppose the trend rate of gro%th of real GD= is 3M per year and the current unemployment rate is )M of the total labor force. (f real GD= then gro%s at -M for a year 41 percentage point above trend5, the unemployment rate %ill fall by 1H! of a percentage point, to -.)M. (f real GD= gre% at only !M per year 41 percentage point belo% trend5, the unemployment rate %ould rise to ).)M. +kunPs la% provides a link bet%een real GD= gro%th and the unemployment rate. +ther economic measures also rise and fall along %ith real GD=. 'oth investment spending and consumption spending rise and fall along %ith increases and decreases in real GD=. he prices of shares of stocks also tend to rise and fall as real GD= goes up and do%n. ,e use the term procyclical

to describe economic measures that move in con&unction %ith real GD=. hus, investment spending, consumption spending, and prices of stocks are all procyclical. Economic measures that fall as real GD= rises are kno%n as countercyclical. "nemployment, for e1ample, is countercyclical. 'e sure you understand that %hen economists say Qbusiness cycle,R they are not referring to a regularly recurring cycle, such as phases of the moon, the rotation of the seasons, or the appearance of the 1*/year locusts. here are no fi1ed time intervals bet%een recessions, as you can see in able 9.1. During the 19;0s and the 1990s, there %ere long periods %ithout economic do%nturns. Let there %ere t%o back/to/back recessions in the early 19@0s. 9oreover, recessions tend to be unpredictable. 6fter a recession has occurred, %e can sometimes pinpoint its possible causesD either e1ternal shocks to the economy 4such as sharp increases in the %orld price of oil5 or changes in economic policy 4such as sharp decreases in government spending5. 6nd the stock market al%ays plunges sharply during recessions. 'ut the %ise men and %omen of ,all #treet never anticipate the precise timing of an economic do%nturn. 6lthough %e have focused on recessions, donPt forget that a sustained period during %hich economic gro%th is too rapid can also damage the economy. 6lthough an economy can operate for a time beyond its level of potential output, if output stays above potential output for too long a time, it %ill also be disruptive to the economy. ,hen real GD= gro%s faster than its trend rate of gro%th, unemployment %ill fall. ,hen the unemployment rate falls sufficiently belo% the natural rate of unemployment, the result %ill be an increase in the inflation rate for the economy.

Stic3y Prices and Demand&Side Economics

,hy do recessions occurG (n >hapter *, %e discussed ho% real, adverse shocks to the economy could cause economic do%nturns. ,e also outlined the theory of real business cycles, %hich focuses on ho% shocks to technology cause economic fluctuations. Fo% %e e1amine another approach to understanding economic fluctuations. 8ohn 9aynard :eynes and many economists since have identified difficulties in coordinating economic affairs as providing the starting point for understanding fluctuations in economic activity. Formally, the price system is the mechanism that coordinates %hat goes on in an economy, even in a comple1 economy. (n microeconomics, %e learn that the price system helps to coordinate %ho does %hat, %hat resources to use, ho% much to make, from %hom to buy, and so on, so that the economy produces as efficiently as possible. =rices give the correct signals to all producers in the economy so that resources are used efficiently and %ithout %aste. (f consumers decide to consume fresh fruit rather than chocolate, the price of fresh fruit %ill rise and the price of chocolate %ill fall. he economy %ill produce more fresh fruit and less chocolate on the basis of these price signals. +n a day/to/day basis, the price system %orks silently in the background, matching the desires of consumers %ith the output from producers. 'ut the price system does not al%ays %ork instantaneously. (f prices are slo% to ad&ust, then the proper signals are not given 2uickly enough to producers and consumers. Demands and supplies %ill not be brought immediately into e2uilibrium, and coordination can break do%n. (n modern economies, some prices are very fle1ible, %hile others are not. 6rthur +kun, the economist %ho came up %ith +kunPs la%, distinguished bet%een auction prices, prices that ad&ust on a nearly daily basis, and custom prices, prices that ad&ust slo%ly. =rices for fresh fish, vegetables, and other food products are e1amples of auction pricesAthey typically are very fle1ible and ad&ust rapidly.

=rices for industrial commodities such as steel rods or machine tools are custom prices and tend to ad&ust slo%ly to changes in demand. 6s shorthand, economists often refer to slo%ly ad&usting prices as sticky prices 4&ust like a door that %onPt open immediately but sometimes gets stuck5. ,ages, the price of labor, ad&ust very slo%ly. ,orkers often have long/term contracts that do not allo% employers to change %orkersP %ages at all during a given year. "nion %orkers, university professors, high/school teachers, and employees of state and local governments are all groups %hose %ages ad&ust very slo%ly. 6s a general rule, there are very fe% %orkers in the economy %hose %ages change 2uickly. =erhaps movie stars, athletes, and rock stars are the e1ceptions3 their %ages rise and fall %ith their popularity. 'ut they are far from the typical %orker in the economy. Even unskilled, lo%/%age %orkers are often protected from decreases in their %ages by minimum %age la%s. 0or most firms, the most important cost of doing business is %ages. (f %ages are sticky, firmsP overall costs %ill be sticky as %ell. his means that firmsP product prices %ill remain sticky. #ticky %ages causing sticky prices get in the %ay of the economyPs ability to coordinate economic activity, and bring demand and supply into balance. 'ecause prices and %ages are sticky over short periods, prices do not fully do the &ob of bringing demands and supplies into balance over short periods of time. ypically, firms such as automobile manufacturers and steel firms let demand determine the level of output in the short run. o understand this idea, consider an automobile firm that buys material from a steelmaker on a regular basis. 'ecause the auto firm and the steel producer have been in business %ith one another for a long time and have an ongoing relationship, they have negotiated a contract that keeps steel prices fi1ed in the short run. #uppose that the automobile companyPs cars suddenly become very popular. he firm needs to e1pand production, so it needs more steel. "nder their agreement, the steel company %ould meet this higher demand for its product and sell more steelA%ithout raising its priceAto the automobile company. #o the production of steel is totally determined in the short run by the demand from automobile producers, not by price. 'ut, %hat if the firm discovered that it had produced an unpopular car and needed to cut back on its planned productionG he firm %ould re2uire less steel. "nder the agreement, the steelmaker %ould supply less steel but not reduce its price. 6gain, demand, not price, determines steel production in the short run. #imilar agreements bet%een firms, both formal and informal, e1ist throughout the economy. ypically, in the short run, firms %ill meet changes in the demand for their products by ad&usting production %ith only small changes in the prices they charge their customers. ,hat %e have &ust illustrated for an input such as steel applies in the same %ay to %orkers as inputs to production. #uppose that the automobile firm hires union %orkers under a contract that fi1es their %ages for a specific period. (f the economy suddenly thrives at some point during that period, the automobile company %ill employ all the %orkers and perhaps re2uire some to %ork overtime. (f the economy stagnates at some point during that period, the firm %ill lay off some %orkers, using only part of the union labor force. (n either case, %ages %ill not change during the period of the contract. +ver longer time, prices do change. #uppose the automobile companyPs car remains popular for a long time. he steel company and the automobile company %ill ad&ust the price of steel on their contract to reflect this increased demand. hese price ad&ustments only occur over long periods3 in the short run, demand, not prices, determines output, and prices are slo% to ad&ust. he short run in macroeconomics

is the period %hen prices do not change or donPt change very much. (n the macroeconomic short run, demand determines output. (n the long run, prices ad&ust fully to changes in demand. 'ut over short periods, both formal and informal contracts bet%een firms mean that changes in demand %ill be reflected primarily in changes in output, not prices. ,e %ill use the term -eynesian economics to mean that demand determines output in the short run.

A''re'ate Demand and A''re'ate S!22ly

,e no% develop the graphical tool kno%n as the aggregate demand and aggregate supply model. ,e consider aggregate demand and aggregate supply to understand ho% output and prices are determined in both the short run and in the long run. ,e %ill be able to do that because %e %ill consider t%o types of aggregate supply curvesD one for the long run and one for the short run. AGGREGATE DEMAND he aggregate demand curve plots the total demand for GD= as a function of price level. 4Cecall that the price level is the average level of prices in the economy, as measured by a price inde1.5 0or each price level, %e ask %hat the total 2uantity demanded %ill be for all goods and services in the economy. (n 0igure 9.3, the aggregate demand curve is do%n%ard sloping. 6s the price level falls, the total 2uantity demanded for goods and services increases. o understand %hat the aggregate demand curve represents, %e must first learn %hy it is do%n%ard sloping, and then %e must learn %hat factors shift it.

Figure 9.3

Aggregate

eman!

The aggregate demand curve plots the total demand for real 8*3 as a function of the price level. The aggregate demand curve slopes downward, indicating that aggregate demand increases as the price level falls.

The Slo2e of the A''re'ate Demand C!r e IetPs consider the supply of money in the economy. ,e discuss the supply of money in detail in later chapters, but for no%, &ust think of the supply of money as being the total amount of currency 4cash plus coins5 held by the public and the value of all deposits in checking accounts in the economy. (f you have E100 in cash and E900 in your checking account, you have E1,000 of money.

6s the price level or average level of prices in the economy changes, so does the purchasing po%er of your money. his is an e1ample of the reality principleD Ceality =rinciple ,hat matters to people is the real value or purchasing po%er of money or income, not the face value of money or income. he change in the purchasing po%er of money %ill affect aggregate demandAthe total demand for all goods and all services in the economy. 6s the price level falls, the purchasing po%er of money %ill increase, and your E1,000 can purchase more goods and services. 6s the price level falls, increasing the purchasing po%er of money, people find that they are %ealthier. ,ith increased %ealth, people %ant to increase their spending on goods and services. 6nd so the 2uantity demanded for goods and services %ill increase as the price level falls. his means that the aggregate demand curve is do%n%ard sloping. ,hen the price level increases, the real value of money decreases, reducing %ealth and thus reducing the total demand for goods and services. 6nd so as the price level increases, total demand for goods and services in the economy decreases. he increase in spending that occurs because the real value of money increases %hen the price level falls is kno%n as the %ealth effect. his is one reason the aggregate demand curve slopes do%n%ard. Io%er prices lead to higher levels of %ealth. 7igher levels of %ealth increase spending on total goods and services. here are t%o other reasons %hy the aggregate demand curve is do%n%ard slopingD one has to do %ith interest rates, and the other has to do %ith international trade. 0irst, consider the interest rate effect. ,ith a given supply of money in the economy, a lo%er price level %ill lead to lo%er interest rates. 6s interest rates fall, the demand for investment goods in the economy 4both investment by firms and consumer durables by households5 %ill increase. ,ePll e1plain this in detail in later chapters. #econd, consider the effects from international trade. (n an open economy, a lo%er price level %ill mean that domestic goods become cheaper relative to foreign goods, so the demand for domestic goods %ill increase. 9oreover, as %e %ill see, lo%er interest rates %ill affect the e1change rate to make domestic goods become relatively cheaper than foreign goods. he %ealth effect, the interest rate effect, and the effects from international trade reinforce one another, leading to the do%n%ard sloping aggregate demand curve in 0igure 9.3. %actors That Shift the A''re'ate Demand C!r e Different factors can shift the aggregate demand curve. 6t any price level, an increase in aggregate demand means that total demand by all sectors of the economy for all the goods and services contained in real GD= has increased, and the curve shifts to the right. 0actors that decrease aggregate demand %ill shift the aggregate demand curve to the left. 6t any price level, a decrease in aggregate demand means that total demand for the goods and services contained in real GD= has decreased. IetPs look at the key factors that shift the aggregate demand curveD

1. >hanges in the supply of money. 6n increase in the supply of money in the economy %ill increase aggregate demand and shift the aggregate demand curve to the right. ,e kno% that an increase in the supply of money %ill lead to higher demand by both consumers and firms. 6t any given price level, a higher supply of money %ill mean more consumer %ealth and an increased demand for goods and services. 6 decrease in the supply of money %ill decrease aggregate demand and shift the aggregate demand curve to the left. 4,e %ill discuss the money supply and aggregate demand further in later chapters.5 !. >hanges in ta1es. 6 decrease in ta1es %ill increase aggregate demand and shift the aggregate demand curve to the right. Io%er ta1es %ill increase income available to households and increase their spending on goods and services. 6ggregate demand %ill increase as ta1es are decreased. 0or opposite reasons, increases in ta1es %ill decrease aggregate demand and shift the aggregate demand curve to the left. 4,e %ill discuss ta1es and aggregate demand further in the ne1t chapter.5 3. >hanges in government spending. 6n increase in government spending %ill increase aggregate demand and shift the aggregate demand curve to the right. 'ecause the government is a source of demand for goods and services, higher government spending naturally leads to an increase in total demand for goods and services. #imilarly, decreases in government spending %ill decrease aggregate demand and shift the curve to the left. 4,e %ill discuss government spending and aggregate demand further in the ne1t chapter.5 -. +ther factors. 6ny change in demand from households, firms, or the foreign sector %ill also change aggregate demand. 0or e1ample, if the 8apanese economy e1pands very rapidly and the 8apanese buy more ".#. goods, our aggregate demand %ill increase. #imilarly, if firms become optimistic about the future and increase their investment spending, aggregate demand %ill also increase. ,hen %e discuss factors that shift aggregate demand, %e must not include any changes in the demand for goods and services that arise from movements in the price level. >hanges in aggregate demand that accompany changes in the price level are already included in the curve and do not shift the curve. he increase in consumer spending that occurs from the %ealth effect %hen the price level falls is included in the curve and does not shift the curve. 'oth 0igure 9.- and able 9.! summari?e our discussion. Decreases in ta1es, increases in government spending, and increases in the supply of money all shift the aggregate demand curve to the right. (ncreases in ta1es, decreases in government spending, and decreases in the supply of money shift it to the left. (n general, any increase in demand 4not brought about by a change in the price level5 %ill shift the curve to the right. Decreases in demand shift it to the left.

Figure 9.3

"hifting Aggregate

eman!

*ecreases in taxes, increases in government spending, and an increase in the supply of money all shift the aggregate demand curve to the right. Higher taxes, lower government spending, and a lower supply of money shift the curve to the left.

Ta%le 9.2

Factors That "hift eman!

Fa2to$# That I 2$ea#e A!!$e!ate De%a d Decrease in ta1es (ncrease in government spending (ncrease in money supply AGGREGATE S#PP/"

Fa2to$# That De2$ea#e A!!$e!ate De%a d (ncrease in ta1es Decrease in government spending Decrease in money supply

he aggregate supply curve depicts the relationship bet%een the level of prices and real GD=. ,e %ill develop t%o different aggregate supply curvesD one corresponding to the long run and one to the short run. The Classical A''re'ate S!22ly C!r e 0irst %ePll consider the aggregate supply curve for the long run, that is, %hen the economy is at full employment3 it is also called the classical aggregate supply curve. (n previous chapters, %e sa% that the level of full/employment output yO depends solely on the supply factorsAcapital and laborAand the state of technology. hese are the fundamental factors that determine output in the long run, that is, %hen the economy operates at full employment. he level of full/employment output does not depend on the level of prices in the economy. 'ecause the level of full/employment output does not depend on the price level, %e can plot the classical aggregate supply curve as a vertical line 4unaffected by the price level5, as in 0igure 9.).

Figure 9.5

Classical Aggregate "u##ly

9n the long run, the level of output y2 is independent of the price level.

,e combine the aggregate demand curve and the classical aggregate supply curve in 0igure 9.;. Given an aggregate demand curve and an aggregate supply curve, their intersection determines the price level and level of output. 6t that intersection point, the total amount demanded %ill &ust e2ual the total amount supplied. he position of the aggregate demand curve %ill depend on the level of ta1es, government spending, and the supply of money. he level of full/employment output determines the classical aggregate supply curve.

Figure 9.&

Aggregate

eman! an! Classical Aggregate "u##ly

:utput and prices are determined at the intersection of #* and #). #n increase in aggregate demand leads to a higher price level.

6n increase in aggregate demand 4perhaps brought about by a ta1 cut or an increase in the supply of money5 %ill shift the aggregate demand curve to the right as in 0igure 9.;. ,ith a classical aggregate supply curve, the increase in aggregate demand %ill raise prices but leave the level of output unchanged. (n general, shifts in the aggregate demand curve %hen %e have a classical supply curve do not change the level of output in the economy but only change the level of prices. hat is, an increase in demand %hen %e have a classical supply curve %ill only raise the average level of prices in the economy but not change the level of real output. his is the main long/run result from the classical model. (n the long run, output is determined solely by the supply of capital and the supply of labor. 6s our model of the aggregate demand curve %ith the classical aggregate supply curve indicates, changes in demand %ill affect only prices, not the level of output. The Keynesian A''re'ate S!22ly C!r e (n the short run, prices are sticky 4slo% to ad&ust5, and output is determined primarily by demand. ,e can use the aggregate demand curve combined %ith a :eynesian aggregate supply curve to illustrate this idea. 0igure 9.* sho%s a relatively flat :eynesian aggregate supply curve 46#5. he :eynesian aggregate supply curve is relatively flat because in the short run, firms are assumed to supply all the output demanded, %ith small changes in prices. ,e previously discussed that %ith formal and informal contracts, firms %ill supply all the output that is demanded %ith only relatively small changes in prices. he :eynesian aggregate supply curve has a small up%ard slope. 6s they supply more output, firms may have to increase prices some%hat if, for e1ample, they have to pay higher %ages to obtain more overtime from %orkers or pay a premium to obtain some ra% materials.

Figure 9.5

Aggregate

eman! an! ;eynesian Aggregate "u##ly

0ith a 1eynesian aggregate supply curve, shifts in aggregate demand lead to changes in output ut small changes in prices.

6s %e &ust e1plained, the :eynesian supply curve is relatively flat because at any point in time, firms are assumed to supply all the output demanded %ith relatively small changes in prices. 7o%ever, the entire :eynesian supply curve can shift up%ard or do%n%ard as prices ad&ust to their long/run levels, as %e shall see later in this chapter. +ur description of the aggregate supply curve is consistent %ith evidence about the behavior of prices in the economy. 9ost studies find that changes in demand have relatively little effect on prices %ithin a fe% 2uarters. hus, the aggregate supply curve can be vie%ed as relatively flat %ithin a limited time. 7o%ever, changes in aggregate demand %ill ultimately have an effect on prices. he intersection of the 6D and 6# curves at point E 0 determines the price level and the level of output. 'ecause the aggregate supply curve is flat, aggregate demand primarily determines the level of output. (n 0igure 9.*, as aggregate demand increases, the ne% e2uilibrium %ill be at a slightly higher price, and output %ill increase from y0 to y1. (t is important to reali?e and understand that the level of output %here the aggregate demand curve intersects the :eynesian aggregate supply curve need not correspond to full/employment output. 0irms %ill produce %hatever is demanded. (f demand is very high, output may e1ceed full/ employment output3 if demand is very lo%, output %ill fall short of full/employment output. 'ecause prices do not ad&ust fully over short periods of time, the economy need not al%ays remain at full employment or potential output. >hanges in demand %ill lead to economic fluctuations %ith sticky prices and a :eynesian aggregate supply curve. +nly in the long run, %hen prices fully ad&ust, %ill the economy operate at full employment. S#PP/" SHOCKS "p to this point, %e have been e1ploring ho% changes in aggregate demand affect output and prices in the short run and in the long run. 7o%ever, even in the short run, it is possible for e1ternal disturbances to hit the economy and cause the :eynesian aggregate supply curve to move. #upply shocks are e1ternal events that shift the aggregate supply curve. he most important illustrations of supply shocks for the %orld economy are the sharp increases in the price of oil that occurred in 19*3 and again in 19*9. ,hen oil prices increased sharply, firms no longer sold all the goods and services that %ere demanded at the current priceAmeaning the price

before the increases in oil prices. 'ecause oil %as a key input to production for many firms in the economy, the additional costs of oil reduced the profits of firms. o maintain their profit levels, firms raised the prices of their products. 0igure 9.@ illustrates a supply shock that raises prices. he :eynesian aggregate supply curve shifts up %ith the supply shock because firms %ill supply their output only at a higher price. he shift of the 6# curve raises the price level and lo%ers the level of output from y 0 to y1. 6dverse supply shocks can therefore cause a recession 4a fall in output5 %ith increasing prices. his situation corresponds closely to the events of 19*3, %hen higher oil prices led to both a recession and rising prices for the economy.

Figure 9.<

"u##ly "hock

#n adverse supply shoc", such as an increase in the price of oil, will shift up the #) curve. The result will e higher prices and a lower level of output.

0avorable supply shocks, such as falling prices, are also possible. (n this case the :eynesian aggregate supply curve %ill shift do%n.

O!t2!t and Prices in the Short R!n and in the /on' R!n
"p to this point, %e have e1amined ho% aggregate demand and aggregate supply determine output and prices both in the short run and in the long run. Lou may be %ondering ho% long is the short run and ho% short is the long run. 7ere is a previe% of ho% the short run and the long run are connected. (n 0igure 9.9, %e sho% the aggregate demand curve intersecting the :eynesian aggregate supply curve at E0 at an output level y 0. ,e also depict the classical aggregate supply curve in this figure. he level of output in the economy, y0, e1ceeds the level of potential output yp. (n other %ords, this is a boom economyD +utput e1ceeds potential. 'ecause the economy is producing at a level beyond its long/run potential, the level of unemployment %ill be very lo%. his %ill make it difficult for firms to recruit and retain %orkers. hey %ill also find it more difficult to purchase needed ra% materials and other inputs for production. 6s firms compete for labor and ra% materials, there %ill be a tendency for both %ages and prices to increase over time.

Figure 9.9

The 0conomy in the "hort 6un

9n the short run, the economy produces at y;, which exceeds potential output y p

(ncreasing %ages and prices %ill shift the :eynesian aggregate supply curve up%ard. 0igure 9.10 illustrates this graphically3 the dashed lines indicating ho% the :eynesian aggregate supply curve shifts up%ard over time. 6s long as the economy is producing at a level of output that e1ceeds potential output, there %ill be continuing competition for labor and ra% materials that %ill lead to continuing increases in %ages and prices. (n the long run, the :eynesian aggregate supply curve %ill keep rising until it intersects the aggregate demand curve at E 1. 6t this point, the economy reaches the long/run e2uilibriumAprecisely the point %here the aggregate demand curve intersects the classical aggregate supply curve.

Figure 9.1.

A!=usting to the 7ong 6un

0ith output exceeding potential, the #) curve shifts upwards as depicted y the dotted lines. The economy ad$usts to the long-run e4uili rium at E<.

he lesson here is that ad&ustments in %ages and prices take the economy from the short/run :eynesian e2uilibrium to the long/run classical e2uilibrium. (n later chapters, %e %ill e1plain in detail ho% this ad&ustment occurs, and %e %ill sho% ho% changes in %ages and prices can steer the economy back to full employment in the long run.

The Sim2lest Keynesian Cross

IetPs begin %ith the simplest model of ho% demand determines output in the short run. he simplest model is a graph %ith the demand for goods and services represented on the vertical a1is, output 4y5 represented on the hori?ontal a1is, and a -)S diagonal line, as sho%n in 0igure 10.1, representing a key relationship bet%een demand and output. 0rom any point on that -)S diagonal line, the distance left%ard over to the vertical a1is is e2ual to the distance do%n%ard to the hori?ontal a1is. hatPs simple graphical mathD 0rom any point on the diagonal, the vertical distance and hori?ontal distance measured to the a1es are e2ualAa key fact that you must understand and remember as %e proceed.

Figure 1..1

The 35> 7ine

#ny point on the '=> line corresponds to the same vertical and hori?ontal distances. The distance ; a e4uals the distance Aa.

"nderstanding %hat the diagonal represents, %e can start to build a simple demand/side model. IetPs start by assuming that neither the government nor the foreign sectors e1ist. +nly consumers and firms can demand outputD >onsumers demand consumption goods, and firms demand investment goods. ,e make things even simpler, assuming that consumers and firms each demand a fi1ed amount of goods. Iet consumption demand be an amount # and let investment demand be an amount I. otal demand %ill be # B I. (n the short run, demand determines outputD output J demmand (n this case, output J demmand J # B 2 0igure 10.! can help us to understand ho% outputAthe level of real GD=Ais determined. +n the demand/output diagram, %e superimpose the line representing demand, # B I, %hich is a hori?ontal line, because both # and I are fi1ed amounts. 'ecause total demand is fi1ed at # B I, it does not depend on output.

Figure 1..2

The ;eynesian Cross

#t e4uili rium output y2, total demand Ey2 e4uals output ;y2.

E2uilibrium output is at yO, the level of output at %hich the demand line crosses the -)S line. hey cross at point E, %here output measured on the hori?ontal a1is e2uals demand by consumers and firms measured on the vertical a1is. 7o% do %e kno% thisG 'ecause point E is on the -)S line3 therefore, the vertical distance EyO e2uals the hori?ontal distance 0yO. Cecall that the vertical distance is total demand and that the hori?ontal distance is the level of output. herefore, at output yO, total demand e2uals output. ,hat %ould happen if the economy %ere producing at a higher level of output, such as y1 in 0igure 10.3G 6t that level of output, more goods and services are being produced than consumers and firms are %anting and buying. Goods that are produced but not purchased %ill pile up on the shelves of stores. 0irms %ill react to this by cutting back on production. he level of output %ill fall until the economy reaches yO, as indicated by the left%ard arro% in 0igure 10.3.

Figure 1..3

0?uili%rium 8ut#ut

,4uili rium output (y2) is determined at E, where demand intersects the '=> line. 9f output were higher ( y<),

it would exceed demand and production would fall. 9f output were lower (y.), it would fall short of demand and production would rise.

(f the economy %ere producing at a lo%er level of output, y !, demand %ould e1ceed total output. ,hen demand e1ceeds output, firms find that the demand for consumption and investment goods is greater than their current production. (nventories disappear from the shelves of stores, and firms face increasing backlogs of orders for their products. 0irms respond by stepping up production, so GD= increases back to yO, as indicated by the right%ard arro% in 0igure 10.3. able 10.1 also helps to illustrate the process that determines e2uilibrium output. he table sho%s, %ith a numerical e1ample, %hat happens to production %hen demand does not e2ual output.
Ta%le 1..1 A!=ustments to 0?uili%rium 8ut#ut

C3I 100 100 100

P$odu2t"o @0 1!0 100

I ve to$"e# Depletion of inventories of !0 E1cess of inventories of !0 Fo change

D"$e2t"o o4 Out5ut +utput increases +utput decreases +utput stays constant

Demand 4consumption plus investment5 e2uals 100 billion dollars. (n the first ro%, %e see that if current production is only @0 billion, stocks of inventories %ill be depleted by !0 billion, so firms %ill increase output to restore their inventory levels. (n the second ro%, production is at 1!0 billion, creating an e1cess of inventories of !0 billion, and firms %ill cut back production. (n the last ro%, demand e2uals outputD Feither inventories nor production changes. 'e sure you remember that in the short run, the e2uilibrium level of output occurs %here total demand e2uals production. (f the economy %ere not producing at that level, %e %ould find either that the demand for goods %as too great relative to production or that there %as insufficient demand relative to production. (n either case, the economy %ould rapidly ad&ust to reach the e2uilibrium level of output.

The Cons!m2tion %!nction and the M!lti2lier

CONS#MER SPENDING AND INCOME ,e no% start to make our model more realistic. Economists have found that consumer spending depends on the level of income in the economy. ,hen consumers have more income, they %ant to purchase more goods and services. he relationship bet%een consumer spending and income is kno%n as the consumption functionD # 0 #a B y %here consumption spending # has t%o parts. he first part, #a, is a constant and is independent of income. his means that much of consumption spending does not depend on the level of income. 0or e1ample, all consumers, regardless of their current income, %ill have to purchase some food. Economists call this autonomous consumption spending. he second part, y, represents the part of consumption that is dependent on income. (t is the product of a fraction , called the marginal propensity to consume T9=>U, and the level of income y in the economy. he 9=> 4or in our

formula5 tells us ho% much consumption spending %ill increase for every dollar that income increases. 0or e1ample, if J 0.;, then for every E1 that income increases, consumption increases by E0.;0. (n our simple economy, output 4or real GD=5 is also e2ual to the income that flo%s to the households. 6s firms produce output, it is paid to the households as income 4%ages, interest, profits, and rents5. ,e can therefore use the symbol y to represent both output and income. ,e plot a consumption function in 0igure 10.-. he consumption function is a line that intersects the vertical a1is at #a , the level of autonomous consumption spending3 autonomous consumption must be greater than ?ero, so the line does not pass through the ?ero point on the origin. (ts slope e2uals , the marginal propensity to consume. 6lthough output is plotted on the hori?ontal a1is, remember that it is also e2ual to income, so income rises dollar for dollar %ith output. hat is %hy %e can plot the consumption function 4%hich depends on income5 on the same graph that determines output.

Figure 1..3

Consum#tion Function

The consumption function relates desired consumer spending to the level of income.

he marginal propensity to consume 4the slope of the line5 is al%ays less than one. 6 consumer %ho receives a dollar of income %ill spend part of it and save the rest. he fraction that the consumer spends is given by his or her 9=>. he fraction that the consumer saves is determined by his or her marginal propensity to save T9=#U. he sum of the marginal propensity to consume and the marginal propensity to save is al%ays e2ual to one. 0or e1ample, if the 9=> is 0.@, then the 9=# must be 0.!. ,hen a consumer receives an additional dollar, he or she spends E0.@0 and saves the remaining E0.!0. CHANGES IN THE CONS#MPTION %#NCTION he consumption function is determined by the level of autonomous consumption and by the 9=>. he level of autonomous consumption can change, and so can the 9=>. >hanges in either shift the consumption function to another position on the graph. 6 higher level of autonomous consumption but no change in 9=> %ill shift the entire consumption function up%ard and parallel to its original position. ,hy it shifts up%ard should be clearD because increased autonomous consumption is represented as a higher intercept on the vertical a1is. ,e sho% an increase in autonomous consumption in panel 6 of 0igure 10.).

Figure 1..5

Mo$ements of the Consum#tion Function

6 number of factors can cause autonomous consumption to change. 7ere are t%oD

(ncreases in consumer %ealth %ill cause an increase in autonomous consumption. 4,ealth consists of the value of stocks, bonds, and consumer durablesAconsumer goods that last a long time, such as automobiles and refrigerators. ,ealth is not the same as income3 income is the amount of money earned during a period, such as in a given year.5 Fobel laureate 0ranco 9odigliani has emphasi?ed that increases in stock prices, %hich raise consumer %ealth, %ill lead to increases in autonomous consumption. >onversely, a sharp fall in stock prices %ould lead to a decrease in autonomous consumption. >hanges in consumer confidence %ill shift the consumption function. (ncreases in consumer confidence %ill increase autonomous consumption. 0orecasters pay attention to consumer confidence, based on household surveys3 consumer confidence is reported regularly in the financial press.

6 change in the marginal propensity to consume %ill cause a change in the slope of the consumption function. ,e sho% an increase in the 9=> in panel ' of 0igure 10.), %here %e assume that autonomous consumption is fi1ed. 6s the 9=> increases, the consumption function rotates up%ard, counterclock%ise3 that means that the consumption function line gets steeper. #everal factors can change the 9=>. 7ere are t%oD

>onsumersP perceptions of changes in their income affect their 9=>. (f consumers believe that an increase in their income is permanent, they %ill consume a higher proportion of the increased income than they %ould if they believed the increase %as temporary. 6s an e1ample, consumers %ill spend a higher proportion of a permanent salary increase than they %ould spend of a one/time bonus. #imilarly, studies have sho%n that consumers saveAnot spendAa high proportion of one/time %indfall gains, such as lottery %innings. >hanges in ta1 rates change the slope of the consumption function, as %e %ill see later in this chapter.

DETERMINING GDP "sing the consumption function, %e are no% ready to sho% ho% real GD= is determined. ,e assume that GD= is ultimately determined by demand 4as before5. ,e continue to assume that investment spending, I, is a constant %ith respect to changes in income. he only difference bet%een %hat %e did

in the preceding section and %hat %e are about to do here is that %e no% recogni?e that consumption increases %ith the level of income. 0igure 10.; sho%s ho% GD= is determined. ,e first plot the consumption function, #, as beforeD a sloping line graphically representing that consumption spending is a function of income. 'ecause %e are assuming that investment is constant at all levels of income, to graphically get the # B I line, %e can simply add vertically the constant level of investment I to the consumption function. Doing this gives us the # B I line, representing total spending in the economy. his line is up%ard sloping because consumption spending increases %ith income. 6t any level of income, %e no% kno% the level of total spending, # B I.

Figure 1..&

etermining ( P

8*3 is determined where the C @ I line intersects the '=> line. #t that level of output, y 2, desired spending e4uals output.

he level of e2uilibrium output, yO, occurs %here the spending line # B I crosses the -)S diagonal line. 6t this level of output, total spending e2uals output. 6t any other level of production, spending %ill not e2ual output and the economy %ill ad&ust back to y O, for the same reasons and in the same %ay as in the corresponding e1ample in the preceding section. (n the appendi1 to this chapter, %e sho% that the e2uilibrium output in this simple economy is e2uilibrium output J 4autonomous consumption B investment5H 41 K 9=>5 or, in the mathematical terms representing those %ords, yO J 4#a 1 25H 41 K 5 0rom this relationship and the numerical values for #a , , and I, %e can calculate e2uilibrium output. #uppose that #
a

10 0 J 0.; I J -0 J

4 his means that the consumption function is # J 233 B 3.4y.5 hen, using our formula for e2uilibrium output, %e have yO J 4100 B -05H 41 K 0.;5 J 1-0H 0.J 3)0 SA5INGS AND IN5ESTMENT E2uilibrium output can be determined in another %ay, %hich highlights the relationship bet%een savings and investment. o understand this relationship, recall that in an economy %ithout ta1ation or government, the value of output, or production 4y5, e2uals the value of income. 7ouseholds receive this income and either consume it 4#5, save it 455, or some of both. Ceali?ing that, %e can say that savings e2uals output minus consumption or, in mathematical terms, 5JyK # (n our simple economy, output is determined by demand, # B I, or y0#1 I (f %e subtract consumption from both sides of this e2uation, %e have y6#0 I 'ut %e &ust sa% that the left side, y K #, e2uals savings, 5, so %e have 50 I hus, e2uilibrium output is determined at the level of income %here savings e2ual investment. he level of savings in the economy is not fi1ed3 it changes, and ho% it changes depends on the real GD=. o illustrate this, letPs return to the previous e1ample in %hich the consumption function is # J 100 B 0.;y. 'ecause 5 J y K #, savings is 5 J y K 4100 B 0.;y5 5 J K100 B 0.-y his is the savings function for this e1ample. 6 savings function describes the relationship bet%een savings and income. (n this e1amplePs savings function, the marginal propensity to save is 0.-. hat means that for every dollar y increases, savings increase by E0.-0. (n our previous e1ample, investment I J -0, and e2uilibrium income %as 3)0. IetPs check that savings does e2ual that level of investment. =lugging in the value of e2uilibrium output 4or income5 into the savings function, %e get

K100 B 0.-43)05 5 J K100 B 1-0 5 J -0 5J #o savings e2uals investment at the level of e2uilibrium output. THE M#/TIP/IER (n all economies, investment spending fluctuates. ,e can use the model %e developed that determines output in the short run to see %hat happens if there are changes in investment spending. #uppose investment spending originally %as I0 and increased to I1, an increase that %e %ill call I 4the symbol , the Greek capital letter delta, is universally used to represent change5. ,hat happens to e2uilibrium outputG 0igure 10.* sho%s ho% e2uilibrium output is determined at the original level of investment and at the ne% level of investment. he increase in investment spending shifts the # B I curve up%ard by I. he intersection of the # B I curve %ith the -)S line shifts from E0 to E1. GD= increases from y0 to y1 by the amount y.

Figure 1..5

Multi#lier y from y ; to y <. The

0hen investment increases y l from l ; to l <, e4uili rium output increases y change in output ( y) is greater than the change in investment ( l).

he figure sho%s that the increase in GD=Athat is, the amount investmentAthe amount IAor y V I.

yAis greater than the increase in

his is a general result3 the increase in output al%ays e1ceeds the increase in investment. he increase in output divided by the increase in investment is called the multiplier for investment. 'ecause output increases more than the initial increase in investment, the multiplier is greater than 1. he basic idea of ho% the multiplier %orks in an economy is simple. IetPs say that a computer firm invests E10 million in building a ne% plant. (nitially, total spending in the economy increases by this E10 million paid to a construction firm. he construction %orkers and o%ners of the construction firm

then spend part of the income they are paid. #uppose the o%ners and %orkers spend E@ million on ne% automobiles. =roducers of these automobiles %ill e1pand their production because of the increase indicated by this demand. (n turn, %orkers and o%ners in the automobile industry %ill earn an additional E@ million in %ages and profits. hey, in turn, %ill spend part of this additional income, letPs say E;.- million, on televisions and other goods and services. 6nd the %orkers in the production of the televisions and those other goods and services %ill earn additional income, and so on, and so on. able 10.! sho%s ho% the multiplier %orks in detail. (n the first round, there is an initial increase of investment spending of E10 million. his additional demand leads to an initial increase in GD= and income of E10 million. 6ssuming that the 9=> is 0.@, the E10 million of additional income %ill increase consumer spending by E@ million. Cound ! begins %ith this E@ million increase in consumer spending. 'ecause of this increase in demand, GD= and income increase by E@ million. 6t the end of round !, consumers %ill have an additional E@ million3 %ith a 9=> of 0.@, consumer spending %ill therefore increase by 0.@ N E@ million, or E;.- million. he process continues in round 3 %ith an increase in consumer spending of E;.- million. (t continues, in diminishing amounts, through subse2uent rounds. (f %e add up the spending in all the 4infinite5 rounds, %e %ill find that the initial E10 million of spending leads to a E)0 million increase in GD= and income. (n this case, the multiplier is ).
Ta%le 1..2 The Multi#lier in Action

Rou d o4 S5e d" ! 1 ! 3 ) . . . otal

I 2$ea#e " De%a d E10 @ ;.).1! -.09; . . . )0 million

I 2$ea#e " GDP a d I 2o%e E10 @ ;.).1! -.09; . . . )0 million

I 2$ea#e " Co #u%5t"o E@ ;.).1! -.09; 3.!** . . . -0 million

Note: #ll figures for increases indicate millions of dollars.

he multiplier also %orks in reverse. #uppose that consumers become pessimistic, cutting back on autonomous consumption by E10 million. Demand for GD= falls by E10 million, %hich means that output and income fall by E10 million. >onsumers then cut back their spending further because their incomes have fallen. ,hat happens is the reverse of %hat %e &ust described for the multiplier %orking in the positive direction. (f the 9=> %ere 0.@, total spending %ould fall by E)0 million. ,e sho% ho% to derive the formula for a simple multiplier in the appendi1 to this chapterD multiplier J 1H 41 K 9=>5 #uppose the 9=> J 0.@3 then the multiplier %ould be 1H41 K 0.@5, or ). Fotice that the multiplier increases as the 9=> increases. (f 9=> J 0.-, the multiplier J 1.;*3 if the 9=> J 0.;, the multiplier J !.). o see %hy the multiplier increases as the marginal propensity to consume 9=> increases, think back to our e1amples of the multiplier. he multiplier occurs because

the initial increase in investment spending increases income, %hich leads to higher consumer spending. ,ith a higher 9=>, the increase in consumer spending %ill be greater, since consumers %ill spend a higher fraction of the additional income they receive as the multiplier increases. ,ith this e1tra spending, the eventual increase in output %ill be greater, and therefore so %ill the multiplier.

Go ernment S2endin' and Ta8ation

KE"NESIAN %ISCA/ PO/IC" ,e no% make our model more realistic, bringing in government spending and ta1ation, therefore making the model useful for understanding economic policy debates. (n those debates, %e often hear recommendations for increasing government spending to increase GD= or cutting ta1es to increase GD=. 6s %e %ill e1plain, both the level of government spending and the level of ta1ation, through their influence on the demand for goods and services, affect the level of GD= in the short run. "sing ta1es and spending to influence the level of GD= in the short run is kno%n as :eynesian fiscal policy. 6s %e discussed in >hapter *, changes in ta1es can also affect the supply of output in the long run through the %ay ta1es can change incentives to %ork or invest. 7o%ever, in this chapter, %e concentrate on the role of ta1es and spending in determining demand for goods and services and, hence, output, in the short run. IetPs look first at the role government spending plays in determining GD=. Government purchases of goods and services are a component of spendingD otal spending including government J # 1 I 1 G (ncreases in government purchases, G, shift the # B I B G line up%ard, &ust as increases in investment I or autonomous consumption do. (f government spending increases by E1, the # B I B G line %ill shift up%ard by E1. =anel 6 of 0igure 10.@ sho%s ho% increases in government spending affect GD=. he increase in government spending from G0 to G 1 shifts the # B I B G line up%ard and increases the level of GD= from y0 to y1.

Figure 1..<

;eynesian Fiscal Policy

6s you can see, changes in government purchases have e1actly the same effects as changes in investment or changes in autonomous consumption. he multiplier for government spending is also the same as for changes in investment or autonomous consumptionD multiplier for government spending J 1H41 K 9=>5 0or e1ample, if the 9=> %ere 0.; and the multiplier %ere !.), a E10 billion increase in government spending %ould increase GD= by E!) billion. he multiplier for government spending %orks &ust like the multiplier for investment or consumption. 6n initial increase in government spending raises GD= and income. he increase in income, ho%ever, generates further increases in demand as consumers increase their spending. Fo% letPs consider ta1es. ,e need to take into account that government programs affect householdsP disposable personal incomeAincome that ultimately flo%s back to households and to consumers after subtraction from their income of any ta1es paid and after addition to their income of any transfer payments they receive 4such as #ocial #ecurity, unemployment insurance, or %elfare5. (f the government takes E10 net out of every E100 you make, your income after ta1es and transfer payments is only E90. 7erePs ho% %e include ta1es and transfers into the modelD ,e make consumption spending depend on income after ta1es and transfers, or y K T, %here T is net ta1es 4ta1es paid to government minus transfers received by households5. 0or simplicity, %ePll &ust refer to T as ta1es, but remember that it is ta1es less transfer payments. he consumption function %ith ta1es is # 0 #a 1 4y 6 T5 (f ta1es increase by E1, after/ta1 income %ill decrease by E1. #ince the marginal propensity to consume is , this means that consumption %ill fall by N E1, and the # B I B G line %ill shift do%n%ard by N E1. 0or e1ample, if is 0.;, a E1 increase in ta1es %ill mean that consumers %ill have a dollar less of income and %ill therefore decrease consumption spending by E0.;0. =anel ' of 0igure 10.@ sho%s ho% an increase in ta1es %ill decrease the level of GD=. 6s the level of ta1es increases, the demand line %ill shift do%n%ard by 4the increase in ta1es5. E2uilibrium income %ill fall from y 0 to y1. he multiplier for ta1es is slightly different than the multiplier for government spending. (f %e cut government spending by E1, the # B I B G %ill shift do%n%ard by E1. 7o%ever, if %e increase ta1es by E1, consumers %ill cut back their consumption by only N E1. hus, the # B I B G line %ill shift do%n%ard by slightly less than E1, or N E1. 0or e1ample, if J 0.;, the demand line %ould shift do%n vertically only by E0.;0. #ince the demand line does not shift by the same amount %ith ta1es as it does %ith government spending, the formula for the ta1 multiplier is slightly different. 7erePs the formula for the ta1 multiplier3 in the appendi1, %e sho% ho% to derive itD ta1 multiplier J K H 42 6 5 he ta1 multiplier is negative because increases in ta1es decrease disposable personal income and lead to a reduction in consumption spending. (f the 9=> J 0.;, the ta1 multiplier %ill be K0.;H41 K 0.;5 J K 1.).

Fotice that the ta1 multiplier is smaller 4in absolute value5 than the government/spending multiplier, %hich for the same 9=> is !.). he reason the ta1 multiplier is smaller is that an increase in ta1es first reduces income of households by the amount of the ta1. 7o%ever, because the 9=> is less than 1, the decrease in consumer spending is less than the increase in ta1es. 0inally, you may %onder %hat %ould happen if %e increased both government spending and ta1es by an e2ual amount at the same time. 'ecause the multiplier for government spending is larger than the multiplier for ta1es, e2ual increases in both government spending and ta1es %ill increase GD=. Economists call the multiplier for e2ual increases in government spending and ta1es the alanced udget multiplier because e2ual changes in government spending and ta1es %ill not unbalance the budget. (n the appendi1, %e sho% that the balanced budget multiplier in our simple model is al%ays e2ual to 1. 0or e1ample, if spending and ta1es are both increased by E10 billion, then GD= %ill also increase by E10 billion. ,e use special terminology to describe government actions taken to effect changes in the economy. Government policies that increase total demand and GD= are called e1pansionary policies. Government policies that decrease total demand and GD= are contractionary policies. a1 cuts and government spending increases are e1amples of e1pansionary policies. a1 increases and government spending cuts are e1amples of contractionary policies. ,hen a government increases its spending or cuts ta1es to stimulate the economy, it %ill increase the governmentPs budget deficit3 the difference bet%een its spending and its ta1 collections. 0or e1ample, suppose the budget %ere initially balanced 4government spending e2ualed ta1es received5 and the government increased its spending. he government %ould then be running a budget deficitA government spending e1ceeding ta1ation. o pay for its additional spending, the government %ould have to borro% money by selling government bonds, %hich are government (+"s, to the public. raditional :eynesian models assume that this borro%ing has no significant effects on the economy. 6lthough :eynesian models are very simple and leave out many factors, like all models, they illustrate some important lessonsD

6n increase in government spending %ill increase the total demand for goods and services. >utting ta1es %ill increase the after/ta1 income of consumers and %ill also lead to an increase in the total demand for goods and services.

(n the short run, the level of GD= is determined primarily by the demand for goods and services. A#TOMATIC STA7I/IAERS ta1es and transfer payments can automatically reduce fluctuations in real GD= and thereby stabili?e the economy. ,e say that ta1es and transfers act as automatic stabili?ers for the economy. 7ere is ho% the automatic stabili?ers %ork. ,hen income is high, the government collects more ta1es and pays out less in transfer payments. 'ecause the government is taking funds out of the hands of consumers, there %ill be reduced consumer spending. +n the other hand, %hen output is lo% 4such as during recessions5, the government collects less ta1es and pays out more in transfer payments, increasing consumer spending because the government is putting funds into the hands of consumers. he automatic stabili?ers prevent consumption from falling as much in bad times and from rising as much in good times. his stabili?es the economy %ithout any need for decisions from the parliament. o see ho% automatic stabili?ers %ork in our model, %e must take into account that the government

levies income ta1es by applying a ta1 rate to the level of income. o simplify, suppose there %ere a single ta1 rate of 0.! 4in percent, !0M5 and income %ere E100. he government %ould then collect 0.! N E100 J E!0 in ta1es. (n general, %e can vie% the total ta1es collected by the government, T, as a product of the ta1 rate, t, and output, yD T 0 ty >onsumerPs after/ta1 income %ill be 4y 6 ty5 J y41 K t5 J 41 K t5y (f consumption depends on after/ta1 income, %e have the follo%ing consumption functionD # 0 #a B 41 K t5y his is the consumption function %ith income ta1es. he only difference bet%een the consumption function %ith income ta1es and the consumption function %ithout income ta1es is that the marginal propensity to consume is ad&usted for ta1es, and so 6d&usted 9=> J 41 K t5 he reason for this ad&ustment is that consumers keep only a fraction 41 K t5 of their income3 the rest, t, goes to the government. ,hen income increases by E1, consumersP after/ta1 incomes increase by only E1 N 41 K t5, and of that E41 K t5, they spend a fraction . Caising the ta1 rate therefore lo%ers the 9=> ad&usted for ta1es. 0igure 10.10 sho%s the conse2uences of raising ta1 rates. ,ith a higher ta1 rate, the government takes a higher fraction of income, and less is left over for consumers. Cecall that the slope of the # B I B G line is the marginal propensity to consume. Caising the ta1 rate lo%ers the ad&usted 9=> and reduces the slope of this line. he # B I B G line %ith ta1es intersects the -)S line at a lo%er level of income. +utput falls from y0 to y1.

Figure 1..1.

2ncrease 2n Ta1 6ates

#n increase in tax rates decreases the slope of the C @ I @ G line. This lowers output and reduces the multiplier.

Cemember that a smaller marginal propensity to consume also leads to a lo%er value for the multiplier. 6s ta1 rates increase and the ad&usted 9=> falls, the multiplier %ill decrease. 6 smaller multiplier means that any shocks, such as shocks to investment, %ill have less of an impact on the economy. 6s %e have seen, higher ta1 rates %ill lo%er the multiplier and make the economy less susceptible to shocks. ,ith higher ta1es and transfer payments, there is a much looser link bet%een fluctuations in disposable personal income and fluctuations in GD=. 'ecause disposable personal income is more stable, consumption spending is also more stable. hus, there is a smaller multiplier, and the economy is more stable. (t is important to emphasi?e that automatic stabili?ers %ork silently in the background, doing their &ob %ithout re2uiring e1plicit action by policymakers. otal ta1 collections rise and fall %ith GD= %ithout re2uiring that policymakers change ta1 rates. he fact that the automatic stabili?ers %ork %ithout any la%s being enacted is particularly important at times %hen it is difficult to obtain a political consensus for taking any action and policymakers are reluctant to use :eynesian fiscal policy as a deliberate policy tool. +ther factors contribute to the stability of the economy. ,e e1plained ho% consumers base their spending decisions in part on their permanent income, not &ust on their current level of income. (f households base their consumption decisions partly on their permanent or long/run income, they %ill not be very sensitive to changes in their current income. (f their consumption does not change very much %ith current income, the marginal propensity to consume out of current income %ill be small, %hich %ill make the multiplier for investment or autonomous consumption spending small as %ell. ,hen consumers base their decisions on long/run factors, not &ust on their current level of income, the economy tends to be stabili?ed.

E82orts and Im2orts

,ith international trade becoming an increasingly important economic and political issue, it is critical to understand ho% e1ports and imports affect the level of GD=. %o simple modifications of our model %ill allo% us to understand ho% e1ports and imports affect GD= in the short run. E1ports and imports affect GD= through their influence on ho% the %orld beyond (ndia demands goods and services producedin (ndia. 6n increase in e1ports means that therePs an increase in the demand for goods produced in (ndia. 6n increase in imports means that therePs an increase in foreign goods purchased by (ndian residents. (mporting goods rather than purchasing them from our domestic producers reduces the demand for (ndian goods. 0or e1ample, if %e in (ndia spend a total of E10 billion on all automobiles but %e imported E3 billion in automobiles, then only E* billion is spent on (ndia automobiles. o get a clearer picture of the effects on GD= from e1ports and imports, letPs for the moment ignore government spending and ta1es. o modify our model to include the effects of e1ports and imports, %e need to take t%o stepsD

1. 6dd e1ports, $, to other sources of spending as another source of demand for (ndian goods
and services. ,e assume that the level of e1ports 4foreign demand for (ndian products5 is given. !. #ubtract imports, M, from total spending by (ndian residents. ,e %ill assume that imports, like consumption, increase %ith the level of income. >onsumers %ill import more goods as income rises. ,e can %rite this as imports J M J my %here m is a fraction kno%n as the marginal propensity to import. ,e subtract this fraction from , the overall marginal propensity to consume, to obtain the 9=> for spending on domestic goods, K m. 0or e1ample, if J 0.@ and m J 0.!, then for every E1 that GD= increases, total consumption increases by E0.@0 but spending on domestic goods increases only by E0.;0 because E0.!0 is spent on imports. he 9=> in this e1ample, ad&usted for imports is 40.@ K 0.!5 J 0.;. 0igure 10.11 sho%s ho% e2uilibrium output is determined in an open economy, that is, an economy that engages in trade %ith the rest of the %orld. ,e plot total demand for (ndian goods and services on our graph and find the level of e2uilibrium income %here it intersects the -)S line. he total demand line has an intercept on the vertical a1is of #a B I B $, %hich is the sum of autonomous consumption, investment, and e1ports. he slope of the line is K m, %hich is the 9=> ad&usted for imports. E2uilibrium output is the value of output %here the demand line for (ndian goods crosses the -)S line.

Figure 1..11

etermining 8ut#ut in an 8#en 0conomy

:utput is determined where the demand for domestic goods e4uals output.

IetPs e1amine an application of the model that %e &ust developed. #uppose the 8apanese decide to buy another E) billion %orth of goods from (ndia. ,hat %ill happen to (ndian domestic outputG =anel 6 of 0igure 10.1! sho%s the effect of an increase in e1ports. he demand line %ill shift vertically up%ard by the increase in e1ports 4 $5. his %ill increase e2uilibrium income from y0 to y1.

Figure 1..12

2ncrease in 01#orts an! 2m#orts

he increase in income %ill be larger than the increase in e1ports because of the multiplier effect. his multiplier is based on the 9=> ad&usted for trade. 0or e1ample, if J 0.@ and m J 0.!, the ad&usted 9=> 4 K m5 is 0.; and the multiplier %ill be 1H41 K 0.;5 J !.). herefore, a E) billion increase in e1ports %ill lead to a E1!.) billion increase in GD=. Fo%, suppose that (ndian residents become more attracted to foreign goods, and as a result, our marginal propensity to import increases. ,hat happens to GD=G =anel ' of 0igure 10.1! depicts the effect of an increase in imported foreign goods. he ad&usted 9=> 4 K m5 %ill fall as the marginal propensity to import increases. his reduces the slope of the demand line, and output %ill fall from y0 to y1.

The /in3s 7et<een the Goods Mar3et and the Money Mar3et
here are t%o key links bet%een the goods market and the money marketD

L" 6 17 I 2o%e a d the De%a d 4o$ 8o e9 he first link bet%een the goods market and the money market e1ists because the demand for money depends on income. 6s aggregate output 4income5 4+5 increases, the number of transactions re2uiring the use of money increases. 4Lou &ust sa% this in >hapter 11.5 6n increase in output, %ith the interest rate held constant, leads to an increase in money demand. (ncome, %hich is determined in the goods market, has considerable influence on the demand for money in the money market.

L" 6 (7 Pla ed I ve#t%e t S5e d" ! a d the I te$e#t Rate he second link bet%een the goods market and the money market e1ists because planned investment spending 4(5 depends on the interest rate 4r5. (n >hapters @ and 9 %e assumed that planned investment spending is fi1ed at a certain level, but %e did so only to simplify that discussion. (n practice, investment is not fi1ed. (nstead, it depends on a number of key economic variables. +ne is the interest rate. he higher the interest rate is, the lo%er the level of planned investment spending.

he interest rate, %hich is determined in the money market, has significant effects on planned investment in the goods market. hese t%o links are summari?ed in 0igure 1!.1.

Figure 12.1

7inks %etween the (oo!s Market an! the Money Market

3lanned investment depends on interest rate, and money demand depends on income.

IN5ESTMENTB THE INTEREST RATEB AND THE GOODS MARKET (t should come as no surprise that the relationship bet%een the level of planned investment and the interest rate is negative. ,hen the interest rate falls, planned investment rises. ,hen the interest rate rises, planned investment falls. o see %hy this occurs, recall that investment refers to the purchase of ne% capitalAne% machines and plants. ,hether a firm decides to invest in a pro&ect depends on %hether the e1pected profits from the pro&ect &ustify its costs. "sually, a big cost of an investment pro&ect is the interest cost. >onsider a firm opening a ne% plant, or the investment re2uired to open a ne% ice cream store. ,hen a manufacturing firm builds a ne% plant, the contractor must be paid at the time the plant is built. ,hen an entrepreneur decides to open a ne% ice cream parlor, free?ers, tables, chairs, light fi1tures, and signs are needed. hese too must be paid for %hen they are installed. he money needed to carry out such pro&ects is generally borro%ed and paid back over an e1tended period. he real cost of an investment pro&ect depends in part on the interest rateAthe cost of borro%ing. ,hen the interest rate rises, it becomes more e1pensive to borro%, and fe%er pro&ects are likely to be undertaken3 increasing the interest rate, ceteris pari us, is likely to reduce the level of planned investment spending. ,hen the interest rate falls, it becomes less costly to borro%, and more investment pro&ects are likely to be undertaken3 reducing the interest rate, ceteris pari us, is likely to increase the level of planned investment spending. he relationship bet%een the interest rate and planned investment is illustrated by the do%n%ard/ sloping demand curve in 0igure 1!.!. he higher the interest rate is, the lo%er the level of planned investment. 6t an interest rate of 3 percent, planned investment is I0. ,hen the interest rate rises from 3 percent to ; percent, planned investment falls from I0 to I1. 6s the interest rate falls, ho%ever, more pro&ects become profitable, so more investment is undertaken.

Figure 12.2

Planne! 2n$estment "che!ule

3lanned investment spending is a negative function of the interest rate.

,e can no% use the fact that planned investment depends on the interest rate to consider ho% this relationship affects planned aggregate e1penditure 4(E5. Cecall that planned aggregate e1penditure is the sum of consumption, planned investment, and government purchases.1 hat isD (E # B I B G ,e no% kno% that there are actually many possible levels of I, each corresponding to a different interest rate. ,hen the interest rate changes, planned investment changes. herefore, a change in the interest rate 4r5 %ill lead to a change in total planned spending 4# B I B G5 as %ell.! 0igure 1!.3 sho%s %hat happens to planned aggregate e1penditure %hen the interest rate rises from 3 percent to ; percent. 6t the higher interest rate, planned investment is lo%er3 planned aggregate e1penditure thus shifts downward. Cecall from >hapters @ and 9D 6 fall in any component of aggregate spending has an even larger 4or .multiplier.5 effect on e2uilibrium income 4 +5. ,hen the interest rate rises, planned investment 4and planned aggregate e1penditure5 falls, and e2uilibrium output 4income5 falls by even more than the fall in planned investment. (n 0igure 1!.3, e2uilibrium + falls from +0 to +1 %hen the interest rate rises from 3 percent to ; percent.

Figure 12.3

The 0ffect of an 2nterest 6ate 2ncrease on Planne! Aggregate 01#en!iture

#n increase in the interest rate from & percent to - percent lowers planned aggregate expenditure and thus reduces e4uili rium income from Y; to Y<.

,e can summari?e the effects of a change in the interest rate on the e2uilibrium level of output. he effects of a change in the interest rate includeD

6 high interest rate 4r5 discourages planned investment 4I5. =lanned investment is a part of planned aggregate e1penditure 4(E5. hus, %hen the interest rate rises, planned aggregate e1penditure 4(E5 at every level of income falls. 0inally, a decrease in planned aggregate e1penditure lo%ers e2uilibrium output 4income5 4+5 by a multiple of the initial decrease in planned investment.

"sing a convenient shorthandD

6s you see, the e2uilibrium level of output 4+5 is not determined solely by events in the goods market, as %e assumed in our earlier simplified discussions. he reason is that the money market affects the level of the interest rate, %hich then affects planned investment in the goods market. here is a different e2uilibrium level of + for every possible level of the interest rate 4r5. he final level of e2uilibrium + depends on %hat the interest rate turns out to be, %hich depends on events in the money market. MONE" DEMANDB AGGREGATE O#TP#T 9INCOME:B AND THE MONE" MARKET ,e have &ust seen ho% the interest rateA%hich is determined in the money marketAinfluences the level of planned investment spending and thus the goods market. Fo% let us look at the other half of the storyD the %ays in %hich the goods market affects the money market. (n >hapter 11, %e e1plored the demand for money by households and firms and e1plained %hy the demand for money depends negatively on the interest rate. 6n increase in the interest rate raises the opportunity cost of holding non/interest/bearing money 4as compared %ith interest/bearing bonds5, encouraging people to keep more of their funds in bonds and less in checking account balances. he do%n%ard/sloping money demand curve 4Md5 is sho%n in 0igure 1!.-.

Figure 12.3

0?uili%rium in the Money Market

9f the interest rate were A percent, the 4uantity of money in circulation would exceed the amount households and firms want to hold. The excess money alances would cause the interest rate to drop as people try to shift their funds into interest- earing onds. #t & percent the opposite is true. ,xcess demand for money alances would push interest rates up. :nly at - percent would the actual 4uantity of money in circulation e e4ual to what the economy wants to hold in money alances.

,e also sa% in >hapter 11 that the demand for money depends on the level of income in the economy. 9ore income means more transactions, and an increased volume of transactions implies a greater demand for money. ,ith more people earning higher incomes and buying more goods and services, more money %ill be demanded to meet the increased volume of transactions. 6n increase in income therefore shifts the money demand curve to the right. 4Cevie% 0igure 11.).5 (f, as %e are assuming, the 0ederal Ceserve<s 40ed<s5 choice of the amount of money to supply does not depend on the interest rate, then the money supply curve is simply a vertical line. he e2uilibrium interest rate is the point at %hich the 2uantity of money demanded e2uals the 2uantity of money supplied. his e2uilibrium is sho%n at a ; percent interest rate in 0igure 1!.-. (f the amount of money demanded by households and firms is less than the amount in circulation as determined by the 0ed, as it is at an interest rate of 9 percent in 0igure 1!.-, the interest rate %ill fall. (f the amount of money demanded is greater than the amount in circulation, as it is at an interest rate of 3 percent in 0igure 1!.-, the interest rate %ill rise. Fo% consider %hat %ill happen to the interest rate %hen there is an increase in aggregate output 4income5 4+5. his increase in + %ill cause the money demand curve to shift to the right. his is illustrated in 0igure 1!.), %here an increase in income from +0 to +1 has shifted the money demand curve from Md0 to Md1. 6t the initial interest rate of ; percent, there is no% e1cess demand for money, and the interest rate rises from ; percent to 9 percent.

Figure 12.5

The 0ffect of an 2ncrease in 2ncome )Y, on the 2nterest 6ate )r,

#n increase in income from Y; to Y< shifts the Md curve to the right. 0ith a fixed supply of money, there is now an excess demand for money (Md B Ms) at the initial interest rate of - percent. This causes the interest rate to rise. #t an interest rate of A percent the money mar"et is again in e4uili rium with Ms C Md, ut at a higher interest rate than efore the increase in income.

he e2uilibrium level of the interest rate is not determined e1clusively in the money market. >hanges in aggregate output 4income5 4+5, %hich take place in the goods market, shift the money demand curve and cause changes in the interest rate. ,ith a given 2uantity of money supplied, higher levels of + %ill lead to higher e2uilibrium levels of r. Io%er levels of + %ill lead to lo%er e2uilibrium levels of r, as represented in the follo%ing symbols

Com4inin' the Goods Mar3et and the Money Mar3et

Fo% that %e are a%are of the links bet%een the goods market and the money market, %e can e1amine the t%o markets simultaneously. o see ho% the t%o markets interact, it %ill be convenient to consider the effects of changes in fiscal and monetary policy on the economy. ,e %ant to e1amine %hat happens to the e2uilibrium levels of aggregate output 4income5 4+5 and the interest rate 4r5 %hen certain key variablesAnotably government spending 4G5, net ta1es 4T5, and money supply 4Ms5A increase or decrease. E6PANSIONAR" PO/IC" E%%ECTS 6ny government policy aimed at stimulating aggregate output 4income5 4+5 is said to be e1pansionary. 6n e1pansionary fiscal policy is an increase in government spending 4G5 or a reduction in net ta1es 4T5 aimed at increasing aggregate output 4income5 4+5. 6n e1pansionary monetary policy is an increase in the money supply aimed at increasing aggregate output 4income5 4+5. E82ansionary %iscal Policy1 An Increase in Go ernment P!rchases 9 G: or Decrease in Net Ta8es 9T: 6s you kno% from >hapter 9, government purchases 4G5 and net ta1es 4T5 are the t%o tools of government fiscal policy. he government can stimulate the economyAthat is, it can increase aggregate output 4income5 4+5Aeither by increasing government purchases or by reducing net ta1es. hough the impact of a ta1 cut is some%hat smaller than the impact of an increase in G, both have a multiplier effect on the e2uilibrium level of +.

>onsider an increase in government purchases 4G5 of E10 billion. his increase in e1penditure causes firms< inventories to be smaller than planned. "nplanned inventory reductions stimulate production, and firms increase output 4+5. 7o%ever, because added output means added income, some of %hich is subse2uently spent, consumption spending 4#5 also increases. 6gain, inventories %ill be smaller than planned and output %ill rise even further. he final e2uilibrium level of output is higher by a multiple of the initial increase in government purchases. his multiplier story is incomplete, ho%ever. "ntil this chapter, %e have assumed that planned investment 4I5 is fi1ed at a certain level, but %e no% kno% that planned investment depends on the interest rate. ,e can no% discuss %hat happens to the multiplier %hen investment varies because %e no% have an understanding of the money market, in %hich the interest rate is determined. Ceturn to our multiplier story at the point that firms first begin to raise output in response to an increase in government purchases. 6s aggregate output 4income5 4+5 increases, an impact is felt in the money marketAthe increase in income 4+5 increases the demand for money 4Md5. 40or the moment, assume the 0ed holds the 2uantity of money supplied TMsU constant.5 he resulting dise2uilibrium, %ith the 2uantity of money demanded greater than the 2uantity of money supplied, causes the interest rate to rise. he increase in G increases both + and r. he increase in r has a side effectAa higher interest rate causes planned investment spending 4 I5 to decline. 'ecause planned investment spending is a component of planned aggregate e1penditure 4 # BI B G5, the decrease in I %orks against the increase in G. 6n increase in government spending 4G5 increases planned aggregate e1penditure and increases aggregate output, but a decrease in planned investment reduces planned aggregate e1penditure and decreases aggregate output. his tendency for increases in government spending to cause reductions in private investment spending is called the cro%ding/out effect. ,ithout any e1pansion in the money supply to accommodate the rise in income and increased money demand, planned investment spending is partially cro%ded out by the higher interest rate. he e1tra spending created by the rise in government purchases is some%hat offset by the fall in planned investment spending. (ncome still rises, but the multiplier effect of the rise in G is lessened because of the higher interest rate<s negative effect on planned investment. his cro%ding/out effect is illustrated graphically in 0igure 1!.;. 6n increase in government purchases from G0 to G1 shifts the planned aggregate e1penditure curve 4# B I0 B G05 up%ard. he increase in 4+5 from +0 to +1 causes the demand for money to rise, %hich results in a dise2uilibrium in the money market. he e1cess demand for money raises the interest rate 4 r5 from r0 to r1, causing I to decrease from I0 to I1. he fall in I pulls the planned aggregate e1penditure curve back do%n, %hich lo%ers the e2uilibrium level of income to +O. 4Cemember that e2uilibrium is achieved %hen +J (E.5

Figure 12.&

The Crow!ing48ut 0ffect

#n increase in government spending G from G; to G< shifts the planned aggregate expenditure schedule from < to .. The crowding-out effect of the decrease in planned investment ( rought a out y the increased interest rate) then shifts the planned aggregate expenditure schedule from . to &.

Fote that the si?e of the cro%ding/out effect and the ultimate si?e of the government spending multiplier depend on several things. 0irst, %e assumed the 0ed did not change the 2uantity of money supplied. (f %e %ere to assume instead that the 0ed e1panded the 2uantity of money to accommodate the increase in G, the multiplier %ould be larger. (n this case, the higher demand for money %ould be satisfied %ith a higher 2uantity of money supplied, and the interest rate %ould not rise. ,ithout a higher interest rate, there %ould be no cro%ding out. #econd, the cro%ding/out effect depends on the sensitivity or insensitivity of planned investment spending to changes in the interest rate. >ro%ding out occurs because a higher interest rate reduces planned investment spending. (nvestment depends on factors other than the interest rate, ho%ever, and investment may at times be 2uite insensitive to changes in the interest rate. (f planned investment does not fall %hen the interest rate rises, there is no cro%ding/out effect. 0or more details on one type of investment sensitive to interest/rate changes, see the Fe%s 6nalysis bo1, .Io%er (nterest Cates (ncrease (nvestment 7ousing and 9ortgages in !00!.. hese effects are summari?ed ne1t. Effects of an e1pansionary fiscal policyD

+ increases less than if r did not increase E1actly the same reasoning holds for changes in net ta1es. he ultimate effect of a ta1 cut on the e2uilibrium level of output depends on ho% the money market reacts. he e1pansion of + that a ta1 cut brings about %ill lead to an increase in the interest rate and thus a decrease in planned investment spending. he ultimate increase in + %ill therefore be less than it %ould be if the interest rate did not rise. E82ansionary Monetary Policy1 An Increase in the Money S!22ly

Fo% let us consider %hat %ill happen %hen the 0ed decides to increase the supply of money through open market operations. 6t first, open market operations in&ect ne% reserves into the system and e1pand the 2uantity of money supplied 4the money supply curve shifts to the right5. 'ecause the 2uantity of money supplied is no% greater than the amount households %ant to hold, the e2uilibrium rate of interest falls. =lanned investment spending 4%hich is a component of planned aggregate e1penditure5 increases %hen the interest rate falls.

Ta3e a moment to a22ly <hat yo!= e learned$

(ncreased planned investment spending means planned aggregate e1penditure is no% greater than aggregate output. 0irms e1perience unplanned decreases in inventories, and they raise output 4 +5. 6n increase in the money supply decreases the interest rate and increases +. 7o%ever, the higher level of + increases the demand for money 4the demand for money curve shifts to the right5, and this keeps the interest rate from falling as far as it other%ise %ould. (f you revie% the se2uence of events that follo%s the monetary e1pansion, you can see the links bet%een the in&ection of reserves by the 0ed into the economy and the increase in output. 0irst, the increase in the 2uantity of money supplied pushes do%n the interest rate. #econd, the lo%er interest rate causes planned investment spending to rise. hird, the increased planned investment spending means higher planned aggregate e1penditure, %hich means increased output as firms react to unplanned decreases in inventories. 0ourth, the increase in output 4income5 leads to an increase in the demand for money 4the demand for money curve shifts to the right5, %hich means the interest rate decreases less than it %ould have if the demand for money had not increased. Effects of an e1pansionary monetary policyD

r decreases less than if Md did not increase he po%er of monetary policy to affect the goods market depends on ho% much of a reaction occurs at each link in this chain. =erhaps the most critical link is the link bet%een r and (. 9onetary policy can be effective only if ( reacts to changes in r. (f firms sharply increase the number of investment pro&ects undertaken %hen the interest rate falls, e1pansionary monetary policy %orks %ell at stimulating the economy. (f, ho%ever, firms are reluctant to invest even at a lo% interest rate, e1pansionary monetary policy %ill have limited success. (n other %ords, the effectiveness of monetary policy depends on the shape of the investment function. (f it is nearly vertical, indicating very little responsiveness of investment to the interest rate, the middle link in this chain is %eak, rendering monetary policy ineffective. 'ecause productivity increased and large firms continued to trim payrolls even as output %as e1panding, the unemployment rate stayed high right into the presidential election of 199!.

CONTRACTIONAR" PO/IC" E%%ECTS

6ny government policy that is aimed at reducing aggregate output 4income5 4+5 is said to be contractionary. ,here e1pansionary policy is used to boost the economy, contractionary policy is used to slo% the economy. >onsidering that one of the four ma&or economic goals is economic gro%th 4>hapter 15, %hy %ould the government adopt policies designed to reduce aggregate spendingG 6s %e %ill see in the ne1t t%o chapters, one %ay to fight inflation is to reduce aggregate spending. ,hen the inflation rate is high, the government may feel compelled to use its po%ers to contract the economy. 'efore %e discuss the contractionary policies that the government has undertaken in recent years, %e need to discuss ho% contractionary fiscal and monetary policy %ork. Contractionary %iscal Policy1 A Decrease in Go ernment S2endin' 9 G: or an Increase in Net Ta8es 9T: 6 contractionary fiscal policy is a decrease in government spending 4G5 or an increase in net ta1es 4T5 aimed at decreasing aggregate output 4income5 4+5. he effects of this policy are the opposite of the effects of an e1pansionary fiscal policy. 6 decrease in government purchases or an increase in net ta1es leads to a decrease in aggregate output 4income5 4+5, a decrease in the demand for money 4Md5, and a decrease in the interest rate 4r5. he decrease in + that accompanies a contractionary fiscal policy is less than it %ould be if %e did not take the money market into account because the decrease in r also causes planned investment 4I5 to increase. his increase in I offsets some of the decrease in planned aggregate e1penditure brought about by the decrease in G. 4 his also means the multiplier effect is smaller than it %ould be if %e did not take the money market into account.5 he effects of a decrease in G, or an increase in T, can be represented as sho%n. Effects of a contractionary fiscal policyD

+ decreases less than if r did not decrease

Contractionary Monetary Policy1 A Decrease in the Money S!22ly 6 contractionary monetary policy is a decrease in the money supply aimed at decreasing aggregate output 4income5 4+5. 6s you recall, the level of planned investment spending is a negative function of the interest rateD he higher the interest rate, the less planned investment there %ill be. he less planned investment there is, the lo%er planned aggregate e1penditure %ill be, and the lo%er the e2uilibrium level of output 4income5 4+5 %ill be. he lo%er e2uilibrium income results in a decrease in the demand for money, %hich means that the increase in the interest rate %ill be less than it %ould be if %e did not take the goods market into account. Effects of a contractionary monetary policyD

r increases less than if Md did not decrease THE MACROECONOMIC PO/IC" MI6

6lthough %e have been treating fiscal and monetary policy separately, it should be clear that fiscal and monetary policy can be used simultaneously. 0or e1ample, both government purchases 4 G5 and the money supply 4Ms5 can be increased at the same time. ,e have seen that an increase in G by itself raises both + and r, %hile an increase in Ms by itself raises + but lo%ers r. herefore, if the government %anted to increase + %ithout changing r, it could do so by increasing both G and Ms by the appropriate amounts. =olicy mi1 refers to the combination of monetary and fiscal policies in use at a given time. 6 policy mi1 that consists of a decrease in government spending and an increase in the money supply %ould favor investment spending over government spending. his is because both the increased money supply and the fall in government purchases %ould cause the interest rate to fall, %hich %ould lead to an increase in planned investment. he opposite is true for a mi1 that consists of an e1pansionary fiscal policy and a contractionary monetary policy. his mi1 favors government spending over investment spending. #uch a policy %ill have the effect of increasing government spending and reducing the money supply. ight money and e1panded government spending %ould drive the interest rate up and planned investment do%n. here is no rule about %hat constitutes the .best. policy mi1 or the .best. composition of output. +n this, as on many other issues, economists 4and others5 disagree. (n part, someone<s preference for a certain composition of outputAsay, one %eighted heavily to%ard private spending %ith relatively little government spendingAdepends on ho% that person stands on such issues as the proper role of government in the economy. able 1!.1 summari?es the effects of various combinations of policies on several important macroeconomic variables. (f you can e1plain the reasoning underlying each of the effects sho%n in the table, you can be satisfied that you have a good understanding of the links bet%een the goods market and the money market.
Ta%le 12.1 The 0ffects of the Macroeconomic Policy Mi1

FISCAL Expansionary E1pansionary Contractionary

8ONETAR/ >ontractionary

1ey/ / Daria le increases. / Daria le decreases. E / Forces push the varia le in different directions. 0ithout additional information, we cannot specify which way the varia le moves.

Other Determinants

of Planned In estment
,e have assumed in this chapter that planned investment depends only on the interest rate. (n reality, planned investment depends on other factors. ,e %ill discuss these factors more in >hapter 1;, but provide a brief description here. E82ectations and Animal S2irits 0irms< e1pectations about their future sales play an important role in their investment decisions. ,hen a firm invests, it adds to its capital stock, and capital is used in the production process. (f a firm e1pects that its sales %ill increase in the future, it may begin to build up its capital stockAthat is, to investAno% so that it %ill be able to produce more in the future to meet the increased level of sales. he optimism or pessimism of entrepreneurs about the future course of the economy can have an important effect on current planned investment. :eynes used the phrase animal spirits to describe the feelings of entrepreneurs, and he argued that these feelings affect investment decisions.

Ca2ital #tiliCation Rates he degree of utili?ation of a firm<s capital stock is also likely to affect planned investment. (f the demand for a firm<s output has been decreasing and the firm has been lo%ering output in response to this decline, the firm may have a lo% rate of capital utili?ation. (t can be costly to get rid of capital 2uickly once it is in place, and firms sometimes respond to a fall in output by keeping the capital in place but utili?ing it lessAfor e1ample, by running machines fe%er hours per day or at slo%er speeds. 0irms tend to invest less in ne% capital %hen their capital utili?ation rates are lo% than %hen they are high. Relati e /a4or and Ca2ital Costs he cost of capital 4of %hich the interest rate is the main component5 relative to the cost of labor can affect planned investment. (f labor is e1pensive relative to capital 4high %age rates5, firms tend to substitute a%ay from labor to%ard capital. hey aim to hold more capital relative to labor %hen %age rates are high than %hen they are lo%. he determinants of planned investment areD

he interest rate E1pectations of future sales >apital utili?ation rates Celative capital and labor costs

A''re'ate DemandB A''re'ate S!22lyB and Monetary and %iscal Policy

,e are no% ready to use the (5H(' frame%ork to consider the effects of monetary and fiscal policy. ,e %ill first consider the short/run effects. Cecall that the t%o fiscal policy variables are government purchases 4G5 and net ta1es 4T5. he monetary policy variable is the 2uantity of money supplied 4M s5. 6n expansionary policy aims at stimulating the economy through an increase in G or M s or a decrease in T. 6 contractionary policy aims at slo%ing do%n the economy through a decrease in G or M s or an increase in T. ,e sa% earlier in this chapter that an e1pansionary policy shifts the (' curve to the right and that a contractionary policy shifts the (' curve to the left. 7o% do these policies affect the e2uilibrium values of the price level 4%5 and the level of aggregate output 4income5G ,hen considering the effects of a policy change, %e must be careful to note %here along the 4short/ run5 (5 curve the economy is at the time of the change. (f the economy is initially on the flat portion of the (5 curve, as sho%n by point ( in 0igure 13.11, then an e1pansionary policy, %hich shifts the (' curve to the right, results in a small price increase relative to the output increaseD he increase in e2uilibrium + 4from +0 to +15 is much greater than the increase in e2uilibrium % 4from %0 to %15. his is the case in %hich an e1pansionary policy %orks %ell. here is an increase in output %ith little increase in the price level.

Figure 13.11

A "hift of the Aggregate eman! Cur$e @hen the 0conomy 2s on the +early Flat Part of the AS Cur$e

#ggregate demand can shift to the right for a num er of reasons, including an increase in the money supply, a tax cut, or an increase in government spending. 9f the shift occurs when the economy is on the nearly flat portion of the AS curve, the result will e an increase in output with little increase in the price level.

(f the economy is initially on the steep portion of the (5 curve, as sho%n by point ) in 0igure 13.1!, then an e1pansionary policy results in a small increase in e2uilibrium output 4from +0 to +15 and a large increase in the e2uilibrium price level 4from %0 to %15. (n this case, an e1pansionary policy does not %ork %ell. (t results in a much higher price level %ith little increase in output. he multiplier is therefore close to ?eroD +utput is initially close to capacity, and attempts to increase it further lead mostly to a higher price level.

Figure 13.12

A "hift of the Aggregate eman! Cur$e @hen the 0conomy 2s 8#erating at or +ear Ma1imum Ca#acity

9f a shift of aggregate demand occurs while the economy is operating near full capacity, the result will e an increase in the price level with little increase in output..

0igures 13.11 and 13.1! sho% it is important to kno% %here the economy is efore a policy change is put into effect. he economy is producing on the nearly flat part of the (5 curve if most firms are producing %ell belo% capacity. ,hen this is the case, firms %ill respond to an increase in demand by increasing output much more than they increase prices. (f the economy is producing on the steep part of the (5 curve, firms are close to capacity and %ill respond to an increase in demand by increasing prices much more than they increase output. o see %hat happens %hen the economy is on the steep part of the (5 curve, consider the effects of an increase in G %ith no change in the money supply. ,hy, %hen G is increased, %ill there be virtually no increase in +G (n other %ords, %hy %ill the e1pansionary fiscal policy fail to stimulate the economyG o ans%er this %e need to go back to >hapter 1! and consider %hat is behind the (' curve. he first thing that happens %hen G increases is an unanticipated decline in firms< inventories. 'ecause firms are very close to capacity output %hen the economy is on the steep part of the (5 curve, they cannot increase their output very much. he result, as 0igure 13.1! sho%s, is a substantial increase in the price level. he increase in the price level increases the demand for money, %hich 4%ith a fi1ed money supply5 leads to an increase in the interest rate, decreasing planned investment. There is nearly complete crowding out of investment. (f firms are producing at capacity, prices and interest rates %ill continue to rise until the increase in G is completely matched by a decrease in planned investment and there is complete cro%ding out. /ONG&R#N AGGREGATE S#PP/" AND PO/IC" E%%ECTS ,e have so far been considering monetary and fiscal policy effects in the short run. >oncerning the long run, it is important to reali?eD (f the (5 curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output in the long run.

Iook back at 0igure 13.10. 9onetary and fiscal policy shift the (' curve. (f the long/run (5 curve is vertical, output al%ays comes back to +0. (n this case, policy affects only the price level in the long run, and the multiplier effect of a change in government spending on aggregate output in the long run is ?ero. "nder the same circumstances, the ta1 multiplier is also ?ero. he conclusion that policy has no effect on aggregate output in the long run is perhaps startling. Do most economists agree that the aggregate supply curve is vertical in the long runG 9ost economists agree that input prices tend to lag output prices in the short run, giving the (5 curve some positive slope. 9ost also agree the (5 curve is likely to be steeper in the long run, but ho% long is the long runG he longer the lag time, the greater the potential impact of monetary and fiscal policy on aggregate output. (f the long run is only 3 to ; months, policy has little chance to affect output3 if the long run is 3 or - years, policy can have significant effects. 6 good deal of research in macroeconomics focuses on the length of time lags bet%een input and output prices. (n a sense, the length of the long run is one of the most important open 2uestions in macroeconomics. 6nother source of disagreement centers on %hether e2uilibria belo% potential GD=, +0 in 0igure 13.10, are self/correcting. Cecall that those %ho believe in a vertical long/run (5 curve believe that slack in the economy %ill put do%n%ard pressure on input prices 4including %ages5, causing the short/ run (5 curve to shift to the right and pushing GD= back to%ard +0. 7o%ever, some argue that %ages and other input prices do not fall during slack periods and that the economy can get .stuck. at an e2uilibrium belo% potential GD=. (n this case, monetary and fiscal policy %ould be necessary to restore full employment. he .ne% classical. economics, assumes prices and %ages are fully fle1ible and ad&ust very 2uickly to changing conditions. Fe% classical economists believe, for e1ample, that %age rate changes do not lag price changes. he ne% classical vie% is consistent %ith the e1istence of a vertical (5 curve, even in the short run. 6t the other end of the spectrum is %hat is sometimes called the simple .:eynesian. vie% of aggregate supply. hose %ho hold this vie% believe there is a kink in the (5 curve at capacity output.

Ca!ses of Inflation
,e no% turn to inflation and use the (5H(' frame%ork to consider the causes of inflation. IN%/ATION 5ERS#S S#STAINED IN%/ATION1 A REMINDER 'efore %e discuss the specific causes of inflation, recall the distinction %e made in >hapter *. (nflation, as you kno%, is an increase in the overall price level. 6nything that shifts the (' curve to the right or the (5 curve to the left causes inflation, but it is often useful to distinguish bet%een a onetime increase in the price level 4a one/time inflation5 and an inflation that is sustained. 6 sustained inflation occurs %hen the overall price level continues to rise over some fairly long period of time. ,hen %e speak of a sustained inflation rate of * percent, for e1ample, %e generally mean that the price level has been rising at a rate of * percent per year over a number of years. (t is generally accepted that there are many possible causes of a one/time increase in the price level. 4,e discuss the main causes ne1t.5 0or the price level to continue to increase period after period, most economists believe it must be .accommodated. by an e1panded money supply. his leads to the assertion that a sustained inflation, %hatever the initial cause of the increase in the price level, is essentially a monetary phenomenon.

DEMAND&P#// IN%/ATION (nflation initiated by an increase in aggregate demand is called demand/pull inflation. Lou can see ho% demand/pull inflation %orks by looking at 0igures 13.11 and 13.1!. (n both, the inflation begins %ith a shift of the aggregate demand schedule from ('0 to ('1, %hich causes the price level to increase from %0 to %1. 4+utput also increases, from +0 to +1.5 (f the economy is operating on the steep portion of the (5 curve at the time of the increase in aggregate demand, as in 0igure 13.1!, most of the effect %ill be an increase in the price level instead of an increase in output. (f the economy is operating on the flat portion of the (5 curve, as in 0igure 13.11, most of the effect %ill be an increase in output instead of an increase in the price level. Cemember, in the long run the initial increase in the price level %ill cause the (5 curve to shift to the left as input prices 4costs5 respond to the increase in output prices. (f the long/run (5 curve is vertical, as depicted in 0igure 13.10, the increase in costs %ill shift the short/run (5 curve 4(505 to the left to (51, pushing the price level even higher, to %!. (f the long/run (5 curve is vertical, a shift in aggregate demand from ('0 to ('1 %ill result, in the long run, in no increase in output and a price/level increase from %0 to %!. COST&P#SHB OR S#PP/"&SIDEB IN%/ATION (nflation can also be caused by an increase in costs, referred to as cost/push, or supply/side, inflation. #everal times in the last t%o decades oil prices on %orld markets increased sharply. 'ecause oil is used in virtually every line of business, costs increased. 6n increase in costs 4a cost shock5 shifts the (5 curve to the left, as 0igure 13.13 sho%s. (f %e assume the government does not react to this shift in (5 by changing fiscal or monetary policy, the (' curve %ill not shift. he supply shift %ill cause the e2uilibrium price level to rise 4from %0 to %15 and the level of aggregate output to decline 4from +0 to +15. Cecall from >hapter 1; that stagflation occurs %hen output is falling at the same time prices are risingAin other %ords, %hen the economy is e1periencing both a contraction and inflation simultaneously. 0igure 13.13 sho%s that one possible cause of stagflation is an increase in costs.

Figure 13.13

Cost4Push- or "u##ly4"i!e 2nflation

#n increase in costs shifts the AS curve to the left. +y assuming the government does not react to this shift, the A curve does not shift, the price level rises, and output falls..

o return to monetary and fiscal policy for a moment, note from 0igure 13.13 that the government could counteract the increase in costs 4the cost shock5 by engaging in an e1pansionary policy 4an increase in G or M s or a decrease in T5. his %ould shift the (' curve to the right, and the ne% (' curve %ould intersect the ne% (5 curve at a higher level of output. he problem %ith this policy, ho%ever, is that the intersection of the ne% (5 and (' curves %ould take place at a price even higher than %1 in 0igure 13.13. >ost shocks are bad ne%s for policy makers. he only %ay they can counter the output loss brought about by a cost shock is by having the price level increase even more than it %ould %ithout the policy action. his situation is illustrated in 0igure 13.1-.

Figure 13.13

Cost "hocks Are Ba! +ews for Policy Makers

# cost shoc" with no change in monetary or fiscal policy would shift the aggregate supply curve from AS; to AS<, lower output from Y; to Y<, and raise the price level from !; to !<. Fonetary or fiscal policy could e changed enough to have the A curve shift from A ; to A <. This would prevent output from falling, ut it would raise the price level further, to !..

E6PECTATIONS AND IN%/ATION ,hen firms are making their priceHoutput decisions, their expectations of future prices may affect their current decisions. (f a firm e1pects that its competitors %ill raise their prices, in anticipation it may raise its o%n price. >onsider a firm that manufactures toasters. he toaster maker must decide %hat price to charge retail stores for its toaster. (f it overestimates price and charges much more than other toaster manufacturers are charging, it %ill lose many customers. (f it underestimates price and charges much less than other toaster makers are charging, it %ill gain customers but at a considerable loss in revenue per sale. he firm<s optimum priceAthe price that ma1imi?es the firm<s profitsAis presumably not too far from the average of its competitors< prices. (f it does not kno% its competitors< pro&ected prices before it sets its o%n price, as is often the case, it must base its price on %hat it e1pects its competitors< prices to be. #uppose inflation has been running at about 10 percent per year. +ur firm probably e1pects its competitors %ill raise their prices about 10 percent this year, so it is likely to raise the price of its o%n toaster by about 10 percent. his is ho% e1pectations can get .built into the system.. (f every firm

e1pects every other firm to raise prices by 10 percent, every firm %ill raise prices by about 10 percent. Every firm ends up %ith the price increase it e1pected. he fact that e1pectations can affect the price level is ve1ing. E1pectations can lead to an inertia that makes it difficult to stop an inflationary spiral. (f prices have been rising, and if people<s e1pectations are adaptiveAthat is, if they form their e1pectations on the basis of past pricing behaviorAthen firms may continue raising prices even if demand is slo%ing or contracting. (n terms of the (5H(' diagram, an increase in inflationary e1pectations that causes firms to increase their prices shifts the (5 curve to the left. Cemember that the (5 curve represents the priceHoutput responses of firms. (f firms increase their prices because of a change in inflationary e1pectations, the result is a left%ard shift of the (5 curve. MONE" AND IN%/ATION (t is easy to see that an increase in the money supply can lead to an increase in the aggregate price level. 6s 0igures 13.11 and 13.1! sho%, an increase in the money supply 4M s5 shifts the (' curve to the right and results in a higher price level. his is simply a demand/pull inflation. 7o%ever, the supply of money may also play a role in creating a sustained inflation. >onsider an initial increase in government spending 4G5 %ith the money supply 4M s5 unchanged. 'ecause the money supply is unchanged, this is an increase in G that is not .accommodated. by the 0ed. he increase in G shifts the (' curve to the right and results in a higher price level. his is sho%n in 0igure 13.1) as a shift from ('0 to ('1. 4(n 0igure 13.1), the economy is assumed to be operating on the vertical portion of the (5 curve.5

Figure 13.15

"ustaine! 2nflation from an 2nitial 2ncrease in G an! Fe! Accommo!ation

#n increase in G with the money supply constant shifts the A curve from A ; to A <. #lthough not shown in the figure, this leads to an increase in the interest rate and crowding out of planned investment. 9f the Fed tries to "eep the interest rate unchanged y increasing the money supply, the A curve will shift farther and farther to the right. The result is a sustained inflation, perhaps hyperinflation.

Cemember %hat happens %hen the price level increases. he higher price level causes the demand for money to increase. ,ith an unchanged money supply and an increase in the 2uantity of money demanded, the interest rate %ill rise, and the result %ill be a decrease in planned investment 4 I5

spending. he ne% e2uilibrium corresponds to higher G, lo%er I, a higher interest rate, and a higher price level. Fo% let us take our e1ample one step further. #uppose that the 0ed is sympathetic to the e1pansionary fiscal policy 4the increase in G %e &ust discussed5 and decides to e1pand the supply of money to keep the interest rate constant. 6s the higher price level pushes up the demand for money, the 0ed e1pands the supply of money %ith the goal of keeping the interest rate unchanged, eliminating the cro%ding/ out effect of a higher interest rate. ,hen the supply of money is e1panded, the (' curve shifts to the right again, from ('1 to ('!. his shift of the (' curve, brought about by the increased money supply, pushes prices up even further. 7igher prices in turn increase the demand for money further, %hich re2uires a further increase in the money supply, and so on. ,hat %ould happen if the central bank tried to keep the interest rate constant %hen the economy is operating on the steep part of the (5 curveG he situation could lead to a hyperinflation, a period of very rapid increases in the price level. (f no more output can be coa1ed out of the economy and if planned investment is not allo%ed to fall 4because the interest rate is kept unchanged5, then it is not possible to increase G. 6s the central bank keeps pumping more and more money into the economy to keep the interest rate unchanged, the price level %ill keep rising. S#STAINED IN%/ATION AS A P#RE/" MONETAR" PHENOMENON $irtually all economists agree that an increase in the price level can be caused by anything that causes the (' curve to shift to the right or the (5 curve to shift to the left. hese include e1pansionary fiscal policy actions, monetary e1pansion, cost shocks, changes in e1pectations, and so forth. (t is also generally agreed that for a sustained inflation to occur, the central bank must accommodate it. (n this sense, a sustained inflation can be thought of as a purely monetary phenomenon. his argument, first put forth by monetarists has gained %ide acceptance. (t is easy to sho%, as %e &ust did, ho% e1panding the money supply can continuously shift the (' curve. (t is not as easy to come up %ith other reasons for continued shifts of the (' curve if the money supply is constant. +ne possibility is for the government to increase spending continuously %ithout increasing ta1es, but this process cannot continue forever. o finance spending %ithout ta1es, the government must borro%. ,ithout any e1pansion of the money supply, the interest rate %ill rise dramatically because of the increase in the supply of government bonds. Fo%, the public must be %illing to buy the government bonds that are being issued to finance the spending increases. 6t some point, the public may be un%illing to buy any more bonds even though the interest rate is very high. 6t this point, the government is no longer able to increase non/ta1/financed spending %ithout the central bankPs cooperation. (f this is true, then a sustained inflation cannot e1ist %ithout the central bankPs cooperation.