Macroeconomics Unit 2

Unit 2 Chapter 7 Economic growth, business cycles, unemployment, inflation  Macroeconomics is study of aggregate moods of the economy, with specific focus on issues with growth business cycles, unemployment, and inflation. 2 Frameworks  Long term: generally considered with issues of growth o Focuses on incentives for supply (supply-side economics)  Short term: business cycles o Focuses on demand (demand-side economics)  Both: inflation and unemployment Growth  Real gross domestic product (real GDP)- market value of final goods and services produced in an economy, stated in prices of a given year. o Real GDP is GDP adjusted for price changes. o US economic output has grown at an annual 2.5 to 3.5 percent rate  Percent growth rate sometimes called secular growth trend  Per capita real output- real GDP divided by total population. Benefits and costs of growth  Economic growth (per capita) allows everyone in society to have more.  Politically, growth (or predictions of growth) allows gov’t to avoid hard questions. o With growth, there is more to go around for everyone  Material growth comes with costs: pollution, resource exhaustion, and destruction of natural habitat Business Cycles  Business cycle- upward/downward movement of economic activity (or real GDP) that occurs around the growth trend.  2 groups of macroeconomists: o Keynesians- generally favor activist government policy  Argue that fluctuations can and should be controlled  Expansions (part of business cycle above long-term trend) and contractions (part of business cycle under long-term trend) are symptoms of underlying problem of the economy. o Classicals- generally favor laissez-fairy or nonactivist policies  Argue that fluctuations in economic activity are to be expected in market economy.  Say that individuals will anticipate gov’t reactions, undermining gov’t’s attempts to control cycle Phase of Business Cycle  Peak- top of cycle o Boom is a very high peak, representing big jump in output  Downturn- describes economic activity starting to fall from peal o Recession- decline in real output that persists for more than two consecutives quarters of a year. o Depression- large recession, much longer and more severe  Trough- bottom of recession/depression  Upturn- total output begins to expand, economy comes out of trough o Expansion- upturn that lasts at least two consecutives quarters of a year Leading indicators- tells us what’s likely to happen 12-15 months from now Unemployment      When people are looking for a job and can’t find one Unemployment rate- percent of people in economy who are willing and able to work but who are not working Relationship b/t business cycle and unemployment: unemployment doesn’t rise, but people start to work less. Cyclical unemployment- unemployment resulting from fluctuations in economic activity. Structural unemployment- unemployment caused by institutional structure of an economy or by economic restructuring making some skills obsolete. Target rate of unemployment- lowest sustainable rate of unemployment that policy makers believe is achievable given existing demographics and economy’s institutional structure. Unemployment measured  Labor force- people in an economy who are willing and able to work  Measured by dividing number of unemployed by number of people in labor force. Unemployment-populations ratio- number of people who are working as a percentage of people available to work. Unemployment and potential output  Capital is second major input to production  Capacity utilization rate- rate at which factories and machines are operating compared to max. sustainable rate at which they could be used.   o Indicates how much capital is available for economic growth Potential output- output that would materialize at the target rate of unemployment and target rate of capacity utilization. o Output that will be achieved at the target rate of unemployment and target level of capacity utilization o Grows at the secular (long-term) trend rate of 2.5-3.5% per year Okun’s rule of thumb- 1% point change in the unemployment rate will be associated with 2% change in output in opposite direction. Inflation   Inflation- continual rise in price level o Price level is an index of all prices in the economy o Fear of inflation prevents gov’t from expanding economy and reducing employment; prevents gov’t from using macroeconomic policies to lower interest rates o Inflation is an ongoing rise in the price level. Deflation- continual fall in price level. o Much of the concern about deflation is about asset deflation (a continual fall in the prices of assets such as house and stocks, not goods/service deflation) Measurement of inflation  Price index- number that summarizes what happens to a weighted composite of prices of a selection of goods (market basket of goods) over time. o Converts prices relative to base year prices.  GDP deflator- index of price level aggregate output average price of components in total output (or GDP) relative to a base year. o Deflator is adjustment for “too much air” ; adjustment for inflation o Inflation index economist favor b/c it includes widest number of goods. o DifÏcult to compute, so published quarterly. But useless b/c the period the figures measure has been over for a while.  Consumer price index (CPI)- measures price of fixed basket of consumer goods, weighted according to each component’s share of an average consumer’s expenditures. o Measures price of fixed basket of goods instead of prices of all goods. o CPI and GDP deflator indexes roughly equal each other when averaged over entire year  Personal consumption expenditure (PCE) deflator- measure of prices of goods that consumers buy that allows yearly changes in the basket of goods that reflect actual consumer purchasing habits. o Measure smoothes out some problems with CPI  Producer price index (PPI)- index of prices that measures average change in selling prices received by domestic producers of goods and services over time. o Measures price change from perspective of sellers, may differ from purchaser’s price b/c of subsidies, taxes, and distribution costs that consumers don’t buy. o 3 diff. PPI for goods at diff. stages of production:  crude materials  intermediate goods  finished goods o PPI serves as early predictor of consumer inflation since when costs go up, firms often raise their prices. Real and Nominal Concepts  Real outputs- total amount of goods/services produces, adjusted for price-level changes. o Measure of output that would exist of price level had remained constant.  Nominal output- total amount of goods/services produced measured at current prices.  “real” amount is the nominal amount divided by the price index, it is the nominal amount adjusted for inflation.  Nominal interest rate is the interest rate you pay or receive  Real interest rate is nominal interest rate adjusted for inflation. Real interest rate = nominal interest rate – inflation rate Expected and unexpected inflation  When individual sets price (for goods/labor), they are actually setÝng relative price.  Expected inflation- inflation people expect to occur.  Unexpected inflation- inflation that surprises people.  Expectation of inflation play important role in any ongoing inflation. o Individuals keep raising their prices b/c they expect inflation, and inflation keeps on growing b/c people keep raising their prices Costs of inflation  Inflation does not make people poorer o Whenever pries go up somebody is worse off, but person to whom the higher price is paid is better off. o Two offset each other.  Inflation does redistribute income from people who can’t or don’t raise their prices to people who can and do raise their prices.  Second cost, effect on info that prices convey to people o When there’s inflation, hard for people to know what is and what isn’t relative price change.  Despite costs, inflation usually accepted by gov’t as long as it stays low. o US: under 2.5-3%  Hyperinflation- when inflation hit triple digits; 100% or more per year. o People try to spend their money quickly, but they still use money. o Leads to economic institutions with built-in expectation of inflation. Chapter 8 Measuring aggregate economy Aggregate accounting   Aggregate accounting system- a set of rules and def. for measuring economic activity in economy as a whole. (goes by national income accounting) Provides way of measuring aggregate production/income. Calculation GDP  Gross domestic product (GDP)- total market value of all final goods/services produced in an economy in one-year period. o Aggregate final output of residents/business in an economy in one-year period. o Single most-used economic measure  To arrive at total output, must somehow add them all together into composite measure. o Can only add like things  If want to add unlike things, must convert them into like things o Can do that by multiplying each good by its price o Economist call this weighing the important of each good by its price. Components of GDP  GDP usually divided into 4 categories depending on who buys the output (called expenditure categories)  4 expenditure categories: o Consumption- spending by households on goods/services  Production in the economy consumers buy.  Ex: food, shampoo, tv, furniture, services of doctors and lawyers o Investment- spending for purpose of additional production.  Output that is used to produce goods/services in future.  Ex: business spending on factories, change in business inventories  In economist’s term, when individuals buy stocks rather than consuming —called savings, not investment.  Inventories- goods that have been produced, so must be counted if one is going to include all produced goods; represent goods to be sold in future. o Government spending- goods/services that gov’t buys  Although gov’t doesn’t sell its “production” but provides it free, aggregate accounting rules count gov’t production at gov’t’s cost of providing that output.  Ex: buys service of analyst, equipment for space program.  Transfer payments- payments to individuals that don’t involve production by those individuals.  Ex: SS payments and unemployment insurance o Net exports- spending on good s/services produced in the US that foreigners buy (exports) minus goods/services produced abroad that US citizens buy (imports)  Use “net concept” for exports b/c GDP measures production within geographic borders of country. Two things to remember about GDP  GDP represents a cash flow o Flow concept: amount of total final output a country produces per year  has time period associated with it. o Stock concept is amount at given point in time; no time interval associated with it. o Wealth accounts- balance sheets of an economy’s stock of assets and liabilities o Real wealth- value of productive capacity of assets of an economy measured by goods/services it can produce now and in the future o Nominal wealth- value of those assets measured at their current market prices. o Price assets can go up for 2 reasons:  b/c of productive capacity of that asset has risen  Asset inflation- rise in price of assets unrelated to increases in their productive capacity.  Rise in nominal wealth, but not real wealth.  GDP Measures final output o GDP doesn’t measure total transactions in economy; measures…  Final output- goods/service purchased for their final use  When one firm sells products to another firm for use in production of another good, first firm’s products aren’t considered final output.  Intermediate products- products used as input in production of some other product.  Count intermediate goods as well as final goods as part of GDP is to double count them.  Double counting would significantly overestimate final output.  2 ways of eliminating intermediate goods: o calculate final sales that make up GDP directly  by measuring expenditures on products by final users or by measuring production done specifically for final users. o value added- increase in value that firm contributes to product or service.  Calculated by subtracting intermediate goods from value of its sales Some complications  Gross and net concepts o Depreciation- decease in asset’s value  Amount by which plants and equipment decrease in value as they grow older.  o Net domestic product (NDP)- GDP less depreciation  Capital consumption allowance rather than depreciation. o Net investment- gross investment less depreciation National and domestic concepts o Whether aggregate output that one is referring to is output produced within borders of country or by the citizen and firms o Gross national product (GNP)- aggregate final output of citizens and business of an economy in a one-year period.  Economic activity of US citizens working abroad is counted in US GNP but not in US GDP. o Net foreign factor income- income from foreign domestic factor source minus foreign factor income earned domestically. Calculating aggregate income  Compensation of employees- wages, salaries, fringe benefits, and gov’t taxes  Rents  Interest  Profits Using GDP figures Comparing GDP among countries  Most countries use somewhat similar GDP calculations  Per capita GDP is another measure to compare nations’ income o Divide GDP by country’s total population Economic welfare overtime  Using GDP figures to compare economy’s performance over time is better than relying merely on our perceptions. Real and Nominal GDP  Nominal GDP- GDP calculated at existing prices  Real GDP- nominal GDP adjusted for inflation o Important to society b/c it measures what is really produced Some limitations of aggregate accounting GDP measures market activity not welfare  GDP measures neither happiness nor economic welfare  GDP measures economic (market) activity; real GDP could rise and economic welfare could fall  Economy’s goal shouldn’t be to increase output for sake of increasing output, but to make people better off or at least happier Measurement Errors  GDP figures are supposed to measure all market economic activity, but they don’t  Adjusting GDP figures for inflation Misinterpretation of subcategories  Possible misinterpretation of components  SetÝng up accounts, large number of decision had to be made; once decisions are made, can influence out interpretation of events. Genuine progress indicator  Genuine progress indicator (GPI) makes variety of adjustments to GDP to better measure progress of society rather than simply economic activity. Chapter 9 Growth, Productivity, and wealth of nations Growth and Economy’s Potential Output  Long-run growth occurs when economy produces more goods/services from existing production processes and resources  Potential output- highest amount of output an economy can produce from existing production processes and resources. o Can also be called potential income b/c in aggregate, income and output are identical. o Conveys sense of growth that is possible. o When economy is below its potential output, it is operating inside its production possibility curve. o Potential output is a barrier beyond which economy can’t expand w/o either increasing available factors of production of increasing productivity  Productivity- output per unit of input.  Say’s Law- supply creates its own demand. o Assumes demand is sufÏcient to buy whatever is supplied o People work and supply goods to the market b/c they want other goods. o Aggregate demand will always equal aggregate supply  Economists consider potential output fixed; consider economy’s output changeable. Importance of growth for living standards  Small differences in growth rates can mean huge diff. in income levels b/c of compounding o Compounding- growth is based not only on original level of income but also on accumulation of previous-year increases in income  Rule of 72- number of years it takes for certain amount to double in value is equal to 72 divided by its annual rate of increase. Markets, specialization, and growth  Specialization- concentration of individuals on certain aspects of production.  Division of labor- splitÝng up a task to allow for specialization of production.  According to smith, markets crate an interdependent economy in which individuals can take advantage of benefits of specialization and trade for their other needs. o Markets increase productivity, and improve the standard of living. Economic growth, distribution, and markets  Markets and growth are often seen as unfair with regard to distribution of income.    Even if markets and growth do not provide equality, they tend to make everyone, even the poor, better off Markets make factors of production more productive and lower cost of goods so that more goods are available to everyone. Just b/c the poor benefit from growth doesn’t mean they might not be better off if income were distributed more in their favor. Per Capita Growth  Per capita growth- producing more goods and services per person.  Per capita income measures average (or mean) income  Median income- income level that divides population in equal halves. Sources of growth  Economists generally single out five important sources of growth: o Growth- compatible institutions o Capital accumulation- investment in productive capacity o Available resources o Technological development o Entrepreneurship Growth-compatible institutions  Institutions that foster growth  must have incentives built into them that lead people to put forth effort and discourage people from spending a lot of their time in leisure pursuits or creating impediments for others to gain income for themselves  when individuals get much of gains of growth themselves, they have incentives to work harder; that’s why market/private ownership of property play important role growth.  Corporation encourages large enterprises b/c legal institution gives owners limited liability Investment and accumulated capital  Societies that can’t afford to save will not grow either; investment is absolutely necessary for growth.  Financial markets provide method of translating saving into investment (which must exist in society)  Savings- supply of loanable funds; upward sloping curve b/c as interest rate rises, more people willing to save more.  Investment- demand for loanable funds; downward-sloping curve b/c as interest rate falls, it pays businesses to borrow and invest more.  Has become clear that capital includes much more than machines  3 types of capital o physical capital o human capital- skills that are embodied in workers through experience, education, and on-the-job training (people’s knowledge)  skilled labor force is far more productive than unskilled o social capital- habitual way of doing things that guides people in how they approach production  embodied in institutions like gov’t, legal system, and fabric of society. Available resources  What is a resource depends on production processes of an economy and technology.  Greater participation in market can increase available resources.  Increasing labor force participation rate is not free way of increasing growth o We lose whatever people were doing before they joined labor force Technological Development  Advances in technology shift production possibility curve out by making workers more productive  Increase their ability to produce more things they already produce, but allows them to produce new and different products  Technology- the way we make goods and supply services. Entrepreneurship  Ability to get things done  Involves creativity, vision, willingness to accept risk, and talent for translating that vision into reality  When country’s population demonstrates entrepreneurship, it can overcome deficiencies in other ingredients that contribute to growth Production Function and theories of growth  Production function- shows relationship between quantity of inputs used in production and quantity of output resulting from production Describing production functions  Scale economies- describes what happens when all inputs increase equally o Describe what happens to output if all inputs increase by same percentage  Constant returns to scale- output will rise by the same proportionate increase as all inputs  Increasing returns to scale- output rises by greater proportionate increase than all inputs  Decreasing returns to scale- output rises by smaller proportionate increase than all inputs  Law of diminishing marginal productivity- increasing one input, keeping all others constant, will lead to smaller and smaller gains in output  Diff b/t decreasing returns and diminishing marginal is that decreasing refers to what happens to output when ALL inputs increase by same proportion o Diminishing marginal refers to what happens to output when some inputs are increase, but others are held constant. Standard Theory of growth  Classical growth model- model of growth that focuses on role of capital accumulation in growth process  The more capital an economy has, the faster it will grow (called capitalist economies)  Saving, investment, and capital are central to classical growth model.   Focus on diminishing marginal productivity of labor o b/c of this, per capita income declines as labor supply increases. o Since each add’l worker adds less output to production than individual before, production function is bowed downward. o As output per person declines, at some point output available is no longer sufÏcient to feed everyone Focus on diminishing marginal productivity of capital o Technological progress and increases in capital have overwhelmed diminishing marginal productivity of labor. The Convergence Debate  Convergence hypothesis- hypothesis that per capita income in countries with similar institutional structures will gravitate toward same level of income per person.  As countries get more capital and become richer, their growth rates would slow down.  Marginal product of capital is higher in developing countries, which leads to capital investment flows out of developed countries and into developing countries.  There will be pressure for equivalent factors of production, using equivalent capital and technology and operating in similar institutional structures, to be paid equally.  Explanation why convergence has not taken place: o Lack of mobility  Speed of convergence depends on factor and technological mobility; transfer of capital and technology.  Occurs b/c firms have inventive to shift production of goods to lower-cost countries o Differing institutional structure  The more similar institutional structures, the more likely it is that convergence will take place b/c firms are likely to have more production to countries whose institutions are well-suited for businesses’ practice and culture o Incomparable factors of production  Measure of labor needs to be adjusted to capture skills, education, experience, and effort that laborers bring to productions. These adjustments make measuring labor, and comparing measurements among diff. countries difÏcult o Technological agglomeration effects  Technological agglomeration- geographic concentration of technological advances caused by tendency of innovations to lead further innovations in that industry and others.  If technology grows, it increases productivity of all inputs and allows growth to continue  If tech. grows faster than diminishing marginal productivity of new capital, and grows fast over time, growth for all practical purposes has no limit.  Technological growth shifts the production function up and production possibility curve out.  As long as new tech. advances occur faster in rich developed countries than older tech. diffuse into less-developed countries, then convergence doesn’t need to happen.  New growth theory  New growth theory- emphasizes role of technology rather that capital in growth process  Focuses on its analysis on technology. Technology  Increases in tech are not as directly linked to investment as are increases in capital.  Increases in tech often have enormous positive spillover effects, especially if new technology involves common knowledge and is freely available to all.  Positive externalities- positive effects on others not taken into account by decision maker. o Result from common knowledge aspect of tech.  Patents- legal protection of technological innovation that gives owner of patent sole rights to its use and distribution for a limited time.   Learning by doing- improve methods of production through experience o Overcomes law of diminishing marginal productivity b/c learning by doing increases productivity of workers. Technological lock-in o Network externalities- use of a good by one individual makes that tech. more valuable to other people Growth policies  Encouraging saving and investment  Formalizing property rights and reducing bureaucracy and corruption  Providing more of the right kind of education  Promoting policies that encourage technological innovation  Promoting policies that allow taking advantage of specialization