The Big Ideas in Macroeconomics

1
LECTURE 8

• The Big Ideas in Macroeconomics

2
Real GDP 1992
U.S. REAL GDP, 1930 - 1990
8,000
Source U.S. Department of Commerce
6,000
4,000
2,000
0
1930
1935
194 0
1945
1950
1955
1960
1965
1970
1975
1975
1980
1985
1990
YEAR
3
U.S. REAL GDP

• The data for real GDP control for changes in
  prices and thus capture movements in real output
  only
• Real GDP has grown substantially over the period
  graphed
• This is what economists term economic growth
  sustained increases in real production of an
  economy over a period of time
• Differences in economic growth between countries
  and changes in economic growth over time are
  among the most important issues of macroeconomics

4
GROWTH RATES

• The growth rate of a variable is the percentage
  change in the variable from one period to another
• If GDP was 100 in year 1, and 104 in year 2
• growth rate percentage change
• change in GDP / initial GDP
• ( GDP year 2 - GDP year 1) / GDP year 1
• ( 104 - 100 ) / 100
• 4 / 100 .04 4

5
GROWTH RATES

• May be negative as well as positive
• If GDP was 104 in year 1, and 100 in year 2
• growth rate change in GDP / initial GDP
• ( GDP year 2 - GDP year 1) / GDP year 1
• ( 100 - 104 ) / 104
• - 4 / 104 -0.38 -3.8

6
GROWTH RATES

• If we know the growth rate and the initial GDP
  value, we can also calculate the GDP for the next
  period
• g is the growth rate,
• GDP year 2 ( 1 g ) GDP year 1
• GDP in the second year is 1 plus the growth rate
  times GDP in the first year
• If g 4 and GDP in year 1 were 100,
• GDP year 2 ( 1 0.04) 100 104

7
GROWTH RATES

• If the economy grew at a rate g for n years, and
  the economy started at 100, the formula for real
  GDP after n years would be
• GDP n years later ( 1 g ) n (100)
• If the economy starts at 100 and grows at a rate
  of 4 for 10 years
• GDP 10 years later ( 1 0.04 ) 10 (100)
• 148
• This is nearly 50 higher than in the first year.

8
RULE OF 70

• If you knew the constant growth rate of real GDP
  but wanted to know how many years it would take
  until the level of real GDP doubled
• years to double 70 / percentage growth rate
• If growth rate were 5
• Years to double 70 / 5 14 years

9
STARTING IN 1960, HOW MANY YEARS IT TOOK FOR GDP
TO DOUBLE
YEARS
25
24.0
20
19.0
17.0
15
10
14.0
8.0
5
Belgium
Germany
Japan
United States
Canada
10
GROWTH AND PRODUCTIVITY

• Economic growth in the US has slowed down
• -- from 1950 to 1973, real GDP grew at an
  annual rate of 3
• -- from 1974 to 1995, real GDP grew at an
  annual rate of 1.9
• The decline in growth rate of real GDP in the US
  was also associated with a decline in the growth
  of labour productivity.

11
LABOR PRODUCTIVITY

• The amount of output produced per worker
• It gives us an idea of how much is produced by
  the average worker
• Living standards can rise over time only if more
  output is produced by the average worker

12
PRODUCTIVITY SLOWDOWN

• Although productivity may continue to grow during
  a period, it grows at a slower rate
• This also means that wages and salaries have not
  grown as fast as they had in the past

13
P
P
T
T
P peak of recessions T trough of recessions
Source U.S. Department of Commerce
14
RECESSION

• A period when economic growth is negative (real
  GDP falls) for two consecutive quarters
• A quarter is three consecutive months during the
  year
• A recession is a period when real GDP falls for
  at least six months

15
RECESSION

• Peak
• The date at which a recession starts
• Trough
• The date at which output starts to increase again
• Since World War II, the United States has
  experienced nine recessions.

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NINE POSTWAR RECESSIONS

• Peak Trough Percent Decline in real GDP
• November 1948 October 1949 1.5
• July 1953 May 1954 3.2
• August 1957 April 1958 3.3
• April 1960 February 1961 1.2
• December 1969 November 1970 1.0
• November 1973 March 1975 4.9
• January 1980 July 1980 2.5
• July 1981 November 1982 3.0
• July 1990 March 1991 1.4

17
DEPRESSION

• A common term for a severe recession
• In the United States, the Great Depression refers
  to the 1929 - 1933 period, in which real GDP fell
  by over 33
• It created the most severe economic dislocations
  that the United States has experienced in the
  twentieth century
• Banks closed, businesses failed, and many people
  lost their life savings
• Unemployment rose sharply
• In 1933, over 25 of the people looking for work
  failed to find jobs

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CAUSES OF RECESSION

• Changes in technology
• Disruptions to the financial system
• Increases in prices of key commodities
• (Deliberate or inadvertent) government policies

19
KEYNESIAN ECONOMICS

• The study of business cycles and economic
  fluctuations that we develop.

20
CLASSICAL ECONOMICS

• The study of how the economy operates at full
  employment
• Based on the principle that prices will adjust in
  the long run to bring markets for goods and
  labour into equilibrium
• Classical economists believed that economic
  episodes of boom and bust were transitory and
  economy would return to full employment.

21
SUPPLY-SIDE ECONOMICS

• A school of thought that emphasizes how
  changes in taxes affect economic activity.

22
FULL EMPLOYMENT

• Corresponds to zero cyclical unemployment
• When the economy is at full employment, the only
  unemployment is frictional and structural.

23
AGGREGATE PRODUCTION FUNCTION

• Explains the relationship of the total inputs
  used throughout the economy to the level of
  production in the economy or GDP.
• There are two primary factors of production
  capital and labour
• the stock of capital comprises all the machines,
  equipment and buildings in the entire economy
• Labour consists of the effort of all workers in
  the economy
• Y F ( K,L )
• Y is total output or GDP
• K is the stock of capital
• L is the labour force.

24
SHORT-RUN PRODUCTION FUNCTION

• Shows the relationship between the amount of
  labour used in an economy and the total level of
  output with a fixed stock of capital ( K ).

25
RELATIONSHIP BETWEEN LABOUR AND OUTPUT WITH FIXED
CAPITAL
Total Output ( Y )
Y1
L1
Labour Force
26
RELATIONSHIP BETWEEN LABOUR AND OUTPUT WITH FIXED
CAPITAL
Total Output ( Y )
Y2
Y1
L2
L1
Labour Force
27
RELATIONSHIP BETWEEN LABOUR AND OUTPUT WITH FIXED
CAPITAL
Total Output ( Y )
Y2
Y1
L2
L1
Labour Force
28
RELATIONSHIP BETWEEN LABOUR AND OUTPUT WITH FIXED
CAPITAL
Total Output ( Y )
Y2
Y1
L2
L1
Labour Force
With capital fixed, output increases with labour
input but at a decreasing rate.
29
PRINCIPLE OF DIMINISHING RETURNS

• Suppose output is produced with two or more
  inputs and we increase one input while holding
  other inputs fixed, beyond some point -- called
  the point of diminishing returns -- output will
  increase at a decreasing rate.

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OUTPUT AND LABOUR INPUT

• Y ( Output ) L ( Labour Input )
• 10 3
• 15 4
• 19 5
• 22 6

31
INCREASE IN THE STOCK OF CAPITAL
Total Output ( Y )
K
L2
Labour Force
32
INCREASE IN THE STOCK OF CAPITAL
Total Output ( Y )
K
L2
Labour Force
33
INCREASE IN THE STOCK OF CAPITAL
Total Output ( Y )
K
L2
Labour Force
34
INCREASE IN THE STOCK OF CAPITAL
K
Total Output ( Y )
K
L2
Labour Force
When capital increases from K to K , the
production function shifts up at any level of
labour input, the level of output increases.
35
REAL WAGE RATE

• The wage rate adjusted for inflation.

36
DEMAND FOR LABOUR

• Firms hire labour to produce output and make
  profits
• The amount of labour they hire depends on the
  real wage rate
• Firms use the Marginal Principle in hiring
  labour

37
THE MARGINAL PRINCIPLE

• Increase the level of activity if its marginal
  benefit exceeds its marginal cost, but reduce the
  level if marginal cost exceeds the marginal
  benefit. If possible, pick the level at which
  the marginal benefit equals the marginal cost.

38
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE / HR
REAL WAGE / HR
REAL WAGE / HR
LABOUR
LABOUR
LABOUR
Demand for and Supply of Labour
Demand for Labour
Supply of Labour
C
A
B
39
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE / HR
REAL WAGE / HR
REAL WAGE / HR
10
10
100
50
LABOUR
LABOUR
LABOUR
Demand for and Supply of Labour
Demand for Labour
Supply of Labour
C
A
B
40
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE / HR
REAL WAGE / HR
REAL WAGE / HR
20
20
10
10
50
100
50
100
LABOUR
LABOUR
LABOUR
Demand for and Supply of Labour
Supply of Labour
Demand for Labour
C
A
B
41
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE / HR
REAL WAGE / HR
REAL WAGE / HR
Labour Demand
Labour Demand
Labour Supply
Labour Supply
20
20
10
10
50
100
50
100
LABOUR
LABOUR
LABOUR
Demand for and Supply of Labour
Supply of Labour
Demand for Labour
C
A
B
42
DEMAND FOR AND SUPPLY OF LABOUR
REAL WAGE / HR
REAL WAGE / HR
REAL WAGE / HR
Labour Demand
Labour Demand
Labour Supply
Labour Supply
20
20
15
10
10
75
50
100
50
100
LABOUR
LABOUR
LABOUR
Demand for and Supply of Labour
Supply of Labour
Demand for Labour
C
A
B
43
LABOUR SUPPLY CURVE

• Based on decisions of workers
• They must decide how many hours they wish to work
  versus how much leisure time they wish to enjoy

44
SUBSTITUTION EFFECT

• An increase in real wage rate will make working
  more attractive and raise the opportunity cost of
  not working
• It leads to workers wanting to supply more hours.

45
INCOME EFFECT

• A higher wage rate raises a workers income for
  the amount of hours that he or she is currently
  working
• As income rises, a worker may choose to enjoy
  more leisure and work fewer hours.

46
INCOME AND SUBSTITUTION EFFECTS

• In principle, a higher wage could lead workers to
  supply either greater or fewer hours of work
• In our analysis, we assume that the substitution
  effect dominates
• A higher wage will lead to increases in the
  supply of labour.

47
SHIFTS IN DEMAND AND SUPPLY
B
A
Real Wages
Real Wages
Labour Supply
Labour Supply
E
E
Labour Demand
Labour Demand
Labour
Labour
48
SHIFTS IN DEMAND AND SUPPLY
B
A
Real Wages
Real Wages
Labour Supply
E
E
Increased Labour Demand
Original Labour Demand
Labour Demand
Labour
Labour
49
SHIFTS IN DEMAND AND SUPPLY
B
A
Real Wages
Real Wages
Labour Supply
Original Labour Supply
E1
E
E
Increased Labour Demand
Original Labour Demand
Labour Demand
Labour
Labour
50
SHIFTS IN DEMAND AND SUPPLY
B
A
Real Wages
Real Wages
Labour Supply
Labour Supply
E1
E
E
Increased Labour Demand
Original Labour Demand
Labour Demand
Labour
Labour
If demand for labour increases, real wages rise
and the amount of labour employed increases
51
SHIFTS IN DEMAND AND SUPPLY
B
A
Real Wages
Real Wages
Labour Supply
Original Labour Supply
E1
Increased Labour Supply
E
E
Increased Labour Demand
Original Labour Demand
Labour Demand
Labour
Labour
If demand for labour increases, real wages rise
and the amount of labour employed increases
52
SHIFTS IN DEMAND AND SUPPLY
B
A
Real Wages
Real Wages
Labour Supply
Original Labour Supply
E1
Increased Labour Supply
E
E
E1
Increased Labour Demand
Original Labour Demand
Labour Demand
Labour
Labour
If demand for labour increases, real wages rise
and the amount of labour employed increases
53
SHIFTS IN DEMAND AND SUPPLY
B
A
Real Wages
Real Wages
Labour Supply
Original Labour Supply
E1
Increased Labour Supply
E
E
E1
Increased Labour Demand
Original Labour Demand
Labour Demand
Labour
Labour
If demand for labour increases, real wages rise
and the amount of labour employed increases
If supply of labour increases, real wages fall
but the amount of labour employed increases
54
FULL-EMPLOYMENT OUTPUT

• The level of output produced when the labour
  market is in equilibrium
• It is also known as the potential output
• Measuring full-employment output
• -- estimate unemployment if cyclical
  unemployment were zero (i.e., only
  frictional and structural factors)
• economists have estimated 5 - 6.5 in
  U.S.
• -- estimate how many workers will be employed
• -- apply short-run production function to
  determine potential output

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DETERMINING FULL-EMPLOYMENT OUTPUT
Real Wage
Labour Supply
Labour
56
DETERMINING FULL-EMPLOYMENT OUTPUT
Real Wage
Labour Supply
Labour Demand
Labour
57
DETERMINING FULL-EMPLOYMENT OUTPUT
Real Wage
Labour Supply
W
Labour Demand
L
Labour
58
DETERMINING FULL-EMPLOYMENT OUTPUT
Output
Labour
Real Wage
Labour Supply
W
Labour Demand
L
Labour
59
DETERMINING FULL-EMPLOYMENT OUTPUT
Output
Y
L
Labour
Real Wage
Labour Supply
W
Labour Demand
L
Labour
60
LAFFER CURVE

• Named after economist Arthur Laffer
• Supply-side economist -- one who emphasizes
  the adverse effects of taxation on potential
  output
• Laffer curve shows the relationship between the
  tax rate that a government levies and total tax
  revenue that the government collects
• The total amount of revenue a government collects
  depends on both the tax rate and the level of
  economic activity
• Laffer curve illustrates that high tax rates may
  not bring in much revenue if economic activity
  decreases.

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LAFFER CURVE
Tax Revenues
Tax Rate
0
At a zero tax rate, the government collects no
revenue.
62
LAFFER CURVE
Tax Revenues
Tax Rate
0
At a zero tax rate, the government collects no
revenue. As tax rates rise, revenues increase.
63
LAFFER CURVE
Tax Revenues
Tax Rate
0
At a zero tax rate, the government collects no
revenue. As tax rates rise, revenues increase.
But at some point, the disincentives from higher
taxes cause revenues to fall.
64
LAFFER CURVE
Tax Revenues
Tax Rate
0
100
At a zero tax rate, the government collects no
revenue. As tax rates rise, revenues increase.
But at some point, the disincentives from higher
taxes cause revenues to fall. At a tax rate of
100, no one will work and tax revenues will
disappear.
65
EFFECTS OF TAX PAID BY EMPLOYERS FOR HIRING LABOUR

• A tax on labour makes labour more expensive and
  raises marginal cost of hiring workers
• Since marginal cost has gone up, but marginal
  benefit has not changed, employers hire fewer
  workers
• Shift left of labour demand leads to lower wage
  and potentially reduced employment

66
EFFECTS OF EMPLOYMENT TAXES
A
B
Real wages
Real wages
Labour supply
Labour supply
E
E
Labour demand before tax
Labour demand before tax
Labour
Labour
67
EFFECTS OF EMPLOYMENT TAXES
A
B
Real wages
Real wages
Labour supply
Labour supply
E
E
Labour demand before tax
Labour demand before tax
Labour demand after tax
Labour demand after tax
Labour
Labour
68
EFFECTS OF EMPLOYMENT TAXES
A
B
Real wages
Real wages
Labour supply
Labour supply
E
E
Labour demand before tax
Labour demand before tax
E1
E1
Labour demand after tax
Labour demand after tax
Labour
Labour
69
EFFECTS OF EMPLOYMENT TAXES
A
B
Real wages
Real wages
Labour supply
Labour supply
E
E
Labour demand before tax
Labour demand before tax
E1
E1
Labour demand after tax
Labour demand after tax
Labour
Labour
A tax on labour shifts the demand curve left and
leads to lower wages and reduced employment.
If the supply curve for labour is vertical,
wages fall but employment does not change.