Principles of Macroeconomics
Principles of Macroeconomics ECO 2013
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CHAPTER 15 AGGREGATE DEMAND AND AGGREGATE SUPPLY Introduction This chapter is the rst of three in Which the aggregate demand and aggregate supply model is used to evaluate shortrun uctuations in the economy De nition of recession a period of declining real incomes and rising unemployment De nition of depression a severe recession 191 Three Facts about Economic Fluctuations Fact 1 Economic Fluctuations are Irregular and Unpredictable Figure 191 shows the business cycle Fact 2 Most Macroeconomic Quantities Fluctuate Together GDP income spending and production are all related and show similar patterns The amounts of the uctuations are what may vary but generally not the direction Fact 3 As Output Falls Unemployment Rises When rms don39t sell as many goods and services they don39t need or can39t afford as many workers FYI Okun39s Law There is a strong correlation between GDP and unemployment When real GDP grows at its average rate of 3 percent the unemployment rate remains unchanged When the economy expands more rapidly than 3 percent the unemployment rate falls by about half as much Though Arthur Okun39s law has to be changed a bit to accommodate data in foreign countries the relationship is generally true 192 Explaining ShortRun Economic Fluctuations How the Short Run Differs from the Long Run Most economists believe that classical theory describes the economy in the long run but not the short run The assumptions of the classical dichotomy and the neutrality of money are relaxed in the model for the shortrun The Basic Model of Economic Fluctuations We focus on real GDP and the overall price level using the aggregate demand and aggregate supply model De nition ofaggregaie demand a curve that shows the quantity of goods and services that households rms and the government want to buy at any price level De nition ofaggregale supply a curve that shows the quantity of goods and services that rms choose to produce and sell at any price level 193 The Aggregate Demand Curve Why the Aggregate Demand Curve is Downward Sloping Each of the four components of GDP contributes to aggregate demand Consumption investment and net exports are affected by changes in the price level and explain the downward slope of the aggregate demand curve Pigou39s Wealth Effect A decrease in the price level 0 makes consumers feel more wealthy 0 which in turn encourages them to spend more The increase in consumer spending means a larger quantity of goods and services are demanded Keynes39s Interest Rate Effect o A lower price level reduces the interest rate 0 encourages greater spending on investment goods 0 increases the quantity of goods and services demanded MundellFleming39s Exchange Rate Effect A fall in the US price level causes 0 US interest rates to fall 0 the real exchange rate depreciates 0 this depreciation stimulates US net exports 0 thereby increases the quantity of goods and services demanded Why the Aggregate Demand Curve Might Shift 0 Changes in spending plans of consumers or rms 0 Changes in scal or monetary policy 194 The Aggregate Supply Curve In the long run the aggregate supply curve is vertical Whereas in the short run the aggregate supply curve is upward sloping Why the Aggregate Supply Curve is Vertical in the Long Run In the long run an economy39s supply of goods and services depends on its supplies of capital and labor and on the available production technology Why the Long Run Aggregate Supply Curve Might Shift The level of output shown by the long run aggregate supply curve is sometimes called the potential output or fullemployment output To be more accurate it is the natural rate afoulpul If the natural rate of unemployment changes the aggregate supply curve shifts Things like a change in the capital stock savings investment technology and education all change economic growth and therefore cause the aggregate supply curve to shift Why the Aggregate Supply Curve is Upward Sloping in the Short Run When the price level deviates from the price level that people expect the aggregate supply curve will have an upward slope There are there explanations 9 1The New Classical Misperceptions Theory Changes in the overall price level can temporarily mislead suppliers about what is happening in the markets in which they sell their outputs A lower price level than expected causes misperceptions about relative prices and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of good and services supplied 2The Keynesian StickyWage Theory This theory assumes nominal wages are slow to adjust to short run changes quotstickyquot A lower price level makes employment and production less pro table This induces rms to reduce the quantity of goods ands services supplied 3The New Keynesian StickyPrice Theory Some prices of goods and services adjust slowly too menu costs An unexpected fall in the price level leaves some rms with higherthandesired prices These depress sales and induce rms to reduce the quantity of goods and services they produce Why the ShortRun Aggregate Supply Curve Might Shift Many of the same variables that shift the long run aggregate supply curve will shift the shortrun aggregate supply curve too However there is a new variable that is important people39s expectation of the price level A higher than expected price level decreases the quantity of goods and services supplied and shifts the shortrun aggregate supply curve to the left Conversely a lower expected price level increases the quantity of goods and services supplied and shifts the shortrun aggregate supply curve to the right 195 Two Causes of Recession The Effects of a Shift in Aggregate Demand Figure 197 In the shortrun shifts in aggregate demand cause uctuations in the economy39s output of goods and services In the longrun shifts in aggregate demand affect the overall price level but do not affect output In the News How Consumers Shift the Aggregate Demand People39s changing perceptions can cause shortrun uctuations in the economy The Effects of a Shift in Aggregate Supply Figure 198 A decrease aggregate supply Will cause stag ation falling output and rising prices Policymakers can choose to do nothing or might accommodate by increasing aggregate demand to stimulate the economy Figure 199 Output can be restored but the price level is permanently raised Shifts in aggregate supply can cause stag ation Policymakers Who can in uence aggregate demand cannot offset both the adverse effects of falling output and rising prices simultaneously Case Study Oil and the Economy Crude oil is such a key input that changes in the price can change shortrun aggregate supply When OPEC raised price in the 197039s we had stag ation When they squabbled in the mid198039s we saw the opposite rising output and falling prices 196 Conclusion The Origins of Aggregate Demand and Aggregate Supply John Maynard Keynes published The General Theory of Employment Interest and Money in 1936 which attempted to explain shortrun uctuations in the economic condition His work was prompted by his observation of the breakdown in the usefulness of Classical Theory as it related to the Great Depression Keynes urged policymakers to be more assertive in combating the ills of shortrun uctuations to spare citizens prolonged periods of low output and high unemployment CHAPTER 6 MEASURING THE COST OF LIVING Review Problems 2 6 11 This chapter examines how economists measure the overall cost of living paying particularly close attention to the calculation use and shortcomings of the consumer price index Introduction Because prices go up and down overtime it is dif cult to compare the standard of living With information about income only Standard of living instead depends on the purchasing power of that income The Consumer Price Index is a statistic Which turns dollar gures into meaningful measures of purchasing power 11 1 The Consumer Price Index De nition of Consumer Price Index CPI A measure of the overall cost of the goods and services bought by a typical consumer It is computed and reported each month by the Bureau of Labor Statistics a part of the Department of Labor How the Consumer Price Index is Calculated Computing the CPI is a ve step process using data on the prices of thousands of good and services 1Fix the basket Determine which goods and services are most important for a typical consumer and determine the relative importance of each The prices of the more important ones will be given more weight than the less important ones 2 Find the prices Once you39ve established the goods nd out what the prices are now and what they were at speci c times in the past 3 Compute the basket39s cost Using the weights established in Step 1 determine the total cost of the basket at each set of prices found in Step 2 Note The market basket isn39t changing only the prices 4 Choose a base year and compute the index Which year is chosen as the base year doesn39t matter The base year is just a benchmark against Which all other years can be compared The consumer price index for each year is the cost of the basket in that year divided by the cost of the basket in the base year multiplied by 100 For instance an index of 150 means that this year39s prices are 150 of the base year prices or 50 higher than the base year 5 Compute the in ation rate The in ation rate is the percentage change in the consumer price index om the preceding period If the index rises from 120 to 150 the in ation rate is 25 percent Producer Price Index The Bureau of Labor Statistics also reports the Producer Price Index Which measures the cost of a basket bought by a typical rm rather than a consumer The PPI is useful in predicting changes in the CPI since rms often pass on rising costs to consumers FYI What39s in the CPI39s Basket See Figure 11 In the News Shopping for the CPI There are 300 employees at the Bureau of Labor Statistics Who gather the information necessary to calculate the CPI This article highlights a few of these and their sleuthing methods Another interesting fact is that the list of items in the market basket is only updated every ten years Cellular phones currently aren39t on the list Three Problems in Measuring the Cost of Living 1 Substitution bias If the price of a good rises sometimes consumers substitute a different good instead of buying less of the good with the new price Therefore the CPI may overstate increases in the cost of living 2 Introduction of new goods New goods mean more choices and more choices mean that the purchasing power of your dollar may go up it producers compete with each other aggressively for your business Therefore it is possible for you to maintain your standard of living with less money The CPI would miss that change 3 Unmeasured quality change It is dif cult to compare one period to the next because even though the BLS tries to adjust for it the quality of a good may change making it more or less valuable relative to its price to the consumer In the News The CPI Commission A 1996 commission of economists found that When the CPI changes changes in the cost of living are overstated by l 1 The GDP De ator versus the Consumer Price Index Differences 1The GDP de ator re ects the prices of all goods and services produced domestically Whereas the consumer price index re ects the prices of all goods and serves bought by consumers When consumers buy foreign goods or producers sell to the government rather than consumers the indexes are different 2 The GDP measures production of goods currently being produced Where as the CPI uses a xed market basket of goods 112 Correcting Economic Variables for the Effects of In ation Dollar Figures from Different Times To compare dollar amounts in different times use this formula Value in Year B Price Level in Year B Price Level in Year A X Value in Year A In the News Mr Index Goes to Hollywood Gone with the Wind is the highest grossing movie of all times in real terms De nition of indexation when some dollar amount is automatically corrected for in ation by law or contract Social Security is indexed and so are tax brackets De nition of COLA a costofliving allowance which means that income is automatically adjusted to offset the effects of in ation Real and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past De nition of nominal interest rate the interest rate that the bank pays tells you how fast the number of dollars in your bank account rises over time De nition of real interest rate the interest rate corrected for in ation tells you how fast the purchasing power of your bank account rises over time Real interest rate nominal interest rate in ation 1 13 Conclusion In ation reduces the purchasing power of money over time Therefore it is necessary to have a tool to compare dollars over time A price index is such a tool CHAPTER 7 PRODUCTION AND GROWTH Review Problems 5 8 9 11 Introduction Average incomes vary around the world and standards of living are vastly different as well The US economy has had an average growth rate of 2 per year for the last century making our income today eight times what it was then Growth rates vary greatly too The level of real GDP is a good gauge of economic prosperity and the growth of real GDP is a good gauge of economic progress 121 Economic Growth around the World Table 121 shows per capita real GDP for 13 countries The average growth rate for the US is 176 The highest average growth rate is Japan39s 3 the lowest is Bangladesh39s 008 FYI The Magic of Compounding and the Rule of 70 Even small differences in percentage growth rates can make a huge difference where compounding is concerned De nition oflhe Rule of 70 If a variable grows at X percent each year then that variable doubles in approximately 7 OX years If incomes grow at a rate of 2 percent each year then it takes 35 years for incomes to double 122 Productivity Its Role and Determinants Why is Productivity s0 Important Recall the story of Robinson Crusoe Crusoe produced sh vegetables and clothing His standard of living was entirely dependent on his own productivity The same is true for countries around the world even with larger and more complex economies De nition ofproduclivily the quantity of goods and services a worker can produce for each hour of work How Productivity is Determined There are four determinants of productivity 1 Physical Capital the stock of equipment and structures that are used to produce goods and services 2Human Capital the knowledge and skills workers acquire through education training and experience 3Natural Resources inputs into production that are provided by nature such as land rivers and mineral deposits They are either renewable or nonrenewable 4Technological Knowledge the understanding of the best ways to produce goods and services Technological knowledge refers to society39s understanding about how the world works while human capital refers to the resources expended transmitting this understanding to the labor force Case Study Are Natural Resources a Limit to Growth Technological progress often yields ways to avoid the limits of having xed supplies of nonrenewable resources like oil and minerals The prices of most natural resources in the world are stable or falling In the News Computers and Productivity Computers have not increased productivity as much as was expected The Production Function De nition of production function describes the relationship between the quantity of inputs used in production and the quantity of output om production Y A FLKHN Y is output A is the level of technology L is labor K is capital H is human capital N is natural resources De nition of constant returns to scale Doubling the inputs doubles the output XY A FXLXKXHXN Measure of productivity YL A FLL KL HL NL A F1 KL HL NL Productivity depends on 0 physical capital per worker 0 human capital per worker 0 natural resources per worker o technological knowledge 123 Economic Growth and Public Policy The Importance of Saving and Investment One way to raise future productivity is to invest more current resources in the production of capital But producing capital requires society to give up current consumption in favor of future consumption Countries Which have high rates of investment tend to have high growth rates as well Diminishing Returns and the CatchUp Effect If a government convinced by Figure 121 pursues policies that raise the nation39s savings rate consumption falls and there are more resources available for investment in capital production Then the capital stock increases productivity rises and GDP grows more rapidly At some point however diminishing returns set in The extra investment leads to smaller and smaller increases in the growth of productivity An increase in the savings rate leads to higher growth only for a while De nition of the catchup effect Because of diminishing returns it is easier for a country to grow faster if it starts out relatively poor Though the growth rate is important it is still also important to look at the level of GDP as well Korea grew at a rate of 6 compared to the US39s 2 Since Korea started out poorer it was easier to grow faster The level of GDP per person is still much higher however in the US Investment from Abroad Increased saving and investment need not be done solely by the domestic economy Foreign countries investing and saving in an economy can spur growth as well De nition of foreign direct investment a capital investment that is owned and operated by a foreign entity Example Ford builds an auto plant in Mexico This raises Mexican GDP more than its GNP since some of the pro ts will accrue to the United States De nition of foreign portfolio investment an investment that is nanced With foreign money but operated by domestic residents Example An American citizen buys stock in a Mexican company The World Bank is an organization that tries to help poor countries grow It encourages poor countries to remove restrictions that will make more foreign investment possible Through the International Monetary Fund the World Bank uses funds provided by advanced countries to make loans to poor countries to develop infrastructure schools and other types of capital Property Rights and Political Stability Protecting property rights and providing a stable political climate helps a country grow De nition Ofproperly rights 7 the ability of people to exercise authority over the resources they own Property rights and the underlying justice system Which enforces property rights are essential for markets to function effectively Political instability can threaten property rights and therefore impede growth Free Trade Inwardoriented policies policies that aim to raise productivity and living standards within the country by avoiding interaction with the rest of the world do not work Free trade makes countries better off In effect free trade is like technology If a country trades wheat for steel it is like developing technology that turns wheat into steel Landlocked countries tend to have lower rates of economic growth because trade by ocean is more dif cult The Control of Population Growth High population growth tends to accompany low growth rates because per capita investment in capital is small and education is a bigger problem Countries can control population growth a number of ways including encouraging policies which foster an equal treatment of women In this case the opportunity cost of having children becomes higher and population growth slows Research and Development To a large extent knowledge is a public good and there is a public interest in promoting efforts of innovation and discovery Tax incentives and patent laws encourage research and development Case Study The Productivity Slowdown When productivity slows growth slows From 1959 to 1973 US productivity growth was 32 From 197 3 to 1994 productivity grew at a rate of only 19 Economists don39t know why They39ve ruled out all the things that are easy to measure Some hypothesize it has to do with few new ideas that have led to technologies to produce goods and services in new and different ways In the News The Sachs Solution to the African Problem 124 Conclusion A country39s standard of living depends on its ability to produce goods and services The success of one generation39s policymakers in learning and heeding the fundamental lessons about economic growth determines What kind of world the next generation will inherit CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE This chapter teaches the bene ts of trade speci cally by illustrating comparative advantage using the Production Possibilities model developed in Chapter 2 Introduction 31 A Parable for the Modern Economy De nition of production possibilities frontier a graph which shows the various mixes of output that an economy can produce A straightline production possibilities frontier rather than bowed out indicates that resources can be shifted om producing one good to another at a constant rate The graph illustrates Principle 1 People face tradeoffs If there is no trade each can describe hisher consumption possibilities With exactly the same graph as hisher production possibilities The decision about the exact consumption choice Will be a matter of personal taste Given the same consumption and production possibilities two individuals might choose different combinations if one is a beeflover and the other is a potatolover 32 The Principle of Comparative Advantage Even though the rancher is better at producing both beef and potatoes has an absolute advantage in both the farmer still has a comparative advantage in What he does relatively well De nition of absolute advantage When a producer requires a smaller quantity of inputs to produce a good than another producer requires compares 2 producers 1 good De nition of comparative advantage When a producer has a smaller opportunity cost When producing a good compared to another producer compares 2 producers and each of two goods Which have opportunity costs described in terms of how much of the other good has to be given up De nition ofopporlumly cost What we give up to get an item Rancher 1 potato 8 hours of work and 8 hours of work 8 pounds of meat so 1 potato has an opportunity cost of 8 pounds of meat Farmer 1 potato 10 hours of work and 10 hours of work 12 pound of meat so 1 potato has an opportunity cost of 12 pound of meat Since the Farmer has the lower opportunity cost for producing potatoes 12 lt 8 he should produce potatoes He can do it relatively better even though the Rancher had an absolute advantage in producing both goods Everyone always has a comparative advantage in something If one producer has a comparative advantage in one good the other producer has a comparative advantage in the other Differences in comparative advantage create opportunities to trade with both parties ending up better off than they were without trade They each obtain goods for a price that is lower than their opportunity costs In addition total production rises The economic pie is bigger Moral of the story Trade can bene t everyone in society because it allows people to specialize in activities in which they have a comparative advantage 33 Applications of Comparative Advantage Should Tiger Woods mow his own lawn No as long as he pays the girl next door more than 20 her opportunity cost and less than 10000 his opportunity cost He has an absolute advantage but not a comparative advantage Even though it takes him only 2 hours compared to her 4 hours his time is worth more per hour in terms of his earning power during that time Should the US Trade with Other Countries Though obviously more complicated the economic answer is basically the same as in the previous example Example U S and Japan produce food and cars De nition ofimporl goods produced abroad and sold domestically De nition ofexpori goods produced domestically and sold abroad International trade is complicated by the fact that international trade can bene t the country While making some of its individuals worse off Textile workers who lost their jobs when foreign countries established a comparative advantage in manufacturing fabric did not feel better off because of it 34 Conclusion Trade can make everyone better off because it allows people to be able to specialize in what they have a comparative advantage in producing Interdependence has benefits