MACROECONOMIC ISSUES: ECONOMIC GROWTH AND THE BUSINESS CYCLE Chapter 11 MACROECONOMIC ISSUES: ECONOMIC GROWTH AND THE BUSINESS CYCLE

1. The Ideal Macroeconomic World The description of the ideal macroeconomic world shows that macroeconomics focuses on two main topics—economic growth and the business cycle. Economic growth is the expansion of the economy’s output over the long run. The business cycle measures the short-run fluctuations around the economy’s expansion of output.

2. Economic Growth Economic growth occurs when the production possibilities frontier (PPF) expands outward to the right. There are two basic sources of economic growth—that is, of outward shifts in the economy’s PPF: The sources are increases in productive resources and technological progress.

2.1 Capital Accumulation Investment is addition to stock of capital. The rate at which society expands its capital depends on the amount of investment Society must choose between capital goods (plant, equipment) and consumer goods.

2.3 Technological Progress Technological progress causes the PPF to shift out. More outputs is produced from the same inputs. The sources of technological progress range from advances in science (the application of computer technology to word processing and hotel and airline reservations) to improvements in management methods (streamlined management structures). The high living standards in the US, Europe, and Japan are the products of more than a century of economic growth.

2.3 Extensive and Intensive Growth: Production Functions The more effective use of inputs shows up as increases in output per unit of input—that is, as increases in factor productivity. Production functions show the relationship between inputs and output. They show how much output can be produced from different amounts of labor and capital with a given state of technology. The total output of technology (Y) depends on the amount of labor and capital inputs used by the economy and on the state of technology. Y = ƒ (K, L,T)

2.3 Extensive and Intensive Growth: Production Functions -cont. Extensive growth is economic growth that results from the expansion of factor inputs (K and L). To expand: labor inputs (L), we must sacrifice leisure or household production; capital inputs (K) we must sacrifice current consumption for future consumption. Intensive growth is growth that results from increases in output per unit of factor input.

2.3 Extensive and Intensive Growth: Production Functions -cont. The major source of productivity improvements is technological change (T). Scientist and engineers discover improved technologies Agronomists develop drought-resistant grains. New modes of communication—fax, e-mail, networks, Production function in terms of annual growth rates: Ẏ = 0.67L + 0.33K + Ṫ The sources of economic growth explain the relative contribution of labor, capital, and technology to growth.

2.4 Diminishing returns versus Technological Improvements Production function can be expressed as: Y/L = ƒ(K/L,T). The output per worker (a measure of average living standards) increases when there is more capital per worker and when technology improves. The law of diminishing returns states that as more and more capital is combined with the same amount of labor, eventually its returns will diminish in the form of smaller and smaller increases in output per worker. The process of economic growth can be viewed as a battle between technological progress and diminishing returns.

2.5 Growth Policy For the advanced industrialized economies, the major source of economic growth has been intensive (technology) rather than extensive (labor and capital) growth. Technological Progress: Moore’s Law Example Economies are in a position to affect their growth through increases either in efficiency or in inputs. The experiences of the four Asian “Tiger” economies show that countries can pursue policies that create rapid economic growth.

2.6 Business Cycles The American economy today produces a volume of output more than 20 times greater than a century ago. The growth of economic output is not smooth; during some periods, growth is well above the long-run trend; in other periods, growth is below the trend. A business cycle is the pattern of upward and downward movement in the general level of real business activity.

2.7 Phases of the Business Cycle Recession (downturn) output declines for six or more months. Unemployment rises, corporate profits fall, and economy activity declines (Prolong = depression) Trough occurs when output stops falling. The economy has reached a low point from which recovery begins. Recovery (expansion) is characterized by rising output, falling unemployment, rising profits, and increasing economic activity. Peak is the final stage and precedes recession. Output growth ceases after the peak is reached. U.S. Business Cycles Example

2.8 The Impact of the Business Cycle The great Depression of 1930 Deep recession of 1970-1980 Longest uninterrupted period of prosperity was the decade of 1990’s. Why does business cycles determine presidential elections?

3. Macroeconomic Variables: Output, Prices and Employment Macroeconomics is particularly interested in the total output of the economy, called gross domestic product (GDP). Macroeconomics studies the price level of the economy as a whole and its rate of change, called inflation. Macroeconomics examines employment and unemployment for the economy as a whole.

3.1 Measuring Real Output: GDP Gross domestic product (GDP) is the market value of all final goods and services produced by the factors of production located in the country in one year’s time. The circular-flow-diagram (chapter 2) shows that the final goods and services flow from the business sector to households. GDP includes only final goods.

3.1 Measuring Real Output: GDP 3.1.1 Four Expenditures Categories Personal Consumption Expenditure (C) Goods and services purchased by households for consumption purposes. For example food and cars Government Expenditures for Goods and Services (G) Government goods are hired civil servants, school teachers, judges, etc. Government services are not sold thus no established market price.

3. 1 Measuring Real Output: GDP 3. 1 3.1 Measuring Real Output: GDP 3.1.1 Four Expenditures Categories - cont Transfer payments are payments to recipients who have not supplied goods or services in return. They are simply transfers of income from one person or organization to another. Investment (I) Investment is defined as expenditures that add to the economy’s stock of capital (plants, equipment, structures, and inventories) Depreciation is the value of the existing capital stock that has been consumed or used up in the process of producing output.

3. 1 Measuring Real Output: GDP 3. 1 3.1 Measuring Real Output: GDP 3.1.1 Four Expenditures Categories - cont Net Exports of Goods and Services (X-M) The sum of all expenditures by households, businesses, and government would not equal the total output of the economy. Imported products (M) must be subtracted from total purchases to obtain domestic production figures. Exported products (X) does not show up in domestic consumption figures. GDP = C + I + G + X – M

3.1.2 Real GDP Macroeconomics focuses its attention on the volume of “real” goods and services produced because that determines economic welfare and employment opportunities. Real GDP measures the volume of real goods and services produced by the economy by removing the effects of rising prices on nominal GDP. Nominal GDP is the value of final goods and services for a given year expressed in that year’s prices.

3.1.3 The Equality of Output and Income The circular-flow diagram shows that firms pay income to the factors of production to produce output. For every dollar of final output produced, the economy produces a dollar’s worth of factor income in the form of wages, rent, interest, and profit. GDP can also be calculated by adding up the sum of all incomes earned in the economy. GDP = consumption (C) + saving (S) + payroll taxes (T)

3.2 From Gross National Product to Personal Income Gross national product (GNP) measures the production of the factors of production supplied by residents of the country, whether that production took at place at home or abroad. National income equals GNP minus depreciation and indirect business (sales) taxes. National income equals the sum of factor payments made to the factors of production in the economy. Personal income equals the sum of all income received by persons—national income minus retained corporate profits, corporate income taxes, and social security contributions plus transfer payments received by individuals.

3.2.1 The Equality of Investing and Saving Because GDP equals the uses of total income, we have: C + I + G = C + S + T Which reduces to: I = S + G - T The natural level of real GDP is that level of output the economy produces when it is at the natural rate of unemployment.

3.3 The Natural Level of Output At the natural rate of unemployment: the number of qualified job seekers equals the number of available jobs. The natural level of real GDP is that level of output the economy produces when it is at the natural rate of unemployment. There is also an association between the natural rate of unemployment and wages. (Too few people and too many jobs, or too many people and too few jobs) When the labor market is in balance at the natural rate, inflationary pressures should be constant.