26.1: Introduction to Fiscal Policy

26.1.1: Defining Fiscal Policy

Learning Objective

Define Fiscal Policy

Key Points

• The government has two levers when setting fiscal policy: it can change the levels of taxation and/or it can change its level of spending.
• There are three types of fiscal policy: neutral policy, expansionary policy,and contractionary policy.
• In expansionary fiscal policy, the government spends more money than it collects through taxes. This type of policy is used during recessions to build a foundation for strong economic growth and nudge the economy toward full employment.
• In contractionary fiscal policy, the government collects more money through taxes than it spends. This policy works best in times of economic booms. It slows the pace of strong economic growth and puts a check on inflation.

Key Term

fiscal policy

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

Fiscal policy is the use of government spending and taxation to influence the economy. Governments use fiscal policy to influence the level of aggregate demand in the economy in an effort to achieve the economic objectives of price stability, full employment, and economic growth.

The government has two levers when setting fiscal policy:

1. Change the level and composition of taxation, and/or
2. Change the level of spending in various sectors of the economy.

There are three main types of fiscal policy:

1. Neutral: This type of policy is usually undertaken when an economy is in equilibrium. In this instance, government spending is fully funded by tax revenue, which has a neutral effect on the level of economic activity.
2. Expansionary: This type of policy is usually undertaken during recessions to increase the level of economic activity. In this instance, the government spends more money than it collects in taxes.
3. Contractionary: This type of policy is undertaken to pay down government debt and to cap inflation. In this case, government spending is lower than tax revenue.

In times of recession, Keynesian economics suggests that increasing government spending and decreasing tax rates is the best way to stimulate aggregate demand. Keynesians argue that this approach should be used in times of recession or low economic activity as an essential tool for building the foundation for strong economic growth and working towards full employment . In theory, the resulting deficit would be paid for by an expanded economy during the boom that would follow.

Times of Recession

In times of recession, the government uses expansionary fiscal policy to increase the level of economic activity and increase employment.

In times of economic boom, Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices when inflation is too high.

26.1.2: How Fiscal Policy Relates to the AD-AS Model

Learning Objective

Examine the effect of government fiscal policy on aggregate demand

Key Points

• Aggregate demand is made up of consumption, investment, government spending, and net exports. The aggregate demand curve will shift as a result of changes in any of these components.
• Expansionary policy involves an increase in government spending, a reduction in taxes, or a combination of the two. It leads to a right-ward shift in the aggregate demand curve.
• Contractionary policy involves a decrease in government spending, an increase in taxes, or a combination of the two. It leads to a left-ward shift in the aggregate demand curve.

Key Term

fiscal policy

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

When setting fiscal policy, the government can take an active role in changing its spending or the level of taxation. These actions lead to an increase or decrease in aggregate demand, which is reflected in the shift of the aggregate demand (AD) curve to the right or left respectively .

Expansionary and Contractionary Fiscal Policy

Expansionary policy shifts the AD curve to the right, while contractionary policy shifts it to the left.

It is helpful to keep in mind that aggregate demand for an economy is divided into four components: consumption, investment, government spending, and net exports. Changes in any of these components will cause the aggregate demand curve to shift.

Expansionary fiscal policy is used to kick-start the economy during a recession. It boosts aggregate demand, which in turn increases output and employment in the economy. In pursuing expansionary policy, the government increases spending, reduces taxes, or does a combination of the two. Since government spending is one of the components of aggregate demand, an increase in government spending will shift the demand curve to the right. A reduction in taxes will leave more disposable income and cause consumption and savings to increase, also shifting the aggregate demand curve to the right. An increase in government spending combined with a reduction in taxes will, unsurprisingly, also shift the AD curve to the right. The extent of the shift in the AD curve due to government spending depends on the size of the spending multiplier, while the shift in the AD curve in response to tax cuts depends on the size of the tax multiplier. If government spending exceeds tax revenues, expansionary policy will lead to a budget deficit.

A contractionary fiscal policy is implemented when there is demand-pull inflation. It can also be used to pay off unwanted debt. In pursuing contractionary fiscal policy the government can decrease its spending, raise taxes, or pursue a combination of the two. Contractionary fiscal policy shifts the AD curve to the left. If tax revenues exceed government spending, this type of policy will lead to a budget surplus.

26.1.3: Expansionary Versus Contractionary Fiscal Policy

Learning Objective

Assess the mechanics and outcomes of fiscal policy

Key Points

• Keynes advocated counter-cyclical fiscal policies–implementing an expansionary fiscal policy during a recession and a contractionary policy during times of rapid economic expansion.
• In pursuing either expansionary or contractionary fiscal policy, the government has two levers – government spending and taxation levels.
• The effects of fiscal policy can be limited by crowding out.

Key Term

multiplier

A ratio used to estimate total economic effect for a variety of economic activities.

Keynesian economists argue that private sector decisions sometimes lead to inefficient macroeconomic outcomes which require active policy responses by the public sector in order stabilize output over the business cycle. Keynes advocated counter-cyclical fiscal policies (policies that acted against the tide of the business cycle). This means deficit spending and decreased taxes when an economy suffers from a recession and decreased government spending and higher taxes during boom times .

Counter-cyclical Fiscal Policies

Keynesian economists advocate counter-cyclical fiscal policies. This means increased spending and lower taxes during recessions and lower spending and higher taxes during economic boom times.

According to Keynesian economics, if the economy is producing less than potential output, government spending can be used to employ idle resources and boost output. Increased government spending will result in increased aggregate demand, which then increases the real GDP, resulting in an rise in prices. This is known as expansionary fiscal policy. Conversely, in times of economic expansion, the government can adopt a contractionary policy, decreasing spending, which decreases aggregate demand and the real GDP, resulting in a decrease in prices.

Highway Construction

The government can implement expansionary fiscal policy through increased spending, such as paying for the construction of new highways.

In instances of recession, government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. The government could stimulate a great deal of new production with a modest expenditure increase if the people who receive this money consume most of it. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase in spending, and so on in a virtuous circle.

In addition to changes in spending, the government can also close recessionary gaps by decreasing income taxes, which increases aggregate demand and real GDP, which in turn increases prices. Conversely, to close an expansionary gap, the government would increase income taxes, which decreases aggregate demand, the real GDP, and then prices.

The effects of fiscal policy can be limited by crowding out. Crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Crowding out also occurs when government spending raises interest rates, which limits investment.

26.1.4: Fiscal Levers: Spending and Taxation

Learning Objective

Analyze the use of changes in the tax rate as a form of fiscal policy

Key Points

• In expansionary policy, the extent to which government spending and tax cuts increase aggregate demand depends on spending and tax multipliers.
• The tax multiplier is smaller than the spending multiplier. This is because the entire government spending increase goes towards increasing aggregate demand, but only a portion of the increased disposable income (resulting for lower taxes) is consumed.
• The multiplier effect of a tax cut can be affected by the size of the tax cut, the marginal propensity to consume, as well as the crowding out effect.

Key Term

Tax multiplier

The change in aggregate demand caused by a change in taxation levels.

Spending and taxation are the two levers available to the government for setting fiscal policy. In expansionary fiscal policy, the government increases its spending, cuts taxes, or a combination of both. The increase in spending and tax cuts will increase aggregate demand, but the extent of the increase depends on the spending and tax multipliers.

The government spending multiplier is a number that indicates how much change in aggregate demand would result from a given change in spending. The government spending multiplier effect is evident when an incremental increase in spending leads to an rise in income and consumption. The tax multiplier is the magnification effect of a change in taxes on aggregate demand. The decrease in taxes has a similar effect on income and consumption as an increase in government spending.

However, the tax multiplier is smaller than the spending multiplier. This is because when the government spends money, it directly purchases something, causing the full amount of the change in expenditure to be applied to the aggregate demand. When the government cuts taxes instead, there is an increase in disposable income. Part of the disposable income will be spent, but part of it will be saved. The money that is saved does not contribute to the multiplier effect .

Spending and Saving

The tax multiplier is smaller than the government expenditure multiplier because some of the increase in disposable income that results from lower taxes is not just consumed, but saved.

The multipliers are calculated as follows:

where MPC is the marginal propensity to consume (the change in consumption divided by the change in disposable income), and MPS is the marginal propensity to save (the change in savings divided by the change in disposable income).

The government spending multiplier is always positive. In contrast, the tax multiplier is always negative. This is because there is an inverse relationship between taxes and aggregate demand. When taxes decrease, aggregate demand increases.

The multiplier effect of a tax cut can be affected by the size of the tax cut, the marginal propensity to consume, as well as the crowding out effect. The crowding out effect occurs when higher income leads to an increased demand for money, causing interest rates to rise. This leads to a reduction in investment spending, one of the four components of aggregate demand, which mitigates the increase in aggregate demand otherwise caused by lower taxes.

26.1.5: How Fiscal Policy Can Impact GDP

Learning Objective

Discuss the mechanisms that allow the fiscal policy to affect GDP

Key Points

• The fiscal multiplier is the ratio of change in national income to the change in governments spending that causes it.
• The multiplier effect occurs when an initial incremental amount of spending leads to an increase in income and consumption, which further increases income, which further increases consumption, and so on in a virtuous circle, resulting in an overall increase in the GDP.
• The multiplier effect is evident when the multiplier is greater or less than one.
• In certain cases, multiplier values of less than one have been empirically measured, suggesting that government spending can crowd out private investment or consumer spending.

Key Term

fiscal multiplier

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

Expansionary fiscal policy can impact the gross domestic product (GDP) through the fiscal multiplier. The fiscal multiplier (which is not to be confused with the monetary multiplier) is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.

The multiplier effect arises when an initial incremental amount of government spending leads to increased income and consumption, increasing income further, and hence further increasing consumption, and so on, resulting in an overall increase in national income that is greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change. The multiplier effect has been used as an argument for the efficacy of government spending or taxation relief to stimulate aggregate demand.

For example, suppose the government spends $1 million to build a plant . The money does not disappear, but rather becomes wages to builders, revenue to suppliers, etc. The builders then will have more disposable income, and consumption may rise, so that aggregate demand will also rise. Suppose further that recipients of the new spending by the builder in turn spend their new income, raising demand and possibly consumption further, and so on. The increase in the gross domestic product is the sum of the increases in net income of everyone affected. If the builder receives $1 million and pays out $800,000 to sub contractors, he has a net income of $200,000 and a corresponding increase in disposable income (the amount remaining after taxes). This process proceeds down the line through subcontractors and their employees, each experiencing an increase in disposable income to the degree the new work they perform does not displace other work they are already performing. Each participant who experiences an increase in disposable income then spends some portion of it on final (consumer) goods, according to his or her marginal propensity to consume, which causes the cycle to repeat an arbitrary number of times, limited only by the spare capacity available.

Fiscal Multiplier Example

The money spent on construction of a plant becomes wages to builders. The builders will have more disposable income, increasing their consumption and the aggregate demand.

In certain cases multiplier values of less than one have been empirically measured, suggesting that certain types of government spending crowd out private investment or consumer spending that would have otherwise taken place.

26.1.6: Fiscal Policy and the Multiplier

Learning Objective

Describe the effects of the multiplier beyond its relevance to fiscal policy

Key Points

• The size of the increase in GDP depends on the type of fiscal policy.
• The multiplier on changes in government spending is larger than the multiplier on changes in taxation levels.
• The taxation multiplier is smaller than the spending multiplier because part of any change in taxes is absorbed by savings.

Key Term

fiscal multiplier

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

Fiscal policy can have a multiplier effect on the economy. For example, if a $100 increase in government spending causes the GDP to increase by $150, then the spending multiplier is 1.5. In addition to the spending multiplier, other types of fiscal multipliers can also be calculated, like multipliers that describe the effects of changing taxes. The size of the multiplier effect depends upon the fiscal policy.

Expansionary fiscal policy can lead to an increase in real GDP that is larger than the initial rise in aggregate spending caused by the policy. Conversely, contractionary fiscal policy can lead to a fall in real GDP that is larger than the initial reduction in aggregate spending caused by the policy .

Multiplier Effect

The multiplier effect determines the extent to which fiscal policy shifts the aggregate demand curve and impacts output.

The size of the shift of the aggregate demand curve and the change in output depend on the type of fiscal policy. The multiplier on changes in government purchases, 1/(1 – MPC), is larger than the multiplier on changes in taxes, MPC/(1 – MPC), because part of any change in taxes or transfers is absorbed by savings. In both of these equations, recall that MPC is the marginal propensity to consume.

For example, the government hands out $50 billion in the form of tax cuts. There is no direct effect on aggregate demand by government purchases of goods and services. Instead, GDP goes up only because households spend some of that $50 billion. But how much will they spend? Households will spend MPC*$50 billion (where MPC is the marginal propensity to consume). If MPC is equal to 0.6, the first-round increase in consumer spending will be $30 billion (0.6*$50 billion = $30 billion). The initial rise in consumer spending will lead to a series of subsequent rounds in which the real GDP, disposable income, and consumer spending rise further.

26.2: Evaluating Fiscal Policy

26.2.1: Automatic Stabilizers

Automatic stabilizers are modern government budget policies that act to dampen fluctuations in real GDP.

Learning Objective

Explain the role of automatic stabilizers in regulating economic fluctuations

Key Points

• During recessions, government spending automatically increases, which raises aggregate demand and offsets decreases in consumer demand. Government revenue automatically decreases.
• During economic booms, government spending automatically decreases, which prevents bubbles and the economy from overheating. Government revenue automatically increases.
• The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. An initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.

Key Terms

fiscal multiplier

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

automatic stabilizer

A budget policy that automatically changes to stabilize fluctuations in GDP.

In macroeconomics, the concept of automatic stabilizers describes how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP. The size of the government budget deficit tends to increase when a country enters a recession, which tends to keep national income higher by maintaining aggregate demand. This effect happens automatically depending on GDP and household income, without any explicit policy action by the government, and acts to reduce the severity of recessions.

Here is an example of how automatic stabilizers would work in a recession. When the country takes an economic downturn, more people become unemployed. As a result more people file for unemployment and other welfare measures, which increases government spending and aggregate demand. The unemployed also pay less in taxes because they are not earning a wage, which in turn decreases government revenue. The result is an increase in the federal deficit without Congress having to pass any specific law or act.

Similarly, the budget deficit tends to decrease during booms, which pulls back on aggregate demand. Because more people are earning wages during booms, the government can collect more taxes. Also, because fewer individuals need social services support during a boom, government spending also decreases. As spending decreases, aggregate demand decreases. Therefore, automatic stabilizers tend to reduce the size of the fluctuations in a country’s GDP.

Fiscal Multiplier Effect

What makes automatic stabilizers so effective in dampening economic fluctuations is the fiscal multiplier effect. The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.

The multiplier effect occurs as a chain reaction. The increased funds received from the government by citizens allows them to increase their consumption. As a result, producers must increase their production, which requires firms to hire more workers. Because of the increased purchases and lower unemployment, people have more money to spend and increase their consumption. This consumption-production-consumption cycle leads to the multiplier effect, resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.

Tax Form 1040

Taxes are a part of the automatic stabilizers a country uses to minimize fluctuations in their real GDP. During boom times when the economy is doing well, people earn more income and this translates to higher tax revenues for the government, lowering the budget deficit.

26.2.2: Automatic Stabilizers Versus Discretionary Policy

Automatic stabilizers and discretionary policy differ in terms of timing of implementation and what each approach sets out to achieve.

Learning Objective

Describe the differences between automatic stabilizers and discretionary policy

Key Points

• Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment as opposed to policy set by predetermined rules. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program.
• When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag before action can be taken.
• Automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy.
• Automatic stabilizers exist prior to economic booms and busts. Discretionary policies are enacted in response to changes in the economy.

Key Terms

discretionary policy

Actions taken in response to changes in the economy. These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner.

automatic stabilizer

A budget policy that automatically changes to stabilize fluctuations in GDP.

In fiscal policy, there are two different approaches to stabilizing the economy: automatic stabilizers and discretionary policy. Both approaches focus on minimizing fluctuations in real GDP but have different means of doing so.

Discretionary Policy

Discretionary policy is a macroeconomic policy based on the judgment of policymakers in the moment, as opposed to a policy set by predetermined rules. Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; rather, they use subjective judgment to treat each situation in unique manner. In practice, most policy changes are discretionary in nature. Examples may include passing a new spending bill that promotes a certain cause, such as green technology, or the creation of a federal jobs program .

WPA

The Works Progress Administration (WPA) was part of the New Deal. The WPA is an example of a Depression-era discretionary policy meant to reduce unemployment by providing jobs for the unemployed.

Discretionary policies are generally laws enacted by Congress, which requires that any policy go through the same vetting and marking up process as any other law.

Automatic Stabilizers and Discretionary Policy

The key difference between these two types of financial policy approaches is timing of implementation. When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. With discretionary policy there is a significant time lag. Before action can be taken, Congress must first determine that there is an issue and that action needs to be taken. Then Congress needs to design and implement a policy response. Then the law needs to be passed and the relevant agencies need to adjust and alter any necessary procedures so they can carry out the law. It is due to these significant lags that economists like Milton Friedman believed that discretionary fiscal policy could be destabilizing.

On the other hand, automatic stabilizers are limited in that they focus on managing the aggregate demand of a country. Discretionary policies can target other, specific areas of the economy. Discretionary policies can address failings of the economy that are not strictly tied to aggregate demand. For example, if an economy is going through a recession because its workers lack a certain set of skills, automatic stabilizers cannot address that problem. Government programs, such as retraining, can address this problem.

Finally, automatic stabilizers, such as the tax code and social service agencies, exist prior to an economic fluctuation. Discretionary policies are made in response to a fluctuation and only come into existence once a fluctuation starts to occur.

Of course, it is not possible to create an automatic stabilizer for every potential economic issue, so discretionary policy allows policymakers flexibility.

26.2.3: The Role of the Federal Budget

The federal budget dictates how much money the government plans to raise and how it plans to spend it in the upcoming year.

Learning Objective

Describe how the federal budget is created and its economic role

Key Points

• Congressional decisions are governed by rules and legislation regarding the federal budget process. Budget committees set spending limits for the House and Senate committees. Appropriations subcommittees then approve individual appropriations bills to allocate funding to various federal programs.
• If Congress fails to pass an annual budget, a series of appropriations bills must be passed as “stop gap” measures.
• The budget is a method of conducting fiscal policy and reflect government intervention in markets.

Key Term

appropriations bill

A legislative motion that authorizes the government to spend money.

The Federal Budget is the roadmap for how the national government plans to spend its money of the course of the upcoming year. It dictates which programs will receive funding and how much money the government will spend on each.

How the Federal Budget is Created

The Budget of the United States Government often begins as the president’s proposal to the U.S. Congress which recommends funding levels for the next fiscal year, beginning October 1. However, Congress is the body required by law to pass a budget annually and to submit the budget passed by both houses to the president for signature. To help Congress pass the best budget possible, several government agencies provide data and analysis. These include the Government Accountability Office (GAO), Congressional Budget Office (CBO), the Office of Management and Budget (OMB), and the U.S. Treasury Department.

Congressional decisions are governed by rules and legislation regarding the federal budget process. Budget committees set spending limits for the House and Senate committees. Appropriations subcommittees then approve individual appropriations bills to allocate funding to various federal programs.

If Congress fails to pass an annual budget, a series of appropriations bills must be passed as “stop gap” measures. After Congress approves an appropriations bill, it is sent to the president, who may sign it into law, or may veto it (as he would a budget when passed by the Congress). A vetoed bill is sent back to Congress, which can pass it into law with a two-thirds majority in each chamber. Congress may also combine all or some appropriations bills into an omnibus reconciliation bill. In addition, the president may request and the Congress may pass supplemental appropriations bills or emergency supplemental appropriations bills.

Economic Role of the Federal Budget

The federal budget is meant to provide the larger American economy with a sense of direction regarding where the Federal government is going to go and what they are going to do. The Federal budget discloses how much the government plans to tax and how it plans to spend its money. Individuals and businesses can then adjust their actions to accommodate what they’ll have to pay in taxes and what resources will be available to them in the government.

The federal budget also is one mechanism for conducting fiscal policy. The government can choose to expand or contract the budget to conduct expansionary or fiscal policy.

The specific items in the budget also have important policy implications: social welfare, social insurance, and government intervention in markets may all be reflected in the budget.

Congress

The U.S. Congress is responsible for passing the Federal Budget. If it cannot pass a Federal Budget, it must pass appropriation bills as a “stop gap. “

26.2.4: Arguments for and Against Balancing the Budget

Balanced budgets, and the associated topic of budget deficits, are a contentious point within both academic economics and politics.

Learning Objective

Describe arguments against maintaining a balanced budget in the United States

Key Points

• A balanced budget is a budget where revenues equal expenditures. A balanced budget can also refer to a budget where revenues are greater than expenditures.
• Most economists have also agreed that a balanced budget would decrease interest rates, increase savings and investment, shrink trade deficits and help the economy grow faster over a longer period of time.
• Keynesians argue for balanced budgets over the course of the business cycle. If a country rigidly pursues a balanced budget regardless of the circumstances, critics argue that economic downturns would be needlessly painful.

Key Term

balanced budget

A (usually government) budget in which income and expenditure are equal over a set period of time.

A balanced budget, particularly a government budget, is a budget with revenues equal to expenditures. There is neither a budget deficit nor a budget surplus; in other words, “the accounts balance. ” More generally, it refers to a budget with no deficit, but possibly with a surplus. A cyclically balanced budget is a budget that is not necessarily balanced year-to-year, but is balanced over the economic cycle, running a surplus in boom years and running a deficit in lean years, with these offsetting over time .

John Maynard Keynes

John Maynard Keynes founded the Keynesian school, which promotes balanced governmental budgets over the course of the business cycle as opposed to annual balanced budgets.

Balanced budgets, and the associated topic of budget deficits, are a contentious point within academic economics and within politics.

Arguments for a Balanced Budget

Most economists agree that a balanced budget would:

• decrease interest rates, making it easier for businesses and individuals to invest;
• increase savings and investment, which would provide security to individuals;
• shrink trade deficits; and
• help the economy grow faster over a longer period of time.

In the US, every state other than Vermont has a version of a balanced budget amendment, which prohibits some deficits. The federal government does not have such an amendment.

Arguments Against a Balanced Budget

The mainstream economic view is that having a balanced budget in every year is not desirable. If a country rigidly pursues a balanced budget regardless of the circumstances, critics argue that economic downturns would be needlessly painful. If balanced budgets were required and if the budget was in deficit during a recession, critics argue that the required cuts would make the economy even worse off.

Keynesian economists argue that government budgets should be balanced over the business cycles. During recessions governments should run deficits. Keynesians argue that increasing government spending and decreasing taxes can minimize the painful effects of a recession. Once an economy moves into a growth cycle, Keynesians believe the government should shift its perspective and try to run a budget surplus by decreasing spending and increasing taxes. By balancing deficits in recessions and surpluses in growth, Keynesians believe that the government can obtain the benefits of a balanced budget without facing the risks of making recessions worse due to spending and revenue limitations.

26.2.5: Long-Run Implications of Fiscal Policy

Expansionary fiscal policy can lead to decreased private investment, decreased net imports, and increased inflation.

Learning Objective

Identify the long-run consequences of fiscal policy

Key Points

• Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.
• When government borrowing increases interest rates, it can attract foreign capital from foreign investors, which can increases demand for that country’s currency and raise it’s value. This increase in the currency’s value increases export the price of exports.
• When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services.
• In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle.

Key Term

inflation

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

Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy. The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors.

It is important to underline that fiscal policy is heavily debated, and that expected outcomes are not achieved with complete certainty. That being said, these changes in fiscal policy can affect the following macroeconomic variables in an economy:

• Aggregate demand and the level of economic activity;
• The distribution of income;
• The pattern of resource allocation within the government sector and relative to the private sector.

Decreased Private Investment

Economists still debate the effectiveness of fiscal policy to influence the economy, particularly when it comes to using expansionary fiscal policy to stimulate the economy. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.

Decreased Net Exports

Some also believe that expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country’s currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country’s currency increases. The increased demand causes that country’s currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.

Increased Inflation

Other possible problems with fiscal stimulus include inflationary effects driven by increased demand. Simply put, increasing the capital in a given system will eventually devalue the currency itself if there is an increase in money supply in circulation. Similarly, if stimulus capital is invested in creating jobs, the overall spending in a given economy will increase (that is, if jobs are actually created). This spending increase will shift demand to potentially increase price points. Whenever fiscal policy decisions are made, modeling the likelihood of inflation is a critical consideration.

WIN

If a country pursues and expansionary fiscal policy, high inflation becomes a concern.

26.2.6: Problems of Long-Run Government Debt

Government debt limits future government actions and can be hard to pay off because Congressmen are unwilling to do what is necessary to pay down the debt.

Learning Objective

Evaluate the consequences of imbalances in the government budget

Key Points

• To raise the necessary funds to pay down debt, governments will ultimately have to lower costs and/or raise taxes. Because cutting spending and raising taxes is unpopular, Congressmen may be hesitant to take those actions because it might prevent them from being re-elected.
• To pay off the debt, the government must maintain a certain level of income. This could limit the government’s ability to pursue expansionary fiscal policies to address future recessions.
• If the government chooses to delay paying down the debt, the compounding interest will lead to more debt which will lead to a higher annual interest expense that future generations will have to pay.

Key Term

cyclically balanced budget

Occurs when the government runs a deficit during recessions and lean years but a surplus during periods of significant growth.

Deficit spending during times of recession widely seen as a beneficial policy that can mitigate the effects of an economic downturn. However, even Keynesians that support deficit spending during recessions advise that governments balance this deficit spending with surpluses during the eventual economic boom. This means generating a government surplus by cutting expenses and raising taxes. This is known as a cyclically balanced budget; the government runs a deficit during recessions and lean years but a surplus during periods of significant growth.

Paying Down Debt

During periods of expansionary fiscal policy, the government will often fund programs by issuing debt . The problem with debt is that it must be paid off with future revenues.

Government debt

Publicly issued debt is one means governments use to fund expansionary fiscal policy. The problem with debt is that it needs to be paid off with future revenues, which curtails future government spending.

To pay off the debt, the government must maintain a certain level of income. This could limit the government’s ability to pursue expansionary fiscal policies to address future recessions. On the other hand, if the government chooses to delay paying down the debt, the compounding interest will lead to more debt which will lead to a higher annual interest expense that future generations will have to pay.

Cutting Expenses and Raising Taxes

To offset the budgetary deficits and raise the necessary funds to pay down debt, governments will ultimately have to lower costs and raise taxes. In any democracy, especially in the U.S., doing those two things are incredibly difficult because both options are unpopular with voters. Since Congress is responsible for making budgetary, spending and taxation decisions, and because these elected officials may be disinclined to do anything that would hurt their chances to be re-elected, taking the necessary steps to balance out the periods of deficit spending during economic boom is difficult.

Credit Rating

A credit rating is an evaluation of the creditworthiness of a government, but not individual consumers. The evaluation is made by a credit rating agency of the country’s ability to pay back the debt and the likelihood of default. A sovereign credit rating is the credit rating of a sovereign entity (i.e., a national government). The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. It takes political risk into account, as well as the amount of debt the country has outstanding.

If a country has a bad credit rating, it generally must have a higher interest rate on the debt it issues. This means it will be more expensive for that country to raise funds by issuing debt.

26.2.7: Limits of Fiscal Policy

Two key limits of fiscal policy are coordination with the nation’s monetary policy and differing political viewpoints.

Learning Objective

Identify the political and economic limits of fiscal policy

Key Points

• Conservatives are more likely to reject Keynesianism and argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt) than Democrats.
• Liberals are more likely to be Keynesian and Post-Keynesians than Republicans; they are more likely to argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.
• There is a dilemma as to whether these monetary and fiscal policies are complementary, or act as substitutes to each other for achieving macroeconomic goals.

Key Term

monetary policy

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

While fiscal policy can be a powerful tool for influencing the economy, there are limits in how effective these policies are.

Coordination with Monetary Policy

Fiscal policy and monetary policy are the two primary tools used by the State to achieve its macroeconomic objectives. While the main objective of fiscal policy is to influence the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. Fiscal policies have an impact on the goods market and monetary policies have an impact on the asset markets and since the two markets are connected to each other via the two macrovariables — output and interest rates – the policies interact while influencing the output or the interest rates.

There is controversy regarding whether these two policies are complementary or act as substitutes to each other for achieving macroeconomic goals. Policy makers are viewed to interact as strategic substitutes when one policy maker’s expansionary (contractionary) policies are countered by another policy maker’s contractionary (expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements,then an expansionary (contractionary) policy of one authority is met by expansionary (contractionary) policies of other.

The issue of interaction and the policies being complement or substitute to each other arises only when the authorities are independent of each other. But when, the goals of one authority is made subservient to that of others, then the dominant authority solely dominates the policy making and no interaction worthy of analysis would arise. Also, it is worthy to note that fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy is not influenced by the other, there is no direct interaction between them.

Political Conflict

Fiscal policy is also a source of significant political conflict along party lines. Conservatives are more likely to reject Keynesianism and are more likely to argue that government should always run a balanced budget (and a surplus to pay down any outstanding debt), and that deficit spending is always bad policy .

American political divide

There are two different approaches to fiscal policy in the US. Broadly, Democrats tend to be more Keynesian than Republicans.

Fiscal conservatism has academic support, predominantly associated with the neoclassical-inclined Chicago school of economics, and has significant political and institutional support, with all but one state of the United States (Vermont is the exception) having a balanced budget amendment to its state constitution. Fiscal conservatism was the dominant position until the Great Depression.

Liberals are more likely to be Keynesian and Post-Keynesians than Republican. They are more likely to argue that deficit spending is necessary, either to create the money supply (Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private investment.

Chartalists argue that deficit spending is logically necessary because, in their view, fiat money is created by deficit spending: one cannot collect fiat money in taxes before one has issued it and spent it, and the amount of fiat money in circulation is exactly the government debt – money spent but not collected in taxes.

Fiscal Multiplier

The fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.

How effective fiscal policy is depends on the multiplier. The greater the multiplier, the more effective the policy. If for some reason outside of the control of the government the multiplier remains low, the effectiveness of fiscal policy will remain limited at best.

26.2.8: Difficulty in Getting the Timing Right

Discretionary fiscal policy relies on getting the timing right, but this can be difficult to determine at the time decisions must be made.

Learning Objective

Explain the effect of timing on the use of fiscal policy tools

Key Points

• Automatic stabilizers are designed to respond to evolving economic conditions without anyone taking action; timing is not an issue.
• Good economic data are a precondition to effective macroeconomic management. The problem with this is that it could be weeks, or even months, before the necessary data is collected and organized in a way that would reveal there is a problem.
• Once a discretionary program is in place, the next step is to measure its effectiveness. Again, measurement becomes a problem. Because it takes so long to measure fluctuations in the economy, it may be months before the program’s effect on the economy can be seen.

Key Term

discretionary fiscal policy

A fiscal policy achieved through government intervention, as opposed to automatic stabilizers.

A nation can respond to economic fluctuations through automatic stabilizers or through discretionary policy. With regards to automatic stabilizers, timing is not an issue. Automatic stabilizers are designed to respond to evolving economic conditions without anyone taking action.

With discretionary fiscal policy, timing plays a very significant role. Discretionary policy often requires that a set of laws must be passed through a legislature. This means that the problem has to be identified first, which means collecting macroeconomic data.

Good economic data are a precondition to effective macroeconomic management. With the complexity of modern economies and the lags inherent in macroeconomic policy instruments, a country must have the capacity to promptly identify any adverse trends in its economy and to apply the appropriate corrective measure. This cannot be done without economic data that is complete, accurate and timely. The problem with this is that it could be weeks, or even months, before the necessary data is collected and organized in a way that would reveal there is a problem.

Once the problem has been established, Congress must then arrive at a plan and hold debates. Any legislation must pass through committees in both chambers, and both chambers must approve. Then, it must be presented to the President for his signature. This entire process would take weeks at least, but would more likely take months .

President Coolidge Signing a Bill into Law

It can take many months before Congress can pass a bill that would address current economic fluctuations.

Once the discretionary program is in place, the next step is to measure its effectiveness. Again, measurement becomes a problem. Because it takes so long to measure fluctuations in the economy, it may be months before the program’s effect on the economy can be seen.

26.2.9: Crowding-Out Effect

Usually the term “crowding out” refers to the government using up financial and other resources that would otherwise be used by private enterprise.

Learning Objective

Explain the crowding out effect

Key Points

• Some commentators and other economists use “crowding out” to refer to government providing a service or good that would otherwise be a business opportunity for private industry.
• An increase in the demand for loanable funds by the government shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing investment and consumption.
• If the economy is at capacity or full employment, the government suddenly implementing a stimulus program could create competition with the private sector for scarce funds available for investment, resulting in reduced private investment.

Key Term

interest rate

The percentage of an amount of money charged for its use per some period of time (often a year).

Usually when economists use the term crowding out they are referring to the government using up financial and other resources that would otherwise be used by private enterprise. However, some commentators and other economists use crowding out to refer to government providing a service or good that would otherwise be a business opportunity for private industry.

The macroeconomic theory behind crowding out provides some useful intuition. What happens is that an increase in the demand for loanable funds by the government (e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption. Thus, the government has crowded out investment .

Crowding out Chart

When crowding-out occurs, the Investment-Savings (IS) curve moves to the right, causing higher interest rates (i) and expansion in the “real” economy (real GDP, or Y). LM stands for Liquidity Preference – Money Supply.

Borrowing and Crowding Out

In economics, crowding-out occurs when increased government borrowing reduces investment spending. The increased borrowing crowds out private investing.

If an increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment. There is some controversy in modern macroeconomics on the subject, as different schools of economic thought differ on how households and financial markets would react to more government borrowing under various circumstances.

Crowding-Out and Stimulus Programs

The extent to which crowding out occurs depends on the economic situation. If the economy is at capacity or full employment, then the government suddenly increasing its budget deficit (e.g., via stimulus programs) could create competition with the private sector for scarce funds available for investment, resulting in an increase in interest rates and reduced private investment or consumption. Therefore, the effect of the stimulus is offset by the effect of crowding out.

26.2.10: Evaluating the Recent United States Stimulus Package

The American Recovery and Reinvestment Act of 2009 (ARRA) was drafted in response to the Great Recession, primarily in order to create jobs.

Learning Objective

Summarize the effects of the use of stimulus in the wake of the Great Recession

Key Points

• Secondary objectives of the ARRA were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and renewable energy.
• Reports on the effectiveness of the ARRA’s ability to create jobs were mixed. One conservative estimate said that the ARRA saved or created 1.6 to 1.8 million jobs and forecast a total impact of 2.5 million jobs saved by the time the stimulus is completed.
• A sizeable number of projects funded by the stimulus could not be started right away, diminishing its immediate impact.

Key Terms

infrastructure

The basic facilities, services and installations needed for the functioning of a community or society

quarter

Related to a three-month term, a quarter of a year.

The American Recovery and Reinvestment Act of 2009 (ARRA), otherwise known as the Stimulus or The Recovery Act, was an economic stimulus package was signed into law on February 17, 2009.

The ARRA was drafted in response to the Great Recession. The primary objective for ARRA was to save and create jobs almost immediately. Secondary objectives were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and renewable energy .

Composition of Stimulus

Tax incentives — includes $15 B for Infrastructure and Science, $61 B for Protecting the Vulnerable, $25 B for Education and Training and $22 B for Energy, so total funds are $126 B for Infrastructure and Science, $142 B for Protecting the Vulnerable, $78 B for Education and Training, and $65 B for Energy.State and Local Fiscal Relief — Prevents state and local cuts to health and education programs and state and local tax increases.

The approximate cost of the economic stimulus package was estimated to be $787 billion at the time of passage, later revised to $831 billion between 2009 and 2019. The Act included direct spending in infrastructure, education, health, and energy, federal tax incentives, and expansion of unemployment benefits and other social welfare provisions. The rationale for ARRA came from Keynesian macroeconomic theory, which argues that during recessions, the government should offset the decrease in private spending with an increase in public spending in order to save jobs and stop further economic deterioration.

The Stimulus’s Impact on Unemployment

The primary justification for the stimulus package was to minimize unemployment. The Obama administration and Democratic proponents presented a graph in January 2009 showing the projected unemployment rate with and without the ARRA. The graph showed that if ARRA was not enacted the unemployment rate would exceed 9%; but if ARRA was enacted it would never exceed 8%. After ARRA became law, the actual unemployment rate exceeded 8% in February 2009, exceeded 9% in May 2009, and exceeded 10% in October 2009. The actual unemployment rate was 9.2% in June 2011 when it was projected to be below 7% with the ARRA. However, supporters of ARRA claim that this can be accounted for by noting that the actual recession was subsequently revealed to be much worse than any projections at the time when the ARRA was drawn up.

One year after the stimulus, several independent firms, including Moody’s and IHS Global Insight, estimated that the stimulus saved or created 1.6 to 1.8 million jobs and forecast a total impact of 2.5 million jobs saved by the time the stimulus is completed. The Congressional Budget Office considered these estimates conservative. The CBO estimated that, according to its model, 2.1 million jobs were saved in the last quarter of 2009, boosting the country’s GDP by up to 3.5% and lowering the unemployment rate by up to 2.1%.

In 2013, the Reason Foundation conducted a study of the results of the ARRA. Only 23% of 8,381 sampled companies hired new workers and kept all of them when the project was completed. Only 41% of sampled companies hired workers at all. 30% of sampled companies laid off all workers once the government money stopped funding. These results cast doubt on previously stated estimates of job creation numbers, which do not take into account those companies that did not retain their workers.

Shovel-Ready Projects

One of the primary purposes and promises of the Act was to launch a large number projects to stimulate the economy. However, a sizable number of these projects, many of which pertained to infrastructure, took longer to implement than they had expected by most. Just because the money was there for the projects did not mean that the projects were “shovel-ready”: there was a delay between when the funding became available and when the project could actually begin. Since the stimulus only is impactful when the money is actually spent, delays could have reduced the overall effectiveness of the stimulus.

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.

John Maynard Keynes

John Maynard Keynes came to fame after publishing his economic theories during the Great Depression.

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.

IS-LM Model

In this figure, the IS (Interest – Saving) curve is shifted outward in a way that raises both interest rates (i) and the ‘real’ economy (Y). The implication is that interest rates affect investment levels, and that these investment levels in turn affect the overall economy.

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.

U.S. Inflation Rates

The inflation rates over time in the U.S. represent some of the evidence put forward by monetarist economists, stating that governmental control of the money supply allows for some control over inflation.

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 .

Aggregate Expenditure

This graph shows the aggregate expenditure model. It is used to determine and graph the real GPD, potential GDP, and point of equilibrium. A shift in supply or demand impacts the GDP.

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 .

Aggregate Expenditure – Equilibrium

In this graph, equilibrium is reached when the total demand (AD) equals the total amount of output (Y). The equilibrium point is where the blue line intersects with the black line.

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 .

Classical Aggregate Expenditure

This graph shows the classical aggregate expenditure where C is consumption expenditure and I is aggregate investment. The aggregate expenditure is the aggregate consumption plus the planned investment (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 .

AD-AS Model

This graph shows the AD-AS model where P is the average price level and Y* is the aggregate quantity demanded. The model is used to show how increases in aggregate demand leads to increases in prices (inflation) and in output.

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.

1953 U.S. Recession

This graph shows the economic recession that occurred in the U.S. in 1953. During recessions, the government can use the multiplier effect in order to stimulate the economy.

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.).

24.2: Introducing Aggregate Demand and Aggregate Supply

24.2.1: Explaining Fluctuations in Output

In the short run, output fluctuates with shifts in either aggregate supply or aggregate demand; in the long run, only aggregate supply affects output.

Learning Objective

Differentiate between short-run and long-run effects of nominal fluctuations

Key Points

• In the short run, output is determined by both the aggregate supply and aggregate demand within an economy. Anything that causes labor, capital, or efficiency to go up or down results in fluctuations in economic output.
• Aggregate supply and aggregate demand are graphed together to determine equilibrium. The equilibrium is the point where supply and demand meet.
• According to Hume, in the short-run, and increase in the money supply will lead to an increase in production.
• According to Hume, in the long-run, an increase in the money supply will do nothing.

Key Terms

economic output

The productivity of a country or region measured by the value of goods and services produced.

nominal

Without adjustment to remove the effects of inflation (in contrast to real).

Economic Output

In economics, output is the quantity of goods and services produced in a given time period. The level of output is determined by both the aggregate supply and aggregate demand within an economy. National output is what makes a country rich, not large amounts of money. For this reason, understanding the fluctuations in economic output is critical for long term growth. There are a series of factors that influence fluctuations in economic output including increases in growth and inputs in factors of production. Anything that causes labor, capital, or efficiency to go up or down results in fluctuations in economic output.

Aggregate Supply and Aggregate Demand

Aggregate supply is the total amount of goods and services that firms are willing to sell at a given price in an economy. The aggregate demand is the total amounts of goods and services that will be purchased at all possible price levels.

In a standard AS-AD model, the output (Y) is the x-axis and price (P) is the y-axis. Aggregate supply and aggregate demand are graphed together to determine equilibrium. The equilibrium is the point where supply and demand meet to determine the output of a good or service.

Short-run vs. Long-run Fluctuations

Supply and demand may fluctuate for a number of reasons, and this in turn may affect the level of output. There are noticeable differences between short-run and long-run fluctuations in output.

Over the short-run, an outward shift in the aggregate supply curve would result in increased output and lower prices. An outward shift in the aggregate demand curve would also increase output and raise prices. Short-run nominal fluctuations result in a change in the output level . In the short-run an increase in money will increase production due to a shift in the aggregate supply. More goods are produced because the output is increased and more goods are bought because of the lower prices.

AS-AD Model

This AS-AD model shows how the aggregate supply and aggregate demand are graphed to show economic output. The AD curve shifts to the right which increases output and price.

In the long-run, the aggregate supply curve and aggregate demand curve are only affected by capital, labor, and technology. Everything in the economy is assumed to be optimal. The aggregate supply curve is vertical which reflects economists’ belief that changes in aggregate demand only temporarily change the economy’s total output. In the long-run an increase in money will do nothing for output, but it will increase prices.

24.2.2: Classical Theory

Classical theory, the first modern school of economic thought, reoriented economics from individual interests to national interests.

Learning Objective

Identify the assumptions fundamental to classical economics

Key Points

• When classical theory emerged, society was undergoing many changes. The primary economic question involved how a society could be organized around a system in which every individual sought his own monetary gain.
• Classical economics focuses on the growth in the wealth of nations and promotes policies that create national economic expansion.
• Classical theory assumptions include the beliefs that markets self-regulate, prices are flexible for goods and wages, supply creates its own demand, and there is equality between savings and investments.

Key Term

self-regulating

Describing something capable of controlling itself.

Classical Theory

Classical theory was the first modern school of economic thought. It began in 1776 and ended around 1870 with the beginning of neoclassical economics. Notable classical economists include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus, and John Stuart Mill . During the period in which classical theory emerged, society was undergoing many changes. The primary economic question involved how a society could be organized around a system in which every individual sought his own monetary gain. It was not possible for a society to grow as a unit unless its members were committed to working together. Classical theory reoriented economics away from individual interests to national interests. Classical economics focuses on the growth in the wealth of nations and promotes policies that create national expansion. During this time period, theorists developed the theory of value or price which allowed for further analysis of markets and wealth. It analyzed and explained the price of goods and services in addition to the exchange value.

Adam Smith

Adam Smith was one of the individuals who helped establish classical economic theory.

Classical Theory Assumptions

Classical theory was developed according to specific economic assumptions:

• Self-regulating markets: classical theorists believed that free markets regulate themselves when they are free of any intervention. Adam Smith referred to the market’s ability to self-regulate as the “invisible hand” because markets move towards their natural equilibrium without outside intervention.
• Flexible prices: classical economics assumes that prices are flexible for goods and wages. They also assumed that money only affects price and wage levels.
• Supply creates its own demand: based on Say’s Law, classical theorists believed that supply creates its own demand. Production will generate an income enough to purchase all of the output produced. Classical economics assumes that there will be a net saving or spending of cash or financial instruments.
• Equality of savings and investment: classical theory assumes that flexible interest rates will always maintain equilibrium.
• Calculating real GDP: classical theorists determined that the real GDP can be calculated without knowing the money supply or inflation rate.
• Real and Nominal Variables: classical economists stated that real and nominal variables can be analyzed separately.

24.2.3: Keynesian Theory

Keynesian economics states that in the short-run, economic output is substantially influenced by aggregate demand.

Learning Objective

Differentiate “Chicago School” or “Austrian School” economists from “Keynesian School” economists

Key Points

• Keynesian theory was first introduced by British economist John Maynard Keynes in his book The General Theory of Employment, Interest, and Money, which was published in 1936 during the Great Depression.
• Keynesian theorists believe that aggregate demand is influenced by a series of factors and responds unexpectedly. Shifts in aggregate demand impact production, employment, and inflation in the economy.
• Unemployment is the result of structural inadequacies within the economic system. It is not a product of laziness as believed previously.
• During a recession the economy may not return naturally to full employment. The government must step in and utilize government spending to stimulate economic growth. A lack of investment in goods and services causes the economy to operate below its potential output and growth rate.
• Overcoming an economic depression required economic stimulus, which could be achieved by cutting interest rates and increasing the level of government investment.

Key Term

Keynesian Economics

A school of thought that is characterized by a belief in active government intervention in an economy and the use of monetary policy to promote growth and stability.

Keynesian Theory

In economics, the Keynesian theory was first introduced by British economist John Maynard Keynes in his book The General Theory of Employment, Interest, and Money which was published in 1936 during the Great Depression . Keynesian economics states that in the short-run, especially during recessions, economic output is substantially influenced by aggregate demand (the total spending in the economy). According to the Keynesian theory, aggregate demand does not necessarily equal the productive capacity of the economy. Keynesian theorists believe that aggregate demand is influenced by a series of factors and responds unexpectedly. The shift in aggregate demand impacts production, employment, and inflation in the economy.

John Maynard Keynes

John Maynard Keynes introduced Keynesian theory in his book, The General Theory of Employment, Interest, and Money.

Economic Thought

At the time that Keynesian theory was developed, mainstream economic thought believed that the economy existed in a state of general equilibrium. The belief was that the economy naturally consumes whatever it produces because the act of producing creates enough income in the economy for that consumption to take place.

Keynesian theory has certain characteristic beliefs:

• Unemployment is the result of structural inadequacies within the economic system. It is not a product of laziness as believed previously.
• During a recession, the economy may not return naturally to full employment. The government must step in and utilize government spending to stimulate economic growth. A lack of investment in goods and services causes the economy to operate below its potential output and growth rate.
• An active stabilization policy is needed to reduce the amplitude of the business cycle. Keynesian economists believed that aggregate demand for goods and services not meeting the supply was one of the most serious economic problems.
• Excessive saving, saving beyond investment, is a serious problem that encouraged recession and even depression.
• Cutting wages will not cure a recession.
• Overcoming an economic depression requires economic stimulus, which could be achieved by cutting interest rates and increasing the level of government investment.

Schools of Economic Thought

It is important to understand the stances of the various school of economic thought. Although the beliefs of each school vary, all of the schools of economic thought have contributed to economic theory is some way.

The Keynesian School of economic thought emphasized the need for government intervention in order to stabilize and stimulate the economy during a recession or depression. In contrast, the Chicago School of economic thought focused price theory, rational expectations, and free market policies with little government intervention. The Austrian School of economic thought focused on the belief that all economic phenomena are caused by the subjective choices of individuals. Unlike other schools, the Austrian school focused on individual actions instead of society as a whole.

24.3: Aggregate Demand

24.3.1: Introducing Aggregate Demand

Aggregate demand (AD) is defined as the total demand for final goods and services in a given economy at a specific time.

Learning Objective

Define Aggregate Demand

Key Points

• To put it simply, AD is the sum of all demand in an economy. It is often called the effective demand or aggregate expenditure (AE), and is the demand of all gross domestic product (GDP).
• In summary, the calculation of aggregate demand can be represented as follows: AD = Consumption + Investment + Government spending + Net export (exports – imports).
• Many societies have increasingly adopted debt and credit as an integral part of their economic system. This has justified the incorporation of debt (also called the credit impulse) into the larger framework of aggregate demand.
• There is some loss of accuracy in combining such a diverse array of economic inputs when calculating aggregate demand.

Key Terms

expenditure

The act of incurring a cost or pay out.

aggregate demand

In macroeconomics, aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level.

Aggregate demand (AD) is defined as the total demand for final goods and services in a given economy at a specific time. Unlike other illustrations of demand, it is inclusive of all amounts of the product or service purchased at any possible price level. Simply put, AD is the sum of all demand in an economy. It is often called the effective demand or aggregate expenditure (AE), and is the demand of all gross domestic product (GDP).

Demand Sources

• Consumption (C): This is the simplest and largest component of aggregate demand (usually 40-60% of all demand), and is often what is intuitively thought of as demand. Consumption is just the amount of consumer spending executed in an economy. Taxes play a role in this exchange as well (i.e. sales tax).
• Investment (I):Investment is a relatively large portion of demand as well, and is referred to as Gross Domestic Fixed Capital Formation. This is the money spent by firms on capital investment (new machinery, factories, stocks, etc.). Investment equates to about 10% of GDP in most economies.
• Government Spending (G):This is referred to as General Government Final Consumption, and is the expenditure by the government. This can include welfare, social services, education, military, etc. Fiscal policy is the way in which governments can alter this spending to drive economic change.
• Net Export (NX):This can be put simply as the sale of goods to foreign countries subtracted by the purchase of goods from other countries (X-M). Trade surpluses and deficits can occur based on whether or not exports or imports are higher.

In summary, the calculation of aggregate demand can be represented as follows: AD = C + I + G + (X-M). The full sum of all demand in an economy takes into account each of these factors in a quantitative way. This curve is illustrated in the figure .

Aggregate Demand and Supply

This graph demonstrates the basic relationship between aggregate demand and aggregate supply. The aggregate demand curve is derived via the consumption, investment, government spending, and net export.

The Role of Debt

Many societies have increasingly adopted debt and credit as an integral part of their economic system. This has justified the incorporation of debt (also called the credit impulse) into the larger framework of aggregate demand. From a quantitative perspective this is simply expressed as: Spending = Income + Net Increase in Debt. Spending capital prior to the receipt of capital is an important consideration at both the consumer level and the government level (deficit spending).

The Aggregation Problem

There are some limitations to the aggregation perspective, generally summarized as the aggregation problem. The difficulty arises in treating all consumer preferences (and thus their respective demands) as homogeneous and continuous. As the numbers of consumers, the tastes of consumers and the distribution levels of incomes will alter, so too will the demand curve. This can create inaccurate assumptions in AD inputs. Simply, there is some loss of accuracy in combining such a diverse array of economic inputs.

24.3.2: The Slope of the Aggregate Demand Curve

Due to Pigou’s Wealth Effect, the Keynes’ Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect, the AD curve slopes downward.

Learning Objective

Explain the factors that influence the slope of the aggregate demand curve

Key Points

• Pigou’s Wealth Effect, the Keynes’ Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect are all theoretical inputs that reaffirm a downwards slope for aggregate demand (AD).
• The critical takeaway from Keynes’s perspective on the slope of the aggregate demand curve is that interest rates affect expenditures more than they affect savings. As a result, insufficient AD is not sustainable in a given system.
• The simplest way to put to wealth effect is that an increase in spending will denote an increase in wealth.
• Robert Mundell and Marcus Fleming noted that incorporating the nominal exchange rate into the mix makes it impossible to maintain free capital movement, a fixed exchange rate and independent monetary policy.
• While these varying effects make the concept of aggregate demand slopes seem somewhat complicated, the most important thing to keep in mind is that people will be demanding more goods when they are cheaper.

Key Term

liquidity trap

Injections of cash into the private banking system by a central bank fail to lower interest rates and stimulate economic growth.

Aggregate demand (AD) is the total demand for all goods within a given market at a given time, or the summation of demand curves within a system. Understanding the basic graphical representation of this curve is useful in grasping the implications of AD on an economic system, as well as the distinct effects which drive it. As a result of Keynes’ interest rate effect, Pigou’s wealth effect, and the Mundell-Fleming exchange rate effect, the AD curve is downward sloping.

Keynes’ Interest Rate Effect

The critical point from Keynes’s perspective on the slope of the aggregate demand curve is that interest rates affect expenditures more than they affect savings. If prices fall, a given amount of money will increase in value. This will drive up interest rates and investments. It is important to note that insufficient demand in a market will not go on forever.

In understanding this fully, it is useful to look at an IS-LM graph (see ). There are only two times when the Keynes observation on the interest rate effect will be inaccurate, and that is if the IS (investment savings) curve were to be vertical or if the LM (liquidity preference money supply) curve were to be horizontal. This makes sense if you think about it, it would basically equate to a liquidity trap. A vertical IS curve or a horizontal LM curve would essentially negate the way in which interest rates could affect aggregate demand.

IS-LM Model

The IS-LM model takes investments and savings and compares that to liquidity and the overall money supply. It is highly useful in understanding macroeconomics from a Keynesian perspective. Interest rates (i) are on the vertical axis, and output (y) is on the horizontal axis.

Pigou’s Wealth Effect

In the context of the above discussion on Keynes, Pigou’s Wealth Effect underlines the fact that liquidity traps are not sustainable. The simplest way to explain the Wealth Effect is that an increase in spending will denote an increase in wealth. In many ways, what Pigou is putting forward is the idea that downwards spiral on the IS-LM model , as predicted by Keynes due to deflation, will be counterbalanced by an increase in real wages and thus an increase in expenditure. In other words, a decrease in employment and prices will eventually see higher purchasing power and an increase in spending, creating wealth.

Mundell-Fleming Exchange Rate Effect

Perhaps the most complex of the three inputs underlined in deriving aggregate demand is the Mundell-Fleming Exchange Rate Effect. Just like the previous two, this builds off of the IS-LM model in a way that discusses it in the context of an open economy (as opposed to a closed system). It essentially takes into account a new factor (in addition to interest rates and outputs, as the traditional IS-LM model incorporates). This new factor is the exchange rates, as the name implies. Robert Mundell and Marcus Fleming noted that incorporating the nominal exchange rate into the mix makes it impossible to maintain free capital movement, a fixed exchange rate and independent monetary policy. This is sometimes referred to as the ‘impossible trinity,’ implying that trade-offs must be made. This concept is illustrated fairly well in this figure , where ‘FE’ is fixed expenditure.

Mundell-Fleming Fixed Exchange Rate Illustration

An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange rate unchanged. Shown here is the case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE curve) is horizontal.

Conclusion

While these varying effects make the concept of aggregate demand slopes seem somewhat complicated, the most important thing to keep in mind is that people will be demanding more goods when they are cheaper. The analysis of interest rates displayed above, through the wealth effect in particular, offsets the negative spiral that could occur as a result of deflation and decreased employment. These effects also play a crucial role in understanding the way in which the larger and more complex environment, including investments and fiscal and monetary policy, will retain this downwards slope.

24.3.3: Reasons for and Consequences of Shifts in the Aggregate Demand Curve

An increase in any of the four inputs into AD will result in higher real output or an increase in prices.

Learning Objective

Describe exogenous events that can shift the aggregate demand curve

Key Points

• There are four basic inputs to consider in calculating AD: consumption (C), investment (I), government spending (G) and net exports (NX, which is exports (X) – imports (I)).
• There are a variety of direct and indirect consequences in AD shifts. For the purpose of this discussion, it is most important to keep in mind changes in output and price.
• As the system moves closer to the highest potential output (optimal utilization of resources, or Y*), scarcity will naturally cause prices to increase more than the overall output in a system.
• As the system moves closer to the highest potential output (or optimal utilization of resources, or Y*), scarcity will naturally see the prices increases more so than the overall output in a system.

Key Term

exogenous

Received from outside a group

Aggregate demand (AD) is the summation of all demand within a given economy at a given time.

Inputs

There are four inputs to consider in calculating AD (and deriving the graphical curve which represents it): consumption (C), investment (I), government spending (G), and net exports (NX, which is exports (X) – imports (I)). Changes in these inputs will have some influence on the AD curve. For example, an increase in total expenditures will result in a shift rightwards, while a decrease in expenditure will result in a shift to the left.

Aggregate Demand Curves

Two specific AD representations are useful to consider:

• Keynesian Cross: The Keynesian Cross is a simple illustration of the relationship between aggregate demand and desired total spending (linear at 45 degrees). The intersecting AD line will generally have an upwards slope, under the assumption that increased national output should result in increased disposable income.
• Aggregate Demand/Aggregate Supply Model (AD/AS):The x-axis represents the overall output, while the y-axis represents the price level. The aggregate quantity demanded (Y = C + I + G + NX) is calculated at every given aggregate average price level.

Exogenous Effects

There are a variety of direct and indirect consequences to AD shifts. For the purpose of this discussion, the key consequences to keep in mind are changes in output and price. Below are some of the driving forces that will shift aggregate demand to the right:

• An exogenous increase in consumer spending;
• An exogenous increase in investment spending on physical capital;
• An exogenous increase in intended inventory investment;
• An exogenous increase in government spending on goods and services;
• An exogenous increase in transfer payments from the government to the people;
• An exogenous decrease in taxes levied;
• An exogenous increase in purchases of the country’s exports by people in other countries; and
• An exogenous decrease in imports from other countries.

Short-term Implications

As noted above, any increase in the overall AD will result in an outwards (right-ward) shift of the AD curve. (Conversely, a decrease in aggregate demand will cause a leftward shift of the AD curve. ) This means that an increase in any of the four inputs to AD will result in a higher quantity of real output or an increase in prices across the board (this is also known as inflation). However, different levels of economic activity will result in different combinations of output and price increases.

is useful for understanding the distribution between price increases and output increases that will result in a given economy when AD increases. To put simply, the lower the utilization of available resources in a system, the more an increase in AD will result in higher output and thus higher employment and GDP growth. However, as the system evolves and aligns itself closer to the highest potential output (optimal utilization of resources or Y*), scarcity will naturally cause the prices to increase more than the overall output in a system. This is somewhat intuitive economically when scarcity and utilization are taken into account. The more difficult it is to generate a supply increase the more likely a shift in AD will drive up prices.

Aggregate Supply/Aggregate Demand

This graph illustrates the relationship between price and output within a given economic system in the context of aggregate demand and supply.

24.4: Aggregate Supply

24.4.1: Introducing Aggregate Supply

Aggregate supply is the total supply of goods and services that firms in a national economy plan to sell during a specific time period.

Learning Objective

Define Aggregate Supply

Key Points

• Aggregate supply is the relationship between the price level and the production of the economy.
• In the short-run, the aggregate supply is graphed as an upward sloping curve.
• The short-run aggregate supply equation is: Y = Y* + α(P-P_e). In the equation, Y is the production of the economy, Y* is the natural level of production of the economy, the coefficient α is always greater than 0, P is the price level, and P_e is the expected price level from consumers.
• In the long-run, the aggregate supply is graphed vertically on the supply curve.
• The equation used to determine the long-run aggregate supply is: Y = Y*. In the equation, Y is the production of the economy and Y* is the natural level of production of the economy.

Key Terms

output

Production; quantity produced, created, or completed.

factor of production

A resource employed to produce goods and services, such as labor, land, and capital.

Aggregate Supply

In economics, aggregate supply is the total supply of goods and services that firms in a national economy plan to sell during a specific time period. It is the total amount of goods and services that the firms are willing to sell at a given price level in the economy. Aggregate supply is the relationship between the price level and the production of the economy .

Aggregate Supply

Aggregate supply is the total quantity of goods and services supplied at a given price. Its intersection with aggregate demand determines the equilibrium quantity supplied and price.

Short-run Aggregate Supply

In the short-run, the aggregate supply is graphed as an upward sloping curve. The equation used to determine the short-run aggregate supply is: Y = Y^* + α(P-P_e). In the equation, Y is the production of the economy, Y* is the natural level of production of the economy, the coefficient α is always greater than 0, P is the price level, and P_e is the expected price level from consumers.

The short-run aggregate supply curve is upward sloping because the quantity supplied increases when the price rises. In the short-run, firms have one fixed factor of production (usually capital). When the curve shifts outward the output and real GDP increase at a given price. As a result, there is a positive correlation between the price level and output, which is shown on the short-run aggregate supply curve.

Long-run Aggregate Supply

In the long-run, the aggregate supply is graphed vertically on the supply curve. The equation used to determine the long-run aggregate supply is: Y = Y*. In the equation, Y is the production of the economy and Y* is the natural level of production of the economy.

The long-run aggregate supply curve is vertical which reflects economists’ beliefs that changes in the aggregate demand only temporarily change the economy’s total output. In the long-run, only capital, labor, and technology affect aggregate supply because everything in the economy is assumed to be used optimally. The long-run aggregate supply curve is static because it is the slowest aggregate supply curve.

24.4.2: The Slope of the Short-Run Aggregate Supply Curve

In the short-run, the aggregate supply curve is upward sloping.

Learning Objective

Summarize the characteristics of short-run aggregate supply

Key Points

• The AS curve is drawn using a nominal variable, such as the nominal wage rate. In the short-run, the nominal wage rate is fixed. As a result, an increasing price indicates higher profits that justify the expansion of output.
• The AS curve increases because some nominal input prices are fixed in the short-run and as output rises, more production processes encounter bottlenecks.
• In the short-run, the production can be increased without much diminishing returns. The average price level does not have to rise much in order to justify increased production. In this case, the AS curve is flat.
• When demand is high, there are few production processes that have unemployed fixed outputs. Any increase in demand production causes the prices to increase which results in a steep or vertical AS curve.

Key Terms

supply

The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.

aggregate

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

Aggregate Supply

Aggregate supply is the total supply of goods and services that firms in a national economy plan to sell during a specific period of time. It is the total amount of goods and services that firms are willing to sell at a given price level.

Short-run Aggregate Supply Curve

In the short-run, the aggregate supply curve is upward sloping. There are two main reasons why the quantity supplied increases as the price rises:

1. The AS curve is drawn using a nominal variable, such as the nominal wage rate. In the short-run, the nominal wage rate is fixed. As a result, an increasing price indicates higher profits that justify the expansion of output.
2. An alternate model explains that the AS curve increases because some nominal input prices are fixed in the short-run and as output rises, more production processes encounter bottlenecks. At low levels of demand, large numbers of production processes do not make full use of their fixed capital equipment. As a result, production can be increased without much diminishing returns. The average price level does not have to rise much in order to justify increased production. In this case, the AS curve is flat. Likewise, when demand is high, there are few production processes that have unemployed fixed outputs. Any increase in demand production causes the prices to increase which results in a steep or vertical AS curve.

Short-run Aggregate Supply Equation

The equation used to calculate the short-run aggregate supply is: Y = Y* + α(P-P_e). In the equation, Y is the production of the economy, Y* is the natural level of production, coefficient is always positive, P is the price level, and P_e is the expected price level.

In the short-run, firms possess fixed factors of production, including prices, wages, and capital. It is possible for the short-run supply curve to shift outward as a result of an increase in output and real GDP at a given price . As a result, the short-run aggregate supply curve shows the correlation between the price level and output.

Aggregate Supply Curve

This graph shows the aggregate supply curve. In the short-run the aggregate supply curve is upward sloping. When the curve shifts outward, it is due to an increase in output and real GDP.

24.4.3: The Slope of the Long-Run Aggregate Supply Curve

The long-run aggregate supply curve is perfectly vertical; changes in aggregate demand only cause a temporary change in total output.

Learning Objective

Assess factors that influence the shape and movement of the long run aggregate supply curve

Key Points

• The long-run is a planning and implementation phase. It is the conceptual time period in which there are no fixed factors of production.
• In the long-run, only capital, labor, and technology affect the aggregate supply curve because at this point everything in the economy is assumed to be used optimally.
• Aggregate supply is usually inadequate to supply ample opportunity. Often, this is fixed capital equipment. The AS curve is drawn given some nominal variable, such as the nominal wage rate.
• In the long run, the nominal wage rate varies with economic conditions (high unemployment leads to falling nominal wages — and vice-versa).
• The equation used to calculate the long-run aggregate supply is: Y = Y*. In the equation, Y is the level of economic production and Y* is the natural level of production.

Key Term

long-run

The conceptual time period in which there are no fixed factors of production.

Aggregate Supply

In economics, aggregate supply is defined as the total supply of goods and services that firms in a national economy are willing to sell at a given price level.

Long-run in Economics

The long-run is the conceptual time period in which there are no fixed factors of production; all factors can be changed. In the long-run, firms change supply levels in response to expected economic profits or losses.

Long-run Aggregate Supply Curve

In the long-run, only capital, labor, and technology affect the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long-run aggregate supply curve is static because it shifts the slowest of the three ranges of the aggregate supply curve. The long-run aggregate supply curve is perfectly vertical, which reflects economists’ belief that the changes in aggregate demand only cause a temporary change in an economy’s total output . In the long-run, there is exactly one quantity that will be supplied.

Aggregate Supply

This graph shows the aggregate supply curve. In the long-run the aggregate supply curve is perfectly vertical, reflecting economists’ belief that changes in aggregate demand only cause a temporary change in an economy’s total output.

The long-run aggregate supply curve can be shifted, when the factors of production change in quantity. For example, if there is an increase in the number of available workers or labor hours in the long run, the aggregate supply curve will shift outward (it is assumed the labor market is always in equilibrium and everyone in the workforce is employed). Similarly, changes in technology can shift the curve by changing the potential output from the same amount of inputs in the long-term.

For the short-run aggregate supply, the quantity supplied increases as the price rises. The AS curve is drawn given some nominal variable, such as the nominal wage rate. In the short run, the nominal wage rate is taken as fixed. Therefore, rising P implies higher profits that justify expansion of output. However, in the long run, the nominal wage rate varies with economic conditions (high unemployment leads to falling nominal wages — and vice-versa).

The equation used to calculate the long-run aggregate supply is: Y = Y*. In the equation, Y is the level of economic production and Y* is the natural level of production.

24.4.4: Moving from Short-Run to Long-Run

In the short-run, the price level of the economy is sticky or fixed; in the long-run, the price level for the economy is completely flexible.

Learning Objective

Recognize the role of capital in the shape and movement of the short-run and long-run aggregate supply curve

Key Points

• When capital increases, the aggregate supply curve will shift to the right, prices will drop, and the quantity of the good or service will increase.
• The short-run aggregate supply curve is an upward slope. The short-run is when all production occurs in real time.
• The long-run curve is perfectly vertical, which reflects economists’ belief that changes in aggregate demand only temporarily change an economy’s total output. The long-run is a planning and implementation stage.
• Aggregate supply moves from short-run to long-run by considering some equilibrium that is the same for both short and long-run when analyzing supply and demand. That state of equilibrium is then compared to the new short-run and long-run equilibrium state from a change that disturbs equilibrium.

Key Term

capital

Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).

In economics, the short-run is the period when general price level, contractual wages, and expectations do not fully adjust. In contrast, the long-run is the period when the previously mentioned variables adjust fully to the state of the economy.

Aggregate Supply

Aggregate supply is the total amount of goods and services that firms are willing to sell at a given price level.

When capital increases, the aggregate supply curve will shift to the right, prices will drop, and the quantity of the good or service will increase.

Short-run Aggregate Supply

During the short-run, firms possess one fixed factor of production (usually capital). It is possible for the curve to shift outward in the short-run, which results in increased output and real GDP at a given price. In the short-run, there is a positive relationship between the price level and the output . The short-run aggregate supply curve is an upward slope. The short-run is when all production occurs in real time.

Aggregate Supply

This graph shows the relationship between aggregate supply and aggregate demand in the short-run. The curve is upward sloping and shows a positive correlation between the price level and output.

Long-run Aggregate Supply

In the long-run only capital, labor, and technology impact the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long-run supply curve is static and shifts the slowest of all three ranges of the supply curve. The long-run curve is perfectly vertical, which reflects economists’ belief that changes in aggregate demand only temporarily change an economy’s total output. The long-run is a planning and implementation stage.

Moving from Short-run to Long-run

In the short-run, the price level of the economy is sticky or fixed depending on changes in aggregate supply. Also, capital is not fully mobile between sectors.

In the long-run, the price level for the economy is completely flexible in regards to shifts in aggregate supply. There is also full mobility of labor and capital between sectors of the economy.

The aggregate supply moves from short-run to long-run when enough time passes such that no factors are fixed. That state of equilibrium is then compared to the new short-run and long-run equilibrium state if there is a change that disturbs equilibrium.

24.4.5: Reasons for and Consequences of Shifts in the Short-Run Aggregate Supply Curve

The short-run aggregate supply shifts in relation to changes in price level and production.

Learning Objective

Identify common reasons for shifts in the short-run aggregate supply curve, Explain the consequences of shifts in the short-run aggregate supply curve

Key Points

• In the short-run, the aggregate supply curve is upward sloping because some nominal input prices are fixed and as the output rises, more production processes experience bottlenecks.
• At low levels of demand, production can be increased without diminishing returns and the average price level does not rise.
• When the demand is high, few production processes have unemployed fixed inputs. Any increase in demand and production increases the prices.
• Any event that results in a change of production costs shifts the short-run supply curve outwards or inwards if the production costs are decreased or increased.

Key Term

short-run

When one or more factors are fixed.

Aggregate Supply

The aggregate supply is the relation between the price level and production of an economy. It is the total supply of goods and services that firms in a national economy plan on selling during a specific time period at a given price level.

Short-run Aggregate Supply

In the short-run, the aggregate supply curve is upward sloping because some nominal input prices are fixed and as the output rises, more production processes experience bottlenecks. At low levels of demand, production can be increased without diminishing returns and the average price level does not rise. However, when the demand is high, few production processes have unemployed fixed inputs. Any increase in demand and production increases the prices. In the short-run, the general price level, contractual wage rates, and expectations many not fully adjust to the state of the economy.

Shifts in the Short-run Aggregate Supply

The short-run aggregate supply shifts in relation to changes in price level and production. The equation used to determine the short-run aggregate supply is: Y = Y* + α(P-P_e). Y is the production of the economy, Y* is the natural level of production, coefficient α is always positive, P is the price level, and P_e is the expected price level.

In the short-run, examples of events that shift the aggregate supply curve to the right include a decrease in wages, an increase in physical capital stock, or advancement of technology. The short-run curve shifts to the right the price level decreases and the GDP increases. When the curve shifts to the left, the price level increases and the GDP decreases.

Any event that results in a change of production costs shifts the short-run supply curve outwards or inwards if the production costs are decreased or increased . Factors that impact and shift the short-run curve are taxes and subsides, price of labor (wages), and the price of raw materials. Changes in the quantity and quality of labor and capital also influence the short-run aggregate supply curve.

Short-run Aggregate Supply

This graph shows the Aggregate Suppy-Aggregate Demand model. In regards to aggregate supply, increases or decreases in the price level and output cause the aggregate supply curve to shift in the short-run.

24.5: The Aggregate Demand-Supply Model

24.5.1: Macroeconomic Equilibrium

In economics, the macroeconomic equilibrium is a state where aggregate supply equals aggregate demand.

Learning Objective

Analyze aggregate demand and supply in the long run

Key Points

• Equilibrium is the price-quantity pair where the quantity demanded is equal to the quantity supplied.
• In the long-run, increases in aggregate demand cause the output and price of a good or service to increase.
• In the long-run, the aggregate supply is affected only by capital, labor, and technology.
• The aggregate supply determines the extent to which the aggregate demand increases the output and prices of a good or service.

Key Terms

aggregate

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

supply

The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.

demand

The desire to purchase goods and services.

Economic Equilibrium

In economics, equilibrium is a state where economic forces (supply and demand) are balanced. Without any external influences, price and quantity will remain at the equilibrium value .

Equilibrium

Similar to microeconomic equilibrium, the macroeconomic equilibrium is the point at which the aggregate supply intersects the aggregate demand.

Supply and Demand

Determining the supply and demand for a good or services provides a model of price determination in a market. In a competitive market, the unit price for a good will vary until it settles at a point where the quantity demanded equals the quantity supplied. The result is the economic equilibrium for that good or service.

There are four basic laws of supply and demand. The laws impact both supply and demand in the long-run.

1. If quantity demand increases and supply remains unchanged, a shortage occurs, leading to a higher price until the quantity demanded is pushed back to equilibrium.
2. If quantity demand decreases and supply remains unchanged, a surplus occurs, leading to a lower price until the quantity demanded is pushed back to equilibrium.
3. If quantity demand remains unchanged and supply increases, a surplus occurs, leading to a lower price until the quantity supplied is pushed back to equilibrium.
4. If quantity demand remains unchanged and supply decreases, a shortage occurs, leading to a higher price until the quantity supplied is pushed back to equilibrium.

Aggregate Supply and Aggregate Demand

Aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing to sell at a specific price level in an economy .

Aggregate supply

This graph shows the three stages of aggregate supply. It is the total supply of goods and services that firms in a national economy plan to sell during a specific time period. Changes in aggregate supply cause shifts along the supply curve.

Aggregate demand is the total demand for final goods and services in an economy at a given time and price level. It is the demand for the gross domestic product (GDP) of a country.

Aggregate Supply-Aggregate Demand Model

Equilibrium is the price-quantity pair where the quantity demanded is equal to the quantity supplied. It is represented on the AS-AD model where the demand and supply curves intersect. In the long-run, increases in aggregate demand cause the price of a good or service to increase. When the demand increases the aggregate demand curve shifts to the right. In the long-run, the aggregate supply is affected only by capital, labor, and technology. Examples of events that would increase aggregate supply include an increase in population, increased physical capital stock, and technological progress. The aggregate supply determines the extent to which the aggregate demand increases the output and prices of a good or service.

When the aggregate supply and aggregate demand shift, so does the point of equilibrium. The aggregate demand curve shifts and the equilibrium point moves horizontally along the aggregate supply curve until it reaches the new aggregate demand point.

24.5.2: Reasons for and Consequences of Shift in Aggregate Demand

A short-run shift in aggregate demand can change the equilibrium price and output level.

Learning Objective

Explain the causes of economic fluctuations using aggregate demand curves

Key Points

• The aggregate supply curve determines the extent to which increases in aggregate demand lead to increases in real output or increases in prices.
• The equation used to calculate aggregate demand is: AD = C + I + G + (X – M).
• The aggregate demand curve shifts to the right as a result of monetary expansion.
• If the monetary supply decreases, the demand curve will shift to the left.

Key Terms

aggregate demand

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

Supply curve

A graph that illustrates the relationship between the price of a good and the quantity supplied.

output

Production; quantity produced, created, or completed.

Aggregate Demand

In economics, aggregate demand is the total demand for final goods and services at a given time and price level. It gives the amounts of goods and services that will be demanded at all possible price levels, which, unless there are shortages, is equivalent to GDP. Aggregate demand equals the sum of consumption (C), investment (I), government spending (G), and net export (X -M). This is often written as an equation, which is given by:

AD = C + I + G + (X – M).

Shifts in the Aggregate Supply-Aggregate Demand Model

The aggregate supply-aggregate demand model uses the theory of supply and demand in order to find a macroeconomic equilibrium. The shape of the aggregate supply curve helps to determine the extent to which increases in aggregate demand lead to increases in real output or increases in prices. An increase in any of the components of aggregate demand shifts the AD curve to the right. When the AD curve shifts to the right it increases the level of production and the average price level. When an economy gets close to potential output, the price will increase more than the output as the AD rises .

AS-AD Model

The Aggregate Supply-Aggregate Demand Model shows how equilibrium is determined by supply and demand. It shows how increases and decreases in output and prices impact the economy in the short-run and long-run. The model is also used to show real and potential output.

When price increase dominates an economy, this means that the economy is near its potential output.

Reasons for Aggregate Demand Shift

The slope of the aggregate demand curve shows the extent to which the real balances change the equilibrium level of spending. The aggregate demand curve shifts to the right as a result of monetary expansion. In an economy, when the nominal money stock in increased, it leads to higher real money stock at each level of prices. The interest rates decrease which causes the public to hold higher real balances. This stimulates aggregate demand, which increases the equilibrium level of income and spending. Likewise, if the monetary supply decreases, the demand curve will shift to the left.

24.5.3: Reasons for and Consequences of Shift in Aggregate Supply

In economics, the aggregate supply shifts and shows how much output is supplied by firms at different price levels.

Learning Objective

Explain shifts in aggregate supply and their impact on the economy

Key Points

• The aggregate supply curve shows how much output is supplied by firms at different price levels.
• The short-run aggregate supply curve is affected by production costs including taxes, subsides, price of labor (wages), and the price of raw materials.
• The long-run aggregate supply curve is affected by events that change the potential output of the economy.

Key Term

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.

Aggregate Supply

In economics, aggregate supply is defined as the total supply of goods and services that firms in a national economy produce during a specific period of time. It is the total amount of goods and services that firms are willing to sell at a specific price level in the economy.

Shift in Aggregate Supply

The aggregate supply curve may shift labor market disequilibrium or labor market equilibrium. If labor or another input suddenly becomes cheaper, there would be a supply shock such that supply curve may shift outward, causing the equilibrium price in to drop and the equilibrium quantity to increase.

Supply Shift

A supply shock could be caused by changing regulations or a sudden change in the price of an input, among other reasons.

During the short-run, there is one fixed factor of production, usually capital. However, the fixed factor does not stop the curve’s ability to shift outward. When the curve shifts to the right, it causes an increase in the output and a decrease in the GDP at a given price. Examples of events that cause the curve to shift to the right in the short-run include a decrease in the wage rate, an increase in physical capital stock, and technological progress.

In the long-run only capital, labor, and technology affect the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long run curve is often seen as static because it shift the slowest. The long-run aggregate supply curve is vertical which shows economist’s belief that changes in aggregate demand only have a temporary change on the economy’s total output. Examples of events that shift the long-run curve to the right include an increase in population, an increase in physical capital stock, and technological progress.

Reasons for Shifts

The short-run aggregate supply curve is affected by production costs including taxes, subsidies, price of labor (wages), and the price of raw materials. All of these factors will cause the short-run curve to shift. When there are changes in the quality and quantity of labor and capital the changes affect both the short-run and long-run supply curves. The long-run aggregate supply curve is affected by events that change the potential output of the economy.

Changes in short-run aggregate supply cause the price level of the good or service to drop while the real GDP increases. In the long-run the prices stabilize and the price level of the good or service increase in response to the changes.

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 .

Theoretical Phillips Curve

The Phillips curve shows the inverse trade-off between inflation and unemployment. As one increases, the other must decrease. In this image, an economy can either experience 3% unemployment at the cost of 6% of inflation, or increase unemployment to 5% to bring down the inflation levels to 2%.

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 .

US Phillips Curve (2000 – 2013)

The data points in this graph span every month from January 2000 until April 2013. They do not form the classic L-shape the short-run Phillips curve would predict. Although it was shown to be stable from the 1860’s until the 1960’s, the Phillips curve relationship became unstable – and unusable for policy-making – in the 1970’s.

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.

Phillips Curve and Aggregate Demand

As aggregate demand increases from AD1 to AD4, the price level and real GDP increases. This translates to corresponding movements along the Phillips curve as inflation increases and unemployment decreases.

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.

NAIRU and Phillips Curve

Although the economy starts with an initially low level of inflation at point A, attempts to decrease the unemployment rate are futile and only increase inflation to point C. The unemployment rate cannot fall below the natural rate of unemployment, or NAIRU, without increasing inflation in the long run.

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.

Short-Run Phillips Curve

The short-run Phillips curve shows that in the short-term there is a tradeoff between inflation and unemployment. Contrast it with the long-run Phillips curve (in red), which shows that over the long term, unemployment rate stays more or less steady regardless of inflation rate.

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.

Expectations and the Phillips Curve

According to adaptive expectations theory, policies designed to lower unemployment will move the economy from point A through point B, a transition period when unemployment is temporarily lowered at the cost of higher inflation. However, eventually, the economy will move back to the natural rate of unemployment at point C, which produces a net effect of only increasing the inflation rate.According to rational expectations theory, policies designed to lower unemployment will move the economy directly from point A to point C. The transition at point B does not exist as workers are able to anticipate increased inflation and adjust their wage demands accordingly.

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.

Aggregate Supply Shock

In this example of a negative supply shock, aggregate supply decreases and shifts to the left. The resulting decrease in output and increase in inflation can cause the situation known as stagflation.

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.

Disinflation

Disinflation can be illustrated as movements along the short-run and long-run Phillips curves.

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 .

Unemployment Rate

Unemployment is calculated as a percentage by dividing the number of unemployed individuals by the number of individual employed in the labor force.

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 .

U.S. Unemployment

The graph shows the unemployment rates in the United States. Full employment is defined as “ideal” unemployment. It is important because it keeps inflation under control.

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.

U.S. Unemployment

This graph shows the average duration of unemployment in the United States from 1950-2010. Unemployment occurs when there are more individuals seeking jobs than there are vacancies.

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 .

Retraining

When there is structural unemployment, workers may seek to learn different skills so that they can apply to new types of jobs.

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.

22.2: Measuring Unemployment

22.2.1: Measuring the Unemployment Rate

The labor force is the actual number of people available for work; economists use the labor force participation rate to determine the unemployment rate.

Learning Objective

Classify the six measures of unemployment calculated by the Bureau of Labor Statistics (BLS)

Key Points

• Unemployment occurs when people are without work and are actively seeking employment.
• There are three types of unemployment: cyclical, structural, and frictional.
• The CPS and CES are two surveys that the U.S. Bureau of Labor Statistics uses to determine the unemployment rate for households, businesses, and government agencies.
• The U.S. Bureau of Labor Statistics uses six measurements when calculating the unemployment rate. The measures range from U1 – U6 and were reported from 1950 through 2010. They calculate different aspects of unemployment.

Key Term

unemployment

The state of being jobless and looking for work.

Unemployment Rate

Unemployment occurs when people are without work and are actively seeking employment. In an economy, the labor force is the actual number of people available for work. Economists use the labor force participation rate to determine the unemployment rate.

Unemployment can be broken down into three types of unemployment:

• Cyclical unemployment: occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.
• Structural unemployment: occurs when the labor market is unable to provide jobs for everyone who wants to work. There is a mismatch between the skills of the unemployed workers and the skills necessary for the jobs available.
• Frictional unemployment: the time period between jobs when a worker is looking for a job or transitioning from one job to another.

Measuring Unemployment

The U.S. Bureau of Labor Statistics measures employment and unemployment for individuals over the age of 16. The unemployment rate is measured using two different labor force surveys.

• The Current Population Survey (CPS): also known as the “household survey” the CPS is conducted based on a sample of 60,000 households. The survey measures the unemployment rate based on the ILO definition.
• The Current Employment Statistics Survey (CES): also known as the “payroll survey” the CES is conducted based on a sample of 160,000 businesses and government agencies that represent 400,000 individual employees.

The unemployment rate is also calculated using weekly claims reports for unemployed insurance. The government provides this data. The unemployment rate is updated on a monthly basis.

Six Measures of Unemployment

The U.S. Bureau of Labor Statistics uses six measurements when calculating the unemployment rate. The measures range from U1 – U6 and were reported from 1950 through 2010 . They calculate different aspects of unemployment. The measures are:

Unemployment Rate

The U.S. Bureau of Labor Statistics used the six employment measures to calculate the unemployment rate in the United States from 1950 to 2010.

• U1: the percentage of labor force unemployed for 15 weeks or longer.
• U2: the percentage of labor force who lost jobs or completed temporary work.
• U3: the official unemployment rate that occurs when people are without jobs and they have actively looked for work within the past four weeks.
• U4: the individuals described in U3 plus “discouraged workers,” those who have stopped looking for work because current economic conditions make them think that no work is available for them.
• U5: the individuals described in U4 plus other “marginally attached workers,” “loosely attached workers,” or those who “would like” and are able to work, but have not looked for work recently.
• U6: the individuals described in U5 plus part-time workers who want to work full-time, but cannot due to economic reasons, primarily underemployment.

22.2.2: Shortcomings of the Measurement

Unemployment is not an absolute calculation and it is prone to errors and biases related to data assembly and inconsistencies in reporting.

Learning Objective

Describe the rates in the U.S. of those who are employed, unemployed, and not in the labor force

Key Points

• The rate of unemployment is a percentage that is calculated by dividing the number of unemployed individuals by the number of individuals currently employed in the work force.
• The rate of unemployment is calculated using four methods: the Labor Force Sample Surveys, Official Estimates, Social Insurance Statistics, and Employment Office Statistics.
• The measurement of unemployment does have some shortcomings based on who is and is not measured.
• By not including all under-employed or unemployed individuals in the measurement of the unemployment rate, the calculation does not provide an accurate assessment of how unemployment truly impacts society.

Key Terms

labor force

The collective group of people who are available for employment, i.e. including both the employed and the unemployed.

unemployment

The state of being jobless and looking for work.

Unemployment

Unemployment, also called joblessness, occurs when people are without work and are actively seeking employment. Unemployment is measured in order to determine the unemployment rate. The rate is a percentage that is calculated by dividing the number of unemployed individuals by the number of individuals currently employed in the labor force .

U.S. Unemployment Rate

This image shows the unemployment rates by county throughout the United States in 2008. The unemployment rate is the percentage of unemployment calculated by dividing the number of unemployed individuals by the number of individuals currently employed in the labor force.

Measurements

In order to find the rate of unemployment, four methods are used:

• Labor Force Sample Surveys: provide the most comprehensive results. Calculates unemployment by different categories such as race and gender. This method is the most internationally comparable.
• Official Estimates: combines information from the three other methods. The method is not the preferred method to use when calculating the rate of unemployment.
• Social Insurance Statistics: these statistics are calculated based on the number of individuals receiving unemployment benefits. The method is criticized because unemployment benefits can expire before an individual finds employment which makes the calculations inaccurate.
• Employment Office Statistics: only include a monthly total of unemployed individuals who enter unemployment offices. This method is the least effective for measuring unemployment.

Measurement Shortcomings

The measurement of unemployment is not an absolute calculation and is prone to errors. For example, the unemployment rate does not take into account individuals who are not actively seeking employment, such as individuals attending college or even individuals who are in U.S. prisons. Individuals who are self-employed, those who were forced to take early retirement, those with disability pensions who would like to work, and those who work part-time and seek full-time employment are not factored in to the unemployment rate. Some individuals also choose not to enter the labor force and these statistics are also not considered. By not including all underemployed or unemployed individuals in the measurement of the unemployment rate, the calculation does not provide an accurate assessment of how unemployment truly impacts society. Errors and biases are also present due to data assembly and reporting inconsistencies.

22.2.3: Typical Lengths of Unemployment

Short-term unemployment is any period of joblessness that lasts fewer than 27 weeks. Long-term unemployment lasts 27 or more weeks.

Learning Objective

Distinguish between short-term and long-term unemployment and the impact on people and economy

Key Points

• Unemployment occurs when people are without work and are actively seeking employment.
• Unemployment impacts the economy and society by increasing inequality, impeding long-term economic growth, wasting resources, and reducing economic efficiency.
• Unemployment impacts individuals because they are not able to meet their financial obligations which can lead to poverty, poor labor mobility, and low self-esteem. Unemployment is also know to cause civil unrest and conflict.
• Unemployment impacts individuals because they are not able to meet their financial obligations which can lead to poverty, poor labor mobility, and low self-esteem. Unemployment is also know to cause civil unrest and conflict.

Key Terms

poverty

The quality or state of being poor or indigent; want or scarcity of means of subsistence; indigence; need.

unemployment

The state of being jobless and looking for work.

Unemployment

Unemployment, also referred to as joblessness, occurs when people are without work and actively seeking employment. Generally, unemployment is high during recessions. Individuals struggle to find work when there are more job-seekers than vacant positions.

There are three types of unemployment:

• Cyclical: occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. The demand for most goods and services declines, less production is needed, and fewer workers are needed. Wages are sticky and do not fall to meet the equilibrium level which results in mass unemployment.
• 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 workers and the skills needed for the jobs that are available.Structural unemployment is similar to frictional unemployment, but it lasts longer.
• Frictional: when a worker is searching for a job or transitioning from one job to another. Frictional unemployment is always present in an economy.

Lengths of Unemployment

Short-term unemployment is considered any unemployment period that lasts less than 27 weeks. The unemployment period is temporary and often includes the time needed to switch from one job to another. Also, if an individual is searching for employment the search period is relatively short.

Long-term unemployment is classified as unemployment that lasts for 27 weeks or longer. Being unemployed for a long period of time can have substantial impacts on individuals. Jobs skills, certifications, and qualifications lessen over time. When the job market finally increases many individuals will no longer match the requirements for the new positions. Long-term unemployment can also result in older workers taking early retirement .

Average Length of Unemployment

This graph shows the average length of unemployment in the United States from 1950-2010. Short-term unemployment is considered less than 27 weeks, while long-term unemployment is joblessness that lasts 27 weeks or longer.

Social and Individual Impacts

Unemployment can have lasting impacts of individual people as well as the economy as a whole.

• Social: Within the economy, long-term unemployment increases the inequality present in the economy and impedes long-run economic growth. Unemployment wastes resources and generates redistributive pressures and distortions within the economy. When unemployment is high, the economy is not using all of the available resources, specifically labor. Unemployment can also reduce the efficiency of the economy because unemployed workers are willing to accept employment that is below their skill level.
• Individual: For individual people, unemployment increases poverty, creates poor labor mobility, and impacts self-esteem. When individuals are unemployed they are unable to meet their financial obligations. It is not uncommon for social unrest and conflict that get worse during times of mass unemployment.

22.3: Understanding Unemployment

22.3.1: Reasons for Unemployment

There are three reasons for unemployment which are categorizes as frictional, structural, and cyclical unemployment.

Learning Objective

Explain why the unemployment rate may fluctuate

Key Points

• The natural rate of unemployment is the unemployment rate when the economy is producing at its full potential output. This natural rate is positve, rather than zero, due to frictional and structural unemployment.
• Frictional unemployment is caused by an inability for workers and employers to find each other immediately.
• Structural unemployment is caused by mismatches between the skills offered by potential employees and those sought by employers.
• Cyclical unemployment occurs whenever the economy is not operating at its full, long-term potential. During low periods in the business cycle, firms demand fewer workers and the result is an unemployment level above the natural rate.

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.

cyclical unemployment

A type of unemployment explained by the demand for labor going up and down with the business cycle.

There are four types of unemployment. The distinction between them is important to economists because the policy prescriptions for addressing each type vary.

Natural Level of Unemployment

The natural level of unemployment is the unemployment rate when an economy is operating at full capacity. This is the unemployment rate that occurs when production is at its long-run level, removing any temporary fluctuations and frictions. It is mainly determined by an economy’s production possibilities and economic institutions. At this level of unemployment, the quantity of labor supplied equals the quantity of labor demanded, though this does not imply that unemployment is zero. The reason why the natural rate of unemployment is still positive is due to frictional and structural unemployment.

Frictional Unemployment

Frictional unemployment is the time period between jobs when a worker is searching for or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual. Frictional unemployment exists because both jobs and workers are heterogenous, and a mismatch can result between the characteristics of supply and demand. Such a mismatch can be related to skills, payment, work-time, location, seasonal industries, attitude, taste, and a multitude of other factors.

There is always at least some frictional unemployment in an economy, so the level of involuntary unemployment is properly the unemployment rate minus the rate of frictional unemployment.

Though economists accept that some frictional unemployment is okay because both potential workers and employers take some time to find the best employee-position match, too much frictional unemployment is undesirable. Governments will seek ways to reduce unnecessary frictional unemployment through multiple means including providing education, advice, training, and assistance such as daycare centers.

Structural Unemployment

Structural unemployment is a form of unemployment where, at a given wage, the quantity of labor supplied exceeds the quantity of labor demanded, because there is a fundamental mismatch between the number of people who want to work and the number of jobs that are available. The unemployed workers may lack the skills needed for the jobs, or they may not live in the part of the country or world where the jobs are available. It is generally considered to be one of the “permanent” types of unemployment, where improvement if possible, will only occur in the long run.

A common cause of structural unemployment is technological change. With the advent of telephones, for example, some telegraph operators were put out of work. Their inability to find work was due to an oversupply of skilled telegraph operators relative to the demand for workers with that ability.

Cyclical Unemployment

Of course, the economy may not be operating at its natural level of employment, so unemployment may be above or below its natural level. This is often attributed to the business cycle: the expansion and contraction of the economy around the long-term growth trend. During periods in the business cycle when the economy is producing below its long-run, optimum level, firms demand fewer workers and the result is cyclical unemployment. In this case the long-run demand for labor is higher than the temporary demand, so the rate of unemployment is higher than its natural rate .

U.S. Unemployment Rate

The short-term fluctuations in the graph are the result of cyclical unemployment that changes when economic activity is above or below its long-term potential. Over time, unemployment has returned to about 5%, which is the approximate natural rate of unemployment.

22.3.2: Impact of Public Policy on Unemployment

Public policy seeks to minimize unemployment by providing information, training, facilities, and other programs to assist the unemployed.

Learning Objective

Review the importance of unemployment benefits in the American social welfare program

Key Points

• Policies to combat unemployment differ depending on the type of unemployment.
• Policies to combat frictional unemployment include providing free and clear information to help match available job-seekers and jobs, providing facilities to increase availability and flexibility, and combating prejudice against certain types of workers, jobs, or locations.
• Unemployment insurance alleviates the short-term hardship faced by the unemployed and allows workers more time to search for a job that fits their skills and preferences.
• Job training and education to equip workers with the skills firms demand are public policy responses to structural unemployment.

Key Terms

frictional unemployment

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

structural unemployment

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

unemployment insurance

Insurance against loss of earnings during the time that an able-bodied worker is involuntarily unemployed.

Most governments strive to achieve low levels of unemployment. However, the types of policies differ depending on what type of unemployment they address.

Frictional Unemployment

Frictional unemployment is the period between jobs in which an employee is searching for or transitioning from one job to another. It exists because the labor market is not perfect and there may be mismatches between job-seekers and jobs before workers are hired for the right position. If the search takes too long and mismatches are too frequent, the economy suffers, since some work will not get done.

Governments can enact policies to try to reduce frictional unemployment. These include offering advice and resources for job-seekers and providing clear and transparent information on available jobs and workers. This can take the form of free career counseling and job boards or job fairs. The government can provide facilities to increase availability and flexibility – for example, providing daycare may allow part-time or non-workers to transition into full-time jobs, and public transportation may widen the number of jobs available to somebody without a car. The government may also fund publicity campaigns or other programs to combat prejudice against certain types of workers, jobs, or locations.

On the other hand, some frictional unemployment is a good thing – if every worker was offered, and accepted, the first job they encountered, the distribution of workers and jobs would be quite inefficient. Many governments offer unemployment insurance to both alleviate the short-term hardship faced by the unemployed and to allow workers more time to search for a job. These benefits generally take the form of payments to the involuntarily unemployed for some specified period of time following the loss of the job. In order to achieve the goal of reducing frictional unemployment, governments typically require beneficiaries to actively search for a job while receiving payments and do not offer unemployment benefits to those who are fired or leave their job by choice.

Structural Unemployment

Structural unemployment is due to more people wanting jobs than there are jobs available. The unemployed workers may lack the skills needed for the jobs, or they may not live in the part of the country or world where the jobs are available.

Public policy can respond to structural unemployment through programs like job training and education to equip workers with the skills firms demand. A worker who was trained in an obsolete field, such as a typesetter who lost his job when printing was digitized, may benefit from free retraining in another field with strong demand for labor .

Job Training Programs

Many organizations seek to minimize structural unemployment by offering job training and education to provide workers with in-demand skills.

22.3.3: Impact of Unions on Unemployment

If the labor market is competitive, unions will typically raise wages but increase unemployment.

Learning Objective

Discuss the impact of unionization on unemployment

Key Points

• Unions function by negotiating with employers to create a collective agreement that applies to all union members and typically lasts for a set time period.
• Unions are able to raise wages because, when they are powerful, they may turn the labor market into a monopoly market.
• Many economists criticize unionization, arguing that it frequently produces higher wages at the expense of fewer jobs. Essentially, unionization benefits the already employed at the expense of the unemployed.
• In labor markets that are not competitive, the equilibrium without unionization may result in wages that are lower than the competitive equilibrium. In this case, unions may be able to raise wages without increasing unemployment.

Key Terms

marginal product of labor

the change in output that results from employing an added unit of labor.

oligopsony

An economic condition in which a small number of buyers exert control over the market price of a commodity.

bargaining power

The ability to influence the setting of prices or wages, usually arising from some sort of monopoly or monopsony position — or a non-equilibrium situation in the market.

A union is a formal organization of workers who have banded together to achieve common goals such as protecting the integrity of its trade, achieving higher pay, increasing the number of employees an employer hires, and better working conditions. They function by negotiating with employers to create a collective agreement that applies to all union members and typically lasts for a set time period. For example, in a unionized industry, rather than each employee negotiating his or her own vacation time with the employer, a union will negotiate with the firm in order to create a contract governing vacation time that applies to every union member. This gives workers as a whole a stronger bargaining position when negotiating working conditions and pay.

Trade unions in their current form became popular during the industrial revolution, when most jobs required little skill or training and therefore almost all of the bargaining power fell with employers rather than employees. While unions have many goals, their primary objective has historically been to achieve higher wages for members of the union – that is, those who are already employed in an industry.

Unions are able to raise wages because, when they are powerful, they may turn the labor market into a monopoly market. Rather than a competitive market with many buyers (employers) and sellers (employees), there are many buyers but only one seller: the union. Like any monopoly market, the outcome will be an equilibrium with higher prices and lower supply than in the competitive equilibrium. In the case of the labor market, this means that wages will be higher, but so will unemployment. This is illustrated in the graphic, in which a union successfully raises the wage rate above the equilibrium wage. The gap between the point where the new wage rate intersects the demand curve and where it intersects the supply curve represents the resulting unemployment .

Raising Wages Above Equilibrium

If a union is able to raise the minimum wage for their members above the equilibrium wage, then wages will be higher but fewer workers will be employed.

Many economists criticize unionization, arguing that it frequently produces higher wages at the expense of fewer jobs. Essentially, unionization benefits the already employed at the expense of the unemployed. Further, by charging higher prices than the equilibrium wage rate, unions promote deadweight loss. Critics also argue that if some industries are unionized and others are not, wages will decline in non-unionized industries.

Unions in Imperfect Labor Markets

The above arguments assume that without unions, the labor market would be competitive – that is, there would be many buyers and many sellers of labor. In this competitive equilibrium, the wage rate would equal the marginal revenue product of labor and the outcome would be efficient. In reality this is often not the case. Rather, many industries are dominated by only a few firms, making the labor market an oligopsony – a market with many sellers of labor but only a few buyers. In an oligopsony firms have the advantage over workers, and wages may be lower than they would be at the competitive equilibrium.

If we assume that the labor market is imperfect and that wages are naturally lower than the marginal revenue product of labor, unions may increase efficiency by raising wage rates closer to the efficient level. In this case, wages will rise without a resulting rise in unemployment.

Unions, Productivity, and Unemployment

The above arguments focus on how unions affect unemployment by negotiating for higher wages, but unions may also affect unemployment in other ways. Many argue that unions are capable of raising productivity by reducing turnover, increasing coordination between workers and management, and by increasing workers’ motivation. More productive workers means a higher marginal product of labor. Since the demand for labor is determined by its marginal product, increased productivity will cause demand to shift to the right and lead to an efficient equilibrium with both higher wages and lower unemployment.

22.3.4: Efficiency Wage Theory

Efficiency wage theory is the idea that firms may permanently hold to a real wage greater than the equilibrium wage.

Learning Objective

Define Efficiency Wage Theory

Key Points

• Efficiency wages are wages that are higher than the market equilibrium. Firms that pay efficiency wages could lower their wages and hire more workers, but choose not to do so.
• Some reasons that managers might choose to pay efficiency wages are to avoid shirking, reduce turnover, and attract productive employees.
• The consequence of the efficiency wage theory is that the market for labor does may not clear, even in the long run, and unemployment may be persistenly higher than its natural rate.

Key Terms

turnover

The number of times a worker is replaced after leaving.

shirking

To provide less quality work than is required.

Efficiency-Wage Theory

The market-clearing wage is the wage at which supply equals demand; there is no excess supply of labor (unemployment) and no excess demand for labor (labor shortage). In the basic economic theory, in the long run the economy will achieve this market-clearing equilibrium and will experience the natural level of unemployment. However, firms may choose to pay wages higher than the market-clearing equilibrium in order to incentivize increased worker productivity or to reduce turnover. This is called efficiency-wage theory.

Why Pay Efficiency Wages?

There are several theories of why managers might pay efficiency wages:

• Avoiding shirking: If it is difficult to measure the quantity or quality of a worker’s effort, there may be an incentive for him or her to “shirk” (do less work than agreed). The manager thus may pay an efficiency wage in order to increase the cost of job loss, which gives a sting to the threat of firing. This threat can be used to prevent shirking .
• Minimizing turnover: As mentioned above, by paying above-market wages, the worker’s motivation to leave the job and look for a job elsewhere will be reduced. This strategy makes sense when it is expensive to train replacement workers.
• Selection: If job performance depends on workers’ ability and workers differ from each other in those terms, firms with higher wages will attract more able job-seekers, and this may make it profitable to offer wages that exceed the market clearing level.

Consequence of Efficiency Wage

The consequence of the efficiency wage theory is that the market for labor does may not clear and unemployment may be persistently higher than its natural rate. Instead of market forces causing the wage rate to adjust to the point at which supply equals demand, the wage rate will be higher and supply will exceed demand. This produces higher wages for those who are employed but higher levels of unemployment.

22.3.5: Job Creation and Destruction

Jobs are created when workers become more productive, the price of output increases, or when total economic output increases.

Learning Objective

Summarize how jobs are created and destroyed on a firm, industry, and economy wide level

Key Points

• Firms will continue to demand labor until the marginal revenue product of labor equal the wage rate – that is, until the marginal benefit of one more employee equals the marginal cost of that employee.
• Any factor that increases the marginal revenue product of labor or that decreases the marginal cost of labor will create jobs.
• At a macroeconomic level, jobs are created when the general level of output rises and jobs are destroyed when the general level of output falls.
• In general, output rises when the demand for consumer goods increases. Thus, factors that stimulate consumer demand also encourage job creation.

Key Terms

business cycle

A fluctuation in economic activity between growth and recession.

marginal productivity

The extra output that can be produced by using one more unit of the input

Job Creation at the Microeconomic Level

Firms decide to create or lose jobs based on the price of output, the price of inputs, and the marginal productivity of inputs. Firms will continue to demand labor until the marginal revenue product of labor equals the wage rate – that is, until the marginal benefit of one more employee equals the marginal cost of that employee. For example, suppose a shoe factory can sell shoes for $50 a pair, and hiring an additional employee to work for an hour allows the factory to produce one extra pair of shoes. As long as the wage rate is less than $50/hour, the firm can increase its profit by hiring more worker and producing more shoes. Eventually, however, the factory will become crowded, workers will need to wait in line for access to necessary tools and machinery, or the supply of materials will fail to keep up with the production pace. This will cause the marginal productivity of labor to fall, so that an additional hour of work produces less than one extra pair of shoes. If the prevailing wage rate is $25/hour, the firm will hire until it takes two hours of work to produce one pair of shoes. At this point, the marginal benefit of hiring labor is $25, equal to the marginal cost.

Factors that increase the productivity of labor will increase demand for labor and create jobs. Suppose a new type of sewing machine is invented that is smaller and allows shoemakers to work more quickly. This increases the productivity of labor, so that at its previous employment levels the firm can now earn $35 for every hour of labor it employs. Just as before, the firm will create more jobs and continue to hire until the marginal revenue product of labor is again equal to the wage rate. Similarly, if the price of output rises firms will hire more employees. If the price of shoes increases to $60, for example, workers that were previously making $25 worth of shoes in an hour will be making $30 worth of shoes each hour instead. Since the wage rate is still $25, the firm will hire more workers until the marginal revenue product of labor is equal to the wage rate.

Job Creation at the Macroeconomic Level

At a macroeconomic level, jobs are created when the general level of output rises and jobs are destroyed when the general level of output falls. The quantity of labor employed and the wage rate are determined by the intersection of labor supply (the number of people willing to enter the workforce at any given wage) and the labor demand (the amount of labor producers are willing to employ at any given wage rate). Labor supply is based primarily upon the size of the population and therefore remains fairly stable. The labor demand, however, shifts to the left when an economy’s output falls, since firms will need fewer workers to produce fewer goods. Likewise, labor demand shifts to the right when an economy’s output rises. These shifts will destroy job and lower wages or create jobs and increase wages, respectively .

Output and Employment

As this hypothetical graph shows, when output (GDP) is rising, jobs are created and unemployment falls. When output is falling, jobs are destroyed and unemployment rises.

One reason that economic activity might rise or fall is the business cycle. The business cycle refers to the periods of expansions and contractions in the level of economic activities around the long-term growth trend. This is typically due to an increase or decrease in the economy-wide demand for consumer goods, but these cycles could also take place due to changes in production technology, changes in governmental policy, and many other factors.

At the macroeconomic level jobs may also shift between industries due to changes in demand or technology. For example, when health researchers uncovered facts about the health risks of smoking, the demand for cigarettes dropped and many jobs were lost in the tobacco industry. As for technology, the invention of the telephone created many jobs in telecommunications, but destroyed most of the jobs associated with telegraphs.

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 .

Inflation and the Money Supply

While the two variables are not exactly equivalent in the short run, over time the money supply has had a direct relationship to the level of inflation. This is consistent with 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 .

U.S. Inflation Rate

The U.S. inflation rate is measured by comparing the price of goods in one year to the price of goods in a previous base year.

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 .

Consumer Price Index and Inflation

The above graph shows the annual inflation rate and the consumer price index from 1913 to 2003. As long as the inflation rate was above zero, the CPI was increasing.

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 .

Menu Costs

The cost to a restaurant to change the prices on menus is incurred even with low and expected inflation.

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).

Hyperinflation in Zimbabwe

The photo shows bills worth millions and billions of dollars that were printed by the Zimbabwe government as a response to massive inflation. At one point the 50 billion dollar note was worth less than three US dollars.

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 .

Interest Rates and Inflation

Part of the reason that lenders charge interest is to recoup the cost of inflation over time.

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.

The Great Depression

Most economists agree that the high levels of deflation during the 1930s made the Great Depression much more severe and long-lasting. It discouraged consumption, borrowing, and investment that would increase economic activity.

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 ).

Production-Possibility Frontier

This outward shift in the Production-Possibility frontier is indicative of economic growth within the economy it represents.

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).

GDP Growth Across Nations

This graph underlines the important fact that economic growth is not mutually or equally distributed, resulting from a wide variety of factors with external and global systems.

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.

Economic Growth in the 20th Century

As a result of technological advances and increased intellectual capacity, real productivity increased by over 400% during this time frame.

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.

Petroleum Consumption Over Time

This figure demonstrates the risk of over-consuming our natural resources, ultimately resulting in scarcity of necessary goods. A continued drive for economic growth could lead to overconsumption of natural resources.

20.2: Assessing Growth

20.2.1: Calculating Economic Growth

Economic growth is the increase in the market value of goods and services produced by an economy over time; the percentage rate of increase in the GDP.

Learning Objective

Calculate various measures of economic growth

Key Points

• In economics, economic growth refers to the growth of potential output. It shows how a country is developing its economy.
• The short-run variation in economic growth is called the business cycle. Economists use it to distinguish between short-run variations in economic growth and long-run economic growth.
• Long-run economic growth is measured as the percentage rate increase in the real gross domestic product.
• The GDP can be calculated using the product approach, income approach, or expenditure approach. The GDP is defined as the market value of all officially recognized final goods and services produced within a country in a given period of time.

Key Terms

business cycle

A fluctuation in economic activity between growth and recession.

gross domestic product

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

economic growth

The increase of the economic output of a country.

Economic Growth

Economic growth is defined as the increase in the market value of goods and services produced by an economy over time. It is usually measured as a percentage rate of increase in the real gross domestic product. In economics, economic growth refers to the growth of potential output. It shows how a country is developing its economy. Economic growth is directly impacted by human capital, which is the level of school or knowledge attainment in a country. The cognitive skills of a population directly impact economic growth. In general, economic growth is recorded and studied over the short-run and long-run.

Short-run Economic Growth

The business cycle refers to economy-wide fluctuations in production, trade, and economic activity over several months or years. The short-run variation in economic growth is called the business cycle. Economists use it to distinguish between short-run variations in economic growth and long-run economic growth. The cycle is made up of increases and decreases in production that occur over months and years. The changes in the business cycle are a result of fluctuations in aggregate demand .

The Business Cycle

The business cycle is used to determine the short-run variation in economic growth. Variations in the business cycle fluctuation over months and years and are attributed to fluctuations in aggregate demand.

Long-run Economic Growth

Long-run economic growth is measured as the percentage rate increase in the real gross domestic product. The GDP is defined as the market value of all officially recognized final goods and services produced within a country in a given period of time. There are three approaches used to determine the GDP:

• Product (output) approach: adds together the outputs of every class of enterprise to provide the total.
• Income approach: calculates the sum of all the producers’ incomes.
• Expenditure approach: the value of the total product must be equal to the people’s total expenditures.

In principle, all of the approaches should yield the same result for the GDP of a country.

For example, the equation for the expenditure approach is: GDP = C + I + G + (X – M).

Written out in full, the gross domestic product (GDP) equals private consumption (C) plus, gross investment (I), government spending (G), and the exports minus the imports (X – M).

For economic purposes, the economic growth is calculated and compared to the population, also know as per capita income (indicator of a country’s standard of living). When the per capita income increases it is called intensive growth. When the GDP growth is only caused by increases in population or territory it is called extensive growth.

20.2.2: Growth in the United States

The economy in the United States is the world’s largest single national economy; 2013 GDP estimation was $16.6 trillion.

Learning Objective

Describe historical growth in the US

Key Points

• Currently, the U.S. has a mixed economy, a stable GDP growth rate, moderate unemployment, and high levels of research and capital investment.
• Throughout its history, the U.S. has experienced economic growth in varying degrees. Time periods can be broken down by century and by decades.
• The U.S. economy experienced its most extensive growth from 1961 to 1969.

Key Terms

financial crisis

A period of serious economic slowdown characterized by devaluing of financial institutions often due to reckless and unsustainable money lending.

recession

A period of reduced economic activity

economic growth

The increase of the economic output of a country.

Economic Growth

Economic growth is defined as the increase in the market value of the goods and services produced by an economy over time. It is measured as the percentage rate of increase in the real gross domestic product (GDP). To determine economic growth, the GDP is compared to the population, also know as the per capita income. When the per capita income increases it is called intensive growth . When the GDP growth is only cause by an increase in population or territory it is called extensive growth.

U.S. GDP per capita (1929-2010)

This graph shows the GDP per capita in the United States from 1929 to 2010. The GDP per capita is the ratio of the GDP to the population. This graph shows the intensive growth of the United States during this time period.

U.S. Economy

The economy in the United States is the world’s largest single national economy. In 2013, the estimated GDP was $16.6 trillion, which is a quarter of the nominal global GDP. Currently, the U.S. has a mixed economy, a stable GDP growth rate, moderate unemployment, and high levels of research and capital investment.

U.S. Economic Growth

Throughout its history, the U.S. has experienced economic growth in varying degrees. Various historical time periods illustrate the rate of growth:

• Prior to industrialization: technological progress caused an increase in population, which was kept in check by food supply and other resources. The per capita income was limited.
• Industrial Revolution: a period of rapid economic growth. Despite the initial excess of population growth, the growth did eventually slow down; a condition called demographic transition. During the first Industrial Revolution mechanization was introduced. During the second Industrial Revolution, wind and water power replaced human and animal labor. This increased the level of production.
• 20th century growth: most economic growth in the 20th century was due to reduced inputs of labor, materials, energy, and land per unit of economic output. The growth was more balanced because more inputs were used due to the growth of output. Also, this time period experienced the production of new goods and services through innovations.
• 1920s: during this time period there was overproduction which was one cause of the Great Depression in the 1930s. Economic growth resumed following the depression and was aided by the demand for new goods and services (telephones, radios, televisions, etc. ).
• 1940 to 1970: the U.S. economy grew by an average of 3.8% and the real median household income surged 74% (2.1% a year).
• 1960s: the U.S. economy experienced its most extensive periods of economic growth from 1961 to 1969 with an expansion of 53% (5.1% a year).
• 1970s: the economy experienced slower growth after 1973. The average growth was 2.7%, there were stagnant living conditions, and household incomes increased by 10% (0.3% annually). The 1973 oil crisis caused the GDP to fall 3.7%. The GDP fell again in late 1973 to 1975 (3.1%).
• 1980s: the U.S. share of the world GDP peaked in 1985 with 23.78% of global GDP. There was a recession from 1981 to 1982 when the GDP dropped by 2.9% .
• 1990s: there was a mild recession in 1990 to 1991 when the output fell by 1.3%.
• 2000s: one of the worst recessions in recent decades occurred in 2008 when the GDP fell by 5.% in one year. The 2008 financial crisis was caused by a derivatives market, the subprime mortgage crisis, and a declining dollar value.

U.S. GDP vs. Household Income (1989-2011)

This graph shows the relationship of the GDP in the United States to the household income. This period from 1989 to 2011 was hit by a number of recessions.

20.2.3: Growth in the Rest of the World

On a global scale, economic growth is the sum of the growth of individual countries to give a worldwide total.

Learning Objective

Describe historical growth in developing and developed countries

Key Points

• Economic growth and global impact varies by country based on the individual economy, the development of the country, accumulation of human and physical capital, and level of productivity.
• Due to the vast number of countries globally, the world economy is usually determined in monetary terms, even in cases where no efficient market is available to evaluate goods and services.
• From 1990 to 2000 the U.S. dominated in expansion. From 2006 to 2006, China’s expansion moved closer to that of the United States. China led in expansion in 2007.
• The global credit crisis started in 2008 and expanded in 2009. By 2010, the U.S. had experienced some economic recovery while the global economic growth had lost momentum.
• From 2010 to 2018, China is expected to led in expansion. The global economic output is projected to expand.

Key Terms

economic growth

The increase of the economic output of a country.

purchasing power

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

gross domestic product

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

Economic Growth

Economic growth is the increase in the market value of goods and services produced by an economy over a period of time. It is measured as the percentage rate increase in the real gross domestic product (GDP). On a global scale, economic growth is the sum of the growth of individual countries to give a worldwide total. Economic growth and global impact varies by country based on the individual economy, the development of the country, accumulation of human and physical capital, and level of productivity .

Share of World GDP

This image shows the share of GDP worldwide. The economic growth and global impact that each country has is influenced by the individual economy, the development of the country, accumulation of human and physical capital, and level of productivity.

Global Economic Growth

Due to the vast number of countries globally, the world economy is usually determined in monetary terms, even in cases where no efficient market is available to evaluate goods and services. The market valuations are translated into a single monetary unit using the idea of purchasing power. Analyzing economic growth in prominent countries provides an overview of global economic growth .

Change in GDP

This graph shows the change in GDP for countries around the world for 1900 to 1999 and 1999 to 2006. The GDP for each individual country is used to determine the global economic growth.

• 1980 to 1990: during this time period the economic output of 112 countries expanded while the output of 34 countries contracted. The purchasing power expanded for 145 markets and contracted for two. The five largest contributors to global output contraction were Argentina, Saudi Arabia, Nigeria, Venezuela, and Vietnam.
• 1990 to 2000: the United States dominated expansion during these years. The economic output expanded for 122 countries and contracted for 29. The purchasing power increased for 148 markets and contracted for three. The five largest contributors to global output contraction were Italy, Finland, Bulgaria, Algeria, and the Demographic Republic of Congo.
• 2000 to 2006: Expansion in China moved the country closer to the United States. The economic output for 176 countries expanded and four contracted. The five largest contributors to the expansion were the United States, China, Germany, the United Kingdom, and France. The purchasing power increased for 180 markets. The largest global output contributors were the United States, China, India, Japan, and Russia. From 2000 to 2010 these was a rise in developing and emerging economies.
• 2007: The nominal GDP expanded in 183 countries. The largest contributors were China, the U.S., Germany, and the United Kingdom.
• 2008: the credit crisis started. Economic output expanded in 171 countries, but 11 countries experienced output contractions. The United Kingdom accounted for half the global contraction while South Korea accounted for two-fifths. The crisis impacted most countries, but it was not deep enough to reverse growth.
• 2009: the credit crisis spread. The economic output of 127 countries contracted. The United Kingdom was impacted the most, followed by Russia and Germany. 56 countries experienced expansion of economic output, including China, Japan, and Indonesia. The purchasing power contracted for 79 markets. The U.S. was the largest victim and accounted for 18%, followed by Japan and Russia. 104 markets expanded purchasing power including China, India, and Indonesia.
• 2010: the economic output expanded for 148 countries and contracted for 35. The purchasing power increased for 169 markets and contracted for 14. It was noted that banks faced a “wall” of maturing debt. The U.S. experienced economic recovery, but the global economic growth lost momentum.
• 2011 to 2012: in 2011 it was projected that global growth would drop 4% followed by another 3.5% drop in 2012.
• 2010 to 2018: it is projected that China will lead economic growth during this period. The global economic output is expected to expand by $32.9 trillion.

Power of Annual Growth

Over long periods of time, small rates of growth have large economic effects. For example, the United Kingdom experienced a 1.97% average annual increase in its GDP from 1830 to 2008. The growth rate averaged 1.97% over 178 years and resulted in a 32-fold increase in the GDP by 2008. The GDP in 1830 was £41,373. It grew to £1,330,088 by 2008.

A growth rate of 2.5% a year leads to a doubling of the GDP within 29 years. A growth rate of 8% a year leads to a doubling of the GDP in 10 years. As a result, small differences in economic growth rates between countries can produced very different standards of living for the populations if the small growth rate continues for many years.

20.2.4: Catch-Up: Possible, but not Certain

Developing countries can catch up to developed countries by achieving growing faster, which is determined by a wide number of country-specific factors.

Learning Objective

Describe different factors that affect the growth rate of developing economies

Key Points

• Every country is unique based on population, technology, government, wealth, ect. Economic growth can be compared between countries, although no two countries are the same.
• Factors that influence economic growth include: growth of productivity, demographics, labor force participation, human capital, inequality, trade, quality of life, and employment rate.
• The economic growth of any country takes time to develop. Some countries have much larger, stronger, and more developed economies than other countries.
• It is possible, but not certain that smaller, underdeveloped economies can experience economic growth and catch-up to more prominent economies.

Key Terms

economic growth

The increase of the economic output of a country.

gross domestic product

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

demographics

The characteristics of human populations for purposes of social studies.

Economic Growth

Economic growth is defined as the increase in the market value of the goods and services produced by an economy over time. In order to assess economic growth it must be measured. It is the percentage rate of increase in real gross domestic product (GDP). When looking at the long-term economic growth of a country, it is important to analyze the ratio of the GDP to the population (GDP per capita).

For a developing country to catch up to a developed country, it must not only grow, but grow faster than the developed country. It is possible for such accelerated growth to occur, but there are many country-specific factors that affect a country’s ability to catch up to developed countries.

Factors that Impact Economic Growth

There are specific factors that have a direct impact on the economic growth of a country. Every country is unique based on population, technology, government, wealth, etc. Economic growth can be compared between countries, although no two countries are the same. Some of the factors that impact economic growth include:

• Growth of productivity: the growth of productivity is the ratio of economic output to input (capital, labor, energy, materials, and services). When productivity increases the cost of goods decreases causing an increase in the per capita GDP. Lower prices create an increase in higher aggregate demand. The growth of productivity is the driving force behind economic growth.
• Demographics: demographics change the employment to population ratio as well as the labor force participation rate. The age structure of the population affects the labor force participation rate. For example, when women entered the workforce in the U.S. it contributed to economic growth, as did the entrance of the baby boomers into the workforce.
• Labor force participation: the rate of labor force participation impacts economic growth. It is the number of people working in the labor force. When manufacturing increased, it created a higher productivity rate, but lowered the labor force participation, prices fell, and employment shrank.
• Human capital: human capital is referred to as the skills of the population. Education is a commonly used measurement for human capital. Human capital increases the society’s skill which increases economic growth.
• Inequality: inequality in wealth and income has a negative impact on economic growth. Inequality results in high and persistent unemployment. This has a negative effect on long-run economic growth.
• Trade: international trade represents a significant part of GDP for most countries. It is the exchange of goods and services across national borders.
• Quality of life: happiness has been shown to increase with a higher GDP per capita. Quality of life is a direct result of economic growth. When poverty is alleviated and society has access to what it needs, the quality of life increases. Consistent quality of life leads to continued economic growth.
• Employment rate: in order for the employment rate to have a positive impact on economic growth there must also be increases in productivity. If employment increases, but productivity does not, then there is a higher number of working poor.

Economic Growth in Developing Countries

The economic growth of any country takes time to develop. Some countries have much larger, stronger, and more developed economies than other countries . The study of the economic aspects of development in low-income countries is called development economics. It focuses on methods for promoting economic development. All of the factors listed previously impact economic growth – most of them positively. It is possible, but not certain that smaller, underdeveloped economies can experience economic growth and catch-up to more prominent economies.

Change in GDP

This graph shows the change in GDP for various countries for the periods of 1990 to 1998 and 1990 to 2006. It is obvious that certain countries have larger and more developed economies than other countries. It is possible for countries with weaker economies to catch up with larger countries, but it is not certain.

20.3: Productivity

20.3.1: The Importance of Productivity

Increasing productivity is a rare win-win, improving the standard of living from a governmental, commercial and consumer perspective.

Learning Objective

Use the production function to determine how different variables affect output and productivity

Key Points

• Productivity is essentially the efficiency in which a company or economy can transform resources into goods, potentially creating more from less.
• Productivity can effectively raise living standards through decreasing the required monetary investment in everyday necessities (and luxuries), making consumers wealthier and business more profitable and in turn enabling higher government tax revenues.
• Economists looking to measure this productivity within a given system generally leverage production functions to determine how different factors of production (i.e. inputs) affect the overall output.
• The final important consideration in assessing productivity potential is the production-possibility frontier (PPF), which outlines the maximum production quantity of two goods in the scope of our current technological capacity and supply.

Key Terms

productivity

the rate at which goods or services are produced by a standard population of workers.

Production function

Relates physical output of a production process to physical inputs or factors of production.

Productivity is essentially the efficiency in which a company or economy can transform resources into goods, potentially creating more from less. Increased productivity means greater output from the same amount of input. This is a value-added process that can effectively raise living standards through decreasing the required monetary investment in everyday necessities (and luxuries), making consumers wealthier (in a relative sense) and businesses more profitable.

From a broader perspective, increased productivity increases the power of an economy through driving economic growth and satisfying more human needs with the same resources. Increased gross domestic product (GDP) and overall economic outputs will drive economic growth, improving the economy and the participants within the economy. As a result, economies will benefit from a deeper pool of tax revenue to draw on in generating necessary social services such as health care, education, welfare, public transportation and funding for critical research. The benefits of increasing productivity are extremely far-reaching, benefiting participants within the system alongside the system itself.

Productivity Beneficiaries

To expand upon this, there are three useful perspectives in which to frame the value in improving productivity within a system from an economic standpoint:

• Consumers/Workers: At the most micro level we have improvements in the standard of living for everyday consumers and workers as a result of increased productivity. The more efficiency captured within a system, the lower the required inputs (labor, land and capital) will be required to generate goods. This can potentially reduce price points and minimize the necessary working hours for the participants within an economy while retaining high levels of consumption.
• Businesses: Businesses that can derive higher productivity from a system also benefit from creating more outputs with the same or fewer inputs. Simply put, higher efficiency equates to better margins through lower costs. This allows for better compensation for employees, more working capital and an improved competitive capacity.
• Governments:Higher economic growth will also generate larger tax payments for governments. This allows governments to invest more towards infrastructure and social services (as noted above).

Factors Affecting Productivity

The final important consideration in assessing productivity potential is the production-possibility frontier (PPF), which essentially outlines the maximum production quantity of two goods (in the scope of our current technological capacity and supply). This demonstrates the confinement of productivity, and thus is well captured in the Leontief production function. The critical takeaway here is that the production function will generally be affected by two things: overall supply and technological capabilities. Note that demand does not come into account in altering the production function or overall productivity potential. The illustration in the following figure demonstrates an increase in PPF, thus affecting the production function.

Production-Possibility Frontier Expansion

In this graph, the prospective production-possibility frontier shifts to the right, implying a higher supply or improved technological production ability of the two goods being discussed (in this case guns and butter).

20.3.2: Measuring Productivity

Productivity is represented by production functions, and is the amount of output that can be generated from a set of inputs.

Learning Objective

Discuss different ways to measure productivity and productivity growth

Key Points

• From an economic standpoint, the production function demonstrates the tangible output created as a result of a production process including all tangible inputs.
• The objective in employing this perspective is to pursue allocative efficiency within the process (as opposed to technical or logistical efficiency, as engineers or supply chain managers may be pursuing).
• Generally speaking, the factors of production include land, labor and capital.
• There are a variety of ways to approach the measuring of productivity in the context of production functions, including the functional form, the linear form, the Cobb-Douglas production Function and the Leontief Production Function.

Key Terms

Allocative efficiency

A type of economic efficiency in which economy/producers produce only those types of goods and services that are more desirable in the society and also in high demand.

Liquid assets

An asset in the form of money or cash in hand, or an asset which can be quickly converted into cash without losing much value.

Productivity, in economic terms, measures inputs and outputs to derive overall production efficiency within a system. Simply put, it measures how much can you get out of what you put into a given system. Increased productivity means more output is produced from the same amount of inputs. In order to generate meaningful information about the productivity of a given system, production functions are used to measure it. Understanding the way in which productivity metrics function, one can more comprehensively grasp the concept and employ it in a meaningful way.

Production Function

From an economic standpoint, the production function demonstrates the tangible output created as a result of a production process including all tangible inputs. The objective in employing this perspective is to pursue allocative efficiency within the process (as opposed to technical or logistical efficiency, as engineers or supply chain managers may be pursuing). This means that the production function identifies optimal inputs (and consequent outputs) to satisfy the needs of a given population via a particular production process. While different economic perspectives often identify different factors of production (i.e. inputs in the system), it is useful to identify the following:

• Land/Natural Resources:Products of nature that have economic value, including metals/agriculture/livestock/land/etc.
• Capital: This is a broad term, capturing more than just financing and investment. Capital can also be fixed capital (i.e. machinery, equipment, buildings, computers, etc.) or working capital (i.e. goods, inventory and liquid assets). Concepts of human, intellectual and social capital is also highlighted, separate from the concept of labor below, which can affect the efficiency of a process.
• Labor: The human skills, time and efforts necessary to add value to the production process. This can range from highly tangible inputs (working hours, products assembled) to highly intangible inputs (entrepreneurship, experience, technology skills, etc.).

Conceptually, the production function makes certain assumptions of the maximum potential production, availability of inputs and demand for outputs to create a boundary of potential production. This will include the derivation of a marginal product for each factor (see ), or essentially the extra output that can be created for each additional unit of input. Naturally, this is theoretically subjected to the concept of diminishing marginal returns, where the marginal product of a given input (in the figure we are illustrating labor) will fall as the starting points for quantity rise.

Product Function

This graph illustrates the way in which a production function identifies the relationship between a quantity of inputs and the resulting output of a given product. This takes into account marginal and average product, which are indicative of the change in efficiency based upon inputs.

Forms of the Production Function

There are a variety of ways to approach the measuring of productivity in the context of production functions:

• Functional Form: One way a production function can be illustrated is through the following equation
  . In this circumstance ‘Q’ is the quantity of output while each ‘x’ is a factor input.
• Linear Form: While this is generally not practical in practice, it is also possible to represent this in a linear mathematical fashion if parameters (a, b, c, and d below) are identified: 
• Cobb-Douglas Production Function: One of the most useful frameworks, that allow for a technological relationship to be illustrated between the amount of two (or more) inputs is the Cobb-Douglas model. This is most often used to illustrate how physical capital and labor effect one another (see ). In the equation, ‘Y’ is total production while ‘L’ is labor, ‘K’ is capital, ‘A’ is total factor productivity and the alpha and beta are the elasticity of the two inputs. 
• Leontief Production Function: The Leontief Production Function assumes a technologically pre-determined set of proportions for the factors of production (i.e. no ability to substitute between factors. This is specifically designed to capture minimums or limiting cases of production. The ‘z’s in the equation are inputs of specific goods while the a and b represent the technological determined constants and ‘q’ being the overall output: 

Cobb-Douglas Production Function

This is an illustration of a two-input Cobb-Douglas Production Function, where the ability to benchmark an output in comparison to two separate quantities of inputs is feasible.

20.3.3: Impacts of Technological Change on Productivity

Technological advances play a crucial role in improving productivity, and thus the standard of living in a system.

Learning Objective

Analyze how changes in technology affect productivity and productivity growth

Key Points

• Productivity growth is bound by what is called the production-possibility frontier (PPF), which essentially stipulates a series of maximum amounts of two commodities that can be generated using a fixed amount the relevant factors of production.
• The variance in technological advances that have driven productivity upwards is remarkable, underlining the ongoing importance of focusing on technology as a primary change agent.
• Advances in energy systems, transportation, communication, logistics, and a variety of other technological trajectories have greatly enabled an increased standard of living through advancing productivity.
• Measuring the affects of technology on productivity is a difficult pursuit. It is generally approached through metrics such as Gross Domestic Product (GDP), GDP per capita, and Total Factor Productivity (TFP).

Key Terms

Production-Possibility Frontier (PPF)

A graph that shows the various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production.

productivity

A ratio of production output to what is required to produce it (inputs).

Productivity measures the way in which an economic system or business can leverage available functional inputs to generate meaningful outputs. This concept drives economies towards higher degrees of efficiency in production and thus higher economic growth and standards of living. As a result, improving productivity is a critical objective for societies to increase their relative wealth. Technological advances play a crucial role in improving productivity, and thus the standard of living in a system.

Production-Possibility Frontier

Productivity growth is bound by what is called the production-possibility frontier (PPF), which essentially stipulates a series of maximum amounts of two commodities that can be generated using a fixed amount the relevant factors of production . In the context of a given PPF, only an increase in overall supply of inputs or a technological advancement will allow for the PPF to shift out and allow for an increase in potential outputs of both goods simultaneously (represented by point ‘X’ in the figure). The shift due to changes in technology represents increased productivity. This is a critical component in understanding the role of technology in productivity, as it is a primary influence on increasing the prospective production possibilities.

Production-Possibility Frontier (PPF)

This graph illustrates the varying theoretical takeaways from a PPF chart. On this, points B, C, and D all lie on a maximum output level, while A is representative of a realistic but inefficient amount. X is beyond the scope of the PPF graph, and thus requires a technological improvement or increase in supply.

Technological Advances: Past, Present, and Future

The variance in technological advances that have driven productivity upwards is remarkable, underlining the ongoing importance of focusing on technology as a primary change agent. Innovative advances in technologies can be either leaps or increments, although the larger technological advances tend to take the limelight. In general, there are a particularly notable categories:

• Energy: Historically, animals and humans were the primary energy input for the generation of products. This was extremely expensive and time-consuming relative to more modern ways to power things, and has been improved upon dramatically over time. Electricity, heat, steam, water, solar, and a wide variety of other energy capturing methodologies have dramatically increased efficiency while freeing up man hours.
• Transportation and Industrial Machinery: Trade has been a part of human history for nearly as long as civilizations knew of one another, bartering being the a central component of human interaction. The improvement of trade venues, such as boats, cars, planes, trains, etc. have enabled rapid increases in trade quantity and efficiency. Similarly, industrial machinery utilizing similar vehicles have enabled mass increases in scale and efficiency, particularly agriculture .
• Communication:Needless to say, the internet and mobile communications have rapidly expedited the transmission of knowledge, data, information, and networking. This has resulted in a massive increase in synergy across the world, alongside the development of economic learning and development.
• Logistics: Increases in technological systems is generally considered to be a tangible innovation, but is not limited to such. Improvements in the ways in which we do things is often just as useful. Henry Ford is a classic example of this, innovating the assembly line to maximize the efficiency the production process through strategic implementation of labor roles.

Implications on Productivity

Measuring the effects of technology on productivity is a difficult pursuit. It is generally approached through metrics such as Gross Domestic Product (GDP), GDP per capita, and Total Factor Productivity (TFP). The former two attempt to capture the overall output of a given economy from a macro-environmental perspective. The latter is slightly more interesting, attempting to measure technologically driven advancement through noting increases in overall output without increases in inputs. This is done through utilizing production function equations and identifying when the output is greater than the supposed input, implying an advance in the external technological environment. This system is more specifically tailored for technological change than GDP.

Wheat Yield

Over the past 60 years, wheat yield (PPF) has dramatically improved as a result of critical technological and logistic advancements.

20.4: Long-Run Growth

20.4.1: Determinants of Long-Run Growth

Long-run growth is defined as the sustained rise in the quantity of goods and services that an economy produces.

Learning Objective

Predict how population growth will affect the level of capital per worker

Key Points

• Economic growth is the increase in the market value of the goods and services that an economy produces over time. It is measured as the percentage rate change in the real gross domestic product (GDP).
• Determinants of long-run growth include growth of productivity, demographic changes, and labor force participation.
• When the economic growth matches the growth of money supply, an economy will continue to grow and thrive.
• Inflation occurs in an economy when the prices of goods and services continue to rise while the purchasing power decreases.
• When the GDP growth is only caused by increases in population, the growth is excessive.

Key Terms

inflation

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

economic growth

The increase of the economic output of a country.

Long-Run Growth

Economic growth is the increase in the market value of the goods and services that an economy produces over time. It is measured as the percentage rate change in the real gross domestic product (GDP) .

Measuring the GDP

Economic growth is the percentage rate increase in the GDP. Long-run growth is directly impacted by the GDP.

Long-run growth is defined as the sustained rise in the quantity of goods and services that an economy produces. The GDP of a country is closely tied to the growth of the population in addition to prices and supply and demand.

Determinants of Long-Run Growth

There are specific determinants that impact the long-run growth of an economy:

• Growth of productivity: is the ratio of economic outputs to inputs (capital, labor, energy, materials, and services). When the productivity increases the cost of goods is lowered. Lower prices increase the demand for the product or service. An increase in demand can lead to higher revenue.
• Demographic changes: demographic factors influence economic growth by changing the employment to population ratio. Factors include the quantity and quality of available natural resources. Age structure of the population also influences employment and long-run growth.
• Labor force participation: the amount of labor force participation and the size of economic sectors influence economic growth. The labor force participation is the amount of workers available. In countries with high development and industrialization, labor force participation is high because of low birth and death rates.

Inflation and Excessive Growth

When the economic growth matches the growth of money supply, an economy will continue to grow and thrive. In this case, population growth would increase, but the need for goods and services would also increase. As a result, more jobs would be available and the employment rate would also increase.

However, when economic growth is not balanced, the result can include inflation and excessive growth. Inflation occurs when the price of goods and services are rising which causes purchasing power to fall if wages don’t also rise . A decrease in the demand for goods and services will lead to a decrease in revenue and employment. A high rate of population growth will cause less capital per worker, lower productivity, and lower GDP growth.

Inflation

Inflation occurs when the price of goods and services are rising which causes purchasing power to fall if wages don’t also rise. Inflation is a negative effect of economic growth that is not balanced.

When the GDP growth is only caused by increases in population (not increases in supply, demand, revenue) the growth is excessive. In order for an economy to be successful, it must meet the needs of the population (supply, demand, revenue, and employment). When a population grows too fast the economic system cannot support the changes. Excessive growth leads to an imbalance in supply and demand and higher levels of unemployment. The quality of living decreases when the economy cannot support the population growth.

20.4.2: Aggregate Production

The aggregate production function examines how the productivity depends on the quantities of physical capital per worker and human capital per worker.

Learning Objective

Discuss how aggregate production impacts long-run growth

Key Points

• Aggregate production functions create an estimated framework to determine how much of an economies’ growth is related to changes in capital or changes in technology.
• The aggregate production function describes the boundary representing the limit of output attainable from each feasible combination of input.
• The aggregate production takes the physical outputs and inputs into account to determine the allocative efficiency of the economy as a whole.
• The long-run growth of a firm can change the scale of operations by adjusting the level of inputs that are fixed in the short-run, which shifts the production function upward as plotted against the variable input.

Key Terms

physical capital

A physical factor of production (or input into the process of production), such as machinery, buildings, or computers.

human capital

The stock of competencies, knowledge, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value.

Aggregate Production

The aggregate production function examines how productivity, or real GDP per worker, depends on the quantities of physical capital per worker and human capital per worker. The production function relates the physical outputs of production to the physical inputs or factors of production. The aggregate production takes the physical outputs and inputs into account to determine the allocative efficiency of the economy as a whole.

Aggregate production functions create an estimated framework to determine how much of an economy’s growth is related to changes in capital or changes in technology. Production functions assume that the maximum output is attainable from a given set on inputs. The aggregate production function describes the boundary representing the limit of output attainable from each feasible combination of input.

To understand how the aggregate production impacts long-run growth, it is important to understand the stages of production :

Graphing Production

The production function of a firm or economy can be graphed using the total, average, and marginal products. The aggregate production is determined based on the stages of production and the results of the graph.

• Stage 1: the variable input is being used with increasing output per unit. The average physical product is at its maximum.
• Stage 2: output increases at a decreasing rate and the average and marginal physical product are declining. The average product of fixed inputs are still rising. The optimum input/output combination will be reached.
• Stage 3: variable input is too high relative to the available fixed inputs. The output of both fixed and variable input declines.

Aggregate Production and Long-Run Growth

The long-run growth of a firm can change the scale of operations by adjusting the level of inputs that are fixed in the short-run, which shifts the production function upward as plotted against the variable input. Aggregate production functions study the short-run inputs and outputs of a firm or economy. The results allow adjustments to be made which improves the long-run growth by balancing the inputs and outputs.

20.4.3: Changing Worker Productivity

In economics and long-run growth, worker productivity is influenced directly by fixed capital, human capital, physical capital, and technology.

Learning Objective

Examine the role of human capital in production and economic growth

Key Points

• Human capital is defined as the stock of competencies, skills, and knowledge that allows individuals to produce economic value.
• Human capital has been show to increase economic development, productivity growth, and innovation.
• When individuals and societies invest in human capital it strengthens the future of the long-run economic growth. The qualitative and quantitative progress of a country is inevitable when human development is a priority.
• When a society invests in human capital, it increases worker productivity and economic growth. Human capital grows cumulatively over a long period of time.

Key Terms

human capital

The stock of competencies, knowledge, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value.

productivity

A ratio of production output to what is required to produce it (inputs).

Worker Productivity

In economics and long-run growth, worker productivity is influenced directly by fixed capital. The four types of fixed capital include: useful machines, instruments of the trade; buildings as the means of procuring revenue; improvements of land; and the acquired and useful abilities of all the inhabitants or members of society.

One way to increase worker productivity is to invest in better machinery, for example. A worker with a more productive tool in more productive.

Another way to increase productivity is to find ways to increase the revenue of the product generated by the workers. Since productivity is measured in dollars per worker, being able to generate more revenue from the same output is reflected in an increase in worker productivity.

Perhaps most interesting, though, is how to change worker productivity through human capital.

Human Capital

Human capital is defined as the stock of competencies, knowledge, social and personal attributes, including creativity, embodied in the ability to perform labor so as to produce economic value. Many economic theories tie education to economic growth explaining that it is an investment in human capital development . Human capital has been shown to increase economic development, productivity growth, and innovation.

Education

Education increases human capital and worker productivity.

A human resource is transformed into human capital with the effective inputs of education, health, and moral values. When individuals and societies invest in human capital it strengthens the future of the long-run economic growth. The qualitative and quantitative progress of a country is inevitable when human development is a priority. Over time, when worker productivity increases the quality and quantity of the goods and services will also increase.

Importance of Worker Productivity

When a society invests in human capital, it increases worker productivity and economic growth. Human capital and increased worker productivity are critical because they are different from the tangible monetary capital or revenue. It is important thought that an economy recognizes the importance of monetary capital. Worker productivity in the long-run is related to real income. If the real income falls over time it will negatively impact worker productivity. Economic revenue goes up and down due to shocks in the business cycle. Human capital grows cumulatively over a long period of time. When a society focuses on human capital and in turn worker productivity, the long-run economic growth will be steady. Economic inputs towards education, health, and worker productivity impacts future generations by ensuring that they will be more advanced and efficient than the current generation. The increase in worker efficiency is the direct result of a superior quality of manpower created through increased human capital.

20.4.4: Technological Change

In economics, technological change is a term used to describe the change in a set of feasible production possibilities.

Learning Objective

Assess the value of technology to a nation’s economic growth

Key Points

• Growth is defined as the increase in output per capita of a country over a long period of time. One primary factor that influences the growth of an economy is technological change.
• When looking at long-run growth, technological change in the economic environment makes production more or less efficient.
• Technology is defined as the making, modification, usage, and knowledge of tools, machines, techniques, systems, and methods of organization in order to solve a problem, improve a preexisting solution to a problem, or achieve a goal.
• The expansion and sharing of technology leads to the further development of goods, processes, applications, materials, and services. All of these areas are critical to the advancement of an economy in the long-run.
• The expansion and sharing of technology leads to the further development of goods, processes, applications, materials, and services. All of these areas are critical to the advancement of an economy in the long-run.

Key Terms

technology

The study of or a collection of techniques.

output

Production; quantity produced, created, or completed.

Technological Change

In economics, growth is defined as the increase in output per capita of a country over a long period of time. One primary factor that influences the growth of an economy is technological change. Technological change is a term used to describe the change in a set of feasible production possibilities. Technological improvement has the ability to increase the amount of output an economy can produce, even if the level of inputs remains constant .

Technological Change

Technological change causes the production possibility frontier to shift outward and initiate economic growth.

Technology and Long-Run Growth

Technology is defined as the making, modification, usage, and knowledge of tools, machines, techniques, systems, and methods of organization in order to solve a problem, improve a preexisting solution to a problem, or achieve a goal . In economics, improvements in technology have helped develop more advanced economies (for example, today’s global economy).

ENIAC

ENIAC, the first general purpose computer, was a technological advancement that affected both productivity and the types of outputs that could be produced.

In a developing country, the government works to ensure that the technologies, skills, knowledge, and methods of manufacturing are tested and developed so that they can be passed on to a broader audience. The expansion and sharing of technology leads to the further development of goods, processes, applications, materials, and services. All of these areas are critical to the advancement of an economy in the long-run.

The field of economics is constantly evolving as is the production of goods and services. In order to advance and continue to grow all markets need to make use of new technology to stay competitive. In the case of long-run economic growth, using the most advanced technology provides a market with a competitive advantage. Advances in technology creates an increased level of output with the same inputs, which improves productivity.

20.4.5: Government Activity

Government activity and policies have a direct impact on long-run growth. It can invest, and operate through monetary and fiscal policy.

Learning Objective

Discuss the long-run implications on growth from government policies

Key Points

• Long-run growth is the increase in the market value of goods and services produced by an economy over a period of time.
• The government may choose to invest in projects that are associated with long-term growth, such as infrastructure.
• Monetary and fiscal policy are used to regulate the economy, economic growth, and inflation so that long-run growth is possible.
• Government activities used to improve long-run growth include stimulating economic growth, enacting monetary policies, fixing the exchange rates, and using wage and price controls.

Key Terms

economic growth

The increase of the economic output of a country.

monetary policy

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

Economic Growth

In macroeconomics, long-run growth is the increase in the market value of goods and services produced by an economy over a period of time. The long-run growth is determined by percentage of change in the real gross domestic product (GDP) . In order for an economy to experience positive long-run growth its outputs and inputs must be in balance for an increase to occur in supply, demand, revenue, and employment. The long-run economic growth is determined by short-run economic decisions.

Gross Domestic Product

The change in GDP is used to determine economic growth within a country.

Government Activity

Government activity and policies have a direct impact on long-run growth. Long-run growth can be redirected and improved when changes are made to short-run actions. When an economy or industry experiences imbalanced in economic growth, the government can respond in order to assist in securing the market. Examples of possible government activity include:

• Investment: the government can stimulate economic growth by investing in the economy. Examples of stimulants include investing in market production, infrastructure, education, and preventative health care. This is especially important when excessive growth occurs. The government must stimulate economic growth to meet the needs of an increasing population.
• Monetary policy: the government enacts monetary policies to keep the growth rate of money steady. This helps to control excess inflation and excess short-term growth, both of which can negatively affect long-run growth. It’s important to note, however, that fiscal policy can also affect the level of inflation within an economy.
• Fiscal Policy: Choices in tax structure, government spending, and economic regulation can all impact long-run growth by affecting the choices that businesses and individuals make.

Government activity impacts long-run growth. It is critical that increasing populations have access to productive resources. It is also important that markets stay balanced in order to be successful and thrive.

20.4.6: Arguments in Favor and Opposed to Economic Growth

Economic growth has the potential to make all people richer, but may have downsides such as increased inequality and environmental impacts.

Learning Objective

Compare and contrast the consequences of economies in which growth is a goal

Key Points

• Over the long-run economic growth looks at the growth of the ratio of GDP to the population. Economic growth is an expansion of the economic output of a country.
• Arguments in support of economic growth include increased productivity, the expansion of power, and an increase in the quality of life.
• Arguments opposed to economic growth include resource depletion, environmental impacts, and equitable growth.

Key Terms

quality of life

The general well-being of societies, including not only wealth and employment, but also the environment, physical and mental health, education, recreation and leisure time, and social belonging.

economic growth

The increase of the economic output of a country.

Economic Growth

Economic growth is defined as the increase in the market value of goods and services produced by an economy over a period of time. It is measured as the percentage increase in the real gross domestic product (GDP) . In other words, economic growth is an expansion of the economic output of a country. Over the long-run economists might look at the per-capita rate of GDP growth (the growth of the ratio of GDP to the population).

GDP

The percentage increase in the GDP of a country is used to measure the country’s economic growth.

Arguments in Favor of Growth

There are numerous arguments in support of economic growth that describe its positive impact on society. Arguments in favor of economic growth include:

• Increased productivity: in countries that experience positive economic growth, the growth is often attributed to an increase in human and physical capital. Also, economic growth is usually accompanied by new and improved technological innovations.
• Expansion of power: economic growth is influential within a country even if the percentage of growth is small. With a small growth rate, a country will experience a substantial increase in power over the long-run. For example, a growth rate of 2.5% per annum leads to a doubling of the GDP within 29 years. In contrast, a growth rate of 8% per annum leads to a doubling of the GDP within 10 years. The power expansion associated with economic growth has long-run influences on a country.
• Quality of life: the quality of life increases in countries that experience economic growth. Economic growth alleviates poverty by increasing employment opportunities and labor productivity. It has been found that happiness increases with a higher GDP per capita, up to a level of at least $15,000 per person.

Arguments Opposed to Growth

There are a series of arguments that are opposed to economic growth. Arguments opposed to growth include:

• Resource depletion: economic growth has the potential to deplete resources if science and technology do not produce viable substitutes or new resources. Also, some arguments state that better technology and more efficient production will deplete resources quicker in the long-run even though advancements are perceived as positive right now.
• Environmental impact: some argue that a narrow view of economic growth combined with globalization could collapse the world’s natural resources. Portions of society have advocated the ideas of uneconomic growth and de-growth (economic contraction) in an attempt to lessen these effects of economic growth.
• Equitable growth: it has been found that while economic growth has a positive impact on society as a whole, it is common that poor sections of society are not able to participate in economic growth. Economic growth has many positive effects, but a society must not favor economic growth over solving pressing social issues such as poverty. For example, in a country with low inequality, a country with a growth rate of 2% per head and 40% of the population living in poverty can halve the poverty in 10 years. In contrast, if the same country has high inequality it will take nearly 60 years to achieve the same level of poverty reduction.

20.5: The Impact of Policy on Growth

20.5.1: Incentivizing Saving and Investment

The government can incentivize savings and investment by changing the relative cost of taking each action.

Learning Objective

Explain how the governments incentivize saving and investment

Key Points

• Monetary policy seeks to encourage investment by lowering interest rates and to encourage savings by borrowing them.
• Governments give tax breaks to industries in which it wants to encourage investment.
• Governments can also make certain types of savings tax exempt if it wishes to encourage savings.

Key Term

monetary policy

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

Governments have a strong interest in affecting the savings and investments in an economy. Both savings and investment affect the overall economy. For example, if an economy is overheating, a government might want to disincentivize investment or consumption, and would therefore be interested in increasing the savings rate. If an economy is in a recession, a government would want to encourage savers to start spending or investing their money .

US Savings Rate

The US government may want to increase the savings rate if the economy is in a downturn, and increase it if the economy is overheating.

There are a number of ways in through which a government can incentivize savings and investment. Broadly, each incentive adjusts the cost of saving or investing. We will discuss two main ways to affect the savings and investment rates here.

Monetary Policy

One of the main tools of central banks is the interest rate that it charges banks to hold their money overnight. This rate is ultimately passed on to the bank’s depositors. Depositors, in turn, adjust their levels of savings and investment based on that rate.

Take, for example, a high interest rate. At a high interest rate, it is very expensive to borrow money: investors will not want to invest because they have to pay a lot of interest on their loans. Savers, on the other hand, love high interest rates: they earn a lot simply by keeping their cash in the bank. High interest rates encourage savings and discourage investment.

The precise opposite is true for low interest rates. When rates are low, investors know they can borrow money to finance investments cheaply. At the same time, savers aren’t earning much by keeping their money in the bank. Low interest rates encourage investment and discourage savings.

Much of a central bank’s actions are focused on adjusting how much people save and invest.

Taxes

The government can also incentivize savings and investment in a number of ways. The most common way of doing so is by adjusting tax rates. Governments offer individuals and firms who take the action it desires. For example, a government can offer a tax break to companies that are investing in a desirable area (e.g. medicine). It can also encourage savings through tax breaks. Roth IRAs are an instrument for saving for retirement that the US has made tax exempt (under certain conditions). In the first example, the government uses tax reductions to encourage investment for companies. In the second, the government encourages saving by helping savers earn more of the interest they earn over time in the savings vehicle.

20.5.2: Improving Education and Health Outcomes

A country can impact its long-term growth by affecting human capital through education and healthcare investments.

Learning Objective

Analyze the long-run implications on growth from education and healthcare policies

Key Points

• Both education and healthcare systems have short- and long-term costs, but can also be viewed as investments in human capital.
• Education economics studies the relationship between schooling and the labor market.
• Health economics is the branch of economics that focuses on issues relating to the efficiency, effectiveness, value, and behavior in the production and consumption of health and healthcare.
• According to the World Health Organization, a successful health policy defines a vision for the future, it outlines national priorities regarding health, and it builds a consensus and informs the public.

Key Terms

economic growth

The increase of the economic output of a country.

human capital

The stock of competencies, knowledge, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value.

Both education and healthcare are important because they have short- and long-term costs, and significantly affect the level of human capital in an economy. If a country can set up its education and healthcare systems to maximize the growth of human capital, it can also significantly impact its long-term economic growth prospects.

Education Economics and Policies

Education economics studies economic issues related to education, such as the demand for education and the financial cost of education. It studies the relationship between schooling and the labor market. By making educational policies and spending money now, a country ensures that it will have the necessary human capital to expand its economy.

Human capital requires investment, but also provides economic returns. As education increases human capital increases, countries will also expect to see higher productivity, wages, and the GDP .

Impact of Education on GDP

This graph shows the positive relationship between education and per capita GDP of a country. As the number of years of education within a country increase, so does the per capita GDP.

Economics is one field of study that researches the effectiveness of education policies. Education policies are designed to cover all education fields from early childhood education through college graduate programs. Policies focus on school size, class size, school choice, tracking, teacher education and certification, teacher pay, teaching methods, curricular content, and graduation requirements. To ensure economic growth, a country must have strong education policies.

Health Economics and Policies

Health economics is the branch of economics that focuses on issues relating to the efficiency, effectiveness, value, and behavior in the production and consumption of health and healthcare. In this field, economists study the function of healthcare systems and public health-affecting behaviors. Health economics focuses on the following topics:

• What influences health
• What is health and what is its value
• What is the demand for healthcare
• What is the supply for healthcare
• Macro-economic evaluation at treatment level
• Market equilibrium
• Evaluation of the whole healthcare system
• Planning, budgeting, and monitoring the system

Although health is not directly related to human capital, it is obvious that without health and life human capital will be impacted negatively. Health policies are the decisions, plans, and actions that are undertaken in a country to achieve specific healthcare goals. According to the World Health Organization, a successful health policy defines a vision for the future, it outlines national priorities regarding health, and it builds a consensus and informs the public.

Health policies can have positive long-run effects on not only human capital, but also economic growth as a whole. Health policies are designed to educate society and improve the current and long-term health of a country. Examples of health policy topics include: vaccination policies, tobacco control, and pharmaceutical policies.

Furthermore, healthcare can constitute a large part of a country’s expenditures. Determining the structure of the healthcare system (private, public, regulated, etc.) can have large economic consequences, and therefore is of great interest to the government.

20.5.3: Defining and Defending Property Rights

Property rights are theoretical constructs that determine how a resource is used and owned.

Learning Objective

Explain the economic consequences of property rights

Key Points

• There are four broad components that property rights consist of: the right to use the good, the right to earn income from the good, the right to transfer the good to others, and the right to enforcement of property rights.
• Property usually refers to ownership and control over a good or resource. Ownership means that the entity or individual has the rights to the proceeds of the output that the property generates.
• There are four types of property rights: open access, state, common, and private.

Key Terms

resource

Something that one uses to achieve an objective, e.g. raw materials or personnel.

property rights

The exclusive rights pertaining to the ownership of a given asset.

Property Rights

Property rights are theoretical constructs that determine how a resource is used and owned. Resources can be owned and used by governments, collective bodies, or individuals. There are four broad components of property rights. They are the right to:

• use the good,
• earn income from the good,
• transfer the good to others, and
• enforce the property rights.

Property usually refers to ownership and control over a good or resource. Ownership means that the entity or individual has the rights to the proceeds of the output that the property generates.

Types of Property Rights

Property rights are determined based on the level of transaction costs associated with the rights. The transaction costs are the costs of defining, monitoring, and enforcing the property rights. The four types of property rights are:

• Open access property: this type of property is not owned by anyone. For this reason, no one can exclude anyone else from using it. It is possible though that one’s person use of the property will reduce the quantity available to others. Open access property is not managed by anyone and access to it is not controlled. Examples include the atmosphere or ocean fisheries.
• State property: also known as public property, this type of property is owned by all, but its access and use is controlled by the state. An example would be a national park .
• Common property: also called collective property, this type of property is owned by a group of individuals. The joint owners control the access, use, and exclusion of the property.
• Private property: use of this type of property is exclude. Private property use and access is managed and controlled by a private owner or a legal group of owners.

Defending Property Rights

For any good, property rights must be monitored and the possession of the rights must be enforced. The rights are put in place to control, monitor, and exclude the use of the stated property. Property rights protect not only land, but also goods, services, and finances associated with the land itself. Corruption impacts the private and public sectors because it increases the cost of doing business and distorts markets.

The concept of property rights are closely related to the law in terms of defending the rights. There is a difference between an economist’s view of property rights and the view of the law, but both work together to reach the final goal of securing and maintaining the rights. For example, suppose a thief steals a good. The thief has economic property right to the good because it is in his possession – he has the ability to use the good. However, the thief does not have legal property right to use the good – by law he is not permitted to have access to or use of the good. Economics sets the property rights and the law is used to enforce the rights. Each of the four types of property rights differ in the amount of money and defense needed to ensure that the rights are upheld. The greater the restrictions that property rights place, the more likely that defense of the rights will be needed.

Yosemite National Park

This picture is a view at Yosemite National Park. National parks in the United States are state property. Access and use of the park is controlled and enforced by the state.

20.5.4: Promoting Free Trade

Government can promote free trade by reducing tariffs, quotas, and non-tariff barriers.

Learning Objective

Describe the effects of free trade and trade barriers on long run growth

Key Points

• Free trade allows countries to produce the good in which they have a comparative advantage, which increases overall welfare.
• Tariffs and quotas are explicit government economic protections that reduce the efficiency of global markets.
• Non-tariff barriers like quality standards and customs paperwork are other government-implemented barriers to trade.
• Governments can reduce barriers to free trade unilaterally, bilaterally, or multilaterally.

Key Terms

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

comparative advantage

The ability of a party to produce a particular good or service at a lower margin and opportunity cost over another.

Free trade is a policy by which a government does not discriminate against imports or interfere with exports by applying tariffs (to imports), subsidies (to exports), or quotas. According to the law of comparative advantage, the policy permits trading partners mutual gains from trade of goods and services.

Government Barriers to Free Trade

There are a number of barriers to free trade that governments can mitigate, most importantly, tariffs (government imposed import taxes) and quotas (government imposed limits on the quantity of a good that can be imported). Tariffs and quotas are explicit government policies that are designed to protect domestic producers, even if they are not the most efficient producers .

Loss Due to Tariffs

There are a number of reasons why governments place tariffs or other barriers to free trade, but they necessarily reduce overall societal welfare. Governments can promote free trade and impact economic growth.

In addition to tariffs and quotas, there are a number of other barriers to free trade that countries use. Broadly, they are categorized as non-tariff barriers (NTBs). NTBs come in a variety of forms. One example of an NTB are product standard requirements. A country can set high quality standards for a product, knowing that not all foreign producers will be able to meet the standard. Another way that countries can implement NTBs is through customs procedures. Countries can force foreign exporters to fill out arduous paperwork over the course of months, and perhaps in a language the foreign producer does not speak. NTBs act just like tariffs and quotas in that they are barriers to free trade.

Government Promotion of Free Trade

Countries that recognize the benefits for growth from promoting free trade can take unilateral, bilateral, or multilateral action to reduce some of these barriers to trade.

Unilateral promotion of free trade is when a country decides to reduce its own trade barriers without any promise of action from its trading partners. This would lead to a reduction in import prices, but could be unpopular with domestic industries who are not afforded lower barriers in the countries with which they wish to trade.

Bilateral promotion of free trade is when two countries come to an agreement to reduce barriers together. This solves the problem of one country giving the benefit of reduced barriers to foreign exporters without any promise of similar benefits in return.

Multilateral promotion of free trade is when a group of countries agree to reduce their barriers together. Examples of multilateral promotion of free trade are trade agreements such as the North American Free Trade Agreement (NAFTA) in which the US, Mexico, and Canada agreed to allow free trade among one another.

Reducing barriers to free trade may be politically difficult, but due to the law of comparative advantage, will allow for increased overall surplus for each trading partner in the long run.

20.5.5: Investing in Research and Development

The government can establish intellectual property laws, directly conduct research, or finance research and development.

Learning Objective

Describe the appropriate role of government in research and development

Key Points

• Patents are a form of intellectual property rights protection that encourages researchers to invest in research.
• The government can conduct research itself. NASA is an example of a government agency that conducts research and development directly.
• The government offers funding to non-government researchers, often through grants.

Key Terms

intellectual property

Any product of someone’s knowledge that has commercial value: copyrights, patents, trademarks and trade secrets.

research and development

The process of discovering and creating new knowledge about scientific and technological topics in order to develop new products

The government has the ability to encourage or discourage research and development. The government can do so by creating a good structure of intellectual property protection, called, broadly, patent law. It can also directly intervene and encourage or discourage research and development in a specific area of interest to the government or society that is not currently being addressed by the market.

Investing in research and development is important because it can result in new products, technologies, or processes. Thus, research and development can improve productivity or simply improve the welfare of society.

This atom will first discuss how the government can establish a patent system, and then ways in which it can directly affect the level of research and development in an economy.

Patents

Patents are temporary monopolies granted to inventors by the government, in exchange for public disclosure of how the invention works. They are one of the basic forms of intellectual property. Essentially, a patent gives the holder the right to exclude others from, among other things, using, selling, and making the claimed invention.

Patents and, more broadly, intellectual property rights, are important because they encourage investment in research. Without intellectual property protection, researchers would be worried that, once they make a breakthrough, competitors would simply sell their product. The original researcher would have made the investment in the research, but would have to compete with others once the research becomes able to generate revenue.

Direct Government Research

When the government directly conducts research, it hires its own scientists, engineers, etc. to study a particular issue. For example, NASA is a government agency that also does research.

Indirect Government Research

The government also finances research and development that it does not directly conduct. Such financing often takes the form of grants given to researchers in companies or organizations by the government. The government incentivizes the researches by making the research financially affordable (or more affordable). Not all research is financed, however. The grants are given to projects that are valuable either to the government or to society as a whole. Such grants can be viewed through the lens of market failure: the open market is not financing a socially or government-desirable project, so the government steps in to correct the failure.

NASA’s Research and Development

The moon landing was the result of research and development conducted directly by a government agency.

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 .

Simple view of expenditures

In an economy, households receive wages that they then use to purchase final goods and services. Since wages eventually are used in consumption (C), the expenditure approach to calculating GDP focuses on the end consumption expenditure to avoid double counting. The income approach, alternatively, would focus on the income made by households as one of its components to derive GDP.

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 .

U.S. GDP Components

The components of GDP include consumption, investment, government spending, and net exports (exports minus imports).

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) .

Circular flow

The circular flow is a simplified view of the economy that provides an ability to assess GDP at a specific point in time.

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):

()

Expenditure accounts

Components of the expenditure approach to calculating GDP as presented in the National Income Accounts (U.S. Bureau of Economic Analysis).

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 .

Global GDP

GDP is a common measure for both inter-country comparisons and intra-country comparisons. The metric is one method of understanding economic growth within a country’s borders.

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).

GDP over time

GDP is measured over consecutive periods to enable policymakers and economic agents to evaluate the state of the economy to set expectations and make decisions.

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 .

GDP across the globe

GDP can be adjusted to compare the purchasing power across countries but cannot be adjusted to provide a view of the economic disparities within a country.

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.

19.2: Other Measures of Output

19.2.1: National Income

A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region.

Learning Objective

Explain the importance of calculating national income.

Key Points

• Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation.
• In order to count a good or service, it is necessary to assign value to it.
• Three strategies have been used to obtain the market values of all the goods and services produced: the product (or output) method, the expenditure method, and the income method.

Key Term

national income

The total amount of goods and services produced within some “boundary. ” The boundary is usually defined by geography or citizenship, and may also restrict the goods and services that are counted.

A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP), net national income (NNI), and adjusted national income (NNI* adjusted for natural resource depletion). All of the measures are especially concerned with counting the total amount of goods and services produced within some boundary. The boundary is usually defined by geography or citizenship, and may also restrict the goods and services that are counted. For instance, some measures count only goods and services that are exchanged for money, excluding bartered goods, while other measures may attempt to include bartered goods by imputing monetary values to them.

Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation. Although some attempts were made to estimate national incomes as long ago as the 17th century, the systematic keeping of national accounts, of which these figures are a part, only began in the 1930s, in the United States and some European countries. The impetus for that major statistical effort was the Great Depression and the rise of Keynesian economics, which prescribed a greater role for the government in managing an economy, and made it necessary for governments to obtain accurate information so that their interventions into the economy could proceed as well-informed as possible .

Expenditure approach

The expenditure approach is a common method for evaluating the value of an economy at a given point in time.

Measuring National Income

In order to count a good or service, it is necessary to assign value to it. The value that the measures of national income and output assign to a good or service is its market value – the price when bought or sold. The actual usefulness of a product (its use-value) is not measured – assuming the use-value to be any different from its market value. Three strategies have been used to obtain the market values of all the goods and services produced: the product or output method, the expenditure method, and the income method.

Product or Output Method

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:

At factor cost = GDP at market price – depreciation + NFIA (net factor income from abroad) – net indirect taxes

Income Method

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

NDP at factor cost = compensation of employees + net interest + rental and royalty income + profit of incorporated and unincorporated NDP at factor cost

Expenditure Method

The expenditure approach focuses on finding the total output of a nation by finding the total amount of money spent and is the most commonly used equational form:

GDP = 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.

19.2.2: Personal Income

Personal income is an individual’s total earnings from wages, investment interest, and other sources.

Learning Objective

Explain personal income

Key Points

• In the United States the most widely cited personal income statistics are the Bureau of Economic Analysis’s (BEA) personal income and the Census Bureau’s per capita money income.
• BEA’s personal income measures the income received by persons from participation in production, from government and business transfers, and from holding interest-bearing securities and corporate stocks.
• The Census Bureau also produces alternative estimates of income and poverty based on broadened definitions of income that include many of these income components that are not included in money income.

Key Term

personal income

An individual’s total earnings from wages, investment enterprises, and other ventures.

Personal income is an individual’s total earnings from wages, investment interest, and other sources.

In the United States the most widely cited personal income statistics are the Bureau of Economic Analysis’s (BEA) personal income and the Census Bureau’s per capita money income. The two statistics spring from different traditions of measurement: personal income from national economic accounts and money income from household surveys.

BEA’s personal income measures the income received by persons from participation in production, from government and business transfers, and from holding interest-bearing securities and corporate stocks. Personal income also includes income received by nonprofit institutions serving households, by private non-insured welfare funds, and by private trust funds. BEA publishes disposable personal income, which measures the income available to households after paying federal and state and local government income taxes. Income from production is generated both by the labor of individuals (for example, in the form of wages and salaries and of proprietors’ income) and by the capital that they own (in the form of rental income of persons). Income that is not earned from production in the current period—such as capital gains, which relate to changes in the price of assets over time—is excluded. BEA’s monthly personal income estimates are one of several key macroeconomic indicators that the National Bureau of Economic Research considers when dating the business cycle. Personal income and disposable personal income are provided both as aggregate and as per capita statistics. BEA produces monthly estimates of personal income for the nation, quarterly estimates of state personal income, and annual estimates of local-area personal income .

Historical personal income by educational attainment

Personal income data can provide governments with useful information in the formulation of public policy to combat income inequality.

The Census Bureau also produces alternative estimates of income and poverty based on broadened definitions of income that include many of these income components that are not included in money income. The Census Bureau releases estimates of household money income as medians, percent distributions by income categories, and on a per capita basis. Estimates are available by demographic characteristics of householders and by the composition of households.

19.2.3: Disposable Income

Disposable income is the income left after paying taxes.

Learning Objective

Define disposable income

Key Points

• Disposable income is total personal income minus personal current taxes.
• Discretionary income is disposable income minus all payments that are necessary to meet current bills.
• Disposable income is often incorrectly used to denote discretionary income.

Key Terms

disposable income

Income left after taxes.

Discretionary Income

Disposable income (after-tax income) minus all payments that are necessary to meet current bills.

Income left after paying taxes is referred to as disposable income. Disposable income is thus total personal income minus personal current taxes . In national accounts definitions:

Disposable income

Disposable income can be spent on essential or nonessential items. Alternatively, it can also be saved. It is whatever income is left after taxes.

Personal income – personal current taxes = disposable personal income

This can be restated as: consumption expenditure + savings = disposable income

For the purposes of calculating the amount of income subject to garnishment, United States federal law defines disposable income as an individual’s compensation (including salary, overtime, bonuses, commission, and paid leave) after the deduction of health insurance premiums and any amounts required to be deducted by law. Amounts required to be deducted by law include federal, state, and local taxes, state unemployment and disability taxes, social security taxes, and other garnishments or levies, but does not include such deductions as voluntary retirement contributions and transportation deductions.

Discretionary income is disposable income minus all payments that are necessary to meet current bills. It is total personal income after subtracting taxes and typical expenses (such as rent or mortgage, utilities, insurance, medical fees, transportation, property maintenance, child support, food and sundries, etc.) needed to maintain a certain standard of living. In other words, it is the amount of an individual’s income available for spending after the essentials (such as food, clothing, and shelter) have been taken care of.

Discretionary income = Gross income – taxes – all compelled payments (bills)

Disposable income is often incorrectly used to denote discretionary income. The meaning should therefore be interpreted from context. Commonly, disposable income is the amount of “play money” left to spend or save.

19.2.4: GDP per capita

Gross domestic product (GDP) per capita is the mean income of people in an economic unit.

Learning Objective

Define GDP per capita and assess its usefulness as a metric.

Key Points

• GDP per capita is often used as average income, a measure of the wealth of the population of a nation, particularly when making comparisons among nations.
• Per capita income is often used to measure a country’s standard of living.
• It is usually expressed in terms of a commonly used international currency such as the Euro or United States dollar, and can be easily calculated from readily-available GDP and population estimates.

Key Term

per capita

per person

Gross domestic product (GDP) per capita is also known as income per person. It is the mean income of the people in an economic unit such as a country or city. GDP per capita is calculated by dividing GDP by the total population of the country.

GDP per capita income as a measure of prosperity

GDP per capita is often used as average income, a measure of the wealth of the population of a nation, particularly when making comparisons to other nations . It is useful because GDP is expected to increase with population, so it may be misleading to simply compare the GDPs of two countries. GDP per capita accounts for population size.

Comparisons of GDP per capita

GDP per capita varies across countries and is highest among developed countries. However, GDP per capita is not an indicator of income distribution in a given country. For this reason GDP per capita may not necessarily be a barometer for the quality of life in a given country.

Per capita income is often used to measure a country’s standard of living. It is usually expressed in terms of a commonly used international currency such as the Euro or United States dollar. It is easily calculated from readily-available GDP and population estimates, and produces a useful statistic for comparison of wealth between sovereign territories. This helps countries know their development status.

However, critics contend that per capita income has several weaknesses as a measure of prosperity, including:

• Comparisons of GDP per capita over time need to take into account changes in prices. Without using measures of income adjusted for inflation, they will tend to overstate the effects of economic growth.
• International comparisons can be distorted by differences in the cost of living between countries that are not reflected in exchange rates. When looking at differences in living standards between countries, using a measure of GDP per capita adjusted for differences in purchasing power parity more accurately reflects the differences in what people are actually able to buy with their money.
• As it is a mean value, it does not reflect income distribution. If the distribution of income within a country is skewed, a small wealthy class can increase GDP per capita far above that of the majority of the population. Median income is a more useful measure of prosperity than GDP per capita because it is less influenced by outliers.

19.3: Comparing Real and Nominal GDP

19.3.1: Calculating Real GDP

Real GDP growth is the value of all goods produced in a given year; nominal GDP is value of all the goods taking price changes into account.

Learning Objective

Calculate real and nominal GDP growth

Key Points

• The following equation is used to calculate the GDP: GDP = C + I + G + (X – M) or GDP = private consumption + gross investment + government investment + government spending + (exports – imports).
• Nominal value changes due to shifts in quantity and price.
• In economics, real value is not influenced by changes in price, it is only impacted by changes in quantity. Real values measure the purchasing power net of any price changes over time.
• Real GDP accounts for inflation and deflation. It transforms the money-value measure, nominal GDP, into an index for quantity of total output.

Key Terms

nominal

Without adjustment to remove the effects of inflation (in contrast to real).

gross domestic product

Known also as GDP, this is a measure of the economic production of a particular territory in financial capital terms over a specific time period.

Example

• Imagine a country with a GDP of $100 in a given year. In the next year the GDP rises to $105 and the inflation rate is %3. Roughly, we can say that real GDP rises to only $102 as the inflation rate accounted for.

Gross Domestic Product

The Gross domestic Product (GDP) is the market value of all final goods and services produced within a country in a given period of time. The GDP is the officially recognized totals. The following equation is used to calculate the GDP:

Written out, the equation for calculating GDP is:

GDP = private consumption + gross investment + government investment + government spending + (exports – imports).

For the gross domestic product, “gross” means that the GDP measures production regardless of the various uses to which the product can be put. Production can be used for immediate consumption, for investment into fixed assets or inventories, or for replacing fixed assets that have depreciated. “Domestic” means that the measurement of GDP contains only products from within its borders.

Nominal GDP

The nominal GDP is the value of all the final goods and services that an economy produced during a given year. It is calculated by using the prices that are current in the year in which the output is produced . In economics, a nominal value is expressed in monetary terms. For example, a nominal value can change due to shifts in quantity and price. The nominal GDP takes into account all of the changes that occurred for all goods and services produced during a given year. If prices change from one period to the next and the output does not change, the nominal GDP would change even though the output remained constant.

Nominal GDP

This image shows the nominal GDP for a given year in the United States.

Real GDP

The real GDP is the total value of all of the final goods and services that an economy produces during a given year, accounting for inflation . It is calculated using the prices of a selected base year. To calculate Real GDP, you must determine how much GDP has been changed by inflation since the base year, and divide out the inflation each year. Real GDP, therefore, accounts for the fact that if prices change but output doesn’t, nominal GDP would change.

Real GDP Growth

This graph shows the real GDP growth over a specific period of time.

In economics, real value is not influenced by changes in price, it is only impacted by changes in quantity. Real values measure the purchasing power net of any price changes over time. The real GDP determines the purchasing power net of price changes for a given year. Real GDP accounts for inflation and deflation. It transforms the money-value measure, nominal GDP, into an index for quantity of total output.

19.3.2: The GDP Deflator

The GDP deflator is a price index that measures inflation or deflation in an economy by calculating a ratio of nominal GDP to real GDP.

Learning Objective

Explain how the calculation of the GDP deflator can measure inflation

Key Points

• The GDP deflator is a measure of price inflation. It is calculated by dividing Nominal GDP by Real GDP and then multiplying by 100. (Based on the formula).
• Nominal GDP is the market value of goods and services produced in an economy, unadjusted for inflation. Real GDP is nominal GDP, adjusted for inflation to reflect changes in real output.
• Trends in the GDP deflator are similar to changes in the Consumer Price Index, which is a different way of measuring inflation.

Key Terms

GDP deflator

A measure of the level of prices of all new, domestically produced, final goods and services in an economy. It is calculated by computing the ratio of nominal GDP to the real measure of GDP.

real GDP

A macroeconomic measure of the value of the economy’s output adjusted for price changes (inflation or deflation).

nominal gdp

A macroeconomic measure of the value of the economy’s output that is not adjusted for inflation.

The GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. It is a price index that measures price inflation or deflation, and is calculated using nominal GDP and real GDP.

Nominal GDP versus Real GDP

Nominal GDP, or unadjusted GDP, is the market value of all final goods produced in a geographical region, usually a country. That market value depends on the quantities of goods and services produced and their respective prices. Therefore, if prices change from one period to the next but actual output does not, nominal GDP would also change even though output remained constant.

In contrast, real gross domestic product accounts for price changes that may have occurred due to inflation. In other words, real GDP is nominal GDP adjusted for inflation. If prices change from one period to the next but actual output does not, real GDP would be remain the same. Real GDP reflects changes in real production. If there is no inflation or deflation, nominal GDP will be the same as real GDP.

Calculating the GDP Deflator

The GDP deflator is calculated by dividing nominal GDP by real GDP and multiplying by 100 .

GDP Deflator Equation

The GDP deflator measures price inflation in an economy. It is calculated by dividing nominal GDP by real GDP and multiplying by 100.

Consider a numeric example: if nominal GDP is $100,000, and real GDP is $45,000, then the GDP deflator will be 222 (GDP deflator = $100,000/$45,000 * 100 = 222.22).

In the U.S., GDP and GDP deflator are calculated by the U.S. Bureau of Economic Analysis.

Relationship between GDP Deflator and CPI

Like the Consumer Price Index (CPI), the GDP deflator is a measure of price inflation/deflation with respect to a specific base year. Similar to the CPI, the GDP deflator of the base year itself is equal to 100. Unlike the CPI, the GDP deflator is not based on a fixed basket of goods and services; the “basket” for the GDP deflator is allowed to change from year to year with people’s consumption and investment patterns. However, trends in the GDP deflator will be similar to trends in the CPI.

19.4: Cost of Living

19.4.1: Introduction to Inflation

Inflation is a persistent increase in the general price level, and has three varieties: demand-pull, cost-push, and built-in.

Learning Objective

Distinguish between demand-pull and cost-push inflation

Key Points

• Inflation is an increase in price levels, which decreases the real value, or purchasing power, of money.
• Demand-pull inflation is an increase in price levels due to an increase in aggregate demand when the employment level is full or close to full.
• Cost-push inflation is an increase in price levels due to a decrease in aggregate supply. Generally, this occurs due to supply shocks, or an increase in the price of production inputs.

Key Terms

inflation

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

demand-pull inflation

A rise in the price level for goods and services in an economy due to greater demand than the economy’s ability to produce those goods and services.

cost-push inflation

A rise in the price level for goods and services in an economy due to increases in the costs of production.

In economics, inflation is a persistent increase in the general price level of goods and services in an economy over a period of time. 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; it is a loss of real value, as a single dollar is able to purchase fewer goods than it previously could.

Types of Inflation

The reasons for inflation depend on supply and demand. Depending on the type of inflation, changes in either supply or demand can create an increase in the price level of goods and services. In Keynesian economics, there are three types of inflation.

Demand-Pull Inflation

Demand-pull inflation is inflation that occurs when total demand for goods and services exceeds the economy’s capacity to produce those goods. Put another way, there is “too much money chasing too few goods. ” Typically, demand-pull inflation occurs when unemployment is low or falling. The increases in employment raise aggregate demand, which leads to increased hiring to expand the level of production. Eventually, production cannot keep pace with aggregate demand because of capacity constraints, so prices rise .

Demand-Pull Inflation

Demand-pull inflation is caused by an increase in aggregate demand. As demand increases, so does the price level.

Cost-Push Inflation

Cost-push inflation occurs when there is an increase in the costs of production. Unlike demand-pull inflation, cost-push inflation is not “too much money chasing too few goods,” but rather, a decrease in the supply of goods, which raises prices .

Cost-Push Inflation

As the costs of production inputs rises, aggregate supply can decrease, which increases price levels.

The reason for decreases in supply are usually related to increases in the prices of inputs. One major reason for cost-push inflation are supply shocks. A supply shock is an event that suddenly changes the price of a commodity or service. (sudden supply decrease) will raise prices and shift the aggregate supply curve to the left. One historical example of this is the oil crisis of the 1970’s, when the price of oil in the U.S. surged. Because oil is integral to many industries, the price increase led to large increases in the costs of production, which translated to higher price levels.

Built-In Inflation

Built-in inflation is the result of adaptive expectations. If workers expect there to be inflation, they will negotiate for wages increasing at or above the rate of inflation (so as to avoid losing purchasing power). Their employers then pass the higher labor costs on to customers through higher prices, which actually reflects inflation. Thus, there is a cycle of expectations and inflation driving one another.

19.4.2: Defining and Calculating CPI

The consumer price index (CPI) is a statistical estimate of the change in prices of goods and services bought for consumption.

Learning Objective

Assess the uses and limitations of the Consumer Price Index

Key Points

• The CPI is calculated by collecting the prices of a sample of representative items over a specific period of time.
• The CPI can be used to index the real value of wages, salaries, pensions, and price regulation. It is one of the most closely watched national economic statistics.
• The equation to calculate a price index using a single item is:
  .
• The equation for calculating the CPI for multiple items is:
  .

Key Terms

market basket

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

consumer price index

A statistical estimate of the level of prices of goods and services bought for consumption purposes by households.

Consumer Price Index

The consumer price index (CPI) is a statistical estimate of the level of prices of goods and services bought for consumption by households. It measures changes in the price level of a market basket of goods and services used by households. The CPI is calculated by collecting the prices of a sample of representative items over a specific period of time. Goods and services are divided into categories, sub categories, and sub indexes. All of the information is combined to produce the overall index of consumer expenditures. The annual percentage change in a CPI is used to measure inflation. The CPI can be used to index the real value of wages, salaries, pensions, and price regulation. It is one of the most closely watched national economic statistics.

Consumer Price Index

The graph shows the consumer price index in the United States from 1913 – 2004. The x-axis indicates year, the left y-axis indicates the Consumer Price Index, and the right y-axis indicates annual percentage change in Consumer Price Index, which can be used to measure inflation.

Calculating CPI using a Single Item

In order to calculate the CPI using a single item the following equation is used:

Calculating the CPI for Multiple Items

When calculating the CPI for multiple items, it must be noted that many but not all price indices are weighted averages using weights that sum to 1 or 100. When calculating the average for a large number of products, the price is given a weighted average between 1 and 100 to simplify calculation. The weighting determines the importance of the quantity of the product on average. The equation for calculating the CPI for multiple items is:

For example, imagine you buy five sandwiches, two magazines, and two pairs of jeans. In the first period, sandwiches are $6 each, magazines are $4 each, and jeans are $35 each. This will be our base period. In the second period, sandwiches are $7, magazines are $6, and jeans are $45.

Market basket at base period prices = 5(6.00) + 2(4.00) + 2(35.00) = 108.00.

Market basket at current period prices = 5(7.00) + 2(6.00) + 2(45.00) = 137.00.

The CPI based on consumption is 127.

CPI Limitations

The CPI is a convenient way to calculate the cost of living and price level for a certain period of time. However, the CPI does not provide a completely accurate estimate for the cost of living. Issues that impede the accuracy of the CPI include substitution bias (consumers substituting goods for others), introducing new products, and changes in quality. The CPI can also overstate inflation because it does not always account for quality improvements or new goods and services.

GDP Deflator vs. CPI

The GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. Unlike the CPI, the GDP deflator is a measure of price inflation or deflation for a specific base year. The GDP deflator differs from the CPI because it is not based on a fixed basket of goods and services. The GDP deflator “basket” changes from year to year depending on people’s consumption and investment patterns. Unlike the CPI, the GDP deflator is not impacted by substitution biases. Despite the GDP being more flexible, the CPI is a more accurate reflection of the changes in the cost of living.

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.

Macroeconomics: Circular Flow of the Economy

Macroeconomics simplifies the complexities of the trading activities in an economy by distilling actions to primary participants and tracing the circular flow of activity between them.

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 .

US Savings Rate

Savings have declined in the US on aggregate since the 1980s, which means that the proportion of income spent on consumption and investment increased.

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.

Equity Markets

Equity markets are the most closely followed of the financial markets. They provide transparent and active trading platforms that promote liquidity and access to funds to on a global scale.

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 Cycles

The phases of a business cycle follow a wave-like pattern over time with regard to GDP, with expansion leading to a peak and then followed by contraction leading to a trough.

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 .

Recessions and panic

Recessions are characterized as periods of fear and uncertainty; historically they also were a time of widespread panic. However, as confidence in the central bank and federal government increased, though fear and uncertainty remain, panic-conditioned “runs” as depicted in the photo above have become an element of the past.

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).

Cycles in the economy

The economy moves through expansion and contraction on a routine basis; policy mechanisms allow for smoother transitions and soften landings.

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 .

Long-run growth rates

Growth in GDP can be significant, especially when annual growth rates are fairly consistent.

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.

Percentage of People Living on Less than $1/Day

This map underlines the overall percentage of people in specific countries living on less than one dollar (USD) per day. The important takeaway is the wide range of countries suffering from varying levels of 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.

Individuals Below National Poverty Line

This graph illustrates the different percentiles of individuals under the poverty line across the world. One criticism of this method is that national poverty lines are not derived objectively in a standardized fashion, and thus there is limited value to this graphic in relative terms.

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.

17.2: Policies for Reducing Poverty

17.2.1: Social Insurance

Social insurance are government-sponsored programs, such as Medicare, that provide benefits to people based on individual contributions to that program.

Learning Objective

Describe the characteristics of social insurance programs

Key Points

• Social insurance programs share four characteristics: they have well-defined eligibility requirements and benefits, have provisions for program income and expenses, are funded by taxes or premiums paid by participants, and have mandatory or heavily subsidized participation.
• Social insurance programs differs from welfare programs in that they take participant contributions into account. Welfare benefits are based on need, not contributions.
• Social Security, Medicare, and unemployment insurance are three well-known social insurance programs in the United States.

Key Term

social insurance

Any government-sponsored program where risks are transferred to and pooled by an organization that is legally required to provide certain benefits.

Social insurance has been defined as a program where risks are transferred to and pooled by an organization (often governmental) that is legally required to provide certain benefits. It is any government-sponsored program with the following four characteristics:

1. The benefits, eligibility requirements, and other aspects of the program are defined by statute;
2. Explicit provision is made to account for income and expenses (often through a trust fund);
3. It is funded by taxes or premiums paid by (or on behalf of) participants (although additional sources of funding may be provided as well); and
4. The program serves a defined population, and participation is either compulsory, or the program is subsidized heavily enough that most eligible individuals choose to participate.

Social insurance differs from welfare in that the beneficiary’s contributions to the program are taken into account. A welfare program pays recipients based on need, not contributions. Medicare is an example of a social insurance program, while Medicaid is an example of a welfare one.

In the United States, Social Security, Medicare, and unemployment insurance are among the most well-known forms of social insurance.

Social Security

Social Security in the U.S. is primarily the Old-Age, Survivors, and Disability Insurance (OASDI) federal insurance program. Social Security is funded through payroll taxes called Federal Insurance Contributions Act tax (FICA) and/or Self Employed Contributions Act Tax (SECA). Tax deposits are collected by the Internal Revenue Service (IRS) and are formally entrusted to the Social Security Trust Funds. Social Security provides monetary benefits to retirees, their spouses and surviving dependent children, and disabled workers .

Social Security Poster

Social Security is one of the best-known social insurance programs in the United States. It provides benefits to retirees, surviving family members, and disabled workers who have contributed to the Social Security Trust Fund through payroll taxes.

Medicare

Medicare is a national program that guarantees access to health insurance for Americans aged 65 and older, younger people with disabilities, and people with certain chronic diseases. Medicare is funded through revenue from FICA and SECA payroll taxes, as well as through premiums paid by Medicare enrollees and general fund revenue from the federal government.

Unemployment Insurance

Unemployment insurance provides a monetary benefit to workers who have become unemployed through no fault of their own. Benefits are generally paid by state governments, and are funded in large part by state and federal payroll taxes levied against employers. These payroll taxes were established by the Federal Unemployment Tax Act (FUTA), and allow the IRS to collect federal employer taxes used to fund state workforce agencies. FUTA covers the costs of administering the Unemployment Insurance and Job Service programs in all states. In addition, FUTA pays one-half of the cost of extended unemployment benefits (during periods of high unemployment) and provides for a fund from which states may borrow, if necessary, to pay benefits.

17.2.2: Public Assistance

Public assistance is the provision of a minimal level of social support for all citizens.

Learning Objective

Define and describe different types of public assistance

Key Points

• Public assistance is provided by the government, charities, social groups, and religious groups. It is funded by government agencies and private organizations.
• Public assistance systems vary by country, but welfare is usually provided to individuals who are unemployed, those with an illness or disability, the elderly, those with dependent children, and veterans.
• Forms of public assistance include monetary payments, subsidies, vouchers, housing assistance, and universal healthcare.

Key Terms

public assistance

Payment made to disadvantaged persons by government in order to alleviate the burdens of poverty, unemployment, disability, old age, etc.

subsidy

Financial support or assistance, such as a grant.

voucher

A piece of paper that entitles the holder to a discount, or that can be exchanged for goods and services.

Public Assistance

Public assistance, also referred to colloquially as welfare, is the provision of a minimal level of social support for all citizens. In most developed countries, public assistance is provided by the government, charities, social groups, and religious groups. It is funded by government agencies and private organizations.

Public assistance systems vary by country, but welfare is usually provided to individuals who are unemployed, those with an illness or disability, the elderly, those with dependent children, and veterans. Individuals must meet specific criteria to be eligible to receive public assistance.

In the United States, the funds for public assistance are given at a flat rate to each state based on population. Each state has to meet certain criteria to ensure that individuals receiving public assistance are being encouraged to work themselves out of welfare. The goal of public assistance is to support individuals who are in need of help while encouraging them to seek employment and better their lives.

Forms of Public Assistance

Public assistance is offered in a variety of forms including:

• Monetary payments: individuals are paid bi-weekly or monthly based on their income level. Individuals must apply for monetary public assistance and meet specific criteria. Monetary payments will be lessened or stopped once the individual’s income reaches a certain level. An example of monetary payments is Temporary Assistance for Needy Families (TANF), which provides a cash benefit to families in need.
• Subsidy: government funded programs that provide assistance to citizens on federal, state, local, and private levels. Subsidies help to provide food, housing, education, healthcare, and financial support to individuals in need. Examples include Medicaid .
• Vouchers: are bonds given out by the government or other welfare organizations. A voucher is worth a certain monetary value and can only be spent on specific goods .
• Housing assistance: provided by the government to ensure that individuals have shelter. In some cases individuals will receive free housing while other will receive housing at a discounted rate. Housing assistance is based on an individual’s level of income.
• Universal healthcare: health care coverage that provides health care and financial protection to all citizens. It provides a specific package of benefits to all members of society with the goal of providing financial risk protection, improved access to health services, and improved health outcomes.