25.1: Major Theories in Macroeconomics

25.1.1: Keynesian Theory

Learning Objective

Explain the main tenets of Keynesian economics

Key Points

• John Maynard Keynes published a book in 1936 called The General Theory of Employment, Interest, and Money, laying the groundwork for his legacy of the Keynesian Theory of Economics.
• Keynes positioned his argument in contrast to this idea, stating that markets are imperfect and will not always self correct.
• Keynes believed that wage reductions in recessions and excessive savings were potential threats to an economy.
• Keynesian theory expects fiscal policy to offset business cycles (employ counter-cyclical strategies).

Key Terms

Keynesian

Of or pertaining to an economic theory based on the ideas of John Maynard Keynes, as put forward in his book The General Theory of Employment, Interest, and Money.

monetary policy

The process of controlling the supply of money in an economy, often conducted by central banks.

fiscal policy

Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.

Historical Background

John Maynard Keynes published a book in 1936 called The General Theory of Employment, Interest, and Money, laying the groundwork for his legacy of the Keynesian Theory of Economics. It was an interesting time for economic speculation considering the dramatic adverse effect of the Great Depression . Keynes’s concepts played a role in public economic policy under Roosevelt as well as during World War II, becoming the dominant perspective in Europe following the war.

At the time, the primary school of economic thought was that of the classical economists (which is still a popular school of thought today). The central tenet of the classical argument says that supply can always create demand, and that surpluses will result in price reductions to the point of consumption. Put simply, people have infinite needs and the market will self-correct to the aggregate demands and available resources. This implies a hands-of public policy where markets are capable of taking care of themselves.

Keynes positioned his argument in contrast to this idea, stating that markets are imperfect and will not always self correct. Keynes theorized that natural inefficiencies in the market will see goods that are not met with demand. This wasted capital can result in market losses, unemployment, and market inefficiency (this was called ‘general glut’ in the classical model, when aggregate demand does not meet supply). Keynes insisted that markets do need moderate governmental intervention through fiscal policy (government investment in infrastructure) and monetary policy (interest rates).

Main Tenets

With this overview in mind, Keynesian Theory generally observes the following concepts:

• Unemployment:Under the classical model, unemployment is often attributed to high and rigid real wages. Keynes argues there is more complexity than that, specifically that societies are highly resistant to wage cuts and furthermore that reducing wages would pose a great threat to an economy. Specifically, cutting wages reduces spending and may result in a downwards spiral.
• Excessive Saving:Keynes’s concept here is somewhat complicated, but in short Keynes notes excessive saving as a threat and prospective cause of economic decline. This is because excessive saving leads to reduced investment and reduced spending, which drives down demand and the potential for consumption. This can be another spiraling issue, as money not being exchanged is actively reducing prospective employment, revenues, and future investments.
• Fiscal Policy:The key concept in fiscal policy for Keynes is ‘counter-cyclical’ fiscal policy, which is the expectation that governments can reduce the negative effects of the natural business cycle. This is, generally, achieved through deficit spending in recessions and suppression of inflation during boom times. Simply put, the government should try to curb the extremes of economic fluctuation through informed fiscal policy.
• The Multiplier Effect: This idea has in many ways already been implied in the atom, but inversely. Consider the unemployment and excessive savings problems, and how they stand to lead to spiraling decline. The other side of that coin is that positive economic situations can spiral upwards. Take for example a government investment in transportation, putting money in the pockets of various individuals who build trains and tracks. These individuals will spend that extra capital, putting money in the hands of other business (and this will continue). This is called the multiplier effect.
• IS-LM : While the IS-LM Model is a complicated byproduct of Keynesian economics, it can be summarized as the relationship between interest rates (y-axis) and the real economic output (x-axis). This is done through analyzing the invest-saving relationship (IS) in contrast to the liquidity preference and money supply relationship (LM), generating an equilibrium where certain interest rates and outputs will be generated.

While Keynesian Theory has been expounded upon significantly over the years, the important takeaway here is that aggregate demand (and thus the amount of supply consumed) is not a perfect system. Instead, demand is affected by various external forces that can create an inefficient market which will in turn affect employment, production, and inflation.

25.1.2: Monetarist

Learning Objective

Explain the main tenets of Monetarism

Key Points

• Clark Warburton, in 1945, has been identified as the first thinker to draft an empirically sound argument in favor of monetarism. This was taken more mainstream by Milton Friedman in 1956.
• More money in the system results in higher spending and vice verse. This would theoretically provide some control over aggregate demand.
• Historical implementation of monetarism demonstrated some correlation with control over inflation rates and increased economic performance. This could have been a result of other factors however.
• The Austrian school of economic thought perceives monetarism as somewhat narrow-minded, not effectively taking into account the subjectivity involved in valuing capital.
• Due to the globalization of the economy, monetarism may have a negative impact on external economies. This is particularly true of the U.S., whose capital is an international standard.

Key Terms

gold standard

A monetary system where the value of circulating money is linked to the value of gold.

Monetarism

The doctrine that economic systems are controlled by variations in the supply of money.

Background

In the rise of monetarism as an ideology, two specific economists were critical contributors. Clark Warburton, in 1945, has been identified as the first thinker to draft an empirically sound argument in favor of monetarism. This was taken more mainstream by Milton Friedman in 1956 in a restatement of the quantity theory of money. The basic premise these two economists were putting forward is that the supply of money and the role of central banking play a critical role in macroeconomics.

The generation of this theory takes into account a combination of Keynesian monetary perspectives and Friedman’s pursuit of price stability. Keynes postulated a demand-driven model for currency; a perspective on printed money that was not beholden to the ‘gold standard’ (or basing economic value off of rare metal). Instead, the amount of money in a given environment should be determined by monetary rules. Friedman originally put forward the idea of a ‘k-percent rule,’ which weighed a variety of economic indicators to determine the appropriate money supply.

Evidence

Theoretically, the idea is actually quite straight-forward. When the money supply is expanded, individuals will be induced to higher spending. In turn, when the money supply retracted, individuals would limit their budgetary spending accordingly. This would theoretically provide some control over aggregate demand (which is one of the primary areas of disagreement between Keynesian and classical economists).

Monetarism began to deviate more from Keynesian economics however in the 70’s and 80’s, as active implementation and historical reflection began to generate more evidence for the monetarist view. In 1979 for example, Jimmy Carter appointed Paul Volcker as Chief of the Federal Reserve, who in turn utilized the monetarist perspective to control inflation. He eventually created a price stability, providing evidence that the theory was sound. In addition, Milton Friedman and Ann Schwartz analyzed the Great Depression in the context of monetarism as well, identifying a shortage of the money supply as a critical component of the recession.

The 1980s were an interesting transitional period for this perspective, as early in the decade (1980-1983) monetary policies controlling capital were attributed to substantial reductions in inflation (14% to 3%)(see ). However, unemployment and the rise of the use of credit are quoted as two alternatives to money supply control being the primary influence of the boom that followed 1983.

Counter Arguments

As these counter arguments in the 1980s began to arise, critics of monetarism became more mainstream. Of the current monetarism critics, the Austrian school of thought is likely the most well-known. The Austrian school of economic thought perceives monetarism as somewhat narrow-minded, not effectively taking into account the subjectivity involved in valuing capital. That is to say that monetarism seems to assume an objective value of capital in an economy, and the subsequent implications on the supply and demand.

Other criticisms revolve around international investment, trade liberalization, and central bank policy. This can be summarized as the effects of globalization, and the interdependence of markets (and consequently currencies). To manipulate money supply there will inherently be effects on other currencies as a result of relativity. This is particularly important in regards to the U.S. currency, which is considered a standard in international markets. Controlling supply and altering value may have effects on a variety of internal economic variables, but it will also have unintended consequences on external variables.

25.1.3: Austrian

Learning Objective

Explain the main tenets of Austrian economics

Key Points

• The Austrian school of economics is one of the oldest economic perspectives, originating in the 19th century in Vienna.
• Austrian economics is attributed for the identification of opportunity cost, capital and interest, inflation, business cycles and the organizing power of markets.
• Austrian economists do not often place much weight on concepts such as econometrics, experimental economics, and aggregate macroeconomic analysis. In this sense, the Austrian school of thought is something of an outsider relative to other perspectives (i.e. classical, Keynesian, etc. ).
• Paul Krugman criticized Austrian economics as lacking explicit models of analysis, or essentially a lack of clarity in their approach. This results in inadvertent blind spots.

Key Terms

Opportunity cost

The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).

time value of money

The time value of money is the principle that a certain currency amount of money today has a different buying power (value) than the same currency amount of money in the future.

Background

The Austrian school of economics originated in the 19th century in Vienna, Austria. While there were a variety of famous economists attributed to the early foundations and later expansions of the Austrian economic perspective, Carl Menger, Friedrich von Weiser, and Eugen von Bohm-Bawerk are widely recognized as critical early pioneers. The general perspective of Austrian economic thought is methodological individualism, or the recognition that people will act in meaningful ways which can be analyzed for trends.

Central Tenets

The Austrian school of thought provided enormous value to the economic climate, both as a foundation for future economics and as a deliberate counterpoint to more quantitative analysis. Of the most important ideologies, the following central tenets are:

• Opportunity Cost: This is a concept you are likely already familiar with, and one of the most important ideas in all of business and economics. Essentially, the price of a good must also incorporate the value sacrificed of the next best alternative. Basically each choice a consumer or business makes intrinsically has the cost of not being able to make an alternative choice.
• Capital and Interest: Largely in response to Karl Marx’s labor theories, Austrian economist Bohm-Bawerk identified the building blocks of interest rates and profit are supply and demand alongside time preference. In short, present consumption is more valuable than future consumption (the time value of money).
• Inflation: The idea that prices and wages must rise as a result of increased money supply is inflation (note: this is different that price inflation). Simply put, more money in the system without a higher demand for that money will drive down the relative value of each dollar.
• Business Cycles:The Austrian business cycle theory (ABCT) is the simple observation that the issuance of credit (by banks) creates economic fluctuations that tend to be cyclical (see ). In simple terms, banks will lend out money at rates lower than the risk in which that money will be used. So when businesses fail more often than they succeed, thus losing interest as opposed to accruing it, will struggle to repay their debts. When the banks call in those debts the business cannot pay, creating negative business cycles.
• The Organizing Power of Markets: The idea of this concept is that no one person knows what the appropriate price of a good should be. Instead, markets naturally generate incentives to identify optimal price points. This negates the ideas of socialism common at the time, as communist systems will be unable to identify the appropriate exchange value of each good.

As you can see from the above points, this school of economics is largely about making qualitative observations of the markets. These observations are absolutely critical in understanding the theoretical landscape, but difficult to enact in practice.

Criticisms

Austrian economists are often criticized for ignoring arithmetic or statistical ways to measure and analyze economics. Indeed, Austrian economists do not often place much weight on concepts such as econometrics, experimental economics, and aggregate macroeconomic analysis. In this sense, the Austrian school of thought is something of an outsider relative to other perspectives (i.e. classical, Keynesian, etc.).

Paul Krugman criticized Austrian economics as lacking explicit models of analysis, or essentially a lack of clarity in their approach. This results in inadvertent blind spots. This is a sensible criticism in many ways, as the fundamental idea behind this economic theory is that it is driven by individuals and individuals are not always rational (indeed, they are quite often irrational). As a result of this, Austrian economics often rests on the integration of social sciences (psychology, sociology, etc.) to explain preferences and consumer behavior, which is often counter-intuitive. As a result, it is very difficult to accurately measure and provide tangible proof of the efficacy of Austrian models.

25.1.4: Alternative Views

Learning Objective

Summarize neoclassical and Neo-Keynesian economics

Key Points

• The history of different economic schools of thought have consistently generated evolving theories of economics as new data and new perspectives are taken into consideration.
• The neoclassical perspective in conjunction with Keynesian ideas is referred to as the neoclassical synthesis, which is largely considered the ‘mainstream’ economic perspective.
• A critical difference between classical and neoclassical perspectives is the introduction of marginalism. Marginalism notes that economic participants make decisions based on marginal utility or margins.
• Neo-Keynesian economics is the formalization and coordination of Keynes’s writings by a number of other economists (most notably John Hicks, Franco Modigliani and Paul Samuelson).
• The important to understand that these economic perspectives add value to one another and the overall efficacy of all economic theory.

Key Terms

static

Unchanging; that cannot or does not change.

stagflation

Inflation accompanied by stagnant growth, unemployment or recession.

Background

The history of different economic schools of thought have consistently generated evolving theories of economics as new data and new perspectives are taken into consideration. The two most well-known schools, classical economics and Keynesian economics, have been adapting to incorporate new information and ideas from one another as well as lesser known schools of economics (Chicago, Austrian, etc.). These different perspectives have motivated economists to generate the neoclassical and neo-Keynesian perspectives. The neoclassical perspective, in conjunction with Keynesian ideas, is referred to as the neoclassical synthesis, which is largely considered the ‘mainstream’ economic perspective.

Neoclassical

In approaching Neoclassical economics, it is most important to keep in mind the following three principles:

1. People have rational preferences in the context of options or outcomes that can be identified and associated with a given value (usually monetary). In short, people make smart choices regarding how they spend their money.
2. Individuals maximize utility and firms maximize profit. People will try to get the most from their money while corporations will try to invest their time and assets to capture the highest margin.
3. People act independently based upon comprehensive and relevant information. People are influenced by rational forces (mostly information and logic), and will make the best personal purchasing decisions based upon this.

A brief timeline of classical to neoclassical perspectives would begin with thought processes put forward by Adam Smith and David Ricardo (alongside many others). The basic idea is that aggregate demand will adjust to supply, and that value theory and distribution will reflect this rational, cost of production model. The next phase was the observation that consumer goods demonstrated a relative value based on utility, which could deviate from consumer to consumer. The final phase, and most central to the advent of the neoclassical perspective, is the introduction of marginalism. Marginalism notes that economic participants make decisions based on marginal utility or margins. For example, a company hiring a new employee will not think of the fixed value of that employee, but instead the marginal value of adding that employee (usually in regards to profitability).

Neo-Keynesian

Neo-Keynesian economics is often confused with ‘New Keynesian’ economics (which attempts to provide microeconomic foundation to Keynesian views, particularly in light of stagflation in the 1970s). Neo-Keynesian economics is actually the formalization and coordination of Keynes’s writings by a number of other economists (most notably John Hicks, Franco Modigliani, and Paul Samuelson). Much of the conceptual value is captured in the previous atoms on Keynesian views, but the substantial value of a few neo-Keynesian ideas is worth reiterating:

• IS/LM Model: This model was put forward by John Hicks in order to capture the inherent relationship between investment and savings (IS) relative to liquidity and the overall money supply (LM) (see ). The implications of this graph pertain to the static representation of monetary policy and the effects on an economic system.
• Phillips Curve: Another important model following Keynes’s publications is the Phillips Curve, put forward by William Phillips in 1958. The idea here was also largely Keynesian, revolving around the relationship between inflation and unemployment (see ).This implies a trade off between inflation rates and the creation of employment, which governments could consider in policy making. Stagflation (economic stagnation and inflation simultaneously) created issues with this however, necessitating New Keynesian ideas (as discussed briefly above).

Synthesis

When learning about these economic perspectives, it is important to understand the value they add to one another and the overall efficacy of all economic theory. Economists are often the product of multiple schools of thought, and don’t fit neatly into one school or another.

24.1: Introducing Aggregate Expenditure

24.1.1: Defining Aggregate Expenditure: Components and Comparison to GDP

Learning Objective

Define aggregate expenditure

Key Points

• The aggregate expenditure is the sum of all the expenditures undertaken in the economy by the factors during a specific time period. The equation is: AE = C + I + G + NX.
• The aggregate expenditure determines the total amount that firms and households plan to spend on goods and services at each level of income.
• The aggregate expenditure is one of the methods that is used to calculate the total sum of all the economic activities in an economy, also known as the gross domestic product (GDP).
• When there is excess supply over the expenditure, there is a reduction in either the prices or the quantity of the output which reduces the total output (GDP) of the economy.
• When there is an excess of expenditure over supply, there is excess demand which leads to an increase in prices or output (higher GDP).

Key Terms

aggregate

A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.

expenditure

Act of expending or paying out.

gross domestic product

A measure of the economic production of a particular territory in financial capital terms over a specific time period.

Aggregate Expenditure

In economics, aggregate expenditure is the current value of all the finished goods and services in the economy. It is the sum of all the expenditures undertaken in the economy by the factors during a specific time period. The equation for aggregate expenditure is: AE = C + I + G + NX.

Written out the equation is: aggregate expenditure equals the sum of the household consumption (C), investments (I), government spending (G), and net exports (NX).

• Consumption (C): The household consumption over a period of time.
• Investment (I): The amount of expenditure towards the capital goods.
• Government expenditure (G): The amount of spending by federal, state, and local governments. Government expenditure can include infrastructure or transfers which increase the total expenditure in the economy.
• Net exports (NX): Total exports minus the total imports.

The aggregate expenditure determines the total amount that firms and households plan to spend on goods and services at each level of income.

Comparison to GDP

The aggregate expenditure is one of the methods that is used to calculate the total sum of all the economic activities in an economy, also known as the gross domestic product (GDP). The gross domestic product is important because it measures the growth of the economy. The GDP is calculated using the Aggregate Expenditures Model .

An economy is at equilibrium when aggregate expenditure is equal to the aggregate supply (production) in the economy. The economy is not in a constant state of equilibrium. Instead, the aggregate expenditure and aggregate supply adjust each other toward equilibrium.

When there is excess supply over the expenditure, there is a reduction in either the prices or the quantity of the output which reduces the total output (GDP) of the economy.

In contrast, when there is an excess of expenditure over supply, there is excess demand which leads to an increase in prices or output (higher GDP). A rise in the aggregate expenditure pushes the economy towards a higher equilibrium and a higher potential of the GDP.

24.1.2: Aggregate Expenditure at Economic Equilibrium

Learning Objective

Identify the assumptions fundamental to classical economics in regards to aggregate expenditure at economic equilibrium

Key Points

• In economics, aggregate expenditure is the current value (price) of all the finished goods and services in the economy. The equation for aggregate expenditure is AE = C+ I + G + NX.
• In the aggregate expenditure model, equilibrium is the point where the aggregate supply and aggregate expenditure curve intersect.
• The classical aggregate expenditure model is: AE = C + I.
• Classical economics states that the factor payments made during the production process create enough income in the economy to create a demand for the products that were produced.

Key Terms

aggregate

A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.

expenditure

Act of expending or paying out.

equilibrium

The condition of a system in which competing influences are balanced, resulting in no net change.

Aggregate Expenditure

In economics, aggregate expenditure is the current value (price) of all the finished goods and services in the economy. The equation for aggregate expenditure is AE = C+ I + G + NX.

Written out in full, the equation reads: aggregate expenditure = household consumption (C) + investments (I) + government spending (G) + net exports (NX).

Aggregate expenditure is a method that is used to calculate the total value of economic activities, also referred to as the gross domestic product (GDP). The GDP of an economy is calculated using the aggregate expenditure model.

Economic Equilibrium

An economy is said to be at equilibrium when aggregate expenditure is equal to the aggregate supply (production) in the economy. The economy is constantly shifting between excess supply (inventory) and excess demand. As a result, the economy is always moving towards an equilibrium between the aggregate expenditure and aggregate supply. On the aggregate expenditure model, equilibrium is the point where the aggregate supply and aggregate expenditure curve intersect. An increase in the expenditure by consumption (C) or investment (I) causes the aggregate expenditure to rise which pushes the economy towards a higher equilibrium .

Classical Economics – Aggregate Expenditure

Classical economists believed in Say’s law, which states that supply creates its own demand. This idea stems from the belief that wages, prices, and interest rage were all flexible. Classical economics states that the factor payments (wage and rental payments) made during the production process create enough income in the economy to create a demand for the products that were produced. This belief is parallel to Adam Smith’s invisible hand – markets achieve equilibrium through the market forces that impact economic activity.

The classical aggregate expenditure model is: AE = C + I .

The aggregate expenditure equals the aggregate consumption plus planned investment. Classical economics assumes that the economy works on a full-employment equilibrium, which is not always true. In reality, many economists argue that the economy operates at an under-employment equilibrium.

24.1.3: Graphing Equilibrium

Learning Objective

Demonstrate how aggregate demand and aggregate supply determine output and price level by using the AD-AS model

Key Points

• Aggregate supply (AS) is the total supply of goods and services that firms in an economy plan on selling during a specific time period.
• Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level.
• Aggregate expenditure is the current value of all the finished goods and services in the economy. The equation for aggregate expenditure is: AE = C + I + G + NX.
• The AD-AS model is used to graph the aggregate expenditure at the point of equilibrium.

Key Terms

equilibrium

The condition of a system in which competing influences are balanced, resulting in no net change.

aggregate demand

The the total demand for final goods and services in the economy at a given time and price level.

aggregate supply

The total supply of goods and services that firms in a national economy plan on selling during a specific time period.

Aggregate Supply and Aggregate Demand

In economics, the aggregate supply (AS) is the total supply of goods and services that firms in an economy produce during a specific time period. It represents the total amount of goods and services that firms are willing to sell at a given price level. The aggregate supply curve is graphed as a backwards L-shape in the short-run and vertical in the long-run.

Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It shows the amounts of goods and services that will be purchased at all the possible price levels. When aggregate demand increases its graph shifts to the right. It shifts to the left when it decreases which shows a fall in output and prices.

The aggregate supply and aggregate demand determine the output and price for goods and services. The AD-AS model is used to graph the aggregate expenditure and the point of equilibrium .

Aggregate Expenditure

Aggregate expenditure is the current value of all the finished goods and services in the economy. The equation for aggregate expenditure is: AE = C + I + G + NX.

The aggregate expenditure equals the sum of the household consumption (C), investments (I), government spending (G), and net exports (NX).

Graphing Equilibrium

The AD-AS model is used to graph the aggregate expenditure at the point of equilibrium. The AD-AS model includes price changes. An economy is said to be at equilibrium when the aggregate expenditure is equal to the aggregate supply (production) in the economy. It is important to note that the economy does not stay in a state of equilibrium. The aggregate expenditure and aggregate supply adjust each other towards equilibrium. When there is excess supply over expenditure, there is a reduction in the prices or the quantity or output. When there is an excess of expenditure over supply, then there is excess demand which leads to an increase in prices out output. In an effort to adjust and reach equilibrium, the economy constantly shifts between excess supply and excess demand. This shift is graphed using the AD-AS model which determines the output and price for the good or service.

24.1.4: The Multiplier Effect

Learning Objective

Explain the fiscal multiplier effect

Key Points

• In economics, the fiscal multiplier is the ratio of change in the national income in relation to the change in government spending that causes it.
• The multiplier is influenced by an incremental amount of spending that leads to higher consumption spending, increased income, and then even more consumption. As a result, the overall national income is greater than the initial incremental amount of spending.
• The multiplier effect is a tool that is used by governments to attempt to stimulate aggregate demand in times of recession or economic uncertainty.
• The multiplier effect is criticized because it can create over crowding and an increase in the number of negative externalities.

Key Terms

fiscal multiplier

The ratio of a change in national income to the change in government spending that causes it.

multiplier effect

A factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.

The Fiscal Multiplier and the Multiplier Effect

In economics, the fiscal multiplier is the ratio of change in the national income in relation to the change in government spending that causes it (not to be confused with the monetary multiplier). National income can change as a direct result in a change in spending whether it is private investment spending, consumer spending, government spending, or foreign export spending. When the fiscal multiplier exceeds one, the resulting impact on the national income is called the multiplier effect.

Cause of the Multiplier Effect

The multiplier is influenced by an incremental amount of spending that leads to higher consumption spending, increased income, and then even more consumption. As a result, the overall national income is greater than the initial incremental amount of spending. Simply put, an initial shift in aggregate demand may cause a change in aggregate output (as well as the aggregate income it creates) that is a multiplier of the initial change.

Use of the Multiplier Effect

The multiplier effect is a tool that is used by governments to attempt to stimulate aggregate demand in times of recession or economic uncertainty . The government invests money in order to create more jobs, which in turn will generate more spending to stimulate the economy. The goal is that the net increase in disposable income will be greater than the original investment.

Criticisms

Although the multiplier effect usually measures values of one, there have been cases where multipliers of less than one are measured. This suggests that types of government spending can crowd out private investment or consumer spending that would have taken place without the government spending. Crowding out can occur because the initial increase in spending can cause an increase in the interest rates or the price level.

It has been argued that when a government relies heavily on fiscal multipliers, externalities such as environmental degradation, unsustainable resource depletion, and social consequences can be neglected. Over reliance on fiscal multipliers can cause increased government spending on activities that create negative externalities (pollution, climate change, and resource depletion) instead of positive externalities (increased educational standards, social cohesion, public health, etc.).

23.1: The Relationship Between Inflation and Unemployment

23.1.1: The Phillips Curve

Learning Objective

Review the historical evidence regarding the theory of the Phillips curve

Key Points

• The relationship between inflation rates and unemployment rates is inverse. Graphically, this means the short-run Phillips curve is L-shaped.
• A.W. Phillips published his observations about the inverse correlation between wage changes and unemployment in Great Britain in 1958. This relationship was found to hold true for other industrial countries, as well.
• From 1861 until the late 1960’s, the Phillips curve predicted rates of inflation and rates of unemployment. However, from the 1970’s and 1980’s onward, rates of inflation and unemployment differed from the Phillips curve’s prediction. The relationship between the two variables became unstable.

Key Terms

stagflation

Inflation accompanied by stagnant growth, unemployment, or recession.

Phillips curve

A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy.

The Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve argues that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases. The relationship, however, is not linear. Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on the y-axis .

History

The early idea for the Phillips curve was proposed in 1958 by economist A.W. Phillips. In his original paper, Phillips tracked wage changes and unemployment changes in Great Britain from 1861 to 1957, and found that there was a stable, inverse relationship between wages and unemployment. This correlation between wage changes and unemployment seemed to hold for Great Britain and for other industrial countries. In 1960, economists Paul Samuelson and Robert Solow expanded this work to reflect the relationship between inflation and unemployment. Because wages are the largest components of prices, inflation (rather than wage changes) could be inversely linked to unemployment.

The theory of the Phillips curve seemed stable and predictable. Data from the 1960’s modeled the trade-off between unemployment and inflation fairly well. The Phillips curve offered potential economic policy outcomes: fiscal and monetary policy could be used to achieve full employment at the cost of higher price levels, or to lower inflation at the cost of lowered employment. However, when governments attempted to use the Phillips curve to control unemployment and inflation, the relationship fell apart. Data from the 1970’s and onward did not follow the trend of the classic Phillips curve. For many years, both the rate of inflation and the rate of unemployment were higher than the Phillips curve would have predicted, a phenomenon known as “stagflation. ” Ultimately, the Phillips curve was proved to be unstable, and therefore, not usable for policy purposes .

23.1.2: The Relationship Between the Phillips Curve and AD-AD

Learning Objective

Relate aggregate demand to the Phillips curve

Key Points

• Aggregate demand and the Phillips curve share similar components. The rate of unemployment and rate of inflation found in the Phillips curve correspond to the real GDP and price level of aggregate demand.
• Changes in aggregate demand translate as movements along the Phillips curve.
• If there is an increase in aggregate demand, such as what is experienced during demand-pull inflation, there will be an upward movement along the Phillips curve. As aggregate demand increases, real GDP and price level increase, which lowers the unemployment rate and increases inflation.

Key Terms

Phillips curve

A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy.

aggregate demand

The the total demand for final goods and services in the economy at a given time and price level.

The Phillips Curve Related to Aggregate Demand

The Phillips curve shows the inverse trade-off between rates of inflation and rates of unemployment. If unemployment is high, inflation will be low; if unemployment is low, inflation will be high.

The Phillips curve and aggregate demand share similar components. The Phillips curve is the relationship between inflation, which affects the price level aspect of aggregate demand, and unemployment, which is dependent on the real output portion of aggregate demand. Consequently, it is not far-fetched to say that the Phillips curve and aggregate demand are actually closely related.

To see the connection more clearly, consider the example illustrated by . Let’s assume that aggregate supply, AS, is stationary, and that aggregate demand starts with the curve, AD₁. There is an initial equilibrium price level and real GDP output at point A. Now, imagine there are increases in aggregate demand, causing the curve to shift right to curves AD₂ through AD4. As aggregate demand increases, unemployment decreases as more workers are hired, real GDP output increases, and the price level increases; this situation describes a demand-pull inflation scenario.

As more workers are hired, unemployment decreases. Moreover, the price level increases, leading to increases in inflation. These two factors are captured as equivalent movements along the Phillips curve from points A to D. At the initial equilibrium point A in the aggregate demand and supply graph, there is a corresponding inflation rate and unemployment rate represented by point A in the Phillips curve graph. For every new equilibrium point (points B, C, and D) in the aggregate graph, there is a corresponding point in the Phillips curve. This illustrates an important point: changes in aggregate demand cause movements along the Phillips curve.

23.1.3: The Long-Run Phillips Curve

Learning Objective

Examine the NAIRU and its relationship to the long term Phillips curve

Key Points

• The natural rate of unemployment is the hypothetical level of unemployment the economy would experience if aggregate production were in the long-run state.
• The natural rate hypothesis, or the non-accelerating inflation rate of unemployment (NAIRU) theory, predicts that inflation is stable only when unemployment is equal to the natural rate of unemployment. If unemployment is below (above) its natural rate, inflation will accelerate (decelerate).
• Expansionary efforts to decrease unemployment below the natural rate of unemployment will result in inflation. This changes the inflation expectations of workers, who will adjust their nominal wages to meet these expectations in the future. This leads to shifts in the short-run Phillips curve.
• The natural rate hypothesis was used to give reasons for stagflation, a phenomenon that the classic Phillips curve could not explain.

Key Terms

non-accelerating inflation rate of unemployment

(NAIRU); theory that describes how the short-run Phillips curve shifts in the long run as expectations change.

Natural Rate of Unemployment

The hypothetical unemployment rate consistent with aggregate production being at the long-run level.

The Phillips curve shows the trade-off between inflation and unemployment, but how accurate is this relationship in the long run? According to economists, there can be no trade-off between inflation and unemployment in the long run. Decreases in unemployment can lead to increases in inflation, but only in the short run. In the long run, inflation and unemployment are unrelated. Graphically, this means the Phillips curve is vertical at the natural rate of unemployment, or the hypothetical unemployment rate if aggregate production is in the long-run level. Attempts to change unemployment rates only serve to move the economy up and down this vertical line.

Natural Rate Hypothesis

The natural rate of unemployment theory, also known as the non-accelerating inflation rate of unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund Phelps. According to NAIRU theory, expansionary economic policies will create only temporary decreases in unemployment as the economy will adjust to the natural rate. Moreover, when unemployment is below the natural rate, inflation will accelerate. When unemployment is above the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural rate, inflation is stable, or non-accelerating.

An Example

To get a better sense of the long-run Phillips curve, consider the example shown in . Assume the economy starts at point A and has an initial rate of unemployment and inflation rate. If the government decides to pursue expansionary economic policies, inflation will increase as aggregate demand shifts to the right. This is shown as a movement along the short-run Phillips curve, to point B, which is an unstable equilibrium. As aggregate demand increases, more workers will be hired by firms in order to produce more output to meet rising demand, and unemployment will decrease. However, due to the higher inflation, workers’ expectations of future inflation changes, which shifts the short-run Phillips curve to the right, from unstable equilibrium point B to the stable equilibrium point C. At point C, the rate of unemployment has increased back to its natural rate, but inflation remains higher than its initial level.

The reason the short-run Phillips curve shifts is due to the changes in inflation expectations. Workers, who are assumed to be completely rational and informed, will recognize their nominal wages have not kept pace with inflation increases (the movement from A to B), so their real wages have been decreased. As such, in the future, they will renegotiate their nominal wages to reflect the higher expected inflation rate, in order to keep their real wages the same. As nominal wages increase, production costs for the supplier increase, which diminishes profits. As profits decline, suppliers will decrease output and employ fewer workers (the movement from B to C). Consequently, an attempt to decrease unemployment at the cost of higher inflation in the short run led to higher inflation and no change in unemployment in the long run.

The NAIRU theory was used to explain the stagflation phenomenon of the 1970’s, when the classic Phillips curve could not. According to the theory, the simultaneously high rates of unemployment and inflation could be explained because workers changed their inflation expectations, shifting the short-run Phillips curve, and increasing the prevailing rate of inflation in the economy. At the same time, unemployment rates were not affected, leading to high inflation and high unemployment.

23.1.4: The Short-Run Phillips Curve

Learning Objective

Interpret the short-run Phillips curve

Key Points

• The long-run Phillips curve is a vertical line at the natural rate of unemployment, but the short-run Phillips curve is roughly L-shaped.
• The inverse relationship shown by the short-run Phillips curve only exists in the short-run; there is no trade-off between inflation and unemployment in the long run.
• Economic events of the 1970’s disproved the idea of a permanently stable trade-off between unemployment and inflation.

Key Term

Phillips curve

A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy.

The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips curve is a vertical line that illustrates that there is no permanent trade-off between inflation and unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the initial inverse relationship between the two variables . As unemployment rates increase, inflation decreases; as unemployment rates decrease, inflation increases.

Consider the example shown in . When the unemployment rate is 2%, the corresponding inflation rate is 10%. As unemployment decreases to 1%, the inflation rate increases to 15%. On the other hand, when unemployment increases to 6%, the inflation rate drops to 2%.

Historical application

During the 1960’s, the Phillips curve rose to prominence because it seemed to accurately depict real-world macroeconomics. However, the stagflation of the 1970’s shattered any illusions that the Phillips curve was a stable and predictable policy tool. Nowadays, modern economists reject the idea of a stable Phillips curve, but they agree that there is a trade-off between inflation and unemployment in the short-run. Given a stationary aggregate supply curve, increases in aggregate demand create increases in real output. As output increases, unemployment decreases. With more people employed in the workforce, spending within the economy increases, and demand-pull inflation occurs, raising price levels.

Therefore, the short-run Phillips curve illustrates a real, inverse correlation between inflation and unemployment, but this relationship can only exist in the short run. The idea of a stable trade-off between inflation and unemployment in the long run has been disproved by economic history.

23.1.5: Relationship Between Expectations and Inflation

Learning Objective

Distinguish adaptive expectations from rational expectations

Key Points

• Nominal quantities are simply stated values. Real quantities are nominal ones that have been adjusted for inflation.
• Adaptive expectations theory says that people use past information as the best predictor of future events. If inflation was higher than normal in the past, people will expect it to be higher than anticipated in the future.
• Rational expectations theory says that people use all available information, past and current, to predict future events. If inflation was higher than normal in the past, people will take that into consideration, along with current economic indicators, to anticipate its future performance.
• According to adaptive expectations, attempts to reduce unemployment will result in temporary adjustments along the short-run Phillips curve, but will revert to the natural rate of unemployment. According to rational expectations, attempts to reduce unemployment will only result in higher inflation.

Key Terms

adaptive expectations theory

A hypothesized process by which people form their expectations about what will happen in the future based on what has happened in the past.

rational expectations theory

A hypothesized process by which people form their expectations about what will happen in the future based on all relevant information.

The short-run Phillips curve is said to shift because of workers’ future inflation expectations. Yet, how are those expectations formed? There are two theories that explain how individuals predict future events.

Real versus Nominal Quantities

To fully appreciate theories of expectations, it is helpful to review the difference between real and nominal concepts. Anything that is nominal is a stated aspect. In contrast, anything that is real has been adjusted for inflation. To make the distinction clearer, consider this example. Suppose you are opening a savings account at a bank that promises a 5% interest rate. This is the nominal, or stated, interest rate. However, suppose inflation is at 3%. The real interest rate would only be 2% (the nominal 5% minus 3% to adjust for inflation).

The difference between real and nominal extends beyond interest rates. In an earlier atom, the difference between real GDP and nominal GDP was discussed. The distinction also applies to wages, income, and exchange rates, among other values.

Adaptive Expectations

The theory of adaptive expectations states that individuals will form future expectations based on past events. For example, if inflation was lower than expected in the past, individuals will change their expectations and anticipate future inflation to be lower than expected.

To connect this to the Phillips curve, consider . Assume the economy starts at point A at the natural rate of unemployment with an initial inflation rate of 2%, which has been constant for the past few years. Accordingly, because of the adaptive expectations theory, workers will expect the 2% inflation rate to continue, so they will incorporate this expected increase into future labor bargaining agreements. This way, their nominal wages will keep up with inflation, and their real wages will stay the same.

Now assume that the government wants to lower the unemployment rate. To do so, it engages in expansionary economic activities and increases aggregate demand. As aggregate demand increases, inflation increases. Because of the higher inflation, the real wages workers receive have decreased. For example, assume each worker receives $100, plus the 2% inflation adjustment. Each worker will make $102 in nominal wages, but $100 in real wages. Now, if the inflation level has risen to 6%. Workers will make $102 in nominal wages, but this is only $96.23 in real wages.

Although the workers’ real purchasing power declines, employers are now able to hire labor for a cheaper real cost. Consequently, employers hire more workers to produce more output, lowering the unemployment rate and increasing real GDP. On , the economy moves from point A to point B.

However, workers eventually realize that inflation has grown faster than expected, their nominal wages have not kept pace, and their real wages have been diminished. They demand a 4% increase in wages to increase their real purchasing power to previous levels, which raises labor costs for employers. As labor costs increase, profits decrease, and some workers are let go, increasing the unemployment rate. Graphically, the economy moves from point B to point C.

This example highlights how the theory of adaptive expectations predicts that there are no long-run trade-offs between unemployment and inflation. In the short run, it is possible to lower unemployment at the cost of higher inflation, but, eventually, worker expectations will catch up, and the economy will correct itself to the natural rate of unemployment with higher inflation.

Rational Expectations

The theory of rational expectations states that individuals will form future expectations based on all available information, with the result that future predictions will be very close to the market equilibrium. For example, assume that inflation was lower than expected in the past. Individuals will take this past information and current information, such as the current inflation rate and current economic policies, to predict future inflation rates.

As an example of how this applies to the Phillips curve, consider again. Assume the economy starts at point A, with an initial inflation rate of 2% and the natural rate of unemployment. However, under rational expectations theory, workers are intelligent and fully aware of past and present economic variables and change their expectations accordingly. They will be able to anticipate increases in aggregate demand and the accompanying increases in inflation. As such, they will raise their nominal wage demands to match the forecasted inflation, and they will not have an adjustment period when their real wages are lower than their nominal wages. Graphically, they will move seamlessly from point A to point C, without transitioning to point B.

In essence, rational expectations theory predicts that attempts to change the unemployment rate will be automatically undermined by rational workers. They can act rationally to protect their interests, which cancels out the intended economic policy effects. Efforts to lower unemployment only raise inflation.

23.1.6: Shifting the Phillips Curve with a Supply Shock

Learning Objective

Give examples of aggregate supply shock that shift the Phillips curve

Key Points

• In the 1970’s soaring oil prices increased resource costs for suppliers, which decreased aggregate supply. The resulting cost-push inflation situation led to high unemployment and high inflation (stagflation), which shifted the Phillips curve upwards and to the right.
• Stagflation is a situation where economic growth is slow (reducing employment levels) but inflation is high.
• The Phillips curve was thought to represent a fixed and stable trade-off between unemployment and inflation, but the supply shocks of the 1970’s caused the Phillips curve to shift. This ruined its reputation as a predictable relationship.

Key Terms

stagflation

Inflation accompanied by stagnant growth, unemployment, or recession.

supply shock

An event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good.

The Phillips curve shows the relationship between inflation and unemployment. In the short-run, inflation and unemployment are inversely related; as one quantity increases, the other decreases. In the long-run, there is no trade-off. In the 1960’s, economists believed that the short-run Phillips curve was stable. By the 1970’s, economic events dashed the idea of a predictable Phillips curve. What could have happened in the 1970’s to ruin an entire theory? Stagflation caused by a aggregate supply shock.

Stagflation and Aggregate Supply Shocks

Stagflation is a combination of the words “stagnant” and “inflation,” which are the characteristics of an economy experiencing stagflation: stagnating economic growth and high unemployment with simultaneously high inflation. The stagflation of the 1970’s was caused by a series of aggregate supply shocks. In this case, huge increases in oil prices by the Organization of Petroleum Exporting Countries (OPEC) created a severe negative supply shock. The increased oil prices represented greatly increased resource prices for other goods, which decreased aggregate supply and shifted the curve to the left . As aggregate supply decreased, real GDP output decreased, which increased unemployment, and price level increased; in other words, the shift in aggregate supply created cost-push inflation.

Shifting the Phillips Curve

The aggregate supply shocks caused by the rising price of oil created simultaneously high unemployment and high inflation. At the time, the dominant school of economic thought believed inflation and unemployment to be mutually exclusive; it was not possible to have high levels of both within an economy. Consequently, the Phillips curve could not model this situation. For high levels of unemployment, there were now corresponding levels of inflation that were higher than the Phillips curve predicted; the Phillips curve had shifted upwards and to the right. Thus, the Phillips curve no longer represented a predictable trade-off between unemployment and inflation.

23.1.7: Disinflation

Learning Objective

Identify situations with disinflation

Key Points

• Disinflation is not the same as deflation, when inflation drops below zero.
• During periods of disinflation, the general price level is still increasing, but it is occurring slower than before.
• The short-run and long-run Phillips curve may be used to illustrate disinflation.

Key Terms

disinflation

A decrease in the inflation rate.

inflation

An increase in the general level of prices or in the cost of living.

deflation

A decrease in the general price level, that is, in the nominal cost of goods and services.

Inflation is the persistent rise in the general price level of goods and services. Disinflation is a decline in the rate of inflation; it is a slowdown in the rise in price level. As an example, assume inflation in an economy grows from 2% to 6% in Year 1, for a growth rate of four percentage points. In Year 2, inflation grows from 6% to 8%, which is a growth rate of only two percentage points. The economy is experiencing disinflation because inflation did not increase as quickly in Year 2 as it did in Year 1, but the general price level is still rising. Disinflation is not to be confused with deflation, which is a decrease in the general price level.

Causes

Disinflation can be caused by decreases in the supply of money available in an economy. It can also be caused by contractions in the business cycle, otherwise known as recessions. The Phillips curve can illustrate this last point more closely. Consider an economy initially at point A on the long-run Phillips curve in . Suppose that during a recession, the rate that aggregate demand increases relative to increases in aggregate supply declines. This reduces price levels, which diminishes supplier profits. As profits decline, employers lay off employees, and unemployment rises, which moves the economy from point A to point B on the graph. Eventually, though, firms and workers adjust their inflation expectations, and firms experience profits once again. As profits increase, employment also increases, returning the unemployment rate to the natural rate as the economy moves from point B to point C. The expected rate of inflation has also decreased due to different inflation expectations, resulting in a shift of the short-run Phillips curve.

Inflation vs. Deflation vs. Disinflation

To illustrate the differences between inflation, deflation, and disinflation, consider the following example. Assume the following annual price levels as compared to the prices in year 1:

• Year 1: 100% of Year 1 prices
• Year 2: 104% of Year 1 prices
• Year 3: 106% of Year 1 prices
• Year 4: 107% of Year 1 prices
• Year 5: 105% of Year 1 prices

As the economy moves through Year 1 to Year 4, there is a continued growth in the price level. This is an example of inflation; the price level is continually rising. However, between Year 2 and Year 4, the rise in price levels slows down. Between Year 2 and Year 3, the price level only increases by two percentage points, which is lower than the four percentage point increase between Years 1 and 2. The trend continues between Years 3 and 4, where there is only a one percentage point increase. This is an example of disinflation; the overall price level is rising, but it is doing so at a slower rate.

Between Years 4 and 5, the price level does not increase, but decreases by two percentage points. This is an example of deflation; the price rise of previous years has reversed itself.

22.1: Introduction to Unemployment

22.1.1: Defining Unemployment

Learning Objective

Classify the different measures and types of unemployment

Key Points

• Types of unemployment determine what the causes, consequences, and solutions. The types of unemployment include: classical, cyclical, structural, frictional, hidden, and long-term.
• Unemployment is calculated as a percentage by dividing the number of unemployed individuals by the number of all the individuals currently employed in the work force.
• When unemployment rates are high and steady, there are negative impacts on the long-run economic growth.
• Demand side and supply side solutions are used to reduce unemployment rates.

Key Term

unemployment

The state of being jobless and looking for work.

Unemployment, also referred to as joblessness, occurs when people are without work and are actively seeking employment. During periods of recession, an economy usually experiences high unemployment rates. There are many proposed causes, consequences, and solutions for unemployment.

Types of Unemployment

• Classical: occurs when real wages for jobs are set above the market-clearing level. It causes the number of job seekers to be higher than the number of vacancies.
• Cyclical: occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. Demand for goods and services decreases, less production is needed, and fewer workers are needed.
• Structural: occurs when the labor market is not able to provide jobs for everyone who wants to work. There is a mismatch between the skills of the unemployed workers and the skills needed for available jobs. It differs from frictional unemployment because it lasts longer.
• Frictional: the time period in between jobs when a worker is searching for work or transitioning from one job to another.
• Hidden: the unemployment of potential workers that is not taken into account in official unemployment statistics because of how the data is collected. For example, workers are only considered unemployed if they are looking for work so those without jobs who have stopped looking are no longer considered unemployed.
• Long-term: usually defined as unemployment lasting longer than one year.

Measuring Unemployment

Unemployment is calculated as a percentage by dividing the number of unemployed individuals by the number of all individuals currently employed in the workforce. The final measurement is called the rate of unemployment .

Effects of Unemployment

When unemployment rates are high and steady, there are negative impacts on the long-run economic growth. Unemployment wastes resources, generates redistributive pressures and distortions, increases poverty, limits labor mobility, and promotes social unrest and conflict. The effects of unemployment can be broken down into three types:

• Individual: people who are unemployed cannot earn money to meet their financial obligations. Unemployment can lead to homelessness, illness, and mental stress. It can also cause underemployment where workers take on jobs that are below their skill level.
• Social: an economy that has high unemployment is not using all of its resources efficiently, specifically labor. When individuals accept employment below their skill level the economies efficiency is reduced further. Workers lose skills which causes a loss of human capital.
• Socio-political: high unemployment rates can cause civil unrest in a country.

Reducing Unemployment

There are numerous solutions that can help reduce the amount of unemployment:

• Demand side solutions: many countries aid unemployed workers through social welfare programs. Individuals receive unemployment benefits including insurance, compensation, welfare, and subsidies to aid in retraining. An example of a demand side solution is government funded employment of the able-bodied poor.
• Supply side solutions: the labor market is not 100% efficient. Supply side solutions remove the minimum wage and reduce the power of unions. The policies are designed to make the market more flexible in an attempt to increase long-run economic growth. Examples of supply side solutions include cutting taxes on businesses, reducing regulation, and increasing education.

22.1.2: Defining Full Employment

Learning Objective

Define full employment

Key Points

• Full employment represents a range of possible unemployment rates based on the country, time period, and political biases.
• Full employment is often seen as an “ideal” unemployment rate. Ideal unemployment excludes types of unemployment where labor-market inefficiency is reflected.
• The full employment unemployment rate is also referred to as “natural” unemployment.
• The Non-Accelerating Inflation Rate of Unemployment (NAIRU) corresponds to the unemployment rate when real GDP equals potential output.

Key Term

full employment

A state when an economy has no cyclical or deficient-demand unemployment.

Full Employment

In macroeconomics, full employment is the level of employment rates where there is no cyclical or deficient-demand unemployment. Mainstream economists define full employment as an acceptable level of unemployment somewhere above 0%. Full employment represents a range of possible unemployment rates based on the country, time period, and political biases .

Ideal Unemployment

Full employment is often seen as an “ideal” unemployment rate. Ideal unemployment excludes types of unemployment where labor-market inefficiency is reflected. Only some frictional and voluntary unemployment exists, where workers are temporarily searching for new jobs. This classifies the unemployed individuals as being without a job voluntarily. Ideal unemployment promotes the efficiency of the economy.

Lord William Beveridge defined “full employment” as the situation where the number of unemployed workers equaled the number of job vacancies available. He preferred that the economy be kept above the full employment level to allow for maximum economic production.

Non-Accelerating Inflation Rate of Unemployment (NAIRU)

The full employment unemployment rate is also referred to as “natural” unemployment. In an effort to avoid this normative connotation, James Tobin introduced the term “Non-Accelerating Inflation Rate of Unemployment” also known as the NAIRU. It corresponds to the level of unemployment when real GDP equals potential output. The NAIRU has been called the “inflation threshold. ” The NAIRU states the inflation does not rise or fall when unemployment equals the natural rate.

As an example, the United States is committed to full employment. The “Full Employment Act” was passed in 1946 and revised in 1978. It states that full employment in the United States is no more than 3% unemployment for persons 20 and older, and 4% for persons aged 16 and over.

22.1.3: Types of Unemployment: Frictional, Structural, Cyclical

Learning Objective

Discuss structural unemployment, frictional unemployment, and the natural unemployment rate

Key Points

• Structural unemployment focuses on the structural problems within an economy and inefficiencies in labor markets.
• Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another.
• Cyclical unemployment is a type of unemployment that occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.
• Classical unemployment occurs when real wages for a jobs are set above the marketing clearing level.
• The natural unemployment rate represents the hypothetical unemployment rate that is consistent with aggregate production being at a long-run level.

Key Terms

structural unemployment

A mismatch between the requirements of the employers and the properties of the unemployed.

frictional unemployment

When people being temporarily between jobs, searching for new ones.

Unemployment

In economics, unemployment occurs when people are without work while actively searching for employment . The unemployment rate is a percentage, and calculated by dividing the number of unemployed individuals by the number of all currently employed individuals in the labor force. The causes, consequences, and solutions vary based on the specific type of unemployment that is present within a country.

Structural Unemployment

Structural unemployment is one of the main types of unemployment within an economic system. It focuses on the structural problems within an economy and inefficiencies in labor markets. Structural unemployment occurs when a labor market is not able to provide jobs for everyone who is seeking employment. There is a mismatch between the skills of the unemployed workers and the skills needed for the jobs that are available. It is often impacted by persistent cyclical unemployment. For example, when an economy experiences long-term unemployment individuals become frustrated and their skills become obsolete. As a result, when the economy recovers they may not fit the requirements of new jobs due to their inactivity .

Frictional Unemployment

Frictional unemployment is another type of unemployment within an economy. It is the time period between jobs when a worker is searching for or transitioning from one job to another. Frictional unemployment is always present to some degree in an economy. It occurs when there is a mismatch between the workers and jobs. The mismatch can be related to skills, payment, work time, location, seasonal industries, attitude, taste, and other factors. Frictional unemployment is influenced by voluntary decisions to work based on each individual’s valuation of their own work and how that compares to current wage rates as well as the time and effort required to find a job.

Cyclical Unemployment

Cyclical unemployment is a type of unemployment that occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. In an economy, demand for most goods falls, less production is needed, and less workers are needed. With cyclical unemployment the number of unemployed workers is greater that the number of job vacancies.

The Natural Unemployment Rate

The natural unemployment rate, sometimes called the structural unemployment rate, was developed by Friedman and Phelps in the 1960s. It represents the hypothetical unemployment rate that is consistent with aggregate production being at a long-run level. The natural rate of unemployment is a combination of structural and frictional unemployment. It is present in an efficient and expanding economy when labor and resource markets are at equilibrium. The natural unemployment rate occurs within an economy when disturbances are not present.

21.1: Defining, Measuring, and Assessing Inflation

21.1.1: Defining Inflation

Learning Objective

Use the quantity theory of money to explain inflation

Key Points

• Inflation refers to the average changes in price economy-wide, not the change in price in a particular industry. Further, inflation refers to the rate of change in prices, not the level of prices at any one time.
• Most economists agree that in the long run, inflation depends on the money supply.
• The idea that increasing the supply of money increases the price levels is known as the quantity theory of money.
• In mathematical terms, the quantity theory of money is based upon the following relationship: M x V = P x Q; where M is the money supply, V is the velocity of money, P is the price level, and Q is total output.
• While most agree with the basic principles behind the quantity theory of money in the long run, many argue that it does not apply in the short run.

Key Terms

money supply

The total amount of money (bills, coins, loans, credit, and other liquid instruments) in a particular economy.

velocity of money

The average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time.

inflation

An increase in the general level of prices or in the cost of living.

Inflation is a persistent increase in the general price level of goods and services in an economy over a period of time. Specifically, the rate of inflation is the percent increase of prices from the start to the end of the given time period (usually measured annually).

When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.

The decrease in purchasing power means that inflation is good for debtors and bad for creditors. Since debtors usually pay back loans in a nominal amount, they want to give up the least purchasing power possible. For example, if you borrowed money and have to pay back $100 next year, you’d like that $100 to be worth as little as possible. Conversely, creditors don’t like inflation because the money they are getting paid is can purchase less than if there were no inflation.

What Causes Inflation?

When looking at individual goods, price changes may result from changes in consumer preferences, changes in the price of inputs, changes in the price of substitute or complement goods, or many other factors. When looking at the inflation rate for an entire economy, however, these microeconomic factors are relatively unimportant.

Instead, most economists agree that in the long run, inflation depends on the money supply. Specifically, the money supply has a direct, proportional relationship with the price level, so if, for example, the currency in circulation increased, there would be a proportional increase in the price of goods. To understand this, imagine that tomorrow, every single person’s bank account and salary doubled. Initially we might feel twice as rich as we were before, but prices would quickly rise to catch up to the new status quo. Before long, inflation would cause the real value of our money to return to its previous levels. Thus, increasing the supply of money increases the price levels. This idea is known as the quantity theory of money .

In mathematical terms, the quantity theory of money is based upon the following relationship: M x V = P x Q; where M is the money supply, V is the velocity of money, P is the price level, and Q is total output. In the long run, the velocity of money (that is, how quickly money flows through the economy) and total output (that is, an economy’s Gross Domestic Product) are exogenous. If all other factors are held constant, an increase in M will require an increase in P. Thus, an increase in the money supply requires an increase in the price level (inflation).

While most agree with the basic principles behind the quantity theory of money in the long run, many argue that it does not apply in the short run. John Maynard Keynes, for example, disagreed that V and Q are exogenous and stable in the near-term, and therefore a change in the money supply may not produce a proportional change in the price level. Instead, for example, an increase in the money supply could boost total output or cause the velocity of money to fall.

21.1.2: Measuring Inflation

Learning Objective

Describe inflation and how to measure it

Key Points

• Economists typically measure the price level with a price index.
• A price index is a number whose movement reflects movement in the average level of prices. If a price index rises 10%, it means the average level of prices has risen 10%.
• The price index is the proportion of the cost of a basket of goods in one period to the cost of the same basket of goods in a previous base period. If the price index is currently 103, for example, the inflation rate was 3% between the base period and today.

Key Terms

market basket

A list of items used specifically to track the progress of inflation in an economy or specific market.

purchasing power

The amount of goods and services that can be bought with a unit of currency or by consumers.

The inflation rate is widely calculated by calculating the movement or change in a price index, usually the consumer price index (CPI) The consumer price index measures movements in prices of a fixed basket of goods and services purchased by a “typical consumer”.

CPI is usually expressed as an index, which means that one year is the base year. The base year is given a value of 100. The index for another year (say, year 1) is calculated by 

The percent change in the CPI over time is the inflation rate.

For example, assume you spend your money on bread, jeans, DVDs, and gasoline, and you’d like to measure the inflation that you experience with this basket of goods. In the base period you purchased three loaves of bread ($4 each), two pairs of jeans ($30 each), five DVDs ($20 each), and 10 gallons of gasoline ($3.50 each). The price of the basket of goods in the base period is the total money spent on this quantity of items at the base period prices; in this case, this equals $207.

Now imagine that in the current period, bread still costs $4, jeans are $35, DVDs are $18, and gasoline is $4. Using the quantities from the base period, the total cost of the market basket in the current period is $212. The price index is (212/207)*100, or 102.4. This means that the inflation rate between the base period and the current period was 2.4%.

In everyday life, we experience inflation as a loss in the purchasing power of money. When the inflation rate is 2.4%, it means that a dollar can buy 2.4% fewer goods and services than it could in the previous period. When inflation is steady, incomes will generally compensate for the effects of inflation by rising or falling at approximately the same rate as the general price level. Money saved as currency, however, will lose its value if inflation occurs .

21.1.3: Price Indices and the Rate of Change of Prices

Learning Objective

Explain how inflation is measured through price indices

Key Points

• Price indices are often normalized and compared to a base year.
• The basket of goods determines which prices are being compared.
• The most commonly used formula is the Laspeyres price index, which determines a basket of goods during a base period, finds the price of this basket, and then compares that to the price of the same basket of goods in a later period of time.
• An alternate type of index, the Paasche index, finds a basket of goods in the current period, determines it’s total price, and compares that price to what the current basket of goods would have cost in the base period.
• The Consumer Price Index (CPI) and the Producer Price Index (PPI) are commonly used inflation indices. The CPI reflects changes in the prices of goods and services typically purchased by consumers.
• The PPI reflects changes in the revenue that producers receive for goods and services.

Key Terms

cost of living

The average cost of a standard set of basic necessities of life, especially of food, shelter and clothing

price index

A statistical estimate of the level of prices of some class of goods or services.

Price Indices

Price indices are tools used to measure price changes for a specific subset of goods and services. A price index is a statistic designed to help compare how a normalized average of prices differ between time periods. Broad price indices, such as the consumer price index (CPI) or the GDP deflator are often used to measure inflation throughout the entire economy, while narrower ones, such as the consumer price index for the elderly (CPI-E) measure the inflation experienced by specific groups of people or industries.

In order to calculate a price index, one must specify a base period and a basket of goods. The base period is the time period against which costs in other periods will be compared. Most often, the base period for an index is a single year and normalized. For example, a the CPI could select 1950 as the base year. In 1950, the CPI would have a value of 100 (this is not the cost of the basket, just a normalized value). Suppose that in 1960, the cost of the basket has increased 15%. The CPI in 1960 would then be listed as 115 (15% greater than the base year).

The basket of goods determines which prices are being compared. If a price index wanted to measure the inflation experienced by young people on the west coast of the United States, for example, it would first have to calculate which goods these particular consumers purchase and in what quantities. For example, this population may spend 40% of its income on housing, 10% on food, 10% on transportation, 20% on entertainment, and 20% on surfing supplies. The basket of goods should reflect these proportions.

Calculating Price Indices

There are different ways to calculate price indices. Suppose we want to find the inflation rate for consumers who, in the base period, bought an average of five CDs ($10 each), eight cans of soda ($1.5 each), and two pairs of shoes ($40 each). In the current period, the same type of consumer bought an average of four CDs ($12 each), six cans of soda ($2 each), and two pair of shoes ($45 each). One very basic approach to finding this price index might multiply the items’ cost and the quantity bought in the base period, and compare that to the cost and quantity in the current period. This calculation would give:

5*10+8*1.5+2*40 = 142 (base period)

4*12+6*2+2*45 = 150 (current period)

Price index = (150/142)*100 = 105.6

This would show that inflation was 5.6%.

However, this is not a very practical way to measure the change in prices since it compares two different baskets of goods. In this type of approach, a higher index number in the current period might mean that prices have gone up, but it might also mean that incomes have risen and people are simply buying more goods. The Laspeyres index and the Paasche index are two price indexes that attempt to compensate for this difficulty.

The most commonly used formula is a form of the Laspeyres price index, which determines a basket of goods during a base period, finds the price of this basket, and then compares that to the price of the same basket of goods in a later period of time. Using the example above, the base period index would be 5*10+8*1.5+2*40=142, and the current period index would be 5*12+8*2+2*45 = 166. The Laspeyres price index is (166/142)*100=116.9, giving an inflation rate of 16.9%.

An alternate type of index, the Paasche index, finds a basket of goods in the current period, determines it’s total price, and compares that price to what the current basket of goods would have cost in the base period. Again, using the above example, the base period index would be 4*10+6*1.5+2*40=129, and the current period index would be 4*12+6*2+2*45=150. The Paasche index is (150/129)*100=116.3, giving an inflation rate of 16.3%.

Common Price Indices

Two common price indices are the Consumer Price Index (CPI) and the Producer Price Index (PPI). The CPI reflects changes in the prices of goods and services typically purchased by consumers, and includes price changes in imported goods. The CPI is often used to measure changes in the cost of living .

The PPI, on the other hand, reflects changes in the revenue that producers receive in return for goods and services. The PPI, unlike the CPI, includes price changes for goods produced within the US but exported abroad. It also does not include sales and excise taxes, nor does it include distribution costs. While we often expect the CPI and PPI to show similar rates of inflation, they measure two different sets of price changes.

21.1.4: The Costs of Inflation

Learning Objective

Show inflation’s impact on purchasing power

Key Points

• In economics, a menu cost is the cost to a firm resulting from changing its prices. With high inflation, firms must change their prices often in order to keep up with economy-wide changes.
• Shoe leather cost refers to the cost of time and effort that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank.
• Money loses value with inflation, leading to a drop in the purchasing power of an individual dollar. Unless wages increase with inflation, individuals’ purchasing power will also drop.
• Unexpected inflation redistributes wealth from creditors to debtors.
• Other costs of high and/or unexpected inflation include the economic costs of hoarding and social unrest.

Key Terms

purchasing power

The amount of goods and services that can be bought with a unit of currency or by consumers.

shoeleather costs

The cost of time and effort that people spend trying to counter-act the effects of inflation.

menu costs

The cost to a firm resulting from changing its prices.

Economists generally regard a relatively low, stable level of inflation as desirable. When inflation is stable and expected, the economy is generally able to adjust easily to slowly rising prices. Further, a low level of inflation encourages people to invest their money in productive projects rather than keeping savings in the form of unproductive currency, since inflation will slowly erode the value of money. However, inflation does have some economic costs, especially when it is high or unexpected.

Menu Costs

In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general. With high inflation, firms must change their prices often in order to keep up with economy-wide changes, and this can be a costly activity: explicitly, as with the need to print new menus, and implicitly, as with the extra time and effort needed to change prices constantly .

Shoeleather Costs

Shoeleather cost refers to the cost of time and effort that people spend trying to counteract the effects of inflation, such as holding less cash, investing in different currencies with lower levels of inflation, and having to make additional trips to the bank. The term comes from the fact that more walking is required (historically, although the rise of the Internet has reduced it) to go to the bank and get cash and spend it, thus wearing out shoes more quickly. A significant cost of reducing money holdings is the additional time and convenience that must be sacrificed to keep less money on hand than would be required if there were less or no inflation.

Loss of Purchasing Power

By definition, inflation causes the value of an individual dollar to decrease over time. Each dollar has less purchasing power with inflation. Thus, individuals who have the same wage next year as this year will be able to purchase less. Purchasing power can be maintained if wages increase exactly at the rate of inflation, but this is not always the case. When wages increase less than the rate of inflation, people lose purchasing power.

Redistribution of Wealth

The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money. For example, with inflation, those segments in society which own physical assets (e.g. property or stocks) benefit from the price of their holdings going up, while those who seek to acquire them will need to pay more for them.

Their ability to do so will depend on the degree to which their income is fixed. For example, increases in payments to workers and pensioners often lag behind inflation, and for some people income is fixed.

Other Costs

Other costs of high and/or unexpected inflation include the economic costs of hoarding and social unrest. When prices are rising quickly, people will buy durable and nonperishable goods quickly as a store of wealth, to avoid the losses expected from the declining purchasing power of money. This can create shortages of hoarded goods and removes an economy from the efficient equilibrium. Further, inflation can lead to social unrest . For example, rises in the price of food is considered to be a contributing factor to the 2010-2011 Tunisian revolution and the 2011 Egyptian revolution (though it was certainly not the only one).

21.1.5: Distribution Effects of Inflation

Learning Objective

Discuss how inflation affects distribution and creates winners and losers

Key Points

• Inflation is good for borrowers and bad for lenders because it reduces the value of the money paid back to the lenders.
• The inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected inflation. When the inflation rate rises or falls unexpectedly, wealth is redistributed between creditors and debtors.
• In general, this means that those with savings in the form of currency or bonds lose money from inflation. Those with negative savings (debt) or savings in the form of stocks, however, are better off with higher inflation.
• In demographic terms, unexpected inflation often manifests as a wealth transfer from older individuals to younger individuals.

Key Terms

nominal interest rate

The rate of interest before adjustment for inflation.

Real interest rate

The rate of interest an investor expects to receive after allowing for inflation.

Whether one regards inflation as a “good” thing or a “bad” thing depends very much on one’s economic situation. Assuming that loans must be paid back according to a nominal amount (i.e. the borrower must pay back $100 in one year), inflation is good for borrowers and bad for lenders. When there is inflation, the value of the money borrowers pay back is less.

When inflation is expected, it has few distribution effects between borrowers and lenders. This is because the inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected inflation. For example, if the real cost of borrowing money is 3% and inflation is expected to be 4%, the nominal interest rate on a loan would be 7%. If the inflation rate unexpectedly jumps to 8% after the loan is made, however, then the creditor is essentially transferring purchasing power to the borrower. Since it benefits debtors and hurts creditors, in practice unexpected inflation is often a transfer of wealth from the rich to the poor .

In general, this means that those with savings in the form of currency or bonds lose money from inflation. The lower purchasing power of money erodes the value of currency, and inflation reduces the real interest rate earned on bonds. Those with negative savings (debt) or savings in the form of stocks, however, are better off with higher inflation. Debtors find themselves paying a lower real interest rate than expected, and stocks tend to rise in value to reflect the inflation level. In demographic terms, this often manifests as a transfer from older individuals, who are wealthier and tend to hold their savings in more conservative assets such as cash and bonds, to younger individuals, who have more debt and tend to hold their savings in more aggressive assets such as stocks.

21.1.6: Deflation

Learning Objective

Define deflation and analyze its effects

Key Points

• When deflation occurs, the general price level is falling and the purchasing power of money is increasing.
• While there are problems associated with high inflation, economists generally believe that deflation is a more serious problem because it increases the real value of debt and may worsen recessions.
• Deflation discourages consumption because consumers know that if they wait to make a purchase, the price will likely drop.
• Deflation discourages borrowing and investment because the real value of the money to be repaid will be higher than the real value of the money borrowed.
• Some economists believe that deflation is caused by a fall in the general level of demand, while others attribute it to a fall in the money supply.

Key Terms

deflationary spiral

A situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.

purchasing power

The amount of goods and services that can be bought with a unit of currency or by consumers.

Deflation

Deflation is a decrease in the general price levels of goods and services. It occurs when the inflation rate falls below 0%. When this happens, the nominal prices of goods are falling on average and the purchasing power of money is increasing.

Effects of Deflation

While there are some problems associated with high levels of inflation, economists generally believe that deflation is a more serious problem because it increases the real value of debt and may worsen recessions.

Suppose you are a borrower that has borrowed $100 at a 5% interest rate to pay back in one year. Next year, you will give your lender $105 regardless of inflation. If there is no inflation, $105 next year buys the same amount as it does today. If there is inflation, $105 next year buys less than $105 does today. And if there is deflation, $105 next year buys more than $105 does today.

Deflation is good for lenders and bad for borrowers: when loans are paid back, the cash is worth more. Thus, deflation discourages borrowing, and by extension, consumption and investment today.

What Causes Deflation?

There are several theories about the causes of deflation. In the IS/LM model, deflation is caused by a shift in the supply and demand curve for goods and services. If there is a fall in how much the whole economy is willing to buy, for example, then the general demand curve shifts to the left and overall prices fall. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. Unemployment rises and investment falls, which in turn leads to further reductions in aggregate demand. This cycle of continuing inflation is called a deflationary spiral.

Recall that in monetarist theory, Money Supply*Velocity of Money = Price Level*Output. According to monetarist economists, therefore, deflation is caused by a reduction in the money supply, a reduction in the velocity of money, or an increase in the number of transactions. However, any of these may occur separately without causing deflation as long as they are offset by another change – for example, the velocity of money could rise and the money supply could fall without causing a change in price levels.

20.1: Comparing Economies

20.1.1: Economic Growth as a Measuring Stick

Learning Objective

Examine the components that cause economic growth

Key Points

• Economic growth could also be described as an outward shift in the production-possibility frontier, allowing for the generation of a higher quantity of goods.
• While measuring real GDP is useful in some ways, and considered a standard measure of economic growth, there is a great deal more complexity than is being captured (both quantitatively and qualitatively).
• Classic growth theory uses the production function to measure economic growth, which ultimately implies that economic growth constantly compounds.
• Growth accounting came into popularity after the classic model, identifying the crucial role of technology in economic growth.
• A more educated workforce will result in increases in real output, as will advances in technology and innovation.

Key Terms

inflation

The rise in the general level of prices of goods and services in an economy over a period of time.

gross domestic product

A measure of the economic production of a particular territory in financial capital terms over a specific time period.

Economic growth can be defined as the increase in real gross domestic product (GDP) in the long-run, or as increased productivity or via an increase in the natural resources (inputs) that create output. It is important to note that real GDP adjusts for inflation, rather than looking at output in nominal dollars. Economic growth could also be described as an outward shift in the production-possibility frontier, allowing for the production of a higher quantity of goods (see ).

Standard Measures of Economic Growth

Measuring economic growth is reasonably straight-forward, primarily focusing on either increases in productivity or increases in the available production inputs in a given system. This increase in productivity is converted into a relative percent based upon previous years, and expressed as a growth or decline. For example, if a given economy is producing $1,000,000 in 1900 and 1,050,000 in 1901, the economic growth rate (or GDP growth) will be expressed as 5%. If inflation is calculated to be 3% between 1900 and 1901, real economic growth will equate to 2%.

Alternative Economic Growth Models

While measuring real GDP is useful in some ways, and considered a standard measure of economic growth, there is a great deal more complexity than is being captured (both quantitatively and qualitatively). An outline of the perspectives of economic growth over time include:

• Classical Growth Theory: Dating back to Adam Smith and the foundation of capitalism, classical growth theory uses the production function to measure economic growth.
  , where Y, K, L and N represent output, capital, labor and land respectively. In this model, the overall growth of an economy will compound exponentially and capture economies of scale, implying that economic expansion via consistent growth is a reasonable proposition.
• Growth Accounting: Growth accounting came into popularity after the classical model, identifying the crucial role of technology in economic growth. Using the same classical growth equation, this method of measuring economic growth replaces the ‘land’ variable with ‘technology’ (technology including all of the contextual components that enable growth). In this scenario, technological leaps and bounds can be captured in the overall growth model.
• Salter Cycle: Economic growth is ultimately enabled by increases in productivity, and thus reductions in the required inputs to achieve each subsequent output per unit. As a result, an economy will continuously decrease price and thus increase demand, minimizing marginal utility over time and saturating markets.
• Endogenous Growth Model: This model takes into account technology, as in the growth accounting system discussed above, alongside increases in skills and intellectual capital. A more educated workforce will result in increases in real output, as will advances in technology and innovation.
• Energy Growth Theory: There has been a consistent correlation between economic growth and energy increase, alongside a paradox that increased energy and resource utilization efficiency actually increases consumption of that resource (similar to the Salter Cycle concept). As a result, energy growth theory economists identify a critical role of energy and resources in measuring overall economic growth.

20.1.2: How to Compare Economies Throughout History

Learning Objective

Describe historical trends in rates of economic growth

Key Points

• Comparing historical economies and economic trends over the course of human history is a difficult endeavor, as the comparisons are not always equal.
• Babylonians are credited with generating the first metric to measure economic value (i.e. currency) and standardizing trade through leveraging this metric.
• The creation of the first official paper currency (or banknotes) by the Tang Dynasty in China around the 9th century.
• As the 20th century dawned, real world GDP is estimated to have quadrupled as a result of the advances in industry (see, technology, and intellectual innovations.
• Modern economies have been consistently measured for growth over the past couple centuries, underlining useful economic data on overall growth between nations. To simplify these comparisons, economic growth is generally assessed as general GDP.

Key Terms

Bartering

Exchange goods or services without involving money.

evolution

Gradual directional change especially one leading to a more advanced or complex form; growth; development.

economic growth

The increase of the economic output of a country.

Comparing historical economies and economic trends over the course of human history is a difficult endeavor, as the comparisons are not always equal. The evolution of trade and the construction of measurement systems, currencies, standards, and the accuracy of historical record present a challenge to economists evaluating economies over time. That being said, timelines have been generated that capture useful insights, and modern economic comparisons (country to country) are growing increasingly accurate. Both of these perspectives shed light as to the overall patterns of economic growth over time.

Relevant Time Periods

For the sake of this discussion, four general time frames are useful to highlight:

• Stone Age: Including the Paleolithic, Mesolithic, and Neolithic time frames (up to 3500 B.C.), economics was virtually basic trade between small, local groups. This age is particularly worthy of note due to the crucial development of bartering and specialization. Specialization refers to the fact that a small group of people performing (and specializing) in different tasks can create substantially more value than every individual learning all tasks (think of Henry Ford’s assembly line).
• Antiquity: This includes the Bronze Age and the Iron Age, antiquity spans from 3500 B.C. around 500 A.D. As the names imply, the leveraging of natural resources (such as metals) were a critical step forward for trade. During this time frame the Babylonians are credited with generating the first metric to measure economic value (i.e. currency), and standardizing trade through leveraging this metric. This is an absolutely critical component to the ultimately measurement and comparison of economies from this time period forward.
• Middle Ages: The Silk Road is a famous economic historical element of this time frame, as is the creation of the first official paper currency (or banknotes) by the Tang Dynasty in China around the 9th century. The Middle Ages stretched from 500 A.D.-1500 A.D., and eventually saw the roots of accounting and financial trade roles in society.
• Modernity: From 1500 A.D. forward, trade grew increasingly global and increasingly standardized as a result. This era is marked by the Industrial Revolution, and the exponential productivity growth inherently found in technological advancement and standardized education systems. As the 20th century dawned, real world GDP is estimated to have quadrupled as a result of the advances in industry (see ), technology and intellectual innovations. Subsequently, population expanded as well.

With these four eras in mind, it is easy to empathize with economists attempting to unveil relative economic strength in the context of capitalist evolution. The modern age provides the most consistent data in which to analyze growth.

Comparing Modern Economies

Modern economies have been consistently measured for growth over the past couple centuries, underlining useful economic data on overall growth between nations. To simplify these comparisons, economic growth is generally assessed as general GDP (or increased productivity within a nation). The figure demonstrates these comparisons between 1990 and 2006, with a few countries standing out (China in particular).

Over time, countries can change significantly, and these changes must be considered in order to make accurate comparisons. Inflation, for example, changes the value of one unit of currency across time, so comparisons across time should be made using Real GDP, a GDP index, or another measure that accounts for changes in price.

There are also a number of other factors that must be taken into account such as GDP per capita, energy consumption, pollution metrics, education levels, innovation, etc. As you can imagine, it is difficult to compare countries across large time horizons, but, after controlling for as many of these effects as you can, comparisons are possible.

20.1.3: Is Economic Growth a Good Goal?

Learning Objective

Identify the value of economic growth objectives.

Key Points

• The relationship between economic growth and the well-being of a society has largely been viewed as positive throughout the course of history.
• Economic growth increases consumer purchasing power and leisure time along with governmental purchasing power for societal benefits.
• The concept of uneconomic growth postulates that the costs of economic growth may outweigh the benefits, those costs being the environmental and societal repercussions.
• It is imperative that increased productivity can be created in a context in which the value can be captured in a positive and meaningful way.
• It is imperative that increased productivity can be created in a context in which the value can be captured in a positive and meaningful way.

Key Term

Jevon’s Paradox

The proposition that technological progress that increases the efficiency with which a resource is used tends to increase the rate of consumption of that resource.

Throughout history, economists have typically assumed a positive relationship between economic growth (increased productivity) and the well-being of a society. It seems logical to assume that a stronger economy would create a higher standard of living. However, there is some debate surrounding the validity of this assumption. Is economic growth the appropriate objective?

Why is Growth Good?

Economic growth is the increase in the market value of the goods and services produced by an economy over time. Simply, more economic growth means that people are able to buy more of the things they like. Presumably, this translates into higher overall utility.

On a societal level, increases in GDP growth and overall productivity generates high prospective tax revenues, both on business profits and consumer purchases. Higher tax revenues will allow governments more financial flexibility to invest in social services such as education, welfare, transportation, etc.

Drawbacks to Economic Growth

There are, however, some downsides to economic growth, which are summarized in the idea of uneconomic growth. The concept of uneconomic growth postulates that the costs of economic growth – primarily environmental and social costs – may outweigh the benefits. There are a few specific observations of this that are worth noting:

• Jevon’s Paradox:Interestingly, increases in efficiency which drive increased economic growth often result in higher consumption. For example, when an economic system creates higher efficiency for generating electricity it will often increase the amount of electricity consumer in spite of that increased efficiency. This creates a culture of consumerism which is often wasteful.
• Malthusian Trap: Named after a political economist named Thomas Robert Malthus, the Malthusian trap simply states that increases in efficiency tend to result in population growth rather than wealth growth. Increased productivity within a system is only useful if it translates to an increase in per capita wealth.
• Imbalanced Distribution:Another issue is income distribution. This is what was meant by the adage that the rich get richer while the poor get poorer. It is quite common to see the rich absorb the vast majority of the value generated through increased productivity, creating a larger relative gap between the rich and the poor. In this circumstance there is limited utilitarian value to economic growth.
• Environmental Degradation: The final criticism is often the most discussed, particularly in light of the overwhelming evidence of global warming and the destructive nature of excessive consumption. It is also reasonable to consider the finite nature of natural resources (see ). Scientific modeling by environmental scientists often demonstrate significant long-term risks for the well-being of the ecosystem, posing a very real threat to the overall value in continued economic growth. Is it worth having more to consume if there is no ecosystem in which to enjoy it?

The important takeaway from this is to think carefully about the value created by economic growth. It is imperative that increased productivity can be created in a context in which the value can be captured in a positive and meaningful way.

19.1: Measuring Output Using GDP

19.1.1: Defining GDP

Learning Objective

Distinguish between the income and expenditure approaches of assessing GDP

Key Points

• GDP can be measured using the expenditure approach: Y = C + I + G + (X – M).
• GDP can be determined by summing up national income and adjusting for depreciation, taxes, and subsidies.
• GDP can be determined in two ways, both of which, in principle, give the same result.

Key Term

GDP

Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.

Gross domestic product (GDP) is the market value of all final goods and services produced within the national borders of a country for a given period of time. GDP can be determined in multiple ways. The income approach and the expenditure approach highlighted below should yield the same final GDP number .

Expenditure Approach

The expenditure approach attempts to calculate GDP by evaluating the sum of all final good and services purchased in an economy. The components of U.S. GDP identified as “Y” in equation form, include Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M).

Y = C + I + G + (X − M) is the standard equational (expenditure) representation of GDP.

• “C” (consumption) is normally the largest GDP component in the economy, consisting of private expenditures (household final consumption expenditure) in the economy. Personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services.
• “I” (investment) includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Spending by households (not government) on new houses is also included in Investment. “Investment” in GDP does not mean purchases of financial products. It is important to note that buying financial products is classed as ‘saving,’ as opposed to investment.
• “G” (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. However, since GDP is a measure of productivity, transfer payments made by the government are not counted because these payment do not reflect a purchase by the government, rather a movement of income. They are captured in “C” when the payments are spent.
• “X” (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.
• “M” (imports) represents gross imports. Imports are subtracted since imported goods will be included in the terms “G”, “I”, or “C”, and must be deducted to avoid counting foreign supply as domestic.

Income Approach

The income approach looks at the final income in the country, these include the following categories taken from the U.S. “National Income and Expenditure Accounts”: wages, salaries, and supplementary labor income; corporate profits interest and miscellaneous investment income; farmers’ income; and income from non-farm unincorporated businesses. Two non-income adjustments are made to the sum of these categories to arrive at GDP:

• Indirect taxes minus subsidies are added to get from factor cost to market prices.
• Depreciation (or Capital Consumption Allowance) is added to get from net domestic product to gross domestic product.

19.1.2: Learning from GDP

Learning Objective

Explain how GDP is calculated.

Key Points

• The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces.
• The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation.
• The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent.

Key Terms

gross national product

The total market value of all the goods and services produced by a nation (citizens of a country, whether living at home or abroad) during a specified period.

gross domestic product

A measure of the economic production of a particular territory in financial capital terms over a specific time period.

There are two commonly used measures of national income and output in economics, these include gross domestic product (GDP) and gross national product (GNP). These measures are focused on counting the total amount of goods and services produced within some “boundary” where the boundary is defined by either geography or citizenship.

Since GDP measures income and output, it can be used to compare two countries. The country with higher GDP is often regarded as wealthier, but, when using GDP to compare countries, it is important to remember to adjust for population.

GDP

GDP limits its focus to the value of goods or services in an actual geographic boundary of a country, where GNP is focused on the value of goods or services specifically attributable to citizens or nationality, regardless of where the production takes place. Over time GDP has become the standard metric used in national income reporting and most national income reporting and country comparisons are conducted using GDP.

GDP can be evaluated by using an output approach, income approach, or expenditure approach.

Output Approach

The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces. Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in the total output. This avoids an issue referred to as double counting, where the total value of a good is included several times in national output, by counting it repeatedly in several stages of production.

For example, in meat production, the value of the good from the farm may be $10, then $30 from the butchers, and then $60 from the supermarket. The value that should be included in final national output should be $60, not the sum of all those numbers, $90.

Formula: GDP (gross domestic product) at market price = value of output in an economy in the particular year – intermediate consumption at factor cost = GDP at market price – depreciation + NFIA (net factor income from abroad) – net indirect taxes.

Income Approach

The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation. The main types of factor income are:

• Employee compensation (cost of fringe benefits, including unemployment, health, and retirement benefits);
• Interest received net of interest paid;
• Rental income (mainly for the use of real estate) net of expenses of landlords;
• Royalties paid for the use of intellectual property and extractable natural resources.

All remaining value added generated by firms is called the residual or profit or business cash flow.

Formula: GDI (gross domestic income, which should equate to gross domestic product) = Compensation of employees + Net interest + Rental & royalty income + Business cash flow

Expenditure Approach

The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. This is acceptable, because like income, the total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output takes all the different areas in which money is spent within the region, and then combines them to find the total output .

Formula: Y = C + I + G + (X – M) ; where: C = household consumption expenditures / personal consumption expenditures, I = gross private domestic investment, G = government consumption and gross investment expenditures, X = gross exports of goods and services, and M = gross imports of goods and services.

19.1.3: The Circular Flow and GDP

Learning Objective

Evaluate the effect of the circular flow on GDP

Key Points

• In the circular flow model, the household sector, provides various factors of production such as labor and capital, to producers who in turn produce goods and services.
• Firms provide consumers with goods and services in exchange for consumer expenditure and “factors of production” from households.
• Investment is equal to savings and is the income not spent but available to both consumers and firms for the purchase of capital investments, such as buildings, factories and homes.
• A portion of income is also allocated to taxes (income is taxed and the remaining is either consumed and or saved); government spending, G, is based on the tax revenue, T.
• The continuous flow of production, income and expenditure is known as circular flow of income; it is circular because it has neither any beginning nor an end.

Key Terms

Factors of production

In economics, factors of production are inputs. They may also refer specifically to the primary factors, which are stocks including land, labor, and capital goods applied to production.

circular flow

A model of market economy that shows the flow of dollars between households and firms.

In economics, the “circular flow” diagram is a simple explanatory tool of how the major elements as defined by the equation Y = Consumption + Investment + Government Spending + (Exports – Imports). interact with one another. Circular flow is basically a continuous loop that for any point and time yields the value “Y” otherwise defined as the sum of final good and services in an economy, or gross domestic product (GDP) .

In the circular flow model, the household sector, provides various factors of production such as labor and capital, to producers who in turn produce goods and services. Firms compensate households for resource utilized and households pay for goods and services purchased from firms. This portion of the circular flow contributes to expenditures on consumption, C and generates income, which is the basis for savings (equal to investment) and government spending (tax revenue generated from income).

Investment, I, is equal to savings and is the income not spent but available to both consumers and firms for the purchase of capital investments, such as buildings, factories and homes. I represents an expenditure on investment capital.

Income generated in the relationship between firms and households is taxed and the remaining is either consumed and or saved. Government spending, G, is based on the tax revenue, T. G can be equal to taxes, less than or more than the tax revenue and represents government expenditure in the economy.

Finally, exports minus imports, X – M, references whether an economy is a net importer or exporter (or potentially trade neutral (X – M = 0)) and the impact of this component on overall GDP. Note that if the country is a net importer the value of X – M will be negative and will have a downward impact to overall GDP; if the country is a net exporter, the opposite will be true.

Circular flow

The continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end. The circular flow involves two basic assumptions:

1. In any exchange process, the seller or producer receives what the buyer or consumer spends.

2. Goods and services flow in one direction and money payment flow in the opposite or return direction, causing a circular flow.

19.1.4: GDP Equation in Depth (C+I+G+X)

Learning Objective

Identify the variables that make up GDP

Key Points

• C (consumption) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy.
• I (investment) includes, for instance, business investment in equipment, but does not include exchanges of existing assets.
• G (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government.
• X (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.
• M (imports) represents gross imports.

Key Terms

government spending

Includes all government consumption, investment but excludes transfer payments made by a state.

consumption

In the expenditure approach, the amount of goods and services purchased for consumption by individuals.

export

Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.

import

To bring (something) in from a foreign country, especially for sale or trade.

investment

A placement of capital in expectation of deriving income or profit from its use.

Gross domestic product (GDP) is defined as the sum of all goods and services that are produced within a nation’s borders over a specific time interval, typically one calendar year.

Components of GDP

GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M):

()

Defining the components

Consumption

Consumption (C) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy. These personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing. Also, it is important to note that goods such as hand-knit sweaters are not counted as part of GDP if they are gifted and not sold. Only expenditure based consumption is counted.

Investment

Investment (I) includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In contrast to common usage, ‘Investment’ in GDP does not mean purchases of financial products. Buying financial products is classified as ‘saving’, as opposed to investment. This avoids double-counting: if one buys shares in a company, and the company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the company spends the money on those things. To count it when one gives it to the company would be to count two times an amount that only corresponds to one group of products. Note that buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products.

Government Spending

Government spending (G) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.

Net Exports

Exports (X) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.

Imports (M) represents gross imports. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.

Sometimes, net exports is simply written as NX, but is the same thing as X-M.

Note that C, G, and I are expenditures on final goods and services; expenditures on intermediate goods and services do not count.

19.1.5: Calculating GDP

Learning Objective

Identify the output approach to calculating GDP

Key Points

• The expenditures approach says GDP= consumption + investment + government expenditure + exports – imports.
• The income approach sums the factor incomes to the factors of production.
• The output approach is also called the “net product” or “value added” approach.

Key Terms

expenditure approach

The total spending on all final goods and services (Consumption goods and services (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) – Imports (M)) GDP = C + I + G + (X-M).

income approach

GDP based on the income approach is calculated by adding up the factor incomes to the factors of production in the society.

output approach

GDP is calculated using the output approach by summing the value of sales of goods and adjusting (subtracting) for the purchase of intermediate goods to produce the goods sold.

Gross Domestic Product

Gross domestic product is one method of understanding a country’s income and allows for comparison to other countries .

By calculating the value of goods and services produced in a country, GDP provides a useful metric for understanding the economic momentum between the major factors of an economy: consumers, firms, and the government. There are a few methods used for calculating GDP, the most commonly presented are the expenditure and the income approach. Both of these methods calculate GDP by evaluating the final stage of sales (expenditure) or income (income). However, another approach referred to as the “output approach” calculates GDP by evaluating the value of all sales and adjusting for the purchase of intermediate goods (to remove double counting).

Expenditures Approach

The most well known approach to calculating GDP, the expenditures approach is characterized by the following formula:

GDP = C + I + G + (X-M)

where C is the level of consumption of goods and services, I is gross investment, G is government purchases, X is exports, and M is imports.

Income Approach

The income approach adds up the factor incomes to the factors of production in the society. It can be expressed as:

GDP = National Income (NY) + Indirect Business Taxes (IBT) + Capital Consumption Allowance and Depreciation (CCA) + Net Factor Payments to the rest of the world (NFP)

Output Approach

The output approach is also called “net product” or “value added” method. This method consists of three stages:

• Estimating the gross value of domestic output;
• Determining the intermediate consumption, i.e., the cost of material, supplies, and services used to produce final goods or services;
• Deducting intermediate consumption from gross value to obtain the net value of domestic output.

Net value added = Gross value of output – Value of intermediate consumption.

Gross value of output = Value of the total sales of goods and services + Value of changes in the inventories.

The sum of net value added in various economic activities is known as GDP at factor cost. GDP at factor cost plus indirect taxes less subsidies on products is GDP at producer price. GDP at producer price theoretically should be equal to GDP calculated based on the expenditure approach. However, discrepancies do arise because there are instances where the price that a consumer may pay for a good or service is not completely reflected in the amount received by the producer and the tax and subsidy adjustments mentioned above may not adequately adjust for the variation in payment and receipt.

19.1.6: Other Approaches to Calculating GDP

Learning Objective

Explain the income approach to calculating GDP.

Key Points

• The sum of COE, GOS, and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices.
• Adding taxes less subsidies on production and imports converts GDP at factor cost (as noted, a net domestic product) to GDP.
• By definition, the income approach to calculating GDP should be equatable to the expenditure approach; however, measurement errors will make the two figures slightly off when reported by national statistical agencies.

Key Terms

expenditure approach

The total spending on all final goods and services (Consumption goods and services (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) – Imports (M)) GDP = C + I + G + (X-M).

income approach

GDP based on the income approach is calculated by adding up the factor incomes to the factors of production in the society.

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

Gross domestic product provides a measure of the productivity of an economy specific to the national borders of a country . It can be measured a few different ways and the most commonly used metric is the expenditure approach; however, the second most commonly used measure is the income approach. The income approach unlike the expenditure approach, which sums the spending on final goods and services across economic agents (consumers, businesses and the government), evaluates GDP from the perspective of the final income to economic participants. GDP calculated in this manner is sometimes referenced as “Gross Domestic Income” (GDI).

This method measures GDP by adding incomes that firms pay households for factors of production they hire- wages for labor, interest for capital, rent for land, and profits for entrepreneurship. The U.S. “National Income and Expenditure Accounts” divide incomes into five categories:

• Wages, salaries, and supplementary labor income
• Corporate profits
• Interest and miscellaneous investment income
• Farmers’ income
• Income from non-farm unincorporated businesses

Two adjustments must be made to get the GDP: Indirect taxes minus subsidies are added to get from factor cost to market prices. Depreciation (or Capital Consumption Allowance) is added to get from net domestic product to gross domestic product.

Income Approach Formula

GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports. Alternatively, this can be expressed as:

GDP = COE + GOS + GMI + T_{P & M} – S_{P & M}

• Compensation of employees (COE) measures the total remuneration to employees for work done.
• Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses.
• Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.
• T_{P & M} is taxes on production and imports.
• S_P&M is subsidies on production and imports.

The sum of COE, GOS, and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So, adding taxes less subsidies on production and imports converts GDP at factor cost (as noted, a net domestic product) to GDP.

By definition, the income approach to calculating GDP should be equatable to the expenditure approach (Y = C + I+ G + (X – M)). In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.

19.1.7: Evaluating GDP as a Measure of the Economy

Learning Objective

Assess the uses and limitations of GDP as a measure of the economy

Key Points

• The sensitivities related to social welfare has continued the argument specific to the use of GDP as a economic growth or progress metric.
• A country with wide disparities in income could appear to be economically stronger, strictly using GDP, than a country where the income disparities were significantly lower (standard of living).
• Therefore, GDP has a tremendous big-picture value but policymakers would be better served using other metrics in combination with the aggregate measure if and when social welfare is being addressed.

Key Terms

qualitative

Based on descriptions or distinctions rather than on some quantity.

welfare

Health, safety, happiness and prosperity; well-being in any respect.

quantitative

Of a measurement based on some number rather than on some quality.

Gross domestic product (GDP) due to its relative ease of calculation and definition, has become a standard metric in the discussion of economic welfare, growth and prosperity. However, the value of GDP as a measure of the quality of life for a given country may be quite poor given that the metric only provides the total value of production for a specific time interval and provides no insight with respect to the source of growth or the beneficiaries of growth. Therefore, growth could be misinterpreted by looking at GDP values in isolation.

Limitations of GDP

Simon Kuznets, the economist who developed the first comprehensive set of measures of national income, stated in his first report to the US Congress in 1934, in a section titled “Uses and Abuses of National Income Measurements”:

“Economic welfare cannot be adequately measured unless the personal distribution of income is known. And no income measurement undertakes to estimate the reverse side of income, that is, the intensity and unpleasantness of effort going into the earning of income. The welfare of a nation can, therefore, scarcely be inferred from a measurement of national income. “

Following on his caution with respect to economic extrapolations from GDP, in 1962, Kuznets stated: “Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what. “

The sensitivities related to social welfare has continued the argument specific to the use of GDP as a economic growth or progress metric.

Austrian School economist Frank Shostak has noted: “The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption. For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well-being of individuals, the GDP framework will regard this as economic growth. In reality, however, the building of the pyramid will divert real funding from wealth-generating activities, thereby stifling the production of wealth. “

GDP as an Evaluation Metric

Although GDP provides a single quantitative metric by which comparisons can be made across countries, the aggregation of elements that create the single value of GDP provide limitations in evaluating a country and its economic agents. Given the calculation of the metric, a country with wide disparities in income could appear to be economically stronger than a country where the income disparities were significantly lower (standard of living). However, a qualitative assessment would likely value the latter country compared to the former on a welfare or quality of life basis .

Therefore, GDP has a tremendous big-picture value but policymakers would be better served using other metrics in combination with the aggregate measure if and when social welfare is being addressed.

18.1: Key Topics in Macroeconomics

18.1.1: Defining Macroeconomics

Learning Objective

Define Macroeconomics.

Key Points

• Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions.
• Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, government spending and international trade.
• Though macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research on the national level: output, unemployment, and inflation.

Key Terms

microeconomics

That field that deals with the small-scale activities such as that of the individual or company.

Macroeconomics

The study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices.

Economics is comprised of many specializations; however, the two broad sub-groupings for economics are microeconomics and macroeconomics.

Macroeconomics

Macroeconomics is a branch of economics that focuses on the behavior and decision-making of an economy as a whole . In this manner it differs from the field of microeconomics, which evaluates the motivations of and relationships between individual economic agents.

Indicators

Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions and develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, government spending, and international trade. These variables taken as a whole comprise a grouping of variables that are referred to as economic indicators. These indicators, which are classified as leading, lagging and coincident relative to their predictive capability, in combination with one another provide economists with a directional attribution for the economy.

Macroeconomic Study

While macroeconomics is a broad field of study, there are two areas of research that are especially well publicized in the media: the evaluation of the business cycle and the growth rate of the economy. As a result, macroeconomics tends to be widely cited in discussions related to government intervention in economic expansion and contraction, as well as, with respect to the evaluation of economic policy.

Though macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research on a national level: output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also extremely important to all economic agents including workers, consumers, and producers.

18.1.2: The Importance of Aggregate Decisions about Consumption versus Saving and Investment

Learning Objective

Explain the relationship between consumption, savings, and investment.

Key Points

• Aggregate demand is downward sloping as a result of three consumption sensitivities: wealth effect, interest rate effect and foreign exchange effect.
• Spending is related to income: Income – Spending = Net Savings.
• For the economy as a whole, aggregate savings is equal to investment, which is usually in the form of borrowed funds available as a result of savings.

Key Term

aggregate demand

The the total demand for final goods and services in the economy at a given time and price level.

There are three choices that market actors can make with their money. They can consume it by spending it on goods and services. For example, buying a movie ticket is spending money on consumption. They can also invest money by lending it to a company or project with the hope of getting back more money in the future. Finally, they can save it by putting it in a bank account (or keeping cash under the bed). Savings is essentially deferred consumption or investment; it is intended for use in the future.

In order to understand the effects of aggregate decisions of consumption, savings, and investment, we must look at aggregate demand (AD). AD is the total demand for final goods and services in the economy at a given time and price level. It specifies the amounts of goods and services that will be purchased at all possible price levels and is the demand for the gross domestic product of a country.

Components of Aggregate Demand

It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is incorrect. The aggregate demand curve is downward sloping but in variation with microeconomics, this is as a result of three distinct effects: the wealth effect, the interest rate effect and the exchange-rate effect.

Basically individuals will consume or purchase more when they feel wealthier or have access to inexpensive funding.

The wealth effect is specifically related to the value of assets; market participants will adjust consumption in-line with their perception of the appreciation or depreciation of held assets (a home; equity investments, etc.). The interest rate effect has to do with access to inexpensive funding, which provides an incentive to increase current period expenditures; while the exchange-rate effect has to do with expenditure decisions related to imports or foreign related expenditures, as the exchange rate is perceived to be favorable to the domestic currency, expenditures on foreign items or imports will increase.

Consumption, Savings, and Investment

Aggregate demand met by the market is spending, be it on consumption, investment, or other categories.

Spending is related to income:

Income – Spending = Net Savings

Rearranging:

Spending = Income – Net Savings = Income + Net Increase in Debt

In words: what you spend is what you earn, plus what you borrow: if you spend $110 and earned $100, then you must have net borrowed $10; conversely if you spend $90 and earn $100, then you have net savings of $10, or have reduced debt by $10, for net change in debt of –$10.

For the economy as a whole, aggregate savings is greater than or equal to investment, which is usually in the form of borrowed funds available as a result of savings. Through investment spending, savings influences aggregate demand.

Furthermore, since consumption and investment are components of GDP but saving is not, increased savings indirectly reduces GDP .

18.1.3: The Role of the Financial System

Learning Objective

Explain the importance of the financial system

Key Points

• An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy.
• Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one “place,” thus making it easier for them to find each other.
• Healthy financial systems are associated with the accelerated development of an economy.

Key Terms

entrepreneurship

The art or science of innovation and risk-taking for profit in business.

investment

A placement of capital in expectation of deriving income or profit from its use.

saving

the act of storing for future use

Financial System

A financial market or system is a market in which people and entities can trade financial securities, commodities, and other fungible items . Securities include stocks and bonds, and commodities include precious metals or agricultural goods.

There are both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded). Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one place, thus making it easier for them to find each other.

An economy that relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy, in contrast either to a command economy or to a non-market economy such as a gift economy.

Role of the Financial System

Financial markets are associated with the accelerated growth of an economy. A financial market helps to achieve the following non-comprehensive list of goals:

• Saving mobilization: Obtaining funds from the savers or surplus units such as household individuals, business firms, public sector units, central government, state governments, etc. is an important role played by financial markets. Borrowers (e.g. bond issuers) are connected with lenders (e.g. bond buyers) in financial markets.
• Investment: Financial markets play a crucial role in arranging to invest funds. Both firms and individuals can invest in companies through financial markets (e.g. by buying stock).
• National Growth: An important role played by financial market is that, they contribute to a nation’s growth by ensuring unfettered flow of surplus funds to deficit units. In other words, financial markets help shift money from industry to industry or firm to firm based on the supply and demand for their products.
• Entrepreneurship growth: Financial markets allow entrepreneurs (and established firms) to access the funds needed to invest in projects or companies.

18.1.4: The Business Cycle: Definition and Phases

Learning Objective

Identify features of the economic business cycle

Key Points

• Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough.
• Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering the growth rate of real gross domestic product.
• In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business cycle.

Key Terms

contraction

A period of economic decline or negative growth.

peak

The highest value reached by some quantity in a time period.

trough

The lowest turning point of a business cycle

expansion

The act or process of expanding.

The Business Cycle

The term “business cycle” (or economic cycle or boom-bust cycle) refers to economy-wide fluctuations in production, trade, and general economic activity. From a conceptual perspective, the business cycle is the upward and downward movements of levels of GDP (gross domestic product) and refers to the period of expansions and contractions in the level of economic activities (business fluctuations) around a long-term growth trend .

Business Cycle Phases

Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough.

An expansion is characterized by increasing employment, economic growth, and upward pressure on prices. A peak is realized when the economy is producing at its maximum allowable output, employment is at or above full employment, and inflationary pressures on prices are evident. Following a peak an economy, typically enters into a correction which is characterized by a contraction, growth slows, employment declines (unemployment increases), and pricing pressures subside. The slowing ceases at the trough and at this point the economy has hit a bottom from which the next phase of expansion and contraction will emerge.

Business Cycle Fluctuations

Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering the growth rate of real gross domestic product.

In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business cycle. An expansion is the period from a trough to a peak, and a recession as the period from a peak to a trough. The NBER identifies a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production. ” This is significantly different from the commonly cited definition of a recession being signaled by two consecutive quarters of decline in real GDP.

18.1.5: Recessions

Learning Objective

Explain the connection between a recession and other macroeconomic variables

Key Points

• Macroeconomic indicators such as GDP (Gross Domestic Product), employment, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise.
• Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions.
• Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow.

Key Term

recession

A period of reduced economic activity

In economics, a recession is a business cycle contraction; a general slowdown in economic activity. Macroeconomic indicators such as GDP (Gross Domestic Product), employment, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock, or the bursting of an economic bubble .

Attributes of Recession

A recession has many attributes that can occur simultaneously, these include declines in component measures (economic indicators) of economic activity (GDP) such as consumption, investment, government spending, and net export activity. These indicators in turn, reflect underlying drivers such as employment levels and skills, household savings rates, corporate investment decisions, interest rates, demographics, and government policies.

Causes of Recession

Under ideal conditions, a country’s economy should have the household sector as net savers and the corporate sector as net borrowers, with the government budget nearly balanced and net exports near zero. When these relationships become imbalanced, recession can develop within a country or create pressure for recession in another country. Policy responses are often designed to drive the economy back towards this ideal state of balance.

Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions.

Policy Responses to Recession

Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow. Monetarists would favor the use of expansionary monetary policy, while Keynesian economists may advocate increased government spending to spark economic growth. Supply-side economists may suggest tax cuts to promote business capital investment. When interest rates reach the boundary of an interest rate of zero percent (zero interest-rate policy) conventional monetary policy can no longer be used and government must use other measures to stimulate recovery.

A severe (GDP down by 10%) or prolonged (three or four years) recession is referred to as an economic depression, although some argue that their causes and cures can be different. As an informal shorthand, economists sometimes refer to different recession shapes, such as V-shaped, U-shaped, L-shaped, and W-shaped recessions.

18.1.6: Managing the Business Cycle

Learning Objective

Identify how changes in monetary and fiscal policy can manage the business cycle, and why that is desirable

Key Points

• If the economy needs to be slowed, enacted policies are referred to as being contractionary and if the economy needs to be stimulated the policy prescription is expansionary.
• Central banks use monetary policy measures to facilitate consistent economic growth, while the government uses fiscal policy.
• The government policy measures are referred to as fiscal policy.

Key Terms

fiscal policy

Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

The business cycle is comprised of the upward and downward movement in the level of Gross Domestic Product (GDP) over time . These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).

Policy Responses

When the economy is not at a steady state and instead is at a point of either overheating (growing to fast) or slowing, the government and monetary authorities have policy mechanisms, fiscal and monetary, respectively, at their disposal to help move the economy back to a steady state growth trajectory. If the economy needs to be slowed, these policies are referred to as contractionary and if the economy needs to be stimulated the policy prescription is expansionary.

Expansionary Policy

Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions. Fiscal authorities will increase government spending in order to revive the economy.

Expansionary monetary policy relies on the central bank increasing availability of loanable funds through three mechanisms: open market operations, discount rate, and the reserve ratio. As the supply of loanable funds increases, the interest rate is expected to decrease and thereby increase the desire to borrow funds for consumption and investment purposes.

Contractionary Policy

Contractionary fiscal policy is opposite of the action taken in an expansionary purpose, and occurs when government spending is lower than tax revenue.

Similarly, contractionary monetary policy is the opposite of expansionary monetary policy and occurs when the supply of loanable funds is limited, to reduce the access and availability to relatively inexpensive credit.

18.1.7: Long Run Growth

Learning Objective

Explain the impact of consistent long-run growth on an economy.

Key Points

• Growth is usually calculated in real terms, meaning that it is inflation-adjusted to eliminate the distorting effect of inflation on the price of goods produced.
• Policymakers strive for continued and consistent growth.
• The large impact of a relatively small growth rate over a long period of time is due to the power of compounding.
• A small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.

Key Term

economic growth

The increase of the economic output of a country.

Long run growth is the increase in the market value of the goods and services produced by an economy over time. It is conventionally measured as the percentage of increase in real gross domestic product, or real GDP. Growth is usually calculated in real terms: it is inflation-adjusted to eliminate the distorting effect of inflation on the price of goods produced. In economics, economic growth or economic growth theory typically refers to growth of potential output, which is production at full employment.

Policymakers strive for steady, continued, and consistent growth because it is predictable and manageable for both policymakers and market participants. Over long periods of time even small rates of growth, like a 2% annual increase, have large effects. For example, the United Kingdom experienced a 1.97% average annual increase in its inflation-adjusted GDP between 1830 and 2008. In 1830, the GDP was £41,373 million. It grew to £1,330,088 million by 2008 (in 2005 pounds). A growth rate that averaged 1.97% over 178 years resulted in a 32-fold increase in GDP by 2008 .

The Power of Compounding

The large impact of a relatively small growth rate over a long period of time is due to the power of compounding. A growth rate of 2.5% per annum leads to a doubling of the GDP within 29 years, while a growth rate of 8% per annum (an average exceeded by China between 2000 and 2010) leads to a doubling of GDP within 10 years. Therefore, a small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.

Note: an easy way to approximate the doubling time of a number with a constant growth rate is to use the Rule of 72. Divide 72 by the percentage annual growth rate to get a rough estimate of the number of years until the number doubles. For example, at a 10%, divide 72 by 10 to get a doubling time of 7.2 years. The actual doubling time is 7.27 years, so the rule of 72 is a good rough approximation.

17.1: Defining and Measuring Inequality, Mobility, and Poverty

17.1.1: Defining and Measuring Poverty

Learning Objective

Describe poverty and the poverty line

Key Points

• The United Nations defines poverty as the inability to obtain choices and opportunities.
• A poverty line pertains to the idea of generating an amount of income that is appropriate to ensure a minimum standard of living for an individual. Someone below a nationally set poverty line lacks the purchasing power to fulfill their needs and capture opportunities.
• In observing poverty over time, the rates of poverty alongside the advances in economic production, demonstrate the value in technological and economic progress.
• Poverty is generally divided into absolute or relative poverty, with absolute concepts referring to a standard consistent over time and geographic location and relative pertaining to social benchmarks.

Key Terms

purchasing power

The amount of goods and services that can be bought with a unit of currency or by consumers.

Poverty line

The threshold of poverty, below which one’s income does not cover necessities.

Poverty is framed from a material or capital possessions perspective, and is loosely defined as lacking a certain amount to fulfill basic standards of living. Absolute poverty is poverty to the extent of which an individual is deprived of the ability to fulfill basic human needs (i.e. water, shelter, food, education, etc.). The United Nations defines poverty as the inability to obtain choices and opportunities. The existence of poverty is one of the greatest challenges faced by the modern world, both in developing and developed nations (see ). Addressing poverty is best approached through the science of understanding monetary exchanges and the creation of wealth, and thus it is useful to employ an economic perspective when discussing and providing solutions to global poverty.

The Poverty Line

When conceptually approaching the idea of a poverty line, it is useful to frame it within the context of generating an amount of income that is appropriate to ensure a reasonable standard of living for an individual. Someone below a nationally set poverty line lacks the purchasing power to fulfill their needs and capture opportunities. The United States, for example, has most recently (2012) set the poverty line at $23,050 (annually) with a total of 16% of the population falling under this level (according to the U.S. Census Bureau). Internationally, the World Bank defines extreme poverty as living on less than $1 per day (adjusted for purchasing power).

In observing poverty over time, the rates of poverty alongside the advances in economic production, demonstrates the value in technological and economic progress. The industrial revolution, the modernization (and thus increased efficiency) of agriculture, mass production in factories, technological innovation and a wide range of factors that have driven production and economies upwards have contributed to an increased standard of living. Economically, while the distribution of wealth heavily has tended to benefit the wealthy, there has been great value derived in technological progress in regards to minimizing poverty.

Measuring Poverty

Varying approaches have been developed to measure poverty levels, with a particular focus on creating standardized tools to capture a global context. Poverty is generally divided into absolute or relative poverty, with absolute concepts referring to a standard that is consistent over time and geographic location. An example of absolute poverty is the number of people without access to clean drinking water, or the number of people eating less food than the body requires for survival. Absolute poverty levels, as discussed above, essentially underline the ability for an individual to survive with autonomy. Relative poverty is an approach based more upon a benchmark, that is to say the upper echelon of society versus the poor. Income distribution measures lend insight into relative poverty levels.

One interesting perspective is the Multidimensional Poverty Index (MPI). This index was created in 2010 by the Oxford Poverty & Human Development Initiative alongside the United Nations Development Programme. It leverages a variety of dimensions and applies it to the number of people and the overall intensity across the poor to create a model to capture the extent of the poverty in the region. This dimensions include health, child mortality, nutrition, standard of living, electricity, sanitation, water, shelter (via the floor), cooking fuel and assets owned.

17.1.2: Defining and Measuring Income Inequality

Learning Objective

Apply indices of income inequality to measure global economic inequality

Key Points

• In pursuing an objective and comparable lens in which to measure income inequality, a variety of methods have been created.
• One of the most commonly used income inequality metric is the Gini Index, which uses a straightforward 0-1 scale to illustrate deviance from perfect income equality.
• The 20:20 Ratio and the Palma Ratio (40:10) use percentile ratios of the richest groups and poorest groups to create scales of income inequality severity.
• The Theil Index takes a slightly different approach than the rest, identifying entropy within the system. Entropy, in this case, means the amount of noise or deviance from par, which is expressed as a scale (0 – 1); 0 indicates perfect equality, and 1 indicates perfect inequality.
• Often touted as the simplest measurement to calculate, the Hoover Index derives the overall amount of income in a system and divides it by the population to create the perfect proportion of distribution in the system.

Key Term

entropy

A measure of the amount of information and noise present in a signal.

Income inequality utilizes the dispersion of capital to identify the way in which economic inequality is defined among a group of individuals in a given economy. Simply put, economics measures income levels and purchasing power across a society to identify averages and distributions to identify the extent of inequalities. Historically this problem was limited to the scope of differences of income and assets between people, creating separate social classes. However, as economists expand their understanding of markets, it has become increasingly clear that there is a relationship between income inequality and the potential for long-term sustainable economic growth. As a result, a wide array of income inequality scales and metrics have been generated in order to identify challenges.

Inequality Metrics

In pursuing an objective and comparable lens in which to measure income inequality, a variety of methods have been created. Models, ratios and indices include:

• Gini Index: One of the most commonly used income inequality metric is the Gini Index, which uses a straightforward 0-1 scale to illustrate deviance from perfect equality of income. A 1 on this scale is essentially socialism, or the perfect distribution of capital/goods. The derivation of the Gini ratio is found via Lorenz curves, or more specifically, the ratio of two areas in a Lorenz curve diagram. The downside to this method is that it does not specifically capture where the inequality occurs, simply the degree of severity in the income gap. This demonstrates the Gini ratio across the globe, with some interesting implications for advanced economies like the U.S.
• 20:20 Ratio:This name indicates the method; the top 20% and the bottom 20% of earners are used to derive a ratio. While this is a simple method of identifying how rich the rich are (and how poor the poor are), it unfortunately only captures these outliers (obscuring the middle 60%).
• Palma Ratio: Quite similar to the 20:20 ratio, the Palma ratio underlines the ratio between the richest 10% and the poorest 40% (dividing the former by the latter). The share of the overall economy occupied by these two groups demonstrates substantial variance from economy to economy, and serves as a strong method to identify how drastic the inequity is.
• Theil Index:The Theil Index takes a slightly different approach than the rest, identifying entropy within the system. Entropy in this context is different than that which is found in thermodynamics, primarily meaning the amount of noise or deviance from par. In this case, 0 indicates perfect equality, and 1 indicates perfect inequality. When there is perfect equality, maximum entropy occurs because earners cannot be distinguished by their incomes. The gaps between two entropies is called redundancy, which acts as a negative entropy measure in the system. Redundancy in some individuals implies scarcity of resources for others. Comparing these gaps and inequality levels (high entropy or high redundancy) is the basic premise behind the Theil Index.
• Hoover Index: Often touted as the simplest measurement to calculate, the Hoover Index derives the overall amount of income in a system and divides it by the population to create the perfect proportion of distribution in the system. In a perfectly equal economy this would equate to income levels, and the deviance from this (on a percentile scale) is representative of the inequality in the system.

To simplify the information above, the basic concept behind measuring inequality is identifying an ideal and tracking any deviance from that ideal (which would be deemed the inequality of a given system). Minimizing this inequality is the sign of a mature and advanced society with high standards of living across the board, while substantial income gaps are indicative of a developing or struggling economy. Some powerful economies, like the United States and China, demonstrate high inequality despite high economic power while others, like Switzerland or Norway, demonstrate high equality despite lower economic output. This is a critical consideration in economic policy (from a political perspective). Minimizing inequality is a central step towards an advanced society.

17.1.3: Defining and Measuring Economic Mobility

Learning Objective

Distinguish between types of economic mobility

Key Points

• This concept of economic mobility is often considered in conjunction with “social mobility,” which is the capacity for an individual to change station within a society.
• Economic mobility can be perceived via a number of approaches, but is best summarized as inter-generational, intra-generational, absolute, or relative.
• Closely related to the concept of economic mobility is that of socio-economic mobility, referring to the ability to move vertically from one social or economic class to another. This is called “vertical” mobility.
• Economists studying economic mobility have identified a number of factors that play an integral role in enabling (or blocking) participants in an economic system from achieving mobility, such as gender, race and education.

Key Terms

glass ceiling

An unwritten, uncodified barrier to further promotion or progression for a member of a specific demographic group.

Economic mobility

The ability of an individual or family to improve their income, and social status, in an individual lifetime or between generations.

Economic mobility is a measurement of how capable a participant in a system can improve (or reduce) their economic status (generally measured in monetary income). This concept of economic mobility is often considered in conjunction with ‘social mobility’, which is the capacity for an individual to change station within a society.

Types of Economic Mobility

Economic mobility can be perceived via a number of approaches, but is best summarized in the following four:

• Intergenerational:Intergenerational mobility pertains to a person’s capacity to alter their station relative to the economic status of their parents or grandparents, essentially the flexibility within a society to allow individuals to grow regardless of their initial station. Contrary to concepts of mobility in America, 42% of individuals in born into the bottom income bracket remain there. An interesting chart, measuring intergenerational income elasticity, can be found in .
• Intragenerational:Intragenerational mobility is defined by an individual’s upwards and downwards movement throughout their lifetime (both relative to their working career and their peers). This type of mobility is shorter term than intergenerational in regards to the way in which it is confined to the lifetime of that individual specifically.
• Absolute:Similar to intergenerational mobility, absolute mobility looks at how widespread economic growth improves (or reduces) an individual or a family’s income over a generational time frame. Put simply, it answers the following question: How likely is a person to exceed their parents income at a given age?
• Relative:Relative mobility, as the name implies, measures the mobility and economic growth of a particular person within the context of the system in which they work.

Closely related to the concept of economic mobility is that of socioeconomic mobility, which refers to the ability to move vertically from one social or economic class to another. This is called “vertical” mobility, which overlaps substantially with the categories discussed above.

Economists studying economic mobility have identified a number of factors that play an integral role in enabling (or blocking) participants in an economic system from achieving mobility. Some of the more well-known issues include:

• Gender: Gender is quite often a limiting factor in economic mobility, with concepts like the “glass ceiling” underlining the difficulty encountered by women in achieving high-earning status. While women have made great strides in some countries, many global economies still struggle to incorporate women into the workplace with equity.
• Race/Ethnicity: In the United States in particular there is huge inequity between Caucasian workers and that of other backgrounds (African American, Hispanic, etc.). Approaching this social tie with income inequity has taken a great deal of political reform over the years, and has much left to accomplish in terms of enabling movement across economic levels.This could in many ways be coupled with immigration, or the concept of being different socially or ethnically from a group that has historically achieved high income levels.
• Education: Access to equitable and affordable education in all places worldwide is a substantial domestic and global challenge in enabling the next generation for success. Access to the best education is highly correlated with access to the best professional opportunities, and thus the expansion and funding of effective public education lies at the center of enabling economic mobility.

17.1.4: Measurement Problems

Learning Objective

Describe issues with measuring poverty and income inequality globally

Key Points

• The most popular measurement of income inequality is the Gini ratio, which leverages a simple scale of 0-1 to derive deviance from a given perfect equality point. The primary drawback to this approach is that it measures relative poverty (as opposed to absolute poverty).
• The poverty line is a useful absolute measurement, but suffers from having no global standard set (for comparative value), having limited nuance to measure deviations from the poverty line, and failing to incorporate intangible societal assets such as health care.
• One interesting risk in measuring poverty is the concept of voluntary poverty, or the active pursuit of living at the absolute bare minimum.
• Overall, while measuring inequality is a necessary and useful economic perspective, there are inherent statistical drawbacks in mathematically approaching complex societal issues.

Key Terms

Poverty line

The threshold of poverty, below which one’s income does not cover necessities.

Gini Index

A measure of income distribution.

As with any statistical modeling and measuring approach, there is a great deal of complexity to capture within a finite algorithmic structure, making the accuracy and efficacy of many poverty and inequality measurements less than ideal. Inequality, poverty and economic mobility in particular have a number of measurement challenges.

Gini Index

The most popular measurement of income inequality is the Gini index, which leverages a simple scale of 0-1 to derive deviance from a given perfect equality point. If a system demonstrates a Gini index of 0, the implication is that income differences among any individuals in the population will be essentially zero, while a measurement of 1 is complete income disparity. The primary drawback to this approach is that it measures relative poverty (as opposed to absolute poverty). This criticism spans across most poverty measurement systems (Thiel entropy, the 20:20 ratio, and the Palma ratio to name a few), and ultimately implies that much of what is measured as inequality does not take into account absolute gains.

For example, if an economy were to grow by 20% over 10 years, it is perfectly possible (and indeed quite likely) that the upper 20% will capture 50% gains while the bottom 20% will only capture 10% gains. That bottom 10% (assuming inflation has been accounted for) will be gaining wealth and purchasing power in absolute terms despite the fact that the Gini index will be much worse. The Gini index still has important implications about relative inequality in this circumstance, but it neglects to point out positive gains.

Criticisms of the Poverty Line

Taking into account the problems with the Gini ratio, a concept like the poverty line does an effective job in offsetting this variability. A poverty line is the determination of a specific income level in which it is considered the absolute minimum amount of capital required for an individual or family to live (and have all necessities) over the course of one year.

While there is great absolute value in utilizing a poverty line to determining the percentage of people still surviving on less than is considered the bare minimum, there are also drawbacks to this method as well. Looking at the , one can see that measuring the percentages of individuals under the poverty line from country to country demonstrates what appears to be a graphic for comparison. However, due to the fact that poverty lines are different in different countries (because there is no standard way in which to enforce setting and measuring the poverty line) it is not relative. As a result, there is high absolute value for each country but minimal comparative value between countries. Another prospective drawback of this method is that the poverty threshold only measures when an individual is above or below it, and not the extent to which each individual deviates. Finally, it is also important to consider less quantitative components that affect the standard of living (for example, education quality, roads, access to public transportation, access to healthcare, etc.), and thus country to country comparisons are somewhat reduced in value.

Voluntary Poverty

One interesting risk in measuring poverty is the concept of voluntary poverty, or the active pursuit of living at the absolute bare minimum. This is done as a result of lifestyle choice or religion, and is counted into poverty and inequality levels despite the fact that the individual being counted has actively pursued this place in society. While this is a somewhat unusual circumstance, it shifts the measurement of poverty in some regions (particularly those with a high population of certain beliefs or religions) higher than would be expected.

16.1: Introduction to Taxes

16.1.1: What Taxes Do

Learning Objective

Explain the role of taxation with respect to consumer and firm behavior

Key Points

• Taxes allow the government to perform and provide services that would not evolve naturally through a free market mechanism, for example, public parks.
• Taxes are the primary source of revenue for most governments.
• Governments also use taxes to establish income equity and modify consumption decisions.

Key Terms

sales tax

A local or state tax imposed as a percentage of the selling price of goods or services payable by the customer. The tax is not recognized as the seller’s earnings; the seller only collects the tax and transmits the same to local or state authorities.

income tax

A tax levied on earned and unearned income, net of allowed deductions.

progressive tax

A tax by which the rate increases as the taxable base amount increases.

regressive tax

A tax imposed in such a manner that the rate decreases as the amount subject to taxation increases.

Taxes are the primary source of revenue for most governments. They are simply defined as a charge or fee on income or commerce. Taxes are most readily understood from the perspective of income taxes or sales tax, although there are many other types of taxes levied on both individuals and firms.

Necessarily, taxes raise the price of purchasing the good or resource for firms and consumers. As a result, the quantity demanded and supplied reacts according to the supply and demand curves.

Tax Authority

In the United States, Congress has the power to tax as stated in The United States Constitution, Article 1, Section 8, Clause 1: “The Congress shall have the Power to lay and collect Taxes, Duties, Imposts, and Excises to pay the Debts and provide for the common Defense and general Welfare of the United States. ” This power was reinforced in the Sixteenth Amendment to the Constitution: “The Congress shall have the power to lay and collect taxes on income, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

It is important to note that Congress has delegated to the Internal Revenue Service (IRS) the responsibility of administering the tax laws, known as the Internal Revenue Code (the Code). Congress enacts these tax laws, and the IRS enforces them. Individual states also have the power to tax as do smaller government entities such as towns, cities, counties, and municipalities.

Purpose of Taxation

On a general level, tax collections provide a revenue source to support the outlays or primary activities of a government including but not limited to public buildings, military, national parks, and public welfare in the form of transfer payments. Taxes allow the government to perform and provide services that would not evolve naturally through a free market mechanism, for example, public parks. However, governments also use taxes to establish income equity and modify consumption decisions .

Sources of Tax Revenue: Income Taxation

Governments use different kinds of taxes and vary the tax rates. This is done to distribute the tax burden among individuals or classes of the population involved in taxable activities, such as business, or to redistribute resources between individuals or classes in the population. This type of taxation is referred to as progressive taxation because the tax liability increases in proportion to income.

Sources of Tax Revenue: Sales Taxes

Sales taxes are borne by the consumer when s/he purchases certain goods. It is an ad valorem tax: the charged value is based on the value of what is being sold. This is in contrast to an excise tax, where the charged value is based on the number of items being sold.

Sales tax is a form of regressive taxation; the liability is based on the percentage of income consumed, which is higher for low income earners. As a result, individuals earning a relatively lower income will pay a higher proportion of income in the form of sales tax, defining the regressive nature of the tax. Though a general revenue source, sales taxes are also used to modify behavior. For example taxes on cigarettes are meant to dissuade purchase due to the inherent health implications of smoking.

16.1.2: How Taxes Impact Efficiency: Deadweight Losses

Learning Objective

Discuss how taxes create deadweight loss

Key Points

• Causes of deadweight loss can include actions that prevent the market from achieving an equilibrium clearing condition and include taxes.
• Deadweight loss can generally be referenced as a loss of surplus to either the consumer, producer, or both.
• Harberger’s triangle refers to the deadweight loss associated with government intervention in a perfect market.

Key Terms

Pareto optimal

Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.

deadweight loss

A loss of economic efficiency that can occur when an equilibrium is not Pareto optimal.

Deadweight Loss

In economics, a deadweight loss (also known as excess burden or allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal (resource allocation where it is impossible to make any one individual better off without making at least one individual worse off). Causes of deadweight loss can include actions that prevent the market from achieving an equilibrium clearing condition (where supply and demand are equal) and include taxes or subsidies and binding price ceilings or floors (including minimum wages). Deadweight loss can generally be referenced as a loss of surplus to either the consumer, producer, or both.

Harberger’s Triangle, Taxes, and Deadweight Loss

Harberger’s triangle, generally attributed to Arnold Harberger, refers to the deadweight loss (as measured on a supply and demand graph) associated with government intervention in a perfect market . This can happen through price floors, caps, taxes, tariffs, or quotas. In the case of a tax on the supplier of a good, the supply curve will shift inward in proportion to the tax and resulting in a non-market clearing level of supply. As a result, the price of the good increases and the quantity available decreases .

The area represented by the Harberger’s triangle results from the intersection of the supply and demand curves above market equilibrium resulting in a reduction in consumer surplus and producer surplus relative to their value before the imposition of the tax. The loss of the surplus, not recouped by tax revenues, is deadweight loss.

Some economists have argued that these triangles do not have a huge impact on the economy, whereas others maintain that they can seriously affect long term economic trends by pivoting the trend downwards, causing a magnification of losses in the long run.