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Production and specialization
We have two producers and two goods: Amanda and Zoe produce vegetables (V) and or fish (F). Their production capabilities are defined in Table 1.1 and in Figure 1.1, where the quantity of V appears on the vertical axis and the quantity of F on the horizontal axis. Zoe and Amanda each have 36-hour weeks and they devote that time to producing the two goods. But their efficiencies differ: Amanda requires two hours to produce a unit of V and three hours for a unit of F. As a consequence, if she devotes all of her time to V she can produce 18 units, or if she devotes all of her time to F she can produce 12 units. Or, she could share her time between the two. This environment can also be illustrated and analyzed graphically, as in Figure 1.1.
Table 1.1 Production possibilities in a two-person economy
Hours/ Hours/ Fish Vegetable
fish vegetable specialization specialization
Amanda 3 2 12 18
Zoe 2 4 18 9
Each producer has a time allocation of 36 hours. By allocating total time to one activity, Amanda can produce 12F or 18V, Zoe can produce 18F or 9V. By splitting their time each person can also produce a combination of the two.
Two-dimensional graphics are a means of portraying the operation of a model, as defined above. We will use these graphical representations throughout the text. In this case, Amanda's production capability is represented by the line that meets the vertical axis at 18 and the horizontal axis at 12. The vertical point indicates that she can produce 18 units of V if she produces zero units of F – keep in mind that where V has a value of 18, Amanda has no time left for fish production. Likewise, if she devotes all of her time to fish she can produce 12 units, since each unit requires 3 of her 36 hours. The point F=12 is thus another possibility for her. In addition to these two possibilities, which we can term 'specialization', she could allocate her time to producing some of each good. For example, by dividing her 36 hours equally she could produce 6 units of F and 9 units of V. A little computation will quickly convince us that different allocations of her time will lead to combinations of the two goods that lie along a straight line joining the specialization points.
Figure 1.1 Absolute advantage – production
Amanda's PPF indicates that she can produce either 18V (and zero F), or 12F (and zero V), or some combination. Zoe's PPF indicates she can produce either 9V (and zero F), or 18F (and zero V), or some combination. Amanda is more efficient in producing V and Zoe is more efficient at producing F.
We will call this straight line Amanda's production possibility frontier (PPF): It is the combination of goods she can produce while using all of her resources – time. She could not produce combinations of goods represented by points beyond this line (to the top right). She could indeed produce combinations below it (lower left) – for example, a combination of 4 units of V and 4 units of F; but such points would not require all of her time. The (4,4) combination would require just 20 hours. In sum, points beyond this line are not feasible, and points within it do not require all of her time resources.
Production possibility frontier (PPF): the combination of goods that can be produced using all of the resources available.
Having developed Amanda's PPF, it is straightforward to develop a corresponding set of possibilities for Zoe. If she requires 4 hours to produce a unit of V and 2 hours to produce a unit of F, then her 36 hours will enable her to specialize in 9 units of V or 18 units of F; or she could produce a combination represented by the straight line that joins these two specialty extremes.
Consider now the opportunity costs for each person. Suppose Amanda is currently producing 18 V and zero F, and considers producing some F and less V. For each unit of F she wishes to produce, it is evident from her PPF that she must sacrifice 1.5 units of V. This is because F requires 50% more hours than V. Her trade-off is 1.5:1.0. The additional time requirement is also expressed in the intercept values: She could give up 18 units of V and produce 12 units of F instead; this again is a ratio of 1.5:1.0. This ratio defines her opportunity cost: The cost of an additional unit of F is that 1.5 units of V must be 'sacrificed'.
Applying the same reasoning to Zoe's PPF, her opportunity cost is 0.5:1; she must sacrifice one half of a unit of V to free up enough time to produce one unit of F.
So we have established two things about Amanda and Zoe's production possibilities. First, if Amanda specializes in V she can produce more than Zoe, just as Zoe can produce more than Amanda if Zoe specializes in F. Second, their opportunity costs are different: Amanda must sacrifice more V than Zoe in producing one more unit of F. The different opportunity costs translate into potential gains for each individual.
The gains from exchange
We shall illustrate the gains that arise from specialization and exchange graphically. Note first that if these individuals are self-sufficient, in the sense that they consume their own production, each individual's consumption combination will lie on their own PPF. For example, Amanda could allocate half of her time to each good, and produce (and consume) 6F and 9V. Such a point necessarily lies on her PPF. Likewise for Zoe. So, in the absence of exchange, each individual's PPF is also her consumption possibility frontier (CPF). In Figure 1.1 the PPF for each individual is thus also her CPF.
Consumption possibility frontier (CPF): the combination of goods that can be consumed as a result of a given production choice.
Figure 1.2 Absolute advantage – consumption
With specialization and trade at a rate of 1:1 they consume along the line joining the specialization points. If Amanda trades 8V to Zoe in return for 8F, Amanda moves to the point A(8,10) and Zoe to Z(10,8). Each can consume more after specialization than before specialization.
Upon realizing that they are not equally efficient in producing the two goods, they decide to specialize completely in producing just the single good where they are most efficient. Amanda specializes in V and Zoe in F. Next they must agree to a rate at which to exchange V for F. Since Amanda's opportunity cost is 1.5:1 and Zoe's is 0.5:1, suppose they agree to exchange V for F at an intermediate rate of 1:1. There are many trading, or exchange, rates possible; our purpose is to illustrate that gains are possible for both individuals at some exchange rate. The choice of this rate also makes the graphic as simple as possible. At this exchange rate, 18V must exchange for 18F. In Figure 1.2, this means that each individual is now able to consume along the line joining the coordinates (0,18) and (18,0).1 This is because Amanda produces 18V and she can trade at a rate of 1:1, while Zoe produces 18F and trades at the same rate of 1:1.
The fundamental result illustrated in Figure 1.2 is that, as a result of specialization and trade, each individual can consume combinations of goods that lie on a line beyond her initial consumption possibilities. Their consumption well-being has thus improved. For example, suppose Amanda trades away 8V to Zoe and obtains 8F in return. The points 'A' and 'Z' with coordinates (8,10) and (10,8) respectively define their final consumption. Pre-specialization, if Amanda wished to consume 8F she would have been constrained to consume 6V rather than the 10V now possible. Zoe benefits correspondingly.2
The foregoing example illustrates that trade is not a zero-sum game; it has a positive net value because both parties to the trade can gain. A zero-sum gain is where the gains to one party exactly offset the losses to another. This is an extraordinarily important principle in trade negotiations, whether international or domestic.
A zero-sum game is an interaction where the gain to one party equals the loss to another party.
Market design
In the preceding example we have shown that specialization provides scope for gains that can accrue to those participating in the exchange. But this tells us little about how a market for these products comes into being: how does the exchange take place, and how is information transmitted? The answer is that while some markets have evolved historically to their current state, many markets are designed by an institution or a firm. Fruit and vegetable markets have been with us for thousands of years - since we ceased being purely a hunter-gatherer society. They exist in every community in the world economy. In contrast, the Dutch tulip auction was designed in the early 1600s and exists in basically the same form to this day: the auctioneer begins with a high price, lowers it at known time intervals (measured in seconds or minutes) until some buyer signals that she is willing to purchase the lot on offer. Supermarkets in contrast offer goods at a fixed price. Government contracts are normally signed after a tendering process, in which interested suppliers submit bids. Amazon Inc. is currently experimenting with cashierless 'bricks and mortar' stores that monitor all transactions electronically. Craig's List and E-Bay have their own sets of rules.
In each of these cases markets are designed, frequently with a specific objective on the part of the supplier or the mediating institution: Amazon wants to increase its share of all goods trades; governments wish to limit costs. Markets do not all grow spontaneously and the structure of a market will influence how the gains from trade are distributed. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/01%3A_Introduction_to_key_ideas/1.04%3A_A_model_of_exchange_and_specialization.txt |
The PPFs in Figures 1.1 and 1.2 define the amounts of the goods that each individual can produce while using all of their productive capacity—time in this instance. The national, or economy-wide, PPF for this two-person economy reflects these individual possibilities combined. Such a frontier can be constructed using the individual frontiers as the component blocks.
First let us define this economy-wide frontier precisely. The economy-wide PPF is the set of goods and services combinations that can be produced in the economy when all available productive resources are in use. Figure 1.3 contains both of the individual frontiers plus the aggregate of these, represented by the kinked line ace. The point on the V axis, a=27, represents the total amount of V that could be produced if both individuals devoted all of their time to it. The point e=30 on the horizontal axis is the corresponding total for fish.
Figure 1.3 Economy-wide PPF
From a, to produce Fish it is more efficient to use Zoe because her opportunity cost is less (segment ac). When Zoe is completely specialized, Amanda produces (ce). With complete specialization this economy can produce 27V or 30F.
Economy-wide PPF: the set of goods and services combinations that can be produced in the economy when all available productive resources are in use.
To understand the point c, imagine initially that all resources are devoted to V. From such a point, a, consider a reduction in V and an increase in F. The most efficient way of increasing F production at the point a is to use the individual whose opportunity cost is lower. Zoe can produce one unit of F by sacrificing just 0.5 units of V, whereas Amanda must sacrifice 1.5 units of V to produce 1 unit of F. Hence, at this stage Amanda should stick to V and Zoe should devote some time to fish. In fact as long as we want to produce more fish Zoe should be the one to do it, until she has exhausted her time resource. This occurs after she has produced 18F and has ceased producing V. At this point the economy will be producing 18V and 18F – the point c.
From this combination, if the economy wishes to produce more fish Amanda must become involved. Since her opportunity cost is 1.5 units of V for each unit of F, the next segment of the economy-wide PPF must see a reduction of 1.5 units of V for each additional unit of F. This is reflected in the segment ce. When both producers allocate all of their time to F the economy can produce 30 units. Hence the economy's PPF is the two-segment line ace. Since this has an outward kink, we call it concave (rather than convex).
As a final step consider what this PPF would resemble if the economy were composed of many persons with differing efficiencies. A little imagination suggests (correctly) that it will have a segment for each individual and continue to have its outward concave form. Hence, a four-person economy in which each person had a different opportunity cost could be represented by the segmented line abcde, in Figure 1.4. Furthermore, we could represent the PPF of an economy with a very large number of such individuals by a somewhat smooth PPF that accompanies the 4-person PPF. The logic for its shape continues to be the same: As we produce less V and more F we progressively bring into play resources, or individuals, whose opportunity cost, in terms of reduced V is higher.
Figure 1.4 A multi-person PPF
The PPF for the whole economy, abcde, is obtained by allocating productive resources most efficiently. With many individuals we can think of the PPF as the concave envelope of the individual capabilities.
The outputs V and F in our economic model require just one input – time, but if other productive resources were required the result would be still a concave PPF. Furthermore, we generally interpret the PPF to define the output possibilities when the economy is running at its normal capacity. In this example, we consider a work week of 36 hours to be the 'norm'. Yet it is still possible that the economy's producers might work some additional time in exceptional circumstances, and this would increase total production possibilities. This event would be represented by an outward movement of the PPF. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/01%3A_Introduction_to_key_ideas/1.05%3A_Economy-wide_production_possibilities.txt |
The PPF can be used to illustrate several aspects of macroeconomics: In particular, the level of an economy's output, the growth of national and per capita output over time, and short-run business-cycle fluctuations in national output and employment.
Aggregate output
An economy's capacity to produce goods and services depends on its endowment of resources and the productivity of those resources. The two-person, two-product examples in the previous section reflect this.
The productivity of labour, defined as output per worker or per hour, depends on:
• Skill, knowledge and experience of the labour force;
• Capital stock: Buildings, machinery, equipment, and software the labour force has to work with; and
• Current state of technology.
The productivity of labour is the output of goods and services per worker.
An economy's capital stock is the buildings, machinery, equipment and software used in producing goods and services.
The economy's output, which we define by Y, can be defined as the output per worker times the number of workers; hence, we can write:
When the employment of labour corresponds to 'full employment' in the sense that everyone willing to work at current wage rates and normal hours of work is working, the economy's actual output is also its capacity output Yc. We also term this capacity output as full employment output:
Full employment output .
Suppose the economy is operating with full employment of resources producing outputs of two types: Goods and services. In Figure 1.5, shows the different combinations of goods and services the economy can produce in a particular year using all its labour, capital and the best technology available at the time.
Figure 1.5 Growth and the PPF
Economic growth or an increase in the available resources can be envisioned as an outward shift in the PPF from PPF0 to PPF1. With PPF1 the economy can produce more in both sectors than with PPF0.
An aggregate economy produces a large variety of outputs in two broad categories. Goods are the products of the agriculture, forestry, mining, manufacturing and construction industries. Services are provided by the wholesale and retail trade, transportation, hospitality, finance, health care, education, legal and other service sectors. As in the two-product examples used earlier, the shape of the PPF illustrates the opportunity cost of increasing the output of either product type. We are not concerned with who supplies the products for the moment: It may be the private sector or the government.
Point X0 on PPF0 shows one possible structure of capacity output. This combination may reflect the pattern of demand and hence expenditures in this economy. Output structures differ among economies with different income levels. High-income economies spend more on services than goods and produce higher ratios of services to goods. Middle income countries produce lower ratios of services to goods, and low income countries much lower ratios of services to goods. Different countries also have different PPFs and different output structures, depending on their labour forces, labour productivity and expenditure patterns.
Economic growth
Three things contribute to growth in the economy. The labour supply grows as the population expands; the stock of capital grows as spending by business (and government) on buildings, machinery, information technology and so forth increases; and labour-force productivity grows as a result of experience, the development of scientific knowledge combined with product and process innovations, and advances in the technology of production. Combined, these developments expand capacity output over time. In Figure 1.5 economic growth shifts the PPF out from to .
This basic description covers the key sources of growth in total output. Economies differ in their rates of overall economic growth as a result of different rates of growth in labour force, in capital stock, and improvements in technology. But improvements in standards of living require more than growth in total output. Increases in output per worker and per person are necessary. Sustained increases in living standards require sustained growth in labour productivity, which in turn is based on advances in the technology along with the amount of capital each worker has to work with.
Recessions and booms
A prime objective of economic policy is to ensure that the economy operates on or near the PPF – it should use its resources to capacity and have minimal unemployment. However, economic conditions are seldom tranquil for long periods of time. Unpredictable changes in business expectations of future profits, in consumer confidence, in financial markets, in commodity and energy prices, in the demand conditions in major trading partners, in government policy and many other events disrupt patterns of expenditure and output. Some of these changes disturb the level of total expenditure and thus the demand for total output. Others disturb the conditions of production and thus the economy's production capacity. Whatever the exact cause, the economy may be pushed off its current PPF. If expenditures on goods and services decline, the economy may experience a recession. Output would fall short of capacity output and unemployment would rise. Alternatively, times of rapidly growing expenditure and output may result in an economic boom: Output and employment expand beyond capacity levels.
An economic recession occurs when output falls below the economy's capacity output.
A boom is a period of high growth that raises output above normal capacity output.
Recent history provides examples. Following the financial crisis of 2008-09 that hit the US and many other developed economies, many economies were pushed into recessions. Expenditure on new residential construction collapsed for lack of income and secure financing, as did business investment, consumption spending and exports. Lower expenditures reduced producers' revenues, forcing cuts in output and employment and reducing household incomes. Lower incomes led to further cutbacks in spending. In Canada in 2009 aggregate output declined by 2.9 percent, employment declined by 1.6 percent and the unemployment rate rose from 6.1 percent in 2008 to 8.3 percent by 2010. The world's economies have been slow to recover, and even by 2017 the output in several developed economies was no higher than it was in 2008. Canada's recession was not nearly as severe as the recessions in economies such as Spain and Italy; but output between 2009 and 2017 has been below the potential of the Canadian economy. In mid-2017 the national output was about 1.4 percent below potential and the unemployment rate was 6.7 percent.
Figure 1.6 Booms and recessions
Economic recessions leave the economy below its normal capacity; the economy might be driven to a point such as Z. Economic expansions, or booms, may drive capacity above its normal level, to a point such as W.
An economy in a recession is operating inside its PPF. The fall in output from X to Z in Figure 1.6 illustrates the effect of a recession. Expenditures on goods and services have declined. Output is less than capacity output, unemployment is up and some plant capacity is idle. Labour income and business profits are lower. More people would like to work and business would like to produce and sell more output, but it takes time for interdependent product, labour and financial markets in the economy to adjust and increase employment and output. Monetary and fiscal policy may be productive in specific circumstances, to stimulate demand, increase output and employment and move the economy back to capacity output and full employment. The development and implementation of such policies form the core of macroeconomics.
Alternatively, an unexpected increase in demand for exports would increase output and employment. Higher employment and output would increase incomes and expenditure, and in the process spread the effects of higher output sales to other sectors of the economy. The economy would move outside its PPF, for example to W in Figure 1.6, by using its resources more intensively than normal. Unemployment would fall and overtime work would increase. Extra production shifts would run plant and equipment for longer hours and work days than were planned when it was designed and installed. Output at this level may not be sustainable, because shortages of labour and materials along with excessive rates of equipment wear and tear would push costs and prices up. Again, we will examine how the economy reacts to such a state in our macroeconomic analysis.
Output and employment in the Canadian economy over the past twenty years fluctuated about growth trend in the way Figure 1.6 illustrates. For several years prior to 2008 the Canadian economy operated slightly above its capacity; but once the recession arrived monetary and fiscal policy were used to fight it – to bring the economy back from a point such as Z towards a point such as X on the PPF.
Macroeconomic models and policy
The PPF diagrams illustrate the main dimensions of macroeconomics: Capacity output, growth in capacity output and business cycle fluctuations in actual output relative to capacity. But these diagrams do not offer explanations and analysis of macroeconomic activity. We need a macroeconomic model to understand and evaluate the causes and consequences of business cycle fluctuations. As we shall see, these models are based on explanations of expenditure decisions by households and business, financial market conditions, production costs and producer pricing decisions at different levels of output. Models also capture the objectives of fiscal and monetary policies and provide a framework for policy evaluation. A full macroeconomic model integrates different sector behaviours and the feedbacks across sectors that can moderate or amplify the effects of changes in one sector on national output and employment. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/01%3A_Introduction_to_key_ideas/1.06%3A_Aggregate_output_growth_and_business_cycles.txt |
Conclusion
We have covered a lot of ground in this introductory chapter. It is intended to open up the vista of economics to the new student in the discipline. Economics is powerful and challenging, and the ideas we have developed here will serve as conceptual foundations for our exploration of the subject.
Key Concepts
Macroeconomics studies the economy as system in which feedback among sectors determine national output, employment and prices.
Microeconomics is the study of individual behaviour in the context of scarcity.
Mixed economy: goods and services are supplied both by private suppliers and government.
Model is a formalization of theory that facilitates scientific inquiry.
Theory is a logical view of how things work, and is frequently formulated on the basis of observation.
Opportunity cost of a choice is what must be sacrificed when a choice is made.
Production possibility frontier (PPF) defines the combination of goods that can be produced using all of the resources available.
Consumption possibility frontier (CPF): the combination of goods that can be consumed as a result of a given production choice.
A zero-sum game is an interaction where the gain to one party equals the loss to another party.
Economy-wide PPF is the set of goods combinations that can be produced in the economy when all available productive resources are in use.
Productivity of labour is the output of goods and services per worker.
Capital stock: the buildings, machinery, equipment and software used in producing goods and services.
Full employment output .
Recession: when output falls below the economy's capacity output.
Boom: a period of high growth that raises output above normal capacity output.
1.09: Exercises for Chapter 1
EXERCISE 1.1
An economy has 100 identical workers. Each one can produce four cakes or three shirts, regardless of the number of other individuals producing each good.
1. How many cakes can be produced in this economy when all the workers are cooking?
2. How many shirts can be produced in this economy when all the workers are sewing?
3. On a diagram with cakes on the vertical axis, and shirts on the horizontal axis, join these points with a straight line to form the PPF.
4. Label the inefficient and unattainable regions on the diagram.
EXERCISE 1.2
In the table below are listed a series of points that define an economy's production possibility frontier for goods Y and X.
Y 1000 900 800 700 600 500 400 300 200 100 0
X 0 1600 2500 3300 4000 4600 5100 5500 5750 5900 6000
1. Plot these pairs of points to scale, on graph paper, or with the help of a spreadsheet.
2. Given the shape of this PPF is the economy made up of individuals who are similar or different in their production capabilities?
3. What is the opportunity cost of producing 100 more Y at the combination (X=5500,Y=300).
4. Suppose next there is technological change so that at every output level of good Y the economy can produce 20 percent more X. Enter a new row in the table containing the new values, and plot the new PPF.
EXERCISE 1.3
Using the PPF that you have graphed using the data in Exercise 1.2, determine if the following combinations are attainable or not: (X=3000,Y=720), (X=4800,Y=480).
EXERCISE 1.4
You and your partner are highly efficient people. You can earn \$20 per hour in the workplace; your partner can earn \$30 per hour.
1. What is the opportunity cost of one hour of leisure for you?
2. What is the opportunity cost of one hour of leisure for your partner?
3. Now consider what a PPF would look like: You can produce/consume two things, leisure and income. Since income buys things you can think of the PPF as having these two 'products' – leisure and consumption goods/services. So, with leisure on the horizontal axis and income in dollars is on the vertical axis, plot your PPF. You can assume that you have 12 hours per day to allocate to either leisure or income. [Hint: the leisure axis will have an intercept of 12 hours. The income intercept will have a dollar value corresponding to where all hours are devoted to work.]
4. Draw the PPF for your partner.
EXERCISE 1.5
Louis and Carrie Anne are students who have set up a summer business in their neighbourhood. They cut lawns and clean cars. Louis is particularly efficient at cutting the grass – he requires one hour to cut a typical lawn, while Carrie Anne needs one and one half hours. In contrast, Carrie Anne can wash a car in a half hour, while Louis requires three quarters of an hour.
1. If they decide to specialize in the tasks, who should cut the grass and who should wash cars?
2. If they each work a twelve hour day, how many lawns can they cut and how many cars can they wash if they each specialize in performing the task where they are most efficient?
3. Illustrate the PPF for each individual where lawns are on the horizontal axis and car washes on the vertical axis, if each individual has twelve hours in a day.
EXERCISE 1.6
Continuing with the same data set, suppose Carrie Anne's productivity improves so that she can now cut grass as efficiently as Louis; that is, she can cut grass in one hour, and can still wash a car in one half of an hour.
1. In a new diagram draw the PPF for each individual.
2. In this case does specialization matter if they are to be as productive as possible as a team?
3. Draw the PPF for the whole economy, labelling the intercepts and the 'kink' point coordinates.
EXERCISE 1.7
Going back to the simple PPF plotted for Exercise 1.1 where each of 100 workers can produce either four cakes or three shirts, suppose a recession reduces demand for the outputs to 220 cakes and 129 shirts.
1. Plot this combination of outputs in the diagram that also shows the PPF.
2. How many workers are needed to produce this output of cakes and shirts?
3. What percentage of the 100 worker labour force is unemployed? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/01%3A_Introduction_to_key_ideas/1.08%3A_Key_Concepts.txt |
Economists, like other scientists and social scientists, observe and analyze behaviour and events. Economists are concerned primarily with the economic causes and consequences of what they observe. They want to understand an extensive range of human experience, including: money, government finances, industrial production, household consumption, inequality in income distribution, war, monopoly power, professional and amateur sports, pollution, marriage, music, art, and much more. Economists approach these issues using theories and models. To present, explain, illustrate and evaluate their theories and models they have developed a set of techniques or tools. These involve verbal descriptions and explanations, diagrams, algebraic equations, data tables and charts and statistical tests of economic relationships. This chapter covers some of these basic techniques of analysis.
02: Theories data and beliefs
The analysis of behaviour necessarily involves data. Data may serve to validate or contradict a theory. Data analysis, even without being motivated by economic theory, frequently displays patterns of behaviour that merit examination. The terms variables and data are related. Variables are measures that can take on different magnitudes. The interest rate on a student loan, for example, is a variable with a certain value at a point in time but perhaps a different value at an earlier or later date. Economic theories and models explain the causal relationships between variables. In contrast, Data are the recorded values of variables. Sets of data provide specific values for the variables we want to study and analyze. Knowing that gross domestic product (a variable) declined in 2009 is just a partial description of events. If the data indicate that it decreased by exactly 3%, we know a great deal more – we know that the decline was significantly large.
Variables: measures that can take on different values.
Data: recorded values of variables.
Sets of data help us to test our models or theories, but first we need to pay attention to the economic logic involved in observations and modelling. For example, if sunspots or baggy pants were found to be correlated with economic expansion, would we consider these events a coincidence or a key to understanding economic growth? The observation is based on facts or data, but it need not have any economic content. The economist's task is to distinguish between coincidence and economic causation.
While the more frequent wearing of loose clothing in the past may have been associated with economic growth because they both occurred at the same time (correlation), one could not argue on a logical basis that this behaviour causes good economic times. Therefore, the past association of these variables should be considered as no more than a coincidence. Once specified on the basis of economic logic, a model must be tested to determine its usefulness in explaining observed economic events.
Table 2.1 House prices and price indexes
Year House Percentage Percentage Real Index for 5-year
prices in change in change in percentage price of mortgage
dollars consumer change housing rate
() prices in
2001 350,000 100 7.75
2002 360,000 102.9 6.85
2003 395,000 35,000/360,000=9.7% 3% 6.7% 112.9 6.6
2004 434,000 124.0 5.8
2005 477,000 136.3 6.1
2006 580,000 165.7 6.3
2007 630,000 180.0 6.65
2008 710,000 202.9 7.3
2009 605,000 -105,000/710,000=-14.8% 1.6% -16.4% 172.9 5.8
2010 740,000 211.4 5.4
2011 800,000 228.6 5.2
Note: Data on changes in consumer prices come from Statistics Canada, CANSIM series V41692930; data on house prices are for N. Vancouver from Royal Le Page; data on mortgage rates from www.ratehub.ca. Index for house prices obtained by scaling each entry in column 2 by 100/350,000. The real percentage change in the price of housing is: The percentage change in the price of housing minus the percentage change in consumer prices.
Data types
Data come in several forms. One form is time-series, which reflects a set of measurements made in sequence at different points in time. The first column in Table 2.1 reports the values for house prices in North Vancouver for the first quarter of each year, between 2001 and 2011. Evidently this is a time series. Annual data report one observation per year. We could, alternatively, have presented the data in monthly, weekly, or even daily form. The frequency we use depends on the purpose: If we are interested in the longer-term trend in house prices, then the annual form suffices. In contrast, financial economists, who study the behaviour of stock prices, might not be content with daily or even hourly prices; they may need prices minute-by-minute. Such data are called high-frequency data, whereas annual data are low-frequency data.
Table 2.2 Unemployment rates, Canada and Provinces, monthly 2012, seasonally adjusted
Jan Feb Mar Apr May Jun
CANADA 7.6 7.4 7.2 7.3 7.3 7.2
NFLD 13.5 12.9 13.0 12.3 12.0 13.0
PEI 12.2 10.5 11.3 11.0 11.3 11.3
NS 8.4 8.2 8.3 9.0 9.2 9.6
NB 9.5 10.1 12.2 9.8 9.4 9.5
QUE 8.4 8.4 7.9 8.0 7.8 7.7
ONT 8.1 7.6 7.4 7.8 7.8 7.8
MAN 5.4 5.6 5.3 5.3 5.1 5.2
SASK 5.0 5.0 4.8 4.9 4.5 4.9
ALTA 4.9 5.0 5.3 4.9 4.5 4.6
BC 6.9 6.9 7.0 6.2 7.4 6.6
Source: Statistics Canada CANSIM Table 282-0087.
Time-series: a set of measurements made sequentially at different points in time.
High (low) frequency data: series with short (long) intervals between observations.
In contrast to time-series data, cross-section data record the values of different variables at a point in time. Table 2.2 contains a cross-section of unemployment rates for Canada and Canadian provinces economies. For January 2012 we have a snapshot of the provincial economies at that point in time, likewise for the months until June. This table therefore contains repeated cross-sections.
When the unit of observation is the same over time such repeated cross sections are called longitudinal data. For example, a health survey that followed and interviewed the same individuals over time would yield longitudinal data. If the individuals differ each time the survey is conducted, the data are repeated cross sections. Longitudinal data therefore follow the same units of observation through time.
Cross-section data: values for different variables recorded at a point in time.
Repeated cross-section data: cross-section data recorded at regular or irregular intervals.
Longitudinal data: follow the same units of observation through time.
Graphing the data
Data can be presented in graphical as well as tabular form. Figure 2.1 plots the house price data from the second column of Table 2.1. Each asterisk in the figure represents a price value and a corresponding time period. The horizontal axis reflects time, the vertical axis price in dollars. The graphical presentation of data simply provides a visual rather than numeric perspective. It is immediately evident that house prices increased consistently during this 11-year period, with a single downward 'correction' in 2009. We have plotted the data a second time in Figure 2.2 to illustrate the need to read graphs carefully. The greater apparent slope in Figure 2.1 might easily be interpreted to mean that prices increased more steeply than suggested in Figure 2.2. But a careful reading of the axes reveals that this is not so; using different scales when plotting data or constructing diagrams can mislead the unaware viewer.
Figure 2.1 House prices in dollars 1999-2012
Figure 2.2 House prices in dollars 1999-2012
Percentage changes
The use of percentages makes the analysis of data particularly simple. Suppose we wanted to compare the prices of New York luxury condominiums with the prices of homes in rural Mississippi. In the latter case, a change in average prices of \$10,000 might be considered enormous, whereas a change of one million dollars in New York might be pretty normal – because the average price in New York is so much higher than in Mississippi. To make comparisons between the two markets, we can use the concept of a percentage change. This is defined as the change in the value of the variable, relative to its initial value, multiplied by 100.
.
The third column of Table 2.1 contains the values of the percentage change in house prices for two pairs of years. Between 2002 and 2003 the price change was \$35,000. Relative to the price in the first of these two years this change was the fraction 35,000/395,000=0.097. If we multiply this fraction by 100 we obtain a percentage price change of 9.7%. Evidently we could calculate the percentage price changes for all pairs of years. A second price change is calculated for the 2008-2009 pair of years. Here price declined and the result is thus a negative percentage change.
Consumer prices
Most variables in economics are averages of the components that go into them. When variables are denominated in dollar terms it is important to be able to interpret them correctly. While the house price series above indicates a strong pattern of price increases, it is vital to know if the price of housing increased more or less rapidly that other prices in the economy. If all prices in the economy were increasing in line with house prices there would be no special information in the house price series. However, if house prices increased more rapidly than prices in general, then the data indicate that something special took place in the housing market during the decade in question. To determine an answer to this we need to know the degree to which the general price level changed each year.
Statistics Canada regularly surveys the price of virtually every product produced in the economy. One such survey records the prices of goods and services purchased by consumers. Statistics Canada then computes an average price level for all of these goods combined for each time period the survey is carried out (monthly). Once Statistics Canada has computed the average consumer price, it can compute the change in the price level from one period to the next. In Table 2.1 two such values are entered in the following data column: Consumer prices increased by 3% between 2002 and 2003, and by 1.6% between 2008 and 2009. These percentage changes in the general price level represent inflation if prices increase, and deflation if prices decline.
In this market it is clear that housing price changes were substantially larger than the changes in consumer prices for these two pairs of years. The next column provides information on the difference between the house price changes and changes in the general consumer price level, in percentage terms. This is (approximately) the change in the relative price of housing, or what economists call the real price of housing.
Consumer price index: the average price level for consumer goods and services.
Inflation (deflation) rate: the annual percentage increase (decrease) in the level of consumer prices.
Real price: the actual price adjusted by the general (consumer) price level in the economy.
Index numbers
Statistics Canada and other statistical agencies frequently present data in index number form. An index number provides an easy way to read the data. For example, suppose we wanted to compute the percentage change in the price of housing between 2001 and 2007. We could do this by entering the two data points in a spreadsheet or calculator and do the computation. But suppose the prices were entered in another form. In particular, by dividing each price value by the first year value and multipling the result by 100 we obtain a series of prices that are all relative to the initial year – which we call the base year. The resulting series in column 6 is an index of house price values. Each entry is the corresponding value in column 2, divided by the first entry in column 2. The key characteristics of indexes are that they are not dependent upon the units of measurement of the data in question, and they are interpretable easily with reference to a given base value. To illustrate, suppose we wish to know how prices behaved between 2001 and 2007. The index number column immediately tells us that prices increased by 80%, because relative to 2001, the 2007 value is 80% higher.
Index number: value for a variable, or an average of a set of variables, expressed relative to a given base value.
Furthermore, index numbers enable us to make comparisons with the price patterns for other goods much more easily. If we had constructed a price index for automobiles, which also had a base value of 100 in 2001, we could make immediate comparisons without having to compare one set of numbers defined in thousands of dollars with another defined in hundreds of thousands of dollars. In short, index numbers simplify the interpretation of data. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/02%3A_Theories_data_and_beliefs/2.01%3A_Data_analysis.txt |
Let us now investigate the interplay between economic theories on the one hand and data on the other. We will develop two examples. The first will be based upon the data on house prices, the second upon a new data set.
House prices – theory
Remember from Chapter 1 that a theory is a logical argument regarding economic relationships. A theory of house prices would propose that the price of housing depends upon a number of elements in the economy. In particular, if borrowing costs are low then buyers are able to afford the interest costs on larger borrowings. This in turn might mean they are willing to pay higher prices. Conversely, if borrowing rates are higher. Consequently, the borrowing rate, or mortgage rate, is a variable for an economic model of house prices. A second variable might be available space for development: If space in a given metropolitan area is tight then the land value will reflect this, and consequently the higher land price should be reflected in higher house prices. A third variable would be the business climate: If there is a high volume of high-value business transacted in a given area then buildings will be more in demand, and that in turn should be reflected in higher prices. For example, both business and residential properties are more highly priced in San Francisco and New York than in Moncton, New Brunswick. A fourth variable might be environmental attractiveness: Vancouver may be more enticing than other towns in Canada. A fifth variable might be the climate.
House prices – evidence
These and other variables could form the basis of a theory of house prices. A model of house prices, as explained in Chapter 1, focuses upon what we would consider to be the most important subset of these variables. In the limit, we could have an extremely simple model that specified a dependence between the price of housing and the mortgage rate alone. To test such a simple model we need data on house prices and mortgage rates. The final column of Table 2.1 contains data on the 5-year fixed-rate mortgage for the period in question. Since our simple model proposes that prices depend (primarily) upon mortgage rates, in Figure 2.3 we plot the house price series on the vertical axis, and the mortgage rate on the horizontal axis, for each year from 2001 to 2011. As before, each point (shown as a '+') represents a pair of price and mortgage rate values.
Figure 2.3 Price of housing
The resulting plot (called a scatter diagram) suggests that there is a negative relationship between these two variables. That is, higher prices are correlated with lower mortgage rates. Such a correlation is consistent with our theory of house prices, and so we might conclude that changes in mortgage rates cause changes in house prices. Or at least the data suggest that we should not reject the idea that such causation is in the data.
House prices – inference
To summarize the relationship between these variables, the pattern suggests that a straight line through the scatter plot would provide a reasonably good description of the relationship between these variables. Obviously it is important to define the most appropriate line – one that 'fits' the data well.1 The line we have drawn through the data points is informative, because it relates the two variables in a quantitative manner. It is called a regression line. It predicts that, on average, if the mortgage rate increases, the price of housing will respond in the downward direction. This particular line states that a one point change in the mortgage rate will move prices in the opposing direction by \$105,000. This is easily verified by considering the dollar value corresponding to say a mortgage value of 6.5, and then the value corresponding to a mortgage value of 7.5. Projecting vertically to the regression line from each of these points on the horizontal axis, and from there across to the vertical axis will produce a change in price of \$105,000.
Note that the line is not at all a 'perfect' fit. For example, the mortgage rate declined between 2008 and 2009, but the price declined also – contrary to our theory. The model is not a perfect predictor; it states that on average a change in the magnitude of the x-axis variable leads to a change of a specific amount in the magnitude of the y-axis variable.
In this instance the slope of the line is given by -105,000/1, which is the vertical distance divided by the corresponding horizontal distance. Since the line is straight, this slope is unchanging.
Regression line: representation of the average relationship between two variables in a scatter diagram.
Road fatalities – theory, evidence and inference
Table 2.3 contains data on annual road fatalities per 100,000 drivers for various age groups. In the background, we have a theory, proposing that driver fatalities depend upon the age of the driver, the quality of roads and signage, speed limits, the age of the automobile stock and perhaps some other variables. Our model focuses upon a subset of these variables, and in order to present the example in graphical terms we specify fatalities as being dependent upon a single variable – age of driver.
Table 2.3 Non-linearity: Driver fatality rates Canada, 2009
Age of driver Fatality rate
per 100,000 drivers
20-24 9.8
25-34 4.4
35-44 2.7
45-54 2.4
55-64 1.9
65+ 2.9
Source: Transport Canada, Canadian motor vehicle traffic collision statistics, 2009.
The scatter diagram is presented in Figure 2.4. Two aspects of this plot stand out. First, there is an exceedingly steep decline in the fatality rate when we go from the youngest age group to the next two age groups. The decline in fatalities between the youngest and second youngest groups is about 20 points, whereas the decline between the third and fourth age groups is less than 2 points. This suggests that behaviour is not the same throughout the age distribution. Second, we notice that fatalities increase for the oldest age group, perhaps indicating that the oldest drivers are not as good as middle-aged drivers.
These two features suggest that the relationship between fatalities and age differs across the age spectrum. Accordingly, a straightline would not be an accurate way of representing the behaviours in these data. A straight line through the plot implies that a given change in age should have a similar impact on fatalities, no matter the age group. Accordingly we have an example of a non-linear relationship. Such a non-linear relationship might be represented by the curve going through the plot. Clearly the slope of this line varies as we move from one age category to another.
Figure 2.4 Non-linearity: Driver fatality rates Canada, 2009
Fatality rates vary non-linearly with age: At first they decline, then increase again, relative to the youngest age group. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/02%3A_Theories_data_and_beliefs/2.02%3A_Data_theory_and_economic_models.txt |
Positive economics studies objective or scientific explanations of how the economy functions. Its aim is to understand and generate predictions about how the economy may respond to changes and policy initiatives. In this effort economists strive to act as detached scientists, regardless of political sympathies or ethical code. Personal judgments and preferences are (ideally) kept apart. In this particular sense, economics is similar to the natural sciences such as physics or biology. To date in this chapter we have been exploring economics primarily from a positive standpoint.
In contrast, normative economics offers recommendations based partly on value judgments. While economists of different political persuasions can agree that raising the income tax rate would lead to some reduction in the number of hours worked, they may yet differ in their views on the advisability of such a rise. One economist may believe that the additional revenue that may come in to government coffers is not worth the disincentives to work; another may think that, if such monies can be redistributed to benefit the needy, or provide valuable infrastructure, the negative impact on the workers paying the income tax is worth it.
Positive economics studies objective or scientific explanations of how the economy functions.
Normative economics offers recommendations that incorporate value judgments.
Scientific research can frequently resolve differences that arise in positive economics—not so in normative economics. For example, if we claim that "the elderly have high medical bills, and the government should cover all of the bills", we are making both a positive and a normative statement. The first part is positive, and its truth is easily established. The latter part is normative, and individuals of different beliefs may reasonably differ. Some people may believe that the money would be better spent on the environment and have the aged cover at least part of their own medical costs. Positive economics does not attempt to show that one of these views is correct and the other false. The views are based on value judgments, and are motivated by a concern for equity. Equity is a vital guiding principle in the formation of policy and is frequently, though not always, seen as being in competition with the drive for economic growth. Equity is driven primarily by normative considerations. Few economists would disagree with the assertion that a government should implement policies that improve the lot of the poor—but to what degree?
Economic equity is concerned with the distribution of well-being among members of the economy.
Most economists hold normative views, sometimes very strongly. They frequently see themselves, not just as cold hearted scientists, but as champions for their (normative) cause in addition. Conservative economists see a smaller role for government than left-leaning economists.
Many economists see a conflict between equity and the efficiency considerations that we developed in Chapter 1. For example, high taxes may provide disincentives to work in the marketplace and therefore reduce the efficiency of the economy: Plumbers and gardeners may decide to do their own gardening and their own plumbing because, by staying out of the marketplace where monetary transactions are taxed, they can avoid the taxes. And avoiding the taxes may turn out to be as valuable as the efficiency gains they forgo.
In other areas the equity-efficiency trade-off is not so obvious: If taxes (that may have disincentive effects) are used to educate individuals who otherwise would not develop the skills that follow education, then economic growth may be higher as a result of the intervention.
Revisiting the definition of economics – core beliefs
This is an appropriate point at which to return to the definition of economics in Chapter 1 that we borrowed from Nobel Laureate Christopher Sims: Economics is a set of ideas and methods for the betterment of society.
If economics is concerned about the betterment of society, clearly there are ethical as well as efficiency considerations at play. And given the philosophical differences among scientists (including economists), can we define an approach to economics that is shared by the economics profession at large? Most economists would answer that the profession shares a set of beliefs, and that differences refer to the extent to which one consideration may collide with another.
• First of all we believe that markets are critical because they facilitate exchange and therefore encourage efficiency. Specialization and trade creates benefits for the trading parties. For example, Canada has not the appropriate climate for growing coffee beans, and Colombia has not the terrain for wheat. If Canada had to be self-sufficient, we might have to grow coffee beans in green-houses—a costly proposition. But with trade we can specialize, and then exchange some of our wheat for Colombian coffee. Similar benefits arise for the Colombians.
A frequent complaint against trade is that its modern-day form (globalization) does not benefit the poor. For example, workers in the Philippines may earn only a few dollars per day manufacturing clothing for Western markets. From this perspective, most of the gains from trade go to the Western consumers and capitalists, come at the expense of jobs to western workers, and provide Asian workers with meagre rewards.
• A corollary of the centrality of markets is that incentives matter. If the price of business class seats on your favourite airline is reduced, you may consider upgrading. Economists believe strongly that the price mechanism influences behaviour, and therefore favour the use of price incentives in the marketplace and public policy more generally. Environmental economists, for example, advocate the use of pollution permits that can be traded at a price between users, or carbon taxes on the emission of greenhouse gases. We will develop such ideas in Principles of Microeconomics Chapter 5 more fully.
• In saying that economists believe in incentives, we are not proposing that human beings are purely mercenary. People have many motivations: Self-interest, a sense of public duty, kindness, etc. Acting out of a sense of self-interest does not imply that people are morally empty or have no altruistic sense.
• Economists believe universally in the importance of the rule of law, no matter where they sit on the political spectrum. Legal institutions that govern contracts are critical to the functioning of an economy. If goods and services are to be supplied in a market economy, the suppliers must be guaranteed that they will be remunerated. And this requires a developed legal structure with penalties imposed on individuals or groups who violate contracts. Markets alone will not function efficiently.
Modern development economics sees the implementation of the rule of law as perhaps the central challenge facing poorer economies. There is a strong correlation between economic growth and national wealth on the one hand, and an effective judical and policing system on the other. The consequence on the world stage is that numerous 'economic' development projects now focus upon training jurists, police officers and bureaucrats in the rule of law!
• Finally, economists believe in the centrality of government. Governments can solve a number of problems that arise in market economies that cannot be addressed by the private market place. For example, governments can best address the potential abuses of monopoly power. Monopoly power, as we shall see in Principles of Microeconomics Chapter 10, not only has equity impacts it may also reduce economic efficiency. Governments are also best positioned to deal with environmental or other types of externalities – the impact of economic activity on sectors of the economy that are not directly involved in the activity under consideration.
In summary, governments have a variety of roles to play in the economy. These roles involve making the economy more equitable and more efficient by using their many powers. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/02%3A_Theories_data_and_beliefs/2.03%3A_Ethics_efficiency_and_beliefs.txt |
Key Concepts
Variables: measures that can take on different sizes.
Data: recorded values of variables.
Time series data: a set of measurements made sequentially at different points in time.
High (low) frequency data series have short (long) intervals between observations.
Cross-section data: values for different variables recorded at a point in time.
Repeated cross-section data: cross-section data recorded at regular or irregular intervals.
Longitudinal data follow the same units of observation through time.
Percentage change.
Consumer price index: the average price level for consumer goods and services.
Inflation (deflation) rate: the annual percentage increase (decrease) in the level of consumer prices.
Real price: the actual price adjusted by the general (consumer) price level in the economy.
Index number: value for a variable, or an average of a set of variables, expressed relative to a given base value.
Regression line: representation of the average relationship between two variables in a scatter diagram.
Positive economics studies objective or scientific explanations of how the economy functions.
Normative economics offers recommendations that incorporate value judgments.
Economic equity is concerned with the distribution of well-being among members of the economy.
2.05: Exercises for Chapter 2
EXERCISE 2.1
An examination of a country's recent international trade flows yields the data in the table below.
Year National Income (\$b) Imports (\$b)
2011 1,500 550
2012 1,575 573
2013 1,701 610
2014 1,531 560
2015 1,638 591
1. Based on an examination of these data do you think the national income and imports are not related, positively related, or negatively related?
2. Plot each pair of observations in a two-dimensional line diagram to illustrate your view of the import/income relationship. Measure income on the horizontal axis and imports on the vertical axis. This can be done using graph paper or a spreadsheet-cum-graphics software.
EXERCISE 2.2
The average price of a medium coffee at Wakeup Coffee Shop in each of the past ten years is given in the table below.
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
\$1.05 \$1.10 \$1.14 \$1.20 \$1.25 \$1.25 \$1.33 \$1.35 \$1.45 \$1.49
1. Construct an annual 'coffee price index' for this time period using 2005 as the base year. [Hint: follow the procedure detailed in the chapter – divide each yearly price by the base year price.]
2. Based on your price index, what was the percentage change in the price of a medium coffee from 2005 to 2012?
3. Based on your index, what was the average annual percentage change in the price of coffee from 2005 to 2010?
4. Assuming the inflation rate in this economy was 2% every year, what was the real change in the price of coffee between 2007 and 2008; and between 2009 and 2010?
EXERCISE 2.3
The following table shows hypothetical consumption spending by households and income of households in billions of dollars.
Year Income Consumption
2006 476 434
2007 482 447
2008 495 454
2009 505 471
2010 525 489
2011 539 509
2012 550 530
2013 567 548
1. Plot the scatter diagram with consumption on the vertical axis and income on the horizontal axis.
2. Fit a line through these points.
3. Does the line indicate that these two variables are related to each other?
4. How would you describe the causal relationship between income and consumption?
EXERCISE 2.4
Using the data from Exercise 2.3, compute the percentage change in consumption and the percentage change in income for each pair of adjoining years between 2006 and 2013.
EXERCISE 2.5
You are told that the relationship between two variables, X and Y, has the form Y=10+2X. By trying different values for X you can obtain the corresponding predicted value for Y (e.g., if X=3, then ). For values of X between 0 and 12, compute the matching value of Y and plot the scatter diagram.
EXERCISE 2.6
For the data below, plot a scatter diagram with variable Y on the vertical axis and variable X on the horizontal axis.
Y 40 33 29 56 81 19 20
X 5 7 9 3 1 11 10
1. Is the relationship between the variables positive or negative?
2. Do you think that a linear or non-linear line better describes the relationship? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/02%3A_Theories_data_and_beliefs/2.04%3A_Key_Concepts.txt |
The marketplace in today's economy has evolved from earlier times. It no longer has a unique form – one where buyers and sellers physically come together for the purpose of exchange. Indeed, supermarkets require individuals to be physically present to make their purchases. But when purchasing an airline ticket, individuals simply go online and interact with perhaps a number of different airlines (suppliers) simultaneously. Or again, individuals may simply give an instruction to their stock broker, who will execute a purchase on their behalf – the broker performs the role of a middleman, who may additionally give advice to the purchaser. Or a marketing agency may decide to subcontract work to a translator or graphic artist who resides in Mumbai. In pure auctions (where a single work of art or a single residence is offered for sale) buyers compete one against the other for the single item supplied. Accommodations in private homes are supplied to potential visitors (buyers) through Airbnb. Taxi rides are mediated through Lyft or Uber. These institutions are all different types of markets; they serve the purpose of facilitating exchange and trade.
Not all goods and services in the modern economy are obtained through the marketplace. Schooling and health care are allocated in Canada primarily by government decree. In some instances the market plays a supporting role: Universities and colleges may levy fees, and most individuals must pay, at least in part, for their pharmaceuticals. In contrast, broadcasting services may carry a price of zero – as with the Canadian Broadcasting Corporation. Furthermore, some markets have no price, yet they find a way of facilitating an exchange. For example, graduating medical students need to be matched with hospitals for their residencies. Matching mechanisms are a form of market in that they bring together suppliers and demanders.
The importance of the marketplace springs from its role as an allocating mechanism. Elevated prices effectively send a signal to suppliers that the buyers in the market place a high value on the product being traded; conversely when prices are low. Accordingly, suppliers may decide to cease supplying markets where prices do not remunerate them sufficiently, and redirect their energies and the productive resources under their control to other markets – markets where the product being traded is more highly valued, and where the buyer is willing to pay more.
Whatever their form, the marketplace is central to the economy we live in. Not only does it facilitate trade, it also provides a means of earning a livelihood. Suppliers must hire resources – human and non-human in order to bring their supplies to market and these resources must be paid a return – income is generated.
In this chapter we will examine the process of price formation – how the prices that we observe in the marketplace come to be what they are. We will illustrate that the price for a good is inevitably linked to the quantity of a good; price and quantity are different sides of the same coin and cannot generally be analyzed separately. To understand this process more fully, we need to model a typical market. The essentials are demand and supply. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/03%3A_The_classical_marketplace__demand_and_supply/3.01%3A_The_marketplace_%E2%80%93_trading.txt |
In economics we use the terminology that describes trade in a particular manner. Non-economists frequently describe microeconomics by saying "it's all about supply and demand". While this is largely true we need to define exactly what we mean by these two central words. Demand is the quantity of a good or service that buyers wish to purchase at each conceivable price, with all other influences on demand remaining unchanged. It reflects a multitude of values, not a single value. It is not a single or unique quantity such as two cell phones, but rather a full description of the quantity of a good or service that buyers would purchase at various prices.
Demand is the quantity of a good or service that buyers wish to purchase at each possible price, with all other influences on demand remaining unchanged.
As a hypothetical example, the first column of Table 3.1 shows the price of natural gas per cubic foot. The second column shows the quantity that would be purchased in a given time period at each price. It is therefore a schedule of quantities demanded at various prices. For example, at a price \$6 per unit, buyers would like to purchase 4 units, whereas at the lower price of \$3 buyers would like to purchase 7 units. Note also that this is a homogeneous good. A cubit foot of natural gas is considered to be the same product no matter which supplier brings it to the market. In contrast, accomodations supplied through Airbnb are heterogeneous – they vary in size and quality.
Table 3.1 Demand and supply for natural gas
Price (\$) Demand (thousands Supply (thousands Excess
of cu feet) of cu feet)
10 0 18 Excess Supply
9 1 16
8 2 14
7 3 12
6 4 10
5 5 8
4 6 6 Equilibrium
3 7 4 Excess Demand
2 8 2
1 9 0
0 10 0
Supply is interpreted in a similar manner. It is not a single value; we say that supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged. Such a supply schedule is defined in the third column of the table. It is assumed that no supplier can make a profit (on account of their costs) unless the price is at least \$2 per unit, and therefore a zero quantity is supplied below that price. The higher price is more profitable, and therefore induces a greater quantity supplied, perhaps by attracting more suppliers. This is reflected in the data. For example, at a price of \$3 suppliers are willing to supply 4 units, whereas with a price of \$7 they are willing to supply 12 units. There is thus a positive relationship between price and quantity for the supplier – a higher price induces a greater quantity; whereas on the demand side of the market a higher price induces a lower quantity demanded – a negative relationship.
Supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged.
We can now identify a key difference in terminology – between the words demand and quantity demanded, and between supply and quantity supplied. While the words demand and supply refer to the complete schedules of demand and supply, the terms quantity demanded and quantity supplied each define a single value of demand or supply at a particular price.
Quantity demanded defines the amount purchased at a particular price.
Quantity supplied refers to the amount supplied at a particular price.
Thus while the non-economist may say that when some fans did not get tickets to the Stanley Cup it was a case of demand exceeding supply, as economists we say that the quantity demanded exceeded the quantity supplied at the going price of tickets. In this instance, had every ticket been offered at a sufficiently high price, the market could have generated an excess supply rather than an excess demand. A higher ticket price would reduce the quantity demanded; yet would not change demand, because demand refers to the whole schedule of possible quantities demanded at different prices.
Other things equal – ceteris paribus
The demand and supply schedules rest on the assumption that all other influences on supply and demand remain the same as we move up and down the possible price values. The expression other things being equal, or its Latin counterpart ceteris paribus, describes this constancy of other influences. For example, we assume on the demand side that the prices of other goods remain constant, and that tastes and incomes are unchanging. On the supply side we assume, for example, that there is no technological change in production methods. If any of these elements change then the market supply or demand schedules will reflect such changes. For example, if coal or oil prices increase (decline) then some buyers may switch to (away from) gas. This will be reflected in the data: At any given price more (or less) will be demanded. We will illustrate this in graphic form presently.
Market equilibrium
Let us now bring the demand and supply schedules together in an attempt to analyze what the marketplace will produce – will a single price emerge that will equate supply and demand? We will keep other things constant for the moment, and explore what materializes at different prices. At low prices, the data in Table 3.1 indicate that the quantity demanded exceeds the quantity supplied – for example, verify what happens when the price is \$3 per unit. The opposite occurs when the price is high – what would happen if the price were \$8? Evidently, there exists an intermediate price, where the quantity demanded equals the quantity supplied. At this point we say that the market is in equilibrium. The equilibrium price equates demand and supply – it clears the market.
The equilibrium price equilibrates the market. It is the price at which quantity demanded equals the quantity supplied.
In Table 3.1 the equilibrium price is \$4, and the equilibrium quantity is 6 thousand cubic feet of gas (we will use the notation 'k' to denote thousands). At higher prices there is an excess supply—suppliers wish to sell more than buyers wish to buy. Conversely, at lower prices there is an excess demand. Only at the equilibrium price is the quantity supplied equal to the quantity demanded.
Excess supply exists when the quantity supplied exceeds the quantity demanded at the going price.
Excess demand exists when the quantity demanded exceeds the quantity supplied at the going price.
Does the market automatically reach equilibrium? To answer this question, suppose initially that the sellers choose a price of \$10. Here suppliers would like to supply 18k cubic feet, but there are no buyers—a situation of extreme excess supply. At the price of \$7 the excess supply is reduced to 9k, because both the quantity demanded is now higher at 3k units, and the quantity supplied is lower at 12k. But excess supply means that there are suppliers willing to supply at a lower price, and this willingness exerts continual downward pressure on any price above the price that equates demand and supply.
At prices below the equilibrium there is, conversely, an excess demand. In this situation, suppliers could force the price upward, knowing that buyers will continue to buy at a price at which the suppliers are willing to sell. Such upward pressure would continue until the excess demand is eliminated.
In general then, above the equilibrium price excess supply exerts downward pressure on price, and below the equilibrium excess demand exerts upward pressure on price. This process implies that the buyers and sellers have information on the various elements that make up the marketplace.
We will explore later in this chapter some specific circumstances in which trading could take place at prices above or below the equilibrium price. In such situations the quantity actually traded always corresponds to the short side of the market: At high prices the quantity demanded is less than the quantity supplied, and it is the quantity demanded that is traded because buyers will not buy the amount suppliers would like to supply. At low prices the quantity demanded exceeds quantity supplied, and it is the amount that suppliers are willing to sell that is traded. In sum, when trading takes place at prices other than the equilibrium price it is always the lesser of the quantity demanded or supplied that is traded. Hence we say that at non-equilibrium prices the short side dominates. We will return to this in a series of examples later in this chapter.
The short side of the market determines outcomes at prices other than the equilibrium.
Supply and the nature of costs
Before progressing to a graphical analysis, we should add a word about costs. The supply schedules are based primarily on the cost of producing the product in question, and we frequently assume that all of the costs associated with supply are incorporated in the supply schedules. In Principles of Microeconomics Chapter 6 we will explore cases where costs additional to those incurred by producers may be relevant. For example, coal burning power plants emit pollutants into the atmosphere; but the individual supplier may not take account of these pollutants, which are costs to society at large, in deciding how much to supply at different prices. Stated another way, the private costs of production would not reflect the total, or full social costs of production. For the moment the assumption is that no such additional costs are associated with the markets we analyze.
3.03: Demand and supply curves
The demand curve is a graphical expression of the relationship between price and quantity demanded, holding other things constant. Figure 3.1 measures price on the vertical axis and quantity on the horizontal axis. The curve D represents the data from the first two columns of Table 3.1. Each combination of price and quantity demanded lies on the curve. In this case the curve is linear—it is a straight line. The demand curve slopes downward (technically we say that its slope is negative), reflecting the fact that buyers wish to purchase more when the price is less.
Figure 3.1 Measuring price & quantity
To derive this demand curve we take each price-quantity combination from the demand schedule in Table 3.1 and insert a point that corresponds to those combinations. For example, point h defines the combination , the point l denotes the combination . If we join all such points we obtain the demand curve in Figure 3.2. In this particular case the demand schedule results in a straight-line, or linear, demand curve. The same process yields the supply curve in Figure 3.2.
The demand curve is a graphical expression of the relationship between price and quantity demanded, with other influences remaining unchanged.
The supply curve is a graphical representation of the relationship between price and quantity supplied, holding other things constant. The supply curve S in Figure 3.2 is based on the data from columns 1 and 3 in Table 3.1. It, too, is linear, but has a positive slope indicating that suppliers wish to supply more at higher prices.
The supply curve is a graphical expression of the relationship between price and quantity supplied, with other influences remaining unchanged.
Figure 3.2 Supply, demand, equilibrium
The demand and supply curves intersect at point E0, corresponding to a price of \$4 which, as illustrated above, is the equilibrium price for this market. At any price below this the horizontal distance between the supply and demand curves represents excess demand, because demand exceeds supply. Conversely, at any price above \$4 there is an excess supply that is again measured by the horizontal distance between the two curves. Market forces tend to eliminate excess demand and excess supply as we explained above. In the final section of the chapter we illustrate how the supply and demand curves can be 'solved' for the equilibrium price and quantity. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/03%3A_The_classical_marketplace__demand_and_supply/3.02%3A_The_market%E2%80%99s_building_blocks.txt |
We have emphasized several times the importance of the ceteris paribus assumption when exploring the impact of different prices on the quantity demanded: We assume all other influences on the purchase decision are unchanged (at least momentarily). These other influences fall into several broad categories: The prices of related goods; the incomes of buyers; buyer tastes; and expectations about the future. Before proceeding, note that we are dealing with market demand rather than demand by one individual (the precise relationship between the two is developed later in this chapter).
The prices of related goods – oil and gas, Kindle and paperbacks
We expect that the price of other forms of energy would impact the price of natural gas. For example, if electricity, oil or coal becomes less expensive we would expect some buyers to switch to these other products. Alternatively, if gas-burning furnaces experience a technological breakthrough that makes them more efficient and cheaper we would expect some users of other fuels to move to gas. Among these examples, it is clear that oil and electricity are substitute fuels for gas; in contrast the efficient new gas furnace complements the use of gas. We use these terms, substitutes and complements, to describe products that influence the demand for the primary good.
Substitute goods: when a price reduction (rise) for a related product reduces (increases) the demand for a primary product, it is a substitute for the primary product.
Complementary goods: when a price reduction (rise) for a related product increases (reduces) the demand for a primary product, it is a complement for the primary product.
Clearly electricity is a substitute for gas in the power market, whereas a gas furnace is a complement for gas as a fuel. The words substitutes and complements immediately suggest the nature of the relationships. Every product has complements and substitutes. As another example: Electronic readers such as Kindle, Nook and Kobo are substitutes for paper-form books; a rise in the price of paper books should increase the demand for electronic readers at any given price for electronic readers. In graphical terms, the demand curve shifts in response to changes in the prices of other goods – an increase in the price of paper-form books will shift the demand for electronic readers outward, because more electronic readers will be demanded at any price.
Buyer incomes – which goods to buy
The demand for most goods increases in response to income increases. Given this, the demand curve for gas will shift outward if household incomes in the economy increase. Household incomes may increase either because there are more households in the economy or because the incomes of the existing households grow.
Most goods are demanded in greater quantity in response to higher incomes at any given price. But there are exceptions. For example, public transit demand may decline at any price when household incomes rise, because some individuals move to cars. Or the demand for laundromats may decline in response to higher incomes, as households purchase more of their own consumer durables – washers and driers. We use the term inferior good to define these cases: An inferior good is one whose demand declines in response to increasing incomes, whereas a normal good experiences an increase in demand in response to rising incomes.
An inferior good is one whose demand falls in response to higher incomes.
A normal good is one whose demand increases in response to higher incomes.
There is a further sense in which consumer incomes influence demand, and this relates to how the incomes are distributed in the economy. In the discussion above we stated that higher total incomes shift demand curves outwards when goods are normal. But think of the difference in the demand for electronic readers between Portugal and Saudi Arabia. These economies have roughly the same average per-person income, but incomes are distributed more unequally in Saudi Arabia. It does not have a large middle class that can afford electronic readers or iPads, despite the huge wealth held by the elite. In contrast, Portugal has a relatively larger middle class that can afford such goods. Consequently, the distribution of income can be an important determinant of the demand for many commodities and services.
Tastes and networks – hemlines and homogeneity
While demand functions are drawn on the assumption that tastes are constant, in an evolving world they are not. We are all subject to peer pressure, the fashion industry, marketing, and a desire to maintain our image. If the fashion industry dictates that lapels or long skirts are de rigueur for the coming season, some fashion-conscious individuals will discard a large segment of their wardrobe, even though the clothes may be in perfectly good condition: Their demand is influenced by the dictates of current fashion.
Correspondingly, the items that other individuals buy or use frequently determine our own purchases. Businesses frequently decide that all of their employees will have the same type of computer and software on account of network economies: It is easier to communicate if equipment is compatible, and it is less costly to maintain infrastructure where the variety is less.
Expectations – betting on the future
In our natural gas example, if households expected that the price of natural gas was going to stay relatively low for many years – perhaps on account of the discovery of large deposits – then they would be tempted to purchase a gas burning furnace rather than an oil burning furnace. In this example, it is more than the current price that determines choices; the prices that are expected to prevail in the future also determine current demand.
Expectations are particularly important in stock markets. When investors anticipate that corporations will earn high rewards in the future they will buy a stock today. If enough people believe this, the price of the stock will be driven upward on the market, even before profitable earnings are registered.
Shifts in demand
The demand curve in Figure 3.2 is drawn for a given level of other prices, incomes, tastes, and expectations. Movements along the demand curve reflect solely the impact of different prices for the good in question, holding other influences constant. But changes in any of these other factors will change the position of the demand curve. Figure 3.3 illustrates a shift in the demand curve. This shift could result from a rise in household incomes that increase the quantity demanded at every price. This is illustrated by an outward shift in the demand curve. With supply conditions unchanged, there is a new equilibrium at , indicating a greater quantity of purchases accompanied by a higher price. The new equilibrium reflects a change in quantity supplied and a change in demand.
Figure 3.3 Demand shift and new equilibrium
The outward shift in demand leads to a new equilibrium E1.
We may well ask why so much emphasis in our diagrams and analysis is placed on the relationship between price and quantity, rather than on the relationship between quantity and its other determinants. The answer is that we could indeed draw diagrams with quantity on the horizontal axis and a measure of one of these other influences on the vertical axis. But the price mechanism plays a very important role. Variations in price are what equilibrate the market. By focusing primarily upon the price, we see the self-correcting mechanism by which the market reacts to excess supply or excess demand.
In addition, this analysis illustrates the method of comparative statics—examining the impact of changing one of the other things that are assumed constant in the supply and demand diagrams.
Comparative static analysis compares an initial equilibrium with a new equilibrium, where the difference is due to a change in one of the other things that lie behind the demand curve or the supply curve.
'Comparative' obviously denotes the idea of a comparison, and static means that we are not in a state of motion. Hence we use these words in conjunction to indicate that we compare one outcome with another, without being concerned too much about the transition from an initial equilibrium to a new equilibrium. The transition would be concerned with dynamics rather than statics. In Figure 3.3 we explain the difference between the points E0 and E1 by indicating that there has been a change in incomes or in the price of a substitute good. We do not attempt to analyze the details of this move or the exact path from E0 to E1.
Application Box 3.1 Corn prices and demand shifts
In the middle of its second mandate, the Bush Administration in the US decided to encourage the production of ethanol – a fuel that is less polluting than gasoline. The target production was 35 billion for 2017 – from a base of 1 billion gallons in 2000. Corn is the principal input in ethanol production. It is also used as animal feed, as a sweetener and as a food for humans. The target was to be met with the help of a subsidy to producers and a tariff on imports of Brazil's sugar-cane based ethanol.
The impact on corn prices was immediate; from a farm-gate price of \$2 per bushel in 2005, the price reached the \$4 range two years later. In 2012 the price rose temporarily to \$7. While other factors were in play - growing incomes and possibly speculation by commodity investors, ethanol is seen as the main price driver: demand for corn increased and the supply could not be increased to keep up with the demand without an increase in price.
The wider impact of these developments was that the prices of virtually all grains increased in tandem with corn: the prices of sorghum and barley increased because of a switch in land use towards corn on account of its profitability.
While farmers benefited from the price rise, consumers – particularly those in less developed economies – experienced a dramatic increase in their basic living costs. Visit the site of the United Nations' Food and Agricultural Organization for an assessment. Since hitting \$7 per bushel in 2012, the price has dropped and averaged \$3.50 in 2016.
In terms of supply and demand shifts: the demand side has dominated, particularly in the short run. The ethanol drive, combined with secular growth in the demand for food, means that the demand for grains shifted outward faster than the supply. In the period 2013–2016, supply has increased and the price has moderated. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/03%3A_The_classical_marketplace__demand_and_supply/3.04%3A_Non-price_influences_on_demand.txt |
To date we have drawn supply curves with an upward slope. Is this a reasonable representation of supply in view of what is frequently observed in markets? We suggested earlier that the various producers of a particular good or service may have different levels of efficiency. If so, only the more efficient producers can make a profit at a low price, whereas at higher prices more producers or suppliers enter the market – producers who may not be as lean and efficient as those who can survive in a lower-price environment. This view of the world yields a positively-sloping supply curve.
As a second example, consider Uber taxi drivers. Some drivers may be in serious need of income and may be willing to drive for a low hourly rate. For other individuals driving may be a secondary source of income, and such drivers are less likely to want to drive unless the hourly wage is higher. Consequently if Uber needs a large number of drivers at any one time it may be necessary to pay a higher wage – and charge a higher fare to passengers, to induce more drivers to take their taxis onto the road. This phenomenon corresponds to a positively-sloped supply curve.
In contrast to these two examples, some suppliers simply choose a unique price and let buyers purchase as much as they want at that price. This is the practice of most retailers. For example, the price of Samsung's Galaxy is typically fixed, no matter how many are purchased – and tens of millions are sold at a fixed price when a new model is launched. Apple also sets a price, and buyers purchase as many as they desire at that price. This practice corresponds to a horizontal supply cuve: The price does not vary and the market equilibrium occurs where the demand curve intersects this supply curve.
In yet other situations supply is fixed. This happens in auctions. Bidders at the auction simply determine the price to be paid. At a real estate auction a given property is put on the market and the price is determined by the bidding process. In this case the supply of a single property is represented by a vertical supply at a quantity of 1 unit.
Regardless of the type of market we encounter, however, it is safe to assume that supply curves do not slope downward. So, for the moment, we adopt the stance that supply curves are generally upward sloping – somewhere between the extremes of being vertical or horizontal – as we have drawn them to this point.
Next, we examine those other influences that underlie supply curves. Technology, input costs, the prices of competing goods, expectations and the number of suppliers are the most important.
Technology – computers and fracking
A technological advance may involve an idea that allows more output to be produced with the same inputs, or an equal output with fewer inputs. A good example is just-in-time technology. Before the modern era, auto manufacturers kept large stocks of components in their production facilities, but developments in communications and computers at that time made it possible for manufacturers to link directly with their input suppliers. Nowadays assembly plants place their order for, say, seat delivery to their local seat supplier well ahead of assembly time. The seats swing into the assembly area hours or minutes before assembly—just in time. The result is that the assembler reduces his seat inventory (an input) and thereby reduces production cost.
Such a technology-induced cost saving is represented by moving the supply curve downward or outward: The supplier is now able and willing to supply the same quantity at a lower price because of the technological innovation. Or, saying the same thing slightly differently, suppliers will supply more at a given price than before.
A second example relates to the extraction of natural gas. The development of 'fracking' means that companies involved in gas recovery can now do so at a lower cost. Hence they are willing to supply any given quantity at a lower price.
Input costs – green power
Input costs can vary independently of technology. For example, a wage negotiation that grants workers a substantial pay raise will increase the cost of production. This is reflected in a leftward, or upward, supply shift: Any quantity supplied is now priced higher; alternatively, suppliers are willing to supply less at the going price.
As a further example, suppose the government decrees that power-generating companies must provide a certain percentage of their power using 'green' sources – from solar power or windmills. Since such sources are not yet as cost efficient as more conventional power sources, the electricity they generate comes at a higher cost.
Competing products – Airbnb versus hotels
If competing products improve in quality or fall in price, a supplier may be forced to follow suit. For example, Asus and Dell are constantly watching each other's pricing policies. If Dell brings out a new generation of computers at a lower price, Asus may lower its prices in turn—which is to say that Asus' supply curve will shift downward. Likewise, Samsung and Apple each responds to the other's pricing and technology behaviours. The arrival of new products in the marketplace also impacts the willingness of suppliers to supply goods at a given price. New intermediaries such as Airbnb and Vacation Rentals by Owner have shifted the supply curves of hotel rooms downward.
These are some of the many factors that influence the position of the supply curve in a given market.
Application Box 3.2 The price of light
Technological developments have had a staggering impact on many price declines. Professor William Nordhaus of Yale University is an expert on measuring technological change. He has examined the trend in the real price of lighting. Originally, light was provided by whale oil and gas lamps and these sources of lumens (the scientific measure of the amount of light produced) were costly. In his research, Professor Nordhaus pieced together evidence on the actual historic cost of light produced at various times, going all the way back to 1800. He found that light in 1800 cost about 100 times more than in 1900, and light in the year 2000 was a fraction of its cost in 1900. A rough calculation suggests that light was five hundred times more expensive at the start of this 200-year period than at the end, and this was before the arrival of LEDs.
In terms of supply and demand analysis, light has been subject to very substantial downward supply shifts. Despite the long-term growth in demand, the technologically-induced supply changes have been the dominant factor in its price determination.
For further information, visit Professor Nordhaus's website in the Department of Economics at Yale University.
Shifts in supply
Whenever technology changes, or the costs of production change, or the prices of competing products adjust, then one of our ceteris paribus assumptions is violated. Such changes are generally reflected by shifting the supply curve. Figure 3.4 illustrates the impact of the arrival of just-in-time technology. The supply curve shifts, reflecting the ability of suppliers to supply the same output at a reduced price. The resulting new equilibrium price is lower, since production costs have fallen. At this reduced price more gas is traded at a lower price.
Figure 3.4 Supply shift and new equilibrium
The supply curve shifts due to lower production costs. A new equilibrium E1 is attained in the market at a lower price.
3.06: Simultaneous supply and demand impacts
In the real world, demand and supply frequently shift at the same time. We present such a case in Figure 3.5. It is based upon real estate data describing the housing market in a small Montreal municipality. Vertical curves define the supply side of the market. Such vertical curves mean that a fixed number of homeowners decide to put their homes on the market, and these suppliers just take whatever price results in the market. In this example, fewer houses were offered for sale in 2002 (less than 50) than in 1997 (more than 70). We are assuming in this market that the houses traded were similar; that is, we are not lumping together mansions with row houses.
During this time period household incomes increased substantially and, also, mortgage rates fell. Both of these developments shifted the demand curve upward/outward: Buyers were willing to pay more for housing in 2002 than in 1997, both because their incomes were on average higher and because they could borrow more cheaply.
The shifts on both sides of the market resulted in a higher average price. And each of these shifts compounded the other: The outward shift in demand would lead to a higher price on its own, and a reduction in supply would do likewise. Hence both forces acted to push up the price in 2002. If, instead, the supply had been greater in 2002 than in 1997 this would have acted to reduce the equilibrium price. And with the demand and supply shifts operating in opposing directions, it is not possible to say in general whether the price would increase or decrease. If the demand shift were strong and the supply shift weak then the demand forces would have dominated and led to a higher price. Conversely, if the supply forces were stronger than the demand forces.
Figure 3.5 A model of the housing market with shifts in demand and supply
The vertical supply denotes a fixed number of houses supplied each year. Demand was stronger in 2002 than in 1997 both on account of higher incomes and lower mortgage rates. Thus the higher price in 2002 is due to both a reduction in supply and an increase in demand. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/03%3A_The_classical_marketplace__demand_and_supply/3.05%3A_Non-price_influences_on_supply.txt |
The freely functioning markets that we have developed certainly do not describe all markets. For example, minimum wages characterize the labour market, most agricultural markets have supply restrictions, apartments are subject to rent controls, and blood is not a freely traded market commodity in Canada. In short, price controls and quotas characterize many markets. Price controls are government rules or laws that inhibit the formation of market-determined prices. Quotas are physical restrictions on how much output can be brought to the market.
Price controls are government rules or laws that inhibit the formation of market-determined prices.
Quotas are physical restrictions on output.
Price controls come in the form of either floors or ceilings. Price floors are frequently accompanied by marketing boards.
Price ceilings – rental boards
Ceilings mean that suppliers cannot legally charge more than a specific price. Limits on apartment rents are one form of ceiling. In times of emergency – such as flooding or famine, price controls are frequently imposed on foodstuffs, in conjunction with rationing, to ensure that access is not determined by who has the most income. The problem with price ceilings, however, is that they leave demand unsatisfied, and therefore they must be accompanied by some other allocation mechanism.
Consider an environment where, for some reason – perhaps a sudden and unanticipated growth in population – rents increase. Let the resulting equilibrium be defined by the point E0 in Figure 3.6. If the government were to decide that this is an unfair price because it places hardships on low- and middle-income households, it might impose a price limit, or ceiling, of Pc. The problem with such a limit is that excess demand results: Individuals want to rent more apartments than are available in the city. In a free market the price would adjust upward to eliminate the excess demand, but in this controlled environment it cannot. So some other way of allocating the available supply between demanders must evolve.
In reality, most apartments are allocated to those households already occupying them. But what happens when such a resident household decides to purchase a home or move to another city? In a free market, the landlord could increase the rent in accordance with market pressures. But in a controlled market a city's rental tribunal may restrict the annual rent increase to just a couple of percent and the demand may continue to outstrip supply. So how does the stock of apartments get allocated between the potential renters? One allocation method is well known: The existing tenant informs her friends of her plan to move, and the friends are the first to apply to the landlord to occupy the apartment. But that still leaves much unmet demand. If this is a student rental market, students whose parents live nearby may simply return 'home'. Others may chose to move to a part of the city where rents are more affordable.
Figure 3.6 The effect of a price ceiling
The free market equilibrium occurs at E0. A price ceiling at Pc holds down the price but leads to excess demand EcB, because Qc is the quantity traded. A price ceiling above P0 is irrelevant since the free market equilibrium E0 can still be attained.
However, rent controls sometimes yield undesirable outcomes. Rent controls are widely studied in economics, and the consequences are well understood: Landlords tend not to repair or maintain their rental units in good condition if they cannot obtain the rent they believe they are entitled to. Accordingly, the residential rental stock deteriorates. In addition, builders realize that more money is to be made in building condominium units than rental units, or in converting rental units to condominiums. The frequent consequence is thus a reduction in supply and a reduced quality. Market forces are hard to circumvent because, as we emphasized in Chapter 1, economic players react to the incentives they face. These outcomes are examples of what we call the law of unintended consequences.
Price floors – minimum wages
An effective price floor sets the price above the market-clearing price. A minimum wage is the most widespread example in the Canadian economy. Provinces each set their own minimum, and it is seen as a way of protecting the well-being of low-skill workers. Such a floor is illustrated in Figure 3.7. The free-market equilibrium is again E0, but the effective market outcome is the combination of price and quantity corresponding to the point Ef at the price floor, Pf. In this instance, there is excess supply equal to the amount EfC.
Figure 3.7 Price floor – minimum wage
In a free market the equilibrium is E0. A minimum wage of Pf raises the hourly wage, but reduces the hours demanded to Qf. Thus EfC is the excess supply.
Note that there is a similarity between the outcomes defined in the floor and ceiling cases: The quantity actually traded is the lesser of the supply quantity and demand quantity at the going price: The short side dominates.
If price floors, in the form of minimum wages, result in some workers going unemployed, why do governments choose to put them in place? The excess supply in this case corresponds to unemployment – more individuals are willing to work for the going wage than buyers (employers) wish to employ. The answer really depends upon the magnitude of the excess supply. In particular, suppose, in Figure 3.7 that the supply and demand curves going through the equilibrium E0 were more 'vertical'. This would result in a smaller excess supply than is represented with the existing supply and demand curves. This would mean in practice that a higher wage could go to workers, making them better off, without causing substantial unemployment. This is the tradeoff that governments face: With a view to increasing the purchasing power of generally lower-skill individuals, a minimum wage is set, hoping that the negative impact on employment will be small. We will return to this in the next chapter, where we examine the responsiveness of supply and demand curves to different prices.
Quotas – agricultural supply
A quota represents the right to supply a specified quantity of a good to the market. It is a means of keeping prices higher than the free-market equilibrium price. As an alternative to imposing a price floor, the government can generate a high price by restricting supply.
Agricultural markets abound with examples. In these markets, farmers can supply only what they are permitted by the quota they hold, and there is usually a market for these quotas. For example, in several Canadian provinces it currently costs in the region of \$30,000 to purchase a quota granting the right to sell the milk of one cow. The cost of purchasing quotas can thus easily outstrip the cost of a farm and herd. Canadian cheese importers must pay for the right to import cheese from abroad. Restrictions also apply to poultry. The impact of all of these restrictions is to raise the domestic price above the free market price.
In Figure 3.8, the free-market equilibrium is at E0. In order to raise the price above P0, the government restricts supply to Qq by granting quotas, which permit producers to supply a limited amount of the good in question. This supply is purchased at the price equal to Pq. From the standpoint of farmers, a higher price might be beneficial, even if they get to supply a smaller quantity, provided the amount of revenue they get as a result is as great as the revenue in the free market.
Figure 3.8 The effect of a quota
The government decides that the equilibrium price P0 is too low. It decides to boost price by reducing supply from Q0 to Qq. It achieves this by requiring producers to have a production quota. This is equivalent to fixing supply at Sq.
Marketing boards – milk and maple syrup
A marketing board is a means of insuring that a quota or price floor can be maintained. Quotas are frequent in the agriculture sector of the economy. One example is maple syrup in Quebec. The Federation of Maple Syrup Producers of Quebec has the sole right to market maple syrup. All producers must sell their syrup through this marketing board. It is a de facto monopoly. The Federation increases the total revenue going to producers by artificially restricting the supply to the market. The Federation calculates that by reducing supply and selling it at a higher price, more revenue will accrue to the producers. This is illustrated in Figure 3.8. The market equilibrium is given by E0, but the Federation restricts supply to the quantity Qq, which is sold to buyers at price Pq. To make this possible the total supply must be restricted; otherwise producers would supply the amount given by the point C on the supply curve, and this would result in excess supply in the amount EqC. In order to restrict supply to Qq in total, individual producers are limited in what they can sell to the Federation; they have a quota, which gives them the right to produce and sell no more than a specific limited amount. This system of quotas is necessary to eliminate the excess supply that would emerge at the above-equilibrium price Pq.
We will return to this topic in Principles of Microeconomics Chapter 4. For the moment, to see that this type of revenue-increasing outcome is possible, examine Table 3.1 again. At this equilibrium price of \$4 the quantity traded is 6 units, yielding a total expenditure by buyers (revenue to suppliers) of \$24. However, if the supply were restricted and a price of \$5 were set, the expenditure by buyers (revenue to suppliers) would rise to \$25. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/03%3A_The_classical_marketplace__demand_and_supply/3.07%3A_Market_interventions_%E2%80%93_governments_and_interest_groups.txt |
Markets are made up of many individual participants on the demand and supply side. The supply and demand functions that we have worked with in this chapter are those for the total of all participants on each side of the market. But how do we arrive at such market functions when the economy is composed of individuals? We can illustrate how, with the help of Figure 3.9.
Figure 3.9 Summing individual demands
At P1 individual A purchases and B purchases . The total demand is the sum of these individual demands at this price (Q1). At P2 individual demands are summed to Q2. Since the points Q1 and Q2 define the demands of the market participants it follows that market demand is the horizontal sum of these curves.
To concentrate on the essentials, imagine that there are just two buyers of chocolate cookies in the economy. A has a stronger preference for cookies than B, so his demand is greater. To simplify, let the two demands have the same intercept on the vertical axis. The curves DA and DB indicate how many cookies A and B, respectively, will buy at each price. The market demand indicates how much they buy together at any price. Accordingly, at P1, A and B purchase the quantities and respectively. Thus . At a price P2, they purchase and . Thus . The market demand is therefore the horizontal sum of the individual demands at these prices. In the figure this is defined by .
Market demand: the horizontal sum of individual demands.
3.09: Useful techniques – demand and supply equations
The supply and demand functions, or equations, underlying Table 3.1 and Figure 3.2 can be written in their mathematical form:
A straight line is represented completely by the intercept and slope. In particular, if the variable P is on the vertical axis and Q on the horizontal axis, the straight-line equation relating P and Q is defined by P=a+bQ. Where the line is negatively sloped, as in the demand equation, the parameter b must take a negative value. By observing either the data in Table 3.1 or Figure 3.2 it is clear that the vertical intercept, a, takes a value of \$10. The vertical intercept corresponds to a zero-value for the Q variable. Next we can see from Figure 3.2 that the slope (given by the rise over the run) is 10/10 and hence has a value of –1. Accordingly the demand equation takes the form P=10–Q.
On the supply side the price-axis intercept, from either the figure or the table, is clearly 1. The slope is one half, because a two-unit change in quantity is associated with a one-unit change in price. This is a positive relationship obviously so the supply curve can be written as P=1+(1/2)Q.
Where the supply and demand curves intersect is the market equilibrium; that is, the price-quantity combination is the same for both supply and demand where the supply curve takes on the same values as the demand curve. This unique price-quantity combination is obtained by equating the two curves: If Demand=Supply, then
10–Q=1+(1/2)Q.
Gathering the terms involving Q to one side and the numerical terms to the other side of the equation results in 9=1.5Q. This implies that the equilibrium quantity must be 6 units. And this quantity must trade at a price of \$4. That is, when the price is \$4 both the quantity demanded and the quantity supplied take a value of 6 units.
Modelling market interventions using equations
To illustrate the impact of market interventions examined in Section 3.7 on our numerical market model for natural gas, suppose that the government imposes a minimum price of \$6 – above the equilibrium price obviously. We can easily determine the quantity supplied and demanded at such a price. Given the supply equation
P=1+(1/2)Q,
it follows that at P=6 the quantity supplied is 10. This follows by solving the relationship 6=1+(1/2)Q for the value of Q. Accordingly, suppliers would like to supply 10 units at this price.
Correspondingly on the demand side, given the demand curve
P=10–Q,
with a price given by , it must be the case that Q=4. So buyers would like to buy 4 units at that price: There is excess supply. But we know that the short side of the market will win out, and so the actual amount traded at this restricted price will be 4 units.
3.10: Conclusion
Conclusion
We have covered a lot of ground in this chapter. It is intended to open up the vista of economics to the new student in the discipline. Economics is powerful and challenging, and the ideas we have developed here will serve as conceptual foundations for our exploration of the subject. Our next chapter deals with measurement and responsiveness.
Key Concepts
Demand is the quantity of a good or service that buyers wish to purchase at each possible price, with all other influences on demand remaining unchanged.
Supply is the quantity of a good or service that sellers are willing to sell at each possible price, with all other influences on supply remaining unchanged.
Quantity demanded defines the amount purchased at a particular price.
Quantity supplied refers to the amount supplied at a particular price.
Equilibrium price: equilibrates the market. It is the price at which quantity demanded equals the quantity supplied.
Excess supply exists when the quantity supplied exceeds the quantity demanded at the going price.
Excess demand exists when the quantity demanded exceeds quantity supplied at the going price.
Short side of the market determines outcomes at prices other than the equilibrium.
Demand curve is a graphical expression of the relationship between price and quantity demanded, with other influences remaining unchanged.
Supply curve is a graphical expression of the relationship between price and quantity supplied, with other influences remaining unchanged.
Substitute goods: when a price reduction (rise) for a related product reduces (increases) the demand for a primary product, it is a substitute for the primary product.
Complementary goods: when a price reduction (rise) for a related product increases (reduces) the demand for a primary product, it is a complement for the primary product.
Inferior good is one whose demand falls in response to higher incomes.
Normal good is one whose demand increases in response to higher incomes.
Comparative static analysis compares an initial equilibrium with a new equilibrium, where the difference is due to a change in one of the other things that lie behind the demand curve or the supply curve.
Price controls are government rules or laws that inhibit the formation of market-determined prices.
Quotas are physical restrictions on output.
Market demand: the horizontal sum of individual demands. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/03%3A_The_classical_marketplace__demand_and_supply/3.08%3A_Individual_and_market_functions.txt |
EXERCISE 3.1
The supply and demand for concert tickets are given in the table below.
Price (\$) 0 4 8 12 16 20 24 28 32 36 40
Quantity demanded 15 14 13 12 11 10 9 8 7 6 5
Quantity supplied 0 0 0 0 0 1 3 5 7 9 11
1. Plot the supply and demand curves to scale and establish the equilibrium price and quantity.
2. What is the excess supply or demand when price is \$24? When price is \$36?
3. Describe the market adjustments in price induced by these two prices.
4. Optional: The functions underlying the example in the table are linear and can be presented as P=18+2Q (supply) and P=60–4Q (demand). Solve the two equations for the equilibrium price and quantity values.
EXERCISE 3.2
Illustrate in a supply/demand diagram, by shifting the demand curve appropriately, the effect on the demand for flights between Calgary and Winnipeg as a result of:
1. Increasing the annual government subsidy to Via Rail.
2. Improving the Trans-Canada highway between the two cities.
3. The arrival of a new budget airline on the scene.
EXERCISE 3.3
A new trend in US high schools is the widespread use of chewing tobacco. A recent survey indicates that 15 percent of males in upper grades now use it – a figure not far below the use rate for cigarettes. This development came about in response to the widespread implementation by schools of regulations that forbade cigarette smoking on and around school property. Draw a supply-demand equilibrium for each of the cigarette and chewing tobacco markets before and after the introduction of the regulations.
EXERCISE 3.4
The following table describes the demand and supply conditions for labour.
Price (\$) = wage rate 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170
Quantity demanded 1020 960 900 840 780 720 660 600 540 480 420 360 300 240 180 120 60 0
Quantity supplied 0 0 0 0 0 0 30 60 90 120 150 180 210 240 270 300 330 360
1. Graph the functions and find the equilibrium price and quantity by equating demand and supply.
2. Suppose a price ceiling is established by the government at a price of \$120. This price is below the equilibrium price that you have obtained in part (a). Calculate the amount that would be demanded and supplied and then calculate the excess demand.
EXERCISE 3.5
In Exercise 3.4, suppose that the supply and demand describe an agricultural market rather than a labour market, and the government implements a price floor of \$140. This is greater than the equilibrium price.
1. Estimate the quantity supplied and the quantity demanded at this price, and calculate the excess supply.
2. Suppose the government instead chose to maintain a price of \$140 by implementing a system of quotas. What quantity of quotas should the government make available to the suppliers?
EXERCISE 3.6
In Exercise 3.5, suppose that, at the minimum price, the government buys up all of the supply that is not demanded, and exports it at a price of \$80 per unit. Compute the cost to the government of this operation.
EXERCISE 3.7
Let us sum two demand curves to obtain a 'market' demand curve. We will suppose there are just two buyers in the market. Each of the individual demand curves has a price intercept of \$42. One has a quantity intercept of 126, the other 84.
1. Draw the demands either to scale or in an Excel spreadsheet, and label the intercepts on both the price and quantity axes.
2. Determine how much would be purchased in the market at prices \$10, \$20, and \$30.
3. Optional: Since you know the intercepts of the market (total) demand curve, can you write an equation for it?
EXERCISE 3.8
In Exercise 3.7 the demand curves had the same price intercept. Suppose instead that the first demand curve has a price intercept of \$36 and a quantity intercept of 126; the other individual has a demand curve defined by a price intercept of \$42 and a quantity intercept of 84. Graph these curves and illustrate the market demand curve.
EXERCISE 3.9
Here is an example of a demand curve that is not linear:
Price (\$) 4 3 2 1 0
Quantity demanded 25 100 225 400 625
1. Plot this demand curve to scale or in Excel.
2. If the supply function in this market is P=2, plot this function in the same diagram.
3. Determine the equilibrium quantity traded in this market.
EXERCISE 3.10
The football stadium of the University of the North West Territories has 30 seats. The demand curve for tickets has a price intercept of \$36 and a quantity intercept of 72.
1. Draw the supply and demand curves to scale in a graph or in Excel. (This demand curve has the form .)
2. Determine the equilibrium admission price, and the amount of revenue generated from ticket sales for each game.
3. A local alumnus and benefactor offers to install 6 more seats at no cost to the University. Compute the price that would be charged with this new supply and compute the revenue that would accrue at this new equilibrium price. Should the University accept the offer to install the seats?
4. Redo the previous part of this question, assuming that the initial number of seats is 40, and the University has the option to increase capacity to 46 at no cost to itself. Should the University accept the offer in this case?
EXERCISE 3.11
Suppose farm workers in Mexico are successful in obtaining a substantial wage increase. Illustrate the effect of this on the price of lettuce in the Canadian winter, using a supply and demand diagram, on the assumption that all lettuce in Canada is imported during its winter. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/03%3A_The_classical_marketplace__demand_and_supply/3.12%3A_Exercises_for_Chapter_3.txt |
Macroeconomics is focused on three key indicators of the economy's performance and the underlying explanations for their behaviour. The indicators are:
1. The rate of growth of real national income.
2. The rate of inflation.
3. The rate of unemployment.
Other aspects of the economy like interest rates, foreign exchange rates, wage rates, government budgets, capital investment, commodity prices, housing and so forth are important to macroeconomic analysis because they work to determine performance as measured by these three indicators.
Macroeconomics involves complex linkage and feedback effects that tie economic conditions and economic policy to economic performance. Macroeconomic theories and models attempt to capture this complexity. They seek to understand and explain the causes of changes in economic performance and the role for economic policy.
Internationally the persistent effects of what seemed to be a local crisis in the US housing market triggered the Great Recession of 2009. International linkages among financial markets spread the effects across European and other financial markets. Government bailouts of major banks and monetary and fiscal stimulus to fight falling output and employment resulted in unprecedented government deficits and historically low interest rates. International financial and fiscal linkages were much stronger than expected initially.
In Canada, the interest rates set by the Bank of Canada were reduced to the lowest historical level. Governments continue to focus their budget policies on reducing or eliminating budget deficits caused by earlier economic conditions and policy decisions, despite pressing needs for infrastructure investment. The recent collapse in crude oil and other commodity prices raise new concerns for domestic economic growth and employment.
By mid-2016 energy and commodity prices had recovered and the new government's expansionary fiscal policy supported a mild economic recovery. Growth in Canadian economic activity and employment increased but, by Bank of Canada estimates, the economy still remained below 'full employment' in the first quarter of 2017.
Macroeconomic theory and models emerged from an earlier major financial collapse and crisis followed by the depression years of the 1930s. Although today's economies are larger and more complex they still behave by the same basic principles.
To understand the different dimensions of economic activity, economic conditions and macroeconomic policies, we need a framework that captures how they are related and how they interact. Macroeconomics provides that framework, using consistent and comprehensive system of definitions for the measurement of economic activity provided by the national accounts.
04: Economic activity and performance
Output, price, and employment are three key dimensions of macroeconomic activity. Output is a measure of the total quantity of goods and services produced in the economy. It is also a measure of the incomes generated by that production. Price or the price level in macroeconomics is the weighted average of the market prices of all final goods and services produced. The price level reflects the costs of production in the economy. Employment is a measure of the number of jobs involved in the production of goods and services, or, in more refined terms, the number of hours of labour input required to produce the economy's output. Economic performance is judged by how these measures change over time.
Output and its rate of growth are measured in terms of real gross domestic product (real GDP). It is the quantity of final goods and services produced in the economy in a specific time period, such as one year, measured in the market prices of a base year, 2007 for example. (It may also be called GDP in constant 2007 dollars). The production of goods and services generates incomes equal to the value of those goods and services. As a result, real GDP is also the real income in the economy and the quantity of goods and services the economy can afford to buy.
Real GDP: the quantity of final goods and services produced by the economy in a specified time period.
In an economy with a growing population and labour force, growth in real GDP is necessary to maintain standards of living. In the Canadian economy, real GDP changes from year to year. By measuring real GDP in the prices of a base year, the changes seen in real GDP are the result of changes in the quantities of goods and services produced, and not the result of changes in prices. This distinction is important: Increased quantities of goods and services provide for increased standards of living in the economy, increases in prices do not. As a result, economic growth is defined as an increase in real GDP, and the annual rate of economic growth is the annual percentage change in real GDP. This is the first key indicator of economic performance.
The rate of growth in real GDP is calculated as follows:
(4.1)
Economic growth: an increase in real GDP.
Rate of economic growth: the annual percentage change in real GDP.
Recent measures of real GDP in Canada provide an example of economic growth and the calculation of the rate of economic growth. In the year 2016, real GDP in Canada measured in 2007 dollars was \$1,781 billion. One year earlier, in 2015, real GDP in 2007 dollars was \$1,751 billion. Using these data:
The price level in the economy is a measure of the weighted average of prices of a wide variety of goods and services. The Consumer Price Index (CPI), for example, compares the cost of a fixed basket of goods and services bought by the typical household at a specific time with the cost of that same basket of goods and services in the base year. It is the most widely used indicator of prices in Canada and is often referred to as the "cost of living."
Price level: a measure of the average prices of all goods and services produced in the economy.
Price index: a measure of the price level in one year compared with prices in a base year.
Consumer Price Index (CPI): a measure of the cost of living in any one year compared to the cost of living in a base year.
The Consumer Price Index is a more comprehensive measure of the change in prices from one year to the next, but the simple example in Example Box 4.1 illustrates the how such an index is constructed and what it tells us.
Example Box 4.1 Constructing a price index
A simple example illustrates the construction of a price index. Suppose a survey of expenditures by university students in the year 2006 gives the information reported in the first three columns in the following table:
University student weekly expenditure basket (Base year 2006)
Quantity 2006 Price 2006 Cost 2011 Price 2011 Cost
Pizza 5 \$7.50 \$37.50 \$8.50 \$42.50
Hamburger 5 \$2.50 \$12.50 \$2.25 \$11.25
Coffee 10 \$1.00 \$10.00 \$1.25 \$12.50
Movies 1 \$10.00 \$10.00 \$8.00 \$8.00
Bus fare 7 \$1.50 \$10.50 \$1.85 \$12.95
Total \$80.50 \$87.20
This table gives us the cost of weekly expenditures on a basket of five items and the weight of each item in the total expenditure. If we choose 2006 as our base year then the cost of the basket in 2006 prices, \$80.50, has an index value of 100 . In other words we have a Student Price Index:
Now we see in the last two columns of the table that this same basket of goods and services in the prices of 2011 would cost \$87.20. Then our SPI in 2011 would be:
The index tells us that even though the prices of some things went up and others went down the Student Price Index increased by 8.3%. This was the weighted average increase in prices and the increase in the cost of student expenditures.
Today, the base year for the consumer price index is 2002 with a value of 100. Statistics Canada uses a fixed basket classified under eight consumer expenditure categories. The weight or importance of each category is its share of expenditure as determined by consumer expenditure surveys. By visiting the Statistics Canada website, www.statcan.gc.ca, and selecting Consumer Price Index in the Latest Indicators table on the right side of the home page, you can scroll down to a table showing the components of the CPI.
For 2015 Statistics Canada reported a CPI of 126.8 compared to a CPI of 100.0 in 2002. That meant the cost of the basket of goods in 2015 was 26.8 per cent higher than it was in 2002. Prices and the cost of living increased over the 13-year period. At the end of 2016 the CPI was 128.7. Prices had increased again. Inflation is defined as a persistent rise in the general price level as indicated by these increases taking the change, as a percentage, in the price level the previous year.
Inflation: a persistent rise in the general price level.
The inflation rate is calculated using the same method used for calculating the growth rate in real GDP. For example, using CPI values for 2015 and 2016:
(4.2)
Statistics Canada also collects and publishes information on the Canadian labour market. It uses a monthly Labour Force Survey of approximately 50,000 Canadian individuals 15 years of age or over living in the provinces of Canada, excluding full-time members of the armed forces, those persons living on Indian reserves, and those in institutions such as penal institutions, hospitals, and nursing homes. The survey provides the data used to estimate the size of the labour force, employment, and unemployment.
Employment is defined as the number of adults (15 years of age and older) employed full-time and part-time and self-employed. Unemployment covers those not working but available for and seeking work. The civilian labour force is those adults who are employed plus those not employed but actively looking for jobs. Based on these concepts, and data on the surveyed population, Statistics Canada reports three key labour market indicators, namely: The participation rate, the unemployment rate, and the employment rate. Employment and unemployment receive most of the media attention and have become familiar indicators of economic conditions. There are, however, two other underlying labour market measures that deserve attention when interpreting the employment and unemployment rates.
Labour force: adults employed plus those not employed but actively looking for work.
Employment: number of adults employed full-time and part-time and self-employed.
Unemployment: number of adults not working but actively looking for work.
The participation rate is the proportion of the surveyed population that is either working or unemployed. It measures the size of the labour force relative to the surveyed population. The participation rate changes as people become more optimistic about finding employment, or discouraged by periods without employment. Discouraged workers want to work but are no longer looking for work because they believe suitable work is not available. As a result they are excluded from the measurement of the labour force and reduce the participation rate. Changes in the participation rate change the size of the labour force and the unemployment rate even if employment and the population are constant.
Participation rate: percent of the population that is either working or unemployed.
(4.3)
The unemployment rate is the number of unemployed persons expressed as a percentage of the labour force. The size of the labour force depends on the participation rate, which reflects the choices people make about looking for work. The unemployment rate will rise if people become more optimistic about job prospects and begin to look for work, increasing the participation rate and the labour force. On the other hand, the unemployment rate will decline if some people become discouraged and give up looking for work, reducing the participation rate and the labour force.
Unemployment rate: the number of unemployed persons as a percentage of the labour force.
The unemployment rate is calculated as follows:
(4.4)
Unemployment as measured by the broad unemployment rate has three important components. Cyclical unemployment is unemployment that would be eliminated by a higher level of economic activity without putting increased pressure on wage rates and inflation. Frictional unemployment comes from the dynamics of the labour market as changing labour force participation and employment opportunities mean that it takes time to match job openings with job candidates. Structural unemployment reflects differences in labour force characteristics and employment opportunities as the structure of the economy changes. In combination, frictional and structural unemployment make up the "full employment" level of unemployment. The corresponding unemployment rate is defined as the natural unemployment rate. In recent years in Canada, estimates of frictional and structural unemployment suggest a natural unemployment rate of about 6.0 percent. An unemployment rate persistently below 6.0 percent would create inflationary pressure in the labour market and the economy.
Cyclical unemployment: would be eliminated by higher levels of economic activity.
Frictional unemployment: a result of the time involved in adjusting to changing labour force and employment opportunities.
Structural unemployment: caused by changes in economic structure relative to labour characteristics.
Natural unemployment rate: the unemployment rate at "full employment".
Employment rate: percent of the population 15 years of age and over that is employed.
Employment rates provide a different perspective on labour market conditions because they are not affected by changes in the participation rate, which can change unemployment rates. If some people become discouraged and stop looking for work the participation rate, the labour force and the unemployment rate decline, but the employment rate is unchanged. The employment rate is calculated as:
(4.5)
Table 4.1 gives recent data on the Canadian labour force and labour market conditions in terms of the Participation, Employment and Unemployment rate concepts.
Table 4.1 The Canadian Labour Market, February 2017 (thousands of persons and percent)
1. Non-institutional population 15+ yrs 29,764
2. Labour force 19,575
3. Employment 18,289
4. Unemployment
1,286
5. Participation rate [] 65.8%
6. Employment rate [] 61.4%
7. Unemployment rate [] 6.6%
Source: Statistics Canada, CANSIM Table 282-0087
Almost every day the media discuss some aspects of economic growth, inflation, and employment. Often these discussions ignore the requirement that employment must grow faster than the growth in the labour force if unemployment is to decline. Good news about 'job creation' needs to be tempered by news on labour force growth. These issues often play large roles in elections and discussions of economic policy. In the chapters that follow, we will study causes of changes in output, income, prices and inflation, and employment and unemployment. As a background to that work, consider recent Canadian economic performance. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/04%3A_Economic_activity_and_performance/4.01%3A_Macroeconomic_performance.txt |
The positive relationship between economic performance and standards of living motivates the study of macroeconomics and macroeconomic policy. The ideal would be an economy in which, starting with full employment of labour and capital equipment, the rate of growth of real GDP matched the rate of growth of the labour force and growth in labour productivity, at a low and stable rate of inflation. This is sometimes referred to as a 'Goldilocks Economy' – neither too hot nor too cold, just right.
Figures 4.1 to 4.4 provide a more detailed look at the actual rate of growth of real GDP, the rate of inflation, and unemployment rate in Canada over the 2000–2016 time period. They show the trends and annual variations in these measures of economic performance. Understanding the causes of these short-term fluctuations in economic performance, their effects on standards of living and the economic policy questions they raise, are major reasons for studying macroeconomics.
Figure 4.1 Real GDP in Canada 2000–2016
Source: Statistics Canada, CANSIM Table 380-0106
Figure 4.2 Annual Real GDP Growth in Canada, 2001–2016
Source: Statistics Canada, CANSIM Table 380-0106
Figure 4.1 shows the substantial growth in real GDP over the 2000–2016 period. It also shows that growth was not steady. Real GDP did increase from 2000–2008 with annual growth rates ranging from 1.5-3.0. Then the real GDP declined sharply by 3.0 percent in 2009. This and other times of negative growth in real GDP are called recessions. Indeed the fall in real GDP in 2009, the largest such decline since the 1930s, is now called the 'Great Recession'.
Recession: decline in economic activity, often defined as two consecutive quarters of negative growth in real GDP.
Figure 4.2 shows more clearly the considerable fluctuations in real GDP annual growth rates and the negative growth rate of the Great Recession. Even when the trend in growth is positive, fluctuations in growth rates can have negative effects on standards of living. They are reflected in changes in employment, changes in incomes and changes in markets that can make life difficult for those affected. We study macroeconomics to find explanations for the causes and effects of these fluctuations in economic activity that will guide stabilization policies.
Figure 4.3 shows annual inflation rates in Canada since 2000. These show the relative stability of Canadian inflation in the years leading up to the Great Recession. That pattern changed after 2008 with the effects of lower output growth and higher unemployment on prices and wage rates.
Figure 4.3 Annual Inflation Rates in Canada, 2000–2016
Source: Statistics Canada, CANSIM Table 326-0022
Our recent experience with low and stable inflation rates in the 2000–2016 period is quite different from past experience. In the late 1980s and early 1990s annual inflation rates were at times higher than 10 percent. We will examine the roles that monetary policies and recessions played in these changes in inflation rates.
Fluctuations in growth rates and inflation rates are also accompanied by fluctuations in unemployment rates. Annual unemployment rates plotted in Figure 4.4 have fluctuated between 6 percent and 8.3 percent. Although employment has grown over time, when job creation has at times fallen short of the growth in the labour force, unemployment rates rise. At other times, strong real GDP growth and job creation have lowered the unemployment rate. The falling unemployment rates from 2002 to 2007 and again from 2009 to 2015 coincided in time with the continuous growth in real GDP we saw in Figure 4.1.
Figure 4.4 Annual Unemployment Rates in Canada 2000–2016
Source: Statistics Canada, CANSIM Table 282-0087
The sharp rise in unemployment in 2009 and the persistence of unemployment rates higher than those in earlier years give us an example of the way growth in real GDP and employment are tied together. The recovery of GDP growth after the Great Recession has not been strong enough to offset modest growth in the labour force and lower unemployment rates to pre-recession levels. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/04%3A_Economic_activity_and_performance/4.02%3A_Canadian_economic_performance.txt |
National accounts provide the framework that is essential for consistent definitions and measurement of spending, output, and incomes. However, it is important to recognize that this is an accounting system that describes the economy, not an economic model that explains the economy's behaviour. That comes later.
The national economy involves all households, businesses, and governments that make decisions about employment, output and expenditures. The results of individual decisions made by these economic units are measured by the economy's total spending, output, and income. The circular flow diagram in Figure 4.5 shows the relationship between spending, output, and income.
Circular flow diagrams: show the flows of money payments, real resources, and goods and services between households and businesses.
Figure 4.5 Circular flows in the economy
We start with the simplest of economies. There are only households and businesses; no government and no trade with other countries. Households own the factors of production: Labour, land, capital, and entrepreneurship. Businesses use these factors of production to produce outputs of goods and services. Businesses pay households for the factor services they use and recover these costs by selling their output to the households.
Figure 4.5 shows the circular flow of inputs to production, outputs of goods and services, costs of the inputs to production, and receipts from sales. The upper half of the diagram, above the horizontal line, shows the outputs of goods and services supplied by business to households and household expenditures on those goods and services. The lower half of the diagram shows the factor services of labour, land capital, and entrepreneurship supplied by households to business in exchange for the factor incomes: wages, rent, interest, and profit.
The figure also suggests an alternative way to look at activity in the aggregate economy. The inner loop in the diagram shows the flows of real factor services between households and businesses. Households provide factor services to business and get goods and services in return. In modern economies this exchange of factor services for goods and services is facilitated by the use of money as a means of payment. The outer loop in the diagram illustrates the flows of money payments made by business to buy factor services, and by households to buy goods and services produced by business. Business pays wages, rent, interest, and profits to households and finances those costs with their receipts from sales to households. To keep the example simple, we assume that households spend all the income they receive from the business sector on goods and services produced by the business sector.
Figure 4.5 illustrates four ways to measure economic activity, namely:
1. the output of goods and services at market prices;
2. the total expenditure on goods and services at market prices;
3. the inputs to the production of goods and services costed at market prices; and
4. the incomes received by households for providing factor inputs to production.
The four rectangles in the diagram show these four alternative but equal measurements.
The accounting framework gives the same measure of total economic activity whether we use the market value of output, total spending on that output, inputs to production, or the factor incomes received by households in return for those inputs.
This circular flow model is kept very simple to illustrate the basic accounting principle:
While the principle illustrated by the circular flow is sound, the economy in Figure 4.5 is too simple. It does not allow households to save or businesses to invest. It leaves out government expenditures and taxes, and transactions between households and businesses with the rest of the world. Including those aspects of economic activity would make our model more complex, and we would need a comprehensive system of national accounts to describe and measure it. But the basic accounting principle would be the same: the four ways to measure total activity in the economy give, by definition, the same answer. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/04%3A_Economic_activity_and_performance/4.03%3A_National_accounts.txt |
Nominal GDP is measured using market prices and a specific time period. It is not possible to add up the final physical outputs of many different businesses and arrive at a meaningful result. Instead, because we have a 'money economy', we let current market prices determine the money values of these different outputs. Then the total market value can be found by adding up the money values. Nominal GDP is the market value at current prices of all final goods and services.
Furthermore, the outputs of goods and services occur over time, not all at once. They flow over time and must be measured relative to time. GDP measured over three-month and one-year time periods are reported as quarterly GDP and annual GDP. Annual nominal GDP for any year is the value of the final goods and services produced in that year at the prices of that year.
Final goods and services: goods and services are purchased by the ultimate users.
In Canada, Statistics Canada uses the Canadian System of National Accounts (CSNA) to measure GDP. This framework is based on the circular flow concept we have discussed, but is applied to the complexity of the actual economy.
Although earlier in this chapter we defined and discussed real GDP, measured at prices of a base year national accounting measures nominal GDP at current prices. The CSNA produces three measurements of nominal GDP:
1. Output-based GDP is the sum of value added (output less the cost of goods and services purchased from other business) by all industries in Canada;
2. Income-based GDP records the earnings generated by the production of goods and services; and
3. Expenditure-based GDP is equal to expenditure on final goods and services produced.
Nominal GDP: the output of final goods and services, the money incomes generated by the production of that output, and expenditure on the sale of that output in a specific time period.
These three alternative measures of GDP provide importantly different perspectives on the level of national economic activity. The output and income measures describe the supply side of the economy in terms of goods and services produced, and cost of production. The expenditure measure of GDP describes the demand side of the economy.
Output-based GDP
To measure output in the economy, and the contribution of particular businesses or industries to that output, we use the value-added approach to GDP. Value added measures the net output of each industry. To find the value added (net output) of a particular business or industry, the costs of the goods and services purchased from other businesses and industries are deducted from the value of the final product. National, or all-industry GDP, is then the sum of GDP by industry.
Value added: the difference between the market value of the output of the business and the cost of inputs purchased from other businesses.
This method recognizes that businesses buy inputs to production from other businesses as well as from households. Automakers like General Motors and Honda buy parts and components like tires and windshields from other businesses, and include the costs of those inputs in the prices of the finished cars they sell. They also buy services like accounting, advertising, and transportation from service producers. Similarly, pizza makers buy cheese and pepperoni from cheese factories and meat processors. If we were to add up the outputs of auto parts manufacturers, cheese makers, meat processors, pizza makers, General Motors, and Honda in our measurement of nominal GDP, we would overstate GDP by double counting. The cheese would be counted once at the cheese factory and again in the pizza. The same applies to the tires and windshields of the new cars. To avoid double counting, we use value added, the increase in the value of goods and services as measured by the difference between market value of output and the cost of intermediate inputs bought from other businesses. Or we could count only the outputs sold to final users. Notice that total GDP by our definition measures the output of final goods and services.
Intermediate inputs: services, materials, and components purchased from other businesses and used in the production of final goods.
Consider a simple example. A coffee shop sells 100 cups of coffee an hour at a price, before tax, of \$1.50. To make 100 cups of coffee the shop uses 2 kilos of ground coffee costing \$10.00 per kilo, 25 litres of pure spring water costing \$0.40 a litre, and electricity and dairy products costing, in total \$20. The coffee shop's sales per hour are \$150 using inputs costing \$50. Its value added is . As we will see shortly, this value added, or \$100, covers the labour costs, rent, interest expenses, and management costs of the business, for producing 100 cups of coffee an hour.
Table 4.2 Outputs of selected industries in GDP, Canada 2016 (percent shares)
All industries 100.0
Goods producing industries
29.5
Service producing industries
70.5
Agriculture, forestry, fishing, etc. 1.7
Mining, oil and gas extraction 8.2
Construction 7.0
Manufacturing 10.4
Wholesale and retail trade 11.2
Transportation 4.5
Finance, insurance and real estate 20.3
Professional, scientific and management 8.6
Health and social assistance 6.7
Educational 5.2
Public administration 6.4
All other 9.8
Source: Statistics Canada, CANSIM Table 379-0031 and author's calculations
Table 4.2 shows the industrial structure of output in Canada in 2016, based on the percentage shares of selected industries in Canadian GDP. Industry outputs are measured by value added. The data illustrate the importance of service-producing industries to economic activity in Canada. This industrial structure is typical of today's high-income economies and raises many interesting questions about the relationship between economic structure, performance, and growth. However, when our main interest is in the total level of economic activity rather than its industrial structure, the expenditure-based and income-based measures of GDP are used.
Expenditure-based GDP and income-based GDP
In the national accounts, expenditure based GDP and income based GDP are equal by definition. Table 4.3 provides an example using the actual accounts for Canada in 2016Q4. Expenditure categories and their shares in total expenditure are recorded in the left hand side of Table 4.3. Income categories and indirect taxes shares and their shares are recorded on the right-hand side.
Table 4.3 Canadian National Accounts 2016Q4
(\$ billions at current prices and seasonally adjusted at annual rates and % GDP)
Expenditure Measures Incomes Measures
At market price \$ % By income source \$ %
C by households 1,196.1 57.8 Employee compensation 1,066.0 51.5
I by business 455.3 22.0 Gross operating surplus 530.7 25.7
G by government 435.8 21.1 Gross mixed income 242.0 11.7
X exports 654.1 31.6 Net indirect taxes 228.2 11.0
IM imports –672.7 –32.5
Statistical discrepancy –0.8 0.0 Statistical discrepancy 0.8 0.0
GDP at market price 2,067.8 100.0 GDP at market price 2,067.8 100.0
Source: Statistics Canada, CANSIM Tables 380-0063 and 380-0064
Expenditure-based nominal GDP adds up the market value of all the final goods and services bought in a given time period, say one year. The national accounts classify this final expenditure into five main categories: Consumption, investment, government expenditure, exports, and imports.
For expenditure, the national accounts classification system is essential for our study of macroeconomic activity for two reasons. First, the classification scheme covers final expenditure in the economy completely; nothing is omitted. Second, the categories represent expenditure decisions made for different reasons in different parts of the economy and the percentage share or importance of each in final expenditure. Understanding expenditure decisions is critical to the work that lies ahead. Defining the expenditure categories is the first step.
Applying a name to each expenditure category in the table and using the notation attached gives:
or
(4.6)
For macroeconomic theory and models, this expenditure GDP is the foundation of theory of aggregate demand introduced in Chapter 5 and developed in detail in later chapters.
Income-based GDP adds up the factor costs of production of all goods and services plus the net in direct taxes included in market price. The national accounts classifications of factor incomes correspond to labour income, corporate profit, unincorporated business income plus investment income, and depreciation. The table also shows the percentage share of each category in GDP and thus the relative importance of each in income or cost respectively. The income categories are: Employment compensation (W), gross operating surplus (corporate profit) (GCS), gross mixed income (unincorporated business income plus investment income) (GMI) and net indirect taxes (). (The allowance for depreciation of capital is included in GCS and GMI.) Then GDP at market price is:
(4.7)
This income based GDP measures total cost of production. The first three components W, GCS and GMI are factor costs of production including the depreciation of capital equipment used in production. Net indirect tax is the revenue generated by taxes applied to goods and services and included in final price. An aggregate supply function for the economy involves these costs of production in relation to total output. Aggregate expenditure at market prices is the revenue that producers receive to cover these costs.
To construct a macroeconomic theory and model of the economy we must explain the linkages, feedbacks and interactions among the elements of the economy defined by national accounting conventions. These linkages, feedbacks and interactions are the important relationships that work together to explain how this economic system determines GDP, business cycle fluctuations in GDP, inflation, and employment. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/04%3A_Economic_activity_and_performance/4.04%3A_Measuring_GDP.txt |
We have used real GDP to measure growth and the growth rate in the beginning of this chapter, and then nominal GDP as recorded in the National Accounts. Now we need to look carefully at both concepts and the relationship between them, which is the GDP deflator, a measure of the general price level. Nominal GDP measures output and incomes based on current market prices for goods and services and factors of production. As a result, changes in nominal GDP from one period to the next might be the result of changes in prices of final outputs and factor inputs, or the result of changes in the quantities of final outputs and factor inputs, or some combination of the two. Since it is physical quantities of goods and services that yield satisfaction or utility, it can be misleading to judge the economy's performance by looking at nominal GDP. For that purpose we need real GDP, as we discussed earlier in this chapter. Real GDP, or GDP in constant prices, measures the value of goods and services produced in any given year using the prices of a base year. In this way, real GDP adjusts changes in GDP for changes in prices by measuring GDP in different years in constant prices.
Table 4.4 Nominal and real GDP
2007 2017 % change
Quantity blue jeans 4,000 5,000 25
solar panels 2,000 4,000 100
Price in current \$ blue jeans 25 50 100
solar panels 100 60 –40
Current value blue jeans 100,000 250,000 150
solar panels 200,000 240,000 20
Nominal GDP 300,000 490,000 63
Value in 2007 \$ blue jeans 100,000 125,000 25
solar panels 200,000 400,000 100
Real GDP 300,000 525,000 75
GDP deflator 100 93.3 6.7
To illustrate this important point, Table 4.4 shows a simple economy that produces both consumer goods, blue jeans, and capital goods, solar panels. In this economy nominal GDP rises from \$300,000 to \$490,000 between 2007 and 2017, a 63 percent increase measured in current prices as a result of changes in both quantities and prices. If we take 2007 as the base year, we can measure real GDP in 2017 by valuing output quantities in 2017 using 2007 prices. This gives real GDP in 2017 of \$525,000 in prices of the base year. In the example in the table, quantities of both products rise over the period but the price of blue jeans rises while the price of solar panels falls. As a result the rise of about 75 percent in real GDP gives a true picture of the extra quantity of goods available in the economy in 2017 compared with 2007. It eliminates the change in nominal GDP that was the result of the fall in the average price level by 6.7 percent between 2007 and 2017 as a result of the fall in the price of solar panels.
The GDP deflator
The Canadian economy is obviously more complex than this economy. We have seen that GDP includes expenditures by households, governments, businesses, and residents of other countries who supply us with imports and buy our exports. To convert nominal GDP to real GDP we need to use an index that includes what is happening to the prices of all these different goods and services. This index is called the GDP deflator.
GDP deflator: index of current final output prices relative to base year prices.
If we have data for both nominal and real GDP, we can calculate the GDP deflator as the ratio of nominal GDP to real GDP expressed as an index with a value of 100 in the base year.
(4.8)
The GDP deflator differs from the consumer price index (CPI) illustrated in Example Box 4.1 and used to measure inflation in consumer prices and the cost of living. First, the CPI is based on a "representative basket" of goods and services that consumers buy, while the GDP deflator is comprehensive and covers all the goods and services included in national accounts. Second, the CPI changes over time with changes in the prices of the basket of consumer goods and services. The GDP deflator, by contrast, is built on the base year prices. It changes over time as the current prices change relative to base year prices. In other words the GDP deflator is used to "deflate" the dollar value of current 2017 output to what value it would be in 2007 prices, while the CPI measures the increase in the cost of the "basket" of consumer goods and services.
But why does the GDP deflator change over time? From our earlier discussion of the national income accounting framework, we can see that costs of production and net indirect taxes are included in the general level of market prices measured by the GDP deflator. Nominal GDP measured by the income approach is reported in Table 4.3. It is the sum of incomes paid to factor inputs to production, plus depreciation allowances and net indirect taxes. These components of nominal GDP are the costs of production, gross profits, and taxes that are built into the market prices of the goods and services.
The general price level in the economy is the dollar amount paid for a 'unit of output' and, subtracting indirect taxes, the revenue received by producers for the sale of 'unit of output'. Revenue per unit of output must cover costs per unit of output, including expected profit, for producers to be willing to continue operations. Changes in costs must be covered eventually by changes in prices. Or if market conditions raise prices—think about crude oil production or lumber production—producers will increase output, as long as higher prices cover higher costs.
Summarizing from the national accounts gives three components of cost per unit of output:
1. employee compensation per unit of output, W/Y;
2. gross business income per unit of output, (GCS+GMI)/Y; and
3. net indirect tax per unit of output, .
Changes in the sum of these three components of the price level must change both price and nominal GDP, whether we measure nominal GDP by the income or the expenditure approach. The GDP deflator is an index of this price level in any particular year relative to a chosen base year. However, the accounting framework does not explain the causes of change in the price level. That requires explanations of changes in unit labour costs, of producer output and pricing decisions and information on the net indirect tax rate. Those explanations are parts of an economic model of the supply side of the economy.
To show the empirical importance of the distinction between real and nominal GDP, Table 4.5 gives Canadian data over the period 2004 to 2016. Nominal GDP rose from \$1,331 billion in 2004 to \$2,027 billion in 2016. Without knowing what happened to prices of goods and services in general, we cannot judge what happened to the quantity of output over that period. To answer this question we use the GDP deflator to convert nominal GDP to real GDP in the prices of the base year 2007 as follows:
(4.9)
Table 4.5 Canadian nominal and real GDP 2004–2016
2004 2008 2012 2016
Nominal GDP (billions \$) 1,331 1,653 1,823 2,027
GDP deflator (2007=100) 91.4 104.0 109.2 112.9
Real GDP (billions 2007 \$) 1,456 1,589 1,669 1,796
Source: Statistics Canada, CANSIM Tables 380-0064 and 380-0066
For example, in 2016, nominal GDP was \$2,027 billion and the GDP deflator () was 112.9. Real GDP measured in constant 2007 dollars was then:
When converted to constant dollars, the change in real GDP is much smaller than the change in nominal GDP. Over the 2004–2016 period shown in the table, real GDP increased by 23.4 percent compared to a 52.3 percent increase in nominal GDP. On average, prices in 2016 were 23.5 percent higher than in 2004. Clearly, it is important to distinguish between nominal and real GDP. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/04%3A_Economic_activity_and_performance/4.05%3A_Nominal_GDP%2C_real_GDP_and_the_GDP_deflator.txt |
Real GDP is a simple measure of the total real income and output of an economy. The percentage change in real GDP we saw in Figures 4.1, 4.2 and 4.3 shows how fast the economy is growing. But we are also interested in what is happening to productivity, the standard of living in the economy and how they change over time. For a given real GDP, the larger the population, the lower is productivity and the smaller is the quantity of goods and services per person. To get a simple measure of the standard of living enjoyed by a person in the economy it is better to look at per capita real GDP, which adjusts for population. Whether or not growth in total GDP improves standards of living depends also on what is happening to the size of the population. To find per capita real GDP for a country, which is real GDP per person, we simply divide real GDP by population.
Per capita real GDP: real GDP per person.
(4.10)
The study of short-run macroeconomics is strongly motivated by the negative effects of recessions on national standards of living. Figure 4.6 shows the negative effects of recessions on per capita GDP in 1982, 1991, and 2009.
Figure 4.6 Quarterly Rates of Growth in Per Capita Real GDP in Canada, 1982–2016
Source: Statistics Canada, CANSIM Table 380-0064 and Series V1
Macroeconomic models are built to help us understand the causes of fluctuations in real GDP, employment, and the price level. Understanding the workings of the economy is essential for the design and implementation of monetary and fiscal policies that contribute to economic stability and protect standards of living.
In longer time horizons macroeconomics seeks to understand and explain the growth of real GDP that is essential to protect and improve standards of living as population grows. Growth also increases the capacity of the economy to direct its resources to a wider range of activities that may include improvements in the quality of goods and services produced or reductions in the effects of growth on social and environmental conditions.
Limitations of real GDP
Because we use GDP to measure the output and income of an economy, the coverage should be as comprehensive as possible. We should also recognize that the composition of GDP and the distribution of income are important to a country's standard of living.
In practice, we encounter several problems when including all production in GDP. First, some production causes noise, pollution, and congestion, which do not contribute to economic welfare. Current national and international concern about greenhouse gases and climate change is a clear and obvious example of the issues involved. We should adjust GDP for these costs to evaluate standards of living more accurately. This is sensible but difficult to do. Recent policy changes by governments to impose carbon taxes on fuels and fuel efficiency targets for automobiles aim to reduce some greenhouse gases. But most such nuisance goods are not traded through markets, so it is hard to quantify their output or decide how to value their costs to society.
Similarly, many valuable goods and services are excluded from GDP because they are not marketed and therefore are hard to measure. These include the home cleaning, maintenance, and improvements households carry out for themselves, and any unreported jobs and incomes in the economy. Deducting nuisance outputs and adding the value of unreported and non-marketed incomes would make GDP a more accurate measure of the economy's production of goods and services.
Furthermore, high GDP and even high per capita GDP are not necessarily good measures of economic well-being. The composition of that output also affects standards of living. Health care services are likely to have different effects than military expenditures. The United Nations prepares an annual Human Development Index (HDI) to provide a more comprehensive measure of a country's achievements. The HDI provides a summary measure based on life expectancy, adult literacy, and real GDP per capita.
Table 4.6 shows HDIs for the top ten countries in 2015, according to the Human Development Report, 2016. The second last and last columns in the table are of particular interest. The second last column shows the HDI adjusted for national per capita GNP. The underlying argument is that ranking national economic wellbeing simply by using per capita GNP would miss the importance of life expectancy and education as indicators of standards of living. For example, Singapore and the United States would rank highest by per capita GNP alone, but that ranking is reduced by lower life expectancy and years of schooling. The last two columns in the table compare HDI rankings in 2015 compared to 2014.
Table 4.6 Top ten countries based on the United Nations human development index
HDI Country HDI Life Expected Mean GNP/pop1 GNP/pop HDI
Rank Expectancy yrs yrs – HDI rank
(years) schooling schooling rank2
2015 2015 2015 2015 2015 2015 2014
1 Norway 0.949 81.7 17.7 12.7 67614 5 1
2 Australia 0.939 82.5 20.4 13.2 42822 19 3
2 Switzerland 0.939 83.1 16 13.4 56364 7 2
4 Germany 0.926 81.1 17.1 13.2 45000 13 4
5 Denmark 0.925 80.4 19.2 12.7 44519 13 6
5 Singapore 0.925 83.2 15.4 11.6 78162 -3 4
7 Netherlands 0.924 81.7 18.1 11.9 46326 8 6
8 Ireland 0.923 81.1 18.6 12.3 37065 11 8
9 Iceland 0.921 82.7 19 12.2 43798 20 9
10 Canada 0.920 82.2 16.3 13.1 42582 12 9
10 United States 0.920 79.2 16.5 13.2 53245 1 11
Source: United Nations Human Development Reports: 2016 HDR Report.
http://hdr.undp.org/en/composite/HDI
Note3: GNP in PPP international dollars.
Note4:
Difference between rank by GNP per capita and by HDI value.
A negative value means the country is better ranked by GDP than HDI.
Do the limitations of GDP matter for our study of macroeconomics? Probably not. We will be examining changes in real GDP from year to year, for the most part. As long as the importance of nuisance and non-marketed outputs, life expectancy, literacy and inequalities do not change dramatically in that time frame, changes in measured real GDP will provide good measures of changes in economic activity and performance. Changes in per capita real GDP will also provide measures of changes in standards of living. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/04%3A_Economic_activity_and_performance/4.06%3A_Per_capita_real_GDP.txt |
In this chapter we have looked at indicators of macroeconomic activity and performance, and the measurement of macroeconomic activity using the national accounts. We have not examined the conditions that determine the level of economic activity and fluctuations in that level. An economic model is required for that work. In the next chapter we introduce the framework of a basic macroeconomic model.
Key Concepts
Macroeconomics studies the whole national economy as a system. It examines expenditure decisions by households, businesses, and governments, and the total flows of goods and services produced and incomes earned.
Real Gross Domestic Product (GDP), prices and inflation rates, and employment and unemployment rates are indicators of macroeconomic activity and performance.
Fluctuations in the growth rate of real GDP, in inflation rates, and in unemployment rates are important aspects of recent economic performance in Canada.
The expenditures by households, production of goods and services by business, and the incomes that result are illustrated by the circular flow of real resources and money payments.
The National Accounts provide a framework for the measurement of the output of the economy and the incomes earned in the economy.
Nominal GDP measures the output of final goods and services at market prices in the economy, and the money incomes earned by the factors of production.
Real GDP measures the output of final goods and services produced, and incomes earned at constant prices.
The GDP deflator is a measure of the price level for all final goods and services in the economy.
Real GDP and per capita real GDP are crude measures of national and individual welfare. They ignore non-market activities, the composition of output, and the distribution of income among industries and households.
4.09: Exercises for Chapter 4
EXERCISE 4.1
You have the following annual data for an economy:
Year Real GDP Consumer price Labour force Employment
(2007 \$) index (2007=100) (000) (000)
2012 1,282 109.1 17.593 16.537
2013 1,307 111.9 17.857 16.696
2014 1,288 138.9 18.125 16.856
1. What was the rate of growth of real GDP from 2012 to 2013, and 2013 to 2014?
2. What was the rate of inflation in 2013 and in 2014?
3. What were the rates of growth of the labour force and employment from 2012 to 2013, and 2013 to 2014?
4. What happened to the unemployment rate between 2012 and 2013, and between 2013 and 2014?
EXERCISE 4.2
Suppose the economy represented by the table in Exercise 4.1 above had a population of 27.885 thousand in 2014.
1. What were the participation and employment rates in the economy in that year?
2. Suppose a mild recession in that year discouraged some unemployed workers and they stop looking for work. As a result the participation rate fell to 64.5 per cent. How would the unemployment rate and the employment rate be affected? Why?
EXERCISE 4.3
If brewers buy barley and hops from agricultural producers, natural gas to fire their brew kettles from gas companies and bottles from glass manufacturers as in the following table, what is the value added of the brewing industry? If brewers also wholesale some of their output to pubs, is that output counted in GDP? Explain your answer.
Costs (millions of current \$) of:
Brewery retail sales Barley and hops Natural gas Bottles
1000 350 125 150
EXERCISE 4.4
The economy has two main industries. One produces services and the other produces goods. The services industries produce services for households and businesses with a total market value of \$10,000. The goods industries produce goods for the use of both households and businesses with a total market value of \$5,000. The service industries spend \$1,000 on computers and paper and envelopes supplied by the goods industries. The goods industries spend \$1,000 to buy financial, insurance, advertising and custodial services supplied by the service industries. Explain how you measure nominal GDP in this economy and the value of output you find?
EXERCISE 4.5
Suppose you are given the following data on incomes and expenditures for the economy of Westland, in current prices for factors of production and outputs.
Consumption expenditures 2,500
Employment compensation 2,800
Government expenditure 800
Net indirect taxes 150
Exports 1,200
Gross corporate surplus and mixed income 1,050
Investment expenditure 600
Imports 1,100
1. What is the value of nominal GDP measured by expenditures?
2. What is net domestic income?
3. What is the value of nominal GDP measured by the income approach?
EXERCISE 4.6
Suppose GDP is \$2,000, consumption expenditure is \$1,700, government expenditure is \$50, and net exports are \$40.
1. What is business investment expenditure?
2. If exports are \$350, what are imports?
3. In this example, net exports are positive. Could they be negative?
EXERCISE 4.7
Consider the following information about a hypothetical economy:
Year Nominal GDP GDP deflator Population
(billions \$) (2000=100) (millions \$)
2012 750 104.0 25.0
2013 825 112.0 30.0
1. Calculate the growth (percentage change) in nominal GDP from 2012 to 2013.
2. What was real GDP in 2012 and 2013? How much did real GDP grow?
3. If changes in the standard of living can be measured by changes in real per capita GDP, did growth in nominal and real GDP raise the standard of living in this economy from 2012 to 2013?
4. Explain the reasons for the change in standard of living that you have found. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/04%3A_Economic_activity_and_performance/4.07%3A_Conclusion.txt |
Many economic events seem simple and limited in their effects on rates of growth of output, rates of inflation and rates of unemployment. A housing market collapse in the US in 2008 was seen, at first as just a collapse in prices in an overheated market. A sharp drop in crude oil prices in early 2015 was seen as a benefit to households that would reduce their driving costs and allow for higher expenditure in other areas. Fiscal austerity aimed at achieving balance government budgets in Europe seemed an obvious way to reduce high government debt to GDP ratios. But none of these initial judgements worked out. In each case, ignoring the complexity of the macro economy led to large errors in early forecasts and persistent, widespread problems with economic performance.
An aggregate demand and aggregate supply model is the workhorse of macroeconomics. It integrates the effects of economic disturbances, economic decisions, relationships and linkages that determine real GDP and the GDP deflator. Analyzing events like financial shocks, commodity price shocks and government policy shifts using a full macroeconomic model provides a better understanding of their effects on rates of growth of GDP, rates of unemployment and rates of inflation. In this chapter we introduce a basic concepts of an aggregate demand and supply model and use it to illustrate the causes and effects of business cycle fluctuations in real output and prices. The objective is to provide the framework for the economic theory on which aggregate demand and supply are based.
05: Output business cycles growth and employment
The short run in macroeconomics is defined by assuming a specific set of conditions in the economy. These are:
1. There are constant prices for factors of production, especially money wage rates for labour.
2. The supply of labour, the stock of capital, and the state of technology are fixed.
Short run: a time frame in which factor prices, supplies of factors of production, and technology are fixed by assumption.
In the short run, changes in output involve changes in the employment of labour and in the use of plant and equipment, but these changes are not sustainable over longer time periods. Furthermore, because supplies of factor inputs and technology are fixed, there is no sustained growth in real GDP. We leave that topic for a later chapter.
The national accounts we studied in Chapter 4 describe and measure economic activity in terms of an accounting framework used to measure aggregate expenditures, outputs, and incomes. But the accounting framework simply measures what has happened in the recent past. It does not explain the level of economic activity and prices or the reasons for changes in output and prices from time to time.
For that we need an analytical framework that looks at cause and effect. An aggregate demand (AD) and aggregate supply (AS) model is such an analytical framework. It helps us understand the conditions that determine output and prices, and changes in output and prices over time.
AD/AS model: a framework used to explain the behaviour of real output and prices in the national economy.
The short-run AD/AS model builds on the national accounts framework. Aggregate demand is the relationship between aggregate expenditure on final goods and services and the general price level. Real GDP by the expenditure approach measures this expenditure at the price level given by the GDP deflator. Aggregate supply is the relationship between the output of goods and services produced by business and the general price level. Real GDP by the income approach measures this output, and the corresponding real incomes. The price level is again the GDP deflator. National accounts tell us that, by definition, these measured outputs and incomes are equal. AD and AS functions describe expenditure plans, outputs, and prices using the national accounts framework. This distinction between measured and planned expenditure and output is important. Planned expenditure is the current output households and businesses would want to buy at different levels of income and price. Output is what businesses actually produce. Planned expenditure and the actual output produced by business may not be the same.
Figure 5.1 gives us a first look at output, real income, and prices for a specific year using an aggregate demand and aggregate supply diagram. The price level as measured by the GDP deflator is measured on the vertical axis. Real output and income are measured on the horizontal axis. The point of intersection of the AD and AS lines shows that real output by the expenditure approach, Y0, is equal to real income by the income approach at the price level P0, as required by national accounts. It also shows planned aggregate expenditures equal to the current output of goods and services. However, we need to explain the aggregate demand and aggregate supply relationships indicated by the slopes and positions of the AD and AS lines in the diagram before we use the model to study output and prices.
Figure 5.1 A basic aggregate demand and supply model
The AD and AS lines show planned expenditures on and output of final goods and services at different aggregate price levels all other conditions held constant. At the intersection of and planned expenditures on final goods and services are equal to real GDP at .
Equilibrium GDP: AD=AS, planned expenditure equals current output and provides business revenues that cover current costs including expected profit.
Aggregate demand (AD) is planned aggregate expenditure on final goods and services at different price levels when all other conditions are constant. This relationship is examined in detail in the chapters that follow. A downward sloping AD curve means the relationship between planned aggregate expenditure and the general price level is negative. A higher price level reduces the expenditures planned by households, businesses, and residents of other countries. Lower price levels increase those expenditure plans.
Aggregate demand: planned aggregate expenditure on final goods and services at different price levels, all other conditions remaining constant.
Aggregate Supply (AS) is the output of final goods and services business produces at different price levels when other conditions are constant. The upward sloping AS curve in Figure 5.1 assumes that the relationship between the quantity of goods and services produced and the price level is positive. Prices and output rise or fall together. We will examine this relationship in more detail below and in later chapters.
As we can see in the diagram, changes in either AD or AS would result in changes in the point of intersection of AD and AS and in equilibrium P and Y. But the important question is: What economic conditions and events determine the positions and slopes of AD and AS? The model is a tool for economic analysis that will only be useful when we know how it works and how to operate it.
Aggregate supply: the output of final goods and services businesses would produce at different price levels, all other conditions held constant.
Aggregate demand
Aggregate Demand and the market demand for an individual product are different. In our discussion of the market for an individual product in Chapter 3, demand is based on the assumptions that incomes and prices of other products are constant. Then a rise in the price of the product makes the product more expensive relative to income and relative to other products. As a result, people buy less of the product. Alternatively, if price falls people buy more.
The link between the general price level and aggregate demand is different. We cannot assume constant incomes and prices of other products. In the aggregate economy a rise in the price level raises money incomes by an equal amount. A 10 percent rise in the general price level is also a 10 percent rise in money incomes. Changes in the price level do not make goods and services either more or less affordable, in terms of incomes. There is no direct price incentive to change aggregate expenditure.
Furthermore, if prices of individual goods and services do not rise or fall in the same proportion as the general price level, the distribution of aggregate expenditure among goods and services may change without a change in aggregate expenditure. If, for example, the general price level is pushed up because oil and commodity prices rise, and expenditure on those products rises in the short run because there are no alternatives, expenditures on other goods and services fall. Aggregate expenditure is unchanged.
As a result, we cannot explain the negative relationship between the general price level and aggregate expenditure as we would explain demand for an individual good or service. Nor can we simply add up all the demands for individual products and services to get aggregate demand. The assumptions of constant incomes and other product prices that underlie market demand do not hold in the aggregate. Different explanations are needed.
Money and financial markets play key roles in the explanation of the price-quantity relationship in aggregate demand and the negative slope of AD as follows:
• Changes in the price level (P) change demand and supply conditions in financial markets. Higher prices raise interest rates and lower prices lower interest rates.
• Interest rates determine costs of credit and foreign exchange rates. Higher interest rates reduce expenditures on goods and services, lower interest rates stimulate expenditure.
• The responsiveness of expenditures to changes in interest rates determines the extent of the change in expenditure (Y) as a result of a change in the price level (P).
• Changes in expenditure then feed back to offset some of the change in financial conditions.
Chapters 8, 9 and 10 examine these financial markets and their effects on expenditure.
The result is a negative relationship between the price level and aggregate expenditure and a negatively sloped AD curve.
In Figure 5.2, the negatively sloped AD line shows planned aggregate expenditures at different price levels, on the assumption that the money supply and anything other than price that might affect expenditure plans are held constant. If the price level falls from P0 to P1, the movement along AD from A to B shows the negative relationship between planned aggregate expenditure and price. A rise in price would reduce planned expenditure as shown by moving up the AD curve.
Figure 5.2 The aggregate demand curve
The AD curve shows planned expenditures at different aggregate price levels all things other than price held constant. A change in the price level causes movement along the AD curve as from A to B if price falls from P0 to P1.
The position of the AD curve depends on all the conditions other than price that affect aggregate expenditure plans. We study these other conditions in detail in later Chapters 6 and 7.
Aggregate supply
Aggregate Supply (AS) is the output of final goods and services businesses would produce at different price levels. The aggregate supply curve is based on the following key assumptions:
1. Prices of the factors of production—the money wage rate for labour in particular—are constant.
2. The stock of capital equipment—the buildings and equipment used in the production process—and the technology of production are constant.
From national accounts we know that the costs of production include labour costs, business and investment incomes and depreciation. Market prices depend on those costs per unit of output and the output and price setting decisions by producers. Aggregate supply is usually described as a positive relationship between quantities of goods and services businesses are willing to produce and prices. Higher outputs of final goods and services and higher prices go together.
This relationship between aggregate output, costs and prices reflects two different market conditions on the supply side. In some markets, particularly those for commodities and standardized products, supply and demand in international markets establish price. Producers of those products are price takers. They decide how much labour and plant capacity to employ to produce based on market price.
Broadly speaking, in these industries cost per unit of output are increasing with increasing output. Employing more labour and plant capacity means expanding into less productive land and natural resource inputs. Mining gold or extracting bitumen from oil sands are good examples. A rise in price justifies expanding the output of higher cost mines and oil wells. However, many raw material markets are like this including those for agricultural products, forestry products, base metals and natural gas. When market price changes these producers respond by changing their outputs.
In other parts of the economy producers are price setters. Major manufacturing and service industries like auto producers, banks and wireless phone companies face market conditions that are different from those of commodity producers. They set prices based on costs of production and sales and profit targets, and supply the number of cars or bank services or cell phone accounts that are in demand at those prices.
In these industries costs per unit of output are constant over a wide range of current outputs. Money wage rates are fixed, the capacity to produce output is flexible and productivity is constant. If demand for their product or service increases they can supply more by hiring more employees at existing wage rates and selling more output at existing prices. Industries like major manufacturing, retail services, financial services, hospitality services, and professional services are some examples. Output and changes in output are determined by demand.
The upward-sloping aggregate supply curve in Figure 5.3 captures both market conditions to show the output producers are willing to produce and the price level. The aggregate supply curve is drawn based on the assumptions that money wage rates and all other conditions except price that might affect output decisions are constant. As we will see in later chapters, money wage rates and productivity are the most important of these conditions. They determine the position of the AS curve.
Figure 5.3 The aggregate supply curve
The AS curve shows the relationship between price level and real GDP, assuming the prices of factors of production are constant. The position of the curve is determined by factor prices and productivity. The slope is determined by changes in costs of production and producer price decisions as output changes.
The slope of the AS curve depends on changes in cost per unit of output and price changes if aggregate output changes. As a result it reflects the structure of industry. In Canada, for example Table 4.2 shows that about 70 percent of real GDP comes from service producing industries. Consequently we would expect a smaller positive slope in the AS curve than in Figure 5.3.
In Figure 5.3, if price were P2 the AS curve shows that business would be willing to produce aggregate output Y2, which would generate an equal flow of real income. A rise in aggregate output from Y2 to Y3 would mean a rise in price to P3 to meet the increased costs and profits associated with output at this level. Changes in output or price, holding all other conditions constant, move the economy along the AS curve. Moving from point C to point D in the diagram shows this relationship.
On the other hand, a change in any of the conditions assumed to be constant will shift the entire AS curve. A rise in money wage rates, for example, would increase labour costs per unit of output (W/Y) at every level of output. The AS curve would shift up vertically as prices rose in order to cover the increased unit labour costs. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/05%3A_Output_business_cycles_growth_and_employment/5.01%3A_Aggregate_demand_and_aggregate_supply.txt |
The distinction between equilibrium output and potential output is very important to our study of the economy. In the short run, AD and AS determine equilibrium output. Potential output is determined by the size of the labour force, the stock of capital, and the state of technology. The general level of prices and short-run aggregate demand and supply conditions do not affect potential output.
Potential output: the real GDP the economy can produce on a sustained basis with current labour force, capital and technology without generating inflationary pressure on prices.
Short-run equilibrium real GDP is determined by AD and AS conditions. Fluctuations in real GDP and price are a result of short-run changes in economic conditions. To evaluate the economy's performance and understand how it behaves over time, we need a benchmark. Potential output is the output the economy can produce on a sustained basis using the current labour force, capital, and technology without putting continuous upward pressure on the price level or the inflation rate.
In the short run, the labour force, the capital stock, and technology are fixed by assumption. Potential output is the economy's output based on "full employment" of these inputs, but it is not the maximum output an economy can conceivably make. For short periods of time we could make more by using labour for longer hours and factories for extra production shifts. Just as a marathon runner can sprint from time to time but cannot sustain the sprint over the whole race, the economy can operate for short time periods at levels of output above potential. Potential output is the output the economy can produce on a sustained basis.
When the economy is at potential output, every worker wanting a job at the equilibrium wage rate can find a job, and every machine that can be profitably used at the equilibrium cost for capital is in use. Thus, potential output includes an allowance for "equilibrium unemployment" or structural unemployment and some excess capacity. Some people, who would work at higher wage rates, do not want to work at the equilibrium wage rate. Moreover, in a constantly changing economy, some people are joining the labour force, others are leaving, and still others are temporarily between jobs. Today, Canadian potential output means an unemployment rate of about 6 to 7 percent. This is usually called the natural unemployment rate.
Natural unemployment rate: the unemployment rate that corresponds to potential GDP.
Actual output can also fall below potential output. Workers who want jobs may be unemployed, and producers may have idle plant and equipment or excess capacity. The unemployment rate rises above the 6 percent "full employment" rate.
A key issue in macroeconomics is the way differences between actual output and potential output affect unemployment rates, wage rates, and inflation rates. These effects are important to how the economy provides the standard of living and the way it might adjust equilibrium output to potential output without policy intervention.
Figure 5.4 illustrates potential real GDP (YP) with a vertical line. Changes in price from P0 to P1, for example, have no effect on YP. Changes in the supply of labour, the stock of capital, or the state of technology would increase potential output and shift the vertical YP line to the right or to the left.
Figure 5.4 Potential GDP
Potential GDP (YP) is the real GDP the economy could produce on a sustained basis without putting pressure on costs and prices. YP is independent of P.
5.03: Growth in potential output
Growth in the labour force and improvements in labour productivity increase the economy's potential output over time. Labour productivity grows as a result of advances in technology and knowledge coming from investments in capital equipment, education and training. Figure 5.5 shows estimated growth rates for potential and actual real GDP each year in Canada over the period from 1990 to 2016. Potential GDP grew over this period, reflecting the underlying growth in labour force, the stock of capital, and improved technology. But annual growth rates were not constant and in the period since 2000 have tended to decline. Part of this decline is attributed to lower rates of productivity growth in recent years as compared to earlier periods.
Figure 5.5 Annual Growth in Potential and Actual Real GDP in Canada, 1990–2016
Sources: Statistics Canada, CANSIM Table 380-0064, Office of the Parliamentary Budget Officer, Bank of Canada, Monetary Policy Reports and author's calculations.
Growth rates in actual GDP were more volatile relative to growth rates in potential output. The negative growth rates in 1991 and 2009 mark the recessions of those years. Fluctuations in AD and AS cause business cycles in real GDP and employment. Unemployment rises when output growth is less than the growth in potential output and falls when it is greater. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/05%3A_Output_business_cycles_growth_and_employment/5.02%3A_Equilibrium_output_and_potential_output.txt |
In some years GDP grows very rapidly, and in other years it actually falls. Growth of potential GDP is also variable but it is consistently positive. These up and down fluctuations in the growth of real GDP are described as business cycles in economic activity.
Business cycles: short-term fluctuations of actual real GDP.
Business cycles cause differences between actual and potential GDP. Output gaps measure these differences. In a short-run aggregate demand and supply model with a constant potential output, the gap is:
(5.1)
Output gap: the difference between actual output and potential output.
In an economy that grows over time the absolute output gap YYP is usually measured relative to potential output. This recognizes that a gap of \$10 million is a more serious matter in an economy with a potential output of \$1,000 million than in an economy with a potential output of \$5,000 million.
Figure 5.6 plots the Bank of Canada's estimates of the differences between actual and potential GDP for Canada for each year from 1992Q1 to 2016Q4, expressed as a percentage of potential GDP, calculated as:
(5.2)
Figure 5.6 The Output Gap in Canada, 1992Q1–2016Q4
Source: Bank of Canada, Indicators of Capacity and Inflation Pressures for Canada, www.bankofcanada.ca.
When we compare growth in actual real GDP and potential GDP in Canada from 2007 to 2013 in Figure 5.5, we see an example of the business cycle caused by the 2008 – 2009 financial crisis. Real GDP growth declined in 2008 to less than growth potential GDP and turned negative in 2009. This was a recession. It created the negative output gap in Figure 5.6 that starts in the first quarter of 2009 and persists in the most recent data for the fourth quarter of 2016.
Output gaps describe and measure the short-run economic conditions, and indicate the strength or weakness of the economy's performance. High growth rates in the boom phase of the cycle create positive output gaps, which are called inflationary gaps because they put upward pressure on costs and prices. Low or negative growth rates that result in negative output gaps and rising unemployment rate are called recessionary gaps. They put downward pressure on costs and prices. As economic conditions change over time, business cycle fluctuations move the economy through recessionary and inflationary gaps. However, you will notice in Figure 5.6 that recessionary gaps in Canada have been deeper and more persistent than inflationary gaps over the past 30 years.
Inflationary gap: a measure of the amount by which actual GDP is greater than potential GDP.
Recessionary gap: a measure of the amount by which actual GDP is less than potential GDP.
We can show output gaps in diagrams using the aggregate demand and supply curves and the potential output line introduced in Figures 5.1 and 5.4. Figure 5.7 provides an example. Panel a) illustrates a recessionary gap. Panel b) shows an inflationary gap.
Figure 5.7 Output Gap
In Figure 5.7 panel a) shows a recessionary gap because AD is too weak to support equilibrium at YP. Alternatively in panel b) AD is too strong and pushes equilibrium past YP.
The AD and AS model provides a basic explanation of the differences we see between actual real GDP and potential real GDP. Short-run AD and AS conditions determine equilibrium real GDP, which may be either greater or less than potential GDP. Furthermore, the business cycles are the results of changes in the short-run AD and AS conditions.
Introduction to the AD/AS model is an important first step in the study of the performance of the macro economy. But there are more questions:
1. What is the relationship between output gaps and unemployment?
2. How would the economy react to a persistent output gap?
3. Why do short-run AD and AS conditions change from time to time?
The first two questions are considered in the remainder of this chapter. Chapter 6 starts on the third question. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/05%3A_Output_business_cycles_growth_and_employment/5.04%3A_Business_cycles_and_output_gaps.txt |
Output gaps and unemployment rates are tied together. Output gaps measure the difference between actual real GDP and potential GDP. When the economy is producing potential output, employment is at the 'natural employment' rate. Any output other than potential output therefore involves an employment rate other than the full employment rate and a corresponding level of unemployment that differs from the approximately 6 to 7 percent natural unemployment rate.
Figures 5.5 and 5.6 show the relationship between growth rates in actual and potential GDP and the output gap. Negative growth rates in actual GDP in recessions, while potential GDP continues to grow, create recessionary gaps. Indeed any time growth in actual GDP differs from growth in potential GDP the output gap changes and the unemployment rate changes.
Differences between the rates of growth in actual and potential output explain the persistence of high rates of unemployment in western industrial countries in the years since the 2008 financial crisis. Real GDP and employment in both Canada and the United States have been growing since 2009. However, potential output has been growing at the same time. As a result, growth in actual GDP has not been strong enough to eliminate output gaps and restore full employment.
Figure 5.8 shows the relationship between output gaps and unemployment rates in Canada. Clearly, a rise in the output gap also involves a fall in the unemployment rate, and vice versa. Business cycle fluctuations in actual output result in predictable changes in output gaps and unemployment rates.
Figure 5.8 Output Gaps and Unemployment Rates in Canada, 1997–2016
Source: Bank of Canada, Indicators of Capacity and Inflation Pressures for Canada. Statistics Canada, CANSIM series V2062815 and author's calculations.
5.06: Adjustments to output gaps?
Potential output is real GDP when all markets are in equilibrium. Output gaps indicate disequilibrium in some markets. If we leave the short run and drop the assumption that factor prices are constant, we can ask:
How does the economy react to persistent output gaps?
The answer to this question depends in part on the flexibility of wage rates and prices and in part on how planned expenditure responds to the flexibility in wage rates and prices.
Figure 5.8 shows that the labour market is one of the markets not in equilibrium when there is an output gap. We also know from national accounts that labour costs are the largest part of factor costs of production, and labour costs per unit of output are the largest part of prices. If the labour market is not in equilibrium—which means unemployment rates not equal to the natural rate—this results in changes in money wage rates. Persistent output gaps will change wage rates and other factor prices and costs. Changes in costs will change prices, shifting the short-run AS curve. The economy may have an adjustment mechanism that tries to eliminate output gaps over time.
This adjustment process assumes that the AD curve is not changed by the fall in wage rates that shifts the AS curve. There are good reasons for skepticism here. In a money economy, with debt and financial contracts denominated in nominal terms, a general fall in money incomes can cause financial distress, extensive insolvencies and reductions in AD. As a result, economists generally agree that deflation, a persistent fall in the general price level, is contractionary, not expansionary as the simple adjustment process suggests. This is reflected in the current concerns that deflation may return to Japan and emerge in Europe as growth stagnates and inflation rates have fallen persistently below 1 percent. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/05%3A_Output_business_cycles_growth_and_employment/5.05%3A_Output_gaps_and_unemployment_rates.txt |
In Chapter 4, performance of the economy was evaluated based on the standard of living, measured as the real GDP per capita, it provided. Recessionary gaps reduce the standard of living in the economy by reducing employment, real GDP, and per capita real GDP.
Inflationary gaps reduce standards of living in more subtle ways. They push up the price level, raising the cost of living. But the rise in the cost of living affects different people in different ways. Those on fixed money incomes suffer a reduction in their standards of living. People holding their wealth in fixed price financial assets like bank deposits and bonds suffer a loss in their real wealth. On the other hand, inflation reduces the real value of debt, whether it is mortgage debt used to finance the purchase of a house, or a student loan used to finance education. The money repaid in the future has a lower purchasing power than the money borrowed. In these and other ways, the costs of inflation are distributed unevenly in the economy, making decisions about employment, household expenditure, and investment more difficult.
We have also seen, in Figure 5.6, that output gaps have been persistent in the Canadian economy despite the possibility that flexible wages and prices might automatically eliminate gaps. These observations raise two questions:
1. Why are output gaps, especially recessionary gaps, persistent?
2. Can government policy work to eliminate output gaps?
To answer the first question, we need to think about two issues. The first is the flexibility or rigidity of wages and prices both up and down. The second is the strong possibility of asymmetry between adjustment effects of absolute increases and absolute decreases in wages and prices. These are topics for later discussion.
The important immediate policy question is: When wages and prices are sticky, should government wait for the self-adjustment process to work, accepting the costs of high unemployment or rising inflation that it produces? This was a very serious and widely debated question since 2008 in the face of growing international recessions as a consequence of serious government debt problems and continued international financial market uncertainty.
Government has policies it can use to reduce or eliminate output gaps. In Chapter 7 we will examine fiscal policy, the government expenditures and tax policy that establish the government's budget and its effect on aggregate demand. Government can use its fiscal policy to change the AD curve and eliminate an output gap without waiting for the economy to adjust itself. Chapters 9 and 10 discuss monetary policy, actions by the monetary authorities designed to change aggregate demand and eliminate output gaps by changing interest rates, money supply, and the availability of credit. Both fiscal and monetary policy work to change aggregate demand and eliminate output gaps, which reduce the standard of living the national economy provides for its citizens.
Fiscal policy: government expenditure and tax changes designed to influence AD.
Monetary policy: changes in interest rates and money supply designed to influence AD.
5.08: Key Concepts
Key Concepts
The Aggregate demand and supply model provides a framework for our study of the operation of the economy.
Aggregate demand is the negative relationship between planned aggregate expenditure on final goods and services and the price level, assuming all other conditions in the economy are constant.
Aggregate supply is the positive relationship between outputs of goods and services and the price level, assuming factor prices, capital stock, and technology are constant.
Short-run equilibrium real GDP and price are determined by short-run aggregate demand and aggregate supply, illustrated by the intersection of the AD and AS curves.
Potential output is the output the economy can produce on an ongoing basis with given labour, capital, and technology without putting persistent upward pressure on prices or inflation rates.
The Natural unemployment rate is the 'full employment' unemployment rate observed when the economy is in equilibrium at potential output.
Growth in potential output comes from growth in the labour force and growth in labour productivity coming from improvements in technology as a result of investment in fixed and human capital.
Business cycles are the short-run fluctuations in real GDP and employment relative to Potential Output (GDP) and full employment caused by short-run changes in aggregate demand and supply.
Output gaps are the differences between actual real GDP and potential GDP that occur during business cycles.
Unemployment rates fluctuate with output gaps.
Inflationary gaps and recessionary gaps are the terms used to describe positive and negative output gaps based on the effects the gaps have on factor prices.
Actual output adjusts to potential output over time if factor input and final output prices are flexible and changes in prices shift the aggregate supply curve to equilibrium with aggregate demand at YP.
Fiscal and monetary policy are tools governments and monetary authorities can use to stabilize real output and employment or speed up the economy's adjustment to output gaps. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/05%3A_Output_business_cycles_growth_and_employment/5.07%3A_The_role_of_macroeconomic_policy.txt |
EXERCISE 5.1
Suppose we have the following information for an economy:
GDP deflator Planned aggregate Planned aggregate
expenditure output
90 550 150
100 500 300
110 450 450
120 400 600
130 350 750
1. Plot the AD and AS curves in a carefully labeled diagram.
2. What are the short-run equilibrium values of real GDP and the price level?
EXERCISE 5.2
Suppose we learn that potential output is 500 for the economy in Exercise 5.1.
1. Add a line to your diagram for Exercise 5.1 to illustrate potential GDP.
2. What is the size of any output gap you see in the diagram?
EXERCISE 5.3
Potential GDP is determined by the size of the labour force, the stock of capital and the state of technology used in the production process. Assume the labour force grows over time, and research and development lead to improvements in technology, and productivity. Use an AD/AS diagram to illustrate potential GDP both before and after the growth in labour force and the improvement in technology.
EXERCISE 5.4
Growth in potential output is determined by growth in the labour force and growth in labour productivity. Suppose the labour force grows by 1.5 percent a year and labour productivity, based on increased capital and improved technology, grows by 1.0 percent a year.
1. What is the annual growth in potential output?
2. Illustrate the growth in potential output in an AD/AS diagram.
3. Aggregate demand is not changed by the change in potential output. Indicate any output gap caused by the change in potential output.
EXERCISE 5.5
Suppose we have the following data for an economy:
Year Potential output Real GDP
(billions 2007\$) (billions 2007\$)
2006 1,038 1,017
2007 1,069 1,030
2008 1,101 1,101
2009 1,134 1,160
2010 1,168 1,139
2011 1,203 1,130
2012 1,240 1,187
2013 1,277 1,163
Calculate the output gap for each year in this economy. Plot the output gap in a time series diagram. Date the timing of the phases of any business cycles you see in your plot of the output gap.
EXERCISE 5.6
Draw an AD/AS diagram that shows an economy called Westland in short-run equilibrium with GDP equal to potential GDP.
1. Suppose a slowdown in the rate of growth of GDP in China cuts Chinese imports of primary products from Westland. Using your AD/AS diagram illustrate and explain your forecast for the effects of this change on the equilibrium GDP and price level in Westland.
2. What effect, if any, would a slowdown in GDP growth in China have on employment and unemployment rates in Westland? Explain why.
EXERCISE 5.7
Optional: Consider an economy described by the following: AD: Y=2250–10P, AS: P=125+0.1Y.
1. What are the short-run equilibrium values for real GDP and the price level?
2. Assume potential output is 500 and draw an AD/AS/YP diagram to show the initial short-run equilibrium real GDP, price level and potential output.
3. Changes in international market conditions drive up prices for crude oil and base metals. Increased production costs driven by these higher input prices raise the general price level by 5 at every level of output. Write the equation of the new AS curve. What are the new short-run equilibrium real GDP and price level?
4. Draw the new AS curve in your diagram for (b). What is the size of the output gap? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/05%3A_Output_business_cycles_growth_and_employment/5.09%3A_Exercises_for_Chapter_5.txt |
The state of the Canadian economy was very much in the news in the early summer of 2016. Economic growth in the first quarter of the year was just 0.7 percent and, by early estimates, was negative in the second quarter. Some commentators said the economy was heading into a 'recession' as defined by two consecutive quarters of negative growth. Others were more positive. Earlier forecasts had called for a short drop in growth after the fall in crude oil prices, offset shortly by increased consumer spending and exports. The Bank of Canada lowered its interest rate in January 2015 and again in July 2015 to support the economy. The earlier fall in the foreign exchange rate had lowered the US dollar price of the Canadian dollar, lowering prices for Canadian goods and services in foreign countries. It was hoped these changes in economic conditions and policy would support increased economic growth. Things had not yet worked out that way.
The Liberal government of Justin Trudeau had been elected in October 2015 on a platform of fiscal stimulus. Short run budget deficits to finance major infrastructure projects were a key shift away for the previous government's policy focused on balanced budgets. But the inevitable lag in the timing and impact of increased government spending meant the effects of fiscal stimulus were small at best in the final two quarters of 2016. Early 2017 indicators like job creation reports suggest the economy may be stronger in 2017.
Forecasting the effects of changes in economic conditions or government policy shifts is complicated by the complex system of interdependencies and feedback effects in the macro economy. In Chapter 5, differences in output, employment and prices were the results of different aggregate demand and supply conditions. The challenge is to sort out how an event like a change in a commodity price or a shift in household expectations of future employment prospects or a change in business expectations of future markets would affect aggregate demand and supply conditions.
This chapter introduces a basic short-run model of the economy as a first step in explaining changes in aggregate demand that can change economic performance.
06: Aggregate expenditure and aggregate demand
Consider first just the private market sector. Assume there are households and businesses in this simple economy, but no government and no financial markets. The households and businesses buy domestically produced and imported goods and services. Businesses also sell some output in export markets to residents of other countries. This basic model offers a simple but useful example of how the actual economy works.
This initial short-run model is based on the following assumptions:
• All prices and wages are fixed at a given level.
• At these prices and wages, businesses produce the output that is demanded and labour accepts opportunities to work.
• Money supply, interest rates and foreign exchange rates are fixed because at this stage we ignore the financial sector.
With constant prices aggregate demand determines total output, real GDP. Figure 6.1 uses an AD/AS diagram like those developed in Chapter 5 to illustrate these conditions and develop an aggregate expenditure function.
Figure 6.1 Aggregate demand, aggregate expenditure and output when the price level is constant
Aggregate demand determines total output, real GDP.
The horizontal AS curve in the upper part of Figure 6.1 shows that the price level is fixed at P0. As a result, the equilibrium real GDP in this example is determined by the position of the AD curve. Changes in the position of the AD curve would cause changes in real output and real income, and corresponding changes in employment.
The position of the AD curve in the diagram is determined by things, other than price, that affect expenditure decisions. Understanding these expenditure decisions and their effects are the focus of this and the next several chapters.
The lower part of Figure 6.1 shows the relationship between planned aggregate expenditure (AE) and income as measured by real GDP(Y) when the price level is fixed. It also shows that, if the aggregate expenditure function (AE) has the right position and slope, there is a level of output at which planned expenditure and output are equal (). Then revenue the business sector receives from sales of current output just covers the costs of production including expected profit. Planned expenditure and planned output are in equilibrium.
Aggregate demand is determined by equality between aggregate expenditure (AE) and real GDP.
This equality between planned expenditure and output determines the position of the AD curve, as shown in the upper part of the diagram.
The interactions of expenditure, output, and income shown in the lower part of Figure 6.1 define a basic macroeconomic model. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/06%3A_Aggregate_expenditure_and_aggregate_demand/6.01%3A_Short-run_aggregate_demand_and_output.txt |
The model starts with the expenditure categories defined and measured in national accounts and described in Chapter 4. By the expenditure approach, GDP (Y) is the sum of consumption (C), investment (I), and exports (X), minus imports (IM). Then we can write:
$\operatorname{GDP}(Y)=C+I+X-I M \label{6.1}$
Expenditure as measured by national accounts is the sum of actual expenditures by business and households.
GDP(Y) is the national accounts measure of the sum of actual expenditure in the economy.
Aggregate expenditure (AE) is planned expenditure by business and households. The distinction between planned and actual expenditures is a key factor in explaining how the national income and employment are determined.
Aggregate expenditure (AE) is planned expenditure by business and households.
Induced expenditure
A simple short-run model of the economy builds on two key aspects of planned expenditure, namely induced expenditure and autonomous expenditure. First, an important part of the expenditure in the economy is directly related to GDP and changes when GDP changes. This is defined as induced expenditure. It is mainly a result of household expenditure plans and expenditure on imported goods and services embodied in those plans.
Induced expenditure is planned expenditure that is determined by current income and changes when income changes.
The largest part of consumption expenditure by households is induced expenditure, closely linked to current income. This expenditure changes when income changes, changing in the same direction as income changes but changing by less than income changes. The marginal propensity to consume (mpc=c) defines this link between changes in income and the changes in consumption they induce. The mpc is a positive fraction.
Marginal propensity to consume () is the change in consumption expenditure caused by a change in income.
Household's expenditures on imports are at least partly induced expenditures that change as income and consumption expenditure changes. The marginal propensity to import (mpm=m) defines this link between changes in income and the changes in imports. The mpm is also a positive fraction because changes in income induce changes in imports in the same direction but by a smaller amount.
Marginal propensity to import () is the change in imports caused by a change in income.
Because expenditure on imports is not demand for domestic output aggregate induced expenditure for the economy is determined by subtracting induced import expenditure from induced consumption expenditure to get induced expenditure on domestic output.
Induced expenditure (cm)Y is planned consumption expenditures net of imports that changes when income changes.
The relationship between expenditures and national income (GDP) is illustrated in Table 6.1 using a simple numerical example and then in Figure 6.2 using a diagram.
Table 6.1 The effects of changes in GDP on consumption, imports and expenditure.
Consumption function: C=0.8Y
Imports function: IM=0.2Y
Y Induced Induced Induced expenditure
0 0 0 0
50 40 10 30
100 80 20 60
75 60 15 45
The first row of the table illustrates clearly that if there were no income there would be no induced expenditure. The next two rows show that positive and increased incomes cause (induce) increased expenditure. The final row shows that a fall in income reduces expenditure. The induced expenditure relationship causes both increases and decrease in expenditure as income increases or decreases.
Figure 6.2 shows the same induced expenditure relationships in a diagram.
Figure 6.2 Induced expenditures
The slope of the CIM line is: .
The positive slopes of the consumption and import lines in the diagram show the positive relationship between income and expenditure. A rise in income from 0 to 50 induces a rise in national expenditure from 0 to 30 because consumption expenditure increases by 40 of which 10 is expenditure on imports. If income were to decline induced expenditure would decline, illustrated by movements to the left and down the expenditure lines.
Figure 6.3 A Consumption Function for Canada, 1990–2016
Source: Statistics Canada, CANSIM Tables 380-0064 and 380-0065
Autonomous expenditure
The second part of GDP expenditure is where the real action lies. It covers the important changes in expenditure that drive the business cycles in economic activity. Autonomous expenditure (A), is the planned expenditure that is not determined by current income. It is determined instead by a wide range of economic, financial, external and psychological conditions that affect decisions to make expenditures on current output.
Autonomous expenditure (A) is planned expenditure that is not determined by current income.
Consumption and imports have an autonomous component in addition to the induced component. But investment (I) and exports (X) are the major autonomous expenditures. Figure 6.4 shows the independence of autonomous expenditure from income. Unlike induced expenditure, autonomous expenditure does not change as a result of changes in GDP. The slope of the A line in the diagram is zero . However, a change in autonomous expenditure would cause a parallel shift in the A line either up or down. An increase in A is shown.
Figure 6.4 Autonomous expenditure
Investment expenditure (I) is one volatile part of aggregate expenditure. It is expenditure by business intended to change the fixed capital stock, buildings, machinery, equipment and inventories they use to produce goods and services. In 2014 investment expenditures were about 21 percent of GDP. Business capacity to produce goods and services depends on the numbers and sizes of factories and machinery they operate and the technology embodied in that capital. Inventories of raw materials, component inputs, and final goods for sale allow firms to maintain a steady flow of output and supply of goods to customers.
Firms' investment expenditure on fixed capital depends chiefly on their current expectations about how fast the demand for their output will increase and the expected profitability of higher future output. Sometimes output is high and rising; sometimes it is high and falling. Business expectations about changes in demand for their output depend on many factors that are not clearly linked to current income. As a result we treat investment expenditure as autonomous, independent of current income but potentially volatile as financial conditions and economic forecasts fluctuate. For example, the sharp drop in crude oil prices in late 2014 changed market and profit expectations dramatically for petroleum producers and for a wide range of suppliers to the industry. Investment and exploration projects were cut back sharply, reducing investment expenditure.
Exports (X), like investment, can be a volatile component of aggregate expenditure. Changes in economic conditions in other countries, changes in tastes and preferences across countries, changes in trade policies, and the emergence of new national competitors in world markets all impact on the demand for domestic exports.
To illustrate this volatility in exports and in investment, Figure 6.5 shows the year-to-year changes in investment, exports, and consumption expenditures in Canada from 1999 to 2016. You can see how changes in investment and exports were much larger than those in consumption. This volatility in investment and exports causes short-term shifts in aggregate expenditure which cause business cycle fluctuations in GDP and employment. More specifically, the data show the sharp declines in investment and exports that caused the Great Recession in 2009 and even though these autonomous expenditures increased in 2010 those increases were not large or persistent enough to restore pre-recession levels of autonomous expenditure. Indeed investment expenditures have declined in 2015 and 2016.
Figure 6.5 Annual percent change in Real Consumption, Investment and Exports, Canada 2000–2016
Source: Statistics Canada, CANSIM Table 380-0064
The aggregate expenditure function
The aggregate expenditure function (AE) is the sum of planned induced expenditure and planned autonomous expenditure. The emphasis on 'planned' expenditure is important. Aggregate expenditure is the expenditure households and businesses want to make based on current income and expectations of future economic conditions. Expenditure based GDP in national accounts measures, after the fact, the expenditures that were made. These may not be the same as planned expenditure. Some plans may not work out.
Aggregate expenditure (AE) is the sum of planned induced and autonomous expenditure in the economy.
Aggregate expenditure (AE) equals the sum of a specific level of autonomous expenditure (A0) and induced expenditure [(cm)Y] or in the simple notation introduced above:
(6.2)
Table 6.2 gives a numerical example of the aggregate expenditure function, assuming the marginal propensity to spend on domestic output (cm)=0.5. It shows constant autonomous expenditure at each level of GDP, induced expenditure changing as GDP changes and aggregate expenditure as the sum of autonomous and induced expenditure at each level of GDP. Induced expenditure changes in the same direction as GDP which raises aggregate expenditure in rows 3 to 5 in the table but lowers aggregate expenditure in the last row when GDP falls.
Table 6.2 An aggregate expenditure function.
GDP (Y) Autonomous Induced Aggregate
Expenditure Expenditure Expenditure
(A0=100) (cm)Y=0.5Y AE=100+0.5Y
0 100 0 100
50 100 25 125
100 100 50 150
175 100 87.5 187.5
200 100 100 200
150 100 75 175
Figure 6.6 shows this aggregate expenditure function with a positive intercept on the vertical axis and positive slope. The positive intercept measures autonomous expenditure. The slope measures induced expenditure. Changes in autonomous expenditure would shift the AE function vertically, up for an increase or down for a decrease. Induced expenditures are usually assumed to be stable in the short run but if they were to change, as a result of change in marginal propensity to import for example, the slope of the AE function would change in the same way.
Figure 6.6 An aggregate expenditure function
The AE function has a vertical intercept equal to autonomous expenditure 100 and a slope of equal to the changes in expenditure induced by changes in Y. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/06%3A_Aggregate_expenditure_and_aggregate_demand/6.02%3A_Aggregate_expenditure.txt |
National Accounts as in Chapter 4 measure actual expenditure, output and national income and GDP(Y). The Aggregate Expenditure function gives planned expenditure (AE). In a modern industrial economy actual output and income may differ from what was planned, either on the output side or on the purchase and sales side. A simple example of the time sequence of output and sales shows why.
In most cases business install capacity and produce output in anticipation of sales in the near future. This is apparent from the stocks of goods offered in most retail outlets or online. Auto manufacturers, for example like to have an inventory of 30 to 60 days of finished vehicle sales available for retail buyers. Coffee and donut shops have coffee and snacks available to customers when they walk in. Even service industries like cell phone companies try to have staff and product on hand and ready to serve customers on demand. In these and other cases producers incur costs that they expect to recover from later sales. If sales don't match expectations some inventories of products build up or fall short, capacity is not matched to demand and some sales opportunities are lost or costs are not recovered.
As a result, if planned expenditure (AE) and GDP are different then plans in some part of the economy have not been realized and there is an incentive to change output. However, when actual output (GDP) is equal to planned expenditure (AE) expenditure and output plans are successful and, unless underlying conditions change there is no incentive to change output.
Equilibrium output
Output is said to be in short-run equilibrium when the current output of goods and services equals planned aggregate expenditure:
Y=A0+(cm)Y (6.2)
Then spending plans are not frustrated by a shortage of goods and services. Nor do business firms make more output than they can sell. In short-run equilibrium, output equals the total of goods and services households, businesses, and residents of other countries want to buy. Real GDP is determined by aggregate expenditure.
Short-run equilibrium output: Aggregate expenditure and current output are equal ().
Figure 6.7 The diagram and equilibrium GDP
The line gives the equilibrium condition. At point E the AE line crosses the line and . This is the equilibrium. At Y1, AE>Y and unplanned reductions in inventories provide the incentive to increase Y.
Income Y2 is the only income at which aggregate expenditure just buys all current output. For example, assume as shown in the diagram, that output and incomes are only Y1. Aggregate expenditure at D is not equal to output as measured at B. Planned expenditure is greater than current output. Aggregate spending plans cannot all be fulfilled at this current output level. Consumption and export plans will be realized only if business fails to meet its investment plans as a result of an unplanned fall in inventories of goods.
In Figure 6.7 all outputs less than the equilibrium output Y2, are too low to satisfy planned aggregate expenditure. The AE line is above the line along which expenditure and output are equal. Conversely, if real GDP is greater than Y2 aggregate expenditure is not high enough to buy all current output produced. Businesses have unwanted and unplanned increases in inventories of unsold goods.
Table 6.3 extends the numerical example in Table 6.2 to show equilibrium when GDP(Y) is 200 and the unwanted inventory changes at other income levels. When GDP in column (1) is less than AE in column (4) current output does not cover current planned expenditure. Inventories fall and producers can't meet their inventory targets. The unwanted change in inventories in column (5) is negative.
Table 6.3 Equilibrium GDP: .
GDP (Y) Autonomous Induced Aggregate Unplanned
Expenditure Expenditure Expenditure Inventory
(A0=100) (cm)Y=0.5Y
(1) (2) (3) (4) (5)
0 100 0 100 -100
50 100 25 125 -75
100 100 50 150 -50
175 100 87.5 187.5 -12.5
200 100 100 200 0
250 100 125 225 +25
300 100 150 250 +50
You can construct a diagram like Figure 6.7 using the numerical values for GDP and aggregate expenditure in Table 6.3 and a line to show equilibrium Ye=200. Example Box 6.1 at the end of the chapter illustrates equilibrium for this basic model using simple algebra.
Adjustment towards equilibrium
Unplanned changes in business inventories cause adjustments in output that move the economy to equilibrium output. Suppose in Figure 6.7 the economy begins with an output Y1, below equilibrium output Ye. Aggregate expenditure is greater than output Y1. If firms have inventories from previous production, they can sell more than they have produced by running down inventories for a while. Note that this fall in inventories is unplanned. Planned changes in inventories are already included in planned investment and aggregate expenditure.
Unplanned changes in business inventories: indicators of disequilibrium between planned and actual expenditures – incentives for businesses to adjust levels of employment and output (Y).
If firms cannot meet planned aggregate expenditure by unplanned inventory reductions, they must turn away customers. Either response—unplanned inventory reductions or turning away customers—is a signal to firms that aggregate expenditure is greater than current output, markets are strong, and output and sales can be increased profitably. Hence, at any output below Ye, aggregate expenditure exceeds output and firms get signals from unwanted inventory reductions to raise output.
Conversely, if output is initially above the equilibrium level, Figure 6.7 shows that output will exceed aggregate expenditure. Producers cannot sell all their current output. Unplanned and unwanted additions to inventories result, and firms respond by cutting output. In the last few years, producers of commodities including iron ore, copper, metallurgical coal, base metals, natural gas, and crude oil have faced declining demand for their products and lower prices and rising inventories. Producers responded by lowering production to try to reduce excess inventory. In general terms, when the economy is producing more than current aggregate expenditure, unwanted inventories build up and output is cut back.
Hence, when output is below the equilibrium level, firms raise output. When output is above the equilibrium level, firms reduce output. At the equilibrium output Ye, firms sell their current output and there are no unplanned changes to their inventories. Firms have no incentive to change output.
Equilibrium output and employment
In the examples of short-run equilibrium we have discussed, output is at Ye with output equal to planned expenditure. Firms sell all they produce, and households and firms buy all they plan to buy. But it is important to note that nothing guarantees that equilibrium output Ye is the level of potential output YP. When wages and prices are fixed, the economy can end up at a short-run equilibrium below potential output with no forces present to move output to potential output. Furthermore, we know that, when output is below potential output, employment is less than full and the unemployment rate u is higher than the natural rate un. The economy is in recession and by our current assumptions neither price flexibility nor government policy action can affect these conditions. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/06%3A_Aggregate_expenditure_and_aggregate_demand/6.03%3A_Aggregate_expenditure_and_equilibrium_output_in_the_short_run.txt |
In our model the slope of the AE line depends on the marginal propensity to consume and the marginal propensity to import. For any given mpc and mpm, the level of autonomous expenditure (A0) determines the height of the AE line. Recall that autonomous expenditure is expenditure that is not related to national income.
In a diagram, changes in autonomous expenditure cause parallel vertical shifts in the AE function. Autonomous expenditure depends chiefly on current expectations about future domestic and foreign demand for output, future prices and future profits. These expectations about the size and strength of future markets can fluctuate significantly, influenced by current pessimism or optimism about the future. We saw this volatility in investment in Figure 6.6. Similarly, changes in conditions in export markets change exports and changes in consumer confidence change autonomous consumption expenditure.
Suppose firms become very optimistic about future demand for their output. They want to expand their factories and add new equipment to meet this future demand. Autonomous expenditure rises. If other components of aggregate expenditure are unaffected, AE will be higher at each income than before. Figure 6.8 shows this upward shift in AE to . Before we go into detail, think about what is likely to happen to output. It will rise, but by how much?
Figure 6.8 The effect of a rise in autonomous expenditure
A rise in autonomous expenditure shifts AE up to . Equilibrium GDP rises by a larger amount from Y0 to Y1.
A fall in autonomous expenditure would have the opposite effect. AE would shift down and equilibrium income would decline by more than the fall in A.
The multiplier is a concept used to define the change in equilibrium output and income caused by a change in autonomous expenditure. If A is autonomous expenditure:
(6.3)
Multiplier : the ratio of the change in equilibrium income Y to the change in autonomous expenditure A that caused it.
We can also show the change in equilibrium output caused by a rise in autonomous investment expenditure using the earlier simple numerical example we used earlier. In Table 6.4 initial autonomous expenditure is 100, induced expenditure is 0.5Y and initial equilibrium is Y=200. Then autonomous expenditure increases, as in column (3) by 25 to a new level of 125. Induced expenditure is still 0.5Y. Aggregate expenditure in column (6) rises as a result of increase in both autonomous and induced expenditure.
Table 6.4 The effect of a rise in autonomous expenditure on equilibrium GDP
Initial New Initial New
GDP Autonomous Autonomous Induced Aggregate Aggregate
(Y) Expenditure Expenditure Expenditure Expenditure Expenditure
(A0=100) (A1=125) (cm)Y=0.5Y
(1) (2) (3) (4) (5) (6)
175 100 - 87.5 187.5 187.5
200 100 - 100 200 200
225 125 112.5 237.5
237.5 125 118.75 243.5
243.5 125 121.75 246.75
246.75 125
125
250 125 125 250
300 125 150 275
The initial increase in aggregate expenditure illustrated is from 200 to 237.5 made up of an increase in autonomous expenditure of 25 and in induced expenditure of . However GDP(Y) is only 225 and planned expenditure is accommodated by a decrease in inventories of 12.5. This unintended fall in inventories is an incentive to increase production to take advantage of higher than expected sales. The incentive exists until producers increase output and income to 250. Aggregate expenditure rises as income increases until equilibrium is reached at Y=250. At that point actual inventory investment meets producer plans.
The size of the multiplier
The multiplier is a number that tells us how much equilibrium output changes as a result of a change in autonomous expenditure. The multiplier is bigger than 1 because a change in autonomous expenditure changes income and sets off further changes in induced expenditure. The marginal propensity to spend on domestic output (cm) determines the induced expenditure.
In more general terms, because mpcmpm=cm is the slope of the AE function, we can write:
(6.4)
In the example in Table 6.4 with a induced expenditure (cm)Y=0.5 wbich also the slope of AE the multiplier is:
But at a different time or in a different economy the marginal propensity to consume might be higher and the marginal propensity to import might be lower, for example let c1=0.85 and m1=0.10. Then induced expenditure on domestic output would be (c1m1)=(0.85–0.10)=0.75 as would the slope of . Now a change in autonomous expenditure raises income and causes a higher change in induced expenditure. As a result the multiplier for this economy would be:
As a result, national incomes in economies with higher rates of induced expenditure on domestic output will fluctuate more; experience stronger business cycles, as a result of changes in autonomous expenditure like investment and exports.
In the basic model we have here, the slope of AE is (mpcmpm), but this simple formula for the multiplier will still be useful when we introduce the tax system in the government sector in Chapter 7. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/06%3A_Aggregate_expenditure_and_aggregate_demand/6.04%3A_The_multiplier_-_Changes_in_aggregate_expenditure_and_equilibrium_output.txt |
In Chapter 5 and at the beginning of this chapter, we used an aggregate demand and aggregate supply model to explain business cycle fluctuations in real GDP and employment. In this chapter we have developed a basic explanation for the shifts in AD that cause changes in real output. In the short run:
• wages, prices, money supply, interest rates and exchange rates are assumed to be constant;
• distinction between autonomous and induced expenditures is important; and
• equilibrium real GDP requires output equal to planned aggregate expenditure.
Figure 6.9 Equilibrium GDP and aggregate demand
Equilibrium in a) determined the position of the AD curve in b). A change in autonomous expenditure in a) changes equilibrium Y and shifts AD by the change in autonomous expenditure times the multiplier.
In this model, investment and exports are the main sources of fluctuations in autonomous expenditures. The marginal propensities to consume and import describe the changes in aggregate expenditure caused by changes in income. These induced expenditures are the source of the multiplier. When business changes its investment plans in response to predictions and expectations about future markets and profits, or exports change in response to international trade conditions, the multiplier translates these changes in autonomous expenditure into shifts in the AD curve. Shifts in the AD curve cause changes in equilibrium output and employment.
Figure 6.9 shows how this works. Equilibrium real GDP in the upper panel determines the position of the AD curve in the lower panel.
Initially, equilibrium real GDP at the price level P0 is determined by the equilibrium condition Ye=A0+(cm)Y in the upper panel and by the equilibrium condition in the lower panel.
Changes in autonomous expenditure shift the AD curve. If autonomous expenditure increased from A0 to A1 as shown in panel (a), equilibrium output would increase from Y0 to . The change in equilibrium output would be (). The AD curve would shift to the right to as a result of the increase in autonomous expenditure. The size of the horizontal shift would be ().
This model provides an important first insight into the sources of business cycles in the economy. However, it is a pure private household/private business sector economy. Autonomous consumption, investment, exports and imports, and the multiplier drive real GDP and income and fluctuations in those measures of economic activity. There is no government, and thus no way for government policy to affect real output and employment. There is no financial sector to explain the interest rates and foreign exchange rates that affect expenditure decisions, and thus no monetary policy. In the next few chapters we extend our discussion of aggregate expenditure and aggregate demand to include the government sector and financial sectors, as well as fiscal and monetary policy. The framework becomes a bit more complicated and realistic, but the basic mechanics are still those we have developed in this chapter.
Nonetheless, this basic model explains why, in the first half of 2015 both Steven Poloz, the Governor of the Bank of Canada and Joe Oliver, the Minister of Finance are both counting on a strong rise in exports to move the Canadian economy from a recession to growth in the second and third quarters of 2015.
Figure 6.5 above shows that export growth has not provided the hoped for increase in aggregate demand nor did investment expenditures rise to add to aggregate demand. Recognizing these weak economic conditions the new Liberal government Minister of Finance, Bill Morneau, initiated an expansionary fiscal policy program. That policy planned for government budget deficits to finance expenditures on major infrastructure to increase the government component of aggregate demand and stimulate growth in real GDP.
Example Box 6.1 The algebra of the basic income – expenditure model.
The basic model has two components:
1. Aggregate expenditure = Autonomous expenditure plus induced expenditure:
(6.2)
• Equilibrium condition: GDP = Aggregate expenditure
• Then equilibrium Y is found by substituting 1 into 2:
Y =A0+(cm)Y
Y–(cm)Y =A0
=A0
Y
Recall that (cm) is the slope of the AE function (i.e. ). Then in equilibrium:
Using the numbers in the example in Table 6.3 and for equilibrium:
Y =100+0.5Y
Y–0.5Y =100
Y =100/(1–0.5)
Y =200
Example Box 6.2 The multiplier in a basic algebraic model.
Initial conditions in a basic model:
Then equilibrium national income is:
Y =100+0.5Y
0.5Y =100
Y =200
Suppose autonomous expenditure increases by 25 to A1=125:
Then the new equilibrium national income is:
Y =125+0.5Y
0.5Y =125
Y1 =250
The change in autonomous expenditure by 25 increased equilibrium national income by 50.
The Multiplier is defined as the change in national income divided by the change in autonomous expenditure that caused it. In this example the multiplier is:
Notice the multiplier is also equal to . In this example the slope of AE is the marginal propensity to spend on domestic output (cm)=0.5. The multiplier is: | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/06%3A_Aggregate_expenditure_and_aggregate_demand/6.05%3A_Key_Concepts.txt |
EXERCISE 6.1
Suppose that in an economy with no government the aggregate expenditure function is: .
1. Draw a diagram showing the aggregate expenditure function, and indicate the level of planned expenditure when income is 150.
2. In this same diagram, show what would happen to aggregate expenditure if income increased to 200.
3. What are the levels of autonomous expenditure and induced expenditure at income levels of 150 and 200.
4. In this same diagram show what would happen if autonomous expenditure increased by 20.
EXERCISE 6.2
Suppose the media predicts a deep and persistent economic recession. Households expect their future income and employment prospects to fall. They cut back on expenditure, reducing autonomous expenditure from 50 to 30.
1. Re-draw the aggregate expenditure functions you have drawn in your diagrams for Exercise 6.1 to show the effects, if any, of this change in household behaviour.
2. Suppose the negative economic forecast also reduces induced expenditure in the economy from 0.75Y to 0.5Y. In a diagram show the effect would this have on the aggregate expenditure functions you have drawn.
EXERCISE 6.3
Construct a table showing autonomous, induced and aggregate expenditure at different income levels (Y) for an economy with autonomous expenditure of 105 and induced expenditure of 0.5Y.
1. Using numbers from your table draw a diagram showing the aggregate expenditure function AE. What is the intercept of this function on the vertical axis?
2. What is the slope of the AE function, and what does the slope measure?
3. Write the equation for the aggregate expenditure function for this economy.
EXERCISE 6.4
Output and income are in equilibrium when planned expenditures AE are equal to national income, Y, in other words, meaning .
1. Suppose the AE function is . Draw a diagram showing the aggregate expenditure function.
2. In your diagram draw the line that shows all points at which national income and aggregate expenditures are equal ().
3. Using your diagram, or a numerical example, or an algebraic solution, find equilibrium output and income in this example and show it in the diagram.
EXERCISE 6.5
The diagram below shows the aggregate expenditure schedule for the economy and the equilibrium condition on the line.
1. Suppose output is 0G. What is the level of planned aggregate expenditure? Is planned expenditure greater or less than output?
2. What is the size of the unplanned change in inventories at output 0G?
3. How will business firms respond to this situation?
4. What is the equilibrium income and expenditure?
5. Suppose output is at 0J: What is there an unplanned change in inventories?
EXERCISE 6.6
The following diagram shows an economy that initially has an aggregate expenditure function AK.
1. What is the initial equilibrium real GDP?
2. Suppose there is an increase in the marginal propensity to import. What is the new aggregate expenditure function?
3. What is the new equilibrium real GDP and income?
4. Suppose, instead, the marginal propensity to consume has increased. What is the new aggregate expenditure function? What is the new equilibrium real GDP and income?
EXERCISE 6.7
The distinction between autonomous and induced expenditure is important for the determination of equilibrium real GDP. Assume that the marginal propensity spend on domestic output is 0.70 and autonomous aggregate expenditure is zero.
1. What is the equation for the aggregate expenditure function under these assumptions?
2. Draw the aggregate expenditure function in an income-expenditure line diagram.
3. What is the equilibrium level of real GDP illustrated by your diagram?
4. Explain why this is the equilibrium level of real GDP.
EXERCISE 6.8
Suppose the slope of the AE function is 0.6. Starting from equilibrium, suppose planned investment increases by 10.
1. By how much and in what direction does equilibrium income change?
2. How much of that change in equilibrium income is the result of the change in induced expenditure?
3. How would your answers to (b) differ if the slope of the AE function was 0.8?
EXERCISE 6.9
Suppose autonomous expenditure is 100 and there is no induced expenditure in the economy.
1. Write the aggregate expenditure function for this economy.
2. Draw the aggregate expenditure function and the line in a diagram.
3. What is the equilibrium level of real output and income?
4. By how much would equilibrium real output change if autonomous expenditure increased to 125? Show the change in expenditure and equilibrium in your diagram for part (b).
5. What is the size of the multiplier? Explain your answer.
6.6: Key Concepts
Aggregate demand determines real output (Y) and national income in the short run when prices are constant.
Aggregate demand: aggregate expenditure (AE) at different price levels when all other conditions are constant.
GDP(Y): the national accounts measure of the sum of actual expenditure and income in the economy.
Aggregate expenditure (AE): planned expenditure by business and households.
Induced expenditure: planned expenditure that is determined by current income and changes when income changes.
Marginal propensity to consume (): the change in consumption expenditure caused by a change in income.
Marginal propensity to import (): the change in imports caused by a change in income.
Induced expenditure (cm)Y: planned consumption and imports expenditures that change when income changes.
Autonomous expenditure (A): planned expenditure that is not determined by current income.
Aggregate expenditure (AE): the sum of planned induced and autonomous expenditure in the economy.
Short-run equilibrium output: Aggregate expenditure current output are equal ().
Unplanned changes in business inventories: indicators of disequilibrium between planned and actual expenditures – incentives for businesses to adjust levels of employment and output (Y).
Multiplier : the ratio of the change in equilibrium income Y to the change in autonomous expenditure A that caused it. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/06%3A_Aggregate_expenditure_and_aggregate_demand/6.06%3A_Exercises_for_Chapter_6.txt |
The federal governments in Canada and their budget policies generated a lot of media coverage and public debate in 2015 and 2016. Minister of Finance, Joe Oliver, in his April 2015 Budget Plan delivered on the Harper Government's promise to balance the budget in 2015. But politics aside there really is no magic to a balanced budget. A balanced budget does not reduce the public debt. Nor does a balanced budget directly increase economic activity in an economy operating with a recessionary gap. Perhaps more interestingly, the government's actual budget balance at the end of its budget year depends importantly on the growth and level of GDP. As it turned out, at the end of the fiscal year 2015–16 actual growth in GDP was less than assumed in the budget plan and the actual budget was in deficit. The public debt as measured by the accumulated deficit continued to increase.
During the general election campaign of 2015 the Liberal Party proposed a sharp change in budget policy. Citing the low growth rates in the economy and an increase in the unemployment rate they promised to stimulate the economy by running budget deficits to finance major infrastructure projects. Minister of Finance Bill Morneau's budget plan of April 2016 forecast the first of these deficits. The underlying argument was that increased government expenditure would lead to increased GDP and employment. Fiscal policy was then focused on improvements in economic activity in contrast to the previous governments focus on balancing the budget. This chapter explains these issues and the role of government in the economy.
A government sector adds important new linkages and feedback effects to the basic model of Chapter 6. Government expenditures on goods and services (G), determined by government policy, are added to other autonomous expenditures. They affect AE and equilibrium income through the multiplier. Government revenue collected by a net tax rate (t) applied to national income reduces the income households have to spend on consumption and reduces induced consumption expenditure. The multiplier is reduced, reducing equilibrium national income and the effects of changes in autonomous expenditure on equilibrium national income.
The linkages and feedbacks work in both directions. Changes in government expenditures and taxes have effects on equilibrium national income. Government can use these effects to manage aggregate expenditure and equilibrium income. However, changes in equilibrium national income caused by changes in expenditure in other parts of the economy changes incomes, government revenues and budget balances. As a result, changing economic conditions often lead to government budget outcomes that differ from initial targets and projections as in 2016.
Furthermore, over time governments must manage their budgets in ways that control the size of their debt relative to GDP. The fiscal policy governments implement through their budgets has dual objectives: Manage aggregate demand and, over time, manage the size of the public debt relative to national income. Until recently, Canadian governments have been more concerned about government budget surpluses, deficits, and debt than about demand management when designing fiscal policy.
To explain the role of government in macroeconomic analysis and policy, we start with a brief look at the data on the size of the government sector in Canada.
07: The government sector
The total government sector in Canada includes the federal, provincial, and municipal governments, as well as hospitals. Table 7.1 shows total outlays by the government sector in 2015. These totaled \$758 billion. Of this total, 31.2 percent was expenditure on government employees and 22.4 percent for the goods and services that provided government services to Canadians. The remaining 46.1 percent was transfer payments to persons, business, and non-residents, and interest paid on the outstanding public debt.
Table 7.1 Total government expense in Canada, 2015
Total Compensation Use of Consumption Subsidies Social Other Interest
Expense of Goods & of Fixed & Grants Benefits Expense
(billions employees Services Capital
\$) % % % % % % %
790.9 30.5 21.6 8.5 2.2 0.6 24.3 4.3
Source: Department of Finance, Fiscal Reference Tables, 2016, Table 34
To provide some perspective, Table 7.2 compares the size of the government sector in Canada, relative to GDP, with the average for the G7 group of industrial countries (Canada, the United States, Japan, the United Kingdom, Germany, France, and Italy) in 2007 and 2015. These data illustrate two aspects of recent government budget activity that are of particular interest. The first is the size of the government sector in each country as measured by revenue, expenditure, budget balance and net public debt, all reported as a percent of GDP. The second is the change in government sector finances from 2007 to 2015, the period of the financial crisis, recession and prolonged recovery.
On the first point the 2007 data show expenditures by Canada's government sector—the combined federal, provincial, and local governments—on goods, services, and transfers were 38.6 percent of GDP. This was less than the average for G7 countries. The difference reflects national political choices about the role the government sector plays in the economy.
Table 7.2 The general government sector in Canada vs. the G7 countries
Total Revenues Total Outlays Budget Balance Net Public Debt
% GDP % GDP % GDP % GDP
2007 2015 2007 2015 2007 2015 2007 2015
Canada 40.1 38.6 38.6 40.3 1.5 –1.7 27.0 26.7
G7 Average 37.3 36.4 39.9 39.8 –2.6 –3.4 49.7 83.0
Source: Canada: Department of Finance, Fiscal Reference Tables, 2016, Tables 51-54
In 2007, Canada differed from the G7 average in terms of their government sector budget balances. Canada operated with a budget surplus (revenues were greater than expenditures), while the other countries had budget deficits. Canada's budget surplus was the latest in a series of annual government-sector budget surpluses over the period from 1997 to 2007. These budget surpluses reduced the outstanding public debt and reduced Canada's ratio of net public debt to GDP well below the average to the lowest in the G7.
The shift in fiscal conditions in the G7 from 2007 to 2015 was dramatic. The recession that followed the financial crisis of 2008 reduced employment and incomes in all countries. Government revenue in Canada and the G7 fell relative to GDP. At the same time governments maintained or increased expenditures to stimulate demand, and some provided financial bailouts to banks to limit the impact of the financial crisis on bank balance sheets. In combination, these fiscal policy actions, although differing across countries had limited effects on average G7 government outlays by 2015, but budget deficits were larger by 0.8 percent of GDP, and, combined with slow growth in GDP, raised the average net public debt ratio more than 30 percentage points. Initially Canada also experienced a rise in the net public debt ratio but improved GDP growth and expenditure restraint reduced the ratio slightly by 2015. The government debt crisis that followed in several countries has dominated European economic conditions and policy debates and remained unsolved in 2017. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/07%3A_The_government_sector/7.01%3A_Government_in_Canada.txt |
A basic government budget has two components:
1. A plan for government expenditures on goods and services, G.
2. A net tax rate on income, t, set to generate revenue to finance expenditure.
When added to the definition of autonomous expenditure, A is expanded to include government expenditure G.
Government expenditure (G): government spending on currently produced goods and services.
We illustrate autonomous government expenditure in the same way we did with other autonomous expenditures, using a simple equation. For a specific level of government expenditure:
(7.1)
In Figure 7.1 with income on the horizontal axis and government expenditure and net tax revenue on the vertical axis, a horizontal line intersecting the vertical axis at G0 illustrates a particular level of government expenditure. Any change in government expenditure would shift this line up or down in a parallel way.
Figure 7.1 Government expenditure and net tax revenue function
The government raises revenue by levying direct taxes on incomes and pays out transfer payments such as old age security, employment insurance benefits, social assistance and interest on the public debt. The difference between taxes collected and transfers paid is net taxes (NT), the net revenue collected by government from households.
Net taxes: taxes on incomes minus transfer payments.
There is another but slightly more complex link between government taxes and non-government expenditures. The net tax rate on income reduces induced consumption. Net taxes reduce disposable income—the amount available to households for spending or saving—relative to national income. If YD is disposable income, Y national income and output, and NT net taxes:
(7.2)
Disposable income (YD): national income minus net taxes.
Suppose taxes net of transfers are about 15 percent of national income. The net tax rate t=0.15. If national income Y increases by \$1, net tax revenue will increase by \$0.15, but household disposable income will increase by only \$0.85.
For simplicity, suppose the marginal propensity to consume (mpc=c) out of disposable income is 0.8. The consumption function is:
Then if:
C=20+0.8YD
And the net tax rate is t=0.15, disposable income is (1–0.15)=0.85 times national income. Thus, consumption expenditure based on national income is:
C
C =20+0.68Y
A change in national income of \$1 changes consumption expenditure by only 0.8 times (1–t) of a dollar. If the net tax rate is 0.15, consumption expenditure changes by only . Each extra dollar of national income increases disposable income by \$0.85, out of which households plan to spend 68 cents and save 17 cents. Table 7.3 gives a numerical example.
Table 7.3 A numerical example
a) C=20+0.8YD b) C=20+0.8YD
NT=0 NT=0.15Y
YD=Y YD=(1–0.15)Y
C=20+0.8(1–0.15)Y
a) Y NT YD C1 b) Y NT YD C2
100 0 100 100 100 15 85 88
300 0 300 260 300 45 255 224
500 0 500 420 500 75 425 360
In the absence of taxation, in part (a) of the table, national income Y and disposable income YD are the same. The consumption function C1 shows how much households wish to consume at each level of national income, based on the numerical example.
With a proportional net tax rate of 0.15, households still consume \$0.80 of each dollar of disposable income. Now part (b) shows YD is now only 0.85 of Y when the net tax rate is 0.15. Households consume only of each extra dollar of national income.
The effects of both government expenditure and taxation
Aggregate expenditure includes both autonomous and induced expenditure. The net tax rate diverts some of national income to the government budget and lowers the disposable income on which induced expenditure is based. Net Taxes and imports both lower the marginal propensity to spend on domestic output. With the marginal propensity to consume out of disposable income (mpc), the marginal propensity to import (mpm) and the net tax rate (t), the slope of the AE function, the marginal propensity to spend on domestic output is:
(7.3)
Figure 7.2 The effect of G and NT on AE
New government expenditure and taxes shift the AE function up by G0 and lower its slope from (cm) to c(1–t)–m. A change in G shifts AE vertically. A change in t changes the slope of AE.
Figure 7.2 shows the combined effect of government expenditure and net taxes on the aggregate expenditure function.
As in the basic model, equilibrium real GDP equals autonomous aggregate expenditure multiplied by the multiplier. The government sector adds a new autonomous expenditure component G0 that shifts the AE function, and a new induced expenditure factor, the net tax rate (t), which lowers the slope of the AE function. Figure 7.3 illustrates the effects on equilibrium GDP and the multiplier.
Figure 7.3 Government expenditure, taxes, and equilibrium real GDP
Part a) of Figure 7.3 shows the effect of adding government expenditure to aggregate expenditure in the basic model. Government expenditure G=25 is autonomous and shifts the AE curve up to a new intercept at 105. With mpc=0.8 and mpm=0.2 the slope of AE is 0.6 and the multiplier is 2.5. Equilibrium Y increases by to the new equilibrium 262.5. An increase in autonomous government expenditure increased equilibrium GDP. A cut in government expenditure would reduce it. In this example, since the government has not introduced a tax system the government expenditure is financed by borrowing money through the sale of bonds.
The multiplier revisited
The multiplier relates changes in equilibrium national income to the changes in autonomous expenditures that cause them. The formula in Chapter 6 still applies.
Without government and taxes, disposable income and national income are the same. With induced expenditure based on the marginal propensity to consume (mpc=c) and the marginal propensity to import (mpm=m) the multiplier is:
With government net taxes proportional to income, NT=tY, disposable income is less than national income namely YtY. This reduces the marginal propensity to consume out of national to c(1–t), reducing the slope of the AE function.
As a result, the multiplier, which is is smaller:
(7.4)
The numerical values in Figure 7.3 provide one example of this change in the multiplier.
Now that we have seen that government expenditure and net tax taxes have effects on aggregate expenditure and equilibrium income, it is time to examine the effects of government budgets on AE, AD, and real GDP. The government implements fiscal policy through its budget.
Application Box 7.1 The multiplier in Canada
The multiplier plays a key role in the AE and AD/AS model of the economy. But what is the size of the multiplier in Canada? A simple statistical estimate, using Statistics Canada annual data for real GDP and consumption expenditures, gives a Canadian marginal propensity to consume out of national income c(1–t)=0.54, and marginal propensity to import m=0.34. Using these estimates, we get a multiplier for Canada:
Recent data gives an estimate of the Canadian marginal propensity to consume out of disposable income of mpc=0.88. If there were no taxes or imports, an mpc=0.88 would mean a multiplier of about 8.33. The difference between the multipliers 1.25 and 8.33 shows clearly the automatic stabilization coming from the net tax rate and marginal propensity to import. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/07%3A_The_government_sector/7.02%3A_Government_expenditure_and_taxes.txt |
It is important to make a clear distinction between a government budget as it affects and is affected by national income and an individual or household budget. The large size of the government sector relative to the economy (see Table 7.2) means any change in government expenditure or taxes also changes national income and government tax revenue. An increase in government expenditure also increases its tax revenue by increasing national income. A cut in government expenditure reduces national income and tax revenue. A household can improve its budget balance by cutting its expenditure without affecting its income. A government cannot. Recent experience in many countries provides a record of the difficulties governments have in trying to reduce budget deficits by cutting government expenditures.
The government budget function provides a useful tool for the discussion of these questions. It illustrates two-way linkages between the government budget and national income and the internal feedback within the government budget.
Think of a budget as the revenue and spending plan of an individual, a company, or a government. The government budget describes what goods and services the government will buy during the coming year, what transfer payments it will make, and how it will pay for them. Most spending is financed by taxes, but some revenue comes from charges for services. A balanced budget has revenues equal to spending. When revenues exceed spending, there is a budget surplus. When revenues fall short of spending, there is a budget deficit, which is financed by borrowing through the sale of government bonds to the public.
Government budget: planned government spending and revenue.
Balanced budget: revenues are equal to expenditures.
Budget surplus: revenues are greater than expenditures.
Budget deficit: revenues are less than expenditures.
Continuing to use G for government expenditure on goods and services, and NT for net tax revenue or taxes minus transfer payments (ignoring other sources of revenue, for simplicity):
(7.5)
The budget balance, whether deficit, surplus or zero, is determined by three things:
1. the net tax rate t set by the government;
2. the level of expenditure G set by the government; and
3. the level of output Y determined by AE and AD.
We can summarize the relationship between national income and the government's budget balance in a way we will find useful for discussing a government's budget and fiscal policies. Figure 7.4 shows a budget function. This budget function assumes t0=0.20 and G0=200. This is a specific fiscal program and budget plan, namely BB0.
BB0=0.2Y–200
Budget function: the relationship between the budget balance and the level of national income for a specific budget program.
Figure 7.4 The government budget function
The budget function is positioned by G=200 with a slope . The budget balance depends on the equilibrium level of GDP determined by AE.
A budget function is a simple illustration of the way the budget balance for one fiscal policy program depends on levels of national income.
In Figure 7.4, if national income Y were 600 the budget BB0 would be in deficit by 80. If a rise in autonomous aggregate expenditure increased equilibrium national income to 1400 the budget BB0 would be in surplus. Changes in national income induce changes in the revenues generated by the tax rate t=0.2 and automatically change the government's budget balance. The fiscal program and budget plan have not changed.
Once that fiscal program is set, the budget function is set, but the budget balance is not. The budget balance depends on the performance of the economy in terms of national income. In presenting the budget, the Minister of Finance gives a forecast of the budget balance based on a forecast of national income. If the income forecast is wrong, the budget program will result in either a larger or smaller budget balance than initially predicted.
Recent experience illustrates this relationship. In April of 2015 the Minister of Finance, Joe Oliver, tabled a government budget plan that was intended to result in a balanced budget (BB=0) in the fiscal year 2015–2016. That budget plan was based on the assumption the GDP in Canada would grow at an annual rate of 2 per cent in 2015–2016 and generate corresponding government tax revenue. However, by mid-July 2015 there were serious questions about that growth rate assumption. The Parliamentary Budget Office in a Budget Update that used the Bank of Canada's latest forecasts for real GDP growth at an annual rate of 1.0 percent estimated a budget deficit of \$1.5 billion for 2015–2016. The promised balanced budget was at risk as real GDP would be less by the end of the budget year. The finance minister makes a budget plan but the performance of the economy determines the budget outcome.
This recent experience is not anomalous. For many years before the financial crisis of 2008 and the recession that followed the Canadian federal government ran budget surpluses that frequently exceeded predictions, while many provincial government budget deficits were smaller than predicted. Economic growth during those years was stronger than forecast when the budgets were designed. Clearly the difficulties in making accurate income forecasts have important effects on the actual government budget balances.
Finally, notice that because a budget function describes one fiscal plan, any change in the fiscal plan will change the BB line to show a new budget function. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/07%3A_The_government_sector/7.03%3A_The_governments_budget_function.txt |
Fiscal policy is the government's use of its taxing and spending powers to affect aggregate expenditure and equilibrium real GDP. The main objective of fiscal policy is to stabilize output by managing aggregate demand, keeping output close to potential output, and reducing the size and duration of business cycle fluctuations. This requires changes in the government's expenditure plans and tax policy to offset changes in autonomous expenditures that would otherwise push the economy away from equilibrium at potential output.
Fiscal policy: government use of taxes and spending to affect equilibrium GDP.
In 2008 and 2009, for example, the international financial crises and the recession that followed led to fiscal stimulus programs in most industrial countries, like Canada's federal 'Economic Action Plan', and calls for international coordination of fiscal stimulus. This fiscal stimulus led in turn to increased budget deficits and national debts and, especially in Europe, to national or sovereign debt crises.
Fiscal stimulus
Figure 7.5 illustrates the use of fiscal policy to eliminate an output gap. In the Part a) of the diagram the economy has a recessionary gap at equilibrium Y0<YP because aggregate expenditure, AE, is not high enough to give equilibrium at YP. Government can intervene to raise AE to by increasing government expenditures or by lowering the net tax rate or a combination of the two. In this case, the government chooses to increase G from G0 to . The increase in G, working through the multiplier raises equilibrium real GDP to potential output.
Figure 7.5 Fiscal policies to eliminate an output gap
An increase in G reduces the budget balance and BB drops to , increasing the deficit from D1 to D2. The higher autonomous G increases AE to and real GDP increases to YP, eliminating the output gap. That increase in Y increases tax revenue and offsets some of the initial increase in the deficit such that the final budget deficit is D3.
Part b) of the diagram shows the change in the fiscal program used to provide fiscal stimulus and expand AE and equilibrium real GDP. Increased G lowers the budget function at every income level by to the new function .
Fiscal austerity
At times government directs fiscal policy not to the level of economic activity but to state of the government budget balance and public debt ratio. A balanced budget (BB=0) is often the target of a fiscal plan that involves some combination of cuts in government expenditure and tax increases. This is fiscal austerity. Federal government fiscal policy in Canada from 2010 to 2015 is a good example.
Fiscal austerity: cuts in government expenditure and/or increases in taxes aimed at improving the government's budget balance.
But the same linkage and feedback effects that work to finance part of a fiscal expansion work to opposite effect in the case of fiscal austerity. If a government cuts expenditures in trying to reduce a budget deficit, some of the initial effect on the budget balance is lost to falling tax revenue. Lower G lowers equilibrium income and lower income lowers tax revenues. Larger budget expenditure cuts to make up for lost revenues make matters worse. This was the experience of many European countries in the years following the recession of 2008. Greece is the extreme case.
Figure 7.6 illustrates the effects of a cut in G designed to reduce a budget deficit.
Figure 7.6 The fiscal policy to reduce a budget deficit
A cut in government expenditure to reduce the budget deficit D0 at Y0 shifts the BB line up to BB1. The deficit is reduced but the austerity policy lowers autonomous aggregate expenditure and equilibrium national income from Y0 to Y1. The net reduction in the deficit is less than the cut in G.
Because the observed budget balance combines autonomous (G) and induced (NT) components it is important to consider if the observed budget balance—whether surplus, balanced, or deficit—is a good measure of the government's policy action or fiscal stance.
Does the budget balance show whether fiscal policy is expansionary, aiming to raise national income, or contractionary, aimed at deficit control and reduction?
In itself, the budget balance may be a poor measure of the government's fiscal stance, because the budget balance can change for reasons unconnected to fiscal policy. Even if G and t are unaltered, a fall in investment or exports will reduce national income and output. In turn, this reduces net tax revenue and reduces the budget balance. Indeed, any change in non-government autonomous expenditure changes equilibrium income, net tax revenue, and the government's budget balance. Recent experience in Canada with oil prices and lower growth is a good illustration.
The structural budget balance provides a fiscal indicator that helps to solve this problem.
The structural budget balance
The structural budget balance (SBB) is an estimate of what the budget balance would be if the economy were operating at potential output. By evaluating the budget at a fixed level of income, namely potential GDP, the structural budget balance does not change as a result of business cycle fluctuations in output. In terms of the budget function we used above, the structural balance is:
(7.6)
Structural budget balance (SBB): the government budget balance at potential output.
Notice that this structural budget function differs from the general budget function of Equation 7.5 by calculating net tax revenue at YP rather than at any Y.
Using the previous numerical example, suppose government expenditure is 200 and the tax rate is 0.20. Holding these terms of the fiscal plan constant, as in Figure 7.4, the budget balance is a deficit at any income below 1000 and a surplus at any income above 1000. If, given other components of aggregate expenditure, the equilibrium output is 800, the actual budget balance will be a deficit. Net tax revenue will be . With government expenditure of G=200, BB=160–200=–40.
Conversely, suppose higher AE makes equilibrium output 1200. With a tax rate of 0.20 and government expenditure of 200, the budget balance would be a surplus of 40. The important point of these examples is that we cannot tell the stance of fiscal policy, or a change in the stance of fiscal policy, by looking at the budget balance reported by the Department of Finance and published in the media. We need to look at a structural budget balance, calculated at potential output (YP) that is not changed by business fluctuations in actual output around potential output. Estimates of structural budget balances in Canada are published by the Department of Finance in Fiscal Reference Tables, www.fin.gc.ca/frt-trf/2016/frt-trf-16-eng.asp, Tables 17 and 46, as 'cyclically adjusted budget balances'.
Figure 7.7 illustrates the concept of the structural budget deficit as compared to the actual budget deficit. The fiscal policy program is BB0=t0YG0. If the economy were operating at potential output YP the budget balance would be SBB0, the structural balance. At any other level of income, resulting for example from cyclical changes in autonomous investment or exports, the actual budget balance would be different from the structural budget balance. A fall in autonomous expenditure that lowered equilibrium GDP to Y1 would result in a budget deficit – BB1 in the diagram. There has been no change in fiscal policy – just a change in the actual budget caused by a business cycle change in national income.
Figure 7.7 Actual and structural budget balances
Structural budget balance SBB0=t0YPG0. Actual budget balance BB1=tY1G0.
A change in the fiscal plan that changed the net tax rate or a change in planned government expenditure would change the budget function and the structural budget balance. There would be a different budget function line in the diagram. The slope of the line would increase with an increase in the tax rate or fall with a cut in the tax rate. A change in planned government expenditure would change the position of the line. In either case the new structural budget balance would indicate that fiscal policy had changed. The change in fiscal policy would increase or decrease aggregate expenditure. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/07%3A_The_government_sector/7.04%3A_Fiscal_policy_and_government_budget_balances.txt |
Automatic fiscal policy
Automatic stabilizers have a great advantage. They are built into the budget program by setting the net tax rate, and work automatically. There is no need to determine if the shift in autonomous expenditure is transitory or persistent. By reducing the sensitivity of the economy to expenditure shocks, automatic stabilizers are always at work reducing the size of output and employment fluctuations.
Automatic stabilizers: tax and transfer programs that reduce the size of the multiplier and the effects of transitory fluctuations in autonomous expenditures on equilibrium GDP.
Income taxes and transfers, such as unemployment benefits, are important automatic stabilizers. At given net tax rates, a fall in national income, output, and employment raises payments of unemployment benefits and reduces tax collections. Both effects mean that disposable income changes by less than the change in national income. The slope of the aggregate expenditure function (c(1–t)–m) is lower, and so is the multiplier. Conversely, in a boom, net tax revenues rise and disposable income rises by less than the rise in national income, which helps dampen the boom.
However, automatic stabilizers only serve to moderate the fluctuations in real GDP caused by fluctuations in autonomous expenditure. They do not offset those autonomous expenditure disturbances. There is no automatic change in autonomous government expenditure or tax rates. Those changes usually come from discretionary fiscal policy.
Discretionary fiscal policy
Governments use discretionary fiscal policies to offset persistent changes in autonomous expenditures. A persistent drop in investment or exports would be offset by an increase in government spending and by cutting taxes, or both as for example the Canadian government's Economic Action Plan in response to the recession of 2009. Alternatively an export or investment boom might be offset by higher tax rates or reduced government expenditures.
Discretionary fiscal policy: changes in net tax rates and government expenditure intended to offset persistent autonomous expenditure shocks and stabilize aggregate expenditure and output.
The budget function and the structural budget balance we discussed earlier provide a good illustration of automatic and discretionary fiscal policy. Figure 7.8 shows a government budget function BB0=t0YG0 and a structural budget balance SBB0 at potential output YP. This budget function represents a fiscal program designed by the Minister of Finance and approved by parliament.
Figure 7.8 Automatic and discretionary fiscal policies
Automatic stabilization comes from changes in the budget balance along the BB0 line as Y fluctuates between Y1 and Y2. Discretionary stabilization shifts the budget function as a result of changes in government expenditure or taxes.
Discretionary fiscal policy sets both the position and slope of the budget function. A change in discretionary policy would change the entire budget line. Figure 7.8 illustrates discretionary policy as shifting the BB line up to BB1, in the case of restraint or austerity, or down to BB2 to provide fiscal stimulus. Automatic stabilization is a part of all these programs. It comes from the slope of the budget function, the net tax rate t0 in this case. Any fluctuations in private sector autonomous expenditures cause changes in income Y. These changes in Y for example, down to Y1 or up to Y2, cause movements along the budget function and a change in the budget balance, as shown in Figure 7.8. The effect of the change in the budget balance is stabilizing. A larger net tax rate would mean larger automatic changes in the budget balance in response to changes in income and more automatic stabilization.
When we use the budget function to show fiscal policy changes, we can also consider more complex programs that change both the slope of the function and the structural balance.
It is quite easy to present fiscal policy in theory and illustrate it in diagrams but does it work in the real world? Why, if governments have fiscal tools to stabilize and offset fluctuations in aggregate expenditure and demand do we still experience business cycles, including the recession of 2009 and the prolonged recovery?
The answer has several dimensions. While automatic stabilizers moderate the severity of fluctuations in autonomous expenditures they do not offset those fluctuations. That calls for discretionary fiscal policy, namely a change in the budget plan involving changes in autonomous government expenditures and net tax rates. The process is partly economic and partly political and can take time.
The timelines involved are frequently defined in terms of recognition lags, decision lags, implementation lags and impact lags. It takes time to recognize a persistent shift in aggregate expenditure and identify its source. This involves the availability of economic data and economic analysis to establish the size and source of shift in economic conditions. That in turn provides the basis for the design of the new budget program required. The implementation of the new budget is a political process. It may involve substantial time and changes to the budget before it passes. Once the budget passes and new expenditure plans and tax rate are in effect it takes time for them to work through the economy and have their full impact on aggregate expenditure and national income. As a result, economic fluctuations are well underway before discretionary fiscal policies can shift to offset them. Discretionary policies may still provide stabilization but they do not completely eliminate business cycle fluctuations. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/07%3A_The_government_sector/7.05%3A_Automatic_and_discretionary_fiscal_policy.txt |
Budget balances and outstanding debt are closely related. A student's debt at the time of graduation is the sum of her budget balances during years of study. In any year in which her income is less than her expenses, she finances the difference by borrowing. In another year, if income is greater than expenses, she can repay some previous borrowing. In the end, the sum of borrowings minus the sum of repayments is her outstanding student debt (loan). This debt is a result of borrowing to finance investment in education.
Similarly, the outstanding public debt (PD) at any point in time is simply the sum of past government budget balances. Governments borrow to finance budget deficits by selling government bonds to households and businesses. Budget surpluses reduce the government's financing requirements. Some bonds previously issued mature without being refinanced. In simple terms, the budget balance in any year changes the outstanding public debt by an equal amount but with the opposite sign. A positive balance, a surplus (BB>0), reduces the public debt (). A negative balance, a deficit (BB<0), increases the public debt (). Using PD to represent the outstanding public debt, we can express the link between the public debt and the government's budget balance as:
(7.7)
Public debt (PD): the outstanding stock of government bonds issued to finance government budget deficits.
Figures 7.9 and 7.10 show the relationship between the government budget balance and the change in the public debt relative to GDP based on Canadian data for the 1991 – 2016 period. Recognizing that growth in the economy makes absolute numbers for deficits and debt hard to evaluate, the budget balance and the change public debt are presented as percentages of nominal GDP. The effects of budget balances on the public debt are illustrated clearly in the diagrams.
Figure 7.9 Government of Canada Budget Balances % GDP
Source: Department of Finance, Fiscal Reference Tables 2016
Figure 7.10 Change in federal government public debt ratio, 1991–92 to 2015–16
Source: Department of Finance, Fiscal Reference Tables 2016, Table 15, Statistics Canada CANSIM series 3800063 and author's calculations
In the years from 1995 to 2007 the Government of Canada had budget surpluses. Things were different in the years before 1995. Large budget deficits, averaging more than 5 percent of GDP, were the norm in the late 1980s and early 1990s. As a result, the outstanding federal government public debt increased, and increased faster than GDP, pushing the ratio of public debt to GDP up from 38 percent of GDP in 1983 to 68 percent of GDP in 1996. The cost of the interest payments the government had to make to the holders of its bonds increased from \$3.9 billion to \$42.4 billion. These costs accounted for almost 30 percent of budgetary expenses in 1995.
As a result, Canadian fiscal and budgetary policy shifted in 1995 to focus much more on deficit and debt control than on income stabilization. As Figure 7.9 shows, the federal budget was in surplus from 1997 until 2007. This reduced the debt to GDP ratio each year until 2008 as in Figure 7.10.
The financial crisis and recession of 2008-2009 and the federal government's Economic Action Plan changed this focus and pattern of fiscal policy. Fiscal stimulus through increased government expenditures and modest tax credits together with the recession in income created budget deficits in 2008-2013. These deficits added directly to the federal government debt. Larger debt combined with little or no growth in nominal GDP in 2009 and 2010 caused a sharp increase in the debt ratio shown in Figure 7.10. The focus of Federal Budget plans for recent years, as the recovery from recession seems to be underway, has shifted back to budget deficit control and reduction and a return to lower public debt ratios.
Although cumulative deficits can raise the public debt dramatically, it is not the absolute value of the outstanding debt that should be of interest or concern. If, at the same time the debt is rising, the economy is growing and tax revenues are rising as a result of a growing tax base, the government may be able to service a growing debt without having to raise taxes. The public debt ratio (PD/Y) is then the appropriate measure of the debt situation. A rise in the outstanding debt is not in itself a source of concern. However, the government cannot allow the debt ratio to rise without limit.
Public debt ratio (PD/Y): the ratio of outstanding government debt to GDP.
Recent sovereign debt crises in Portugal, Ireland, Greece and Spain provide clear examples of the difficulties high and rising public debt ratios cause. In those countries and others in Europe, and in the US, the government costs of rescuing banks in financial distress after 2008 combined in many cases with already large budget deficits, compounded by the recession in economic growth raised public debt ratios sharply. Table 7.2 shows increase in public debt ratios from 2007 to 2015. The consequence was a loss of financial market confidence in the ability of some of these countries to pay interest on and subsequently retire outstanding government bonds, let alone service new bond issues to finance current deficits. Interest rates for new bond issues increased sharply and Greece and Ireland needed financial bailouts from joint EU rescue funds. This has provided time for fiscal adjustment but the economic growth required to solve sovereign debt issues remains elusive.
We will return to the relationship between fiscal policy and the public debt and examine the dynamics of the public debt ratio in Chapter 11.
This completes our introduction to the government budget, fiscal policy, aggregate expenditure, and the economy. It recognizes the importance of another set of linkages and feedback effects within the macro economy. We have seen two ways in which the government sector affects aggregate expenditure and output. Government expenditure is a part of autonomous aggregate expenditure. It affects the position of the AE function, equilibrium output, and the aggregate demand curve. The net tax rate diverts income from the household sector to government revenue and reduces induced expenditures. It changes the slope of the AE function, the size of the multiplier. Together the change in autonomous government expenditure and the effect of the net tax rate on induced expenditure change equilibrium income, and the AD curve. The size and direction of the change depends on the government's actual budget balance.
At the same time, conditions in the economy have significant effects on the government's budget. Recessions cause induced budget deficits and booms generate budget surpluses, both of which complicate the evaluation of the government's policy stance. Furthermore feedback effects within the government budget provide revenue support for fiscal expansion and revenue resistance to fiscal restraint or austerity. These effects mean government budget cannot be judged in the same way a private or household budget might be. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/07%3A_The_government_sector/7.06%3A_The_public_debt_and_the_budget_balance.txt |
Our objective in this chapter was to extend the model of Chapter 6 to include a government sector and fiscal policy in aggregate demand. To do this we continued to assume that wages, prices, money supply, interest rates, and foreign exchange rates are constant. We also continued to make the important distinction between autonomous expenditure and induced expenditure, which leads to the existence of a multiplier. The equilibrium condition is still Y=AE and AD=AS, output and income equal to planned expenditure. Even though the model is more complex, it still shows us that fluctuations in autonomous expenditures, working through the multiplier, cause fluctuations in Aggregate Demand, output, income, and employment.
Changes in autonomous expenditures are still the sources of business cycles. If business changes planned investment expenditure in response to changed expectations about future markets, or if changes in economic conditions in other countries change exports or imports, the multiplier translates these changes into larger changes or fluctuations in income and employment. Government expenditure plans and net tax rates are fiscal policy tools that could be used to moderate or offset these fluctuations through a combination of automatic and discretionary fiscal policy.
Figure 7.11 shows the relationship between equilibrium income and output, and the link between changes in aggregate expenditure, aggregate demand, and equilibrium income. In the upper diagram a fall in autonomous expenditure from A0 to A1 reduces AE and equilibrium Y from to , which is the fall in A times the multiplier.
The fall in autonomous expenditure and equilibrium is a leftward shift in the AD curve in the lower diagram. The size of that shift in AD is the change in equilibrium income in the upper diagram, namely the fall in A times the multiplier. Because the price level is constant, giving a horizontal AS curve at P0, the fall in equilibrium determined by AD/AS is the same as the horizontal shift in AD.
Figure 7.11 AE, AD and equilibrium output
Example Box 7.1 The effect of the government sector on equilibrium income
a) Equilibrium with no Government
Autonomous expenditure =A0 Autonomous expenditure =80
Induced expenditure =(cm)Y Induced expenditure =(0.8–0.2)Y=0.6Y
Aggregate expenditure =A0+(cm)Y Aggregate expenditure =80+0.6Y
Equilibrium income: Equilibrium income:
Y=A0+(cm)Y Y=80+0.6Y
Y=200
b) Equilibrium with added government sector: G=25, NT=0.10Y
Autonomous expenditure =A0+G0 Autonomous expenditure =105
Induced expenditure =c(1–t)–m Induced expenditure
Aggregate expenditure Aggregate expenditure =105+0.52Y
Equilibrium income: Equilibrium income:
Y=105+0.52Y
Y(1–0.52)=105
Y=218.4
In this example adding government expenditure G=25 financed in part by a net tax rate t=0.10 raised autonomous expenditure by 25 but lowered the multiplier from 2.5 to 2.08 with the result that equilibrium income increased by 18.4. Equilibrium income increased because the government sector ran a budget deficit. G was 25 but net tax revenue was only .
7.08: Key Concepts
Canadian governments directly buy about 25 percent of GDP according to the national accounts data. They also spend about 17 percent on transfer payments to persons and business, including interest payments to holders of government bonds.
Government expenditure G on goods and services, including the public services provided to households and business is a policy variable and an autonomous component of aggregate expenditure.
Net taxes (NT=tY), the revenue collected by government from households, are difference between taxes collected and transfers paid.
Disposable income is national income minus net taxes. Changes in disposable income cause changes in household consumption expenditure based on the MPC.
The net tax rate (t) reduces changes in disposable income relative to national income and reduces the marginal propensity to consume out of national income to c(1–t). This lowers the slope of AE and the size of the multiplier.
Government expenditure and net taxes affect equilibrium national income by changing both autonomous expenditure and the multiplier.
The government budget describes what goods and services the government plans to buy during the coming year, what transfer payments it will make, and how it will pay for them. Most spending is financed by taxes, but some revenue comes from charges for services.
The government budget balance is the difference between net revenues and government expenditures. Because net tax revenues depend on national income (NT=tY) the actual budget balance is determined by the government's budget plan and the level of national income. The actual budget balance will change with changes in national income.
A balanced budget has revenues equal to expenditures.
A budget surplus means revenues are greater than expenditures.
A budget deficit means revenues are less than expenditures.
Fiscal policy is the government's use of its taxing and spending powers to affect aggregate demand and equilibrium GDP.
The structural budget balance (SBB) is an estimate of what the budget balance would be if the economy were operating at potential output. Changes in the structural budget balance are indicators of changes in fiscal policy because they measure changes in expenditure and tax programs at a standardized income level.
The government's tax and transfer programs are automatic (fiscal) stabilizers that reduce the size of the multiplier and the effects of transitory fluctuations in autonomous expenditures on equilibrium GDP.
Discretionary fiscal policies are changes in net tax rates and government's expenditure intended to offset persistent autonomous expenditure shocks and stabilize aggregate demand and equilibrium output at potential output.
Public debt (PD) is the outstanding stock of government bonds issued to finance past government budget deficits minus the retirement of government bonds in times of past government budget surpluses. The annual change in the public debt is .
Public debt ratio (PD/Y) is the ratio of outstanding government debt to GDP, PD/Y.
Recent sovereign debt crises in Portugal, Ireland, Greece and Spain provide clear examples of the difficulties high and rising public debt ratios cause.
The government sector and fiscal policy are important determinates of aggregate demand and equilibrium GDP. Government expenditures are an autonomous policy variable. Net tax rates and policy affect the size of the multiplier. Changes in government expenditure and tax programs through the setting of the government's budget affect AE, AD and equilibrium GDP.
7.09: Exercises for Chapter 7
EXERCISE 7.1
Suppose a government is established in a country where none previously existed. The government spends 100, financed by borrowing, to provide public services. If autonomous expenditure before government is set up is 200 and induced expenditure is 0.6Y (based on mpc=0.75 and mpm=0.15) what is the equilibrium value of real GDP before the government is established and what would equilibrium GDP be after government is established?
EXERCISE 7.2
If the government expenditure in Exercise 7.1 were financed by imposing a net tax rate on income of t=0.10:
1. Calculate and compare the slopes of the AE functions in Exercises 7.1 and 7.2.
2. Calculate and compare the multipliers in Exercises 7.1 and 7.2.
3. What is the equilibrium real GDP in Exercise 7.2 compared to Exercise 7.1?
EXERCISE 7.3
If government expenditure is 100 and the net tax rate is t=0.20:
1. Complete the following table:
Y NT=tY G BB=NTG
100
200
300
400
500
600
700 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/07%3A_The_government_sector/7.07%3A_Aggregate_demand_and_equilibrium_output.txt |
Banks are the front line of the financial system. Bank deposits are a form in which people hold their wealth and they are also the main means of payment, making them the main component of the money supply in the economy. Furthermore banks are the major sources of credit for households and businesses, either directly through bank loans or indirectly through the credit card systems they own.
The financial sector provides the important link between and aggregate expenditure and aggregate demand. It is the key to understanding the slope and position of the AD curve. It also creates the framework for central bank monetary policy.
08: Money banking and money supply
You can see the variety of things that have been used as money in Canada in James Powell's A History of the Canadian Dollar, available at the Bank of Canada's website: http://goo.gl/BnIgpK. Our money in the seventeenth and eighteenth centuries was silver and gold coins from many countries, and playing cards. The British pound sterling, the Spanish silver dollar, and the US dollar were the main moneys in Canada in the nineteenth century, followed by paper currencies issued by banks and by the government since the late nineteenth century.
It is not the commodity or token used as money that matters, but the social convention that it is accepted without question as a means of payment. Money makes it easier for everyone to buy and sell goods and services and economize on the use of scarce resources.
Money is defined by four important functions. It provides:
1. A means of payment as a medium of exchange
2. A unit of account
3. A store of value
4. A standard of deferred payments
As a means of payment money is involved in most exchanges. We use money to pay for the goods and services – from food and clothing to transportation, to rent, to fees and taxes. People receive wages and salaries and other types of income in money. Money is not consumed in these transactions. It is used as a medium of exchange.
Means of payment: a commodity or token generally accepted in payment for goods and services or the repayment of debt.
Exchange transactions without money are barter exchanges, a direct exchange of one good for another. These exchanges depend on a double coincidence of wants. Each party to the exchange has a good the other party wants and is willing to trade one good for another. This means exchange transactions are expensive as people must find others who have what they want and want what they have. Using a money as a medium of exchange dramatically lowers the cost and increases the ease and efficiency of trade.
Barter exchanges: direct exchanges of goods or services for goods or services without the use of money.
Money also serves as a unit of account. Prices in Canada are quoted in Canadian dollars. Similarly in other countries prices are quoted in domestic currency. In much of Europe prices are in euros, in the United States in US dollars and in Japan in yen. This reflects the convenience of using the same units for the means of payment and the unit of account. However, there are exceptions. Historically, in Canada, during the time of the fur trade, books were kept in "currency" but actual currency never changed hands in the barter of trade goods for furs.
Unit of account: the standard in which prices are quoted and accounts are kept.
To serve as a medium of exchange, money must also be a store of value. Money works as a time machine allowing people to separate the timing of their expenditures from the timing of their incomes. Money is accepted today with confidence that it can be used some time in the future to make payments when buying goods and services. You would not accept money today that you thought would be unacceptable when you offered it in payment at some later date.
Store of value: an asset that carries purchasing power forward in time for future purchases.
Money is not a unique store of value. Other assets including real estate, financial assets like corporate and government bonds, fine art and antiques all serve as stores of value. These may be better ways to store value, but people still choose to hold some of their wealth as money. This choice to hold money balances is very important to the effects money balances have on financial markets and aggregate expenditure. Chapter 9 examines it in detail.
Money provides a standard for deferred payments. If you take out a student loan the amounts you will repay in the future are measured in dollars. Similarly, servicing and retiring a mortgage on a property or a loan on a car calls for future payments specified in dollars. Domestic money is not essential for this function. Individuals, businesses and governments often borrow or lend in the money of other countries. In those cases the currency in which the loan transaction takes place is usually the standard for payments to settle the debt. The essential attribute of money is its general acceptance as a means of payment. For this money must also be a store of value. This works well when money is also a unit of account and a standard of deferred payments.
Standard of deferred payments: the units in which future financial obligations are measured.
The development of money
The money we use today is the product of a long and continuing evolution in the financial services industry. It is a testament to the ingenuity of people and society seeking to reduce the costs and increase the volume of trade in goods and services.
Historically, there were no banks. Money was a commodity. Gold and silver bullion are two commodities that came to be used extensively because of their relative scarcity and durability. Concerns about the purity of these metals and the inconvenience of weighing out small quantities to make payments led to coinage. The minting of gold and silver coins by heads of state offered a solution to these problems. The 'monarch' certified the purity and quantity of the metal in the coin by having his or her likeness stamped into the metal.
Unfortunately, coinage did not completely solve the concerns about the quantity and quality of gold and silver money. The quantity of gold in a coin could be reduced by clipping its edges, or by rubbing the surfaces of the coin to wear some of the metal away. "Sweating" coins by placing them in a leather bag and shaking them was one technique used to remove some of their precious metal. The edge designs, millings, or facets that we still see on coins today were introduced to combat clipping, and wear on the heads and tails stamped into coins provided evidence of sweating. Coins that were worn or clipped were not accepted at full value in exchange for goods and services.
A second difficulty with precious metal coinage came from the sovereign who controlled the minting process. Adding a little base metal to the gold or silver being minted resulted in coins with less precious metal content than their face value certified. A little of the precious metal was withheld and could be used to mint more coin, which was, in effect, free money for the sovereign. This "debasing" of the coinage was a serious problem at times and, like clipping and sweating, reduced the acceptability of precious metal coinage as money.
The emergence of banks and paper money was a response to the problems with gold and silver commodity money. The first banks were goldsmiths who used gold in the production of jewelry and ornaments. They were accustomed to buying and selling gold bullion, and holding stocks of gold bullion. It was a natural extension of their business to offer to hold gold for safekeeping. Those who stored their gold with goldsmiths were given paper claims or receipts (IOUs), which were convertible back into gold on demand.
When people began to use gold receipts to make payments, gold receipts became a means of payment. They were token money, representing a fixed amount of the precious metal.
Token money: convertible claims on commodity money.
Goldsmiths became bankers when they realized that not all their customers would show up at the same time and want their gold back. The convertibility of gold receipts made them acceptable as a medium of exchange. Gold merchants could make loans by issuing more gold receipts than they had gold in their storage vaults. They only needed gold holdings equal to a fraction of the gold receipts they had issued, as long as people used the receipts as a medium of exchange.
Banks as we know them grew out of this acceptance by society of credit (IOU) money as a medium of exchange. Banks began to accept customer deposits of token money and to issue their own bank notes (credits) as receipts. People liked the convenience and safety of storing some of their wealth with banks. As society became more comfortable with banks and confident in the safety of banks, bank deposits, which could be transferred by cheque, became widely accepted as the medium of exchange. Bank notes and deposits were no longer convertible into gold or commodity money, but they were convertible into legal tender. Governments established central banks to control the supply of legal tender, bank notes, or cash. Bank notes now serve as both a medium of exchange and as the reserves banks hold to ensure the convertibility of their customers' deposits.
Legal tender: money that by law must be accepted as a means of payment.
Bank reserves: cash (legal tender) held by banks to meet possible withdrawals by depositors.
Unlike other financial institutions, such as pension funds and insurance companies, the key aspect of banks is that some of their liabilities are used as the medium of exchange; cheques and debit cards allow their deposits to be used as money to make payments. Bank deposits are credit money.
In Canada today, as in most industrial countries, we use a combination of fiat money and credit money. Fiat money, in contrast to commodity or token money is money that the government has declared to be legal tender. Coins and paper bank notes are fiat money in Canada. If you look carefully at a \$5, \$10, or \$20 Bank of Canada bill you will find the statement: "This note is legal tender." By law it must be accepted as a means of payment for goods and services bought or debts repaid.
Fiat money: money the government has declared as legal tender.
Credit money: the debt of a private business or individual.
Our fiat money is supplemented by credit money. A bank deposit is credit money, and is redeemable in fiat money on demand, or in the case of some savings and time deposits, after a short waiting period. Furthermore, the bank is obliged to pay when your cheque is presented, or when you use your debit card. Bank deposits are a medium of exchange because they are generally accepted as a means of payment, even though they are not legal tender. The sum of bank deposits and fiat money in circulation outside the banks at any time is the stock of medium of exchange and the economy's money supply.
Money supply: the means of payment in the economy, namely currency (notes and coin) in circulation outside the banks and bank deposits. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/08%3A_Money_banking_and_money_supply/8.01%3A_Money_and_the_functions_of_money.txt |
The money supply is traditionally defined as cash in circulation outside the banks, plus bank deposits. But as the banking and financial system evolved so did the types of deposits issued to the non-bank public. Now there are questions about the measurement of money supply.
Money supply: notes and coin in circulation outside banks plus bank deposits.
In the early days of banking there were demand deposits on which cheques could be written and savings deposits which often required a period of notice before funds could be withdrawn. Today banks offer a much wider spectrum of deposits to customers from demand to savings deposits that may or may not be chequable, pay interest under different terms, and some which can only be accessed online. Not all deposits serve as means of payment. For these the balance must be transferred to another account before it is available to make a payment. Which deposits should be counted in the money supply?
The structural evolution of the financial system raises further questions. What is a 'bank'? Today banks compete vigorously for deposits with other businesses, including trust companies and credit unions whose deposits are widely accepted as means of payment. There is no longer a reason to exclude those deposits from measures of the money supply. Different measures of the money supply illustrate the importance of different financial institutions in the industry.
The Bank of Canada now publishes data on the monetary base in response to continuing changes in the types of bank deposits available to households and businesses. Advances in technology, financial deregulation, and competition in the financial services sector, which have led to more types of financial assets, make it easy for customers to substitute between those assets we include in narrow definitions of money supply and other assets. But once we leave the monetary base as a measure of money supply, there is no single measure of money that is clearly the means of payment. There is, however, only one type of money that is legal tender; namely, notes and coin.
Monetary base: legal tender comprising notes and coins in circulation plus the cash held by the banks.
Table 8.1 shows the size of the money supply in Canada based on different definitions and money aggregates. These data illustrate the range of choice involved in the selection of a specific measure of the money supply. But one thing is clear: Bank deposits are the major component of money supply by any measure other than the currency component of the monetary base.
Table 8.1 The money supply in Canada in January 2017 (billions \$)
Monetary base (MB) 84.6
Currency in circulation (CR) 78.8
814.8
1,510.5
1,905.5
Source: Statistics Canada, CANSIM Table 176-0025
Currency in circulation is only about 5 percent of M2. Deposits account for the remaining 95 percent. The importance of bank deposits as money means that understanding the operations of banks as sources of loans and deposits is the key to understanding the money supply function in the economy.
Example Box 8.1 E-Payments and E-money and Fintech
Payment methods, monies and financial services continue to evolve as illustrated by the development of e-payments and e-money and more broadly by fintech.
E-payments are now familiar and widely used. Debit cards, telephone banking, internet banking and mobile banking provide access to manage deposit accounts and make payments, but they do not involve any creation of money. The central bank still controls money supply.
E-monies fall into two categories. Centralized e-money, for example a multi-purpose pre-paid payment card, denominated in the currency of the controller of the currency, has a money value based on funds received by the issuer. It is accepted as a means of payment in transactions with parties other than the issuer. Stored-value cards that use the Visa or MasterCard systems are widely accepted in payment. In Canada, transactions using these and similar cards are in Canadian dollars.
Decentralized e-money has no centralized issuer and is not denominated in any national currency. It is a cryptocurrency. The bitcoin is an example. It is completely decentralized and does not represent a claim on the issuer in the way that a Canadian dollar bank deposit represents a claim on a bank. Furthermore, no bank or institution is an intermediary in a transaction between payor and payee. A cryptocurrency is decentralized over a peer-to peer computer network that directly links users, but no one user in control of the network. It uses 'blockchain technology' which is a shared, continually reconciled data base. However, because cryptocurrencies are not redeemable in national currencies they generally trade online and their values are highly volatile in terms of national currencies.
Fintech describes this emerging and evolving range of technology based financial services. E-payments and e-money are part of this process. But it extends more widely to include technology based loaning, stock trading, robo-advising, digital wallets and all-in-one money management tools, to name a few examples. The growth in fintech is based on the possibility of a wider range of improved services available at lower cost to banks, businesses and consumers. Banks continue to play a major role in financial markets and the payments system and continually adapt to the new technology and competition in other aspects of their operations. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/08%3A_Money_banking_and_money_supply/8.02%3A_Measures_of_the_Canadian_money_supply.txt |
In Canada today, and in other industrial countries, the mainstream banking system is made up of a central bank and a number of commercial banks and other deposit-taking institutions called near banks. Table 8.2 illustrates the structure of the banking industry in Canada. The industry is defined broadly to include deposit-taking institutions, not just those that operate under the federal Bank Act.
Table 8.2 The Canadian banking system in 2017
Banking Institution Number
Central Bank:
The Bank of Canada
1
Number of Chartered Banks:
Schedule I domestic banks
26
Schedule II foreign banks subsidiaries
17
Schedule III foreign bank branches
20
Total 64
Source: Canadian Bankers' Association. http://www.cba.ca/memberbanks
Banks are financial intermediaries. They borrow money from the public, crediting them with a deposit. The deposit is a liability of the bank. It is money owed to depositors. The money raised from depositors provides the funds to support the bank loans made to businesses, households, and governments.
Financial intermediary: a business that specializes in bringing borrowers and lenders together.
Banks are not the only financial intermediaries. Trust companies, credit unions, caisses populaires, insurance companies, securities dealers, mutual fund companies, and independent financial advisors all play a role in this industry. But banks hold more than 70 percent of the assets in the financial services sector, and the six largest Canadian banks account for over 90 percent of the assets of the banking industry. Trust companies, credit unions, and caisses populaires also accept deposits that are used as money, but those deposits are a small fraction of the total of deposit money. As a result, bank deposits are the focus of our discussion of money in Canada.
The Bank of Canada is Canada's central bank. It is the source of the bank notes used to make payments and held as cash reserves by commercial banks. Established by the government in 1935, it has the responsibility to regulate the national money supply and support the operation of financial markets. The Bank's power to meet these responsibilities comes from its monopoly on the issuance of bank notes.
Bank of Canada: Canada's central bank.
The Bank of Canada also is the provider of:
• Banking services for the commercial banks in the system
• Banking services for the federal government
• Lender-of-last-resort facilities in times of liquidity crises and reserve shortfalls
Commercial banks hold some of their reserves as deposits in the Bank of Canada, and make payments among themselves using their Bank of Canada deposits. These interbank payments arise from wire transfers, direct deposits, pre-authorized debits, bill payments, point-of-sale debits, and online payments made by bank customers. For example, cheques written by customers at one bank, say Scotiabank, but paid to and deposited by customers of the Royal Bank result in transfers of deposits between these banks. To settle these transfers, Scotiabank must pay the Royal Bank. Funds held by Scotiabank on deposit in the Bank of Canada are used for this purpose. They are called "settlement balances." In 2016, Payments Canada, which coordinates this clearing of interbank transactions, handled more than 7.4 trillion transactions including 600 million cheques and 4.5 billion point-of-sale debits.
The government holds some deposits in the Bank of Canada. Government receipts, like income taxes paid to the Receiver General, are deposited in government accounts in the Bank of Canada. Government payments like Old Age Security, Employment Insurance benefits, bond interest, and income tax refunds are paid with government cheques or transfers drawn on its Bank of Canada account. Government funds over and above those needed to make regular payments are held on deposit in the commercial banks, and earn interest income for the government.
The key difference between a central bank and the commercial banks in the banking system is the profit motive. Central banks do not pursue profits. Their operations focus on the management of the cash reserves available to the public and the banks. The supply of cash reserves affects the behaviour of other banks and financial markets more generally. This is the monetary policy role of the central bank. We will examine it in detail in Chapter 10.
Commercial banks, on the other hand, are profit-oriented businesses. They operate, as we will see shortly, to maximize the profit they earn for their owners. To this end, they offer banking services to the public. Using the notes and deposits issued by the Bank of Canada as reserves, they issue bank deposits to their customers—which are widely used as the medium of exchange—and they make loans to finance purchases made by businesses and households.
To illustrate the business of these banks, Table 8.3 shows the consolidated balance sheet of Canadian chartered banks in December 2016. In the table we see that the banks held small cash balances as reserves against their deposit liabilities. Their other Canadian assets were mainly loans to households and businesses, including mortgage loans, and their holdings of financial securities. Because cash and many of their financial securities have high liquidity, banks can make long-term loans and still have cash and funds available if depositors withdraw their money.
Liquidity: the cost, speed, and certainty with which asset values can be converted into cash.
Table 8.3 Balance sheet of Canadian chartered banks, December 2016
Assets billions Liabilities billions
\$ \$
Canadian dollars: Canadian dollars:
Cash
33.5
Personal deposits
927.9
Government of Canada securities
275.6
Non-personal deposits
830.3
Corporate securities
193.6
Government deposits
17.2
Personal and business loans
951.0
Advances from Bank of Canada
1.0
Mortgages
1,127.5
Other liabilities
807.0
Foreign currency assets
2,585.7
Foreign currency liabilities
2,638.3
Other assets
54.8
Total assets 5,221.7 Total liabilities and shareholders' equity 5,221.7
Source: Bank of Canada, Banking and Financial Statistics, December 2016, Tables C3 and C4 and author's calculations. Figures have been rounded to one decimal place.
However, many loans to businesses and households are quite illiquid. The bank cannot easily get its money back in a hurry. This is not really a cause for concern when people and businesses have confidence in the banks and make widespread use of bank deposits as money. Payments and receipts are both in bank deposit form, which are cleared quickly and efficiently through the cheque-clearing and transfer facilities. Banks need only small cash balances to cover the net clearings and net public demand for cash. In Table 8.3, the banks are holding only \$33.5 billion against deposit liabilities of \$1,775.4 billion.
Canadian banks also carry on important international banking operations, as do banks in many other countries. We see this business recorded on the balance sheet as foreign currency assets and liabilities. The foreign currency assets are mainly loans to customers and holdings of foreign financial securities. Foreign currency deposits of customers are the main foreign currency liabilities. These foreign currency operations are similar to the banks' domestic currency operations. The banks provide loan financing to customers needing foreign currency to make payments in other countries, and they provide deposit facilities for customers using foreign currency for international transactions.
Competition and co-operation are important to the efficient operation of the banking system. Banks compete among themselves for customer deposits and customer loans. Some of the competition for deposits is based on the location, convenience, and quality of bank branches, some on the offers of service packages including personal financial advice and wealth management, and some on the interest rates offered on deposit balances. If you watch TV, you are probably aware that some small banks like President's Choice Financial and Tangerine Bank offer you a relatively high interest rate and will make no service charges if you would put some of your funds on deposit with them. Success in attracting deposits is very important to size and growth of a bank's business.
Credit-worthy customers willing to borrow funds are equally important to a bank's operations. Interest income earned on customer loans is the major source of bank revenue. As a result, banks compete in the personal and business loan markets, using both the terms of loans and the interest rates charged on loans to attract borrowers. The market for mortgage funds is one of the most competitive areas of bank operations. Mortgage rates and terms are advertised widely in the media and in displays in bank offices and even in supermarkets.
Despite this competition for deposits and loans, the banking system depends on the co-operation among banks that makes deposits the medium of exchange. Co-operation in the cheque-clearing system and the debit card Interac system are two important examples of banks working jointly to provide the payments system. A cheque book or a debit card is not very useful if it can make payments only to other people or businesses that do business with the same bank you use. Joint interests in VISA and MASTERCARD are a second important part of inter-bank co-operation that makes these cards widely acceptable as a source of credit.
There are also important areas of bank co-operation on the lending side of their operations. It often happens that businesses and industries have projects that need more financing than any one bank can or wants to provide. However, several banks might agree to provide funding jointly, increasing their lending capacity and spreading the risks associated with the project among them.
These dimensions of competition and co-operation among banks, and their contribution to the efficient functioning of the money and financial sector of the economy, appear regularly in the debate over bank mergers in Canada.
Banking operations and profits
A commercial bank is a profit-oriented business. Its profits come from the difference between what it costs it to raise funds and the revenues it earns from lending. To bring deposits in, the bank offers customers a range of banking services, including safekeeping, record keeping, access to banking offices or bank machines, chequing, internet banking, e-transfers and debit card facilities, and interest income on some types of deposits. Service charges or fees cover the costs of some of these services. The interest payments to depositors are the main net cost of funds to the bank.
To be profitable, banks have to find ways to lend, at acceptable levels of risk, the funds they have attracted from depositors. Table 8.3 shows how banks lend their money. In Canadian dollars, most is lent to households and businesses at interest rates established for different types of personal, business, and mortgage lending. Some is used to buy government securities and other financial assets, usually with a short time to maturity. These assets pay a lower rate of interest than loans, but they are more liquid and provide the banks with funds if people decide to withdraw a lot of money from their deposit accounts. Notice that the banks also hold some cash, on which no interest is earned, to cover the day-to-day clearing balances that come from the withdrawals, deposits, and transfers made by their customers.
Bank profits come from the difference or spread between the interest cost of raising funds from depositors and the interest income earned on bank assets. If, for example, the banks pay, on average, 4 percent on their deposit liabilities of all types and earn, on average, 6 percent on their assets of all types, their net interest income would be 2 percent. To take an actual example, the Scotiabank Annual Report for 2016 reports net interest income of 2.38 percent of average assets in 2016. Scotiabank net interest income was higher than the same quarter of the previous year as a result of asset growth in residential mortgages, consumer auto and commercial lending, which increased deposit to lending interest rate spreads. The other large banks report net interest income of the same order of magnitude but there are variations among them. The key to profitability is choosing the right mix of high-quality (low-risk) loans and investments while at the same time controlling the costs of raising funds.
Net interest income: the excess of loan interest earned over deposit interest paid.
As we saw in Table 8.3 Canadian banks held only \$33.5 billion in cash against \$1,775.4 billion in personal and non-personal deposit liabilities. Their cash reserve assets were about 1.9 percent of their total deposits. The skill in running a bank entails being able to judge just how much must be held in liquid assets, including cash, and how much can be lent out in less liquid forms that earn higher interest income. The profit motive pushes the bank toward riskier, higher interest paying assets and higher net interest income. Banker's risk, the risk that customers will withdraw their deposits and demand cash, pushes the bank toward holding higher cash balances. But cash balances earn no interest income and reduce the bank's net interest income.
Bankers risk: the risk that customers may demand cash for their deposits. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/08%3A_Money_banking_and_money_supply/8.03%3A_Banking_in_Canada_today.txt |
Banks create money when they increase their deposit liabilities to pay for the loans they make to customers, or for the financial securities they buy. The public uses the deposit liabilities of the banks as money to make payments or to hold as a store of wealth. There are four key conditions that give banks the ability to create money:
1. The non-bank public has confidence in banks and is willing to hold and use bank deposits as money.
2. The non-bank public is willing to borrow from the banks to finance expenditure or asset purchases.
3. The banks are willing to operate with cash reserves equal to some small fraction of their deposit liabilities.
4. The banks are willing to accept the risks involved in lending to the non-bank public.
If any of these is absent, the banks cannot create money, although they may provide safekeeping services.
The first two conditions underlie the demand for banking services. Banks acquire cash by providing customers deposit services and bank customers use bank loans as a source for funds to pay for purchases of goods, services and financial assets like equities and bonds. If the non-bank public is unwilling to use bank services there is no banking industry.
The third condition required for the banks to create money is a bank reserve ratio that is less than one. The reserve ratio (rr) is the ratio of cash on hand to deposit liabilities that banks choose to hold.
(8.1)
Reserve ratio (rr): the ratio of cash reserves to deposit liabilities held by banks.
Cash holdings are reserve assets. If banks choose to hold reserves equal to their deposit liabilities, rr=1 and the banks cannot create deposits. They are simple safety deposit boxes.
A simplified case shows how banks can and do create deposits. Assume banks use a reserve ratio of 10 percent (rr=0.10). Suppose initially the non-bank public has wealth of \$1,000 held in cash, before they decide to switch to bank deposit money. This cash is a private sector asset. It is a liability of the central bank or government, which issued it, but not a liability of the private banks. The 'Initial position' in Table 8.4 uses a simple balance sheet to show this cash as an asset of the non-bank private sector.
Table 8.4 How the banking system creates money
Banks Non-bank public
Assets Liabilities Assets Liabilities
Cash 0 Deposits 0 Cash 1,000 Bank loans 0
Cash 1,000 Deposits 1,000 Cash 0 Bank loans 0
Deposits 1,000
Cash 1,000 Deposits 10,000 Cash 0 Bank loans 9,000
Loans 9,000 Deposits 10,000
Then in the second part of the table people deposit this \$1,000 of cash into the banks by opening bank accounts. Banks get assets of \$1,000 in cash, distributed among individual banks by their customers and issue total deposit liabilities of \$1,000. These deposits are money the banks owe to their depositors. If banks were simply safety deposit boxes or storerooms, they would hold cash assets equal to their deposit liabilities. Their reserve ratio would be 100 percent of deposits, making rr=1.0. Table 8.4 would end with part 2.
However, if the public uses bank deposits as money, the banks don't need all deposits to be fully covered by cash reserves. It is unlikely that all depositors will show up at the same time and demand cash for their deposits. Recognizing this, the banks decide that reserves equal to 10 percent (rr=0.10) of deposits will cover all net customer demands for cash. In this case, the banks have excess reserves which in total equal 90 percent of their deposit liabilities or, initially, \$900.
The banks use their excess reserves to expand their lending. Each bank makes new loans equal to its excess reserves. It pays for those loans by creating an equal amount of deposits. If you were to borrow from bank your personal deposit would be increased by the amount of the loan. The same thing happens to other people who borrow from their banks.
In our example, all banks combined can create \$9,000 of loans based on \$1,000 in new cash reserves. In part 3 of Table 8.4, we see loans of \$9,000, as assets on the banks' balance sheets, and \$9,000 of new deposits to customers, against which they can write cheques or make payments online or by transfers. The newly created deposits of \$9,000 are a part of the \$10,000 liability on the banks' balance sheets. The public now has bank deposit assets of \$10,000 and liabilities, loans owed to the banks, of \$9,000. Non-bank public net worth, assets minus liabilities is \$1,000, the cash they originally deposited in the banks. Because the public uses bank deposits as money, the banks can buy new loans by creating new deposits.
The reserve ratio is 10 percent in part 3 of Table 8.4 ( cash/\$10,000 deposits =0.10 or 10%). It does not even matter whether the 10 percent reserve ratio is imposed by law or is merely smart profit-maximizing behaviour by the banks that balances risk and reward. The risk is the possibility of being caught short of cash; the reward is the net interest income earned.
Why were the banks able to create money? Originally, there was \$1,000 of cash in circulation. That was the money supply. When paid into bank vaults, it went out of circulation as a medium of exchange. But the public got \$1,000 of bank deposits against which cheques could be written. The money supply, cash in circulation plus bank deposits, was still \$1,000. Then the banks created deposits not fully backed by cash reserves. Now the public had \$10,000 of deposits against which to write cheques. The money supply rose from \$1,000 to \$10,000. The public was willing to use bank deposits as money, willing to borrow from the banks and the banks were willing to lend. This allowed the banks to create money by making loans based on their fractional reserve ratio.
Alternatively, suppose the public loses confidence in banks and withdraws and holds more currency. The banks are still able to create deposits but the extent of the deposit creation is limited by the public's withdrawal of currency. Bank reserves are reduced. A fall in public confidence in the banks in times of financial problems and bank failures like those in that arose in the autumn of 2008 and even today in some European countries would result in a rise in the currency holdings outside banks. Bank deposits and lending capacity would be reduced as a result, and in extreme cases bank solvency might be at risk without central bank support.
Financial panics
Most people know that banks operate with fractional reserve ratios and are not concerned. But if people begin to suspect that a bank has lent too much, made high risk loans or faces problems in raising funds which would make it difficult to meet depositors' claims for cash, there would be a run on the bank and a financial panic. Recognizing the bank cannot repay all depositors immediately, you try to get your money out first while the bank can still pay. Since everyone does the same thing, they ensure that the bank is unable to pay. It holds cash equal to a small percentage of its deposit liabilities and will be unable to liquidate its loans in time to meet the demands for cash.
Financial panic: a loss of confidence in banks and rush to withdraw cash.
Banking problems in Greece in the spring and early summer of 2015 provide an example. Concerns that the Greek government might default on loan payment agreements with IMF and European Union raised the possibility that Greece might leave the euro and return to its earlier national currency: the drachma. Should that happen, all euro deposits in Greek banks would convert to drachmas at an exchange rate that would reduce their real value substantially. Fearing this possibility, depositors in Greek banks tried to withdraw their balances in cash while they were still convertible into euros.
Greek banks, like other banks, operate on a fractional reserve basis. They could not meet this 'run on the bank' without outside support and assistance. The European Central Bank provided emergency cash to the banks but the run continued. In response, limits were placed on the amount of cash a depositor could withdraw at any one time. These measures sustained the banks until a solution to Greek debt crisis was negotiated and immediate concerns about Greek membership in the euro and the value of Greek bank deposits subsided.
However, earlier experience shows how financial crises can arise in other ways. In 2008-2009 the crisis originating in the US mortgage market and real estate sector caused wide spread problems for banks. Many banks had become reliant on large denomination, short-term deposits as sources of funds to support their mortgage lending. Other non-bank financial institutions like insurance companies and pension funds, as well as a relatively small number of individual customers bought these deposits. As the recession and falling property values emerged, the financial community began to worry that home-owners would not be able to pay back their mortgages.
If that happened banks would not be able to pay back depositors money, especially the large denomination short-term deposits. Once non-bank portfolio managers realized that it was difficult if not impossible to evaluate the risks of large denomination deposits, financial institutions that relied on renewing and issuing new deposits to raise funds were in difficulties. The supply of funds to replace expiring deposits dried up and banks could not repay depositors. Several large financial institutions in the United States and in other countries required government rescues or failed. The plight of famous names like Bear Sterns, Countrywide Financial, Fannie May, and Freddie Mac became headline news.
Banks in Canada were not immune to the financial difficulties created by the collapse of the large denomination deposit markets. All the major chartered banks were holding some. They were forced to accept that without a market these deposits would no longer be a source of funds. Fortunately, Canadian banks relied more heavily on strong smaller retail depositor bases as sources of funds. The banks remained financially strong and public confidence in the banks did not collapse. No Canadian bank failed or required a government bailout.
Fortunately, financial panics involving depositor runs on the bank are rare, particularly in Canada. A key reason for this, which we discuss in the next chapter, is that the central bank, the Bank of Canada, and other national central banks, will lend cash to banks in temporary difficulties. Furthermore, deposit insurance plans like the Canadian Deposit Insurance Corporation, CDIC, cover individual bank deposits up to \$100,000 against default. Knowledge of these institutional arrangements helps prevent a self-fulfilling stampede to withdraw deposits before the bank runs out of cash.
By contrast, the financial crisis and the extended real estate and credit collapse in 2008 created large problems for US banks. Loan and financial asset defaults destroyed bank assets and bank liquidity. Even in the absence of panics and bank runs, many banks became insolvent without sufficient liquid assets to cover their liabilities. Failed bank data illustrates the scale of the problem. The US Federal Deposit Insurance Corporation lists 457 US bank failures over the period January 2008 to September 2012. In the four preceding years, January 2004 to December 2007 there were just 7 US bank failures. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/08%3A_Money_banking_and_money_supply/8.04%3A_Money_created_by_banks.txt |
Table 8.1 showed that bank deposits are the major component of the money supply in Canada, as in most industrial countries. Bank deposits depend in turn on the cash reserves held by banks and the public's willingness to hold bank deposits and borrow from the banks.
To complete our analysis of how the money supply is determined, we need to examine three things:
1. The source of the cash in the economy.
2. The amount of that cash that is deposited in the banking system, rather than held as cash balances by the public.
3. The relationship between the cash supply to the economy and the money supply that results from public and bank behaviour.
Today, in developed countries, central banks are the source of bank reserves. The central bank, the Bank of Canada in Canada, controls the issue of token money in the form of Bank of Canada notes. These are the \$5, \$10, \$20, \$50, and \$100 bank notes you can withdraw from the bank when you wish to covert some of your bank balance to cash. Bank reserves are mainly the banks' holdings of these central bank notes in their vaults and bank machines. Our bank deposits are now convertible into Bank of Canada notes. The central bank has the responsibility to manage the supply of cash in the economy. We will examine the details of central bank operations in Chapter 10.
The cash the central bank provides to the economy is called the monetary base (MB) and is sometimes referred to as the stock of high-powered money. It is the legal tender into which bank deposits can be converted. It is the ultimate means of payment in transactions and the settlement of debts. Notes and coins in circulation and held by the banking system are the main part of the money issued by the central bank. As we discussed earlier, the commercial banks hold small settlement balances in the central bank to make inter-bank payments arising from cheque clearings.
Monetary base (MB): legal tender comprising notes and coins in circulation plus the cash held by the banks.
The public's decisions about the use of cash or banks deposits determine how much of the monetary base is held by the banks. The simple example of deposit creation in Table 8.4 assumed the public deposited all its cash with the banks. This was a useful simplification that ignores changes in the cash people hold. We will drop this assumption in what follows.
Our main interest is the relationship between the money supply in the economy, the total of cash in circulation plus bank deposits, and the monetary base created by the central bank. Assuming the public holds just a small fixed amount of cash and using our earlier discussion of the fractional reserve ratio in the banking system, we can define a deposit multiplier. The deposit multiplier provides the link between the monetary base created by the central bank and the money supply in the economy. It also predicts the change in money supply that would result from a change in the monetary base supplied by the central bank.
Deposit multiplier: the change in the bank deposits caused by a change in the monetary base.
The value of the deposit multiplier depends on rr, the banks' ratio of cash reserves to total deposits. Banks' choice of a ratio of cash reserves to total deposits (rr) determines how much they can expand lending and create bank deposits based on their reserve holdings. The lower the reserve ratio (rr), the more deposits banks can create against given cash reserves, and the larger is the multiplier. This is the relationship illustrated in Table 8.4.
Similarly, the lower the non-bank public's holding of cash, the larger is the share of the monetary base held by the banks. When the banks hold more monetary base, they can create more bank deposits. The lower the non-bank public's currency ratio, the larger are bank holdings of monetary base and the larger the money supply for any given monetary base.
The money multiplier
Suppose banks wish to hold cash reserves R equal to a fraction rr of their deposits D. Then:
(8.2)
To keep the example simple assume that we can ignore the small amount of cash held by the non-bank sector. As a result, the monetary base is mainly held as cash in bank vaults and automatic banking machines. This means from Equation 8.2 that:
(8.3)
and the deposit multiplier, which defines the change in total deposits as a result of a change in the monetary base, is:
(8.4)
which will be greater than 1 as long as rr is less than 1.
If, for example, banks want to hold cash reserves equal to 5 percent, and the non-bank public does not change their holdings of cash, the deposit multiplier will be:
When public cash holdings are constant, the deposit multiplier tells us how much deposits (and therefore the money supply in the economy), notes, and coins in circulation (outside the banks and bank deposits) would change as a result of a change in the monetary base. In this example, a \$1 change in the monetary base results in a change in deposits and the money supply equal to \$20.
(8.5)
We can see from the way we have found the deposit multiplier that it depends on the decisions made by the banks in terms of their reserve holdings. For simplicity the public holds a fixed amount of cash in addition to bank deposits as money. If you experiment with different values for rr, you will see how the deposit and money multiplier would change if the reserve ratio were to change. Furthermore, if the public were to change their cash holdings the cash reserves available to the banks would change and the deposit multiplier would cause a larger change in the money supply.
The importance of bank reserve decisions and public cash holdings decisions is illustrated by recent financial conditions in Europe. As a result of banking crisis and bailouts during and after the financial crisis of 2008, the public had concerns about the safety of bank deposits and decided to hold more cash. At the same time banks found it difficult to evaluate the credit worthiness of potential borrowers and the risks involved in short-term corporate lending or junior government bonds. The public's cash holdings increased and the banks increased their reserve ratios. These shifts in behaviour would reduce the money supply, making credit conditions tighter, unless the central bank provided offsetting increases in the monetary base.
How big is the money multiplier?
Now that we have a formula for the money multiplier, we can ask: What is the size of the multiplier in Canada? Based on data in Table 8.1 above, in January 2017, the monetary base was \$84.6 billion, and the money supply defined as M1B was \$814.8 billion. These data suggest a bank reserve ratio with respect of M1B which is approximately 10.4 percent giving a money supply multiplier of 1/0.104=9.6.
Each \$100 change in monetary base would change the money supply by about \$960.
However, using a broader definition of money supply such as 'currency outside banks and all chartered bank deposits' gives a Canadian money supply of \$1,510.5 and a money multiplier of \$1,510.5/\$84.6 = 17.85.
Figure 8.1 summarizes the relationship between the monetary base and the money supply. It shows the monetary base used either as cash in circulation or held as cash reserves by the banks. Since banks operate with fractional reserve ratios, the leverage banks have to expand the money supply through their lending and deposits creation based on their reserves RR. We also see that the money supply is heavily dependent on the size of the monetary base, reserve ratios used by the banks and the willingness of the public to hold bank deposits and the willingness of the banks to lend.
Figure 8.1 The monetary base and the money supply
The explanation of banking and the money supply in this chapter provides the money supply function we will use in the next chapter. It is combined there with a demand for money function in the money market to determine the equilibrium rate of interest. That rate of interest integrates money and financial markets with the markets for goods and services in aggregate demand.
A simple money supply function illustrates the determinants of the money supply. The three key variables are:
1. MB, the monetary base;
2. the public's holdings of cash; and
3. rr, the banks' reserve ratio.
Using Equation 8.5 above, where M is the money supply, we can write:
(8.6)
The central bank's control of the monetary base, MB, gives it control of the money supply, M, as long as cash holdings and rr are constant.
Figure 8.2 uses a diagram to illustrate the money supply function and changes in the money supply. The line M0 shows the size of the money supply for a given monetary base MB0 and the money multiplier. The money supply in this diagram is vertical, because we assume cash holdings and the reserve ratio are not affected by the interest rate. M is therefore independent of the nominal interest rate i, which is measured on the vertical axis. This is the supply side of the money market with quantity measured on the horizontal axis and interest rate, which is analogous to price, on the vertical axis.
Figure 8.2 The money supply function
The vertical M1 illustrates the increase in the money supply as a result of an increase in monetary base from MB0 to MB1, working through the money multiplier. A reduction in the monetary base would shift the M line to the left based on the same relationship.
Monetary policy
The central bank conducts monetary policy through its control of the monetary base. The money supply function shows us how, if rr is constant, the central bank's control of the monetary base gives it the power to change money supply and other financial conditions in the economy. If the central bank increases the monetary base, banks have larger cash reserves and increase their lending, offering favourable borrowing rates to attract new loans and create more deposits. In Figure 8.2 the increase in the monetary base to MB1 causes an increase in money supply () by the change in MB (), multiplied by the money multiplier. The money supply function shifts to the right to M1. A decrease in the monetary base would shift the M function to the left, indicating a fall in the money supply.
Next
Now that we have examined money, the banking system, and the size of the money supply, we have one important side of the financial market that will link money to expenditure and economic activity. This is the supply side of the market. In the next chapter, we will study the reasons why people wish to hold money balances. We also study how the portfolio choices people make between money and other assets create the demand for money balances. The interaction between the supply of money balances and the demand for money balances determines the prices of financial assets and interest rates. Interest rates in turn provide an important link between money, financial markets, and expenditures in markets for goods and services, both directly and through the foreign exchange rate. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/08%3A_Money_banking_and_money_supply/8.05%3A_The_monetary_base_and_the_money_supply.txt |
Money has four functions: a medium of exchange or means of payment, a store of value, a unit of account, and a standard of deferred payment. The medium of exchange function distinguishes money from other assets.
In a barter economy, trading is costly because there must be a double coincidence of wants. Money, a medium of exchange, reduces the costs of exchange and allows resources to be used for other things.
A token money is a convertible claim on commodity money. Because its monetary value greatly exceeds its production costs, token money economizes on the resource costs of transactions.
Fiat money is money the government has declared legal tender. The central bank controls the supply of legal tender.
The Canadian money supply is the sum of currency in circulation outside the banks and bank deposits.
The monetary base is comprised of notes and coins in circulation plus cash held by banks.
The Canadian banking system is made up of a central bank and a number of commercial banks and other institutions called near banks.
Banks are financial intermediaries. Bank deposits, which can be transferred by cheque or debit card, provide a convenient means of payment. Bank services plus interest payments on deposits attract funds into the bank. Banks use these funds to make loans, purchase securities, and finance expenditures. The general acceptance of bank deposits as money, and well-developed financial markets, allow modern banks to operate with very low cash reserve ratios.
Banks create money by making loans and creating deposits based on a fractional cash reserve ratio, rr. The banks' reserve ratio involves a trade-off between earnings and bankers' risk.
The monetary base MB is currency in circulation plus banks' cash reserves. The money multiplier is a ratio of a change in the money supply to the change in the monetary base that caused it, . The money multiplier is larger the smaller is the cash reserve ratio of the banks, rr.
The money supply, M, is currency in circulation plus bank deposits. The size of the money supply is determined by the monetary base, MB, the banks' cash reserve ratio, rr, and the private sector's cash holdings, when cash holdings are constant. From Equation 8.5:
8.07: Exercises for Chapter 8
Exercises for Chapter 8
EXERCISE 8.1
What are the functions of money? What is money in Canada today? What is the money supply in Canada today? Are debit cards and credit cards money?
EXERCISE 8.2
Since both central banks and commercial banks can create money what is the key difference between a central bank, like the Bank of Canada, and the many commercial banks in the financial industry?
EXERCISE 8.3
Suppose the banks receive \$100 cash from a new deposit of funds previously held outside the banking system. If banks operate with a 5% reserve ratio, use simple balance sheets to show by how much this new cash would affect lending and deposits of all banks in the system.
EXERCISE 8.4
If banks have a 10% reserve ratio how much lending and deposit creation can they undertake after they receive a new \$1,000 cash deposit? Would it be in the banks' interest to find ways to reduce any cash balances the public holds? Why?
EXERCISE 8.5
What protection does the Canadian Deposit Insurance Corporation provide for your money if your bank is unable to pay cash to its depositors?
EXERCISE 8.6
Define the money multiplier and explain how it might be used.
EXERCISE 8.7
Suppose a crisis in financial markets, like the collapse of public willingness to hold large denomination term deposits in 2007 and 2008, increases the risk banks attach to lending and the non-bank public attaches to all bank deposits. What are the implications for the desired reserve ratio, the money supply multiplier, and the money supply?
EXERCISE 8.8
Using a diagram illustrate and explain the determinants of the position and slope of the money supply function assuming an initial monetary base of \$1,000 when . If the monetary base were to increase by 10% how would the money supply and the money supply function in your diagram change? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/08%3A_Money_banking_and_money_supply/8.06%3A_Key_Concepts.txt |
Interest rates are everywhere. They provide income to lenders and impose costs on borrowers. Many types of bank and near-bank deposits pay interest income to their holders, as do guaranteed investment certificates (GICs) and bonds issued by businesses and governments and other income paying assets. These are assets to holders and liabilities to issuers in terms of interest payments and redemptions.
Households, businesses and governments borrow using consumer loans, credit cards, lines of credit, mortgages, leases, bonds and other forms of debt. The interest rate attached to these borrowings is a cost of financing expenditures not covered by current income.
The interest rate links financial markets to markets for goods and services. But what is 'the interest rate'? There are different interest rates attached to different forms of borrowing. There are different spectrums of interest rates based on the terms of the loan and the perceived risk of default. However, it is usually the case that interest rates across a spectrum rise or fall together. Changes in 'the interest rate' describe these shifts up or down across the spectrum for all assets.
This chapter addresses two key questions:
1. How is the interest rate determined?
2. How does the interest rate affect aggregate demand?
Explaining why the public decides to hold some wealth in money balances rather than other types of financial assets is the first step.
09: Financial markets interest rates foreign exchange rates and AD
A financial portfolio is a collection of financial assets. It might include money balances, bonds, equities, mortgages, and mutual funds. The structure of a portfolio, the proportion held in each type of asset, reflects two main characteristics of the assets involved:
1. The returns paid by different financial assets
2. The risks arising from changes in the market prices of assets
Wealth holders and institutional portfolio managers for pension funds and insurance companies like their portfolios to pay high returns with low risk. To achieve this, they hold mixed portfolios of money and other financial assets.
Suppose you win \$10 million in a lottery. Now that you have wealth, what are you going to do with it? You will no doubt spend some and give some away. That is a wealth effect, but what about the balance of your winnings? You have to make a portfolio choice. Will you hold your wealth as money in the bank? Will you put your money in the stock market? Will you put your money in the bond market?
If you consult a financial planner, he or she will probably recommend a mixed portfolio made up of money, bonds, and equities. That recommendation will be based on your intention to increase your wealth and draw income from it while protecting it from losses in financial markets.
Money holdings are an important part of the portfolio. Money is the medium of exchange. It can be used directly to make payments for goods and services or to settle debts. Other assets, for example bonds, cannot be used as a means of payment. Furthermore, money has a fixed nominal price. It is a "safe asset." Wealth held as money does not rise or fall with the rise or fall in financial asset prices on stock and bond markets. However, money is exposed to the risk that inflation will lower its real purchasing power.
Other financial assets differ from money in three respects. First, they cannot be used as a means of payment. To use them to make a payment you would first have to sell them for money, at their current market price, and then use the money to make the payment. Second, they offer a return in the form of an interest payment, a dividend payment, or a rise in price that provides income to the portfolio holder. Third, because the prices of financial assets like bonds or stocks fluctuate daily on financial markets, these assets carry the risk that their values may decline significantly from time to time.
Portfolio management recognizes these differences between assets by trading some return for lower risk and greater convenience in the mix of assets held. Money in the portfolio offers the convenience of the means of payment, providing low risk but zero return. Other assets offer a flow of interest and dividend income, and possible capital gains if asset prices rise, but the risk of capital loss if prices fall.
This portfolio choice between money balances and other assets is the basis for our discussion of the demand for money balances in the remainder of this chapter.
Bond prices, yields and interest rates
The demand for money comes from an understanding of the relationship between interest rates, bond coupons, the prices of financial assets, and yields on financial assets. To keep the examples simple assume only one type of financial asset, a bond. However, the prices and yields of other financial assets are related to interest rates in the same way as bond prices.
Several basic concepts and definitions are important. A bond is an asset that makes one or more fixed money payments to its holder each year until its maturity date. On its maturity date, it also repays its principal value. Governments and businesses issue and sell bonds on financial markets to raise funds to finance expenditures.
Bond: a financial contract that makes one or more fixed money payments at specific dates in the future.
The interest rate is the current market rate, expressed as a percentage, paid to lenders or charged to borrowers.
Interest rate: the current market rate paid to lenders or charged to borrowers.
A bond coupon is the fixed money payment made annually to the holders of the bond from the date of issue until the date of maturity. The coupon rate is a fixed percentage of the principal value of the bond at the time of issue. For example a 3% bond pays \$3.00 annually per \$100 of principal until its maturity date.
Bond coupon: the annual fixed money payment paid to a bond holder.
The price of a marketable bond is the current price at which it can be bought or sold on the open bond market at any time between its date of issue and its maturity date.
Price of a marketable bond: the current price at which the bond trades in the bond market.
The yield on a bond is the return to a bond holder expressed as an annual percentage rate, which is a combination of the coupon payments and any change in the market price of the bond during the period in which it is held.
Yield on a bond: the return to a bond holder expressed as an annual percentage.
Bond prices depend on current market interest rates. The current price of a bond is the present value of the future payments it will provide. The present value is the discounted value of those future payments. It recognizes that money payments in the future are worth less than money payments today.
Bond price: the present value of future payments of interest and principal.
Present value is the discounted value of future payments.
To help understand present value, ask the following question: If someone promises to give you \$1,000, would you rather have it today or a year from today? Notice that \$1,000 lent at an interest rate of 3% (i.e. 3/100=0.03) would give you a sum of:
one year from today. In the same way, the amount of money you need to lend today to have \$1,000 one year from today is:
When the market rate of interest is 3 percent, the present value of \$1,000 to be received one year in the future is \$970.87.
Experimenting with different interest rate assumptions in this present value calculation illustrates that the present value of \$1,000 to be paid one year from today changes with the rate of interest. Higher interest rates reduce present values while lower rates increase them. For example, if the current market rate is 5% the present value of \$1,000 to be received one year from today is:
This relationship is the key to understanding bond prices and how they fluctuate over time. A rise in market interest rates lowers the present value of fixed future payments. A fall in market rates increases present values of fixed future payments.
In general, because the future payments offered by bonds are fixed in dollar terms, the prices of marketable bonds vary inversely to market rates of interest. Rising interest rates mean falling bond prices, and falling interest rates mean rising bond prices. There are many types of bonds that differ by coupon, maturity date, frequency of future payments, and in other ways. However, the relationship between prices, yields, and interest rates remains the same. Because bond prices are the present value of future payments, prices and interest rates move in opposite directions.
Furthermore, the size of the change in the price of a bond as a result of a change in the interest rate depends on the bond's term to maturity. The prices of longer-term bonds are more volatile than those of shorter-term bonds. This an important consideration for bond portfolio managers concerned with trade-offs between risk and return.
Asset markets like the bond market are very active. Large volumes of bonds are bought and sold every business day. Example Box 9.1 at the end of the chapter gives a more detailed example of the relationship between market interest rates and bond prices. You can find a long list of outstanding bonds and see their coupons, term to maturity and current prices and yields at:
http://www.globeinvestor.com/servlet/Page/document/v5/data/bonds/ | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/09%3A_Financial_markets_interest_rates_foreign_exchange_rates_and_AD/9.01%3A_Portfolio_choices_between_money_and_other_assets.txt |
Canadians held M2 money balances of \$1,510 billion in January 2017. Three variables that may explain the size of these holdings are: the interest rate, the price level, and real income. Together they provide the basis for a theory of the demand for money.
Why hold money?
It is important to distinguish between money and income when discussing the demand for money. You might have a high income but no money, or no income and lots of money. That is because income is a flow of funds over a period of time. If you spend your income as it is received you will not accumulate a stock of money. Alternatively, you might have a stock of money or a money balance but no income. Then you can choose to either hold or spend your money. If you have no income you can finance a flow of expenditures by spending your money balance.
In Chapter 8, money was a means of payment and a store of value. Those two functions motivate the demand to hold at least some wealth in money balances. There are alternative stores of value. Bonds, equities, precious metals, real estate, and art are a few examples. The quantity of money people choose to hold is part of the portfolio decision they make about their wealth. They choose money instead of some other asset.
To develop the demand for money balances it is useful to simplify the portfolio decisions by assuming there are only two assets:
1. Money, which has a constant money price, pays no interest income but does serve as the means of payment.
2. Bonds, representing all interest-earnings assets, have money prices that change if market interest rates change, but are not means of payment.
The financial wealth people build up by saving some of their income calls for a decision. People could hold this wealth as money, which pays no interest, but is a safe asset because its price is constant. Or they could hold this wealth in bonds, which pay interest income but are risky because bond prices move up and down as market interest rates move down and up. If the expected return to holding bonds is positive (due to the interest rate together with any change in price) why would people hold any money balances?
The demand for money comes in three parts, namely:
1. The transactions demand;
2. The precautionary demand; and
3. The asset or speculative demand.
The transactions demand
As the name suggests, the transactions demand for money is based on money being the means of payment. People and businesses hold some money to pay for their purchases of goods, services and assets. This demand reflects the lack of coordination of receipts and payments. Income is paid bi-weekly or monthly but purchases are made more frequently and in smaller amounts. Pocket money and bank balances that can be transferred by debit card are readily available to make these purchases between paydays. If all income receipts were used on paydays to buy bonds to earn interest income it would be costly and inconvenient to sell bond holdings bit by bit as payments were made. The costs of frequent switching between money, bonds and money would more than offset any interest income earned from very-short-term bond holdings.
The precautionary demand
Uncertainty about the timing of receipts and payments creates a precautionary demand for money balances. There are two sides to this uncertainty. On one side there may be some unexpected changes in the timing or size of income receipts. Regular payments can still be made if enough money is available, over and above that need for usual expenses and payments. Alternatively, unexpected or emergency expenses in terms of appliance, computer or car breakdowns or unexpected opportunities for bargains or travel can by covered by precautionary money holdings. Money balances cover the unexpected gaps between income receipts and payment requirements without the costs and inconvenience of selling bonds on short notice.
The asset or speculative demand
The asset or speculative demand comes from financial portfolio decisions rather than the lack of coordination and uncertainty behind the two preceding demands. Businesses and professional portfolio managers use money balances to take advantage of expected changes in interest rates. Essentially they speculate by switching between bonds and money based on their own forecasts of future interest rates.
Recall that bond prices and interest rates vary inversely. If while holding money balances you predict a fall in interest rates, you buy bonds. If your prediction is right and interest rates do fall, the prices of your bonds rise. Now you can sell and harvest the capital gain you earned by speculating in the bond market. Alternatively, if you correctly predict a rise in interest rates and act before it happens you can avoid a capital loss on your bond holds by selling and holding money before the interest rate rises.
Even if portfolio managers are not interested in speculating on interest rate changes there is an asset demand for money. A mixed portfolio of money and bonds is less risky than one that holds only bonds. The money component has a stable market price while the bond component provides interest income along with the risk of a variable price. Changing the shares of money and bonds in the portfolio allows the manager a trade-off between return and risk. However, as interest rates rise the opportunity cost of holding a share of the portfolio in money rises. Furthermore, the estimated risk from the bond share of the portfolio may fall if interest rates are expected to fall in the near future. As a result, rising interest rates reduce the asset demand for money balances.
The demand for money function
The demand for money balances is summarized by a simple equation. Let the size of the real money balances people wish to hold for transactions and precautionary reasons (Lt) be a fraction k of GDP. With nominal GDP defined as real GDP (Y) times the GDP deflator (P), nominal . Using this notation, the demand for nominal money balances for transactions and precautionary reasons is kPY, and the demand for real balances is kY, where k is a positive fraction. When real income changes, bringing with it changes in spending, the change in the demand for real money balances changes is determined by k. This makes a link between part of the demand for money balances (Lt) and income, namely Lt=kY.
What is the value of k in Canada? In the second quarter of 2015, Canadians held money balances as measured by M2 of \$1,325 billion. Nominal GDP in that quarter was \$1,364 billion measured at an annual rate. If we divide M2 holdings by GDP, we get k=1,325/1,364=0.97, or about 97 percent of annual income. This value of k suggests that a rise in GDP of \$100 will increase the demand for money balances by \$97, measured in either nominal or real terms.
Changes in nominal interest rates also change the size of the money balances people wish to hold, based on the asset motive. A rise in interest rates increases the opportunity cost of holding money balances rather than bonds. It may also create the expectation that interest rates in the future will fall back to previous levels. As a result, people will want to use some of their money balances to buy bonds, changing the mix of money and bonds in their wealth holdings. A fall in interest rates has the opposite effect.
The way people adjust their portfolios in response to changes in interest rates results in a negative relationship between the asset demand for money balances and the nominal interest rate. Then using –h to measure the change in money balances in response to a change in interest rates can be written as . If individual and institutional portfolio mangers' decisions are very sensitive to the current interest rates, h will be a large negative number. A small rise in interest rates will cause a large shift from money to bonds. Alternatively, if portfolio decisions are not at all sensitive to interest rate changes, h would be zero.
Putting these components of the demand for real money balances together gives the demand for money function, which is a demand to hold real money balances L:
(9.1)
Figure 9.1 shows the relationship between the demand for real money balances and the interest rate, drawn for a given level of real GDP, Y0. The demand for money function would have an intercept of kY0 on the horizontal axis. At higher interest rates the opportunity cost of holding money balances is higher because the expected return from holding bonds is positive. The negative slope of the demand function shows how people change their demand for money when interest rates change. The slope of the demand curve for money is –1/h. The effect of a change in the interest rate is shown by a movement along the L function. A change in real income would require us to draw a new demand for money function, to the right of L0 if Y increased, or to the left if Y decreased.
Figure 9.1 The demand for real money balances
This straight line demand for money function is a useful simplification. However, it would be more realistic to draw the function with a decreasing slope as interest rates decline. That would capture two important ideas.
First, as interest rates fall, and fall relative to the costs of buying and selling bonds, opportunity costs decline faster than interest rates.
Second, consider the speculative demand for money. As interest rates fall, the riskiness of bonds increases. A subsequent rise in interest rates has a larger negative effect on bond prices. Expectations of future increases in interest rates may strengthen as interest rates decline. As a result, portfolio managers may shift funds increasingly from bonds to money as interests fall. If their expectations are confirmed by events they avoid the capital losses caused by falling bond prices. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/09%3A_Financial_markets_interest_rates_foreign_exchange_rates_and_AD/9.02%3A_The_demand_for_money_balances.txt |
The money supply and the demand for money in the financial market determine nominal interest rates. From Chapter 8 a nominal money supply depends primarily on the monetary base and the money multiplier, namely:
(8.6)
The demand for money is a demand for real money balances as determined by real income and interest rates.
L=kYhi
The real money supply is simply the nominal money supply M divided by the price level P, M/P, which measures its purchasing power in terms of goods and services.
Real money supply (M/P): the nominal money supply M divided by the price level P.
The central bank, as the source of the monetary base MB, controls the nominal money supply, as long as the reserve ratio rr and the public's holdings of cash are constant. The next chapter explains how the central bank manages the monetary base. If the price level is fixed, the central bank also controls the real money supply. Changes in nominal money tend to lead eventually to changes in prices. However, the central bank can still control the real money supply in the short run—it can change M faster than prices P respond—but in the long run other forces determine real money M/P. For the moment, assume the price level as fixed.
The demand for money as a demand for real money balances is summarized above. The quantity of real money demanded rises when real income rises, but falls when nominal interest rates rise.
Money market equilibrium
Figure 9.2 combines the demand curve for real money balances from Figure 9.1 with the money supply function in Figure 8.2 to give a money market diagram. The demand curve is drawn for a given level of real income, Y0, and the supply curve for a given monetary base MB0. With a given price level, the central bank controls the supply of nominal and real money. The supply curve is vertical at M0/P0. Equilibrium in the money market is at E. At the interest rate i0, the real money balances people wish to hold just equal the money supplied by the central bank and the banking system.
Figure 9.2 Equilibrium in the money market
To see how this market operates, suppose the interest rate is i1, lower than the equilibrium level i0. There is excess demand for money in the amount AB in the diagram. People want to hold money balances equal to B at the interest rate i0, but only A is available. How does the market adjust to remove this excess demand? The answer lies in the portfolio decisions that distribute wealth between money holdings and bonds.
Consider the interaction between the bond and money markets. When portfolio managers want to restructure their holdings of bonds and money they do so by buying or selling bonds on the bond market. Their actions cannot change the supply of money balances. That is fixed by the monetary base and the money supply multiplier. As a result, bond prices and interest rates change to maintain money market equilibrium.
In Figure 9.2 the excess demand for money at the interest rate i1 will result in a rise in interest rates. With an excess demand for money, people sell bonds to adjust their money balances. There is an excess supply of bonds. Bond prices fall. Lower bond prices mean higher bond yields and interest rates, as you will recall from our earlier discussion of asset prices and yields. The higher interest rates reduce both the excess supply of bonds and the excess demand for money. The money market adjusts by moving along the L curve from B to E, as people want smaller money balances relative to their bond holdings at higher interest rates.
This inverse interest rate – bond price relationship is the key to adjustments in the money market caused by changes in either the demand for or supply of money balances. Those adjustments involve trades in bonds that change bond prices and interest rates to maintain money market equilibrium.
Changes in financial market equilibrium
A shift in either the money supply or money demand changes equilibrium in the money market (and the bond market). Interest rates move to restore equilibrium. Figures 9.3 and 9.4 give examples.
The effect of a change in the money supply
Suppose the central bank lowers the monetary base and the money supply contracts. For a fixed price level, lower nominal money reduces the real money supply. Figure 9.3 shows this leftward shift in the money supply curve from M0/P0 to M1/P0. The equilibrium interest rate rises from i0 to i1 as people sell bonds. A higher interest rate reduces the quantity of real money balances demanded, moving along the demand curve L(Y0), bringing quantity of balances demanded into line with the reduced supply. Hence, a lower money supply raises equilibrium interest rates. Conversely, a rise in the money supply lowers the equilibrium interest rate.
Figure 9.3 Effect of a fall in the money supply
The effect of a change in real income
Figure 9.4 shows real money demand L(Y0) for the real income Y0. A rise in real income increases the quantity of real money balances demanded at each interest rate, shifting the demand for money function from L(Y0) to L(Y1). The equilibrium interest rate rises as portfolio managers sell bonds in an attempt to increase their money holdings. The rise in the interest rate lowers the quantity of real balances demanded, moving along the money demand function L(Y1), and keeps demand for money equal to the unchanged supply. Conversely, a fall in real income would shift the demand for money to the left and reduce the equilibrium interest rate.
Figure 9.4 Effect of a rise in real income | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/09%3A_Financial_markets_interest_rates_foreign_exchange_rates_and_AD/9.03%3A_Financial_market_equilibrium_and_interest_rates.txt |
The interest rates determined in the money market have important effects on the foreign exchange rate. With free international trade in financial assets, portfolio managers, having chosen to hold some part of their portfolios in bonds, have an additional choice. They can hold some bonds issued by domestic borrowers and some issued by foreign borrowers. They might, for example, hold some bonds issued by the Government of Canada, some issued by the United States Treasury and some issued by other governments. Similarly, residents of other countries can choose to include bonds issued by the Government of Canada in their holdings. These choices are made on the basis of the yields on bonds established by conditions in different national money and bond markets.
Foreign exchange rate: the domestic currency price of a unit of foreign currency.
To achieve the highest return on the bond portion of their portfolios, managers buy bonds that offer the highest rate of return for a given level of risk. If interest rates are constant in other financial markets, a rise in Canadian interest rates and bond yields makes Canadian bonds more attractive to both domestic and foreign bondholders. The demand for Canadian bonds increases. A fall in Canadian interest rates has the opposite effect.
Bonds are issued and priced in national currency. Most Government of Canada bonds are denominated in Canadian dollars. US Treasury bonds are denominated in US dollars, and bonds issued by European governments are denominated in euros. If Canadians want to purchase bonds on foreign bond markets they need foreign currency to make payment. Similarly, if residents of other countries want to purchase Canadian bonds they need Canadian dollars to make payment. These foreign exchange requirements for trading in financial assets are the same as those for trading in goods and services. The foreign exchange market is the market in which currencies of different countries are bought and sold and foreign exchange rates are determined.
Foreign exchange markets and rates are examined in detail in Chapter 12. For now it will be enough to consider the effects of changes in domestic interest rates on the foreign exchange rate.
Consider an increase in the domestic money supply in Canada. Money and bond market adjustments to this increased money supply lower the Canadian interest rate. At these lower interest rates domestic bond yields are lower relative to foreign bond yields than they were before. This provides the incentive for domestic portfolio managers to switch their purchases from domestic bonds to foreign (US) bonds. To pay for foreign bonds they need foreign currency. The demand for US dollars increases.
Simultaneously, bond holders in the US shift their purchases from the now relatively low-yield Canadian bonds to US bonds. Lower sales of Canadian securities in the US market reduce the supply of US dollars. This drop in the supply of US dollars combined with the increase in demand raises the Canadian dollar price of U.S dollars. This is a depreciation of the Canadian currency. If the initial exchange rate was \$1.20Cdn = 1.00US, the exchange rate would be somewhat higher, say \$1.25Cdn = \$1.00US
Depreciation of the national currency: a decline in the value of the currency relative to other national currencies, which results in a rise in the domestic price of foreign currencies.
In this example a fall in domestic interest rates, other things constant, causes depreciation in the domestic currency relative to foreign currencies. This interest rate-exchange rate linkage is symmetrical. Rises in domestic interest rates cause appreciation of the national currency.
Appreciation of the national currency: an increase in the value of the currency relative to other national currencies, which results in a fall in the domestic currency price of foreign currencies.
A decrease in the money supply or a change in the demand for money with a fixed money supply would affect the foreign exchange rate through the same linkages. Changes in domestic financial markets and foreign exchange markets happen simultaneously. With current communications and information technology these markets adjust very rapidly and continuously. The changes in interest rates and foreign exchange rates that result from changes in domestic money market conditions have important effects on aggregate expenditure and aggregate demand. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/09%3A_Financial_markets_interest_rates_foreign_exchange_rates_and_AD/9.04%3A_Interest_rates_and_foreign_exchange_rates.txt |
Interest rates and exchange rates link the changes in money and financial markets to the expenditure decisions that determine aggregate demand.
The impact of financial markets, interest rates, and exchange rates on aggregate expenditure, aggregate demand, and real output is described by the transmission mechanism. It has three important channels, namely:
1. the effect of interest rate changes on consumption expenditure;
2. the effect of interest rate changes on investment expenditure; and
3. the effect of interest rate changes on foreign exchange rates and net exports.
Transmission mechanism: links money, interest rates, and exchange rates through financial markets to output and employment and prices.
Interest rates and consumption expenditure
The basic consumption function in Chapter 6 was illustrated by a straight line relating aggregate consumption to disposable income. The positive slope of that line, the marginal propensity to consume, showed the change in consumption expenditure that would result from a change in disposable income. The vertical intercept of the consumption function showed autonomous consumption expenditure, the consumption expenditure not determined by disposable income. Changes in income moved households along the consumption function. Changes in autonomous consumption expenditure changed the vertical intercept, shifting the consumption function up or down.
Changes in interest rates affect autonomous consumption expenditure in two ways.
1. Through a wealth effect from changes in the prices of financial assets; and
2. Through a cost of credit effect.
Wealth effect: the change in expenditure caused by a change in real wealth.
Cost of credit: the cost of financing expenditures by borrowing at market interest rates.
The market prices of bonds are the present values of expected future interest and principal payments. Current market interest rates are the key factor in this relationship. Similarly, interest rates and the expected stream of profits and dividend payments determine the present values and prices of company shares. Lower discount rates give higher present values and higher interest rates reduce present values. As a result, falling interest rates raise financial asset prices and rising interest rates reduce financial asset prices.
This means that changes in interest rates, by changing prices of financial assets, change the wealth held in household portfolios. A fall in market interest rates raises household financial wealth which increases household consumption expenditure. Autonomous consumption expenditure increases as a result of this wealth effect. A rise in interest rates would reduce autonomous consumption expenditure.
Changes in interest rates also have important effects on house prices by lowering the cost of credit, increasing the present values of rental incomes, and increasing the market prices of residential real estate. Households often used the increased market values and equity in their housing to set up home equity lines of credit with relatively low borrowing rates. This borrowing is used to finance other expenditures. Autonomous consumption expenditures change as interest rate changes change the cost and extent of this financing.
Thus, two forces—wealth effects, and availability and cost of credit—explain the effects of money on planned consumption expenditure. This is one part of the transmission mechanism through which money and interest rates affect expenditure. Operating through wealth effects and the supply and cost of credit, changes in money supply and interest rates shift the consumption function. We can recognize the effects of both income and interest rates on consumption by using an equation, namely:
Consumption expenditure depends on both national income and interest rates, or:
(9.2)
The marginal propensity to consume out of national income is a positive fraction, , and the relationship between consumption and interest rates is negative, .
When consumption expenditure is plotted relative to national income as in the line diagrams of Chapters 6 and 7, a change in the interest rate shifts the consumption function but does not change its slope.
Interest rates and investment expenditure
In Chapters 4 and 6 we defined investment expenditure as the purchase of currently produced fixed capital, which includes plants, machinery and equipment; and inventories of raw materials, components, and finished goods. Spending on new residential and non-residential construction is also included in investment. Assume investment is independent of current income and therefore an autonomous component of aggregate expenditure. However, the interest rates determined in money and financial markets affect investment expenditure.
The data in Chapters 4 and 6 showed investment at about 20 percent of GDP in 2016 but with the level of investment spending changing from year to year within a range of +/- 11 percent. Although the total change in inventories is quite small, this component of total investment is volatile and contributes to the fluctuations in the total level of investment. Interest rate changes are responsible for some part of the volatility in investment spending.
Government capital expenditures on buildings, roads, bridges, and machinery and equipment are a part of government expenditure G. We treat government capital expenditure as part of fiscal policy and include it in G, not in I.
Businesses spend on fixed capital, plant and equipment to expand their output capacity if they expect growth in demand for their output, or if they see opportunities to reduce costs by adopting new technology and production techniques. Wireless companies like Bell Canada, Rogers and Telus spend continuously on new equipment to accommodate subscriber growth and new products that require more and faster data and voice transmission. Auto makers add to or reduce assembly capacity and develop new product and production technologies to remain competitive and to meet needs for increased fuel efficiency. Solar, wind energy and biofuel companies build new solar farms, wind farms and ethanol plants to provide new sources of electricity and fuels.
The firm's decision to invest is based on its expectation of future markets and profits that will justify the estimated cost of new plant and equipment. Financial markets provide some important guidance.
The current market values of existing firms are the present values of their expected profits. A firm thinking about entering an industry or expanding its current capacity can compare the cost of building a new plant and buying equipment with the market value of capital already in the industry. The investment looks profitable if the cost to enter the industry or build and install new capacity is less than the value the market places on existing businesses. Alternatively, if the value the market places on existing business is less than the capital cost of new business there is no incentive to invest in more plant and equipment. However, there might be an opportunity to enter the industry, or expand by taking over an existing business.
The present value of expected profits depends on the interest rate. Changes in interest rates change both the values the market puts on existing businesses and productive capacity and the costs of financing new investment. A rise in interest rates lowers the market value of existing firms and increases the costs of financing new investment. A fall in interest rates increases current market values and lowers financing costs. As a result, investment expenditures are inversely related to interest rates, if all other conditions are constant.
Inventory management is another important part of investment expenditure. Some firms hold inventories of basic inputs to production like raw materials and may also hold components and finished product. Other firms organize their production and coordinate with suppliers to minimize inventories to achieve 'just in time' delivery of inputs. Financial services firms often hold inventories of bonds and other assets to help customers adjust their portfolios.
Inventories can accommodate differences in the timing of production and sales for the benefit of both producers and consumers. If demand for output rises sharply, plant capacity cannot be changed overnight. If demand exceeds current output, sellers would rather not disappoint potential customers. Car dealers hold inventories in part to help smooth the flow of production, and in part to be able to offer immediate delivery. Retail stores carry inventories so customers can buy what they want when they want it. As demand fluctuates, it can be more efficient to allow inventories of finished goods to fluctuate than to try to adjust production to volatile market conditions.
But inventories involve costs. To the producer, unsold goods represent costs of labour, materials, and energy paid but not yet recovered from the sale of the product. These costs have to be financed, either by borrowing or tying up internal funds. Retailers have similar carrying costs for their inventories. Thus, interest rates determine the important finance costs of holding inventories. If we assume prices are constant and interest rates rise, producers and retailers will want smaller inventories. Alternatively, if prices are rising, the difference between the nominal interest rate and the rate of inflation is the real cost of carrying inventories.
The investment function is based on these explanations of expenditure on fixed capital and inventories. The negative effect of interest rates in the investment function, , shows that higher interest rates cause lower levels of planned investment expenditure. But how sensitive are investment plans to financing costs? If these financing costs were not a large factor in the investment decision, would be small. A rise in the interest rate from i0 to i1 would still lower planned investment, but by only a small amount. Alternatively, a larger value for would mean that investment plans are sensitive to interest rates.
Investment expenditure depends on the interest rates:
(9.3)
A rise in the interest rate lowers investment expenditure: .
Investment function, I=I(i): explains the level of planned investment expenditure at each interest rate.
When plotted in a diagram with interest rate (i) on the vertical axis and investment (I) on the horizontal axis, the slope of the investment function, I=I(i), is . The position of the investment function reflects the effect of all factors, other than interest rates, that affect investment decisions. The price of new capital equipment, optimism or pessimism about future markets and market growth, the introduction of new technologies embodied in newly available equipment, and many other factors underlie investment decisions. Changes in any of these conditions would shift the I function and change planned investment at every interest rate. The sharp drop in oil company expenditures on new equipment and production capacity in response to the collapse in oil prices is a clear example of a shift in the investment function. Increased business confidence and expectations of stronger and larger markets shift the I curve to the right. Pessimism shifts it to the left.
The volatility of investment that causes business cycle fluctuations in output and national income comes from volatility in business profit expectations, rather than from interest rates. Changes in investment, a result of changes in interest rates or as a result of other factors, shift aggregate expenditure and work through the multiplier to change AD, output, and employment. The reaction of investment expenditure to changes in interest rates provides the important link in the monetary transmission mechanism but does not explain the volatility of investment expenditure we saw in Chapter 6.
Exchange rates and net exports
The changes in foreign exchange rates caused by changes in interest rates affect the competitiveness and profitability of imports and exports relative to domestically produced goods and services. A rise in interest rates leads to an appreciation of the domestic currency. Import prices fall relative to the prices of domestic goods and services. Exports become less competitive and less profitable. Imports rise and exports fall, lowering the net export component of aggregate expenditure and demand. Alternatively, a fall in interest rates leads to a depreciation of the domestic currency. Prices of imported goods and services rise relative to the prices of domestic goods and services. Exports are more competitive and more profitable. Net exports increase.
In Chapter 6 we assumed exports were autonomous, independent of national income but dependent on foreign incomes, foreign prices relative to domestic prices, and the exchange rate, which we held constant. Imports were a function of national income, based on a marginal propensity to import, with an autonomous component to capture relative price and exchange rate conditions. Exchange rates were assumed to be constant.
Dropping the assumption that the exchange rate is constant makes the important third link between interest rates and aggregate expenditure through net exports. Exchange rate effects reinforce the negative relationship between interest rates and expenditures in the consumption and investment functions. If interest rates rise, other things constant, the domestic currency appreciates and the exchange rate, er, falls. Exports fall, and imports rise, reducing net exports and aggregate expenditure. A net export function that describes this relationship would be:
(9.4)
In Equation 9.4, the variable er(i) captures the effect of interest rates on exchange rates, and exchange rates on net exports. The variable Y captures the effect of changes in Y through the marginal propensity to import. From the foreign exchange market we know that a rise in interest rates leads to an appreciation of the domestic currency that lowers the exchange rate, . Also, a fall in the exchange rate lowers net exports, .
The appreciation of the Canadian dollar that reduced the Canadian/US dollar exchange rate from \$1.57Cdn for \$1.00US in 2002 to \$1.014Cdn to \$1.00US in March 2008 and \$0.9814Cdn to \$1.00US in November 2012 illustrates the point. Although due more to the rise in commodity and energy prices than to interest rate differentials, the lower exchange rate increased imports and reduced the viability of manufacturing based on exports to the US market, or competition with imports. To the extent that interest rate changes affect exchange rates, they also change net exports and aggregate expenditure.
The depreciation of the Canadian dollar following the collapse of energy and commodity prices in late 2014, and the subsequent lowering of interest rates by the Bank of Canada raised the Cdn/US dollar exchange rate to \$1.31Cdn to \$1.00US in early August 2015. Although only partly a result of lower Canadian interest rates, this lower dollar makes exports more competitive and profitable and imports more expensive. Over time, net exports should increase and increase aggregate demand.
Figure 9.5 Interest rates & autonomous expenditure
Figure 9.5 summarizes the relationship between interest rates and expenditures, assuming all things other than interest rates and exchange rates are constant. The downward sloping line A(i) illustrates the inverse relationship between the consumption, investment, and net export components of autonomous expenditure and the interest rate. Starting with interest rate i0, the level expenditure related to interest rates is A(i0), given by point D on the expenditure function. A fall in interest rates from i0 to i1 increases expenditure to A(i1), moving along the expenditure function to point E. Lower interest rates increase consumption and investment expenditure directly through wealth and cost and availability of finance effects. Lower interest rates also increase net exports through the effects of lower interest rates on the foreign exchange rate. A rise in interest rates would have the opposite effect.
The changes in interest rates and exchange rates are the key linkages between the monetary and financial sector and aggregate demand. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/09%3A_Financial_markets_interest_rates_foreign_exchange_rates_and_AD/9.05%3A_Interest_rates_exchange_rates_and_aggregate_demand.txt |
We can now summarize and illustrate the relationships that transmit changes in money, financial markets, and interest rates to aggregate demand, output, and employment. There are four linkages in the transmission mechanism:
1. With prices constant, changes in money supply change interest rates.
2. Changes in interest rates change consumption expenditure through the wealth effect and the cost and availability of credit.
3. Changes in interest rates also cause changes in planned investment expenditure through the cost and availability of credit to finance the purchase of capital equipment and to carry inventories.
4. Changes in interest rates also cause changes in exchange rates, which change the price competitiveness and profitability of trade goods and services.
Working through these linkages, the effects of changes in money and interest rates on aggregate expenditure, aggregate demand and equilibrium real GDP is illustrated as follows:
Figure 9.6 The monetary transmission mechanism
Figure 9.6 shows the transmission mechanism using four interrelated diagrams: a) the money market, b) interest rates and planned expenditure, c) aggregate expenditure and equilibrium output, and d) aggregate demand and supply, output, and prices. We continue to assume a constant price level, as the diagrams show. Changes in the money and financial sector affect aggregate demand and output, to add another dimension to our understanding of the sources of AD and fluctuations in AD.
To see the linkages in the transmission mechanism start in Panel a) with an equilibrium interest rate i0 determined by the initial money supply M0/P and demand for money L(Y0). This interest rate i0 induces autonomous expenditure A(i0) in Panel b). That autonomous expenditure is the vertical intercept A(i0) of the aggregate expenditure function in Panel c), and through the multiplier the equilibrium GDP, Y0. In Panel d) the corresponding aggregate demand curve crosses the horizontal AS curve at the equilibrium real GDP Y0.
An increase in the money supply in Panel a) lowers equilibrium i to i1. This causes an increase in autonomous expenditure to A(i1) in Panel b) and an upward shift in the AE function on Panel c). Increased autonomous expenditure and the multiplier increase equilibrium real GDP and shift the AD curve to the right by the increase in A times the multiplier. The new equilibrium is Y1 at the price level P0.
There are several key aspects to these linkages between money, interest rates, and expenditure. The effect of changes in the money supply on interest rates in the money market depends on the slope of the demand curve for real money balances. A steep curve would show that portfolio managers do not react strongly to changes in market interest rates. It would take relatively large changes in rates to get them to change their money balances. Alternatively, if their decisions were very sensitive to the interest rates, the L function would be quite flat. The difference is important to the volatility of financial markets and interest rates, which in turn affect the volatility of expenditure.
Panel a) in Figure 9.7 shows the effects of an increase in money supply under different money demand conditions.
The sensitivity of expenditure to interest rates and financial conditions is a second important aspect of the transmission mechanism. If the interest rate/expenditure function in Panel b) is steep, changes in interest rates will have only small effects on expenditure, aggregate demand, and output. A flatter expenditure function has the opposite implication.
Figure 9.7 The transmission mechanism under different conditions
a) The change in interest rates caused by a change in money supply depends on the interest rate elasticity of the demand for money. L2 is more elastic than L1. A small change in interest rates under L2 induces portfolio managers to increase their money holdings. b) The change in autonomous expenditure caused by a change in interest rates depends on the rate elasticity of autonomous expenditure. Under A2(i) changes in interest rates have very small effects on expenditures.
Business cycles, output gaps, and policy issues
The effect of money and financial markets on expenditure, output, and employment raises two issues for macroeconomic policy. First, fluctuations in money supply and financial conditions are an important source of business cycle fluctuations in output and employment. These effects are particularly strong and important when the small changes in money supply have big impacts on interest rates and expenditure. A steep L(i) function and a flat expenditure/interest rate function would create these conditions. Stabilization policy would then need to control and stabilize the money supply, a policy approach advocated by monetarists, who see money supply disturbances as the major source of business cycles. If you can fix money supply at M0 in Figure 9.6, and the demand for money L(Y,i) and the interest rate/expenditure function are stable, you remove monetary disturbances as a source of business cycles.
This Monetarist approach to money and the financial sector concentrates on the "automatic" stabilization effects of money supply control. With the money supply fixed, any tendency for the economy to experience a recessionary or inflationary gap changes the demand for money, and interest rates change in an offsetting direction. A fall in real output that creates a recessionary gap reduces the demand for money L(Y,i) and, with a fixed money supply, interest rates fall to induce additional expenditure. An inflationary gap would produce an automatic rise in interest rates. The monetary sector automatically resists fluctuations in expenditure and output.
The second policy issue is the alternative to this approach. Discretionary monetary policy would attempt to manage money supply or interest rates or financial conditions more broadly. The objective would be to counter persistent autonomous expenditure and financial disturbances that create output gaps. The intent is to manage aggregate demand in an active way. In other words, if business cycles were caused by shifts and fluctuations in the interest rate/expenditure function in Panel b) of Figure 9.6, monetary policy would react by changing interest rates and money supply and move the economy along the new expenditure function to stabilize autonomous expenditure and aggregate demand. Keynesian and New-Keynesian economists advocate this active approach to policy in the money and financial sector, based on a different and broader view of the sources of business cycles in the economy.
Recent experience extends beyond these two policy concerns. A collapse in the financial sector on the supply side was a major cause of the recession of 2009. Banks and other financial institutions suffered losses on mortgages and other assets followed as energy and commodity prices dropped and expectations of business profits followed. Uncertainty on the part of many lenders about the quality of assets and the risks of lending reduced the availability of credit. Uncertainty on the part of households and businesses reduced their confidence in financial institutions. Although central banks worked to keep interest rates low and bank reserves strong, shifts in the availability of credit and the willingness to borrow shifted the A(i) curve in Figure 9.6 sharply to the left, expenditure fell, and AD shifted left, opening a strong recessionary gap that has been persistent in many industrial countries.
This recent experience has led to serious debates about the role and effectiveness of monetary policy and the objectives of fiscal policy. These are issues we examine in more detail in the chapters that follow.
Next
This chapter makes the link between money, interest rates, aggregate demand, and output in the model of the economy. It also shows that monetary policy, working through the monetary transmission mechanism, provides a second policy channel, in addition to fiscal policy, which government might use to stabilize business cycle fluctuations. Chapter 10 studies in detail the monetary policy operations of central banks, including the Bank of Canada.
Example Box 9.1 Bond prices and interest rates
Consider the price of the 4.25 percent bond with a maturity date of June 1, 2018. Let's assume that the 3 year market rate of interest on the date you buy the bond, say June 1, 2015 is 4.25 percent. The price of the bond is the present value of the future payments: \$4.25 on June 1, 2016, \$4.25 on June 1, 2017, and \$104.25 on June 1, 2018. Payments to be received two years in the future are discounted twice, and three years in the future three times, to give:
PV
PV
PV
A bond bought for \$100 and held to maturity would yield 4.25 percent, the current market rate of interest assumed in this example. The bond is trading at par because the market price equals the face value.
As an alternative assume that the 3 year market rate of interest on June 1, 2015 is 1.75 percent. The price of the bond is then the present value of the future payments: \$4.25 on June 1, 2016, \$4.25 on June 1, 2017, and \$104.25 on June 1, 2018. Payments to be received two years in the future are discounted twice, and three years in the future three times, to give:
PV
PV
PV
The price of this 4.25 percent bond on June 1, 2018 would be \$107.26 per \$100 of face value. The assumption that the market rate of interest is 1.75 percent, which is clearly lower than the 4.25 percent coupon on the bond, means the bond trades at a premium. The premium price means that buying the bond and holding it to its maturity date will give an annualized return of 1.75 percent on your money. That is the then current assumed 3 year rate.
Taking account of the changes in bond prices as market interest rates change, the yield on the bond—the present value of its coupon payment plus the capital loss as its price falls to par at maturity—gives a rate of return equal to the market interest rate of 1.75 percent.
Application Box 9.1 A basic guide to financial assets
Three broad classes of financial assets are bought and sold in financial markets. These are bills, bonds, and equities.
Bills are short-term financial assets that make no interest payment to the holder but do make specified cash payment on their maturity date. They trade at a discount. A government treasury bill or T-Bill is an example. Every second week the government sells T-Bills that promise to pay the buyer \$100 for each \$100 of face value on the date that is about three months in the future. The interest earned is the difference between the price paid and the face amount received at the maturity date.
Bonds are longer-term financial assets that pay a fixed money income payment each year and repay their face value on a fixed maturity date. Bonds are marketable, and trade on the bond market between their issue dates and maturity dates at prices determined by supply and demand. As with T-Bills, the return to the holder of a bond depends on the price paid for the bond. In this case, the calculation is more complex however, because it involves a fixed annual money payment and a fixed value at maturity.
Equities are shares in the ownership of the business. They give the holder the right to a share in the profits of the business, either in the form of dividend payments or in terms of the increase in the size of the business if profits are used for business expansion. The shares or stocks in publicly traded businesses can be bought and sold on stock markets like the Toronto Stock Exchange. The financial pages of major newspapers give you daily reports on stocks prices and stock markets. Shareholders' returns from their stock holdings depend on the combination of dividend income they receive and the changes in the market price of the shares they hold. Equity prices are the expected value of the future profits of business. Because expectations of future business performance are volatile, equity prices are volatile and therefore risky. Equities do however offer the prospect of higher long-term returns.
Application Box 9.2 Nominal and real interest rates
Both nominal and real interest rates play important roles in the economy. The nominal (or money) interest rate is the annual percentage of the principal of a loan that the borrower pays to the lender. It is determined by supply and demand conditions in money markets. The real interest rate is the nominal interest rate adjusted for annual changes in the price level (real interest rate = nominal interest rate minus the inflation rate). When the inflation rate is zero, nominal and real interest rates are equal.
Nominal interest rates and financial asset prices are linked. The present value calculation of asset prices uses the nominal rate for discounting. Nominal interest rates and asset prices vary inversely.
Nominal interest rates also affect nominal cash flows of both households and businesses. A rise in nominal rates on lines of credit or mortgages increases the current cash cost of that borrowing. A fall in nominal rates on lines of credit or mortgages releases current cash commitments.
Real interest rates determine the real cost of borrowing and the real return to lending.
A family borrows \$200,000 for one year at a nominal interest rate of 5 percent to buy a house. At the end of the year they would owe the lender \$200,000 plus \$10,000 interest. Their nominal interest cost is \$10,000. If the price level has been constant over the year, their nominal interest cost and their real interest cost are equal at 5 percent.
Suppose however that the all prices are rising by 3 percent a year. The house bought today for \$200,000 will sell for \$206,000 one year from now. Borrowing at 5 percent to buy the house cost \$10,000 but the rise in the price of the house by \$6,000 offsets part of that cost. The real interest cost is . The real interest rate is 2 percent based on the nominal interest rate of 5 percent minus the change in the price level of 3 percent.
With inflation rates greater than zero, lenders' real interest earnings are less than nominal interest earnings. In the preceding example, the mortgage lender's real return was just 2 percent because the \$210,000 received at the end of the year had its purchasing power reduced to approximately \$204,000 by the 3 percent rise in the price level.
Nominal and real interest rates affect expenditure decisions by their effects on asset prices, cash flows, and the real costs and returns involved in borrowing and lending. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/09%3A_Financial_markets_interest_rates_foreign_exchange_rates_and_AD/9.06%3A_The_transmission_mechanism.txt |
A financial portfolio is a mixed holding of money and other financial assets, such as bonds and equities, structured, to balance expected return and risk.
The price of a financial asset like a bond that promises to make future payments is the present value of those payments. Because current interest rates are used to discount future payments and determine this present value, bond prices and interest rates are inversely related.
The demand for money (L) is a demand for real money balances measured in terms of purchasing power over goods and services. It arises from the portfolio decisions people make about the form in which to hold their wealth. Holding money reduces the costs of making both routine and unexpected transactions. It also provides a safe asset, with a fixed nominal price, as a store of wealth. The cost of holding money is the interest income and potential capital gain sacrificed by not holding bonds.
The quantity of real money demanded rises with real incomes, to finance higher transactions, and falls with higher nominal interest rates, the opportunity cost of holding money instead of bonds. The demand for money function is L=kYhi.
The interest rate (i), is determined by supply and demand in the money market, together with supply and demand in the bond market. As people adjust the holdings of bonds and money in their wealth portfolios, bond prices and yields adjust to clear both bond and money markets simultaneously.
Changes in interest rates lead to changes in exchange rates that change net exports. The international sector makes an additional link between money, interest rates, and expenditure.
Interest rates play a key role in the transmission mechanism that links money and financial markets to aggregate expenditure.
Household consumption expenditure and business investment expenditure are dependent, in part, on interest rates. A higher interest rate reduces household wealth and increases the finance costs of borrowing. Lower wealth and higher finance costs reduce planned autonomous consumption, shifting the consumption function down. Lower interest rates have the opposite effect.
The monetary transmission mechanism links changes in money supply to changes in aggregate expenditure, aggregate demand, and output through interest rates and exchange rates.
9.08: Exercises for Chapter 9
EXERCISE 9.1
If the current market interest rate is 3 percent and a bond promises a coupon of \$3 each year in perpetuity (forever), what is the current market price of the bond? Suppose you were holding such a bond and current market interest rates fell from 3 percent to 2.5 percent. Would you be pleased or disappointed by the return on your bond holding? Why?
EXERCISE 9.2
Suppose you are holding a bond that will pay \$5 each year for the next two years from today and mature two years from today.
1. If current two-year market interest rates are 5 percent, what is the market price of your bond?
2. If market interest rates rise tomorrow to 6 percent, what happens to the market price of your bond?
3. What is the "market risk" in holding bonds?
EXERCISE 9.3
Draw a diagram to illustrate the relationship between the demand for real money balances (L), GDP (Y) and the interest rate (i), L=kYhi, when real GDP has a given value Y0.
1. Explain your choice of the intersection of your demand for money function with the horizontal axis, and your choice of the slope of the function.
2. Using your diagram, illustrate and explain the quantity of real money balances demanded for a specific interest rate, say i0. Pay particular attention to the underlying motives for holding these money balances.
3. Suppose interest rates declined from your initial assumption of i0 to a new lower rate i1. Illustrate and explain the effect of the change in interest rates on the demand for money balances.
4. Holding interest rates constant at either i0 or i1, suppose real GDP were to increase. Illustrate and explain the effect of the increase in real GDP on the demand function and the quantity of real money balances people hold.
EXERCISE 9.4
Today it costs \$1.25Cdn to buy \$1US. Suppose tomorrow US interest rates rise. What would happen to the foreign exchange rate between Canadian and US dollars? Explain why.
EXERCISE 9.5
1. Draw a diagram to illustrate equilibrium in the money market.
2. Starting from your initial equilibrium, suppose real national income (Y) increased. Illustrate and explain how the money market would adjust to this change in economic conditions.
3. How does the interest rate in the new equilibrium compare with the interest rate in the initial equilibrium?
EXERCISE 9.6
Construct a set of diagrams that shows the monetary transmission mechanism linking interest rates to aggregate demand and output. Using these diagrams, show and explain:
1. How a reduction in the money supply would affect aggregate demand and output.
2. Alternatively, how an increase in the precautionary demand for money balances caused by terrorist activity, or severe weather events, or an increase in uncertainty in general would affect aggregate demand and output. Assume the money supply is held constant.
3. Alternatively, how would an increase in autonomous investment expenditure and exports affect aggregate demand, output, and interest rates? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/09%3A_Financial_markets_interest_rates_foreign_exchange_rates_and_AD/9.07%3A_Key_Concepts.txt |
On January 21, 2015 Stephen Poloz, the Governor of the Bank of Canada, announced a cut in the Bank's key monetary policy rate, the overnight rate, from 1.00% to 0.75%. The Bank wanted provide monetary stimulus to offset the negative growth rate and inflation rate effects of the sharp drop in oil prices. A further cut in the overnight rate to 0.50% followed on July 15, 2015. The Bank's forecast for growth and inflation in Canada had been revised downward based on weakness in the international economy, particularly the slowdown in growth in China and declining commodity prices. Although growth in real GDP was stronger in 2016 the output gap remained at an estimated 1.25% to 0.25% based on estimation procedures. The Bank of Canada in its April 2017 Monetary Policy Report, expecting slow economic growth and stable inflation beyond the first half of 2017, maintained the 0.50% overnight rate. These are recent examples of monetary policy decisions by the Bank of Canada to defend its inflation rate target and support the economy's growth rate.
This chapter examines the role of the central bank. The central bank is responsible for monetary policy. Its monopoly control of the supply of cash, or monetary base, gives it a powerful influence in financial markets. Sometimes the central bank controls the monetary base to control the supply of money. Other times it controls short-term interest rates. In either case, central bank actions are designed to affect inflation, output, and employment. They work through the transmission mechanism that links monetary policy to aggregate demand, as we discussed in the last chapter.
10: Central Banking and Monetary Policy
Most countries have a central bank. Some of these central banks, like the Bank of England, were private firms originally in business for profit, but began to operate in part to promote stability in financial market conditions. The focus of their business shifted to take on an informal role in what is now called monetary policy. As governments also became interested in monetary policy, central banking institutions were established in countries where none previously existed. The Federal Reserve System, the United States central bank, was created under federal law in 1913. It is a system of 12 regional banks, each owned by the commercial banks that are its members. Canada's central bank, the Bank of Canada, was set up and started operations in 1935 as a privately owned institution, but was nationalized in 1938. In the United Kingdom, the Bank of England was nationalized in 1947.
Central bank: an institution that conducts monetary policy using its control of monetary base and interest rates.
In every case, the important distinction between a private bank and a central bank is the purpose that drives the institution's operations. Private banks are profit-oriented businesses providing financial services to businesses and households. Central banks conduct their operations to influence the behaviour of other banks and intermediaries in the financial system. Profits are not the motive behind central banks' operations, although they do make profits. They also serve as banker to the government and to the banks. But their primary role and responsibility is to conduct monetary policy: To control inflation and support economic growth through their control of the monetary base and interest rates, and perhaps the foreign exchange rate.
Monetary policy: central bank action to control inflation and support economic growth through control of the money supply, interest rates, and exchange rates in order to change aggregate demand and economic performance.
The Bank of Canada is Canada's central bank. A visit to its website www.bankofcanada.ca provides detailed information on its structure, operations and monetary policy objectives. The information the bank provides on monetary policy is of particular relevance for this chapter.
The current governor, Stephen Poloz, like governors before him, manages the Bank's balance sheet to implement monetary policy. He can expand the Bank's asset holdings and pay for that expansion by creating new Bank of Canada liabilities, which are additions to the monetary base. Alternatively, he can sell some of the Bank's assets, destroying an equal amount of liabilities and monetary base. No reserve requirements (explained in Section 10.2) limit these operations. The management of the Bank's balance sheet and the monetary base depends on the wisdom and judgment of the Governor and management of the Bank. They work to get the monetary base and interest rates that are appropriate for the economy.
There is a further interesting difference between the commercial and central bank balance sheets. Private banks concentrate on their deposit base and loan operations. These are the main entries in their balance sheets and the source of their banking profits as discussed in Chapter 8. The Bank of Canada, by contrast, does very little direct lending, and any it does is of very short duration. Indeed lending to banks and other financial institutions, advances to members of the Canadian Payments Association, which would be central bank loans, were zero at the end of March 2017.
Nor does the Bank of Canada hold many deposits. It does not need deposits as a source of funds. Deposit facilities are provided to the commercial banks and other members of the Canadian Payments Association for their use in settling cheque-clearing balances and transfers among the banks, and to the Government of Canada. Cheques issued by the Government of Canada, like income tax refunds, Old Age Security payments, and Employment Insurance benefits, are drawn on the government's account in the Bank of Canada. This difference in the structure of operations again shows the difference between profit-oriented commercial banks and a central bank with responsibility for monetary policy.
Having the power to conduct monetary policy is one thing; how you use it is another. The Bank of Canada's responsibilities are set out in the Bank of Canada Act, the act of Parliament that established the Bank in 1934. According to the Act, the Bank is to conduct its policy in ways that support the economy by reducing fluctuations in output, prices, and employment while protecting the external value of the currency. In terms of our study of the economy, we can describe these goals of monetary policy as the pursuit of potential output and low, stable inflation rates.
Exactly how the Bank is to achieve those objectives has been, and continues to be, a topic for discussion and debate. Over the years, our understanding of what monetary policy can and cannot do has evolved, as have the Bank's interpretation of its mandate and the techniques it uses to conduct monetary policy. The Canadian economist Robert Mundell has been a major contributor to this work. His explanations of the transmission mechanism and the strength of monetary policy under different foreign exchange rate systems were recognized by his Nobel Prize in economics.
Currently, the Bank works to maintain inflation within a target range of 1 percent to 3 percent, but that has not always been its explicit policy objective. Gordon Thiessen, a recent Governor of the Bank of Canada, provides an interesting overview of the evolution of monetary policy in Canada from the 1930s to the end of the 1990s1. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/10%3A_Central_Banking_and_Monetary_Policy/10.01%3A_Central_banking_and_the_Bank_of_Canada.txt |
The money supply—currency in circulation plus the deposits of the commercial or chartered banks—is partly a liability of the central bank (currency) and partly a liability of the commercial banks (deposits). In Chapter 8 we discussed the monetary base supplied by the central bank. You will recall that the money multiplier ties the size of the money supply to the size of the monetary base. The money multiplier is larger when
1. the reserve ratio (rr) banks hold is smaller; and
2. the amount of currency the non-bank public wishes to hold is small and constant.
If these two ratios are constant, the central bank can change the size of the money supply by changing the size of the monetary base.
In general, central banks have three main techniques for the control of the monetary base and the money supply. These are:
1. Establishing reserve requirements
2. Using open-market operations
3. Adjusting central bank lending rates
Not all central banks use all three techniques, but we will examine each of them. Later we will see that the Bank of Canada has some additional operating techniques it uses to influence interest rates in the short run.
In the financial crisis and deep recession of 2008-2009, central banks developed additional techniques to support the banking system, the availability of credit, and the money supply. The 'Quantitative Easing' techniques used in the US and more recently in Europe are examples of these techniques discussed later in this chapter.
Reserve requirements
In some cases, commercial banks operate under a legal required reserve ratio. They are required by law to hold cash reserves and central bank deposits not less than some specified percentage of their deposit liabilities.
Required reserve ratio: a legal minimum ratio of cash reserves to deposits.
Banks can hold more than the required reserves but not less. If their reserves fall below the required amount, they must borrow cash, from the central bank, to restore their required reserve ratio. Since a loan from the central bank carries an interest rate, usually higher than the market interest rate, borrowing imposes a cost on the bank and lowers profitability. Banks usually hold slightly larger reserves than required to avoid the costs of falling short.
A required reserve ratio is essentially a regulation used to give the central bank control of the money supply. The reserve ratio is a key determinant of the money multiplier. If a central bank has the power to change the commercial banks' required reserve ratio, it can use it to change the money supply. For a given monetary base, a rise in the required reserve ratio reduces the size of the money multiplier and the money supply. A reduction in the reserve ratio has the opposite effect.
However, changing required reserve ratios are blunt techniques for monetary control. They simultaneously affect the reserve positions of all banks in a system and require large adjustments in financial markets. As a result, changes in reserve ratios are not widely used as techniques for money supply control.
Required reserve ratios are different in different national banking systems. In the United States, for example, the Federal Reserve is authorized to impose reserve requirements of 8 percent to 14 percent on chequable deposits, and up to 9 percent on non-personal time deposits. As of February 2002, the ratios were set at 10 percent for chequable deposits and 0 percent for time deposits. The European Central Bank also imposes reserve requirements. In 2012, both India and China reduced deposit reserve ratios on several occasions to encourage monetary expansion in the face of declining GDP growth rates.
Until 1994, banks in Canada were subject to legal minimum reserve requirements. These have now been phased out, as have reserve requirements in many other countries. In Canada, the banks hold reserves made up of very small settlement balances in the Bank of Canada, in addition to their cash holdings. The banks decide the size of their reserve ratios based on their own assessments of their reserve needs, rather than a legal requirement. We will see later that reserve holdings, and the Bank of Canada's management of the available cash reserves, are important to the implementation of monetary policy in Canada.
The absence of legal reserve requirements in Canada means that reserve ratios in the banking system change from time to time. They may change as the banks change their outlook on financial conditions and their evaluation of banker's risk. These changes are linked to the profit motive of the banks rather than the control interests of the central bank. Whether they come from central bank action or commercial bank asset management, changes in the banks' reserve ratio change the money multiplier and the money supply.
Open market operations
Open market operations are central bank purchases or sales of government securities in the open financial market. They are the main technique used by central banks to manage the size of the monetary base. Whereas reserve requirements affect the money supply through control of the money multiplier, open market operations work directly on the monetary base. Since the money supply is the monetary base multiplied by the money multiplier, open market operations alter the money supply.
Open market operation: central bank purchases or sales of government securities in the open financial market.
Central banks use open market operations to provide the monetary base needed to support the demand for money and the increase in the demand for money as the economy grows. If monetary policy is conducted by setting interest rates, as discussed later in the chapter, open market operations are passive. They provide the monetary base needed to meet the demand for money at the interest rate set by the central bank. An open market purchase makes a permanent addition to the central bank's assets and monetary base.
There are times when monetary policy is conducted through control of the money supply. If the money multiplier is constant, a central bank can control the size of the money supply by controlling the monetary base using open market operations. Open market purchases increase the monetary base and increased bank lending increases the money supply. Open market sales have the opposite effect.
In times of financial and economic crisis, as in 2008 and 2009, open market operations are used along with interest rate setting. High uncertainty in financial markets and falling demand in goods-and-services markets increased the demand for liquid cash balances. If interest rates are reduced close to zero without increasing lending and spending and asset demand, the central bank may undertake "quantitative easing," using open market purchase to increase the monetary base and offset a shortage of liquidity in the economy. This topic comes up again after we look at monetary policy in more normal times.
Table 10.1 illustrates an open market purchase and its effect on bank reserves and the money supply. To keep the example simple, we will assume the banks hold reserves equal to 5 percent of their deposits, rr=0.05, but the public's currency holdings are constant. This means a simple money multiplier is equal to 1/rr=1/0.05=20.
Table 10.1 An open market purchase and the money supply
1. Open market purchase of \$100 million in government bonds.
Central Bank Commercial Banks
Assets Liabilities Assets Liabilities
Gov't bond +100 Cheque issued +100 No change No change
2. Pension fund deposits proceeds of bond sale in commercial bank.
Central Bank Commercial Banks
Assets Liabilities Assets Liabilities
No change No change Central bank cheque +100 Pension fund
deposit account +100
3. Central bank cheque clears giving commercial banks \$100 million in cash.
Central Bank Commercial Banks
Assets Liabilities Assets Liabilities
No change Cheque o/s –100 Central bank cheque –100 No change
Cash issued +100 Cash reserves +100
(excess reserves +95)
4. Commercial banks increase lending and create new deposits backed by their increased cash reserves.
Central Bank Commercial Banks
Assets Liabilities Assets Liabilities
No change No change Loans +1,900 Deposits +1,900
5. Final effect of central bank open market purchase.
Central Bank Commercial Banks
Assets Liabilities Assets Liabilities
Gov't bond +100 Cash issued +100 Cash reserves +100 Deposits +2,000
Loans +1,900
+2,000
In the example, the central bank buys \$100 million of government bonds on the open market. Assume a large pension fund sold these bonds, and received in payment a cheque for \$100 million issued by the central bank. This transaction is recorded (as \$100) under item 1 in the table.
Item 2 in the table records the pension fund's deposit of the central bank cheque in the commercial banking system. The commercial bank issues a deposit to the pension fund in return for the cheque drawn on the central bank.
The commercial bank does not want to hold the central bank cheque. It presents it for payment and receives, in this example, cash in the form of central bank notes. Cash is a reserve asset for the commercial bank. In item 3 in the table, the central bank has created new monetary base, which has increased the cash reserves of the commercial bank by \$100. The commercial bank now has new reserves of \$100 against its increased deposit liabilities of \$100. Based on its reserve ratio rr=0.05, it has excess reserves of \$95.
Excess reserves in the commercial banking system support an increase in lending and the creation of new bank deposits. Item 4 in the table shows the final results of this loan and deposit expansion, for the entire banking system. Based on a simple money multiplier of 20, we know that the increase in the monetary base in the form of new cash reserves by \$100 will result in an increase in the money supply of \$2,000. Bank lending and deposit creation continue until total deposits have increased by \$2,000, based on an initial deposit of \$100 and increased lending of \$1,900. Item 5 in the table shows these final results.
In this example, an open-market purchase increased the monetary base and the money supply. The purchase was paid for by the creation of new monetary base. An open market sale would have the opposite effect. The monetary base and the money supply would be reduced. An open market operation is a technique a central bank can use to shift the money supply function and affect equilibrium conditions in the money market.
Open market operations are today the principal channel by which central banks, including the Bank of Canada, manage the longer-term growth of the monetary base.
The bank rate
The bank rate is the interest rate the central bank charges the commercial banks if the commercial banks borrow reserves. The bank rate or lending rate is set by central banks as a part of their monetary policy operations.
Bank rate: the interest rate the central bank charges on its loans to commercial banks.
Suppose the banks think the minimum safe ratio of reserves to deposits is 5 percent. It does not matter whether this figure is a commercial judgment, as in Canada, or a legal requirement, as in the United States. Banks may also hold a little extra cash to cover day-to-day ups and downs in deposits and withdrawals, but maximum profit requires minimum cash holdings.
One way in which an individual bank can cover a shortage in its reserves is to borrow from other banks that have unexpected excess reserves. This creates a market for monetary base. In Canada, this borrowing and lending takes place on an overnight basis—you borrow today and repay tomorrow, at the overnight interest rate. In the United States, the rate for similar lending and borrowing among banks is the federal funds rate.
If it happens that no other bank in the system has excess reserves to lend, a bank that is short of reserves borrows from the central bank. The interest rate charged is the bank rate, which is set higher than the overnight rate by the central bank, to encourage banks to borrow and lend reserves in the overnight market.
The bank rate is used in different ways by different central banks. There is a long tradition of using changes in the rate as a signal of changes in monetary policy. A cut in the bank rate signals the central bank's intention to increase the monetary base. A rise in the bank rate signals tighter monetary conditions. The role the bank rate currently plays in Canada is discussed later in this chapter.
Money supply versus interest rates
Control of the monetary base through open-market operations and stable desired reserve and cash ratios for the banks and the public give the central bank control of the money supply. This is easy in theory but not in practice.
There are several problems. Can the central bank control the monetary base precisely? The commercial banks can borrow from the central bank at the bank rate when they are short of reserves. Borrowings increase the monetary base. In more difficult financial market circumstances, like those of 2007 to 2009, orderly financial markets may call for large changes in the monetary base to offset extraordinary demands for cash. Meeting these demands takes time and adds to turmoil in markets.
What is the size of the money multiplier? Are desired reserve ratios and cash ratios stable and predictable or do they fluctuate? If they fluctuate, the size of the money multiplier is difficult to predict. The money supply function may be unstable.
What money supply measure should the central bank control: MB, M1B+, M2, M2+, or some other aggregate? Households and businesses can shift among the different deposits with different terms and interest rates. Furthermore, the banks are imaginative and competitive in developing new types of deposits.
In short, precise control of the money supply is difficult. Most central banks no longer try. Instead, they set interest rates. The television news and financial press report decisions by the central bank about interest rates, not decisions about money supply. The Bank of Canada and the United States Federal Reserve make regular announcements about their settings of the overnight rate and the federal funds rate, respectively. Two examples of changes in the overnight interest rate by the Bank of Canada were noted in the introduction to this chapter.
Figure 10.1 shows the money market under two different conditions. In both cases we draw the demand for money function L(Y0) for a given level of real GDP. If the central bank can control money supply, then, for a given level of prices, it fixes the money supply at M0/P. The equilibrium interest rate is i0. This is the case in Panel a) of the figure.
Figure 10.1 Money supply control vs. interest rate control
a) We assume the central bank can fix the money supply at M0/P and the equilibrium rate is i0. An increase in Y increases demand for money from L(Y0) to L(Y1). With a fixed money supply, the interest rate rises to i1. Alternatively, if the central bank knows the demand for money it can control money supply using interest rates. When Y increases it increases i to i1 to reduce the demand for money to its money supply target. A fall in Y would call for a fall in interest rates to control money supply. b) We assume the Bank sets the interest rate at i0. To do this it must supply whatever quantity of money is demanded at i0. An increase in Y increases L and results in an increase in M/P. Now the money supply is demand determined.
Alternatively, the central bank can fix the interest rate at i0 and supply whatever money is needed to clear the market at this rate. This is the case in Panel b). In equilibrium, the central bank supplies exactly the quantity of money demanded at interest rate i0. The quantity of money supplied is still M0/P, but the money supply function is horizontal at the interest rate i0.
The central bank can fix either the money supply or the interest rate but not both. If it fixes the money supply, it must accept the equilibrium interest rate implied by the demand for money. If it fixes the interest rate, it must accept the equilibrium money supply implied by the demand for money equation. Central banks now do the latter. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/10%3A_Central_Banking_and_Monetary_Policy/10.02%3A_Central_bank_operating_techniques.txt |
A central bank can use the power it has over the monetary base and interest rates to pursue any one of three possible instrument targets. It might:
1. Control the foreign exchange rate, or
2. Control the money supply, or
3. Control the inflation rate.
However, it must choose. Controlling one of these instrument targets uses all the central bank's power, and it cannot pursue a second target at the same time.
The central bank chooses among these instrument targets based on its judgment as to which target will achieve the best results in terms of its broad monetary policy objective: To promote economic stability at potential output with low inflation. The Bank of Canada has conducted its monetary policy in terms of each of these instruments at different times in the recent past.
The brief discussion of the foreign exchange rate in Chapter 9 explained that changes in interest rates will result in changes in the foreign exchange rate. Wealth holders shift their financial portfolios between assets of different countries based on differences in interest rates and bond yields between countries. Rather than allow private supply and demand in the foreign exchange market to set the exchange rate, the central bank can intervene to control the rate. It buys or sells foreign exchange in the market, which affects the supply or demand for Canadian dollars in the foreign exchange market and changes the exchange rate.
Central bank purchases or sales in the foreign exchange market change the domestic monetary base just like open market operations in domestic money market. The domestic money supply and interest rates change until the difference between domestic and foreign interest rates is eliminated. To maintain a fixed exchange rate target, the central bank matches domestic interest rates to those set in the country to which it wishes to fix its exchange rate. In Canada, for example, to fix the exchange rate between the Canadian dollar and the US dollar, the Bank of Canada would set its interest rate equal to that set by the Federal Reserve.2
Exchange rate target: monetary policy maintains a fixed price for foreign currency in terms of domestic currency.
A central bank may choose to fix the exchange rate because it believes that is the best way to achieve the broader objectives of monetary policy. Canada operated with fixed exchange rates from 1962 to 1970. The Canadian-dollar price of the US dollar was fixed at \$1.075, and the Bank of Canada focused its monetary policy on that target. During the late 1950s and early 1960s, there was an intense debate over the monetary policy pursued by the Bank of Canada. Economic growth was slow, unemployment rates were high, and there was turmoil in financial markets. A fixed exchange rate was seen as the best solution to these economic problems. It essentially gave Canada the monetary policy of the United States, where economic performance had been stronger and more stable than in Canada. The fixed exchange rate target determined Canadian interest rates and money supply until 1970.
Rather than fixing the exchange rate, a central bank can choose to fix the size or growth rate of the domestic money supply. Chapter 9 discussed the money market in terms of a fixed money supply. However, central banks have found that the money multiplier, based on the desired reserve ratios of the banks and cash holdings of the public, is not stable enough to give them control of the money supply directly through their control of the monetary base. Instead, they set interest rates to get their target money supply from the demand for money. If money supply is above their target, they raise interest rates, reducing the demand for money until money holdings fall within their target range. They reduce interest rates if money holdings are less than their target.
In the 1970s, a sharp rise in inflation shifted the focus of monetary policy toward inflation control. At that time, developments in economic theory emphasized a strong link between money, money supply growth, and inflation. Central banks in many industrial countries shifted their focus to money supply control. Canada had dropped the fixed exchange rate target in 1970. In 1975, the Bank of Canada adopted money supply targets as its policy instrument and used them until 1982 in an attempt to control inflation and promote a strong economy. By adjusting interest rates based on its understanding of the demand for money balances, the Bank was able to meet the targets for the growth in the money supply M1 that it set and revised from time to time.
Money supply target: a central bank adjusts interest rates and the monetary base to control the nominal money supply, or the rate of growth of the nominal money supply.
However, controlling the money supply required wide fluctuations in interest rates and in the exchange rate. Financial markets did not like this volatility. More importantly, success in controlling M1 did not bring success in controlling inflation. The relationship between money supply, prices, and inflation turned out to be less stable than expected. The Bank abandoned its M1 control targets in 1982 and began a search for a better target for monetary policy.
In the early 1990s, the Bank of Canada and central banks in many other countries, including Australia, New Zealand, Sweden, the United Kingdom, and the European Union, decided to set explicit inflation rate targets for monetary policy. The Bank of Canada began to use interest rate setting as its monetary policy instrument, making changes in the interest rate, as necessary, to keep the Canadian inflation rate within a target range of 1 percent to 3 percent.
The shifts to formal inflation targets for monetary policy in 1991, and the adjustment to that policy shift, were sources of a substantial policy debate in Canada. Inflation was reduced as planned, but with a deep and prolonged recession in real GDP and persistently high rates of unemployment. Sustained economic growth did not resume until the mid-1990s, and by most estimates, including those by the Bank of Canada, the recessionary GDP gap persisted until the end of the decade.3 The Bank continues today to focus on an inflation rate in the 1 percent to 3 percent range as its monetary policy target. A summary of the costs and benefits of inflation that lie behind its inflation targeting are offered by the Bank of Canada at:
www.bankofcanada.ca/wp-content/uploads/2010/11/benefits_low_inflation.pdf
Inflation rate target: monetary policy objective defined as an announced target inflation rate.
Monetary policy instrument: the monetary variable the central bank manipulates in pursuit of its policy target.
Bank of Canada operating techniques
In Canada, the overnight rate is now the Bank of Canada's key policy instrument. This is the interest rate that large financial institutions receive or pay on loans from one day until the next. The Bank implements monetary policy by setting a target for the overnight rate at the midpoint of an operating band that is plus or minus one-quarter of one percentage point, or 25 basis points, from the target rate.
Overnight rate: the interest rate large financial institutions receive or pay on loans from one day until the next.
The bank rate now marks the upper end of this operating band for the overnight rate. It is still the rate at which the Bank of Canada is willing to lend to the banks. The lower end of the operating band, the deposit rate, is the interest rate the Bank of Canada pays on deposits. Because the highest cost of borrowing cash is the bank rate, and the lowest return from lending cash is the deposit rate paid by the Bank of Canada, the rate on overnight borrowing and lending among the banks falls within the target range set by the Bank of Canada.
The Bank of Canada tells financial markets the direction in which it wants interest rates to move, by making changes to its target overnight rate and operating band as it did in January and July 2015. Changes in the target overnight rate lead to changes in interest rates banks offer to lenders and depositors. A lower target lowers bank lending rates, encouraging more borrowing by households and businesses and a corresponding expansion in the money supply.
Figure 10.2 shows the Bank's settings and changes of the overnight interest rate operating band over the past 13 years. From mid-2004 to late 2007, for example, the plot shows the Bank raised its overnight rate setting by steps of 0.25 percent (25 basis points) from 2.5 percent to 4.5 percent. Its intention was to reduce monetary stimulus to keep the economy working at potential output, with projected growth of real GDP at 3.0 percent and projected inflation at its target 2.0 percent.
Figure 10.2 The Bank of Canada Operating Band for the Overnight Rate, 2000–2017
Source: Statistics Canada, CANSIM Table 176-0048
By contrast from July 2007 to March 2009 the Bank cut its setting for the overnight rate, in steps of 25 to 75 basis points, by a total of 400 basis points from 4.5 percent to 0.5 percent. Its intention then was to provide stimulus to and support for domestic financial markets and economic activity as the global financial crisis developed and spread. As economic conditions improved in 2010 and 2011 the Bank raised the overnight rate to 1.0 percent only to lower it again in 2015 to 0.5 percent, where it remains in mid-2017. You can read a brief analysis underlying each of the Bank's decisions to change or hold constant its overnight rate target in the press releases on the Bank's website:
By setting the overnight interest rate, the Bank has a direct impact on interest rates that are important to the monetary transmission mechanism. Banks respond to a rise in the overnight rate by raising their prime lending rate, which is the base for most of the interest rates on their lending. Rates on business and consumer lines of credit, for example, are linked to the prime rate, and move up and down with it. The connection to mortgage rates is also strong and they move with the overnight rate, although the link is not quite as tight. These interest rates cover about two thirds of bank financing in Canada. They make a strong link between the Bank of Canada's monetary policy action, expenditure, and aggregate demand. Figure 10.3 shows the relationship between changes in the setting of the overnight rate and other interest rates.
Prime lending rate: the base for setting the interest rates charged by banks on loans and lines of credit.
Figure 10.3 The overnight rate, prime rate and 5 year mortgage rate
Source: Statistics Canada, CANSIM Series V39079, V122495, V122521.
Other countries implement monetary policy by setting similar interest rates. The overnight rate set by the Bank of Canada is comparable to the United States Federal Reserve's target for the 'federal funds rate', and the Bank of England's two-week 'repo rate', and the minimum bid rate for refinancing operations, the 'repo rate', set by the European Central Bank.
Institutional arrangements are the key to the Bank of Canada's use of the overnight rate as its policy instrument. The payments made by individuals and businesses, and their receipts, flow through the banking system. Some are small paper-based transactions that involve the writing of cheques on deposit accounts. Others, and indeed the majority, are transfers of large deposits between bank customers. On any day, an individual bank may take in more deposits through these transfers than it pays out, or pay out more than it takes in. Any difference in either case is settled using balances held on deposit at the Bank of Canada. Technology now allows for same day settlement of large-value transactions, and an individual bank's settlement balances can change quickly.
Chartered banks in Canada operate under a zero settlement balance requirement. This means that the balances they hold in their deposit accounts at the Bank of Canada cannot be less than zero at the end of the day. If a bank's account is overdrawn from making payments to other banks, it must borrow to cover the overdraft either from another bank or from the Bank of Canada. Borrowing from other banks costs the overnight rate. Borrowing from the Bank of Canada costs the bank rate, which is set by the Bank of Canada as one-quarter of a percentage point above the overnight rate. As a result, falling short of the zero-balance requirement imposes a cost on a bank, reducing its profitability, which it would like to avoid.
A positive settlement balance also imposes a cost. The Bank of Canada does pay interest on a positive balance in a bank's account, but it pays at its deposit rate. That rate is set one-quarter of one percentage point below the overnight rate. Not lending a positive balance to another bank at the overnight rate and accepting the Bank of Canada's deposit rate carries an opportunity cost a bank would prefer to avoid. This is a further incentive to maintain a zero settlement balance at the Bank of Canada.
This regulatory and institutional environment gives the Bank of Canada a framework for setting the interest rate to implement its monetary policy. The Bank makes eight scheduled announcements per year about its target for the overnight rate, and the operating band it is setting for the overnight rate. These announcements are made in press releases and include a brief explanation of the economic conditions on which the Bank's rate-setting decision is based.
Special purchases and sales (SPRAs and SRAs)
To maintain the overnight interest rate within the target band, the Bank of Canada must intervene in the market to cover any shortages or remove any surpluses of funds that would push rates beyond its target. The Bank has two tools it uses for this purpose.
One tool is the special purchase and resale agreement (SPRA). This is a transaction initiated by the Bank of Canada that puts cash into the system on a very short-term basis. It is used to maintain the target overnight rate, more specifically to offset upward pressure on the rate.
In an SPRA, the Bank offers to buy Government of Canada securities from major financial institutions with an agreement to sell them back the next business day, at a predetermined price. The financial market gets an overnight injection of monetary base. The difference between the purchase and resale price determines the overnight interest rate on the transactions. Banks are willing to enter into these agreements with the Bank of Canada because they provide cash for the banks at rates of interest below what they would otherwise have to pay in the overnight market.
SPRA: A Bank of Canada purchase of securities one day combined with an agreed resale of the securities the next day.
Figure 10.4 shows how this works. We start in equilibrium at E0 with the demand for cash reserves just equal to the supply of monetary base at the overnight rate set by the Bank. Suppose a change in economic and financial circumstances causes a temporary increase in the demand for cash and settlement balances. The demand for monetary base shifts to the right to D1. If the Bank took no action the overnight rate would rise to E1 at or even above the target band the Bank has set for the overnight rate. To prevent this, the Bank provides an overnight increase in the monetary base by buying securities on the agreement that it will sell them back the next business day. This is an SPRA. It gives a temporary increase in monetary base to MB1 and reinforces the Bank's overnight rate.
Figure 10.4 Setting the overnight interest rate
In the opposite case of a fall in the demand for monetary base, the Bank makes use of a second tool to reduce the monetary base; namely, a sale and repurchase agreement (SRA). This is a sale of securities to major financial institutions for one day combined with a repurchase the following day. It makes a one day reduction on the monetary base to offset a drop in the demand for cash that has put downward pressure on the overnight rate.
SRA: A Bank of Canada sale of securities one day combined with an agreed repurchase of the securities the next day.
What if the increased demand for monetary base is permanent, not just a one-day event? Chapter 8 showed how the demand for monetary base comes from public demand and from bank demand for cash and reserve balances. Increases in nominal income increase the demand for money, including cash. Suppose the increased demand for monetary base shown in Figure 10.4 is permanent, the result of growth in the economy. Now, if the Bank of Canada wants to keep the overnight rate constant, it must make a permanent increase in the monetary base, not just an overnight increase. It will do this using the open-market operations discussed earlier. An open-market purchase of government securities makes a lasting increase in the Bank of Canada's asset holdings, permanently increasing the monetary base.
While these operations by the Bank of Canada may seem quite complex, they have a simple effect. Like open-market operations, SPRAs and SRAs increase or decrease the monetary base. In this case, however, the buyers and sellers in the market are limited to a few major financial institutions rather than the full market. Furthermore, changes in the monetary base are very short term, just one day. The objective is to set and control short-term interest rates, the monetary policy instrument used by the Bank of Canada. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/10%3A_Central_Banking_and_Monetary_Policy/10.03%3A_Monetary_policy_objectives_and_instruments_targets.txt |
Most central banks now use interest rates as the main instrument of monetary policy. But how does a central bank decide what rate of interest to set and when to change its settings of the interest rate? What lies behind the announcement of the overnight rate by the Bank of Canada or the setting of the federal funds rate in the United States? How are these interest rate decisions related to economic variables? Professor John Taylor of Stanford University found that most central banks, in fact, adjust interest rates in response to changes in two variables, output and inflation.
This finding was contentious. It implied monetary supply targets no longer played a role in decisions about setting interest rates. Instead, the interest rate target was and is set based on expected inflation and expected output relative to the central bank's inflation target and the economy's potential output.
A central bank that follows a Taylor rule cares about output stability as well as price stability. However, the basic aggregate demand and supply model in Chapter 5 showed that deviations of output from potential output had predictable effects on prices and inflation rates. Booms leading to inflationary gaps push prices up and lead to inflation. Recessionary gaps tend to reduce inflation. Thus, a Taylor rule is also compatible with the interpretation that the central bank cares about prices and inflation, both now and in the future. It is hard to distinguish empirically between these two interpretations of why a Taylor rule is being followed. Indeed, recently inflation rates in most industrial economies have been very low and central banks have come to focus more on output gaps and corresponding unemployment rates in making their interest rate setting decisions.
Nevertheless, until the financial crisis of 2008, Taylor's claim that such a rule effectively described central bank policy had strong empirical support. Most of the leading central banks, including the US Federal Reserve, the Bank of England, and the new European Central Bank used an interest rate target as a policy instrument in pursuit of an inflation control objective. Taylor's insight is so widely used that it is called the "Taylor rule". It still provides a useful way to explain monetary policy decisions.
Taylor rule: central bank interest rate settings based on inflation and output targets.
A simple monetary policy rule
It is useful to assume prices are constant, so the inflation rate is zero for the first part of the study of policy rules. When prices are constant, monetary policy follows the output part of a policy rule. In simple terms, the rule is:
The overnight rate set (i) equals:
1. (i0) the interest consistent with equilibrium at potential output (YP) plus an adjustment to that rate if:
2. there is currently an output gap , which can be written as:
(10.1)
Figure 10.5 Interest rates and output with a simple monetary policy rule
a) Central bank sets interest rate i0 consistent with YP. changes i with a set range. Slope of line defines central bank reaction to temporary . b) A fall in A(i) causes recessionary fluctuation in Y to Y1. Bank reacts, allowing i<i1. Lower i increases A(i) to restore AE and equilibrium Y=YP. If decline in A is persistent and not offset by small fall in i the Bank will reset its target rate.
Alternatively, for an output greater than YP, the central bank would raise interest rates to reduce aggregate expenditure. This simple policy rule describes how the central bank resets its interest rate to achieve the target of equilibrium output at YP, and reacts to offset or moderate temporary fluctuations about YP.
Panel b) shows the effect of the changes in interest rates on equilibrium output. We studied the transmission mechanism from interest rate changes to expenditure changes in Chapter 9. The central bank chooses the interest rate i0 that gives aggregate expenditure and equilibrium output at YP.
Policy rules and inflation
The assumption that prices are constant ignores the importance of inflation, making a policy rule based on the output gap alone too simple. Central banks today, like the Bank of Canada, conduct their monetary policy by setting inflation targets. This does not mean that they ignore the level of output in the economy. Instead, inflationary and recessionary gaps, and changes in unemployment rates, are seen as important predictors of future inflation. The simple monetary policy rule of Equation 10.1 is easily extended to recognize this current approach to monetary policy.
The central bank's setting of its interest rate instrument could then be:
1. (i0) the interest consistent with equilibrium at potential output (YP) plus an adjustment to that rate if:
2. () the current inflation rate differs from , the Bank's inflation rate target plus a second adjustment if:
3. (YYP) the output gap does not equal zero.
This gives a basic equation that describes the central bank's policy reaction to economic conditions.
(10.2)
As before, the central bank sets an interest rate i0. This is the nominal interest rate the bank thinks is consistent with output at potential output and inflation at the target rate under current conditions.
The Bank of Canada's current inflation target, for example, is percent, the midpoint of a 1 percent to 3 percent range. If inflation rises above the target , the central bank raises the nominal interest rate. The parameter a in the equation tells us by how much the nominal interest rate is changed in response to an inflation rate different from the bank's target.
Expenditure decisions depend on the interest rate. To stick to its inflation target, the bank must change the interest rate by changing the nominal interest rate by more than any change in inflation. This requires the parameter a>1. A rise in inflation is then met by a rise in interest rates that is large enough to reduce expenditure and inflationary pressure.
By this rule, the central bank also reacts to any departure of output from potential output, as it did in our earlier study of the simple rule, Equation 10.1. The parameter measures how much the central bank would raise the interest rate in response to an inflationary gap, or lower it in response to a recessionary gap. Output stabilization requires that interest rates be raised in the case of an inflationary gap or lowered in the case of a recessionary gap thus is greater than zero ().
Changing interest rates to offset an output gap is intended to stabilize output, but it will also work to offset any changes in the future inflation rate that would be caused by a persistent output gap. The size of the central bank's reactions, as measured by the parameters a and are indications of the relative importance it attaches to inflation control and output stabilization.
Any change in economic conditions that the central bank thinks is going to last for some time will result in a change in its setting of i0. The policy line in a diagram would shift up or down. Interest rates would then be higher or lower for all inflation rates and output gaps, depending on the change in i0. The central bank would announce this change in the setting of its policy instrument, the overnight rate in Canada or the federal funds rate in the United States. Bank of Canada press releases explain overnight rate settings. See for example:
http://www.bankofcanada.ca/2017/04/fad-press-release-2017-04-12/
This approach to monetary policy has similarities to our earlier discussion of fiscal policy. In that case, we distinguished between automatic and discretionary policy. In the case of monetary policy, the discretionary component is the setting of the operating range for the overnight rate. These decisions are based on an evaluation of longer-term economic conditions relative to the target inflation rate. It positions the monetary policy line in a diagram in much the same way as the structural budget balance positions the government's BB line in Chapter 7. Short-term fluctuations in economic conditions result in short-term variations in the overnight rate—movements along the monetary policy line. This is similar to the automatic stabilization that comes from movements along the government's BB line as a result of fluctuations in output and income.
There is, however, an important difference between monetary and fiscal policy. Monetary policy that uses the interest rate as the policy instrument provides strong automatic stabilization in response to money and financial market disturbances. Automatic stabilization in fiscal policy reduces the effects of fluctuations in autonomous expenditures.
The effective lower bound (ELB)
The financial crisis and recession of 2008-09 led to new and more intense monetary policy actions by central banks. Most continued with cuts to basic policy rates as their first response. The Federal Reserve in the United States lowered its federal funds rate, in steps, to a range of zero to 0.25 percent. The Bank of Canada followed, lowering its overnight rate setting to 0.5 percent by early March 2009. But these lower rates were not sufficient to stimulate borrowing and expenditure. Banks and other lenders were concerned by the increased risks of losses on their current lending and the risks involved in new lending. They had suffered losses on previous large denomination fixed term and mortgage lending. Bankruptcies were rising across many business and consumer loan markets.
With their policy interest rates cut to near zero, central banks hit the effective lower bound (ELB). Nominal interest rates could not be reduced any further. Central banks needed additional policy tools to meet deep concerns about risk and liquidity in financial markets. Increased demands for liquidity raised desired reserve and currency holdings and lowered money supply multipliers in many countries, and restricted access to bank credit.
Effective lower bound (ELB): A Bank's policy interest rate cannot be set below a small positive number.
Two previously used techniques were introduced. The first was increased "moral suasion," an increase in communications with financial market participants to emphasize the central bank's longer-term support for markets and its actions to promote stability. More directly the banks were urged to maintain their lending operations.
Moral suasion: a central bank persuades and encourages banks to follow its policy initiatives and guidance.
The second was "quantitative easing," and in the case of the US, an even more extensive "credit easing." "Quantitative easing" is the large scale purchase of government securities on the open market. It expands the central bank's balance sheet and the size of the monetary base. A version of this policy action was used in Japan earlier in the decade after the Bank of Japan had lowered its borrowing rate to zero and wanted to provide further economic stimulus.
Quantitative easing: a large scale purchase of government securities to increase the monetary base.
Credit easing is measured by the expanded variety of loans and securities the central bank willingly holds on its balance sheet. These come from purchases of private sector assets in certain troubled credit markets. The mortgage market for example was in trouble as a result of falling real estate prices and mortgage defaults. Cash is put directly into specific markets rather than letting it feed it through commercial banks' lending and loan portfolio decisions.
Credit easing: the management of the central bank's assets designed to support lending in specific financial markets.
Monetary policy practice continues to evolve. In the last few years, with policy interest rates at or near the effective lower bound and persistent weakness in economic growth and employment, major central banks have relied increasingly on "forward guidance" to support their economies. Forward guidance is contained in the explanation a Bank gives in its formal announcement of setting of the policy interest rate. If for example the Bank's opinion that economic growth and inflation will be slow and weak, the Bank suggests that interest rates will be unchanged for some time into the future. Alternatively a prediction of a revival in growth and inflationary pressure may lead the Bank to predict increases in policy interest rates in the near future.
Forward guidance: information on the timing of future changes in the central bank's interest rate setting.
This forward guidance is intended to help firms and households make expenditure decisions that require debt financing. In some cases it is based on an explicit economic criterion.
For example, the US and the UK recently introduced unemployment rate thresholds for changes in the monetary policy rate settings. This is in essence a variety of forward guidance. In the UK, for example, in August 2013 the Bank of England, under the heading "Forward Guidance" announced:
In particular, the MPC [Monetary Policy Committee] intends not to raise Bank Rate from its current level of 0.5% at least until the Labour Force Survey headline measure of the unemployment rate has fallen to a threshold of 7%, subject to the conditions below.
Source:
www.bankofengland.co.uk/monetarypolicy/pages/forwardguidance.aspx
In effect, putting an unemployment rate target into the interest rate setting rule is a variation on the rule specified by Equation 10.2. It adds to or replaces the output gap target with an unemployment rate target. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/10%3A_Central_Banking_and_Monetary_Policy/10.04%3A_Monetary_policy_rules.txt |
Policy rules describe how a central bank, like the Bank of Canada, would use interest rates to stabilize output, prices, and inflation in the economy. To see how the Bank's actions affect economic activity and inflation, we need some indicators of the expansionary or restrictive stance of monetary policy. These monetary policy indicators will allow us to go beyond the central bank's descriptions of its policy and observe the effects of its policy actions on monetary conditions in the economy.
Monetary policy indicators: variables that provide information about the stimulus or restraint coming from the central bank's policy.
Our earlier discussion of the monetary transmission mechanism suggests two monetary policy indicators, namely, interest rates and exchange rates. The central bank sets nominal interest rates, which have important effects on asset prices, cash flows, and expenditures. Interest rates are also important to expenditure decisions. Changes in nominal interest rates over time will show how monetary policy has been implemented.
The foreign exchange rate as it affects net exports also provides an indicator of policy stance. Because exchange rates change in part as a result of interest rate differences between countries, changes in the exchange rate provide an indicator of the thrust of domestic monetary policy relative to foreign monetary policy. Although in Canada it is important to recognize that commodity prices also have strong exchange rate effects as illustrated by the recent depreciation of the Canadian dollar.
The monetary transmission mechanism works through both interest rates and exchange rates. In setting its interest rates, a central bank in a small open economy needs to consider recent changes in the exchange rate. If economic conditions, or policies in other countries, have caused changes in the foreign exchange rate, those changes will affect expenditures and output in Canada.
The depreciation of the Canadian dollar in 2015 is an important example. The corresponding appreciation of the US dollar raised import prices and increased the profitability of exports. Even without monetary policy, action expenditure and output in Canada would rise. The Bank of Canada had to make a decision. Was the setting of its operating range for the overnight rate still consistent with its inflation target once the exchange rate had risen? Should the Bank count on the stimulus from the exchange rate to offset the effects of lower energy and commodity prices or cut its interest rate to provide some further stimulus? If it were to respond, by how much should it lower interest rates? The Bank of Canada lowered interest rates. In this case the combined effect of interest rates and exchange rates was increased stimulus. However, the Bank could have decided that the exchange rate alone would suffice or even that the exchange rate depreciation gave too much stimulus. Clearly both are very important for designing and judging and monetary policy.
While interest rates and exchange rates provide important indicators of monetary policy, many economists and the Bank also regard the money supply or the rate of growth of the money supply as a policy indicator. Some suggest a monetary policy rule for money supply, which uses money supply as the central bank's policy instrument. The demand for nominal money balances depends on nominal income. Taking this into account, the difference between the rate of growth of the money supply measure, M1B, and the rate of growth of nominal GDP provides an indicator of the stance of monetary policy. M1B growth that exceeds growth in nominal GDP provides easier financial market conditions and suggests an expansionary policy stance.
The growth rates in the money aggregates M1B+ and real M2+, adjusted for inflation, provide alternative indicators of the effect of monetary policy. In the current policy context, the Bank of Canada sets the interest rates and the growth rates of money supply reflect the demand for money balances at those interest rates. Empirical research at the Bank and by other monetary economists has found that the growth in real M1B+ is a useful indicator of future growth in real GDP. Growth in real M2+ also provides a leading indicator of inflation. From these findings, an observed increase in the growth rates of these money aggregates indicates that the Bank's current policy is adding to aggregate demand.
Thus we have a basic set of monetary policy indicators: interest rates, exchange rates, and the growth rate in nominal and real measure of money supply. They come from our understanding of the way changes in monetary variables may affect expenditures, incomes, and prices and from our discussion of how monetary policy is designed and implemented. The Bank of Canada provides a more extensive list of key monetary policy variables at:
http://www.bankofcanada.ca/rates/indicators/key-variables/
Next
This chapter completes the development and explanation of the basic expenditure and monetary structure of the economy under the assumption that the general price level is constant. Chapter 11 introduces a basic modern AD/AS model that explains short-run fluctuations, output, and inflation. That model is built on modern monetary policy that sets interest rates to achieve inflation control. It is used to illustrate and evaluate recent Canadian fiscal and monetary policies. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/10%3A_Central_Banking_and_Monetary_Policy/10.05%3A_Monetary_policy_indicators.txt |
Central banks operate to influence the behaviour of other banks and intermediaries in the financial system.
A central bank conducts monetary policy through its control of the monetary base and interest rates. It is also banker to the government and to the commercial banks.
The Bank of Canada is Canada's central bank. It is the source of the monetary base. It sets short-term interest rates, acts as banker to the commercial banks and the federal government, and is the lender of last resort to the banks.
Monetary policy in Canada is the responsibility of the Bank of Canada. The Bank uses its control of the monetary base and interest rates to promote economic stability at potential output and a low stable inflation rate.
Central banks have three main operating techniques: reserve requirements imposed on commercial banks, open-market operations, and bank rate setting. These techniques are used to manage the monetary base, the money multiplier, and interest rates.
Central banks can implement monetary policy through the monetary base and money supply control or through interest rate control, but cannot do both simultaneously.
In practice, the Bank cannot control money supply exactly. Thus, for most central banks, a short-term interest rate is the instrument of monetary policy.
The Bank of Canada uses the overnight interest rate as its policy instrument, and an inflation rate of 1 percent to 3 percent as its policy target.
The Bank of Canada uses SPRAs and SRAs to intervene in the market for overnight funds and to reinforce its setting of the overnight interest rate.
A monetary policy rule such as a rule for setting the interest rate provides a useful description of the way the central bank sets and adjusts its interest rate policy instrument.
Changes in the central bank's policy instrument change nominal and real interest rates and change aggregate demand through the transmission mechanism, which includes wealth effects, cost of financing effects, and exchange rate effects on the components of aggregate expenditure.
Quantitative easing is the use of central bank purchases of securities with the aim of increasing the monetary base to meet unusually high demands for liquid cash balances in times of financial and economic crisis.
Credit easing is the increase in specific kinds of central bank asset holdings (for example, commercial paper) designed to provide liquidity and support lending in specific markets facing shortages of funds.
Forward guidance: information on the timing of future changes in the central bank's interest rate setting.
Real and nominal interest rates, exchange rates and rates of growth of money aggregates relative to national income can be used as monetary policy indicators.
10.07: Exercises for Chapter 10
EXERCISE 10.1
Explain carefully why a central bank does not operate to make a profit but a commercial bank does. What is the central bank's operating objective? What unique power does a central bank have that allows it to pursue its operating objective?
EXERCISE 10.2
Explain carefully why a central bank's power to conduct monetary policy is based on its unique position as supplier of the monetary base.
EXERCISE 10.3
Why would a change in the monetary base cause a change in the money supply?
1. Suppose a central bank buys \$10 million on the open market. What effect does this have on the monetary base and the reserve position of the commercial banks?
2. If the banks hold reserves equal to 2.5 percent of their deposit liabilities, and the public holds a constant amount of cash, calculate the effect of this open-market transaction on:
1. The money supply.
2. The banks' reserve balances.
EXERCISE 10.4
Suppose the central bank decides to use its power to set interest rates. Use a money market diagram to show and explain what happens to the real money supply if real output increases and the central bank maintains a constant interest rate.
EXERCISE 10.5
In terms of a monetary policy rule
1. What is the Bank of Canada's monetary policy target?
2. What monetary policy instrument does the Bank use to pursue this target?
3. What do the Bank's procedures for implementing policy mean for its control over money supply?
EXERCISE 10.6
Use a diagram to show circumstances in the market for overnight funds that might lead the Bank of Canada to make an SRA. Why would the Bank use an SRA in this case rather than an open market operation?
EXERCISE 10.7
Suppose a central bank decides to conduct monetary policy according to a rule for interest rates.
1. How does it choose the basic setting for the interest rate within the rule?
2. How would it respond to a rise in the output gap (YYP)?
3. How would the bank react to an inflation rate higher than its target inflation rate?
4. Why would the bank decide to change the basic setting of its interest rate? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/10%3A_Central_Banking_and_Monetary_Policy/10.06%3A_Key_Concepts.txt |
Chapter 11: Inflation, real GDP, monetary policy & fiscal policy
In this chapter we will explore:
11.1Inflation and aggregate demand
11.2Aggregate supply
11.3The equilibrium inflation rate
11.4Adjustment to output gaps
11.5Monetary & fiscal policy
11.6Recession, disinflation and deflation
Chapter 4 identified the inflation rate, the unemployment rate and the GDP growth rate as key indicators of economic performance. This chapter combines the concepts of earlier chapters into a full basic macroeconomic model of the economy for the study of causes of change in the first two of these indicators. It is representative of the models currently used by central banks and policy analysts to evaluate current economic performance and policy, forecast future performance and prescribe policy action. Economic growth and growth rates are covered in Chapter 13.
Underlying short-run conditions on the supply side of the economy are the same in this chapter as in earlier chapters. Labour force and technology are fixed by assumption, fixing potential output at YP. Instead of a fixed short-term equilibrium price level, the modern model assumes equilibrium rates of change in money wage rates, and inflation rates are stable in the short run and adjust slowly to output gaps.
On the demand side, monetary policy is aimed at inflation control using the short-term interest rate as the instrument as explained in Chapter 10. It reflects current Bank of Canada monetary policy as explained by the Bank at: www.bankofcanada.ca/core-functions/monetary-policy/. In normal conditions this allows fiscal policy to target the budget deficit and public debt ratio.
The model provides explanations of business cycle fluctuations in output, employment and inflation rates. It also provides a basis for evaluating recent changes in economic conditions and monetary and fiscal policy actions.
11.1 Inflation and aggregate demand
Monetary policy establishes the link between the inflation rate and aggregate expenditure that determines the slope of the AD curve. Central banks set interest rates to control the inflation rate based on an inflation rate target. A monetary policy that reacts to changes in the inflation rate by changing the interest rate causes changes in expenditures. The link between the inflation rate and aggregate expenditure still comes through interest rates and the monetary transmission mechanism, but it is the central bank's decision to change its policy interest rate that provides the impulse.
Changes in autonomous expenditure that are independent of interest rates are still an important part of aggregate demand. They cause shifts in the AD curve based on the multiplier as explained in earlier chapters. Changes in government fiscal policy and in the central bank setting of its interest rate target also shift AD. It is the monetary policy response to transitory variations in the inflation rate that give the AD curve its slope.
Figure 11.1 illustrates this monetary policy. Assume the central bank has an inflation control target such as . Based on its evaluation of current and near future aggregate expenditure and supply conditions the Bank sets the interest rate i0 to get its target inflation rate. If the actual inflation rate differs from as a result of changes in economic conditions that the Bank views as temporary, rather than fundamental, it reacts with temporary changes in its interest rate within a narrow range, allowing some variation around i0 such as i1 to i2. The Bank of Canada, for example, sets its overnight rate as the midpoint between the bank rate and the deposit rate. The upward sloping line in the diagram shows this 'reaction function'.
Figure 11.1 Monetary policy sets interest rate
A monetary policy rule: .
This is a simple policy rule you will recall from Chapter 10. An equation that describes this policy rule would be:
(11.1)
Alternatively if the Bank does not react to temporary departures from , that is if , the interest rate line is horizontal. Changes in the Bank's official setting of the overnight rate would then shift the interest rate line up or down as the case may be.
This approach to monetary policy and the inflation rate aggregate demand is based on two familiar relationships:
1. The monetary transmission mechanism as in Chapter 9, and
2. The expenditure multiplier from Chapters 6 & 7.
Figure 11.2 shows the derivation of the aggregate demand curve labelled AD. This is to differentiate it from the AD curve in Figure 9.5. In that example and examples in earlier chapters in which the equilibrium price level was constant, the inflation rate was zero, and a change in the money supply shifted the AD curve.
Figure 11.2 The function
Start in equilibrium with and interest rate i=i0 in a), and and Y0 at A in d). Suppose the inflation rate rises to . The central bank then raises its interest rate to i1. The higher interest rate reduces expenditure in b), lowering AE in c) and equilibrium real GDP to Y1. The new equilibrium combination is point B on the curve.
Figure 11.2 illustrates the relationship between the inflation rate, monetary policy and the slope of the curve. In this example the central bank does react to temporary variations in , (). Monetary policy as described by a policy rule or reaction function like Equation 11.1 is in Panel a) of the diagram. Interest rates set by policy in Panel a) determine autonomous expenditures in Panel b) giving the monetary transmission mechanism. Autonomous expenditures determine the position of the AE line in Panel c) and work through the multiplier to determine equilibrium real GDP. The combination of the inflation rate and equilibrium real GDP, Y0, give one point on an curve plotted in Panel d) and labeled A.
The central bank's reactions to changes in the inflation rate, other things constant, move the economy along the function. In Panel a) the Bank reacts to a temporary or transitory rise in the inflation rate to by allowing its policy interest rate to rise to i1. This reduces autonomous expenditure in Panel b) to A0vi1 and lowers the AE curve in Panel c) to . The multiplier then lowers equilibrium real GDP to Y1 and plotting in Panel d) gives a second point on an curve labeled B.
Changes in autonomous expenditures () not caused by changes in interest rates, like changes in autonomous consumption, investment, exports, or government expenditure would shift the function by amounts driven by the multiplier. Similarly, a change in monetary policy made by changing i0, in response to a change in economic fundamentals would shift the function.
The recession of 2009, for example, brought a sharp drop in Canadian exports and a shift in to the left. The Bank of Canada lowered its setting for the overnight interest rate in steps from 4.75 percent to 0.25 percent, as illustrated in Figure 10.2, to offset some of this drop in . However the monetary stimulus to through lower interest rates was not enough by itself to avoid a recession. Fiscal stimulus was also needed.
11.2 Aggregate supply
The supply side of the economy explains output, inflation, and the economy's adjustment to equilibrium at YP, potential output. If the economy is operating with an output gap, changes in the rate of increase in wage rates and other factor prices may push the economy toward a long-run equilibrium at potential output and a constant rate of inflation. But this internal adjustment process is slow at best.
No matter what time frame we use, the economy's output depends on:
1. The state of technology;
2. The quantities of factor inputs to production (labour, capital, land, energy, and entrepreneurship); and
3. The efficiency with which resources and technology are used.
A simple production function defines the relationship between outputs and labour and capital inputs to production as follows:
(11.2)
In this equation, Y is real GDP, A is the state of technology, and N and K are inputs of labour and capital, respectively, used in the production process.
Production function: outputs determined by technology and inputs of labour and capital.
The notation F(...) tells us that the size of output as measured by real GDP depends on the amount of labour and capital used in the production process. More labour and more capital used means more output. An improvement in technology would make A larger, and increase the output produced by any given amount of labour and capital employed. This would be an increase in productivity, an increase in output per unit of input.
Productivity: output per unit of input.
Long-run aggregate supply (YP)
Potential output (YP) is determined by the current state of technology, A0, the current stock of capital, K0, and the equilibrium level of employment, NF. In terms of the simple production function, this means:
Potential output (YP): the real GDP the economy can produce on a sustained basis with current labour capital and technology without generating inflationary pressure on prices.
The short-run fluctuations in output studied in earlier chapters are linked to differences between actual labour input N and the "full employment" labour input NF. Unemployment rates fluctuate as a result of these changes in actual output and employment relative to potential output.
Short-run aggregate supply
Short-run aggregate supply in the 'modern' model defines the relationship between output and the inflation rate, when capital stock, technology and the rate of growth in money wages are fixed. The basic argument is that monopolistically competitive firms set prices at a mark-up over marginal costs of production. The rates of increase in marginal costs of production depend in turn on the rates of increase in money wage rates, prices of material inputs, and productivity.
Prices are sticky in the very short run. Changing prices is costly and competition among producers means relative prices are important to market position. Furthermore, stable prices may help to build customer loyalty. As a result, price changes only follow changes in costs that last beyond the current short term. A horizontal short-run aggregate supply curve as in Figure 11.3 captures this output-inflation relationship.
Persistently strong aggregate demand would increase employment, output and capacity utilization, and lower productivity. Employment would rise and the unemployment rate would fall below the NAIRU, increasing the growth in money wage rates. This upward pressure on current and future marginal costs would compress producers' markups and profitability. Alternatively, persistently weak aggregate demand would lower rates of increase in money wage rates, lower material costs, lower marginal costs, and increase mark-ups. Producers wouldn't adjust price setting practices immediately in either case. But they would react if their mark-ups are persistently pushed away from what they see as the profit maximizing level.
NAIRU: the 'non-accelerating inflation rate of unemployment' that corresponds to NF at YP.
These short-run aggregate conditions are described in a simple function that explains the current inflation rate as:
1. () The rate of inflation last period or last year.
2. () The output gap last period or last year.
3. () A term that captures the effects of disturbances such as commodity price shocks or extreme climate conditions or political events that would shift supply conditions.
These factors are combined in an equation along with the parameter which measures the size of the effect an output gap has on the inflation rate:
(11.3)
Equation 11.3 gives a horizontal short-run curve that is sometimes called an 'inflation adjustment' function. The current inflation rate () is 'last year's' inflation rate adjusted up or down in reaction to 'last year's' output gap. In other words the inflation rate changes with a lag in response to the effect of an output gap on costs and prices. If there is no output gap, the inflation rate would be the same from year to year. As an alternative, could be specified as an upward sloping function by dropping the lag on the output gap, but that would remove some of the short-run stickiness observed in wage rates and prices. Figure 11.3 illustrates potential output (YP) and short-run aggregate supply .
Figure 11.3 Potential output and short-run AS
In the short run the inflation rate is constant as long as the economy is at YP. If the economy is not at YP the output gap will change the rate, shifting the line up or down in the next time period.
11.3 The equilibrium inflation rate
Figure 11.4 shows the aggregate demand curve and the vertical long-run aggregate supply curve YP. Output is at potential output, and the inflation rate, , is determined by aggregate demand. At point A there is equilibrium in all markets: for output, money, and labour.
Figure 11.4 The equilibrium inflation rate
The equilibrium inflation rate is determined by and YP, as at point A in the diagram. This is also the short-run equilibrium inflation rate. If is the central bank's monetary policy target, the bank sets its interest rate to get .
In practice, central banks do not set zero inflation targets for monetary policy. Some, including the Bank of Canada, set explicit low inflation rate targets. Others, including the United States Federal Reserve, work to implicit inflation rate targets that are also positive and low. There has been and still is a lot of discussion among economists about the appropriate level of the inflation rate target. The Bank of Canada's 2 percent target represents a current consensus on the issue.
The curve in Figure 11.4 is based on a monetary policy inflation target of . In setting its inflation target, the central bank recognizes that money is neutral when wages and prices are flexible and there is no money illusion. This means that the central bank cannot influence potential output, but it can determine the equilibrium inflation rate. It sets the interest rate and accepts growth in the money supply consistent with its inflation target. A rate of inflation, , greater than zero means the rate of growth of the money supply, , is greater than zero. This puts the curve at , and keeps it there as inflation raises the price level at the target rate.
11.4 Adjustments to output gaps
Now consider how demand or supply shocks that move the economy away from potential output trigger an adjustment process. In combining the and curves, it is assumed the market for goods and services clears even in the short run, but the labour market takes longer to adjust. The inflation rate changes over time as wage rate growth adjusts to the unemployment rate. If this process goes smoothly and other conditions are tranquil, it may eventually restore full employment at potential output. But in the meantime output gaps can be quite persistent.
Figure 11.5 Output Gaps: Canada and the US, 1995–2017
Source: IMF World Economic Outlook Database, April 2017.
Estimated 2017 gaps
Figure 11.5 provides some empirical evidence. For Canada, the recessionary gap of the last half of the 1990s lasted for about five years. The small inflationary gaps that followed persisted for seven years, and were followed by large recessionary gaps in the financial crisis of 2008–09, which have diminished in size but persist into 2016–17. The data show that automatic adjustments are slow at best.
An aggregate demand shock
Figure 11.6 shows the adjustment to an output gap that is built into the model. In the diagram, an unexpected fall in aggregate demand shifts the function to the left. A decline in exports or investment or government expenditure, or a change in the inflation target set for monetary policy, would have this effect on . Before this change, the economy was in equilibrium at full employment and potential output with inflation rate , the central bank's inflation target.
Figure 11.6 Adjustment to a recessionary gap
A fall in to creates a recessionary gap (Y1YP). The increase in unemployment and reduction in output cuts the rate of increase in wage rates and prices to . Lower inflation leads the central bank to reduce its interest rate, supporting a move along to Y2.
In the short run, the fall in creates a recessionary gap (Y1YP). Since producers cannot cut costs per unit of output, they reduce employment and output to Y1 to cut total costs. Unemployment rates rise. At Y1 the goods market clears. It is a point on both the and curves. Inflation has not fallen because of the short-run stickiness in wage rate increases and price increases.
An inflationary gap results in the opposite process. Employment and output rise. Unemployment rates fall. Wage rate increases rise, inflation rises, and monetary policy reactions result in higher interest rates to reduce expenditure. In both cases, the eventual changes in wage rate agreements and rates of inflation together with the reaction of monetary policy to changes in inflation rates move the economy, over time, from short-run to long-run equilibrium. But the new equilibrium inflation rate would be higher than the Bank's target.
This adjustment process has important implications for the inflation targets set by monetary policy. It means prolonged changes in aggregate demand conditions require changes in the central bank's interest rate setting to defend the inflation target. It also means that, if the inflation target is cut, shifting the curve to the left, the economy will go through a recession, and perhaps a prolonged recession, while money wage rate agreements are renegotiated and price setting practices adjust to reflect the new inflation target. The time required for this adjustment is linked in a very important way to the independence and the credibility of the central bank. Canadian experience in the 1990s provides an interesting example. Recessionary gaps were persistent after the Bank of Canada adopted an inflation target of 2 percent at a time when current inflation rates were about 5 percent.
An aggregate supply shock
Figure 11.7 shows the model's internal adjustment to unexpected shift in . A sharp increase in crude oil and commodity prices, for example, enters the function as an increase in () in Equation 11.3. That pushes costs up and prices follow, increasing the inflation rate at least temporarily. Increases in indirect taxes like the HST or the taxes on alcohol and gasoline would have a similar effect. They increase the sellers' tax remittances to government, which sellers attempt to offset by increasing prices.
Figure 11.7 An aggregate supply shift
An increase in commodity prices increase as shifts up to . Inflation is higher than the Bank's target and output falls, creating a recessionary gap. This is 'stagflation'. The central bank faces a dilemma. It cannot defend its inflation target without increasing the gap. Alternatively it can wait until falls back to .
In Figure 11.7 the curve shifts up to . The inflation rate is higher and output falls creating a recessionary gap. These are the economic conditions often described as 'stagflation'. They pose a dilemma for the central bank.
Inflation is higher than its official target rate but trying to bring inflation down by raising the policy interest setting would only make things worse by raising the unemployment rate. Alternatively, cutting the policy interest rate to reduce the recessionary gap would shift to the right and validate the higher inflation rate. Doing nothing, on the assumption that the increase in commodity prices is a one-time jump, would mean living with inflation above the target and high unemployment until the rates of increase in wage rates and prices fall. Then would shift down to . The cost of waiting is the cumulative loss of employment and output during the adjustment process and the redistribution of income in favour of commodity producers if that is the source of the supply shift.
11.5 Monetary and fiscal policies
The inflation-output model sets clear roles for monetary and fiscal policies, at least in normal times. Monetary policy, which is embedded in the curve, is aimed at an inflation control target using a short-term interest rate instrument. Within the structure of the model this monetary policy simultaneously moderates business cycle fluctuations in output and supports equilibrium output at potential output. Fiscal policy can be aimed at a government debt ratio target through budget balance control. The net tax rate in the government's budget provides automatic fiscal stabilization to moderate business cycle fluctuations.
Canadian monetary and fiscal policy followed this pattern from the early 1990s until the financial crisis of 2008. The Bank of Canada, in consultation with the Ministry of Finance has set inflation control targets for monetary policy since 1991. With the policy independence provided by a flexible exchange rate, the Bank uses the overnight interest rate as its policy instrument and intervenes in the market for overnight clearing balances. This keeps the overnight rate within the operating band it sets. An interest rate policy rule provides a useful description of the Bank's reactions to inflation rates that deviate from its control target.
Monetary policy
In practical terms central banks set their short-term interest rate instruments based on their inflation rate control target and their assessment of current and future economic conditions. This approach is described by a policy rule for setting the interest rate like that introduced in Chapter 10, namely:
(11.4)
Adding a term for the output gap means the central bank looks at both the inflation rate and the state of the economy in making its interest rate setting decisions. In terms of the model, the output gap is a predictor of the way the inflation rate will move if current conditions persist. In times of recession, for example, the output gap term in the policy rule calls for a cut in interest rates even if the inflation rate is still . This way the central bank pre-empts the fall in inflation that a recession would cause.
Figure 11.8 Central bank lowers overnight rate target
Initially, equilibrium is in a) with the Bank's overnight rate set at i0. Then falls to as a global recession reduces exports. GDP falls to Y1 causing an output gap Y1YP. The central bank reacts to the output gap with a cut in its overnight rate target to i1 in b), to provide stimulus and increase .
Figure 11.9 shows that the Bank of Canada's setting for its overnight interest rate has been related to the output gap over the 1995–2017 period. The interest rate setting rule described by Equation 11.4 calls for the Bank to lower its overnight rate as the output gap (YYP)/YP is <0 and increase its rate when the output gap (YYP)/YP is >0. Figure 11.8 gives one example of how this works in theory. It is indeed the pattern of overnight rate settings we see in the data plotted in Figure 11.9.
Figure 11.9 The ONR and the Output Gap
Source: CANSIM Series V39078, Bank of Canada, Indicators and author's calculations.
More recent examples of the Bank's reaction to an anticipated recession were the cuts in the overnight rate in 2015 following the drop in oil and commodity prices. This rate cut was intended to offset the negative effects of lower oil prices on the revenue, employment and investment expenditures of major oil and commodity producers. The economy was already working with a recessionary gap and that gap was growing in the first half of 2015.
Figure 11.10 Canadian Inflation: Quarterly at Annual Rates, 1996–2016
Source: CANSIM V41690914 and author's calculations.
The data plotted in Figure 11.10 show the volatility of the annualized quarterly inflation rates but the average rate over the period is indeed 1.8 percent, just below the Bank's 2.0 percent target. Over the same period the economy went through both recessionary and inflationary gaps, with a small recessionary gap, -0.5 percent of YP, on average. If the period following the financial crisis of 2008 is excluded the average output gap from 1995 to 2008 is -0.2 percent with a range of -2.1 percent to +2.4 percent.
While success with inflation control did not eliminate the business cycle in real GDP and employment, economic performance was consistent with the argument of the model. From 1995 to 2007 the inflation rate fluctuated around the 2 percent target and output was, on average, close to estimates of potential output.
The financial crisis of 2008 changed the economic fundamentals, the focus of monetary and fiscal policies, and the economic performance of the economy. This more recent experience is covered after a discussion of recent fiscal policy in terms of the model.
Fiscal policy
Under normal conditions in the model with a flexible foreign exchange rate, monetary policy dominates discretionary fiscal policy. Monetary policy sets the interest rate that will give the needed to get the inflation rate target at potential output. A change in discretionary fiscal policy would change the conditions on which the Bank's interest rate is set. To defend its inflation rate target the Bank would react, changing its interest rate setting to offset any new fiscal stimulus or restraint. Monetary policy aimed at inflation control deliberately crowds out the effect of fiscal policy on through the interest rate-exchange rate links in the monetary transmission mechanism.
For example, in 2006 and 2007 the Government of Canada cut the GST by a total of 2.0 percentage points. The Bank of Canada raised its overnight interest rate from 3.25 percent to 4.50 over the same time period. At the time the economy was also working at an inflationary gap. The increase in interest rates offset the fiscal stimulus from the GST cut by raising costs of current and future credit.
However, fiscal policy does have two important roles to play when the central bank successfully targets inflation and potential output:
1. Provide automatic fiscal stabilization; and
2. Control, and perhaps reduce, the ratio of the public debt to GDP.
Fiscal policy is implemented through the government's budget. The budget balance function provides the framework. Elaborating on the basic government budget of Chapter 7 to recognize the importance of the public debt gives:
(11.5)
The term iPD is the interest paid on the government bonds, PD, issued in the past to finance budget deficits. G represents program spending. G+iPD is total government spending.
The fiscal policy instruments are:
1. The net tax rate, t, set in the budget plan, which will also be a component of,
2. The primary budget balance, PBB=tYG, which excludes interest payments on the public debt.
The Department of Finance, Fiscal Reference Tables, 2016 (www.fin.gc.ca) report the Government of Canada paid interest (iPD) of \$25.6 billion in the fiscal year 2015–16. That was an amount equal to 2.7 percent of its outstanding interest bearing debt and 8.6 percent of total government expense (G+iPD).
Government tax and expenditure programs linked to GDP provide automatic fiscal stabilization, as explained in Chapter 7. In addition, with a monetary policy consistent with equilibrium at potential output, discretionary fiscal policy can aim to control the public debt ratio (PD/Y) by managing the government's primary budget balance. This is the fiscal policy objective that has caused serious debates in both the US and Europe, and in the 2015 federal election campaign in Canada.
Public debt ratio (PD/Y): the ratio of government debt to GDP.
Primary budget balance (PBB=tYG): the difference between net tax revenue at YP and government program expenditure. It excludes interest payments on the public debt.
Current interest payments on the public debt are the result of past issues of government bonds and the average of coupon rates on those bonds. This expenditure cannot be changed in the current budget but can be controlled going forward as current budget balances reduce or increase the public debt.
Automatic stabilization
Automatic fiscal stabilization comes from the net tax rate t in the budget function. This rate changes government revenues and transfers automatically when GDP changes. Cyclical changes in the government budget balance reduce the size of the expenditure multiplier and the size of the change in GDP caused by shifts in conditions. The budget function:
(11.6)
separates the cyclical component t(YYP) of the budget balance BB from the structural primary budget balance SPBB. The structural primary budget balance evaluates the government's fiscal program net of interest payments on the public debt at YP. The cyclical component is the effect of an output gap on the actual budget balance. The actual budget balance BB in Equation 11.6 has three components, the structural primary budget balance (SPBB), the cyclical component and the interest payments on the public debt (iPD).
Setting the net tax rate that will provide automatic stabilization is a simple mechanical question but a difficult economic and political question. A higher net tax rate provides more stabilization. It involves the design of the tax system and transfer payment programs like employment insurance, social assistance programs and subsidy programs where revenues collected and expenditures made vary inversely to economic conditions. The types of taxes to be used and the bases to which those taxes are to be applied generate heated debates. The design and eligibility requirements for transfer benefits are also controversial. There are also strong differences of opinion over the economic impacts of different types and rates of taxes and transfers. These issues have been important to recent election campaigns in Canada and the US and will dominate ongoing US debates about budget deficits and public debt control.
We will leave the details of those debates to specialists in public finance and ask a question that is somewhat easier to answer. Have changes in the cyclical balance of the Canadian federal government budget provided automatic stabilization? To answer this question, Figure 11.11 plots the output gap and the cyclical budget balance over the 1995–2016 time period. These data show a pattern of cyclical budget deficits and surpluses that coincide with recessionary and inflationary gaps to provide automatic fiscal stabilization.
Figure 11.11 Output Gaps and the Cyclical Budget Balance, 1995–96 to 2015–16
Source: Department of Finance, Fiscal Reference Tables, 2016, Bank of Canada Indicators and author's calculations.
For most years in the period covered by Figure 11.11 the absolute magnitude of the cyclical budget balance is noticeably less than that of the output gap. That pattern changes after 2008 when expansionary fiscal policy, the 'Economic Action Plan' of 2009 was introduced to fight the recession that followed the 2008 financial crisis. Although this was clearly a discretionary policy change, the Department of Finance reported it in its Fiscal Reference Tables, 2011 as a component of the cyclical balance, excluding it from its structural budget balance estimates, and continues this practice with additional revisions in the Fiscal Reference Tables, 2016. This is an interesting treatment of this discretionary stimulus program that was extended into 2011 and 2014 and continued to feature prominently in government advertisements. As a result, the 'automatic stabilization' illustrated in Figure 11.11 is overstated in the 2009–2014 period and the reported structural budget balance is increased. Furthermore, in the 2013–2015 period the changes in cyclical budget balance reflect a shift to fiscal austerity driven by the Harper Conservative government's commitment to achieve a balanced budget, BB = 0, by 2015 even in a time of economic recession.
The Liberal government elected in 2015 offered an alternative approach. Government budget deficits for at least a few years based on infrastructure expenditure. The objective was to stimulate economic growth, reduce recessionary income gaps and unemployment by increasing aggregate demand and productivity. As economic conditions deteriorated as a result of falling oil and commodity prices budget deficits were larger than initially proposed, undermining the original time frame set for achieving a balanced budget. Control of the public debt ratio became the new constraint on fiscal stimulus and the budget deficit.
Setting a target for the public debt ratio defines both the size of the primary budget balance and the budget deficit the government can run. It also defines the scale of the fiscal expansion or austerity the government has to work with.
Controlling the debt ratio
The public debt ratio is usually defined as the outstanding public debt as a percentage of annual nominal GDP. Explaining the budget balances required to control and reduce the public debt ratio is a bit more complicated. The annual change in the outstanding public debt, PD, is equal to the annual budget deficit or surplus, . The change in the debt ratio, PD/Y from one year to the next is determined by two conditions namely:
1. The percentage change in the debt, , which is the change in the numerator of the ratio and
2. The percentage change in GDP, , which is the change in the denominator of the ratio.
Recall that the government's budget balance function is:
BB=tYGiPD
Where the net tax rate t, and government program expenditure G are set in annual budgets. The third component, iPD, is determined outstanding public debt and the average interest rate on that debt. As a result it is only the primary budget balance (PBB = tYG) that can be changed in annual budgets.
Furthermore, if the primary budget is balanced, (PBB = tYG = 0) interest payments on the outstanding debt will still increase the debt by iPD. This increase in the public debt will increase the debt ratio unless there is an offsetting increase in GDP. As a result the difference between the interest rate, i, that increases the debt, the growth rate of GDP, g, and the current debt ratio, PD/Y, determine the primary budget balance relative to GDP, PBB/Y, required to keep the debt ratio constant, namely:
(11.7)
Table 11.1 uses Equation 11.7 to provide a numerical example of a change in the Government of Canada's debt ratio based on a small sample of recent data from the Department of Finances Fiscal Reference Tables 2016. Columns (2), (3) and (4) show the interest rate, growth rate and public debt ratio used to estimate the primary budget balance required to stabilize the public debt ratio at its fiscal year end value of 31.3 percent.
Based on these conditions, with the interest rate on the public debt, i = 3.2 percent, less than the growth rate in nominal GDP, g = 4.5 percent, the debt ratio would have been constant even with a small primary budget deficit, PBB < 0, of about 0.04 percent. As it turned out, the government's actual primary budget surplus reduced the debt ratio from 31.3 percent in 2013–14 to 29.6 percent in 2014–15. Strong growth in nominal GDP was important for this outcome.
Table 11.1 A numerical example of the primary budget balance required for a constant debt ratio based on equation 11.7
(1) (2) (3) (4) (5) (6) (7)
Time Interest rate Growth rate Public debt PBB/Y required Observed Observed
Period on public debt of nominal GDP ratio for PBB/Y
i g PD/Y
2013–2014 0.032 0.045 0.313 -0.004 0.012 -0.016
Source: Department of Finance, Fiscal Reference Tables, 2016, Tables 13, 15, and 17, Statistics Canada, CANSIM, Table 380-0083 and author's calculations.
The current Government of Canada is not the first to identify the debt ratio as a constraint on fiscal policy. In 1994 the Government of Canada announced A New Framework for Economic Policy that focused fiscal policy on deficit control and debt ratio reduction: goo.gl/GZKyxP. It set an initial budget deficit target of 3 percent of GDP as the first step in a fiscal policy program aimed at achieving first a balanced budget and then a surplus to reduce the federal government debt as a percentage of GDP. This was followed in 2004 by a target: Reducing the debt-to-GDP ratio to 25 percent within 10 years. The government then managed the budget balance through a combination of taxation and expenditure programs to pursue this debt ratio target.
When this policy announcement was made the public debt stood at 68 percent of GDP. The primary budget balance was in deficit and interest payments on the public debt absorbed about 35 percent of government revenue. In the years that followed, the public debt ratio declined steadily to a low 29 percent in 2008–09. Interest payments on the debt fell to less than 13 percent of revenue. Fiscal policy was on track to meet the debt ratio target of 25 percent set in the 2004 Budget. Significant primary surpluses were the major fiscal contributor to this decline in the ratio. The fiscal stimulus introduced in 2009 reversed this pattern, creating budget deficits and raising the net public debt by 30 percent between 2009 and 2014.
Canadian success with debt ratio control and reduction from 1995 until 2009 has been cited as an example for countries currently facing very high debt ratios. But it may not fit with current economic conditions in those countries. Canada's fiscal adjustment was made easier by a substantial easing of monetary conditions in terms of both interest rates and exchange rates and strong growth in the US economy, which all supported a large increase in exports and growth in Canadian GDP. This economic environment is not available to the countries that now face a debt crisis.
Even with favourable conditions, the Canadian adjustment was costly. There was a cumulative loss of output from an output gap that lasted from 1995 to 1999 that was at times as large as 2 percent of YP. Unemployment rates reached 9 percent and low rates of capacity utilization in industry reduced profitability and investment in new capacity and technology.
These and the negative fiscal effects of the earlier monetary restraint following the shift to inflation targeting are now sunk costs. In the years that followed monetary and fiscal policies worked to deliver stable inflation and declining public debt ratios until the crisis and recession of 2008–09.
11.6 Recession, disinflation and deflation
The financial crisis of 2008 and the recession that followed uncovered the limitations of monetary policy and renewed the case for fiscal stimulation. The assignment of monetary policy to an inflation target at YP and fiscal policy to debt ratio control did not work in the new economic conditions. Moreover, the depth of the recession and the collapse of the U.S. banking and financial sectors led to disinflation and raised fears of deflation as a result of rising real interest rates and output gaps. The Great Depression of the 1930s was an historical example. The Japanese experience starting in the 1990s with zero interest rates and a continuing slump was another. Stephan Poloz, the Governor of the Bank of Canada has at times worried out loud about the risks of deflation in Canada and discussed concerns briefly in an earlier speech on monetary policy. The full text of that speech is available at:
http://www.bankofcanada.ca/2013/12/monetary-policy-as-risk-management/
Although the risk of deflation has receded the issues raised by disinflation remain at least as long as central banks have reached the zero lower bound and cannot provide monetary stimulus through interest rate cuts. A rethinking of macroeconomic policy was necessary.
Disinflation: a persistent fall in the inflation rate.
Deflation: a persistent fall in the general price level.
Some of the issues involved can be explained with the basic model. In Figure 11.12 a financial crisis shifts by undermining the interest rate-expenditure link in the monetary transmission mechanism. Financial risk and uncertainty increase and demands for liquidity increase. Banks are reluctant to lend and businesses are reluctant to borrow. The curve shifts left and pivots to show the reduction in financing and the fall in the interest sensitivity of expenditure. Equilibrium shifts to with a recessionary gap.
Figure 11.12 Recession, disinflation & monetary policy
Financial crisis undermines monetary transmission mechanism. falls but central bank interest rate cuts cannot offset the fall in . At zero lower bound deflation raises real interest rate and the output gap continues to grow.
The recessionary gap triggers two reactions. The inflation rate falls and the central bank cuts its interest rate to offset the fall in inflation and output. But the steeper function reflects the disruption to financial markets. Nominal interest rate cuts have limited the effects on expenditure. To prevent a rise in the real interest rate the Bank must cut its nominal policy rate by more than the fall in inflation.
But the central bank cannot lower its rate below zero – it hits the lower bound. If the output gap persists and pushes disinflation into deflation, rising real interest rates cut expenditure and increase the gap. The function would be kinked backward at i=0 to capture these negative effects of disinflation and deflation. Falling inflation rates reduce aggregate expenditure and aggregate demand along the curve.
Fortunately economic conditions did not deteriorate badly enough to trigger deflation:
"It appears today that the world will likely avoid a major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates and larger and larger output gaps."
Blanchard, O. et al. (2010). Rethinking Macroeconomic Policy. IMF Staff Position Note, SPN/10/03
Nevertheless, faced with the financial crisis and recession, major industrial countries shifted their policy programs. Cutting interest rates to defend inflation targets was the first policy initiative. The Bank of Canada cut its target overnight interest rate from 4.25 percent in late 2007 to a record low 0.25 percent in early 2009 and held the rate at that level until mid-2010. In the US the Federal Reserve cut its federal funds rate, the policy rate that corresponds to the Bank of Canada's overnight rate, from 5.25 percent in late 2007 to 0.0 percent in late 2008. It is still at that rate today in late 2014. These interest rate cuts reduced policy rates to the zero lower bound and exhausted the potential for monetary stimulus with that policy instrument.
Monetary policy in the US turned then to instruments used before it adopted interest rate setting to get an inflation target. The first was increased "moral suasion," an increase in communications with financial market participants, including conditional statements about the future path of policy rates, to emphasize the central bank's longer-term support for markets and its actions to promote stability. More directly the banks were urged to maintain their lending operations. The second was "quantitative easing," and in the case of the US, an even more extensive "credit easing." "Quantitative easing" extends the use of open market operations described above. The central bank purchases a broader range of financial assets to expand its balance sheet to increase substantially the monetary base and cash positions of the banks. In other words, the objective is to increase the quantity of cash reserves in the banking system directly.
Quantitative easing: a central bank purchase of financial assets to increase its asset holdings and the monetary base.
Credit easing: the management of the central bank's assets designed to support lending in specific financial markets.
Open market operations usually involve central bank purchases of short-term government bonds. The US Federal Reserve went beyond this, introducing three sets of policy tools:
1. lending to financial institutions,
2. providing liquidity directly to other key credit markets by buying highly rated commercial paper, and
3. buying longer-term securities, including mortgage backed securities.
Using these tools increases the size of the central bank's balance sheet and changes the structure of central bank asset holdings. Quantitative easing is measured by the impact on the quantity of bank reserves. Credit easing is measured by the wider variety of loans and securities the central bank willingly holds on its balance sheet. A purchase of these assets puts cash directly into specific markets rather than feeding it through banks and bank lending. Both are intended to increase lending to businesses and households in times when very low, near zero, interest rates alone are not working.
The effect of three rounds of quantitative easing by the US Federal Reserve has been to raise the monetary base in the US from about \$800 billion in to \$2.62 trillion in October 2012. While this monetary stimulus has not offset the full effects of the 2008-09 recession, it is credited with avoiding a US deflation. A version of this policy action was used in Japan earlier in the decade after the Bank of Japan had lowered its borrowing rate to zero and wanted to provide further economic stimulus. In terms of the model the intent was to support demand and shift the curve to the right or least avoid deflation if recessionary gaps persisted.
The Bank of Canada also developed plans for quantitative easing that were not used as economic conditions improved more quickly here than in some other countries. You can see the Bank's explanation of these policies in its Monetary Policy Report, April 2009 pp. 24-28, at http://www.bankofcanada.ca/wp-content/uploads/2010/03/mpr230409.pdf.
These monetary policies were supported by discretionary fiscal policies. With interest rates a zero, crowding out was not a concern and increased was the objective. The earlier focus on deficit and debt ratio control was set aside to provide aggregate demand stimulus. In Canada the federal government's 'Action Plan' included direct support for infrastructure projects and tax incentives for certain household expenditures. In terms of budget data the federal government structural budget shifted from a surplus of \$3.8 billion in fiscal 2007–08 to a deficit of \$10.6 billion in 2009–10. But as noted earlier, the 'Action Plan' stimulus was treated as a 'cyclical' budget component. Thus the change in the actual federal budget balance from a surplus of \$9.6 billion in fiscal 2007–08 to a deficit of \$55.6 billion in fiscal 2009–10 is probably a better measure of the fiscal stimulus that addressed the recession. However, this stimulus was relatively short lived as the government returned to its earlier deficit and debt control focus and left monetary policy to provide sustained support for economic recovery. The monetary/fiscal policy mix remained that way in mid-2015 leading up to the federal election in the fall of that year.
The new federal government led by Prime Minister Justin Trudeau shifted from a balanced budget fiscal plan to budgets designed to promote economic growth based on major infrastructure investment and modest tax cuts financed by modest budget deficits. This fiscal stimulus together with continued monetary stimulus from the Bank of Canada shifted policy mix from fiscal austerity/monetary stimulus to fiscal and monetary stimulus combined. Evaluating the effectiveness of this mix lies in the future.
Example Box 11.1 The Algebra of the AD curve
The curve is based on:
1. An AE function that includes the effect of interest rates on expenditures, and
2. Central bank monetary policy that sets interest rates to defend an inflation rate target.
The AE function is:
(1)
In this equation A0 is autonomous expenditure, v measures the impact of a change in the interest rate, i, on expenditure, and , the marginal propensity to spend. Using the equilibrium expenditure condition gives:
(2)
The central bank sets interest rates to achieve a target inflation rate and reacts to changes in the inflation rate by changing short-term interest rates according to:
(3)
In this equation i is the Bank's interest rate instrument, is the Bank's inflation rate target and is the actual inflation rate. With the central bank's response to a change in the inflation rate changes the nominal interest rate enough to change the real interest rate. The monetary policy objective is to keep inflation at the target value . Substituting the interest rate determined by monetary policy in 11.10 into the equilibrium expenditure condition 11.9 gives an aggregate demand curve that includes the inflation rate:
(4)
This aggregate demand curve is labeled to distinguish it from the traditional P, Y aggregate demand curve. is the relationship between real output and inflation. A numerical example illustrates this AD curve. Suppose and the central bank has an inflation target percent. The bank estimates that a real interest rate of 2.0 percent is needed for equilibrium at potential output. It sets the nominal interest rate and reacts to transitory departures from its inflation target according to the policy rule: Then by substitution,
In equilibrium giving:
(5)
The aggregate demand curve: defines a negative relationship between the inflation rate and equilibrium real GDP. When the inflation rate is equal to the monetary policy target of 1 percent (), the equilibrium level of real GDP and demand is 340. If the inflation rate were to rise to 1.5 percent, which exceeds the target by 0.5 percent, the Bank's reaction would be to raise the interest rate by percent. This would lower aggregate expenditure by and equilibrium real GDP by to 325, moving up along the curve. A fall in inflation from the target would bring the opposite reaction. This scenario is depicted in Figure 11.13.
Figure 11.13 The curve
Next
This chapter provides the basic model for the analysis of macroeconomic performance and policy that integrates the design, instruments and objectives of modern monetary and fiscal policies. Inflation, deflation, public debt ratios and business cycles are explained. But two issues remain. One is international macroeconomics and the importance of exchange rate policy for the effectiveness of monetary and fiscal policies. The second is economic growth, growth theory and growth accounting. These are covered in the next two chapters.
Key Concepts
The AD curve describes the relationship between equilibrium real GDP and the inflation rate.
Monetary policy that sets an inflation rate target and uses the short-run interest rate as a policy instrument is integral to the AD curve.
The production function determines the output of goods and services.
In the long run, labour market equilibrium determines the equilibrium level of employment and potential output YP.
In the short run, employment and output fluctuate in response to changing economic conditions. However, there is no trade-off between inflation rates and output.
The short run AS function describes the lagged adjustment to the inflation rate in reaction to output gaps.
The AS function is based on the price setting decisions of producers in imperfectly competitive markets.
The equilibrium inflation rate is the inflation control target set by the central bank.
Business cycles in output and employment caused by persistent AD and/or AS shifts create output gaps.
Persistent output gaps lead to an internal adjustment based on changes in the rate of increase in money wage rates and changes in the rate of inflation.
A monetary policy rule describes the central bank's setting of its interest rate policy instrument as reactions to inflation rates that differ from its inflation control target and to output gaps.
Fiscal policy controls government budget balances to control or reduce the size of the public debt ratio.
The primary budget balance is the fiscal policy instrument.
The arithmetic of changes in the public debt ratio links the change in the debt ratio to the primary budget balance and the difference between the interest rate on the debt and the growth rate of GDP.
Over the 1995–2008 period Canadian monetary and fiscal policies effectively controlled the Canadian inflation rate and reduced the federal government debt ratio.
The financial crisis of 2008 and the recession that followed in 2008–09 demonstrated the limits of monetary policies based on interest rates and fiscal policies focused on debt ratio control. In Canada, a combination of monetary and fiscal stimulus reduced the fall in output and employment. In other countries, a broader set of monetary policy instruments and fiscal austerity have yet to solve employment and public debt issues.
Exercises for Chapter 11
EXERCISE 11.1
Use a diagram to illustrate an economy at the equilibrium inflation rate. In this diagram, show how a permanent increase in exports would affect the equilibrium inflation rate and the equilibrium level of GDP if the central bank did not react and change its monetary policy.
EXERCISE 11.2
Suppose the central bank reacted to defend its inflation target from the effect of the increase in exports in Exercise 11.1. Use an diagram to show the change in the equilibrium interest rate setting and real GDP you would observe.
EXERCISE 11.3
Suppose opportunities for investing in high tech applications boost aggregate demand in the short run, and aggregate supply in the long run. Using and curves with equilibrium at potential output, show why output might rise in the long run without much of an increase in inflation.
EXERCISE 11.4
Suppose a new round of labour negotiations results in a higher average rate of increase in money wage rates for the next three years. Illustrate and explain how this would affect short-run aggregate supply conditions and the curve.
EXERCISE 11.5
Draw an aggregate supply and demand curve diagram to show an economy in short-run equilibrium at potential output. Suppose a wide-spread recession reduces incomes in foreign countries, leading to reduced demand for exports. Illustrate and explain how this would affect the short-run equilibrium Y and in your diagram.
EXERCISE 11.6
Suppose central banks have reduced their policy interest rates to the lower bound to fight a deep and prolonged recession. Use a diagram to show how either a reduction in the inflation rate, or deflation, would change the slope of the curve. Would cuts in nominal money wage rates and further reductions in the inflation rate reduce the recessionary gap when the central bank is constrained by the lower bound on its interest rate?
EXERCISE 11.7
In the two years before 2008 the Canadian federal government reduced the GST from 7 percent to 5 percent. Use an diagram to illustrate and explain the effects of this tax change on equilibrium output and inflation. If the economy was in equilibrium at YP and the target inflation rate before the tax cut, what monetary policy action, if any, would the central bank make to maintain those equilibrium conditions after the tax cut? What short-run net benefit, if any, would households and businesses realize as a result of the cut in the GST?
EXERCISE 11.8
Define the 'public debt' and explain why and how it might increase from one year to the next.
EXERCISE 11.9
Would it be possible for the ratio of the public debt to GDP (PD/Y) to fall even if the government's primary budget is in deficit? Explain your answer.
EXERCISE 11.10
Would it be possible for the ratio of public debt to GDP (PD/Y) to rise even if the government's primary budget balance is in surplus? Explain your answer.
EXERCISE 11.11
Optional: Suppose the central bank's monetary policy sets the interest rate according to the function:
and aggregate expenditure is the sum of:
C=200+0.75Y
I=85–2i
G=100
XIM=50–0.15Y–3i
1. What is the equation for the curve?
2. Plot the curve in a diagram, not necessarily to scale, that shows the horizontal intercept and slope of the curve.
EXERCISE 11.12
Optional: If careful research estimates potential output YP at 1,000, and the function is as derived in Exercise 11.11, what is the equilibrium inflation rate? What interest rate must the central bank set to defend its inflation target? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/11%3A_Inflation_real_GDP_monetary_policy_and_fiscal_policy.txt |
In 1999 the Canadian economist Robert Mundell won the Nobel Prize in Economics for his work on the importance of exchange rate policy for the effectiveness of monetary and fiscal policies as tools to manage aggregate demand. Mundell showed for a small open economy like Canada, with a high degree of international capital mobility, that:
• With flexible exchange rates monetary policy is a powerful demand management tool, but fiscal policy is weak, and
• With fixed exchange rates monetary policy is ineffective as a demand management tool, but fiscal policy is strong.
The Bank of Canada's monetary policy framework, using interest rates, flexible exchange rates and an inflation rate target reflects these strong theoretical arguments. Furthermore, the difficulties European countries using the euro have experienced trying to cut budget deficits and stimulate income growth show the constraint a fixed exchange rate imposes on fiscal adjustments.
This chapter explains the foreign exchange market, flexible and fixed exchange rates and the reasons why different exchange rate policies affect the design and effectiveness of monetary and fiscal policy.
12: Exchange rates monetary policy and fiscal policy
The balance of payments accounts provide the background to supply and demand in the foreign exchange market. They record transactions between residents of one country and the rest of the world that involve payments in different national currencies. Taking the Canadian economy as the domestic economy and the United States as the "rest of the world," all transactions that give rise to an inflow of US dollars to Canada are entered as credits in the Canadian balance of payments. Transactions requiring payments in US dollars are debits, entered with a minus sign.
Table 12.1 shows the actual Canadian balance of payments accounts in 2016. Entries in the 'Exports' column represent supplies of foreign currency coming to the Canadian foreign exchange market, converted to Canadian dollars. Entries in the 'Imports' column represent the demand for foreign currency in the Canadian foreign exchange market, converted to Canadian dollars. Row 5 in the table shows that after adjustment for statistical error and changes in official reserves, the foreign exchange market is in equilibrium – supply equals demand.
Balance of payments accounts: a record of trade and financial transactions between residents of one country and the rest of the world.
Table 12.1 The Canadian Balance of Payments, 2016 (Billions of Canadian \$)
Receipts Payments Balance
(Exports) (Imports)
1. Current account
Goods
521.4 547.2 –25.8
Services
107.2 129.3 –22.1
Investment income
91.5 106.3 –14.8
Transfers, etc.
13.6 18.6 –5.0
Balance 67.7
2. Financial account
Investment:
Foreign in Canada Canada in foreign
Direct investment:
41.8 85.1 –43.3
Portfolio investment
161.3 13.8 147.5
Other investment
59.3 91.0 –31.7
Balance 72.5
3. Statistical discrepancy 2.7
4. Official reserves 7.4
5. Balance of payments 0
Source: Statistics Canada, CANSIM Tables 376-0101, 376-0102
The Current Account of the balance of payments records international flows of goods, services, and transfer payments. The merchandise trade is exports and imports of goods; things like cars and car parts, steel, wheat, and electronic equipment. Non-merchandise trade measures exports and imports of services like travel, banking and financial services, transportation, and tourism. The total of merchandise and non-merchandise trade is the trade balance defined as net exports in our earlier study of planned expenditure and aggregate demand.
Current Account: a record of trade in goods, services, and transfer payments.
However, the trade balance is not the same thing as the current account of the balance of payments. There are also flows of investment income in the form of interest payments, dividends and reinvested earnings, and transfer payments between countries as a result of government programs like foreign aid, and private receipts and payments.
But exports and imports of goods and services are the largest components of the current account. Trade in goods and services is based, in part on differences across countries in tastes, in the types of goods and services available, in economic structure, in national income levels and differences in the prices of domestic goods and services relative to foreign goods and services.
Three factors determine the prices of foreign goods and services relative to prices of domestic goods, namely:
1. The domestic price level () for Canada;
2. The foreign currency price of imports () in the case of imports from the US; and
3. The nominal exchange rate (er): the domestic currency price of foreign currency.
International price competitiveness is measured by the real exchange rate, which combines these three factors. For example, the real exchange rate between Canada and the United States would be:
(12.1)
where the nominal exchange rate er is the Canadian dollar price of the US dollar and and are general price levels as measured, for example, by GDP deflators or consumer price indexes. The real exchange rate measures the price of United States goods and services in Canadian dollars relative to Canadian goods and services in Canadian dollars.
The real exchange rate makes an important link in the transmission mechanism between the foreign exchange rate and the impact of domestic price levels and inflation rates on net exports, aggregate expenditure and aggregate demand.
Nominal exchange rate (er): the domestic currency price of a unit of foreign currency.
Real exchange rate: the relative price of goods and services from different countries measured in a common currency.
Consider the following example:
• The nominal exchange rate er=\$1.25Cdn/\$1US
• The GDP deflator for Canada is 121.3, on the base year 2002.
• The GDP deflator for the US is 110.4, on the base year 2002.
Then the real exchange rate, which gives the price of US goods in Canadian dollars relative to the price of Canadian goods in Canadian dollars, is:
(12.2)
By this example, US goods and services are about 14 percent more expensive than Canadian goods and services, on average, when both are priced in Canadian dollars. At the same time, Canadian goods and services are less expensive than domestic goods in the US when both are priced in US dollars. These price differentials as are important to the flows of exports and imports of goods and services between countries.
The Financial Account of the balance of payments makes a link between interest rates and the supply and demand for foreign exchange and the exchange rate.
The financial account records the flows of funds for international purchases and sales of real and financial assets. Table 12.1 shows a net capital inflow of \$72.5 billion in 2016. The payments by foreigners buying Canadian assets exceeded the payments made by Canadians buying foreign physical and financial assets. A financial account surplus was the result.
Financial Account: the record of capital transfers and the purchases and sales of real and financial assets.
Receipts and payments in the financial account reflect sales and purchases of foreign assets. These flows have become increasingly important. Computers and electronic communications make it as easy for a Canadian resident to buy and sell stocks and bonds in the financial markets of New York or London as in Toronto. Moreover, controls on international capital flows have gradually been dismantled with globalization and financial integration.
The world's financial markets now have two crucial features. First, financial account restrictions on capital flows between advanced countries have been abolished. Funds can move freely from one country to another in search of the highest expected rate of return. Second, trillions of dollars are internationally footloose, capable of being switched between countries and currencies when assets with similar degrees of risk are expected to offer different rates of return in different countries and currencies.
This is the age of perfect capital mobility when small differences in expected returns trigger very large flows of funds from country to country. Indeed, the stock of international funds is now so huge that capital flows could swamp the typical current account flows from exports and imports.
Perfect capital mobility: when very small differences in expected returns cause very large international flows of funds.
In international asset markets, capital gains or losses arise not merely from changes in the domestic price of an asset, but also from interest rate differentials and changes in exchange rates while temporarily holding foreign assets. Table 12.2 provides an example.
Table 12.2 Returns from lending \$1,000 for a year
Interest Rate Exchange rate Final
\$1,000 (%) (\$Cdn/\$US) asset value
Lent in Initial Final \$Cdn \$US
1. Canada 4.0 1,040.00
2. United States 5.0 1.03 1.009 1,028.50 1,019.41
Suppose you can invest \$1,000 Canadian for a year. Canadian one-year interest rates are 4 percent. In the United States one-year rates are 5 percent. The higher United States rates look attractive. If you keep your funds in Canadian dollars, Row 1 shows that you will have \$1,040 at the end of the year. Can you do better by buying a United States asset?
Row 2 shows what happens if you convert \$1,000Cdn into US dollars at an initial exchange rate of \$1.03Cdn/\$1US you have \$970.87US to invest at the United States interest rate of 5 percent. You get \$1,019.41US. You would be ahead if the exchange rate remained constant. \$1,019.41US is \$1,050Cdn, a return of 5 percent, as you would expect.
Suppose, however, the exchange rate changes while your funds are out of the country. Let's say the Canadian dollar appreciates by 2 percent during the year, lowering the exchange rate to \$1.009Cdn/\$1US When converted back to Canadian dollars your \$1,019.41US now buys \$1,028.50 Cdn. You get 1 percent more interest income from holding the United States asset instead of the Canadian asset, but you suffer a capital loss of 2 percent by temporarily holding US dollars, whose value relative to Canadian dollars fell by 2 percent in that year.
In this example, you end up with about \$1,028.50Cdn if you lend in US dollars. The Canadian dollar appreciated by more than 1 percent, the difference between Canadian and United States interest rates. As a result, the capital loss from the exchange rate while holding US dollars outweighed the gain on interest. This was the experience of many portfolios in 2008 as the Canadian dollar appreciated strongly and the exchange rate fell. The total return on lending in US dollars was lower than the return in Canadian dollars.
Conversely, if the Canadian dollar depreciated against the US dollar while you were holding your United States asset, your total return would be higher than the 1 percent interest rate differential. You would get a gain on the exchange rate when you converted back to Canadian dollars. This was the experience of portfolios holding assets denominated in US dollars as the Canadian dollar depreciated over the period from May 2008 to March 2009, raising the nominal exchange rate from er=0.9994 to er=1.2645. The exchange rate movement provided a 26.5% annual return, in terms of Canadian dollars, to portfolios holding US dollar assets. The depreciation of the Canadian dollar in 2014-15 had the same effect.
Equation 12.3 summarizes this important result. The total return on temporarily lending in a foreign currency is the interest paid on assets in that currency plus any capital gain (or minus any capital loss) arising from the depreciation (appreciation) of the domestic currency during the period.
Return on holding = Interest rate on % increase/ % decrease in
foreign asset foreign asset nominal exchange rate (er)
(12.3)
As a result, the net capital flow in the balance of payments depends positively on the differential between domestic and foreign nominal interest rates (iif). A rise in domestic rates relative to foreign rates would attract a flow of funds into the domestic financial market. A fall in domestic rates would push the flow toward foreign financial markets, assuming in both cases that the exchange rate is not expected to change in an offsetting direction.
Alternatively, assuming the interest rate differential is constant, the net capital flow depends negatively on the expected rate of depreciation of the domestic currency suggested by . An expectation that the domestic currency will depreciate (a rise in ere) will increase the returns from holding foreign assets and lead to a net capital outflow. An expected appreciation would reduce expected returns on foreign assets with the opposite effect. These capital flows are important parts of the supply and demand for foreign exchange on the foreign exchange market.
The change in official international reserves in Table 12.1 records the increase or decrease in the Government of Canada's holdings of foreign currency balances. A government's holdings of foreign currencies are in its official international reserves account. These balances are like investments in foreign countries because they are the government's holdings of foreign assets. An increase in the official reserves is like a payment item in the financial account of the balance of payments. Because Canada maintains a flexible exchange rate, annual changes in international reserves are small. When it comes to discussing different exchange rate policies, countries that adopt fixed exchange rates often experience large changes in their foreign currency reserves in defense of the exchange rate they have set.
Change in official international reserves: the change in the Government of Canada's foreign currency balances.
The balance of payments is the sum of the balances in current and financial accounts minus the change in the official international reserves account. In Table 12.1, this balance is shown as the sum of accounts (1+2+3–4) namely . If all items in the accounts were measured correctly, the balance would be zero. To recognize this, a statistical discrepancy adjustment is made, as shown in the table, to account for any errors in the measurement of other items.
Balance of payments: the sum of the balances in current accounts and financial accounts, minus the change in the holdings of official reserves.
The record of the change in official reserves is always of equal magnitude to the sum of the balances on the current and financial accounts, if there is no statistical discrepancy in the measurements. As a result, the balance of payments always balances, but the state of the individual accounts underlying that overall balance need not be in balance. Indeed, changes in the foreign exchange rate in the foreign exchange market reconcile the different account balances to produce overall balance. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/12%3A_Exchange_rates_monetary_policy_and_fiscal_policy/12.01%3A_The_balance_of_payments.txt |
The foreign exchange market is the market in which the currencies of different countries are bought and sold and the prices of currencies, the foreign exchange rates, are established. Consider the market for US dollars as the foreign currency. The sources of supply and demand for foreign exchange are shown by the balance of payments in Table 12.1. Exports of goods, services, and financial assets generate a supply of foreign currencies that are sold in the foreign exchange market for Canadian dollars. Imports of goods, services, and securities must be paid for in foreign currencies. The demand for foreign exchange is derived from this demand for imports. Without intervention by governments, demand and supply determine the exchange rate, as, for example, er0=1.05 in Figure 12.1.
Different economic and financial conditions would change supply and demand for foreign exchange and result in a different exchange rate. In May of 2017, for example, the Canadian dollar price of the US dollar was \$1.36. By contrast when energy and commodity prices were high in 2010 the price of a US dollar was \$1.0299 Canadian dollars.
Figure 12.1 The foreign exchange market
The supply of US dollars on the foreign exchange market comes from US purchases of Canadian goods, services and assets. The demand for US dollars comes from Canadian demand for imports of goods, services and assets. Supply and demand determine the equilibrium exchange rate er0.
The US dollars supplied on the foreign exchange market are the receipts from the export of goods, services, and securities to US residents. From the discussion of the current and financial accounts of the balance of payments, exports of goods and services depend on foreign income, the relative prices of domestic and foreign goods and services, and the exchange rate. Net exports of securities depend on the difference between domestic and foreign interest rates, for given expectations of the future exchange rate.
At the equilibrium exchange rate er0, the quantities of US dollars supplied and demanded are equal. In terms of the balance of payments, the balance is zero. Receipts equal payments.
In practice, as seen in Table 12.2, the balance of payments is recorded in domestic currency. However, the equality of receipts and payments still holds. Both are easily converted to Canadian dollars by multiplying the US dollar amounts by the exchange rate. In terms of Figure 12.1, multiplying U0 on the horizontal axis by the exchange rate er0 on the vertical axis gives the area of the rectangle er0AU0O, the Canadian dollar value of total receipts or total payments recorded in the balance of payments.
What would change the equilibrium in Figure 12.1? A change in any of the factors held constant in order to draw the supply and demand curves will shift one or the other or both curves. We see this in both the net export and capital flow functions. A rise in United States income would increase US imports from Canada and shift the supply of foreign exchange to the right. As discussed above and in Chapter 9, a change in interest rates in Canada or the United States would change the trade in financial assets and affect both the supply curve and the demand curve. In short, a change in any market condition other than the exchange rate er will change supply and demand conditions in the market. The exchange rate will then change to a new equilibrium. Figure 12.2 and 12.3 provide examples.
The effect of a recession in the US economy on the exchange rate
The demand and supply curves in the foreign exchange market of Figure 12.2 are drawn on the assumption that tastes, incomes, prices of goods and services, interest rates, and expectations of future exchange rates are constant. The flows of payments and receipts under these conditions result in the equilibrium exchange rate er0. This would be a Canadian dollar price for the US dollar of, for example, \$1.35. From the United States perspective, a Canadian dollar costs a United States resident about \$0.74US.
Figure 12.2 The effect of a recession in the US on the exchange rate
A recession in the US reduces Canadian exports to the US and reduces the supply of US\$ on the foreign market. S shifts from S0 to S1. The exchange rate rises as the Can\$ depreciates.
Now suppose, as occurred in early 2008 and 2009, a recession in the United States lowers United States real income. United States imports fall, based on the US marginal propensity to import. United States imports are Canadian exports, and the US dollar receipts of Canadian exporters are reduced. The recession and difficult household financial conditions reduce US residential construction and Canadian lumber exports decline. Recession also reduces travel by US residents, and the Canadian tourism industry suffers a decline in bookings and receipts. If expenditures on new cars in the United States are reduced, Canadian auto industry sales to the United States market are reduced. In the balance of payments, the balance on trade in goods and services falls, and in the foreign exchange market the supply of US dollars on the market is reduced.
The supply curve in Figure 12.2 shifts leftward to S1. At the initial exchange rate er0, the demand for US dollars exceeds the supply, putting upward pressure on the exchange rate. In terms of the balance of payments, the excess demand for US dollars represents a balance of payments deficit. In the example shown here, the Canadian dollar depreciates and the exchange rate rises to restore equilibrium in the foreign exchange market and the balance of payments. A higher price for the US dollar reduces Canadian imports and increases the Canadian dollar receipts of Canadian exporters. The effects of the US recession on the Canadian balance of payments are offset by the exchange rate change.
The rise in the exchange rate in this case is a depreciation of the Canadian dollar and a corresponding appreciation of the US dollar.
Currency depreciation: a fall in external value of the domestic currency that raises domestic currency price of foreign currency.
Currency appreciation: a rise in external value of the domestic currency that lowers the domestic currency price of foreign currency.
Before the recession of 2009, Canadian experience was the opposite of this example. High GDP growth rates in the US and Asia created very strong international demand for Canadian commodities and crude oil at high international prices. Strong oil and commodity exports increased the supply of foreign currencies on the Canadian foreign exchange market. The Canadian dollar appreciated strongly, with the exchange rate falling from \$1.57Cdn/\$1US in 2002 to an average of \$0.9994 Cdn/\$1US in May of 2008, a fall of about 60 percent over the six year period. Exchange rate changes led to a restructuring of both exports and imports to maintain equilibrium in the balance of payments as Canada's international trade changed dramatically.
The effect of a fall in foreign interest rates on the foreign exchange rate
In the previous example a change in foreign income and the supply of foreign exchange disrupted the equilibrium in the foreign exchange market and changed the exchange rate. As an alternative to that example, consider the effects of a cut in foreign interest rates.
In Figure 12.3 the foreign exchange market is in equilibrium, initially at an exchange rate er0. A fall in foreign interest rates, other things constant, disrupts this equilibrium. Now lower foreign rates make domestic (Canadian) bonds more attractive to foreign portfolios than they were previously. The demand for domestic bonds rises. The supply of US dollars on the market to pay for these bond exports increases, shifting S0 to S1 in the diagram. At the same time, the attractiveness of foreign bonds for domestic portfolios is reduced, reducing the demand for US dollars to pay for them. The demand curve shifts from D0 to D1. The equilibrium exchange rate falls to er1.
Figure 12.3 The effect of a cut in foreign interest rates
A cut in foreign interest rates shifts portfolios toward the Canadian bond market and away from foreign markets. The supply of foreign currency increases from the increased export of bonds at the same time as the demand for foreign currency to buy foreign bonds falls. The domestic currency appreciates and the exchange rate falls.
In balance of payments terms the net capital inflow, the balance on financial account, is increased. The change in the exchange rate causes an offsetting change in the current account that restores equilibrium in the foreign exchange market and the balance of payments. A lower nominal exchange rate lowers the real exchange rate. Imports are now cheaper and exports, priced internationally in US dollars, are less profitable. Export receipts are reduced. As we saw in Chapter 9, changes in the exchange rate are one channel by which changes in financial conditions impact AD and equilibrium GDP.
Figures 12.2 and 12.3 provide two examples of adjustments in the foreign exchange rate. The underlying assumption is that exchange rates are flexible and allow the market to adjust freely and quickly to changing circumstances.
However, there are alternative exchange rate arrangements. To understand how the foreign exchange rate operates in different countries, we need to consider the different exchange rate policies governments can adopt. These result in different foreign exchange rate regimes, different ways that the balance of payments adjusts to change, and different roles for monetary and fiscal policies. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/12%3A_Exchange_rates_monetary_policy_and_fiscal_policy/12.02%3A_The_foreign_exchange_market.txt |
To grasp the basics of exchange rate regimes, we focus on two extreme forms that have been adopted to handle international transactions in the world economy: flexible exchange rates and fixed exchange rates.
Exchange rate regime: the policy choice that determines how foreign exchange markets operate.
Floating or flexible rates
In a floating or flexible exchange rate regime, the exchange rate is allowed to find its equilibrium level on the foreign exchange market without central bank intervention.
Flexible exchange rates: Supply and demand in the foreign exchange market determine the equilibrium exchange rate without central bank intervention.
Figures 12.2 and 12.3 showed the exchange rates that would result if rates adjusted flexibly and freely in response to changes in demand and supply. The central bank did not intervene to fix or adjust the rate. The rise in the demand for US dollars would result in a rise in the exchange rate to clear the foreign exchange market and maintain the balance of payments. Alternatively, the fall in demand would result in a fall in the exchange rate. The Bank of Canada would not intervene in either case. The holdings of official foreign exchange reserves and the domestic money supply would not be affected by foreign exchange market adjustments.
The alternative is a fixed exchange rate as explained below. In this regime, the central bank sets an official exchange rate and intervenes in the foreign exchange market to offset the effects of fluctuations in supply and demand and maintain a constant exchange rate. In Canada in the 1960s the exchange rate was fixed by policy at \$1US=\$1.075 Cdn (\$1Cdn\$0.925US) and the Bank of Canada intervened in the foreign exchange market to maintain that rate.
How do countries choose between fixed and floating exchange rates? Obviously, there is not one answer for all countries or we would not see different exchange rate regimes today. With flexible rates, the foreign exchange market sets the exchange rate, and monetary policy is available to pursue other targets. On the other hand, fixed exchange rates require central bank intervention. Monetary policy is aimed at the exchange rate.
The importance a country attaches to an independent monetary policy is one very important factor in the choice of an exchange rate regime. Another is the size and volatility of the international trade sector of the economy. A flexible exchange rate provides some automatic adjustment and stabilization in times of change in net exports or net capital flows.
Fixed exchange rates
In a fixed exchange rate regime, the government intervenes actively through the central bank to maintain convertibility of their currency into other currencies at a fixed exchange rate. A currency is convertible if the central bank will buy or sell as much of the foreign currency as people wish to trade at a fixed exchange rate.
Fixed exchange rate: an exchange rate set by government policy that does not change as a result of changes in market conditions.
Convertible currency: a national currency that can be freely exchanged for a different national currency at the prevailing exchange rate.
In Figure 12.4, suppose the exchange rate is fixed at . There would be a free market equilibrium at A if the supply curve for US dollars is S1 and the demand curve for US dollars is D1. The central bank does not need to buy or sell US dollars. The market is in equilibrium and clears by itself at the fixed rate.
Figure 12.4 Central bank intervention to fix the exchange rate
With exchange rate fixed at a shift in demand for US\$ to D2 creates excess demand AC. The central bank intervenes, supplying AC US\$ from official reserve holdings in exchange for Can\$. To maintain if demand shifted to D3 would create the opposite condition and central bank would have to buy US\$.
Suppose demand for US dollars shifts from D1 to D2. Canadians want to spend more time in Florida to escape the long, cold Canadian winter. They need more US dollars to finance their expenditures in the United States. The free market equilibrium would be at B, and the exchange rate would rise if the Bank of Canada took no action.
However, with the exchange rate fixed by policy at there is an excess demand for US dollars equal to AC. To peg1 the exchange rate, the Bank of Canada sells US dollars from the official exchange reserves in the amount AC. The supply of US dollars on the market is then the "market" supply represented by S1 plus the amount AC supplied by the Bank of Canada. The payment the Bank receives in Canadian dollars is the amount (AC), which reduces the monetary base by that amount, just like an open market sale of government bonds. The lower monetary base pushes domestic interest rates up and attracts a larger net capital inflow. Higher interest rates also reduce domestic expenditure and the demand for imports and for foreign exchange. The exchange rate target drives the Bank's monetary policy, which in turn changes both international capital flows and domestic income and expenditure.
Official exchange reserves: government foreign currency holdings managed by the central bank.
What if the demand for US dollars falls to D3? The market equilibrium would be at F. At the exchange rate at there is an excess supply of US dollars EA. To defend the peg, the Bank of Canada would have to buy EA US dollars, reducing the supply of US dollars on the market to meet the "unofficial" demand. The Bank of Canada would have to buy EA US dollars, reducing the supply of US dollars on the market to meet the "unofficial" demand. The Bank of Canada's purchase would be added to foreign exchange reserves. The Bank would pay for these US dollars by creating more monetary base, as in the case of an open market purchase of government securities. In either case, maintaining a fixed exchange rate requires central bank intervention in the foreign currency market. The central bank's monetary policy is expansionary because it is committed to the exchange rate target.
Central bank intervention: purchases or sales of foreign currency intended to manage the exchange rate.
When the demand schedule is D2, foreign exchange reserves are running down. When the demand schedule is D3, foreign exchange reserves are increasing. If the demand for US dollars fluctuates between D2 and D3, the Bank of Canada can sustain and stabilize the exchange rate in the long run.
However, if the demand for US dollars is, on average, D2, the foreign exchange reserves are steadily declining to support the exchange rate , and the monetary base is falling as well. In this case, the Canadian dollar is overvalued at ; or, in other words, is too low a price for the US dollar. A higher er is required for long-run equilibrium in the foreign exchange market and the balance of payments. As reserves start to run out, the government may try to borrow foreign exchange reserves from other countries and the International Monetary Fund (IMF), an international body that exists primarily to lend to countries in short-term difficulties.
At best, this is only a temporary solution. Unless the demand for US dollars decreases, or the supply increases in the longer term, it is necessary to devalue the Canadian dollar. If a fixed exchange rate is to be maintained, the official rate must be reset at a higher domestic currency price for foreign currency.
Devaluation (revaluation): a reduction (increase) in the international value of the domestic currency.
For many years frequent media and political discussions of the persistent rise in China's foreign exchange holdings provide a good example of the defense of an undervalued currency. With the yuan at its current fixed rate relative to US dollars and other currencies, China has a large current account surplus that is not offset by a financial account deficit. Balance of payments equilibrium requires ongoing intervention by the Chinese central bank to buy foreign exchange and add to official reserve holdings. Buying foreign exchange adds to the monetary base and money supply, raising concerns about inflation. The Bank has responded in part with a small revaluation of the yuan and in part with an increase in the reserve requirements for Chinese banks. Neither of these adjustments has been sufficient to change the situation fundamentally and growth in official foreign exchange reserves continues.
In Europe the euro currency system effectively fixes exchange rates among member countries. Individual member countries do not have national monetary policies. Monetary policy is set by the European Central Bank. In the years following the 'great recession' this has been a source of controversy because economic and fiscal conditions have differed significantly among countries. Countries trying to adjust fiscal deficits and national public debt crises have been forced into fiscal austerity without offsetting monetary policy support. In many cases the results have been deep and prolonged recessions without solving their debt problems. Greece is the poster child.
Of course, it is not necessary to adopt the extreme regimes of pure or clean floating on the one hand and perfectly fixed exchange rates on the other hand. Dirty or managed floating is used to offset large and rapid shifts in supply or demand schedules in the short run. The intent is to smooth the adjustment as the exchange rate is gradually allowed to find its equilibrium level in response to longer-term changes. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/12%3A_Exchange_rates_monetary_policy_and_fiscal_policy/12.03%3A_Flexible_exchange_rates_and_fixed_exchange_rates.txt |
In a closed economy with slow wage and price adjustments, monetary and fiscal policies are both important tools for aggregate demand management in the short run. Things are different in open economies with high international capital mobility. With flexible exchange rates monetary policy is powerful for changing AD. It works through both interest rate and exchange rate linkages in the transmission mechanism, not just the interest rate linkages of the closed economy. By contrast, the effects of fiscal policy on aggregate demand are reduced. In the absence of supporting monetary policy, fiscal expansions crowd out private sector expenditures through both interest rate and exchange rate linkages, leaving AD unchanged.
Fixed exchange rates have the opposite implications for policy effectiveness as an AD management tool. The effects of fiscal policy are enhanced by induced changes in monetary conditions, but monetary policy alone is almost powerless to change AD. As a result, the first important step in the design of macroeconomic policy in the open economy is the choice of an exchange rate regime.
Monetary policy
With flexible exchange rates, monetary policy causes changes in both interest rates and exchange rates. Net international capital flows link exchange rates and changes in domestic interest rates when exchange rates are flexible. Given the exchange rate expected in the long run, higher interest rates in the short to medium run cause a capital inflow, an increased supply of foreign exchange on the foreign exchange market, which lowers the exchange rate, er.
Conversely, lower domestic interest rates relative to international rates cause a rise in the exchange rate, er.
As a result, current monetary policy and expected future monetary policies have strong effects on the nominal exchange rate and the international competitiveness of the domestic economy and AD. Changing current interest rates for a short time will have only small exchange rate effects. However, a credible change in monetary policy for a sustained period will cause a large and persistent change in current exchange rates, an important factor in the monetary transmission mechanism. This can have large short-run effects on the real economy.
As a result, in an open economy with flexible exchange rates, monetary policy affects aggregate demand not just through the effects of interest rates on consumption and investment. Changing interest rates, by changing the exchange rate, also change the international competitiveness of exports and imports. Net exports change in the same direction as domestic expenditure, increasing the impact of interest changes on aggregate demand. Lower interest rates boost domestic expenditure, raise the exchange rate, and increase net exports. Higher interest rates reduce domestic expenditure, lower the exchange rate, and reduce net exports. With linkages through both domestic and international components of expenditure, monetary policy is more powerful under flexible exchange rates than in a closed economy.
Canada and a number of other countries conduct monetary policy in terms of a target for the domestic inflation rate. A flexible exchange rate policy is essential for the monetary policy independence and power required to pursue that target. That is why the Bank of Canada defines Canada's flexible exchange rate as a key component of Canada's monetary policy framework. The other key component is the Bank's inflation control target.
Fiscal policy
With flexible exchange rates, but without monetary policy accommodation or support, the effect of interest rate changes on exchange rates and competitiveness undermines the power of fiscal policy to manage aggregate demand.
Suppose the government undertakes a fiscal expansion, raising government expenditures or lowering taxes or some combination of the two: Aggregate demand increases. When monetary policy targets an inflation rate based on either an interest rate rule or a money supply rule, the expansion in AD caused by fiscal policy changes the economic fundamentals on which the central bank's policy had been set and induces the bank to raise interest rates. The higher interest rates cause a net capital inflow and an increased supply of foreign exchange on the foreign exchange market, and the nominal exchange rate falls. A fall in the nominal foreign exchange rate lowers the real exchange rate. International price competitiveness (as measured by the real exchange rate) is reduced and net exports fall, offsetting the expansionary effects of the change in fiscal policy. With flexible exchange rates monetary policy targeted to the inflation rate dominates fiscal policy as a tool for AD management.
As discussed previously, Canadian experience provides an example. In the 2005-2007 period, the federal government provided fiscal stimulus through tax cuts and expenditure increases. The primary structural budget balance fell from an average 3.4 percent of potential GDP for 2002 to 2004 to 2.6 percent for 2005 to 2007. At the same time the Bank of Canada's estimates showed the economy operating with a small but persistent inflationary gap. The inflation rate was in the upper level of the Bank's target range. The Bank responded to strong current and expected demand (coming from both the government and private sector) by raising its overnight rate in steps, from 2.5 percent in late-2005 to 4.5 percent by mid-2007, to defend its inflation target. The inflationary gap and inflation were contained as higher interest rates and lower exchange rates limited the growth of aggregate demand, including that coming from fiscal stimulus.
In a closed economy, fiscal expansions that push up interest rates cause partial crowding out of private expenditure by reducing consumption and investment. In an open economy with flexible exchange rates the crowding out mechanism is stronger. Fiscal expansion causes both a rise in interest rates and a fall in the exchange rate. Both domestic expenditure and net exports are reduced. The extended crowding out through the change in exchange rates and net exports when exchange rates are flexible reduces the power of fiscal policy to manage aggregate demand in the short run.
However, if control or reduction of the debt ratio is the prime target of fiscal policy, the flexible exchange rate is helpful. If the government raises tax rates or cuts expenditures to raise its structural budget balance and reduce the debt ratio, lower settings for the central bank's interest rate and a rising exchange rate provide some offsetting "crowding in" through both domestic expenditure and net exports. The limited aggregate demand effects of fiscal policy under flexible exchange rates facilitate control of the government's budget balance and debt ratio.
Policy co-ordination
This analysis of the policy implications of flexible rate regimes leads to a clear recommendation for policy co-ordination. Flexible exchange rates provide the framework for effective monetary policy focused on a medium term inflation target. The exchange rate regime enhances the power of monetary policy to moderate business cycle fluctuations and the output gaps they create. Stabilizing the economy at or close to potential output avoids the cumulative inflationary or recessionary pressures that would push inflation rates away from the monetary policy target. Monetary policy is then the aggregate demand management tool.
Fiscal policy is not an effective AD management tool when exchange rates are flexible. Its impacts on aggregate demand are limited by crowding out and dominated by monetary policy. However, this does enhance the power of fiscal policy to pursue deficit control and debt ratio control. The effects of fiscal restraint aimed at improved public finances are moderated by a monetary policy focused on an inflation target in a flexible exchange rate regime.
The Canadian experience with economic policy and performance provides an excellent example of this sort of coordinated policy. Starting in 1995 the federal government introduced a policy of strong fiscal adjustment through restraint aimed at reducing the public debt-to-GDP ratio. The structural primary budget balance was increased through expenditure cuts and tax increases. At the same time, monetary policy was aimed at maintaining inflation within the 1-3 percent target band, which required monetary stimulus. The nominal and real overnight interest rates were reduced. Economic growth was constrained by the fiscal austerity but still sufficient to eliminate the recessionary gap by the end of the decade. The support of domestic monetary policy, a significant depreciation of the Canadian dollar, strong growth in the US economy and strong export growth were keys to this successful fiscal adjustment. The coordination of fiscal restraint and monetary stimulus moved the economy to potential output with stable inflation and a falling ratio of public debt to GDP.
Policy responses to the recession of 2009 also involved strong policy co-ordination, both domestic and international. Monetary policy was the first line response, with central banks in most industrial countries lowering their interest rate to or close to the zero lower bound. Some countries, like the US, then went further to provide quantitative and credit easing through general and selective open market operations. Fiscal stimulus added to these highly accommodative monetary conditions. Central bank commitments, like those in both the US and Canada, to maintain policy rates at their minimum for periods as long as a year or more eliminated concerns about fiscal crowding out.
Coordinating the focus of both monetary policy and fiscal policy was designed to stimulate aggregate demand and restore growth in real GDP. In a time of deep recession, high indebtedness, and high uncertainty even very low interest rates won't induce households and business to take on more debt to build more houses or factories. There is already an excess supply of productive capacity and housing. Monetary conditions can support an expansion in expenditure but cannot trigger it.
Fiscal policy, by contrast, can add directly to expenditure and aggregate demand, especially expenditure on infrastructure, education, research, and similar public investments. Tax cuts are likely to have smaller expenditure effects if only because the recipients have marginal propensities to spend that are less than one. Nonetheless, there is an important debate about whether expenditure increases or tax cuts should be used for fiscal stimulus, and which will have the larger and more desirable effect.
With this policy coordination there is no cause for concern about crowding out. Central banks were not concerned about the effects of increased aggregate demand on inflation rates and their inflation targets. Quite the opposite, like the Bank of Canada they hoped to raise inflation to their target. Fiscal expansion will not induce higher interest rates or lower exchange rates. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/12%3A_Exchange_rates_monetary_policy_and_fiscal_policy/12.04%3A_Monetary_and_fiscal_policy_with_flexible_exchange_rates.txt |
Monetary policy
If a country adopts a fixed exchange rate policy, the exchange rate is the target of monetary policy. Monetary policy cannot pursue an inflation target or an output target at the same time as it pursues an exchange rate target. Nor can it set either interest rates or money supply growth rates independently.
With a fixed exchange rate, interest rates must be set as needed to maintain the exchange rate when capital mobility is high. Indeed, the higher international capital mobility is, the less is the scope for independent monetary policy. This is what we mean when we say fixed exchange rates eliminate monetary policy sovereignty. The central bank cannot follow an independent monetary policy.
Fiscal policy with fixed exchange rates
A fixed exchange rate and perfect capital mobility undermine the scope for monetary policy, but maintain the effectiveness of fiscal policy.
In a closed economy, in the short run, fiscal expansion raises output. Under a monetary policy rule with the interest rate as the policy instrument, as long as output is less than potential output, the central bank supports the increase in output by maintaining interest rates and increasing the money supply as output expands. However, at outputs equal to or greater than potential output, central banks raise interest rates to crowd out the effect of fiscal expansion.
In an open economy with fixed exchange rates, monetary policy adjusts passively to keep the interest rate fixed in order to defend the exchange rate. Interest rates do not change to support fiscal policy or moderate the effect of fiscal policy. Hence, any fall in domestic demand can be offset by a fiscal expansion to help restore potential output. If the change in domestic demand is the only reason that the current account balance departed from equilibrium, this fiscal expansion will also restore the current account balance.
Fiscal policy is potentially an important stabilization policy under fixed exchange rates. It helps to compensate for the fact that monetary policy can no longer be used. Automatic fiscal stabilizers play this role. Discretionary changes in government spending or taxes are useful only if fiscal policy can react quickly to temporary shocks. In some political systems, such as in Canada, this is feasible. In others, such as in the United States, where Congress and the President may be from different parties and budget decisions are more protracted, rapid changes in fiscal policy are more difficult.
In times of prolonged recession, discretionary fiscal policy can contribute importantly to a return to potential output, provided it is not constrained by high public debt ratios. With interest rates tied to the exchange rate, financing a fiscal expansion does not push rates up to crowd out private sector expenditure; nor does the recovery of the economy result in rising rates. Indeed, fiscal policy is the only effective domestic demand management tool available.
Unfortunately, high public debt ratios and concerns about the default risk of sovereign debt cause problems for fiscal policy. This is the current situation in Europe. Fiscal expansion is impossible if financial markets are unwilling to buy more sovereign debt from economies in recession that already have high debt ratios. On the other hand, fiscal austerity to control deficits and debt ratios makes recessions worse and may even raise already high debt ratios as GDP and government net revenue fall. The euro fixes exchange rates within Europe and precludes stimulus from currency depreciation. Neither domestic fiscal nor monetary policy offers a solution.
Things are further complicated because many European countries have similar economic and financial difficulties. Canadian success with fiscal austerity and adjustment in the 1990s came from a very different economic environment. Monetary policy and exchange rate depreciation provided stimulus. Strong economic growth in major trade partners provided further stimulus through export growth. These conditions are clearly not met in Europe and coordinated fiscal austerity to address sovereign debt issues has been described as an 'economic suicide pact'.
Next
This chapter extended the discussion of short-run macroeconomic performance and policy by covering in more detail the importance of international trade, capital flows, and exchange rates for the design, coordination and effectiveness of monetary and fiscal policies. The next chapter introduces the theory of economic growth that explains the long-run growth in potential output based on growth in the labour force, growth in the capital stock and changes in productivity based on advances in technology. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/12%3A_Exchange_rates_monetary_policy_and_fiscal_policy/12.05%3A_Monetary_and_fiscal_policy_with_fixed_exchange_rates.txt |
The balance of payments records transactions between residents of one country and the rest of the world. The current account shows the trade balance plus net international transfer payments, and income earned on holdings of foreign assets. The financial account shows net purchases and sales of foreign assets. The balance of payments is the sum of the current and financial account balances.
The trade in goods and services recorded in the current account is net exports, based on tastes, incomes, and the real exchange rate, which measures the price of foreign goods and services relative to the price of domestic goods and services.
The trade in financial assets recorded in the financial account is based on the total return expected from holding foreign rather than domestic assets.
The total return on holdings of foreign assets depends on the interest rate differential between countries and the change in the exchange rate during the period in which assets are held. Perfect international capital mobility means that an enormous quantity of funds shifts between currencies when the perceived rate of return differs across currencies.
The foreign exchange market is the market in which currencies of different countries are bought and sold and foreign exchange rates are established. The exchange rate is the price at which one currency trades for another.
The demand for foreign currency on the foreign exchange market arises from imports of goods and services and purchases of foreign assets. The supply of foreign currency on the foreign exchange market arises from exports of goods and services and sales of domestic assets to foreigners.
Under a fixed exchange rate regime, a balance of payments surplus or deficit must be matched by an offsetting quantity of official financing. The central bank intervenes in the foreign exchange market.
Under floating or flexible exchange rates, supply and demand in the foreign exchange market change the exchange rate as necessary for a current account balance that offsets a capital account balance. As a result, the balance of payments is zero and no official intervention is involved.
The choice between fixed and floating exchange rate regimes reflects a country's assessment of the importance of an independent monetary policy, the volatility of exports and imports, and the financial discipline that may come with fixed rates.
Flexible exchange rates increase the effectiveness of monetary policy as a tool to manage aggregate demand. The effectiveness of fiscal policy for demand management is reduced, but pursuit of deficit and debt ratio control may be enhanced.
Monetary policy sovereignty is lost when fixed exchange rates are adopted. Monetary policy cannot effectively pursue domestic inflation or output targets. However, the effectiveness of fiscal policy as a demand management tool is enhanced.
12.07: Exercises for Chapter 12
EXERCISE 12.1
Consider a country with a fixed exchange rate that has a current account surplus of \$20 billion, but a financial account deficit of \$18 billion.
1. Is its balance of payments in deficit or surplus? Why?
2. What change in official exchange reserves would you see? Why?
3. Is the central bank buying or selling foreign currency?
4. What effect does the central bank's foreign currency purchase or sale have on the monetary base? Explain why.
EXERCISE 12.2
Assume the initial exchange rate is \$1.20Cdn for \$1.00US After 10 years, the United States price level has risen from 100 to 200, and the Canadian price level has risen from 100 to 175. What was the inflation rate in each country? What nominal exchange rate would preserve the initial real exchange rate? Which country's currency depreciated?
EXERCISE 12.3
Suppose portfolio managers shift \$100 million in assets under their control out of Canadian government securities and into United States government securities. What change would this portfolio shift make in the Canadian balance of payments?
EXERCISE 12.4
What is the expected rate of appreciation of the US dollar if interest rate parity prevails and Canadian nominal interest rates are 1 percent higher than United States interest rates?
EXERCISE 12.5
Suppose natural gas and crude oil prices were to drop sharply and expectations were they would remain low. Use a foreign exchange market diagram to show the effect on the Canadian/US dollar exchange rate?
EXERCISE 12.6
Using a diagram to illustrate:
1. The demand for foreign exchange and the demand curve for foreign exchange.
2. The supply of foreign exchange and the supply curve for foreign exchange.
3. The equilibrium exchange rate.
EXERCISE 12.7
Use a foreign exchange market diagram with a flexible or floating exchange rate to show:
1. How a decline in exports would affect the foreign exchange rate.
2. How exports and imports would change to give balance of payments equilibrium at the new equilibrium exchange rate.
3. The effects, if any, on the holdings of official reserves.
EXERCISE 12.8
Use a foreign exchange market diagram to show:
1. Equilibrium with a fixed exchange rate.
2. The effect of a decline in exports on conditions in the foreign exchange market when the exchange rate is fixed.
3. The amount of the purchase or sale of foreign exchange reserves required if the central bank defends the fixed exchange rate.
4. The effects of a change in the holdings of official reserves and the monetary base as a result of the defence of the fixed exchange rate.
EXERCISE 12.9
Use AD/AS and foreign exchange market diagrams to show why monetary policy is powerful and fiscal policy is weak when a country has a flexible exchange rate regime.
EXERCISE 12.10
Use AD/AS and foreign exchange market diagrams to show why the choice of a fixed exchange rate makes fiscal policy a more powerful tool for demand management. What happens to the domestic money supply when a government austerity program cuts its expenditures on goods and services and raises taxes? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/12%3A_Exchange_rates_monetary_policy_and_fiscal_policy/12.06%3A_Key_Concepts.txt |
Economic growth is one of the most historic, challenging and important topics in macroeconomics. Standards of living within a country are measured by real GDP per capita. Growth in real GDP is growth in potential output, YP, and growth in real GDP per capita is a measure of change in the standard of living. Over time, growth in YP that exceeds population growth raises per capita real GDP and standards of living. But growth that falls persistently short validates Thomas Malthus' prediction in his First Essay on Population (1798) that population growth would exceed output growth causing starvation and the end of population growth. But what determines growth in real GDP and real GDP per capita? A theory of economic growth is needed to answer that question.
Observations on the recent history of economic growth raise four questions.
1. What is long-term growth?
2. What are the causes or sources of growth?
3. What are the effects of economic growth, both positive and negative?
4. Can economic policies affect growth?
Although the focus here is mainly on industrial countries, the growth or lack of it in poor countries is also an extremely important issue for the economics of development. To see many other interesting dimensions of growth compared across a much larger sample of countries over longer time periods, visit Gapminder World on the web site www.gapminder.org.
13: Economic growth
Recall, from Chapter 4, that the growth rate of a variable is its percentage change over time. To define economic growth we must specify both the variable to measure and the period over which to measure it. Percentage changes in real GDP and real GDP per person over periods of one year are used to measure annual rates of economic growth.
Economic growth: the annual percentage change in real GDP or per capita real GDP.
Annual real GDP measures the total output of final goods and services in the economy for one-year periods. As a result, the annual rate of growth in real GDP is the change in the size of the total economy. But, as discussed in Chapter 4, increases in the size of the total economy may not reflect changes in standards of living or economic welfare. To get an indication of how these grow, stagnate or decline we need to look at growth in real GDP per person. Growth in real GDP can raise standards of living only if it exceeds the growth in population, providing, on average, more goods and services to the average individual.
Figure 13.1 Indexes of real GDP & real GDP per capita, 1995–2014
Source: Statistics Canada, CANSIM tables 380-0084 and 051-0005 and author's calculations
Figure 13.1 illustrates the growth of real GDP and real GDP per capita in Canada from 1995 to 2014. In that time frame the index of real GDP, with 1995 as the base year, increased by about 45 percent from 1995 until the financial crisis of 2008, then declined during the 'Great Recession' before resuming growth in 2010. Over the full 1995–2014 period real GDP grew by 60 percent.
Population in Canada was also growing in the 1995–2014 period. As a result the growth in per capita real GDP was less than in real GDP. Figure 13.1 shows that growth in real GDP per capita grew by about 32 percent over the 1995–2014 period. This is a rough measure of the improvement in standard of living for the average Canadian over that time. But there are questions about the distribution of the changes in standard of living.
Structural change in economic output and employment are an integral part of economic growth. In industrial economies evolving supply and demand conditions lead to higher rates of growth in service sector output and employment relative to the goods sector. Different underlying trends in investment in physical and human capital, technology and entrepreneurial experience by sector, together with differences in sector income and price elasticities of demand explain the longer term evolution of output structures. Table 4.2 showed that in Canada by 2016 the service sector produced 70 percent of real GDP and the goods sector approximately 30 percent.
Structural changes leading to this distribution of output have also had important effects on employment by sector in Canada. Different sector rates of investment and change in technology have resulted in slower rates of employment growth in the goods producing sector. Figure 13.2 uses indexes of employment to show the Canadian experience. From 1995 to 2004 goods sector employment increased by about 15 percent and service sector employment by about 18 percent. After that, from 2004 to 2016, goods sector employment fell by about 6 percent. However, service sector employment increased by 18 percent. As a result employment in the goods producing sector fell from about 29 per cent of total employment in 1995 to about 24 per cent in 2016. These changes have implications for the future growth in output, employment, real incomes and the ways in which the per capital real income gains from growth are shared.
Figure 13.2 Indexes of Employment by Industry Sector, 1995–2016
Source: Statistics Canada, CANSIM Table 282-0092 and author's calculations
Differences in growth rates
Another interesting aspect of growth in real GDP or any other variable is the importance of small differences in compound annual growth rates on growth paths over time. Table 13.1 provides an illustration for selected time periods from one year to 40 years. Annual growth rates in the range of about 0.5% to 4.0% in real GDP and per capita real GDP are common among industrialized countries.
Table 13.1 Importance of small differences in annual growth rates
Growth Rate 0.5% 1.0% 2.0% 3.0% 3.5% 4.0%
Initial value 100 100 100 100 100 100
Year 1 100.5 101.0 102.0 103.0 103.5 104
Year 5 102.5 105.1 110.4 115.9 118.8 121.7
Year 10 105.1 110.5 121.9 134.4 141.5 148.0
Year 20 110.5 122.0 148.6 180.6 199.0 219.1
Year 40 122.1 148.9 220.8 326.2 395.9 480.1
Over a twenty year period an annual growth rate of 2.0 percent would increase per capita real GDP by almost 50 percent, a growth rate of 3.0 percent would increase it by 80 percent and a growth rate of 3.5 percent would double it. Even over a shorter period like the Great Recession and recovery of 2007–2012, a drop in the average annual growth rate from 3.0 percent to 1.0 percent would mean a GDP 10 percent lower than it would have been under steady 3.0 percent growth.
Table 13.2 illustrates the actual variations in growth rates of per capita real GDP across selected industrial economies from 1995 to 2014. Differences in growth rates in 1995–2001 were relatively small and in the range of 2.3 percent and 3.5 percent for most countries in this sample, except for Japan and Korea with rates of 0.5 percent and 4.6 percent respectively. The standard of living was catching up with those in other countries while that in Japan was roughly constant. Except for Japan, all these growth rates by country declined in the next two time periods reported, with particularly large declines as a result of the international financial crisis and recession after 2008. The underlying causes of this slowdown in growth will be examined in terms of a basic theory of economic growth.
Table 13.2 Growth rates in per capita real GDP: Selected countries
(Average annual % change)
1995–2001 2002–2008 2009–2014
Australia 2.7 1.9 0.9
Canada 2.7 1.6 0.5
France 2.3 1.1 -0.1
Greece 3.3 3.8 -4.5
Japan 0.5 1.5 0.5
Korea 4.6 4.5 2.7
Spain 3.5 1.7 -1.2
Sweden 3.1 2.8 0.3
United Kingdom 2.7 2.4 -0.1
United States 2.6 1.7 0.5
Source: International Monetary Fund, World Economic Outlook Database, October 2015, and authors' calculations. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/13%3A_Economic_growth/13.01%3A_Patterns_of_economic_growth.txt |
Basic economic growth theory steps back from short-run variations in growth rates. It applies to the very long run, a time frame in which wages and prices are fully flexible, and the labour force, the stock of capital equipment, and the technology used in production can change. In this time frame, output fluctuations around potential output are swamped by the growth of potential output itself.
Very long run: the time required for changes to occur in the stock of capital, the size of the labour force, and the technology of production.
The aggregate production function used in Section 11.2 described the links between inputs to production and real GDP produced. Recall that, for the whole economy, Y is real GDP produced by using inputs of labour (N) and capital (K). The function F tells us how much we get out of particular amounts of labour and capital used in the production process.
(13.1)
The function F(...) does not change, but changes in N and K cause changes in output Y. Technical progress or improvements in technology are captured separately through A, which measures the state of technology at any date. As technology improves, A increases and more real GDP is produced from the same inputs of labour and capital. A 10 percent increase in A gives 10 percent more real GDP from the same inputs of labour and capital. We describe this as an increase in productivity because outputs per worker and per unit of capital increase. A is often called a measure of total factor productivity (TFP).
Total factor productivity (TFP): output relative to the combined inputs of labour and capital, the total factor inputs to production.
Actual real GDP is the output produced at any time based on the actual inputs of capital and labour. In terms of the production function:
• Yt is real GDP in year t;
• At is determined by the current state of technology; and
• Kt and Nt measure the actual use of capital and labour.
These inputs are combined to give output in year t:
(13.2)
Potential output is the real GDP produced when labour and capital are employed at equilibrium rates using the best available technology. A specific production function to recognize this is:
(13.3)
YP is potential output produced by operating plants and machinery at their designed capacity (K0) and using the full employment equilibrium supply of labour services (NF). At is the state of knowledge and technology used in the production process and reflected in the productivity of labour and capital.
Any growth in the potential output of goods and services then comes from growth in labour inputs to production, growth in capital inputs to production, and changes in factor productivity as a result of new and improved technology.
Growth accounting measures the sources of growth in real GDP. From the production function, it follows that:
Effect of Effect of Effect of
Growth in = Growth in + Growth + Growth in
Real GDP Total Factor in Labour Capital
Productivity Inputs Inputs
Growth accounting: measurement of the contributions of labour, capital, and technology to growth in output.
The way that growth in capital and labour affects the growth in total output can be measured by the incomes they receive. The income approach to the measurement of net domestic product and GDP identifies these factor income shares in Canada in 2013 as the sum of:
Employee compensation \$957 billion
Net Corporate surplus \$240 billion
Net mixed income \$168 billion
Total factor income \$1,365 billion
From that data, employment income was about 70 percent of factor income. This is higher than the longer-term average share of employment income in total factor income, but it shows where the measure comes from. Labour's average contribution to and share of national income, measured over time periods of many years, is approximately two-thirds of total factor income. Capital's contribution and share is the remaining one-third of factor income.
The growth in potential GDP over time can then be expressed as the growth in total factor productivity plus the weighted sum of the growth in the capital and labour inputs to production as follows:
This is the basic growth accounting equation.
The weights (2/3) and (1/3) applied to growth in labour and capital inputs are based on their shares in national income. They determine the rate of growth in real GDP as a result of growth in the inputs of capital and labour. By these weights, a 10 percent increase in labour input, capital and technology held constant, would result in an increase in real GDP of percent, which is 6.6 percent. Similarly, a 10 percent increase in capital input would result in a percent increase in real GDP. However, if both N and K grow by 10 percent real GDP grows by 10 percent.
The increase in productivity from improvements in technology cannot be seen and measured directly. As a result, growth accounting classifies these effects as a residual. The difference between the growth in real GDP and the weighted sum of the growth in labour and capital inputs is called the Solow residual, named after Professor Robert Solow, whose work on growth theory was recognized with a Nobel Prize. The Solow Residual is a measure of the contribution to growth made by improvements in the technology of production that raise the productivity of both labour and capital.
Solow residual: the growth in real GDP or per capita real GDP not caused by growth in factor inputs, but attributed to improved technology.
The Solow residual measured by growth in A is found by rearranging the growth accounting equation as follows:
The numerical example in Table 13.3 illustrates the procedure. It assumes data are available for a specific sample period; say 10 years, for the growth rates of real GDP, capital stock, and employment, measured as average annual percentage changes.
Table 13.3 An estimate of the Solow residual using growth accounting
Observed average annual growth rates, , in:
Real GDP(Y) 5.0 Employment(N) 2.4 Capital stock(K) 3.9
By growth accounting:
Growth in A=5.0–(2/3)(2.4)–(1/3)(3.9)
Growth in A=5.0–1.6–1.3
Contribution of growth in A to growth in real GDP=2.1 percent
The calculation made using growth accounting shows that the increased productivity of both labour and capital resulting from improvements in technology was the source of 2.1 percent of the 5.0 percent growth in real GDP in this example.
Recent research at the Bank of Canada1 estimated the sources of growth in real GDP and potential GDP in Canada over the period 1950 to 1996 and projections for future growth in potential GDP. The contributions of capital and labour inputs are weighted as in the simple example above. Growth in actual and potential real GDP are the result of growth in factor inputs and the growth in productivity coming from improvements in the technology of production.
That work shows growth in real GDP and potential GDP declined over the 1950 to 1996 period. This slowdown was partly a result of a slowdown in the growth of population, and labour and capital inputs to production. But starting in the 1970s there was also a slowdown in productivity growth, which reduced the rate of growth of output per worker. This slowdown in productivity is examined in more detail later in this chapter. It had important implications for the standard of living in many countries, including Canada. Some further research on productivity growth in Canada by the Centre for the Study of Standards of Living, www.csls.ca, and at the Bank of Canada has uncovered another productivity slowdown in Canada relative to the United States after the year 2000, which has continued and is a current source of concern. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/13%3A_Economic_growth/13.02%3A_Growth_in_potential_output.txt |
Growth in potential GDP measures the increase in the size of the economy, but it does not tell us what is happening to per capita GDP and standards of living. To discover the sources of growth in per capita GDP and improvements in standards of living, we need to study the production function in more detail. Then we can use growth accounting to uncover the sources of past growth in per capita GDP.
Consider the same production function we have used for total GDP:
(13.1)
Again, assume that if technology (A) is constant, real GDP (Y) will grow by 2/3 of the growth in labour input and 1/3 the growth in capital input. If, for example, labour force growth increases employment by 10 percent, with fixed capital stock (K), and technology (A), GDP will increase by 6.67 percent. A similar calculation shows the effects of growth in the capital stock. The weights 1/3 and 2/3 are the elasticities of output with respect to the inputs of labour and capital based on factor income shares in national accounts.
Factor contributions and scale economies
The increase in total output when an additional unit of a factor (labour or capital) is used in the production process, and other inputs are held constant, is the marginal product of that added factor. The production functions widely used in economics have diminishing marginal productivity. As more and more workers are employed using a fixed number of machines, each additional worker adds less and less to total output. The marginal product of labour, the change in total output as a result of using one more worker (), falls. Furthermore, because each additional input of labour adds less to total output than the unit before it, output per worker, Y/N, also falls.
Marginal product: the change in total output caused by a change of one unit in the input of that factor to production.
It is often assumed that production involves constant returns to scale. Instead of increasing just one input to production, suppose all inputs are increased together, in the same proportions. Labour and capital inputs might both be doubled, for example. Then, if output increases in exactly the same proportions as inputs have increased, there are constant returns to scale.
The production functions used in growth accounting have these properties. Consider the following example. Holding technology constant at A=1 to simplify matters, we can write:
(13.4)
using the weights we have used in growth accounting to measure the contributions of labour and capital to output, based on their shares in national income, as the exponents on labour and capital inputs. Table 13.4 gives numerical examples of the way this production function works.
Table 13.4 Changes in outputs as factor inputs change
Production function:
Labour Capital Output (Y)
input (N) input (K)
50 20 36.8
55 20 39.3 10.0 0 6.6
55 22 40.5 0 10.0 3.3
60.5 24.2 44.6 10.0 10.0 10.0
The first row of the table shows that a labour input of 50 units combined with a capital input of 20 units gives output:
The next three rows illustrate the underlying diminishing returns and constant returns to scale in this production process. An increase of either labour input of 10 percent or capital input of 10 percent with the other input constant increases output, but by less than 10 percent in each case. Because output grows by less than the growth of the input in each case, output per worker or per unit of capital falls.
However, when only one input grows, output per unit of the factor held constant rises. In the second row of the table, capital input is constant when labour input grows. More labour inputs increase total output and output per unit of capital. Similarly, in the third row an increase in capital input increases labour productivity.
The fourth row of the table shows constant returns to scale. When labour and capital inputs both increase by the same proportion, output also increases by that proportion – 10 percent in this example. As a result, output per worker and output per unit of capital are constant. In terms of economic growth, equal growth rates of labour input and capital stock make total GDP grow at that same rate, but leave per capita GDP unchanged.
Constant returns to scale: equal percentage increases in inputs of labour and capital increase output by the same percentage.
To see the sources of growth in per capita GDP, we can manipulate the production function and apply growth accounting. To get per capita GDP, simply divide both sides of the production function in Equation 13.4 by N to give output per worker as follows:
(13.4)
Output per worker , the number of workers employed.
To make the notation a bit neater, we can use lower case letters to indicate output per worker (y=Y/N) and capital per worker (k=K/N). This gives:
(13.5)
Figure 13.3 illustrates this production function in a diagram. The ratio of capital stock to labour, k, is measured on the horizontal axis. Output per worker, y, is measured on the vertical axis. Two per-worker production functions are used to distinguish between the effects of increases in capital stock and the effects of improvements in technology.
Figure 13.3 The effects of increases in the capital labour ratio and improvements in technology on output per worker
An increase in the capital to labour ratio from k1 to k2 raises output per worker from y1 to y2. The shape of the production function shows that further increases in k will give further but smaller increases in y. A change in technology shifts the production function up as y increases at every k. The combined effects of an increase in k and an increase in A are increased output per worker from y1 to y3.
The declining slopes of both production functions illustrate the diminishing returns that lead to the smaller and smaller changes in output per worker as the capital/labour ratio increases. For example, starting at point C, an increase in the ratio of capital to labour moves the economy along the production function to point D. Output per worker increases at a decreasing rate. This shows that increased capital to labour ratios can increase output per worker until diminishing returns set in and limit sustained increases in output per worker. Sustained growth in per capita real GDP, in this basic model of growth, depends on improvements in technology to overcome the diminishing returns to increases in the capital to labour ratio.
Sustained growth in per capita real GDP: improvements in technology overcome the diminishing returns to increases in the capital to labour ratio.
An improvement in technology that increases productivity (A2>A1) shifts the production function up. At capital to labour ratio k2, for example, the increased productivity moves the economy from D to E as output per worker rises from y2 to y3. This shows that growth in per capita output, moving from y1 to y3, points C to E in Figure 13.3, is a result of both the growth in the capital to labour ratio and improvements in productivity.
Once again, growth accounting allows us to sort out the effects of these two factors on growth in output per worker and per capita GDP. Table 13.5 uses Canadian experience from 1990 to 2013 as an example.
Table 13.5 Sources of growth in per-worker GDP in Canada, 1990–2013
Real Employ Capital Real Capital Growth Growth Contribution Solow
GDP N Stock K GDP per in Y/N in K/N from Residual
Y (M) (\$B) per worker % % % %
(\$B) worker K/N
Y/N=y (\$K)
(\$K)
(1) (2) (3) (4) (5) (6) (7) (8)=(7)/3 (9)=(6)–(8)
1990 993 13.1 1,427 75.98 109.18
1995 1,082 13.3 1,491 81.54 112.36 7.3 2.9 1.0 6.4
2000 1,328 14.8 1,603 89.97 108.60 10.3 –3.3 –1.1 11.5
2005 1,502 16.2 1,739 92.83 107.48 3.2 –1.0 –0.3 3.5
2013 1,698 17.7 2,094 95.99 118.37 3.4 10.1 3.4 0.0
Source: Statistics Canada, CANSIM Tables: 380-0106, 282-0087 and 031-0002 and author's calculations.
The first three columns of the table give data on real GDP, employment, and real capital stock for selected years over the 1990 to 2013 period. Columns (4) and (5) use these data to calculate the output per worker and capital per worker that we see in our per-worker production function. The growth in output per worker and the growth in capital per worker are reported in columns (6) and (7) as the percentage changes over three five-year periods and a final eight year period to use the latest data available.
Growth accounting divides the sources of growth in output per worker between increases in capital per worker and increases in productivity based on improvements in technology. From the production function, we know that an increase in the capital/labour ratio increases output per worker by a factor of 1/3. Column (8) in the table reports this weighted contribution of the increase in capital per worker to the increase we see in output per worker. Subtracting these contributions from the increases in output per worker gives the Solow residual, column (9), which again is a measure of the effect of improvements in technology on output per worker.
The 1990 to 2013 period is of interest because the Canadian experience provides different examples of growth in GDP per worker. In the first five years, 1990 to 1995, there was very little growth in employment but some growth in capital stock. As a result, the capital to labour ratio, k, increased by 2.9 percent and accounted for 1.0 percentage points, or 13 percent of the 7.3 percent growth in real GDP per worker. Improved technology as measured by the Solow residual contributed the other 6.4 percentage points.
By contrast, employment and capital stock both grew strongly from 1995 to 2000, but employment growth (11.2 percent) exceeded capital stock growth (7.6 percent). As a result, the growth in the capital to labour ratio was negative, at percent. Nevertheless, output per worker grew more in the second period, up 10.3 percent. Productivity gains from improved technology, again measured by the Solow residual, were the major source of strong growth in GDP per worker.
The decline in the capital to labour ratio in the 1995 to 2000 period appears to have reduced the growth in output per worker in the 2000 to 2005 period. Even though capital stock increased by about 8 percent and employment grew by 9.5 percent, output per worker increased by only 3.2 percent over the period. The Solow residual in column (9) shows a very small contribution to growth in output per worker from improved technology.
In the final period, 2005–2013 the calculated Solow residual is zero. A strong increase in capital stock and the capital labour ratio explains all the observed growth in output per worker.
Thinking of these experiences in terms of the production functions in Figure 13.3 illustrates the differences between sub-periods. From 1990 to 1995, the economy moved to the right along the production function as k grew by 2.9 per cent, for example, from C to D in the diagram. This provided a 1.0 percent increase in y, as from y1 to y2. Improved technology shifted the production function up to further increase output per worker from y2 to y3 at point E in the diagram. In the next period, 1995 to 2000, the movement along the production function was in the opposite direction, to the left from E, as k declined. However, a very strong effect from improved technology as measured by the Solow residual of 11.5 percent shifted the production function upward (not shown in the diagram) and sustained the growth in output per worker at 10.3 percent.
These examples and the discussion of the sources of growth emphasize two key aspects of the growth process. One aspect is the growth in the stock of capital, which comes from the flow of savings and investment in the economy. The other is changing technical knowledge and technology of production. These are the keys to sustained growth in total output and standards of living, but their sources are more obscure than the sources of growth in capital stock. Indeed, pessimism about the fate of society was based on both the inadequacy of investment and stagnant technology. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/13%3A_Economic_growth/13.03%3A_Growth_in_per_capita_GDP.txt |
Advances in knowledge based on research and development and experience are the key to sustained rates of productivity growth and improvements in standards of living.
Technical knowledge
Every society has some level of technical knowledge about production practices. Part of this knowledge is recorded in technical documents, books, and plans. But it develops and is often captured in current working practices based on experience. This technical knowledge grows through invention that uncovers new understanding and knowledge. What usually follows is innovation that applies new knowledge to actual production techniques.
Invention: the discovery of new knowledge.
Innovation: the application of new knowledge into production techniques.
Industrial and economic history is often written in terms of the sequence of major inventions and innovations. Improvements in transportation from the wheel, to steam engines, internal combustion engines and aircraft transformed the size of the market and the degree of specialization and trade. The generation and transmission of electricity provided a new, more efficient and flexible source of light and power leading to improved communications and data management.
Historically, the agriculture 'revolution' was based on the application of science and technology to products and production processes. That evolution continues: New organization and techniques increased productivity; new machinery further increased labour productivity and yielded economies of scale; and new science provided better seed, fertilizer and fuels to power new mechanical equipment. Increases in agriculture productivity based on these and other advances reduced the labour and land required to supply food to the population. At the same time, increased industrialization increased the demand for labour. Economies became more sector specialized with identifiable primary, manufacturing and service sectors that worked together to improve productivity and standards of living.
Additions to human capital were as important as increases in physical capital in this growth process. Human capital is knowledge and experience with production processes. Experience improves workers' efficiency. Higher levels of education and training lets workers use more complex production equipment and techniques and contribute to cost improvements in the organization of production. In short, productivity is enhanced by the complementarity and synergy between human and physical capital.
The role of research and development
The invention and innovation that lies behind productivity improvements has many sources. Familiarity with a product, process or production technique often suggests a better way to work, or a better product design. Experience and frustration can lead to curiosity and invention. However, most invention and innovation has its origin in specialized research and development. From this perspective the output of new ideas depends on the resources allocated to R&D. There are costs involved and the focus and usefulness of the results may not be apparent for some time, if ever. Some research is pure research that seeks new knowledge and understanding. Most of it takes place in university departments, usually funded in part by industry, in part by government and in part by private individuals. Applied research, on the other hand is usually based in and financed by industrial firms, with some support from government grants and tax incentives. New knowledge with commercial applications is the goal of this applied R&D.
Investment in R&D, like investment in human and fixed capital, is risky. It cannot be known in advance that new, useful knowledge will result. Funding is provided and committed in the hope and expectation that research projects will be successful. Even if research succeeds it may be difficult to apply the new knowledge or technology in a way that increases your market power enough to allow recovery of the costs. Success gives competitors strong incentives to copy the new product or create a close substitute for it. Patent laws and government subsidies are designed to help private companies and individuals recover their costs of R&D, recognizing that society benefits from improvements in technology. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/13%3A_Economic_growth/13.04%3A_Technology_and_growth_in_per_capita_output.txt |
Basic growth theory and the basic growth accounting methodology leave a large part of aggregate growth and productivity growth in the Solow Residual and unexplained. Growth in employment and capital stock, and the relationship between them, play important roles in aggregate growth and labour productivity growth, but the effects of changes in the characteristics of labour and the composition of capital stock reside in the total factor productivity estimates of the Solow residual. This residual captures changes in technology along with other undefined factors.
Recent work on productivity growth still uses the growth accounting methodology, but focused on particular sectors of the economy and with extensions designed to unpack some things previously left in the residual. These include, in particular, investment in different components of the capital stock and changes in the composition and quality of labour.
Increases in capital per worker or per hour of work—capital deepening—continues to be important, but increases in capital stock are disaggregated into investment into several categories such as:
• Information and communications technology;
• Machinery and equipment; and
• Physical structures.
Changes in educational qualifications, gender structure, and age structure are used as indicators of changes in the composition and quality of the labour force. To the extent that these measures of change in characteristics and structure affect productivity less remains in the residual. More importantly, these are areas in which policies to support education, training, and labour force participation could affect productivity growth. Table 13.6 gives an example of some recent results based on this approach.
The estimates in the table show the effect of increases in the information, communications, and technology components of the capital stock. Particularly over the 1997 to 2000 period, the increase in ICT capital per unit of labour input was the largest part of capital deepening. This is also the period of strongest growth in labour productivity and the largest increase in total factor productivity. The latter captures the effects of other improvements in technology.
Table 13.6 Sources of Canadian business sector labour productivity growth, 1974–2005 (%/yr)
1974–1996 1997–2000 2000–2005
Labour productivity 1.4 3.0 1.0
Capital deepening 1.1 1.0 0.7
Info & communications technology (ICT)
0.4 0.7 0.3
Non-ICT
0.7 0.4 0.4
Labour quality 0.4 0.4 0.4
Total factor productivity 0.0 1.6 –0.1
Source: R. Dion, "Interpreting Canada's Productivity Performance in the Past Decade: Lessons from Recent Research." Bank of Canada Review, Summer 2007.
The estimated contributions of changes in labour quality to labour productivity growth provide an interesting refinement of the growth accounting methodology. Ignoring this change, as the simple accounting process did in earlier examples, leaves the contribution of changes in the structure and characteristics of the labour force in the residual measure of total factor productivity. The results in the table extract and quantify this important source of productivity growth.
Changes in the structure of investment and in the quality of labour are both areas in which public policy plays a role. Government tax policy can be designed to encourage producers to direct investment to areas like communications and information technology. Some of this investment has effects confined to specific industries. Other parts create and strengthen national capacity and efficiency that is widely available and used by business and households, for example high-speed internet service and expanded wireless service and capacity. Educational policy and other human resource policies contribute to the quality, adaptability, and mobility of the labour force.
Endogenous growth theory
Another interesting strand of work makes more fundamental changes in growth theory. The simple neoclassical growth theory made economic growth depend on exogenous variables, the rate of population growth, the saving rate, and the rate of capital accumulation, whose values are determined outside the growth model. The subsequent work on catch-up and convergence makes technical progress respond to economic and political factors. But it would be nice to have a stronger link between economic behaviour and the rate of economic growth. We want to make growth endogenous, or determined within our model. Endogenous growth implies that the steady-state growth rate is affected by economic behaviour and economic policy.
Exogenous variable: a variable with a value determined outside the model.
Endogenous growth: growth determined economic behaviour and policy within the model.
Professor Paul Romer of the University of Chicago pioneered endogenous growth theory. Growth theories are built on the saving that drives investment and capital accumulation. While the production function used the basic growth model, increasing the stock of capital and the capital labour ratio leads to a diminishing marginal product of capital. Output and output per worker increase at a decreasing rate but in the steady state output grows at the rate of growth of population and labour force. Output per worker cannot grow indefinitely.
Endogenous growth theory is based on a different view of the roles capital plays in the growth process. It retains the assumption that, for the individual firm, the marginal product of capital decreases as capital stock increases. But it adds the insight that in the aggregate economy there may be significant positive externalities to the increase in capital stock. In other words increases in capital stock by one firm may result in improved productivity and output in other firms. Improved internet speed and access, or faster wireless voice and data transmission comes from investment by internet service providers and wireless companies. Using the new capacity provided improves the efficiency and productivity of production in other companies. Aggregate productivity and output grows as a result of increased investment by individual producers.
This line of argument is illustrated by the shapes of the production functions. For the individual firm the production function still looks like that in Figure 13.1, concave to the horizontal axis. Increases in the capital/labour ratio increase output per worker at a decreasing rate. For the aggregate economy, according to endogenous growth theory, increases in capital per worker do not face diminishing returns because of the externalities that come with increases in the capital stock. As a result, the aggregate production function has constant returns to capital. It is a straight line rising from the origin with a constant slope. Growth in the capital/labour ratio produces a constant rate of growth in output per worker and aggregate output. A 10 percent increase in capital per worker gives a 10 percent increase in output per worker.
Constant returns to raising the aggregate capital to labour ratio in the economy allows an escape from the key growth limitation in the neoclassical theory. It makes growth endogenous and dependent upon parameters that could be influenced by private behaviour or public policy. Any policy that succeeded in raising the rate of investment would permanently raise the growth rate. Similarly, any policy achieving a one-time improvement in technology (for example, greater workplace efficiency) would permanently raise the growth rate of capital per worker. This would mean permanently faster output growth.
Not only can government policy affect growth in this framework, government intervention may also increase efficiency. In the simple endogenous model described here, there are externalities to capital accumulation. Individual producers may not realize that by investing to increase their capital stock they may also improve productivity in other firms. Public policy that recognizes this economy wide effect can subsidize investment to increase investment and aggregate economic growth. By the same argument, externalities to investment in human capital support government subsidies to education and training.
However, endogenous growth theory faces criticism based on the assumption that there are exactly constant returns in the aggregate from accumulating one factor of production. The diminishing returns in the basic model make long-run growth exogenous. An economy with increasing returns experiences continuously increasing capital stock and output. This sort of explosive growth does not correspond to any empirical observation.
New growth theory emphasizes the roles of research and development, innovation, education and "learning by doing" as sources of improved technology and productivity. Research, development, and innovation come from decisions to invest in new knowledge and to apply it to production processes. Education comes from decisions to invest in human capital. Learning by doing is a natural outcome of employment experience. All these are ongoing processes, although they may be pursued unevenly over time as economic conditions and economic policies change.
As a result, increases in the stock of capital and the level of employment always embody new technology and knowledge. There is no separation between increases in the capital to labour ratio and the state of technology, as in the basic neoclassical model. But if new capital stock and new employees bring new technology to the production process, the per worker production function shifts up as capital per worker increases. As capital per worker increases, the economy moves up and along a new per worker production function because the embodied technological improvements offset otherwise diminishing returns.
Recent studies of the sources of productivity growth based on growth accounting are consistent with this approach to reconciling neoclassical and new growth theory. The findings reported in Table 13.6 above show the contributions to productivity growth made by different types of capital equipment and changes in labour force structure. These changes in "technology" are made integral parts of the growth in capital stock and employment rather than left as exogenous residuals.
The costs of growth
Can the benefits of economic growth be outweighed by its costs? Pollution, congestion, and a hectic lifestyle are a high price to pay for more cars and trucks, washing machines, video games, smart phones and tablets.
Since GDP is an imperfect measure of the true economic value of goods and services produced by the economy, there is no presumption we should want to maximize the growth of measured GDP. Without government intervention, a free market economy produces too much pollution. But the elimination of all pollution is also wasteful. Society should undertake activities accompanied by pollution up to the point at which the marginal net benefit of the goods produced equals the marginal pollution cost imposed on society. Government intervention, through pollution taxes or regulation of environmental standards, can move the economy towards a more efficient allocation of resources and a higher standard of living, broadly defined.
The full implementation of such a policy would (optimally) reduce growth of measured GDP to below the rate when there is no restriction on pollution and congestion. This is the most sensible way in which to approach the problem. It tackles the issues directly.
In contrast, the "zero growth" solution is a blunt instrument. It does not differentiate measured outputs that have social costs, from outputs without new social costs. As a result there are no new incentives to minimize the externalities already caused by pollution, congestion and environmental degradation. These call for taxes or incentives to reduce current social costs. 'No growth' does not go far enough.
A more extensive and inclusive measure of GDP would be a step toward recognizing and dealing with the costs of growth. Such a measure might include both positive aspects of production and consumption that contribute to welfare, such as environmental quality and low levels of congestion. It might also adjust to give a more complete measure of both private and social costs of different patterns of production, consumption and leisure. We have seen one way to approach this in the United Nations Human Development Index in Chapter 4, but a broader based index is needed. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/13%3A_Economic_growth/13.05%3A_Recent_growth_studies_and_policy_issues.txt |
This completes the introduction to the theory and modelling needed to study the major performance and policy issues in the macro economy. This approach has integrated household and business expenditure decisions, government taxation, expenditure and budget balances, and the monetary, financial sectors and monetary policy, to explain the causes and effects of business cycle fluctuations in national output and employment. It also defines and explains monetary and fiscal policy stabilization roles for the central bank and the government. The brief discussion of the theory of economic growth puts a longer-term perspective on the changes in standards of living over time. Perhaps most importantly, modelling the macro economy emphasizes the complex linkages and interdependencies that determine the modern industrial economy's responses to aggregate demand and supply disturbances.
13.07: Key Concepts
Economic growth is the percentage annual increase in real GDP or per capita real GDP. It is an imperfect measure of the rate of increase of economic well-being because of the limitations of the measurement of GDP.
Very long run: the time required for changes to occur in the stock of capital, the size of the labour force, and the technology of production.
Total factor productivity (TFP): output relative to the combined inputs of labour and capital, the total factor inputs to production.
Growth accounting: a method of measuring the contributions of growth in inputs of labour and capital and the state of technology to overall growth.
Solow residual: the growth in real GDP or per capita real GDP not caused by growth in factor inputs, but attributed to improved technology.
Growth in per capita real GDP has two main sources, namely, growth in the ratio of capital to labour in the production process, and improvements in technology. Growth accounting provides a way of measuring the sources of growth in per capita real GDP.
Marginal product: the change in total output caused by a change of one unit in the input of that factor to production.
Sustained growth in per capita real GDP: improvements in technology overcome the diminishing returns to increases in the capital to labour ratio.
Recent research on the growth of Canada's potential GDP found that the contribution of productivity growth from technology declined in the 1980s and early 1990s and again from 2000 to 2005.
Invention: the discovery of new knowledge.
Innovation: the application of new knowledge into production techniques.
Exogenous variable: a variable with a value determined outside the model.
Endogenous growth: growth determined economic behaviour and policy within the model.
13.08: Exercises for Chapter 13
EXERCISE 13.1
1. What is the distinction between growth in potential GDP and growth in per capita real GDP?
2. Why is this distinction important to an evaluation of the relationship between economic growth and growth in standards of living?
3. Which grows more rapidly, potential GDP or per capita real GDP?
EXERCISE 13.2
Consider two countries with the same level of potential GDP, say \$100 billion, today. Suppose potential GDP grows at an annual rate of 3.5 percent (0.035) in one country and 3.25 percent (0.0325) in the second country. Based on this information:
1. What do you predict for the percentage difference in potential GDP between the two countries 10 years in the future?
2. 20 years in the future? [Note that the growth rates will compound to determine real GDP according to the following formula: .]
EXERCISE 13.3
Suppose you have the following information about an economy:
Average annual rates of growth from 1998 to 2008:
Potential GDP 3.5%
Labour force 2.1%
Capital stock 3.0%
Share of labour income in national income: 2/3. Using growth accounting, find the contribution to the annual growth in potential GDP that came from:
1. Growth in labour force
2. Growth in capital stock
3. Improved productivity as measured by the Solow residual.
EXERCISE 13.4
If technology were constant while labour force grew at a rate of 2.5% a year, capital stock grew at 1.5% per year and the share of labour income in national income was 70%, how fast would potential GDP grow?
EXERCISE 13.5
Suppose you have the following information for two economies:
Country A Country B
Average annual i. Labour force 2.5% 4.0%
growth rates: ii. Capital stock 3.5% 3.5%
Labour income/national income: 2/3 2/3
1. Assuming a constant state of technology, which of these two countries will have the faster rate of growth in total real GDP?
2. Which of the two countries will have the faster rate of growth in per capita real GDP?
3. What differences, if any, do you see in the growth rates of the capital to labour ratios in the two countries?
4. Explain the reasons for the differences in growth rates you have found.
EXERCISE 13.6
In Wonderland, labour force and capital stock both grow at the rate of 2.5% a year but technology is constant. At what rate will potential GDP grow? At what rate will per capita GDP grow? If improvements in technology increased total factor productivity by 1.5% year, how fast would per capita real GDP grow?
EXERCISE 13.7
1. Why do economists emphasize that improvements in technology are the key to improvements in standards of living?
2. Using a diagram that shows the relationship between capital per worker and output per worker, illustrate and explain why growth in capital per worker cannot provide sustained growth in output per worker and standards of living.
3. In the diagram in part (b), show how an improvement in productivity coming from improved technology could provide sustained increases in standards of living. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/13%3A_Economic_growth/13.06%3A_Conclusion.txt |
Part 1: The Building Blocks
1.Introduction to key ideas
2.Theories, models and data
3.The classical marketplace – demand and supply
Economics is a social science; it analyzes human interactions in a scientific manner. We begin by defining the central aspects of this social science – trading, the marketplace, opportunity cost and resources. We explore how producers and consumers interact in society. Trade is central to improving the living standards of individuals. This material forms the subject matter of Chapter 1.
Methods of analysis are central to any science. Consequently we explore how data can be displayed and analyzed in order to better understand the economy around us in Chapter 2. Understanding the world is facilitated by the development of theories and models and then testing such theories with the use of data-driven models.
Trade is critical to individual well-being, whether domestically or internationally. To understand this trading process we analyze the behaviour of suppliers and buyers in the marketplace. Markets are formed by suppliers and demanders coming together for the purpose of trading. Thus, demand and supply are examined in Chapter 3 in tabular, graphical and mathematical form.
15: Introduction to Macroeconomics
Part 2: Introduction to Macroeconomics
4.Economic activity & performance
5.Output, business cycles and employment
6.Aggregate expenditure & aggregate demand
7.The government sector
The four chapters in this part of the text introduce and develop the expenditure side of a basic traditional macroeconomic model. Chapter 4 explains the measurement of macroeconomic activity and performance. Then Chapter 5 introduces an aggregate demand and supply model of national output, the general price level and business cycles. Market based aggregate expenditure components that determine aggregate demand, when prices, interest rates and exchange rates are constant, are modelled in Chapter 6. Chapter 7 extends the expenditure model to include Government expenditure, taxes, budgets, public debt and basic fiscal policy.
16: Financial Markets and Economic Activity
Part 3: Financial Markets & Economic Activity
8.Money, banking & money supply
9.Financial markets, interest rates, foreign exchange rates and aggregate demand
10.Central banking and monetary policy
Three chapters in this part examine the financial sector of the economy and the important role it has in the determination of output and employment. They cover money, banks and banking, financial markets, asset prices and foreign exchange rates. When integrated, these parts of the economy provide the 'monetary transmission mechanism' and a framework for the design and implementation of central bank monetary policy. Moreover, the financial sector is the key to price level and inflation rate elasticities in the aggregate demand functions derived in later chapters.
17: Real GDP Business Cycles Policy and Growth
Part 4: Real GDP, Business Cycles, Policy and Growth
11.Inflation, real GDP, monetary policy and fiscal policy
12.Exchange rates, monetary policy and fiscal policy
13.Economic growth
This Part integrates the material of the preceding chapters. Chapter 11 builds a 'modern' aggregate demand-aggregate supply model to explain the inflation rate, and real GDP and stabilization policy. The current approaches in inflation control, in which monetary policy sets the interest rate, are discussed. Chapter 12 introduces international aspects of macroeconomics and the importance of foreign exchange rates to the design and effectiveness of monetary and fiscal policy, using the model from Chapter 11. Chapter 13 introduces theories of economic growth and the importance of technology and productivity growth for standards of living. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(Curtis_and_Irvine)/14%3A_The_Building_Blocks.txt |
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01: Economics: The Study of Choice
Learning Objective
1. Define economics.
2. Explain the concepts of scarcity and opportunity cost and how they relate to the definition of economics.
3. Understand the three fundamental economic questions: What should be produced? How should goods and services be produced? For whom should goods and services be produced?
Economics is a social science that examines how people choose among the alternatives available to them. It is social because it involves people and their behavior. It is a science because it uses, as much as possible, a scientific approach in its investigation of choices.
Scarcity, Choice, and Cost
All choices mean that one alternative is selected over another. Selecting among alternatives involves three ideas central to economics: scarcity, choice, and opportunity cost.
Scarcity
Our resources are limited. At any one time, we have only so much land, so many factories, so much oil, so many people. But our wants, our desires for the things that we can produce with those resources, are unlimited. We would always like more and better housing, more and better education—more and better of practically everything.
If our resources were also unlimited, we could say yes to each of our wants—and there would be no economics. Because our resources are limited, we cannot say yes to everything. To say yes to one thing requires that we say no to another. Whether we like it or not, we must make choices.
Our unlimited wants are continually colliding with the limits of our resources, forcing us to pick some activities and to reject others. Scarcity is the condition of having to choose among alternatives. A scarce good is one for which the choice of one alternative requires that another be given up.
Consider a parcel of land. The parcel presents us with several alternative uses. We could build a house on it. We could put a gas station on it. We could create a small park on it. We could leave the land undeveloped in order to be able to make a decision later as to how it should be used.
Suppose we have decided the land should be used for housing. Should it be a large and expensive house or several modest ones? Suppose it is to be a large and expensive house. Who should live in the house? If the Lees live in it, the Nguyens cannot. There are alternative uses of the land both in the sense of the type of use and also in the sense of who gets to use it. The fact that land is scarce means that society must make choices concerning its use.
Virtually everything is scarce. Consider the air we breathe, which is available in huge quantity at no charge to us. Could it possibly be scarce?
The test of whether air is scarce is whether it has alternative uses. What uses can we make of the air? We breathe it. We pollute it when we drive our cars, heat our houses, or operate our factories. In effect, one use of the air is as a garbage dump. We certainly need the air to breathe. But just as certainly, we choose to dump garbage in it. Those two uses are clearly alternatives to each other. The more garbage we dump in the air, the less desirable—and healthy—it will be to breathe. If we decide we want to breathe cleaner air, we must limit the activities that generate pollution. Air is a scarce good because it has alternative uses.
Not all goods, however, confront us with such choices. A free good is one for which the choice of one use does not require that we give up another. One example of a free good is gravity. The fact that gravity is holding you to the earth does not mean that your neighbor is forced to drift up into space! One person’s use of gravity is not an alternative to another person’s use.
There are not many free goods. Outer space, for example, was a free good when the only use we made of it was to gaze at it. But now, our use of space has reached the point where one use can be an alternative to another. Conflicts have already arisen over the allocation of orbital slots for communications satellites. Thus, even parts of outer space are scarce. Space will surely become more scarce as we find new ways to use it. Scarcity characterizes virtually everything. Consequently, the scope of economics is wide indeed.
Scarcity and the Fundamental Economic Questions
The choices we confront as a result of scarcity raise three sets of issues. Every economy must answer the following questions:
1. What should be produced? Using the economy’s scarce resources to produce one thing requires giving up another. Producing better education, for example, may require cutting back on other services, such as health care. A decision to preserve a wilderness area requires giving up other uses of the land. Every society must decide what it will produce with its scarce resources.
2. How should goods and services be produced? There are all sorts of choices to be made in determining how goods and services should be produced. Should a firm employ a few skilled or a lot of unskilled workers? Should it produce in its own country or should it use foreign plants? Should manufacturing firms use new or recycled raw materials to make their products?
3. For whom should goods and services be produced? If a good or service is produced, a decision must be made about who will get it. A decision to have one person or group receive a good or service usually means it will not be available to someone else. For example, representatives of the poorest nations on earth often complain that energy consumption per person in the United States is 17 times greater than energy consumption per person in the world’s 62 poorest countries. Critics argue that the world’s energy should be more evenly allocated. Should it? That is a “for whom” question.
Every economy must determine what should be produced, how it should be produced, and for whom it should be produced. We shall return to these questions again and again.
Opportunity Cost
It is within the context of scarcity that economists define what is perhaps the most important concept in all of economics, the concept of opportunity cost. Opportunity cost is the value of the best alternative forgone in making any choice.
The opportunity cost to you of reading the remainder of this chapter will be the value of the best other use to which you could have put your time. If you choose to spend \$20 on a potted plant, you have simultaneously chosen to give up the benefits of spending the \$20 on pizzas or a paperback book or a night at the movies. If the book is the most valuable of those alternatives, then the opportunity cost of the plant is the value of the enjoyment you otherwise expected to receive from the book.
The concept of opportunity cost must not be confused with the purchase price of an item. Consider the cost of a college or university education. That includes the value of the best alternative use of money spent for tuition, fees, and books. But the most important cost of a college education is the value of the forgone alternative uses of time spent studying and attending class instead of using the time in some other endeavor. Students sacrifice that time in hopes of even greater earnings in the future or because they place a value on the opportunity to learn. Or consider the cost of going to the doctor. Part of that cost is the value of the best alternative use of the money required to see the doctor. But, the cost also includes the value of the best alternative use of the time required to see the doctor. The essential thing to see in the concept of opportunity cost is found in the name of the concept. Opportunity cost is the value of the best opportunity forgone in a particular choice. It is not simply the amount spent on that choice.
The concepts of scarcity, choice, and opportunity cost are at the heart of economics. A good is scarce if the choice of one alternative requires that another be given up. The existence of alternative uses forces us to make choices. The opportunity cost of any choice is the value of the best alternative forgone in making it.
Key Takeaways
• Economics is a social science that examines how people choose among the alternatives available to them.
• Scarcity implies that we must give up one alternative in selecting another. A good that is not scarce is a free good.
• The three fundamental economic questions are: What should be produced? How should goods and services be produced? For whom should goods and services be produced?
• Every choice has an opportunity cost and opportunity costs affect the choices people make. The opportunity cost of any choice is the value of the best alternative that had to be forgone in making that choice.
Try It!
Identify the elements of scarcity, choice, and opportunity cost in each of the following:
1. The Environmental Protection Agency is considering an order that a 500-acre area on the outskirts of a large city be preserved in its natural state, because the area is home to a rodent that is considered an endangered species. Developers had planned to build a housing development on the land.
2. The manager of an automobile assembly plant is considering whether to produce cars or sport utility vehicles (SUVs) next month. Assume that the quantities of labor and other materials required would be the same for either type of production.
3. A young man who went to work as a nurses’ aide after graduating from high school leaves his job to go to college, where he will obtain training as a registered nurse.
Case in Point: The Rising Cost of Energy
Oil is an exhaustible resource. The oil we burn today will not be available for use in the future. Part of the opportunity cost of our consumption of goods such as gasoline that are produced from oil includes the value people in the future might have placed on oil we use today.
It appears that the cost of our use of oil may be rising. We have been using “light crude,” the oil found in the ground in deposits that can be readily tapped. As light crude becomes more scarce, the world may need to turn to so-called “heavy crude,” the crude oil that is found in the sandy soil of places such as Canada and Venezuela. That oil exists in such abundance that it propels Venezuela to the top of the world list of available oil. Saudi Arabia moves to the second position; Canada is third.
The difficulty with the oil mixed in the sand is that extracting it is far more costly than light crude, both in terms of the expenditures required and in terms of the environmental damage that mining it creates. Northern Alberta, in Canada, boasts a Florida-sized area whose sandy soils are rich in crude oil. Some of that oil is 1,200 feet underground. Extracting it requires pumping steam into the oily sand and then pumping up the resultant oily syrup. That syrup is then placed into huge, industrial-sized washing machines that separate crude oil. What is left over is toxic and will be placed in huge lakes that are being created by digging pits in the ground 200 feet deep. The oil produced from these sands has become important—Alberta is the largest foreign supplier of oil to the United States.
Sands that are closer to the surface are removed by bulldozers and giant cranes; the forest over it is cleared away. The oily sand is then hauled off in two-story dump trucks which, when filled, weigh more than a Boeing 747. Total SA, a French company, is leading the race to develop Canada’s oil. Jean Luc-Guiziou, the president of Total SA’s Canadian operations, says that the extraordinarily costly process of extracting heavy crude is something the world is going to have to get used to. “The light crude undiscovered today is getting scarcer and scarcer,” he told The Wall Street Journal. “We have to accept the reality of geoscience, which is that the next generation of oil resources will be heavier.”
Already, Total SA has clear-cut thousands of acres of forest land in order to gain access to the oily sand below. The process of extracting heavy crude oil costs the company \$25 a barrel—compared to the \$6 per barrel cost of extracting and refining light crude. Extracting heavy crude generates three times as much greenhouse gas per barrel as does light crude. By 2015, Fort McMurray, the small (population 61,000) town that has become the headquarters of Northern Alberta’s crude oil boom, will emit more greenhouse gas than the entire country of Denmark (population 5.4 million). Canada will exceed its greenhouse gas quota set by the Kyoto Accords—an international treaty aimed at limiting global warming—largely as a result of developing its heavy crude deposits.
No one even considered the extraction of heavy crude when light crude was cheap. In the late 1990s, oil cost just \$12 per barrel, and deposits of heavy crude such as those in Canada attracted little attention. By mid-2006, oil sold for more than \$70 per barrel, and Canada’s heavy crude was suddenly a hot commodity. “It moved from being just an interesting experiment in northern Canada to really this is the future source of oil supply,” Greg Stringham of the Canadian Association of Petroleum Producers told Al Jazeera.
Alberta’s energy minister, Greg Melchin, defends the province’s decision to proceed with the exploitation of its oily sand. “There is a cost to it, but the benefits are substantially greater,” he insists.
Not everyone agrees. George Poitras, a member of the Mikisew Cree tribe, lives downstream from the oil sands development. “You see a lot of the land dug up, a lot of the boreal forest struck down and it’s upsetting, it fills me with rage,” he says. Diana Gibson of the Parkland Institute, an environmental advocacy group, says that you can see the environmental damage generated by the extraction of oil sands around Fort McMurray from the moon. “What we are going to be having is destruction of very, very valuable ecosystems, and permanent pollution,” she says.
Answers to Try It! Problems
1. The 500-acre area is scarce because it has alternative uses: preservation in its natural state or a site for homes. A choice must be made between these uses. The opportunity cost of preserving the land in its natural state is the forgone value of the land as a housing development. The opportunity cost of using the land as a housing development is the forgone value of preserving the land.
2. The scarce resources are the plant and the labor at the plant. The manager must choose between producing cars and producing SUVs. The opportunity cost of producing cars is the profit that could be earned from producing SUVs; the opportunity cost of producing SUVs is the profit that could be earned from producing cars.
3. The man can devote his time to his current career or to an education; his time is a scarce resource. He must choose between these alternatives. The opportunity cost of continuing as a nurses’ aide is the forgone benefit he expects from training as a registered nurse; the opportunity cost of going to college is the forgone income he could have earned working full-time as a nurses’ aide. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/01%3A_Economics%3A_The_Study_of_Choice/1.1%3A_Defining_Economics.txt |
Learning Objective
1. Explain the distinguishing characteristics of the economic way of thinking.
2. Distinguish between microeconomics and macroeconomics.
We have examined the basic concepts of scarcity, choice, and opportunity cost in economics. In this section, we will look at economics as a field of study. We begin with the characteristics that distinguish economics from other social sciences.
The Economic Way of Thinking
Economists study choices that scarcity requires us to make. This fact is not what distinguishes economics from other social sciences; all social scientists are interested in choices. An anthropologist might study the choices of ancient peoples; a political scientist might study the choices of legislatures; a psychologist might study how people choose a mate; a sociologist might study the factors that have led to a rise in single-parent households. Economists study such questions as well. What is it about the study of choices by economists that makes economics different from these other social sciences?
Three features distinguish the economic approach to choice from the approaches taken in other social sciences:
1. Economists give special emphasis to the role of opportunity costs in their analysis of choices.
2. Economists assume that individuals make choices that seek to maximize the value of some objective, and that they define their objectives in terms of their own self-interest.
3. Individuals maximize by deciding whether to do a little more or a little less of something. Economists argue that individuals pay attention to the consequences of small changes in the levels of the activities they pursue.
The emphasis economists place on opportunity cost, the idea that people make choices that maximize the value of objectives that serve their self-interest, and a focus on the effects of small changes are ideas of great power. They constitute the core of economic thinking. The next three sections examine these ideas in greater detail.
Opportunity Costs Are Important
If doing one thing requires giving up another, then the expected benefits of the alternatives we face will affect the ones we choose. Economists argue that an understanding of opportunity cost is crucial to the examination of choices.
As the set of available alternatives changes, we expect that the choices individuals make will change. A rainy day could change the opportunity cost of reading a good book; we might expect more reading to get done in bad than in good weather. A high income can make it very costly to take a day off; we might expect highly paid individuals to work more hours than those who are not paid as well. If individuals are maximizing their level of satisfaction and firms are maximizing profits, then a change in the set of alternatives they face may affect their choices in a predictable way.
The emphasis on opportunity costs is an emphasis on the examination of alternatives. One benefit of the economic way of thinking is that it pushes us to think about the value of alternatives in each problem involving choice.
Individuals Maximize in Pursuing Self-Interest
What motivates people as they make choices? Perhaps more than anything else, it is the economist’s answer to this question that distinguishes economics from other fields.
Economists assume that individuals make choices that they expect will create the maximum value of some objective, given the constraints they face. Furthermore, economists assume that people’s objectives will be those that serve their own self-interest.
Economists assume, for example, that the owners of business firms seek to maximize profit. Given the assumed goal of profit maximization, economists can predict how firms in an industry will respond to changes in the markets in which they operate. As labor costs in the United States rise, for example, economists are not surprised to see firms moving some of their manufacturing operations overseas.
Similarly, economists assume that maximizing behavior is at work when they examine the behavior of consumers. In studying consumers, economists assume that individual consumers make choices aimed at maximizing their level of satisfaction. In the next chapter, we will look at the results of the shift from skiing to snowboarding; that is a shift that reflects the pursuit of self-interest by consumers and by manufacturers.
In assuming that people pursue their self-interest, economists are not assuming people are selfish. People clearly gain satisfaction by helping others, as suggested by the large charitable contributions people make. Pursuing one’s own self-interest means pursuing the things that give one satisfaction. It need not imply greed or selfishness.
Choices Are Made at the Margin
Economists argue that most choices are made “at the margin.” The margin is the current level of an activity. Think of it as the edge from which a choice is to be made. A choice at the margin is a decision to do a little more or a little less of something.
Assessing choices at the margin can lead to extremely useful insights. Consider, for example, the problem of curtailing water consumption when the amount of water available falls short of the amount people now use. Economists argue that one way to induce people to conserve water is to raise its price. A common response to this recommendation is that a higher price would have no effect on water consumption, because water is a necessity. Many people assert that prices do not affect water consumption because people “need” water.
But choices in water consumption, like virtually all choices, are made at the margin. Individuals do not make choices about whether they should or should not consume water. Rather, they decide whether to consume a little more or a little less water. Household water consumption in the United States totals about 105 gallons per person per day. Think of that starting point as the edge from which a choice at the margin in water consumption is made. Could a higher price cause you to use less water brushing your teeth, take shorter showers, or water your lawn less? Could a higher price cause people to reduce their use, say, to 104 gallons per person per day? To 103? When we examine the choice to consume water at the margin, the notion that a higher price would reduce consumption seems much more plausible. Prices affect our consumption of water because choices in water consumption, like other choices, are made at the margin.
The elements of opportunity cost, maximization, and choices at the margin can be found in each of two broad areas of economic analysis: microeconomics and macroeconomics. Your economics course, for example, may be designated as a “micro” or as a “macro” course. We will look at these two areas of economic thought in the next section.
Microeconomics and Macroeconomics
The field of economics is typically divided into two broad realms: microeconomics and macroeconomics. It is important to see the distinctions between these broad areas of study.
Microeconomics is the branch of economics that focuses on the choices made by individual decision-making units in the economy—typically consumers and firms—and the impacts those choices have on individual markets. Macroeconomics is the branch of economics that focuses on the impact of choices on the total, or aggregate, level of economic activity.
Why do tickets to the best concerts cost so much? How does the threat of global warming affect real estate prices in coastal areas? Why do women end up doing most of the housework? Why do senior citizens get discounts on public transit systems? These questions are generally regarded as microeconomic because they focus on individual units or markets in the economy.
Is the total level of economic activity rising or falling? Is the rate of inflation increasing or decreasing? What is happening to the unemployment rate? These are questions that deal with aggregates, or totals, in the economy; they are problems of macroeconomics. The question about the level of economic activity, for example, refers to the total value of all goods and services produced in the economy. Inflation is a measure of the rate of change in the average price level for the entire economy; it is a macroeconomic problem. The total levels of employment and unemployment in the economy represent the aggregate of all labor markets; unemployment is also a topic of macroeconomics.
Both microeconomics and macroeconomics give attention to individual markets. But in microeconomics that attention is an end in itself; in macroeconomics it is aimed at explaining the movement of major economic aggregates—the level of total output, the level of employment, and the price level.
We have now examined the characteristics that define the economic way of thinking and the two branches of this way of thinking: microeconomics and macroeconomics. In the next section, we will have a look at what one can do with training in economics.
Putting Economics to Work
Economics is one way of looking at the world. Because the economic way of thinking has proven quite useful, training in economics can be put to work in a wide range of fields. One, of course, is in work as an economist. Undergraduate work in economics can be applied to other careers as well.
Careers in Economics
Economists work in three types of organizations. About 58% of economists work for government agencies (Bureau of Labor Statistics). The remainder work for business firms or in colleges and universities.
Economists working for business firms and government agencies sometimes forecast economic activity to assist their employers in planning. They also apply economic analysis to the activities of the firms or agencies for which they work or consult. Economists employed at colleges and universities teach and conduct research.
Peruse the website of your college or university’s economics department. Chances are the department will discuss the wide variety of occupations that their economics majors enter. Unlike engineering and accounting majors, economics and other social science majors tend to be distributed over a broad range of occupations.
Applying Economics to Other Fields
Suppose that you are considering something other than a career in economics. Would choosing to study economics help you?
The evidence suggests it may. Suppose, for example, that you are considering law school. The study of law requires keen analytical skills; studying economics sharpens such skills. Economists have traditionally argued that undergraduate work in economics serves as excellent preparation for law school. Economist Michael Nieswiadomy of the University of North Texas collected data on Law School Admittance Test (LSAT) scores for undergraduate majors listed by 2,200 or more students taking the test in 2003. Table 1.1 “LSAT Scores and Undergraduate Majors” gives the scores, as well as the ranking for each of these majors, in 2003 and in two previous years in which the rankings were compiled. In rankings for all three years, economics majors recorded the highest scores.
Table 1.1: LSAT Scores and Undergraduate Majors
Major field LSAT average 2003–2004 2003–2004 Rank 1994–1995 Rank 1991–1992 Rank
Economics 156.6 1 1 1
Engineering 155.4 2 4 2
History 155.0 3 2 3
English 154.3 4 3 4
Finance 152.6 5 6 5
Political science 152.1 6 9 9
Psychology 152.1 7 7 8
Accounting 151.1 8 8 6
Communications 150.5 9 10 10
Sociology 150.2 10 12 13
Bus. Administration 149.6 11 13 12
Criminal Justice 144.7 12 14 14
Here are the average LSAT scores and rankings for the 12 undergraduate majors with more than 2200 students taking the test to enter law school in the 2003–2004 academic year.
Did the strong performance by economics, engineering, and history majors mean that training in those fields sharpens analytical skills tested in the LSAT, or that students with good analytical skills are more likely to major in them? Both factors were probably at work. Economics clearly attracts students with good analytical skills—and studying economics helps develop those skills.
Economics majors shine in other areas as well. According to the Bureau of Labor Statistics Occupational Outlook Handbook, a strong background in economic theory, mathematics, and statistics provides the basis for competing for the best job opportunities, particularly research assistant positions, in a broad range of fields. Many graduates with bachelor’s degrees will find good jobs in industry and business as management or sales trainees or as administrative assistants. Because economists are concerned with understanding and interpreting financial matters, among other subjects, they will also be attracted to and qualified for jobs as financial managers, financial analysts, underwriters, actuaries, securities and financial services sales workers, credit analysts, loan and budget officers, and urban and regional planners.
Table 1.2 “Average Yearly Salary Offers, May 2006 and Occupational Outlook 2004–2014, Selected Majors/Occupations” shows average yearly salary offers for bachelor degree candidates for May 2006 and the outlook for related occupations to 2014.
Table 1.2: Average Yearly Salary Offers, May 2006 and Occupational Outlook 2004–2014, Selected Majors/Occupations
Undergraduate major Average \$ Offer May, 2006 Projected % Change in Total Employment in Occupation 2004–2014
Computer Engineering \$54,200 10.1
Electrical/Electronic Engineering 54,053 11.8
Computer Science 50,892 25.6
Accounting 46,188 22.4
Economics and Finance 45,058 12.4
Management Information Systems 44,755 25.9
Logistics and Materials Management 43,426 13.2
Business Administration 40,976 17.0
Environmental Sciences (including forestry and conservation science) 39,750 6.3
Other Business Majors (e.g., Marketing) 37,446 20.8
Human Resources (incl. Labor Relations) 36,256 15.9
Geology and Geological Sciences 35,034 8.3
Sociology 33,752 4.7
Political Science/Government 33,151 7.3
Liberal Arts & Sciences (general studies) 32,627 na
Public Relations 32,623 21.7
Special Education 31,817 23.3
Elementary Education 31,778 18.2
Foreign Languages 31,364 na
Letters (incl. English) 31,204 20.4
Other Social Sciences (Including Criminal Justice and History) 30,788 12.3
Psychology 30,308 9.9
Pre-elementary Education 27,550 22.4
Social Work 25,865 19.6
Visual and Performing Arts 21,726 15.2
One’s choice of a major, or minor, is not likely to be based solely on considerations of potential earnings or the prospect of landing a spot in law school. You will also consider your interests and abilities in making a decision about whether to pursue further study in economics. And, of course, you will consider the expected benefits of alternative courses of study. What is your opportunity cost of pursuing study of economics? Does studying more economics serve your interests and will doing so maximize your satisfaction level? These considerations may be on your mind as you begin to study economics at the college level and obviously students will make many different choices. But, should you decide to pursue a major or minor in economics, you should know that a background in this field is likely to serve you well in a wide range of careers.
Key Takeaways
• Economists focus on the opportunity costs of choices, they assume that individuals make choices in a way that maximizes the value of an objective defined in terms of their own self-interest, and they assume that individuals make those choices at the margin.
• Economics is divided into two broad areas: microeconomics and macroeconomics.
• A wide range of career opportunities is open to economics majors. Empirical evidence suggests that students who enter the job market with a major in economics tend to earn more than do students in most other majors. Further, economics majors do particularly well on the LSAT.
Try It!
The Department of Agriculture estimated that the expenditures a middle-income, husband–wife family of three would incur to raise one additional child from birth in 2005 to age 17 would be \$250,530. In what way does this estimate illustrate the economic way of thinking? Would the Department’s estimate be an example of microeconomic or of macroeconomic analysis? Why?
Case in Point: The Financial Payoff to Studying Economics
College economics professors have long argued that studying economics is good preparation for a variety of careers. A recent study suggests they are right and that studying economics is even likely to make students more prosperous. Students who major in economics but did not pursue graduate work are likely to earn more than students in virtually every other college major. Students who major in economics and then go on to law school or an MBA program are likely to earn more than students who approach those areas of study having majored in most other areas.
Economists Dan A. Black, Seth Sanders, and Lowell Taylor used the 1993 National Survey of College Graduates, which included more than 86,000 college-educated workers between the ages of 25 and 55 that asked what field they had majored in. They then controlled for variables such as gender, race, and ethnicity. They found that students who had not done graduate work and had majored in economics earned more than students in any other major except engineering. Specifically, economics majors earned about 13% more than other social sciences majors, 11% more than business administration majors, and about the same as natural science and accounting majors. The economics majors in their survey, like those who majored in other social sciences and business administration and unlike those who majored in engineering or accounting, were spread out over a wide range of occupations but with many in management positions.
Based on the survey they used, over 40% of economics majors went on to earn graduate degrees, many in law and business. Economics majors ranked first in terms of wages, as compared to other law school graduates with the 12 most common pre-law majors (including such majors as business administration, finance, English, history, psychology, and political science). MBA graduates who had majored in economics earned more than those who had majored in any other field except chemical engineering. Specifically, undergraduate economics majors with MBAs earned about 15% more than those who had majored in other disciplines represented in the survey, including business-related majors.
It is remarkable that all of the business-related majors generated salaries much lower than those earned by economics majors with an MBA. One could argue that this reflects self-selection; that students who major in economics are simply brighter. But, students who major in physics have high SAT scores, yet they, too, earned wages that were about 20% lower than MBA students who had majored in economics. This finding lends some credence to the notion that the marketplace rewards training in the economic way of thinking.
Source: Dan A. Black, Seth Sanders, and Lowell Taylor, “The Economic Reward for Studying Economics,” Economic Inquiry, 41(3), July 2003, 365–377.
Answer to Try It! Problem
The information given suggests one element of the economic way of thinking: assessing the choice at the margin. The estimate reflects the cost of one more child for a family that already has one. It is not clear from the information given how close the estimate of cost comes to the economic concept of opportunity cost. The Department of Agriculture’s estimate included such costs as housing, food, transportation, clothing, health care, child care, and education. An economist would add the value of the best alternative use of the additional time that will be required for the child. If the couple is looking far ahead, it may want to consider the opportunity cost of sending a child to college. And, if it is looking very far ahead, it may want to consider the fact that nearly half of all parents over the age of 50 support at least one child over the age of 21. This is a problem in microeconomic analysis, because it focuses on the choices of individual households. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/01%3A_Economics%3A_The_Study_of_Choice/1.2%3A_The_Field_of_Economics.txt |
Learning Objective
1. Explain how economists test hypotheses, develop economic theories, and use models in their analyses.
2. Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems.
3. Distinguish between normative and positive statements.
Economics differs from other social sciences because of its emphasis on opportunity cost, the assumption of maximization in terms of one’s own self-interest, and the analysis of choices at the margin. But certainly much of the basic methodology of economics and many of its difficulties are common to every social science—indeed, to every science. This section explores the application of the scientific method to economics.
Researchers often examine relationships between variables. A variable is something whose value can change. By contrast, a constant is something whose value does not change. The speed at which a car is traveling is an example of a variable. The number of minutes in an hour is an example of a constant.
Research is generally conducted within a framework called the scientific method, a systematic set of procedures through which knowledge is created. In the scientific method, hypotheses are suggested and then tested. A hypothesis is an assertion of a relationship between two or more variables that could be proven to be false. A statement is not a hypothesis if no conceivable test could show it to be false. The statement “Plants like sunshine” is not a hypothesis; there is no way to test whether plants like sunshine or not, so it is impossible to prove the statement false. The statement “Increased solar radiation increases the rate of plant growth” is a hypothesis; experiments could be done to show the relationship between solar radiation and plant growth. If solar radiation were shown to be unrelated to plant growth or to retard plant growth, then the hypothesis would be demonstrated to be false.
If a test reveals that a particular hypothesis is false, then the hypothesis is rejected or modified. In the case of the hypothesis about solar radiation and plant growth, we would probably find that more sunlight increases plant growth over some range but that too much can actually retard plant growth. Such results would lead us to modify our hypothesis about the relationship between solar radiation and plant growth.
If the tests of a hypothesis yield results consistent with it, then further tests are conducted. A hypothesis that has not been rejected after widespread testing and that wins general acceptance is commonly called a theory. A theory that has been subjected to even more testing and that has won virtually universal acceptance becomes a law. We will examine two economic laws in the next two chapters.
Even a hypothesis that has achieved the status of a law cannot be proven true. There is always a possibility that someone may find a case that invalidates the hypothesis. That possibility means that nothing in economics, or in any other social science, or in any science, can ever be proven true. We can have great confidence in a particular proposition, but it is always a mistake to assert that it is “proven.”
Models in Economics
All scientific thought involves simplifications of reality. The real world is far too complex for the human mind—or the most powerful computer—to consider. Scientists use models instead. A model is a set of simplifying assumptions about some aspect of the real world. Models are always based on assumed conditions that are simpler than those of the real world, assumptions that are necessarily false. A model of the real world cannot be the real world.
We will encounter our first economic model in Chapter 35 “Appendix A: Graphs in Economics”. For that model, we will assume that an economy can produce only two goods. Then we will explore the model of demand and supply. One of the assumptions we will make there is that all the goods produced by firms in a particular market are identical. Of course, real economies and real markets are not that simple. Reality is never as simple as a model; one point of a model is to simplify the world to improve our understanding of it.
Economists often use graphs to represent economic models. The appendix to this chapter provides a quick, refresher course, if you think you need one, on understanding, building, and using graphs.
Models in economics also help us to generate hypotheses about the real world. In the next section, we will examine some of the problems we encounter in testing those hypotheses.
Testing Hypotheses in Economics
Here is a hypothesis suggested by the model of demand and supply: an increase in the price of gasoline will reduce the quantity of gasoline consumers demand. How might we test such a hypothesis?
Economists try to test hypotheses such as this one by observing actual behavior and using empirical (that is, real-world) data. The average retail price of gasoline in the United States rose from an average of \$2.12 per gallon on May 22, 2005 to \$2.88 per gallon on May 22, 2006. The number of gallons of gasoline consumed by U.S. motorists rose 0.3% during that period.
The small increase in the quantity of gasoline consumed by motorists as its price rose is inconsistent with the hypothesis that an increased price will lead to an reduction in the quantity demanded. Does that mean that we should dismiss the original hypothesis? On the contrary, we must be cautious in assessing this evidence. Several problems exist in interpreting any set of economic data. One problem is that several things may be changing at once; another is that the initial event may be unrelated to the event that follows. The next two sections examine these problems in detail.
The All-Other-Things-Unchanged Problem
The hypothesis that an increase in the price of gasoline produces a reduction in the quantity demanded by consumers carries with it the assumption that there are no other changes that might also affect consumer demand. A better statement of the hypothesis would be: An increase in the price of gasoline will reduce the quantity consumers demand, ceteris paribus. Ceteris paribus is a Latin phrase that means “all other things unchanged.”
But things changed between May 2005 and May 2006. Economic activity and incomes rose both in the United States and in many other countries, particularly China, and people with higher incomes are likely to buy more gasoline. Employment rose as well, and people with jobs use more gasoline as they drive to work. Population in the United States grew during the period. In short, many things happened during the period, all of which tended to increase the quantity of gasoline people purchased.
Our observation of the gasoline market between May 2005 and May 2006 did not offer a conclusive test of the hypothesis that an increase in the price of gasoline would lead to a reduction in the quantity demanded by consumers. Other things changed and affected gasoline consumption. Such problems are likely to affect any analysis of economic events. We cannot ask the world to stand still while we conduct experiments in economic phenomena. Economists employ a variety of statistical methods to allow them to isolate the impact of single events such as price changes, but they can never be certain that they have accurately isolated the impact of a single event in a world in which virtually everything is changing all the time.
In laboratory sciences such as chemistry and biology, it is relatively easy to conduct experiments in which only selected things change and all other factors are held constant. The economists’ laboratory is the real world; thus, economists do not generally have the luxury of conducting controlled experiments.
The Fallacy of False Cause
Hypotheses in economics typically specify a relationship in which a change in one variable causes another to change. We call the variable that responds to the change the dependent variable; the variable that induces a change is called the independent variable. Sometimes the fact that two variables move together can suggest the false conclusion that one of the variables has acted as an independent variable that has caused the change we observe in the dependent variable.
Consider the following hypothesis: People wearing shorts cause warm weather. Certainly, we observe that more people wear shorts when the weather is warm. Presumably, though, it is the warm weather that causes people to wear shorts rather than the wearing of shorts that causes warm weather; it would be incorrect to infer from this that people cause warm weather by wearing shorts.
Reaching the incorrect conclusion that one event causes another because the two events tend to occur together is called the fallacy of false cause. The accompanying essay on baldness and heart disease suggests an example of this fallacy.
Because of the danger of the fallacy of false cause, economists use special statistical tests that are designed to determine whether changes in one thing actually do cause changes observed in another. Given the inability to perform controlled experiments, however, these tests do not always offer convincing evidence that persuades all economists that one thing does, in fact, cause changes in another.
In the case of gasoline prices and consumption between May 2005 and May 2006, there is good theoretical reason to believe the price increase should lead to a reduction in the quantity consumers demand. And economists have tested the hypothesis about price and the quantity demanded quite extensively. They have developed elaborate statistical tests aimed at ruling out problems of the fallacy of false cause. While we cannot prove that an increase in price will, ceteris paribus, lead to a reduction in the quantity consumers demand, we can have considerable confidence in the proposition.
Normative and Positive Statements
Two kinds of assertions in economics can be subjected to testing. We have already examined one, the hypothesis. Another testable assertion is a statement of fact, such as “It is raining outside” or “Microsoft is the largest producer of operating systems for personal computers in the world.” Like hypotheses, such assertions can be demonstrated to be false. Unlike hypotheses, they can also be shown to be correct. A statement of fact or a hypothesis is a positive statement.
Although people often disagree about positive statements, such disagreements can ultimately be resolved through investigation. There is another category of assertions, however, for which investigation can never resolve differences. A normative statement is one that makes a value judgment. Such a judgment is the opinion of the speaker; no one can “prove” that the statement is or is not correct. Here are some examples of normative statements in economics: “We ought to do more to help the poor.” “People in the United States should save more.” “Corporate profits are too high.” The statements are based on the values of the person who makes them. They cannot be proven false.
Because people have different values, normative statements often provoke disagreement. An economist whose values lead him or her to conclude that we should provide more help for the poor will disagree with one whose values lead to a conclusion that we should not. Because no test exists for these values, these two economists will continue to disagree, unless one persuades the other to adopt a different set of values. Many of the disagreements among economists are based on such differences in values and therefore are unlikely to be resolved.
Key Takeaways
• Economists try to employ the scientific method in their research.
• Scientists cannot prove a hypothesis to be true; they can only fail to prove it false.
• Economists, like other social scientists and scientists, use models to assist them in their analyses.
• Two problems inherent in tests of hypotheses in economics are the all-other-things-unchanged problem and the fallacy of false cause.
• Positive statements are factual and can be tested. Normative statements are value judgments that cannot be tested. Many of the disagreements among economists stem from differences in values.
Try It!
Look again at the data in Table 1.1 “LSAT Scores and Undergraduate Majors”. Now consider the hypothesis: “Majoring in economics will result in a higher LSAT score.” Are the data given consistent with this hypothesis? Do the data prove that this hypothesis is correct? What fallacy might be involved in accepting the hypothesis?
Case in Point: Does Baldness Cause Heart Disease?
A website called embarrassingproblems.com received the following email:
“Dear Dr. Margaret,
“I seem to be going bald. According to your website, this means I’m more likely to have a heart attack. If I take a drug to prevent hair loss, will it reduce my risk of a heart attack?”
What did Dr. Margaret answer? Most importantly, she did not recommend that the questioner take drugs to treat his baldness, because doctors do not think that the baldness causes the heart disease. A more likely explanation for the association between baldness and heart disease is that both conditions are affected by an underlying factor. While noting that more research needs to be done, one hypothesis that Dr. Margaret offers is that higher testosterone levels might be triggering both the hair loss and the heart disease. The good news for people with early balding (which is really where the association with increased risk of heart disease has been observed) is that they have a signal that might lead them to be checked early on for heart disease.
Figure 1.3
Answer to Try It! Problem
The data are consistent with the hypothesis, but it is never possible to prove that a hypothesis is correct. Accepting the hypothesis could involve the fallacy of false cause; students who major in economics may already have the analytical skills needed to do well on the exam. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/01%3A_Economics%3A_The_Study_of_Choice/1.3%3A_The_Economists_Tool_Kit.txt |
Thumbnail: https://pixabay.com/photos/worker-grinder-factory-workplace-5736096/
02: Confronting Scarcity: Choices in Production
Learning Objective
1. Define the three factors of production—labor, capital, and natural resources.
2. Explain the role of technology and entrepreneurs in the utilization of the economy’s factors of production.
Choices concerning what goods and services to produce are choices about an economy’s use of its factors of production, the resources available to it for the production of goods and services. The value, or satisfaction, that people derive from the goods and services they consume and the activities they pursue is called utility. Ultimately, then, an economy’s factors of production create utility; they serve the interests of people.
The factors of production in an economy are its labor, capital, and natural resources. Labor is the human effort that can be applied to the production of goods and services. People who are employed or would like to be are considered part of the labor available to the economy. Capital is a factor of production that has been produced for use in the production of other goods and services. Office buildings, machinery, and tools are examples of capital. Natural resources are the resources of nature that can be used for the production of goods and services.
In the next three sections, we will take a closer look at the factors of production we use to produce the goods and services we consume. The three basic building blocks of labor, capital, and natural resources may be used in different ways to produce different goods and services, but they still lie at the core of production. We will then look at the roles played by technology and entrepreneurs in putting these factors of production to work. As economists began to grapple with the problems of scarcity, choice, and opportunity cost two centuries ago, they focused on these concepts, just as they are likely to do two centuries hence.
Labor
Labor is human effort that can be applied to production. People who work to repair tires, pilot airplanes, teach children, or enforce laws are all part of the economy’s labor. People who would like to work but have not found employment—who are unemployed—are also considered part of the labor available to the economy.
In some contexts, it is useful to distinguish two forms of labor. The first is the human equivalent of a natural resource. It is the natural ability an untrained, uneducated person brings to a particular production process. But most workers bring far more. The skills a worker has as a result of education, training, or experience that can be used in production are called human capital. Students who are attending a college or university are acquiring human capital. Workers who are gaining skills through experience or through training are acquiring human capital. Children who are learning to read are acquiring human capital.
The amount of labor available to an economy can be increased in two ways. One is to increase the total quantity of labor, either by increasing the number of people available to work or by increasing the average number of hours of work per week. The other is to increase the amount of human capital possessed by workers.
Capital
Long ago, when the first human beings walked the earth, they produced food by picking leaves or fruit off a plant or by catching an animal and eating it. We know that very early on, however, they began shaping stones into tools, apparently for use in butchering animals. Those tools were the first capital because they were produced for use in producing other goods—food and clothing.
Modern versions of the first stone tools include saws, meat cleavers, hooks, and grinders; all are used in butchering animals. Tools such as hammers, screwdrivers, and wrenches are also capital. Transportation equipment, such as cars and trucks, is capital. Facilities such as roads, bridges, ports, and airports are capital. Buildings, too, are capital; they help us to produce goods and services.
Capital does not consist solely of physical objects. The score for a new symphony is capital because it will be used to produce concerts. Computer software used by business firms or government agencies to produce goods and services is capital. Capital may thus include physical goods and intellectual discoveries. Any resource is capital if it satisfies two criteria:
1. The resource must have been produced.
2. The resource can be used to produce other goods and services.
One thing that is not considered capital is money. A firm cannot use money directly to produce other goods, so money does not satisfy the second criterion for capital. Firms can, however, use money to acquire capital. Money is a form of financial capital. Financial capital includes money and other “paper” assets (such as stocks and bonds) that represent claims on future payments. These financial assets are not capital, but they can be used directly or indirectly to purchase factors of production or goods and services.
Natural Resources
There are two essential characteristics of natural resources. The first is that they are found in nature—that no human effort has been used to make or alter them. The second is that they can be used for the production of goods and services. That requires knowledge; we must know how to use the things we find in nature before they become resources.
Consider oil. Oil in the ground is a natural resource because it is found (not manufactured) and can be used to produce goods and services. However, 250 years ago oil was a nuisance, not a natural resource. Pennsylvania farmers in the eighteenth century who found oil oozing up through their soil were dismayed, not delighted. No one knew what could be done with the oil. It was not until the mid-nineteenth century that a method was found for refining oil into kerosene that could be used to generate energy, transforming oil into a natural resource. Oil is now used to make all sorts of things, including clothing, drugs, gasoline, and plastic. It became a natural resource because people discovered and implemented a way to use it.
Defining something as a natural resource only if it can be used to produce goods and services does not mean that a tree has value only for its wood or that a mountain has value only for its minerals. If people gain utility from the existence of a beautiful wilderness area, then that wilderness provides a service. The wilderness is thus a natural resource.
The natural resources available to us can be expanded in three ways. One is the discovery of new natural resources, such as the discovery of a deposit of ore containing titanium. The second is the discovery of new uses for resources, as happened when new techniques allowed oil to be put to productive use or sand to be used in manufacturing computer chips. The third is the discovery of new ways to extract natural resources in order to use them. New methods of discovering and mapping oil deposits have increased the world’s supply of this important natural resource.
Technology and the Entrepreneur
Goods and services are produced using the factors of production available to the economy. Two things play a crucial role in putting these factors of production to work. The first is technology, the knowledge that can be applied to the production of goods and services. The second is an individual who plays a key role in a market economy: the entrepreneur. An entrepreneur is a person who, operating within the context of a market economy, seeks to earn profits by finding new ways to organize factors of production. In non-market economies the role of the entrepreneur is played by bureaucrats and other decision makers who respond to incentives other than profit to guide their choices about resource allocation decisions.
The interplay of entrepreneurs and technology affects all our lives. Entrepreneurs put new technologies to work every day, changing the way factors of production are used. Farmers and factory workers, engineers and electricians, technicians and teachers all work differently than they did just a few years ago, using new technologies introduced by entrepreneurs. The music you enjoy, the books you read, the athletic equipment with which you play are produced differently than they were five years ago. The book you are reading was written and manufactured using technologies that did not exist ten years ago. We can dispute whether all the changes have made our lives better. What we cannot dispute is that they have made our lives different.
Key Takeaways
• Factors of production are the resources the economy has available to produce goods and services.
• Labor is the human effort that can be applied to the production of goods and services. Labor’s contribution to an economy’s output of goods and services can be increased either by increasing the quantity of labor or by increasing human capital.
• Capital is a factor of production that has been produced for use in the production of other goods and services.
• Natural resources are those things found in nature that can be used for the production of goods and services.
• Two keys to the utilization of an economy’s factors of production are technology and, in the case of a market economic system, the efforts of entrepreneurs.
Try It!
Explain whether each of the following is labor, capital, or a natural resource.
1. An unemployed factory worker
2. A college professor
3. The library building on your campus
4. Yellowstone National Park
5. An untapped deposit of natural gas
6. The White House
7. The local power plant
Case in Point: Technology Cuts Costs, Boosts Productivity and Profits
Figure 2.1
Technology can seem an abstract force in the economy—important, but invisible.
It is not invisible to the 130 people who work on a Shell Oil Company oil rig called Mars, located in the deep waters of the Gulf of Mexico, about 160 miles southwest of Pensacola, Florida. The name Mars reflects its otherworld appearance—it extends 300 feet above the water’s surface and has steel tendons that reach 3,000 feet to the floor of the gulf. This facility would not exist if it were not for the development of better oil discovery methods that include three-dimensional seismic mapping techniques, satellites that locate oil from space, and drills that can make turns as drilling foremen steer them by monitoring them on computer screens from the comfort of Mars. “We don’t hit as many dry holes,” commented Shell manager Miles Barrett. As a result of these new technologies, over the past two decades, the cost of discovering a barrel of oil dropped from \$20 to under \$5. And the technologies continue to improve. Three-dimensional surveys are being replaced with four-dimensional ones that allow geologists to see how the oil fields change over time.
The Mars project was destroyed by Hurricane Katrina in 2005. Royal Dutch Shell completed repairs in 2006—at a cost of \$200 million. But, the facility is again pumping 130,000 barrels of oil per day and 150 million cubic feet of natural gas—the energy equivalent of an additional 26,000 barrels of oil.
Technology is doing more than helping energy companies track oil deposits. It is changing the way soft drinks and other grocery items are delivered to retail stores. For example, when a PepsiCo delivery driver arrives at a 7-Eleven, the driver keys into a handheld computer the inventory of soft drinks, chips, and other PepsiCo products. The information is transmitted to a main computer at the warehouse that begins processing the next order for that store. The result is that the driver can visit more stores in a day and PepsiCo can cover a given territory with fewer drivers and trucks.
New technology is even helping to produce more milk from cows. Ed Larsen, who owns a 1,200-cow dairy farm in Wisconsin, never gets up before dawn to milk the cows, the way he did as a boy. Rather, the cows are hooked up to electronic milkers. Computers measure each cow’s output, and cows producing little milk are sent to a “hospital wing” for treatment. With the help of such technology, as well as better feed, today’s dairy cows produce 50% more milk than did cows 20 years ago. Even though the number of dairy cows in the United States in the last 20 years has fallen 17%, milk output has increased 25%.
Who benefits from technological progress? Consumers gain from lower prices and better service. Workers gain: Their greater ability to produce goods and services translates into higher wages. And firms gain: Lower production costs mean higher profits. Of course, some people lose as technology advances. Some jobs are eliminated, and some firms find their services are no longer needed. One can argue about whether particular technological changes have improved our lives, but they have clearly made—and will continue to make—them far different.
Answers to Try It! Problems
1. An unemployed factory worker could be put to work; he or she counts as labor.
2. A college professor is labor.
3. The library building on your campus is part of capital.
4. Yellowstone National Park. Those areas of the park left in their natural state are a natural resource. Facilities such as visitors’ centers, roads, and campgrounds are capital.
5. An untapped deposit of natural gas is a natural resource. Once extracted and put in a storage tank, natural gas is capital.
6. The White House is capital.
7. The local power plant is capital. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/02%3A_Confronting_Scarcity%3A_Choices_in_Production/2.1%3A_Factors_of_Production.txt |
Learning Objective
1. Explain the concept of the production possibilities curve and understand the implications of its downward slope and bowed-out shape.
2. Use the production possibilities model to distinguish between full employment and situations of idle factors of production and between efficient and inefficient production.
3. Understand specialization and its relationship to the production possibilities model and comparative advantage.
An economy’s factors of production are scarce; they cannot produce an unlimited quantity of goods and services. A production possibilities curve is a graphical representation of the alternative combinations of goods and services an economy can produce. It illustrates the production possibilities model. In drawing the production possibilities curve, we shall assume that the economy can produce only two goods and that the quantities of factors of production and the technology available to the economy are fixed.
Constructing a Production Possibilities Curve
To construct a production possibilities curve, we will begin with the case of a hypothetical firm, Alpine Sports, Inc., a specialized sports equipment manufacturer. Christie Ryder began the business 15 years ago with a single ski production facility near Killington ski resort in central Vermont. Ski sales grew, and she also saw demand for snowboards rising—particularly after snowboard competition events were included in the 2002 Winter Olympics in Salt Lake City. She added a second plant in a nearby town. The second plant, while smaller than the first, was designed to produce snowboards as well as skis. She also modified the first plant so that it could produce both snowboards and skis. Two years later she added a third plant in another town. While even smaller than the second plant, the third was primarily designed for snowboard production but could also produce skis.
We can think of each of Ms. Ryder’s three plants as a miniature economy and analyze them using the production possibilities model. We assume that the factors of production and technology available to each of the plants operated by Alpine Sports are unchanged.
Suppose the first plant, Plant 1, can produce 200 pairs of skis per month when it produces only skis. When devoted solely to snowboards, it produces 100 snowboards per month. It can produce skis and snowboards simultaneously as well.
The table in Figure 2.2 gives three combinations of skis and snowboards that Plant 1 can produce each month. Combination A involves devoting the plant entirely to ski production; combination C means shifting all of the plant’s resources to snowboard production; combination B involves the production of both goods. These values are plotted in a production possibilities curve for Plant 1. The curve is a downward-sloping straight line, indicating that there is a linear, negative relationship between the production of the two goods.
Neither skis nor snowboards is an independent or a dependent variable in the production possibilities model; we can assign either one to the vertical or to the horizontal axis. Here, we have placed the number of pairs of skis produced per month on the vertical axis and the number of snowboards produced per month on the horizontal axis.
The negative slope of the production possibilities curve reflects the scarcity of the plant’s capital and labor. Producing more snowboards requires shifting resources out of ski production and thus producing fewer skis. Producing more skis requires shifting resources out of snowboard production and thus producing fewer snowboards.
The slope of Plant 1’s production possibilities curve measures the rate at which Alpine Sports must give up ski production to produce additional snowboards. Because the production possibilities curve for Plant 1 is linear, we can compute the slope between any two points on the curve and get the same result. Between points A and B, for example, the slope equals −2 pairs of skis/snowboard (equals −100 pairs of skis/50 snowboards). (Many students are helped when told to read this result as “−2 pairs of skis per snowboard.”) We get the same value between points B and C, and between points A and C.
To see this relationship more clearly, examine Figure 2.3. Suppose Plant 1 is producing 100 pairs of skis and 50 snowboards per month at point B. Now consider what would happen if Ms. Ryder decided to produce 1 more snowboard per month. The segment of the curve around point B is magnified in Figure 2.3. The slope between points B and B′ is −2 pairs of skis/snowboard. Producing 1 additional snowboard at point B′ requires giving up 2 pairs of skis. We can think of this as the opportunity cost of producing an additional snowboard at Plant 1. This opportunity cost equals the absolute value of the slope of the production possibilities curve.
Figure 2.3 The Slope of a Production Possibilities Curve
The slope of the linear production possibilities curve in Figure 2.2 is constant; it is −2 pairs of skis/snowboard. In the section of the curve shown here, the slope can be calculated between points B and B′. Expanding snowboard production to 51 snowboards per month from 50 snowboards per month requires a reduction in ski production to 98 pairs of skis per month from 100 pairs. The slope equals −2 pairs of skis/snowboard (that is, it must give up two pairs of skis to free up the resources necessary to produce one additional snowboard). To shift from B′ to B″, Alpine Sports must give up two more pairs of skis per snowboard. The absolute value of the slope of a production possibilities curve measures the opportunity cost of an additional unit of the good on the horizontal axis measured in terms of the quantity of the good on the vertical axis that must be forgone.
The absolute value of the slope of any production possibilities curve equals the opportunity cost of an additional unit of the good on the horizontal axis. It is the amount of the good on the vertical axis that must be given up in order to free up the resources required to produce one more unit of the good on the horizontal axis. We will make use of this important fact as we continue our investigation of the production possibilities curve.
Figure 2.4 shows production possibilities curves for each of the firm’s three plants. Each of the plants, if devoted entirely to snowboards, could produce 100 snowboards. Plants 2 and 3, if devoted exclusively to ski production, can produce 100 and 50 pairs of skis per month, respectively. The exhibit gives the slopes of the production possibilities curves for each plant. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes (that is, the number of pairs of skis that must be given up per snowboard).
The exhibit gives the slopes of the production possibilities curves for each of the firm’s three plants. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes. More generally, the absolute value of the slope of any production possibilities curve at any point gives the opportunity cost of an additional unit of the good on the horizontal axis, measured in terms of the number of units of the good on the vertical axis that must be forgone.
The greater the absolute value of the slope of the production possibilities curve, the greater the opportunity cost will be. The plant for which the opportunity cost of an additional snowboard is greatest is the plant with the steepest production possibilities curve; the plant for which the opportunity cost is lowest is the plant with the flattest production possibilities curve. The plant with the lowest opportunity cost of producing snowboards is Plant 3; its slope of −0.5 means that Ms. Ryder must give up half a pair of skis in that plant to produce an additional snowboard. In Plant 2, she must give up one pair of skis to gain one more snowboard. We have already seen that an additional snowboard requires giving up two pairs of skis in Plant 1.
Comparative Advantage and the Production Possibilities Curve
To construct a combined production possibilities curve for all three plants, we can begin by asking how many pairs of skis Alpine Sports could produce if it were producing only skis. To find this quantity, we add up the values at the vertical intercepts of each of the production possibilities curves in Figure 2.4. These intercepts tell us the maximum number of pairs of skis each plant can produce. Plant 1 can produce 200 pairs of skis per month, Plant 2 can produce 100 pairs of skis at per month, and Plant 3 can produce 50 pairs. Alpine Sports can thus produce 350 pairs of skis per month if it devotes its resources exclusively to ski production. In that case, it produces no snowboards.
Now suppose the firm decides to produce 100 snowboards. That will require shifting one of its plants out of ski production. Which one will it choose to shift? The sensible thing for it to do is to choose the plant in which snowboards have the lowest opportunity cost—Plant 3. It has an advantage not because it can produce more snowboards than the other plants (all the plants in this example are capable of producing up to 100 snowboards per month) but because it is the least productive plant for making skis. Producing a snowboard in Plant 3 requires giving up just half a pair of skis.
Economists say that an economy has a comparative advantage in producing a good or service if the opportunity cost of producing that good or service is lower for that economy than for any other. Plant 3 has a comparative advantage in snowboard production because it is the plant for which the opportunity cost of additional snowboards is lowest. To put this in terms of the production possibilities curve, Plant 3 has a comparative advantage in snowboard production (the good on the horizontal axis) because its production possibilities curve is the flattest of the three curves.
Plant 3’s comparative advantage in snowboard production makes a crucial point about the nature of comparative advantage. It need not imply that a particular plant is especially good at an activity. In our example, all three plants are equally good at snowboard production. Plant 3, though, is the least efficient of the three in ski production. Alpine thus gives up fewer skis when it produces snowboards in Plant 3. Comparative advantage thus can stem from a lack of efficiency in the production of an alternative good rather than a special proficiency in the production of the first good.
The combined production possibilities curve for the firm’s three plants is shown in Figure 2.5. We begin at point A, with all three plants producing only skis. Production totals 350 pairs of skis per month and zero snowboards. If the firm were to produce 100 snowboards at Plant 3, ski production would fall by 50 pairs per month (recall that the opportunity cost per snowboard at Plant 3 is half a pair of skis). That would bring ski production to 300 pairs, at point B. If Alpine Sports were to produce still more snowboards in a single month, it would shift production to Plant 2, the facility with the next-lowest opportunity cost. Producing 100 snowboards at Plant 2 would leave Alpine Sports producing 200 snowboards and 200 pairs of skis per month, at point C. If the firm were to switch entirely to snowboard production, Plant 1 would be the last to switch because the cost of each snowboard there is 2 pairs of skis. With all three plants producing only snowboards, the firm is at point D on the combined production possibilities curve, producing 300 snowboards per month and no skis.
Notice that this production possibilities curve, which is made up of linear segments from each assembly plant, has a bowed-out shape; the absolute value of its slope increases as Alpine Sports produces more and more snowboards. This is a result of transferring resources from the production of one good to another according to comparative advantage. We shall examine the significance of the bowed-out shape of the curve in the next section.
The Law of Increasing Opportunity Cost
We see in Figure 2.5 that, beginning at point A and producing only skis, Alpine Sports experiences higher and higher opportunity costs as it produces more snowboards. The fact that the opportunity cost of additional snowboards increases as the firm produces more of them is a reflection of an important economic law. The law of increasing opportunity cost holds that as an economy moves along its production possibilities curve in the direction of producing more of a particular good, the opportunity cost of additional units of that good will increase.
We have seen the law of increasing opportunity cost at work traveling from point A toward point D on the production possibilities curve in Figure 2.5. The opportunity cost of each of the first 100 snowboards equals half a pair of skis; each of the next 100 snowboards has an opportunity cost of 1 pair of skis, and each of the last 100 snowboards has an opportunity cost of 2 pairs of skis. The law also applies as the firm shifts from snowboards to skis. Suppose it begins at point D, producing 300 snowboards per month and no skis. It can shift to ski production at a relatively low cost at first. The opportunity cost of the first 200 pairs of skis is just 100 snowboards at Plant 1, a movement from point D to point C, or 0.5 snowboards per pair of skis. We would say that Plant 1 has a comparative advantage in ski production. The next 100 pairs of skis would be produced at Plant 2, where snowboard production would fall by 100 snowboards per month. The opportunity cost of skis at Plant 2 is 1 snowboard per pair of skis. Plant 3 would be the last plant converted to ski production. There, 50 pairs of skis could be produced per month at a cost of 100 snowboards, or an opportunity cost of 2 snowboards per pair of skis.
The bowed-out production possibilities curve for Alpine Sports illustrates the law of increasing opportunity cost. Scarcity implies that a production possibilities curve is downward sloping; the law of increasing opportunity cost implies that it will be bowed out, or concave, in shape.
The bowed-out curve of Figure 2.5 becomes smoother as we include more production facilities. Suppose Alpine Sports expands to 10 plants, each with a linear production possibilities curve. Panel (a) of Figure 2.6 shows the combined curve for the expanded firm, constructed as we did in Figure 2.5. This production possibilities curve includes 10 linear segments and is almost a smooth curve. As we include more and more production units, the curve will become smoother and smoother. In an actual economy, with a tremendous number of firms and workers, it is easy to see that the production possibilities curve will be smooth. We will generally draw production possibilities curves for the economy as smooth, bowed-out curves, like the one in Panel (b). This production possibilities curve shows an economy that produces only skis and snowboards. Notice the curve still has a bowed-out shape; it still has a negative slope. Notice also that this curve has no numbers. Economists often use models such as the production possibilities model with graphs that show the general shapes of curves but that do not include specific numbers.
Movements Along the Production Possibilities Curve
We can use the production possibilities model to examine choices in the production of goods and services. In applying the model, we assume that the economy can produce two goods, and we assume that technology and the factors of production available to the economy remain unchanged. In this section, we shall assume that the economy operates on its production possibilities curve so that an increase in the production of one good in the model implies a reduction in the production of the other.
We shall consider two goods and services: national security and a category we shall call “all other goods and services.” This second category includes the entire range of goods and services the economy can produce, aside from national defense and security. Clearly, the transfer of resources to the effort to enhance national security reduces the quantity of other goods and services that can be produced. In the wake of the 9/11 attacks in 2001, nations throughout the world increased their spending for national security. This spending took a variety of forms. One, of course, was increased defense spending. Local and state governments also increased spending in an effort to prevent terrorist attacks. Airports around the world hired additional agents to inspect luggage and passengers.
The increase in resources devoted to security meant fewer “other goods and services” could be produced. In terms of the production possibilities curve in Figure 2.7, the choice to produce more security and less of other goods and services means a movement from A to B. Of course, an economy cannot really produce security; it can only attempt to provide it. The attempt to provide it requires resources; it is in that sense that we shall speak of the economy as “producing” security.
At point A, the economy was producing SA units of security on the vertical axis—defense services and various forms of police protection—and OA units of other goods and services on the horizontal axis. The decision to devote more resources to security and less to other goods and services represents the choice we discussed in the chapter introduction. In this case we have categories of goods rather than specific goods. Thus, the economy chose to increase spending on security in the effort to defeat terrorism. Since we have assumed that the economy has a fixed quantity of available resources, the increased use of resources for security and national defense necessarily reduces the number of resources available for the production of other goods and services.
The law of increasing opportunity cost tells us that, as the economy moves along the production possibilities curve in the direction of more of one good, its opportunity cost will increase. We may conclude that, as the economy moved along this curve in the direction of greater production of security, the opportunity cost of the additional security began to increase. That is because the resources transferred from the production of other goods and services to the production of security had a greater and greater comparative advantage in producing things other than security.
The production possibilities model does not tell us where on the curve a particular economy will operate. Instead, it lays out the possibilities facing the economy. Many countries, for example, chose to move along their respective production possibilities curves to produce more security and national defense and less of all other goods in the wake of 9/11. We will see in the chapter on demand and supply how choices about what to produce are made in the marketplace.
Producing on Versus Producing Inside the Production Possibilities Curve
An economy that is operating inside its production possibilities curve could, by moving onto it, produce more of all the goods and services that people value, such as food, housing, education, medical care, and music. Increasing the availability of these goods would improve the standard of living. Economists conclude that it is better to be on the production possibilities curve than inside it.
Two things could leave an economy operating at a point inside its production possibilities curve. First, the economy might fail to use fully the resources available to it. Second, it might not allocate resources on the basis of comparative advantage. In either case, production within the production possibilities curve implies the economy could improve its performance.
Idle Factors of Production
Suppose an economy fails to put all its factors of production to work. Some workers are without jobs, some buildings are without occupants, some fields are without crops. Because an economy’s production possibilities curve assumes the full use of the factors of production available to it, the failure to use some factors results in a level of production that lies inside the production possibilities curve.
If all the factors of production that are available for use under current market conditions are being utilized, the economy has achieved full employment. An economy cannot operate on its production possibilities curve unless it has full employment.
Figure 2.8 shows an economy that can produce food and clothing. If it chooses to produce at point A, for example, it can produce FA units of food and CA units of clothing. Now suppose that a large fraction of the economy’s workers lose their jobs, so the economy no longer makes full use of one factor of production: labor. In this example, production moves to point B, where the economy produces less food (FB) and less clothing (CB) than at point A. We often think of the loss of jobs in terms of the workers; they have lost a chance to work and to earn income. But the production possibilities model points to another loss: goods and services the economy could have produced that are not being produced.
Inefficient Production
Now suppose Alpine Sports is fully employing its factors of production. Could it still operate inside its production possibilities curve? Could an economy that is using all its factors of production still produce less than it could? The answer is “Yes,” and the key lies in comparative advantage. An economy achieves a point on its production possibilities curve only if it allocates its factors of production on the basis of comparative advantage. If it fails to do that, it will operate inside the curve.
Suppose that, as before, Alpine Sports has been producing only skis. With all three of its plants producing skis, it can produce 350 pairs of skis per month (and no snowboards). The firm then starts producing snowboards. This time, however, imagine that Alpine Sports switches plants from skis to snowboards in numerical order: Plant 1 first, Plant 2 second, and then Plant 3. Figure 2.9 illustrates the result. Instead of the bowed-out production possibilities curve ABCD, we get a bowed-in curve, AB′C′D. Suppose that Alpine Sports is producing 100 snowboards and 150 pairs of skis at point B′. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it could have operated at a point such as C. It would be producing more snowboards and more pairs of skis—and using the same quantities of factors of production it was using at B′. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it would have operated at point C. It would be producing more snowboards and more pairs of skis—and using the same quantities of factors of production it was using at B′. When an economy is operating on its production possibilities curve, we say that it is engaging in efficient production. If it is using the same quantities of factors of production but is operating inside its production possibilities curve, it is engaging in inefficient production. Inefficient production implies that the economy could be producing more goods without using any additional labor, capital, or natural resources.
Points on the production possibilities curve thus satisfy two conditions: the economy is making full use of its factors of production, and it is making efficient use of its factors of production. If there are idle or inefficiently allocated factors of production, the economy will operate inside the production possibilities curve. Thus, the production possibilities curve not only shows what can be produced; it provides insight into how goods and services should be produced. It suggests that to obtain efficiency in production, factors of production should be allocated on the basis of comparative advantage. Further, the economy must make full use of its factors of production if it is to produce the goods and services it is capable of producing.
Specialization
The production possibilities model suggests that specialization will occur. Specialization implies that an economy is producing the goods and services in which it has a comparative advantage. If Alpine Sports selects point C in Figure 2.9, for example, it will assign Plant 1 exclusively to ski production and Plants 2 and 3 exclusively to snowboard production.
Such specialization is typical in an economic system. Workers, for example, specialize in particular fields in which they have a comparative advantage. People work and use the income they earn to buy—perhaps import—goods and services from people who have a comparative advantage in doing other things. The result is a far greater quantity of goods and services than would be available without this specialization.
Think about what life would be like without specialization. Imagine that you are suddenly completely cut off from the rest of the economy. You must produce everything you consume; you obtain nothing from anyone else. Would you be able to consume what you consume now? Clearly not. It is hard to imagine that most of us could even survive in such a setting. The gains we achieve through specialization are enormous.
Nations specialize as well. Much of the land in the United States has a comparative advantage in agricultural production and is devoted to that activity. Hong Kong, with its huge population and tiny endowment of land, allocates virtually none of its land to agricultural use; that option would be too costly. Its land is devoted largely to nonagricultural use.
Key Takeaways
• A production possibilities curve shows the combinations of two goods an economy is capable of producing.
• The downward slope of the production possibilities curve is an implication of scarcity.
• The bowed-out shape of the production possibilities curve results from allocating resources based on comparative advantage. Such an allocation implies that the law of increasing opportunity cost will hold.
• An economy that fails to make full and efficient use of its factors of production will operate inside its production possibilities curve.
• Specialization means that an economy is producing the goods and services in which it has a comparative advantage.
Try It!
Suppose a manufacturing firm is equipped to produce radios or calculators. It has two plants, Plant R and Plant S, at which it can produce these goods. Given the labor and the capital available at both plants, it can produce the combinations of the two goods at the two plants shown.
Output per day, Plant S
Combination Calculators Radios
D 50 0
E 25 50
F 0 100
Put calculators on the vertical axis and radios on the horizontal axis. Draw the production possibilities curve for Plant R. On a separate graph, draw the production possibilities curve for Plant S. Which plant has a comparative advantage in calculators? In radios? Now draw the combined curves for the two plants. Suppose the firm decides to produce 100 radios. Where will it produce them? How many calculators will it be able to produce? Where will it produce the calculators?
Case in Point: The Cost of the Great Depression
Figure 2.10
The U.S. economy looked very healthy in the beginning of 1929. It had enjoyed seven years of dramatic growth and unprecedented prosperity. Its resources were fully employed; it was operating quite close to its production possibilities curve.
In the summer of 1929, however, things started going wrong. Production and employment fell. They continued to fall for several years. By 1933, more than 25% of the nation’s workers had lost their jobs. Production had plummeted by almost 30%. The economy had moved well within its production possibilities curve.
Output began to grow after 1933, but the economy continued to have vast numbers of idle workers, idle factories, and idle farms. These resources were not put back to work fully until 1942, after the U.S. entry into World War II demanded mobilization of the economy’s factors of production.
Between 1929 and 1942, the economy produced 25% fewer goods and services than it would have if its resources had been fully employed. That was a loss, measured in today’s dollars, of well over \$3 trillion. In material terms, the forgone output represented a greater cost than the United States would ultimately spend in World War II. The Great Depression was a costly experience indeed.
Answer to Try It! Problem
The production possibilities curves for the two plants are shown, along with the combined curve for both plants. Plant R has a comparative advantage in producing calculators. Plant S has a comparative advantage in producing radios, so, if the firm goes from producing 150 calculators and no radios to producing 100 radios, it will produce them at Plant S. In the production possibilities curve for both plants, the firm would be at M, producing 100 calculators at Plant R.
Figure 2.11 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/02%3A_Confronting_Scarcity%3A_Choices_in_Production/2.2%3A_The_Production_Possibilities_Curve.txt |
Summary
Economics deals with choices. In this chapter we have examined more carefully the range of choices in production that must be made in any economy. In particular, we looked at choices involving the allocation of an economy’s factors of production: labor, capital, and natural resources.
In addition, in any economy, the level of technology plays a key role in determining how productive the factors of production will be. In a market economy, entrepreneurs organize factors of production and act to introduce technological change.
The production possibilities model is a device that assists us in thinking about many of the choices about resource allocation in an economy. The model assumes that the economy has factors of production that are fixed in both quantity and quality. When illustrated graphically, the production possibilities model typically limits our analysis to two goods. Given the economy’s factors of production and technology, the economy can produce various combinations of the two goods. If it uses its factors of production efficiently and has full employment, it will be operating on the production possibilities curve.
Two characteristics of the production possibilities curve are particularly important. First, it is downward sloping. This reflects the scarcity of the factors of production available to the economy; producing more of one good requires giving up some of the other. Second, the curve is bowed out. Another way of saying this is to say that the curve gets steeper as we move from left to right; the absolute value of its slope is increasing. Producing each additional unit of the good on the horizontal axis requires a greater sacrifice of the good on the vertical axis than did the previous units produced. This fact, called the law of increasing opportunity cost, is the inevitable result of efficient choices in production—choices based on comparative advantage.
The production possibilities model has important implications for international trade. It suggests that free trade will allow countries to specialize in the production of goods and services in which they have a comparative advantage. This specialization increases the production of all goods and services.
Increasing the quantity or quality of factors of production and/or improving technology will shift the production possibilities curve outward. This process is called economic growth. In the last 50 years, economic growth in the United States has resulted chiefly from increases in human capital and from technological advance.
Choices concerning the use of scarce resources take place within the context of a set of institutional arrangements that define an economic system. The principal distinctions between systems lie in the degree to which ownership of capital and natural resources and decision making authority over scarce resources are held by government or by private individuals. Economic systems include market capitalist, mixed, and command socialist economies. An increasing body of evidence suggests that market capitalist economies tend to be most productive; many command socialist and mixed economies are moving in the direction of market capitalist systems.
The presumption in favor of market-based systems does not preclude a role for government. Government is necessary to provide the system of laws on which market systems are founded. It may also be used to provide certain goods and services, to help individuals in need, and to regulate the actions of individuals and firms.
Concept Problems
1. How does a college education increase one’s human capital?
2. Why does the downward-sloping production possibilities curve imply that factors of production are scarce?
3. In what ways are the bowed-out shape of the production possibilities curve and the law of increasing opportunity cost related?
4. What is the relationship between the concept of comparative advantage and the law of increasing opportunity cost?
5. Suppose an economy can produce two goods, A and B. It is now operating at point E on production possibilities curve RT. An improvement in the technology available to produce good A shifts the curve to ST, and the economy selects point E′. How does this change affect the opportunity cost of producing an additional unit of good B?
Figure 2.18
1. Could a nation’s production possibilities curve ever shift inward? Explain what such a shift would mean, and discuss events that might cause such a shift to occur.
2. Suppose blue-eyed people were banned from working. How would this affect a nation’s production possibilities curve?
3. Evaluate this statement: “The U.S. economy could achieve greater growth by devoting fewer resources to consumption and more to investment; it follows that such a shift would be desirable.”
4. Two countries, Sportsland and Foodland, have similar total quantities of labor, capital, and natural resources. Both can produce two goods, figs and footballs. Sportsland’s resources are particularly well suited to the production of footballs but are not very productive in producing figs. Foodland’s resources are very productive when used for figs but are not capable of producing many footballs. In which country is the cost of additional footballs generally greater? Explain.
5. Suppose a country is committed to using its resources based on the reverse of comparative advantage doctrine: it first transfers those resources for which the cost is greatest, not lowest. Describe this country’s production possibilities curve.
6. The U.S. Constitution bans states from restricting imports of goods and services from other states. Suppose this restriction did not exist and that states were allowed to limit imports of goods and services produced in other states. How do you think this would affect U.S. output? Explain.
7. By 1993, nations in the European Union (EU) had eliminated all barriers to the flow of goods, services, labor, and capital across their borders. Even such things as consumer protection laws and the types of plugs required to plug in appliances have been standardized to ensure that there will be no barriers to trade. How do you think this elimination of trade barriers affected EU output?
8. How did the technological changes described in the Case in Point “Technology Cuts Costs, Boosts Productivity and Profits” affect the production possibilities curve for the United States?
Numerical Problems
1. Nathan can mow four lawns in a day or plant 20 trees in a day.
1. Draw Nathan’s production possibilities curve for mowing lawns and planting trees. Assume the production possibilities curve is linear and put the quantity of lawns mowed per day on the horizontal axis and the quantity of trees planted per day on the vertical axis.
2. What is Nathan’s opportunity cost of planting trees?
3. What is Nathan’s opportunity cost of mowing lawns?
2. David can mow four lawns in a day or plant four trees in a day.
1. Draw David’s production possibilities curve for mowing lawns and planting trees. Again, assume a linear production possibilities curve and put the quantity of lawns mowed per day on the horizontal axis.
2. What is David’s opportunity cost of planting trees?
3. What is David’s opportunity cost of mowing lawns?
3. Given the production information in problems 1 and 2 above, who has the comparative advantage in planting trees? Mowing lawns?
4. The exhibits below describe the production possibilities for Germany and Turkey.
Figure 2.19
Figure 2.20
1. What is the slope of Germany’s production possibilities curve?
2. What is the slope of Turkey’s production possibilities curve?
3. What is the opportunity cost of producing T-shirts in Germany?
4. What is the opportunity cost of producing T-shirts in Turkey?
5. What is the opportunity cost of producing optical instruments in Germany?
6. What is the opportunity cost of producing optical instruments in Turkey?
7. In which good does Germany have a comparative advantage?
8. In which good does Turkey have a comparative advantage? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/02%3A_Confronting_Scarcity%3A_Choices_in_Production/2.4%3A_Review_and_Practice.txt |
Thumbnail: www.pexels.com/photo/crop-man-drawing-on-whiteboard-during-financial-training-5310563/
03: Demand and Supply
Learning Objective
1. Define the quantity demanded of a good or service and illustrate it using a demand schedule and a demand curve.
2. Distinguish between the following pairs of concepts: demand and quantity demanded, demand schedule and demand curve, movement along and shift in a demand curve.
3. Identify demand shifters and determine whether a change in a demand shifter causes the demand curve to shift to the right or to the left.
How many pizzas will people eat this year? How many doctor visits will people make? How many houses will people buy?
Each good or service has its own special characteristics that determine the quantity people are willing and able to consume. One is the price of the good or service itself. Other independent variables that are important determinants of demand include consumer preferences, prices of related goods and services, income, demographic characteristics such as population size, and buyer expectations. The number of pizzas people will purchase, for example, depends very much on whether they like pizza. It also depends on the prices for alternatives such as hamburgers or spaghetti. The number of doctor visits is likely to vary with income—people with higher incomes are likely to see a doctor more often than people with lower incomes. The demands for pizza, for doctor visits, and for housing are certainly affected by the age distribution of the population and its size.
While different variables play different roles in influencing the demands for different goods and services, economists pay special attention to one: the price of the good or service. Given the values of all the other variables that affect demand, a higher price tends to reduce the quantity people demand, and a lower price tends to increase it. A medium pizza typically sells for \$5 to \$10. Suppose the price were \$30. Chances are, you would buy fewer pizzas at that price than you do now. Suppose pizzas typically sold for \$2 each. At that price, people would be likely to buy more pizzas than they do now.
We will discuss first how price affects the quantity demanded of a good or service and then how other variables affect demand.
Price and the Demand Curve
Because people will purchase different quantities of a good or service at different prices, economists must be careful when speaking of the “demand” for something. They have therefore developed some specific terms for expressing the general concept of demand.
The quantity demanded of a good or service is the quantity buyers are willing and able to buy at a particular price during a particular period, all other things unchanged. (As we learned, we can substitute the Latin phrase “ceteris paribus” for “all other things unchanged.”) Suppose, for example, that 100,000 movie tickets are sold each month in a particular town at a price of \$8 per ticket. That quantity—100,000—is the quantity of movie admissions demanded per month at a price of \$8. If the price were \$12, we would expect the quantity demanded to be less. If it were \$4, we would expect the quantity demanded to be greater. The quantity demanded at each price would be different if other things that might affect it, such as the population of the town, were to change. That is why we add the qualifier that other things have not changed to the definition of quantity demanded.
A demand schedule is a table that shows the quantities of a good or service demanded at different prices during a particular period, all other things unchanged. To introduce the concept of a demand schedule, let us consider the demand for coffee in the United States. We will ignore differences among types of coffee beans and roasts, and speak simply of coffee. The table in Figure 3.1 shows quantities of coffee that will be demanded each month at prices ranging from \$9 to \$4 per pound; the table is a demand schedule. We see that the higher the price, the lower the quantity demanded.
The information given in a demand schedule can be presented with a demand curve, which is a graphical representation of a demand schedule. A demand curve thus shows the relationship between the price and quantity demanded of a good or service during a particular period, all other things unchanged. The demand curve in Figure 3.1 shows the prices and quantities of coffee demanded that are given in the demand schedule. At point A, for example, we see that 25 million pounds of coffee per month are demanded at a price of \$6 per pound. By convention, economists graph price on the vertical axis and quantity on the horizontal axis.
Price alone does not determine the quantity of coffee or any other good that people buy. To isolate the effect of changes in price on the quantity of a good or service demanded, however, we show the quantity demanded at each price, assuming that those other variables remain unchanged. We do the same thing in drawing a graph of the relationship between any two variables; we assume that the values of other variables that may affect the variables shown in the graph (such as income or population) remain unchanged for the period under consideration.
A change in price, with no change in any of the other variables that affect demand, results in a movement along the demand curve. For example, if the price of coffee falls from \$6 to \$5 per pound, consumption rises from 25 million pounds to 30 million pounds per month. That is a movement from point A to point B along the demand curve in Figure 3.1. A movement along a demand curve that results from a change in price is called a change in quantity demanded. Note that a change in quantity demanded is not a change or shift in the demand curve; it is a movement along the demand curve.
The negative slope of the demand curve in Figure 3.1 suggests a key behavioral relationship of economics. All other things unchanged, the law of demand holds that, for virtually all goods and services, a higher price leads to a reduction in quantity demanded and a lower price leads to an increase in quantity demanded.
The law of demand is called a law because the results of countless studies are consistent with it. Undoubtedly, you have observed one manifestation of the law. When a store finds itself with an overstock of some item, such as running shoes or tomatoes, and needs to sell these items quickly, what does it do? It typically has a sale, expecting that a lower price will increase the quantity demanded. In general, we expect the law of demand to hold. Given the values of other variables that influence demand, a higher price reduces the quantity demanded. A lower price increases the quantity demanded. Demand curves, in short, slope downward.
Changes in Demand
Of course, price alone does not determine the quantity of a good or service that people consume. Coffee consumption, for example, will be affected by such variables as income and population. Preferences also play a role. The story at the beginning of the chapter illustrates as much. Starbucks “turned people on” to coffee. We also expect other prices to affect coffee consumption. People often eat doughnuts or bagels with their coffee, so a reduction in the price of doughnuts or bagels might induce people to drink more coffee. An alternative to coffee is tea, so a reduction in the price of tea might result in the consumption of more tea and less coffee. Thus, a change in any one of the variables held constant in constructing a demand schedule will change the quantities demanded at each price. The result will be a shift in the entire demand curve rather than a movement along the demand curve. A shift in a demand curve is called a change in demand.
Suppose, for example, that something happens to increase the quantity of coffee demanded at each price. Several events could produce such a change: an increase in incomes, an increase in population, or an increase in the price of tea would each be likely to increase the quantity of coffee demanded at each price. Any such change produces a new demand schedule. Figure 3.2 shows such a change in the demand schedule for coffee. We see that the quantity of coffee demanded per month is greater at each price than before. We show that graphically as a shift in the demand curve. The original curve, labeled D1, shifts to the right to D2. At a price of \$6 per pound, for example, the quantity demanded rises from 25 million pounds per month (point A) to 35 million pounds per month (point A′).
Just as demand can increase, it can decrease. In the case of coffee, demand might fall as a result of events such as a reduction in population, a reduction in the price of tea, or a change in preferences. For example, a definitive finding that the caffeine in coffee contributes to heart disease, which is currently being debated in the scientific community, could change preferences and reduce the demand for coffee.
A reduction in the demand for coffee is illustrated in Figure 3.3. The demand schedule shows that less coffee is demanded at each price than in Figure 3.1. The result is a shift in demand from the original curve D1 to D3. The quantity of coffee demanded at a price of \$6 per pound falls from 25 million pounds per month (point A) to 15 million pounds per month (point A″). Note, again, that a change in quantity demanded, ceteris paribus, refers to a movement along the demand curve, while a change in demand refers to a shift in the demand curve.
A variable that can change the quantity of a good or service demanded at each price is called a demand shifter. When these other variables change, the all-other-things-unchanged conditions behind the original demand curve no longer hold. Although different goods and services will have different demand shifters, the demand shifters are likely to include (1) consumer preferences, (2) the prices of related goods and services, (3) income, (4) demographic characteristics, and (5) buyer expectations. Next we look at each of these.
Preferences
Changes in preferences of buyers can have important consequences for demand. We have already seen how Starbucks supposedly increased the demand for coffee. Another example is reduced demand for cigarettes caused by concern about the effect of smoking on health. A change in preferences that makes one good or service more popular will shift the demand curve to the right. A change that makes it less popular will shift the demand curve to the left.
Suppose the price of doughnuts were to fall. Many people who drink coffee enjoy dunking doughnuts in their coffee; the lower price of doughnuts might therefore increase the demand for coffee, shifting the demand curve for coffee to the right. A lower price for tea, however, would be likely to reduce coffee demand, shifting the demand curve for coffee to the left.
In general, if a reduction in the price of one good increases the demand for another, the two goods are called complements. If a reduction in the price of one good reduces the demand for another, the two goods are called substitutes. These definitions hold in reverse as well: two goods are complements if an increase in the price of one reduces the demand for the other, and they are substitutes if an increase in the price of one increases the demand for the other. Doughnuts and coffee are complements; tea and coffee are substitutes.
Complementary goods are goods used in conjunction with one another. Tennis rackets and tennis balls, eggs and bacon, and stationery and postage stamps are complementary goods. Substitute goods are goods used instead of one another. iPODs, for example, are likely to be substitutes for CD players. Breakfast cereal is a substitute for eggs. A file attachment to an e-mail is a substitute for both a fax machine and postage stamps.
Figure 3.4
Income
As incomes rise, people increase their consumption of many goods and services, and as incomes fall, their consumption of these goods and services falls. For example, an increase in income is likely to raise the demand for gasoline, ski trips, new cars, and jewelry. There are, however, goods and services for which consumption falls as income rises—and rises as income falls. As incomes rise, for example, people tend to consume more fresh fruit but less canned fruit.
A good for which demand increases when income increases is called a normal good. A good for which demand decreases when income increases is called an inferior good. An increase in income shifts the demand curve for fresh fruit (a normal good) to the right; it shifts the demand curve for canned fruit (an inferior good) to the left.
Demographic Characteristics
The number of buyers affects the total quantity of a good or service that will be bought; in general, the greater the population, the greater the demand. Other demographic characteristics can affect demand as well. As the share of the population over age 65 increases, the demand for medical services, ocean cruises, and motor homes increases. The birth rate in the United States fell sharply between 1955 and 1975 but has gradually increased since then. That increase has raised the demand for such things as infant supplies, elementary school teachers, soccer coaches, in-line skates, and college education. Demand can thus shift as a result of changes in both the number and characteristics of buyers.
Buyer Expectations
The consumption of goods that can be easily stored, or whose consumption can be postponed, is strongly affected by buyer expectations. The expectation of newer TV technologies, such as high-definition TV, could slow down sales of regular TVs. If people expect gasoline prices to rise tomorrow, they will fill up their tanks today to try to beat the price increase. The same will be true for goods such as automobiles and washing machines: an expectation of higher prices in the future will lead to more purchases today. If the price of a good is expected to fall, however, people are likely to reduce their purchases today and await tomorrow’s lower prices. The expectation that computer prices will fall, for example, can reduce current demand.
Heads Up!
Figure 3.5
It is crucial to distinguish between a change in quantity demanded, which is a movement along the demand curve caused by a change in price, and a change in demand, which implies a shift of the demand curve itself. A change in demand is caused by a change in a demand shifter. An increase in demand is a shift of the demand curve to the right. A decrease in demand is a shift in the demand curve to the left. This drawing of a demand curve highlights the difference.
Key Takeaways
• The quantity demanded of a good or service is the quantity buyers are willing and able to buy at a particular price during a particular period, all other things unchanged.
• A demand schedule is a table that shows the quantities of a good or service demanded at different prices during a particular period, all other things unchanged.
• A demand curve shows graphically the quantities of a good or service demanded at different prices during a particular period, all other things unchanged.
• All other things unchanged, the law of demand holds that, for virtually all goods and services, a higher price induces a reduction in quantity demanded and a lower price induces an increase in quantity demanded.
• A change in the price of a good or service causes a change in the quantity demanded—a movement along the demand curve.
• A change in a demand shifter causes a change in demand, which is shown as a shift of the demand curve. Demand shifters include preferences, the prices of related goods and services, income, demographic characteristics, and buyer expectations.
• Two goods are substitutes if an increase in the price of one causes an increase in the demand for the other. Two goods are complements if an increase in the price of one causes a decrease in the demand for the other.
• A good is a normal good if an increase in income causes an increase in demand. A good is an inferior good if an increase in income causes a decrease in demand.
Try It!
All other things unchanged, what happens to the demand curve for DVD rentals if there is (a) an increase in the price of movie theater tickets, (b) a decrease in family income, or (c) an increase in the price of DVD rentals? In answering this and other “Try It!” problems in this chapter, draw and carefully label a set of axes. On the horizontal axis of your graph, show the quantity of DVD rentals. It is necessary to specify the time period to which your quantity pertains (e.g., “per period,” “per week,” or “per year”). On the vertical axis show the price per DVD rental. Since you do not have specific data on prices and quantities demanded, make a “free-hand” drawing of the curve or curves you are asked to examine. Focus on the general shape and position of the curve(s) before and after events occur. Draw new curve(s) to show what happens in each of the circumstances given. The curves could shift to the left or to the right, or stay where they are.
Case in Point: Solving Campus Parking Problems Without Adding More Parking Spaces
Figure 3.6
Unless you attend a “virtual” campus, chances are you have engaged in more than one conversation about how hard it is to find a place to park on campus. Indeed, according to Clark Kerr, a former president of the University of California system, a university is best understood as a group of people “held together by a common grievance over parking.”
Clearly, the demand for campus parking spaces has grown substantially over the past few decades. In surveys conducted by Daniel Kenney, Ricardo Dumont, and Ginger Kenney, who work for the campus design company Sasaki and Associates, it was found that 7 out of 10 students own their own cars. They have interviewed “many students who confessed to driving from their dormitories to classes that were a five-minute walk away,” and they argue that the deterioration of college environments is largely attributable to the increased use of cars on campus and that colleges could better service their missions by not adding more parking spaces.
Since few universities charge enough for parking to even cover the cost of building and maintaining parking lots, the rest is paid for by all students as part of tuition. Their research shows that “for every 1,000 parking spaces, the median institution loses almost \$400,000 a year for surface parking, and more than \$1,200,000 for structural parking.” Fear of a backlash from students and their parents, as well as from faculty and staff, seems to explain why campus administrators do not simply raise the price of parking on campus.
While Kenney and his colleagues do advocate raising parking fees, if not all at once then over time, they also suggest some subtler, and perhaps politically more palatable, measures—in particular, shifting the demand for parking spaces to the left by lowering the prices of substitutes.
Two examples they noted were at the University of Washington and the University of Colorado at Boulder. At the University of Washington, car poolers may park for free. This innovation has reduced purchases of single-occupancy parking permits by 32% over a decade. According to University of Washington assistant director of transportation services Peter Dewey, “Without vigorously managing our parking and providing commuter alternatives, the university would have been faced with adding approximately 3,600 parking spaces, at a cost of over \$100 million…The university has created opportunities to make capital investments in buildings supporting education instead of structures for cars.” At the University of Colorado, free public transit has increased use of buses and light rail from 300,000 to 2 million trips per year over the last decade. The increased use of mass transit has allowed the university to avoid constructing nearly 2,000 parking spaces, which has saved about \$3.6 million annually.
Answer to Try It! Problem
Since going to the movies is a substitute for watching a DVD at home, an increase in the price of going to the movies should cause more people to switch from going to the movies to staying at home and renting DVDs. Thus, the demand curve for DVD rentals will shift to the right when the price of movie theater tickets increases [Panel (a)].
A decrease in family income will cause the demand curve to shift to the left if DVD rentals are a normal good but to the right if DVD rentals are an inferior good. The latter may be the case for some families, since staying at home and watching DVDs is a cheaper form of entertainment than taking the family to the movies. For most others, however, DVD rentals are probably a normal good [Panel (b)].
An increase in the price of DVD rentals does not shift the demand curve for DVD rentals at all; rather, an increase in price, say from P1 to P2, is a movement upward to the left along the demand curve. At a higher price, people will rent fewer DVDs, say Q2 instead of Q1, ceteris paribus [Panel (c)].
Figure 3.7 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/03%3A_Demand_and_Supply/3.1%3A_Demand.txt |
Learning Objective
1. Define the quantity supplied of a good or service and illustrate it using a supply schedule and a supply curve.
2. Distinguish between the following pairs of concepts: supply and quantity supplied, supply schedule and supply curve, movement along and shift in a supply curve.
3. Identify supply shifters and determine whether a change in a supply shifter causes the supply curve to shift to the right or to the left.
What determines the quantity of a good or service sellers are willing to offer for sale? Price is one factor; ceteris paribus, a higher price is likely to induce sellers to offer a greater quantity of a good or service. Production cost is another determinant of supply. Variables that affect production cost include the prices of factors used to produce the good or service, returns from alternative activities, technology, the expectations of sellers, and natural events such as weather changes. Still another factor affecting the quantity of a good that will be offered for sale is the number of sellers—the greater the number of sellers of a particular good or service, the greater will be the quantity offered at any price per time period.
Price and the Supply Curve
The quantity supplied of a good or service is the quantity sellers are willing to sell at a particular price during a particular period, all other things unchanged. Ceteris paribus, the receipt of a higher price increases profits and induces sellers to increase the quantity they supply.
In general, when there are many sellers of a good, an increase in price results in an increase in quantity supplied, and this relationship is often referred to as the law of supply. We will see, though, through our exploration of microeconomics, that there are a number of exceptions to this relationship. There are cases in which a higher price will not induce an increase in quantity supplied. Goods that cannot be produced, such as additional land on the corner of Park Avenue and 56th Street in Manhattan, are fixed in supply—a higher price cannot induce an increase in the quantity supplied. There are even cases, which we investigate in microeconomic analysis, in which a higher price induces a reduction in the quantity supplied.
Generally speaking, however, when there are many sellers of a good, an increase in price results in a greater quantity supplied. The relationship between price and quantity supplied is suggested in a supply schedule, a table that shows quantities supplied at different prices during a particular period, all other things unchanged. Figure 3.8 gives a supply schedule for the quantities of coffee that will be supplied per month at various prices, ceteris paribus. At a price of \$4 per pound, for example, producers are willing to supply 15 million pounds of coffee per month. A higher price, say \$6 per pound, induces sellers to supply a greater quantity—25 million pounds of coffee per month.
A supply curve is a graphical representation of a supply schedule. It shows the relationship between price and quantity supplied during a particular period, all other things unchanged. Because the relationship between price and quantity supplied is generally positive, supply curves are generally upward sloping. The supply curve for coffee in Figure 3.8 shows graphically the values given in the supply schedule.
A change in price causes a movement along the supply curve; such a movement is called a change in quantity supplied. As is the case with a change in quantity demanded, a change in quantity supplied does not shift the supply curve. By definition, it is a movement along the supply curve. For example, if the price rises from \$6 per pound to \$7 per pound, the quantity supplied rises from 25 million pounds per month to 30 million pounds per month. That’s a movement from point A to point B along the supply curve in Figure 3.8.
Changes in Supply
When we draw a supply curve, we assume that other variables that affect the willingness of sellers to supply a good or service are unchanged. It follows that a change in any of those variables will cause a change in supply, which is a shift in the supply curve. A change that increases the quantity of a good or service supplied at each price shifts the supply curve to the right. Suppose, for example, that the price of fertilizer falls. That will reduce the cost of producing coffee and thus increase the quantity of coffee producers will offer for sale at each price. The supply schedule in Figure 3.9 shows an increase in the quantity of coffee supplied at each price. We show that increase graphically as a shift in the supply curve from S1 to S2. We see that the quantity supplied at each price increases by 10 million pounds of coffee per month. At point A on the original supply curve S1, for example, 25 million pounds of coffee per month are supplied at a price of \$6 per pound. After the increase in supply, 35 million pounds per month are supplied at the same price (point A′ on curve S2).
An event that reduces the quantity supplied at each price shifts the supply curve to the left. An increase in production costs and excessive rain that reduces the yields from coffee plants are examples of events that might reduce supply. Figure 3.10 shows a reduction in the supply of coffee. We see in the supply schedule that the quantity of coffee supplied falls by 10 million pounds of coffee per month at each price. The supply curve thus shifts from S1 to S3.
A variable that can change the quantity of a good or service supplied at each price is called a supply shifter. Supply shifters include (1) prices of factors of production, (2) returns from alternative activities, (3) technology, (4) seller expectations, (5) natural events, and (6) the number of sellers. When these other variables change, the all-other-things-unchanged conditions behind the original supply curve no longer hold. Let us look at each of the supply shifters.
Prices of Factors of Production
A change in the price of labor or some other factor of production will change the cost of producing any given quantity of the good or service. This change in the cost of production will change the quantity that suppliers are willing to offer at any price. An increase in factor prices should decrease the quantity suppliers will offer at any price, shifting the supply curve to the left. A reduction in factor prices increases the quantity suppliers will offer at any price, shifting the supply curve to the right.
Suppose coffee growers must pay a higher wage to the workers they hire to harvest coffee or must pay more for fertilizer. Such increases in production cost will cause them to produce a smaller quantity at each price, shifting the supply curve for coffee to the left. A reduction in any of these costs increases supply, shifting the supply curve to the right.
Returns from Alternative Activities
To produce one good or service means forgoing the production of another. The concept of opportunity cost in economics suggests that the value of the activity forgone is the opportunity cost of the activity chosen; this cost should affect supply. For example, one opportunity cost of producing eggs is not selling chickens. An increase in the price people are willing to pay for fresh chicken would make it more profitable to sell chickens and would thus increase the opportunity cost of producing eggs. It would shift the supply curve for eggs to the left, reflecting a decrease in supply.
Technology
A change in technology alters the combinations of inputs or the types of inputs required in the production process. An improvement in technology usually means that fewer and/or less costly inputs are needed. If the cost of production is lower, the profits available at a given price will increase, and producers will produce more. With more produced at every price, the supply curve will shift to the right, meaning an increase in supply.
Impressive technological changes have occurred in the computer industry in recent years. Computers are much smaller and are far more powerful than they were only a few years ago—and they are much cheaper to produce. The result has been a huge increase in the supply of computers, shifting the supply curve to the right.
While we usually think of technology as enhancing production, declines in production due to problems in technology are also possible. Outlawing the use of certain equipment without pollution-control devices has increased the cost of production for many goods and services, thereby reducing profits available at any price and shifting these supply curves to the left.
Seller Expectations
All supply curves are based in part on seller expectations about future market conditions. Many decisions about production and selling are typically made long before a product is ready for sale. Those decisions necessarily depend on expectations. Changes in seller expectations can have important effects on price and quantity.
Consider, for example, the owners of oil deposits. Oil pumped out of the ground and used today will be unavailable in the future. If a change in the international political climate leads many owners to expect that oil prices will rise in the future, they may decide to leave their oil in the ground, planning to sell it later when the price is higher. Thus, there will be a decrease in supply; the supply curve for oil will shift to the left.
Natural Events
Storms, insect infestations, and drought affect agricultural production and thus the supply of agricultural goods. If something destroys a substantial part of an agricultural crop, the supply curve will shift to the left. The terrible cyclone that killed more than 50,000 people in Myanmar in 2008 also destroyed some of the country’s prime rice growing land. That shifted the supply curve for rice to the left. If there is an unusually good harvest, the supply curve will shift to the right.
The Number of Sellers
The supply curve for an industry, such as coffee, includes all the sellers in the industry. A change in the number of sellers in an industry changes the quantity available at each price and thus changes supply. An increase in the number of sellers supplying a good or service shifts the supply curve to the right; a reduction in the number of sellers shifts the supply curve to the left.
The market for cellular phone service has been affected by an increase in the number of firms offering the service. Over the past decade, new cellular phone companies emerged, shifting the supply curve for cellular phone service to the right.
Heads Up!
There are two special things to note about supply curves. The first is similar to the Heads Up! on demand curves: it is important to distinguish carefully between changes in supply and changes in quantity supplied. A change in supply results from a change in a supply shifter and implies a shift of the supply curve to the right or left. A change in price produces a change in quantity supplied and induces a movement along the supply curve. A change in price does not shift the supply curve.
The second caution relates to the interpretation of increases and decreases in supply. Notice that in Figure 3.9 an increase in supply is shown as a shift of the supply curve to the right; the curve shifts in the direction of increasing quantity with respect to the horizontal axis. In Figure 3.10 a reduction in supply is shown as a shift of the supply curve to the left; the curve shifts in the direction of decreasing quantity with respect to the horizontal axis.
Because the supply curve is upward sloping, a shift to the right produces a new curve that in a sense lies “below” the original curve. Students sometimes make the mistake of thinking of such a shift as a shift “down” and therefore as a reduction in supply. Similarly, it is easy to make the mistake of showing an increase in supply with a new curve that lies “above” the original curve. But that is a reduction in supply!
To avoid such errors, focus on the fact that an increase in supply is an increase in the quantity supplied at each price and shifts the supply curve in the direction of increased quantity on the horizontal axis. Similarly, a reduction in supply is a reduction in the quantity supplied at each price and shifts the supply curve in the direction of a lower quantity on the horizontal axis.
Figure 3.11
Key Takeaways
• The quantity supplied of a good or service is the quantity sellers are willing to sell at a particular price during a particular period, all other things unchanged.
• A supply schedule shows the quantities supplied at different prices during a particular period, all other things unchanged. A supply curve shows this same information graphically.
• A change in the price of a good or service causes a change in the quantity supplied—a movement along the supply curve.
• A change in a supply shifter causes a change in supply, which is shown as a shift of the supply curve. Supply shifters include prices of factors of production, returns from alternative activities, technology, seller expectations, natural events, and the number of sellers.
• An increase in supply is shown as a shift to the right of a supply curve; a decrease in supply is shown as a shift to the left.
Try It!
If all other things are unchanged, what happens to the supply curve for DVD rentals if there is (a) an increase in wages paid to DVD rental store clerks, (b) an increase in the price of DVD rentals, or (c) an increase in the number of DVD rental stores? Draw a graph that shows what happens to the supply curve in each circumstance. The supply curve can shift to the left or to the right, or stay where it is. Remember to label the axes and curves, and remember to specify the time period (e.g., “DVDs rented per week”).
Case in Point: The Monks of St. Benedict’s Get Out of the Egg Business
Figure 3.12
It was cookies that lured the monks of St. Benedict’s out of the egg business, and now private retreat sponsorship is luring them away from cookies.
St. Benedict’s is a Benedictine monastery, nestled on a ranch high in the Colorado Rockies, about 20 miles down the road from Aspen. The monastery’s 15 monks operate the ranch to support themselves and to provide help for poor people in the area. They lease out about 3,500 acres of their land to cattle and sheep grazers, produce cookies, and sponsor private retreats. They used to produce eggs.
Attracted by potential profits and the peaceful nature of the work, the monks went into the egg business in 1967. They had 10,000 chickens producing their Monastery Eggs brand. For a while, business was good. Very good. Then, in the late 1970s, the price of chicken feed started to rise rapidly.
“When we started in the business, we were paying \$60 to \$80 a ton for feed—delivered,” recalls the monastery’s abbot, Father Joseph Boyle. “By the late 1970s, our cost had more than doubled. We were paying \$160 to \$200 a ton. That really hurt, because feed represents a large part of the cost of producing eggs.”
The monks adjusted to the blow. “When grain prices were lower, we’d pull a hen off for a few weeks to molt, then return her to laying. After grain prices went up, it was 12 months of laying and into the soup pot,” Father Joseph says.
Grain prices continued to rise in the 1980s and increased the costs of production for all egg producers. It caused the supply of eggs to fall. Demand fell at the same time, as Americans worried about the cholesterol in eggs. Times got tougher in the egg business.
“We were still making money in the financial sense,” Father Joseph says. “But we tried an experiment in 1985 producing cookies, and it was a success. We finally decided that devoting our time and energy to the cookies would pay off better than the egg business, so we quit the egg business in 1986.”
The mail-order cookie business was good to the monks. They sold 200,000 ounces of Monastery Cookies in 1987.
By 1998, however, they had limited their production of cookies, selling only locally and to gift shops. Since 2000, they have switched to “providing private retreats for individuals and groups—about 40 people per month,” according to Brother Charles.
The monks’ calculation of their opportunity costs revealed that they would earn a higher return through sponsorship of private retreats than in either cookies or eggs. This projection has proved correct.
And there is another advantage as well.
“The chickens didn’t stop laying eggs on Sunday,” Father Joseph chuckles. “When we shifted to cookies we could take Sundays off. We weren’t hemmed in the way we were with the chickens.” The move to providing retreats is even better in this regard. Since guests provide their own meals, most of the monastery’s effort goes into planning and scheduling, which frees up even more of their time for other worldly as well as spiritual pursuits.
Answer to Try It! Problem
DVD rental store clerks are a factor of production in the DVD rental market. An increase in their wages raises the cost of production, thereby causing the supply curve of DVD rentals to shift to the left [Panel (a)]. (Caution: It is possible that you thought of the wage increase as an increase in income, a demand shifter, that would lead to an increase in demand, but this would be incorrect. The question refers only to wages of DVD rental store clerks. They may rent some DVD, but their impact on total demand would be negligible. Besides, we have no information on what has happened overall to incomes of people who rent DVDs. We do know, however, that the cost of a factor of production, which is a supply shifter, increased.)
An increase in the price of DVD rentals does not shift the supply curve at all; rather, it corresponds to a movement upward to the right along the supply curve. At a higher price of P2 instead of P1, a greater quantity of DVD rentals, say Q2 instead of Q1, will be supplied [Panel (b)].
An increase in the number of stores renting DVDs will cause the supply curve to shift to the right [Panel (c)].
Figure 3.13 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/03%3A_Demand_and_Supply/3.2%3A_Supply.txt |
Learning Objective
1. Use demand and supply to explain how equilibrium price and quantity are determined in a market.
2. Understand the concepts of surpluses and shortages and the pressures on price they generate.
3. Explain the impact of a change in demand or supply on equilibrium price and quantity.
4. Explain how the circular flow model provides an overview of demand and supply in product and factor markets and how the model suggests ways in which these markets are linked.
In this section we combine the demand and supply curves we have just studied into a new model. The model of demand and supply uses demand and supply curves to explain the determination of price and quantity in a market.
The Determination of Price and Quantity
The logic of the model of demand and supply is simple. The demand curve shows the quantities of a particular good or service that buyers will be willing and able to purchase at each price during a specified period. The supply curve shows the quantities that sellers will offer for sale at each price during that same period. By putting the two curves together, we should be able to find a price at which the quantity buyers are willing and able to purchase equals the quantity sellers will offer for sale.
Figure 3.14 combines the demand and supply data introduced in Figure 3.1 and Figure 3.8 Notice that the two curves intersect at a price of \$6 per pound—at this price the quantities demanded and supplied are equal. Buyers want to purchase, and sellers are willing to offer for sale, 25 million pounds of coffee per month. The market for coffee is in equilibrium. Unless the demand or supply curve shifts, there will be no tendency for price to change. The equilibrium price in any market is the price at which quantity demanded equals quantity supplied. The equilibrium price in the market for coffee is thus \$6 per pound. The equilibrium quantity is the quantity demanded and supplied at the equilibrium price.
With an upward-sloping supply curve and a downward-sloping demand curve, there is only a single price at which the two curves intersect. This means there is only one price at which equilibrium is achieved. It follows that at any price other than the equilibrium price, the market will not be in equilibrium. We next examine what happens at prices other than the equilibrium price.
Surpluses
Figure 3.15 shows the same demand and supply curves we have just examined, but this time the initial price is \$8 per pound of coffee. Because we no longer have a balance between quantity demanded and quantity supplied, this price is not the equilibrium price. At a price of \$8, we read over to the demand curve to determine the quantity of coffee consumers will be willing to buy—15 million pounds per month. The supply curve tells us what sellers will offer for sale—35 million pounds per month. The difference, 20 million pounds of coffee per month, is called a surplus. More generally, a surplus is the amount by which the quantity supplied exceeds the quantity demanded at the current price. There is, of course, no surplus at the equilibrium price; a surplus occurs only if the current price exceeds the equilibrium price.
A surplus in the market for coffee will not last long. With unsold coffee on the market, sellers will begin to reduce their prices to clear out unsold coffee. As the price of coffee begins to fall, the quantity of coffee supplied begins to decline. At the same time, the quantity of coffee demanded begins to rise. Remember that the reduction in quantity supplied is a movement along the supply curve—the curve itself does not shift in response to a reduction in price. Similarly, the increase in quantity demanded is a movement along the demand curve—the demand curve does not shift in response to a reduction in price. Price will continue to fall until it reaches its equilibrium level, at which the demand and supply curves intersect. At that point, there will be no tendency for price to fall further. In general, surpluses in the marketplace are short-lived. The prices of most goods and services adjust quickly, eliminating the surplus. Later on, we will discuss some markets in which adjustment of price to equilibrium may occur only very slowly or not at all.
Shortages
Just as a price above the equilibrium price will cause a surplus, a price below equilibrium will cause a shortage. A shortage is the amount by which the quantity demanded exceeds the quantity supplied at the current price.
Figure 3.16 shows a shortage in the market for coffee. Suppose the price is \$4 per pound. At that price, 15 million pounds of coffee would be supplied per month, and 35 million pounds would be demanded per month. When more coffee is demanded than supplied, there is a shortage.
In the face of a shortage, sellers are likely to begin to raise their prices. As the price rises, there will be an increase in the quantity supplied (but not a change in supply) and a reduction in the quantity demanded (but not a change in demand) until the equilibrium price is achieved.
Shifts in Demand and Supply
A change in one of the variables (shifters) held constant in any model of demand and supply will create a change in demand or supply. A shift in a demand or supply curve changes the equilibrium price and equilibrium quantity for a good or service. Figure 3.17 combines the information about changes in the demand and supply of coffee presented in Figure 3.2Figure 3.3Figure 3.9 and Figure 3.10 In each case, the original equilibrium price is \$6 per pound, and the corresponding equilibrium quantity is 25 million pounds of coffee per month. Figure 3.17 shows what happens with an increase in demand, a reduction in demand, an increase in supply, and a reduction in supply. We then look at what happens if both curves shift simultaneously. Each of these possibilities is discussed in turn below.
An Increase in Demand
An increase in demand for coffee shifts the demand curve to the right, as shown in Panel (a) of Figure 3.17. The equilibrium price rises to \$7 per pound. As the price rises to the new equilibrium level, the quantity supplied increases to 30 million pounds of coffee per month. Notice that the supply curve does not shift; rather, there is a movement along the supply curve.
Demand shifters that could cause an increase in demand include a shift in preferences that leads to greater coffee consumption; a lower price for a complement to coffee, such as doughnuts; a higher price for a substitute for coffee, such as tea; an increase in income; and an increase in population. A change in buyer expectations, perhaps due to predictions of bad weather lowering expected yields on coffee plants and increasing future coffee prices, could also increase current demand.
A Decrease in Demand
Panel (b) of Figure 3.17 shows that a decrease in demand shifts the demand curve to the left. The equilibrium price falls to \$5 per pound. As the price falls to the new equilibrium level, the quantity supplied decreases to 20 million pounds of coffee per month.
Demand shifters that could reduce the demand for coffee include a shift in preferences that makes people want to consume less coffee; an increase in the price of a complement, such as doughnuts; a reduction in the price of a substitute, such as tea; a reduction in income; a reduction in population; and a change in buyer expectations that leads people to expect lower prices for coffee in the future.
An Increase in Supply
An increase in the supply of coffee shifts the supply curve to the right, as shown in Panel (c) of Figure 3.17. The equilibrium price falls to \$5 per pound. As the price falls to the new equilibrium level, the quantity of coffee demanded increases to 30 million pounds of coffee per month. Notice that the demand curve does not shift; rather, there is movement along the demand curve.
Possible supply shifters that could increase supply include a reduction in the price of an input such as labor, a decline in the returns available from alternative uses of the inputs that produce coffee, an improvement in the technology of coffee production, good weather, and an increase in the number of coffee-producing firms.
A Decrease in Supply
Panel (d) of Figure 3.17 shows that a decrease in supply shifts the supply curve to the left. The equilibrium price rises to \$7 per pound. As the price rises to the new equilibrium level, the quantity demanded decreases to 20 million pounds of coffee per month.
Possible supply shifters that could reduce supply include an increase in the prices of inputs used in the production of coffee, an increase in the returns available from alternative uses of these inputs, a decline in production because of problems in technology (perhaps caused by a restriction on pesticides used to protect coffee beans), a reduction in the number of coffee-producing firms, or a natural event, such as excessive rain.
Heads Up!
Figure 3.18
You are likely to be given problems in which you will have to shift a demand or supply curve.
Suppose you are told that an invasion of pod-crunching insects has gobbled up half the crop of fresh peas, and you are asked to use demand and supply analysis to predict what will happen to the price and quantity of peas demanded and supplied. Here are some suggestions.
Put the quantity of the good you are asked to analyze on the horizontal axis and its price on the vertical axis. Draw a downward-sloping line for demand and an upward-sloping line for supply. The initial equilibrium price is determined by the intersection of the two curves. Label the equilibrium solution. You may find it helpful to use a number for the equilibrium price instead of the letter “P.” Pick a price that seems plausible, say, 79¢ per pound. Do not worry about the precise positions of the demand and supply curves; you cannot be expected to know what they are.
Step 2 can be the most difficult step; the problem is to decide which curve to shift. The key is to remember the difference between a change in demand or supply and a change in quantity demanded or supplied. At each price, ask yourself whether the given event would change the quantity demanded. Would the fact that a bug has attacked the pea crop change the quantity demanded at a price of, say, 79¢ per pound? Clearly not; none of the demand shifters have changed. The event would, however, reduce the quantity supplied at this price, and the supply curve would shift to the left. There is a change in supply and a reduction in the quantity demanded. There is no change in demand.
Next check to see whether the result you have obtained makes sense. The graph in Step 2 makes sense; it shows price rising and quantity demanded falling.
It is easy to make a mistake such as the one shown in the third figure of this Heads Up! One might, for example, reason that when fewer peas are available, fewer will be demanded, and therefore the demand curve will shift to the left. This suggests the price of peas will fall—but that does not make sense. If only half as many fresh peas were available, their price would surely rise. The error here lies in confusing a change in quantity demanded with a change in demand. Yes, buyers will end up buying fewer peas. But no, they will not demand fewer peas at each price than before; the demand curve does not shift.
Simultaneous Shifts
As we have seen, when either the demand or the supply curve shifts, the results are unambiguous; that is, we know what will happen to both equilibrium price and equilibrium quantity, so long as we know whether demand or supply increased or decreased. However, in practice, several events may occur at around the same time that cause both the demand and supply curves to shift. To figure out what happens to equilibrium price and equilibrium quantity, we must know not only in which direction the demand and supply curves have shifted but also the relative amount by which each curve shifts. Of course, the demand and supply curves could shift in the same direction or in opposite directions, depending on the specific events causing them to shift.
For example, all three panels of Figure 3.19 show a decrease in demand for coffee (caused perhaps by a decrease in the price of a substitute good, such as tea) and a simultaneous decrease in the supply of coffee (caused perhaps by bad weather). Since reductions in demand and supply, considered separately, each cause the equilibrium quantity to fall, the impact of both curves shifting simultaneously to the left means that the new equilibrium quantity of coffee is less than the old equilibrium quantity. The effect on the equilibrium price, though, is ambiguous. Whether the equilibrium price is higher, lower, or unchanged depends on the extent to which each curve shifts.
If the demand curve shifts farther to the left than does the supply curve, as shown in Panel (a) of Figure 3.19, then the equilibrium price will be lower than it was before the curves shifted. In this case the new equilibrium price falls from \$6 per pound to \$5 per pound. If the shift to the left of the supply curve is greater than that of the demand curve, the equilibrium price will be higher than it was before, as shown in Panel (b). In this case, the new equilibrium price rises to \$7 per pound. In Panel (c), since both curves shift to the left by the same amount, equilibrium price does not change; it remains \$6 per pound.
Regardless of the scenario, changes in equilibrium price and equilibrium quantity resulting from two different events need to be considered separately. If both events cause equilibrium price or quantity to move in the same direction, then clearly price or quantity can be expected to move in that direction. If one event causes price or quantity to rise while the other causes it to fall, the extent by which each curve shifts is critical to figuring out what happens. Figure 3.20 summarizes what may happen to equilibrium price and quantity when demand and supply both shift.
As demand and supply curves shift, prices adjust to maintain a balance between the quantity of a good demanded and the quantity supplied. If prices did not adjust, this balance could not be maintained.
Notice that the demand and supply curves that we have examined in this chapter have all been drawn as linear. This simplification of the real world makes the graphs a bit easier to read without sacrificing the essential point: whether the curves are linear or nonlinear, demand curves are downward sloping and supply curves are generally upward sloping. As circumstances that shift the demand curve or the supply curve change, we can analyze what will happen to price and what will happen to quantity.
An Overview of Demand and Supply: The Circular Flow Model
Implicit in the concepts of demand and supply is a constant interaction and adjustment that economists illustrate with the circular flow model. The circular flow model provides a look at how markets work and how they are related to each other. It shows flows of spending and income through the economy.
A great deal of economic activity can be thought of as a process of exchange between households and firms. Firms supply goods and services to households. Households buy these goods and services from firms. Households supply factors of production—labor, capital, and natural resources—that firms require. The payments firms make in exchange for these factors represent the incomes households earn.
The flow of goods and services, factors of production, and the payments they generate is illustrated in Figure 3.21. This circular flow model of the economy shows the interaction of households and firms as they exchange goods and services and factors of production. For simplicity, the model here shows only the private domestic economy; it omits the government and foreign sectors.
The circular flow model shows that goods and services that households demand are supplied by firms in product markets. The exchange for goods and services is shown in the top half of Figure 3.21. The bottom half of the exhibit illustrates the exchanges that take place in factor markets. factor markets are markets in which households supply factors of production—labor, capital, and natural resources—demanded by firms.
Our model is called a circular flow model because households use the income they receive from their supply of factors of production to buy goods and services from firms. Firms, in turn, use the payments they receive from households to pay for their factors of production.
The demand and supply model developed in this chapter gives us a basic tool for understanding what is happening in each of these product or factor markets and also allows us to see how these markets are interrelated. In Figure 3.21, markets for three goods and services that households want—blue jeans, haircuts, and apartments—create demands by firms for textile workers, barbers, and apartment buildings. The equilibrium of supply and demand in each market determines the price and quantity of that item. Moreover, a change in equilibrium in one market will affect equilibrium in related markets. For example, an increase in the demand for haircuts would lead to an increase in demand for barbers. Equilibrium price and quantity could rise in both markets. For some purposes, it will be adequate to simply look at a single market, whereas at other times we will want to look at what happens in related markets as well.
In either case, the model of demand and supply is one of the most widely used tools of economic analysis. That widespread use is no accident. The model yields results that are, in fact, broadly consistent with what we observe in the marketplace. Your mastery of this model will pay big dividends in your study of economics.
Key Takeaways
• The equilibrium price is the price at which the quantity demanded equals the quantity supplied. It is determined by the intersection of the demand and supply curves.
• A surplus exists if the quantity of a good or service supplied exceeds the quantity demanded at the current price; it causes downward pressure on price. A shortage exists if the quantity of a good or service demanded exceeds the quantity supplied at the current price; it causes upward pressure on price.
• An increase in demand, all other things unchanged, will cause the equilibrium price to rise; quantity supplied will increase. A decrease in demand will cause the equilibrium price to fall; quantity supplied will decrease.
• An increase in supply, all other things unchanged, will cause the equilibrium price to fall; quantity demanded will increase. A decrease in supply will cause the equilibrium price to rise; quantity demanded will decrease.
• To determine what happens to equilibrium price and equilibrium quantity when both the supply and demand curves shift, you must know in which direction each of the curves shifts and the extent to which each curve shifts.
• The circular flow model provides an overview of demand and supply in product and factor markets and suggests how these markets are linked to one another.
Try It!
What happens to the equilibrium price and the equilibrium quantity of DVD rentals if the price of movie theater tickets increases and wages paid to DVD rental store clerks increase, all other things unchanged? Be sure to show all possible scenarios, as was done in Figure 3.19. Again, you do not need actual numbers to arrive at an answer. Just focus on the general position of the curve(s) before and after events occurred.
Case in Point: Demand, Supply, and Obesity
Figure 3.22
Why are so many Americans fat? Put so crudely, the question may seem rude, but, indeed, the number of obese Americans has increased by more than 50% over the last generation, and obesity may now be the nation’s number one health problem. According to Sturm Roland in a recent RAND Corporation study, “Obesity appears to have a stronger association with the occurrence of chronic medical conditions, reduced physical health-related quality of life and increased health care and medication expenditures than smoking or problem drinking.”
Many explanations of rising obesity suggest higher demand for food. What more apt picture of our sedentary life style is there than spending the afternoon watching a ballgame on TV, while eating chips and salsa, followed by a dinner of a lavishly topped, take-out pizza? Higher income has also undoubtedly contributed to a rightward shift in the demand curve for food. Plus, any additional food intake translates into more weight increase because we spend so few calories preparing it, either directly or in the process of earning the income to buy it. A study by economists Darius Lakdawalla and Tomas Philipson suggests that about 60% of the recent growth in weight may be explained in this way—that is, demand has shifted to the right, leading to an increase in the equilibrium quantity of food consumed and, given our less strenuous life styles, even more weight gain than can be explained simply by the increased amount we are eating.
What accounts for the remaining 40% of the weight gain? Lakdawalla and Philipson further reason that a rightward shift in demand would by itself lead to an increase in the quantity of food as well as an increase in the price of food. The problem they have with this explanation is that over the post-World War II period, the relative price of food has declined by an average of 0.2 percentage points per year. They explain the fall in the price of food by arguing that agricultural innovation has led to a substantial rightward shift in the supply curve of food. As shown, lower food prices and a higher equilibrium quantity of food have resulted from simultaneous rightward shifts in demand and supply and that the rightward shift in the supply of food from S1 to S2 has been substantially larger than the rightward shift in the demand curve from D1 to D2.
Figure 3.23
Answer to Try It! Problem
An increase in the price of movie theater tickets (a substitute for DVD rentals) will cause the demand curve for DVD rentals to shift to the right. An increase in the wages paid to DVD rental store clerks (an increase in the cost of a factor of production) shifts the supply curve to the left. Each event taken separately causes equilibrium price to rise. Whether equilibrium quantity will be higher or lower depends on which curve shifted more.
If the demand curve shifted more, then the equilibrium quantity of DVD rentals will rise [Panel (a)].
If the supply curve shifted more, then the equilibrium quantity of DVD rentals will fall [Panel (b)].
If the curves shifted by the same amount, then the equilibrium quantity of DVD rentals would not change [Panel (c)].
Figure 3.24 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/03%3A_Demand_and_Supply/3.3%3A_Demand_Supply_and_Equilibrium.txt |
Summary
In this chapter we have examined the model of demand and supply. We found that a demand curve shows the quantity demanded at each price, all other things unchanged. The law of demand asserts that an increase in price reduces the quantity demanded and a decrease in price increases the quantity demanded, all other things unchanged. The supply curve shows the quantity of a good or service that sellers will offer at various prices, all other things unchanged. Supply curves are generally upward sloping: an increase in price generally increases the quantity supplied, all other things unchanged.
The equilibrium price occurs where the demand and supply curves intersect. At this price, the quantity demanded equals the quantity supplied. A price higher than the equilibrium price increases the quantity supplied and reduces the quantity demanded, causing a surplus. A price lower than the equilibrium price increases the quantity demanded and reduces the quantity supplied, causing a shortage. Usually, market surpluses and shortages are short-lived. Changes in demand or supply, caused by changes in the determinants of demand and supply otherwise held constant in the analysis, change the equilibrium price and output. The circular flow model allows us to see how demand and supply in various markets are related to one another.
Concept Problems
1. What do you think happens to the demand for pizzas during the Super Bowl? Why?
2. Which of the following goods are likely to be classified as normal goods or services? Inferior? Defend your answer.
1. Beans
2. Tuxedos
3. Used cars
4. Used clothing
5. Computers
6. Books reviewed in The New York Times
7. Macaroni and cheese
8. Calculators
9. Cigarettes
10. Caviar
11. Legal services
3. Which of the following pairs of goods are likely to be classified as substitutes? Complements? Defend your answer.
1. Peanut butter and jelly
2. Eggs and ham
3. Nike brand and Reebok brand sneakers
4. IBM and Apple Macintosh brand computers
5. Dress shirts and ties
6. Airline tickets and hotels
7. Gasoline and tires
8. Beer and wine
9. Faxes and first-class mail
10. Cereal and milk
11. Cereal and eggs
4. A study found that lower airfares led some people to substitute flying for driving to their vacation destinations. This reduced the demand for car travel and led to reduced traffic fatalities, since air travel is safer per passenger mile than car travel. Using the logic suggested by that study, suggest how each of the following events would affect the number of highway fatalities in any one year.
1. An increase in the price of gasoline
2. A large reduction in rental rates for passenger vans
3. An increase in airfares
5. Children under age 2 are now allowed to fly free on U.S. airlines; they usually sit in their parents’ laps. Some safety advocates have urged that they be required to be strapped in infant seats, which would mean their parents would have to purchase tickets for them. Some economists have argued that such a measure would actually increase infant fatalities. Can you say why?
6. The graphs below show four possible shifts in demand or in supply that could occur in particular markets. Relate each of the events described below to one of them.
Figure 3.25
1. How did the heavy rains in South America in 1997 affect the market for coffee?
2. The Surgeon General decides french fries are not bad for your health after all and issues a report endorsing their use. What happens to the market for french fries?
3. How do you think rising incomes affect the market for ski vacations?
4. A new technique is discovered for manufacturing computers that greatly lowers their production cost. What happens to the market for computers?
5. How would a ban on smoking in public affect the market for cigarettes?
7. As low-carb diets increased in popularity, egg prices rose sharply. How might this affect the monks’ supply of cookies or private retreats? (See the Case in Point on the Monks of St. Benedict’s.)
8. Gasoline prices typically rise during the summer, a time of heavy tourist traffic. A “street talk” feature on a radio station sought tourist reaction to higher gasoline prices. Here was one response: “I don’t like ’em [the higher prices] much. I think the gas companies just use any excuse to jack up prices, and they’re doing it again now.” How does this tourist’s perspective differ from that of economists who use the model of demand and supply?
9. The introduction to the chapter argues that preferences for coffee changed in the 1990s and that excessive rain hurt yields from coffee plants. Show and explain the effects of these two circumstances on the coffee market.
10. With preferences for coffee remaining strong in the early part of the century, Vietnam entered the market as a major exporter of coffee. Show and explain the effects of these two circumstances on the coffee market.
11. The study on the economics of obesity discussed in the Case in Point in this chapter on that topic also noted that another factor behind rising obesity is the decline in cigarette smoking as the price of cigarettes has risen. Show and explain the effect of higher cigarette prices on the market for food. What does this finding imply about the relationship between cigarettes and food?
12. In 2004, The New York Times reported that India might be losing its outsourcing edge due to rising wages (Scheiber, N., 2004) The reporter noted that a recent report “projected that if India continued to produce college graduates at the current rate, demand would exceed supply by 20% in the main outsourcing markets by 2008.” Using the terminology you learned in this chapter, explain what he meant to say was happening in the market for Indian workers in outsourcing jobs. In particular, is demand for Indian workers increasing or decreasing? Is the supply of Indian workers increasing or decreasing? Which is shifting faster? How do you know?
13. For more than a century, milk producers have produced skim milk, which contains virtually no fat, along with regular milk, which contains 4% fat. But a century ago, skim milk accounted for only about 1% of total production, and much of it was fed to hogs. Today, skim and other reduced-fat milks make up the bulk of milk sales. What curve shifted, and what factor shifted it?
14. Suppose firms in the economy were to produce fewer goods and services. How do you think this would affect household spending on goods and services? (Hint: Use the circular flow model to analyze this question.)
Numerical Problems
Problems 1–5 are based on the graph below.
Figure 3.26
1. At a price of \$1.50 per dozen, how many bagels are demanded per month?
2. At a price of \$1.50 per dozen, how many bagels are supplied per month?
3. At a price of \$3.00 per dozen, how many bagels are demanded per month?
4. At a price of \$3.00 per dozen, how many bagels are supplied per month?
5. What is the equilibrium price of bagels? What is the equilibrium quantity per month?
Problems 6–9 are based on the model of demand and supply for coffee as shown in Figure 3.17 You can graph the initial demand and supply curves by using the following values, with all quantities in millions of pounds of coffee per month:
Price Quantity demanded Quantity supplied
\$3 40 10
4 35 15
5 30 20
6 25 25
7 20 30
8 15 35
9 10 40
1. Suppose the quantity demanded rises by 20 million pounds of coffee per month at each price. Draw the initial demand and supply curves based on the values given in the table above. Then draw the new demand curve given by this change, and show the new equilibrium price and quantity.
2. Suppose the quantity demanded falls, relative to the values given in the above table, by 20 million pounds per month at prices between \$4 and \$6 per pound; at prices between \$7 and \$9 per pound, the quantity demanded becomes zero. Draw the new demand curve and show the new equilibrium price and quantity.
3. Suppose the quantity supplied rises by 20 million pounds per month at each price, while the quantities demanded retain the values shown in the table above. Draw the new supply curve and show the new equilibrium price and quantity.
4. Suppose the quantity supplied falls, relative to the values given in the table above, by 20 million pounds per month at prices above \$5; at a price of \$5 or less per pound, the quantity supplied becomes zero. Draw the new supply curve and show the new equilibrium price and quantity.
Problems 10–15 are based on the demand and supply schedules for gasoline below (all quantities are in thousands of gallons per week):
Price per gallon Quantity demanded Quantity supplied
\$1 8 0
2 7 1
3 6 2
4 5 3
5 4 4
6 3 5
7 2 6
8 1 7
1. Graph the demand and supply curves and show the equilibrium price and quantity.
2. At a price of \$3 per gallon, would there be a surplus or shortage of gasoline? How much would the surplus or shortage be? Indicate the surplus or shortage on the graph.
3. At a price of \$6 per gallon, would there be a surplus or shortage of gasoline? How much would the surplus or shortage be? Show the surplus or shortage on the graph.
4. Suppose the quantity demanded increased by 2,000 gallons per month at each price. At a price of \$3 per gallon, how much would the surplus or shortage be? Graph the demand and supply curves and show the surplus or shortage.
5. Suppose the quantity supplied decreased by 2,000 gallons per month at each price for prices between \$4 and \$8 per gallon. At prices less than \$4 per gallon the quantity supplied becomes zero, while the quantities demanded retain the values shown in the table. At a price of \$4 per gallon, how much would the surplus or shortage be? Graph the demand and supply curves and show the surplus or shortage.
6. If the demand curve shifts as in problem 13 and the supply curve shifts as in problem 14, without drawing a graph or consulting the data, can you predict whether equilibrium price increases or decreases? What about equilibrium quantity? Now draw a graph that shows what the new equilibrium price and quantity are. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/03%3A_Demand_and_Supply/3.4%3A_Review_and_Practice.txt |
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04: Applications of Demand and Supply
Learning Objective
1. Learn how to apply the model of demand and supply to explaining the behavior of equilibrium prices and quantities in a variety of markets.
2. Explain how technological change can be represented using the model of demand and supply.
3. Explain how the model of demand and supply can be used to explain changes in prices of shares of stock.
A shift in either demand or supply, or in both, leads to a change in equilibrium price and equilibrium quantity. We begin this chapter by examining markets in which prices adjust quickly to changes in demand or supply: the market for personal computers, the markets for crude oil and gasoline, and the stock market. These markets are thus direct applications of the model of demand and supply.
The Personal Computer Market
In the 1960s, to speak of computers was to speak of IBM, the dominant maker of large mainframe computers used by business and government agencies. Then between 1976, when Apple Computer introduced its first desktop computer, and 1981, when IBM produced its first personal computers (PCs), the old world was turned upside down. In 1984, just 8.2% of U.S. households owned a personal computer. By 2007, Google estimates that 78% did. The tools of demand and supply tell the story from an economic perspective.
Technological change has been breathtakingly swift in the computer industry. Because personal computers have changed so dramatically in performance and in the range of the functions they perform, we shall speak of “quality-adjusted” personal computers. The price per unit of quality-adjusted desktop computers fell by about half every 50 months during the period 1976–1989. In the first half of the 1990s, those prices fell by half every 28 months. In the second half of the 1990s, the “halving time” fell to every 24 months (Tuomi, I).
Consider another indicator of the phenomenal change in computers. Between 1993 and 1998, the Bureau of Labor Statistics estimates that central processing unit (CPU) speed rose 1,263%, system memory increased 1,500%, hard drive capacity soared by 3,700%, and monitor size went up 13%. It seems safe to say that the dizzying pace of change recorded in the 1990s has increased in this century. A “computer” today is not the same good as a “computer” even five years ago. To make them comparable, we must adjust for these changes in quality.
Initially, most personal computers were manufactured by Apple or Compaq; both companies were very profitable. The potential for profits attracted IBM and other firms to the industry. Unlike large mainframe computers, personal computer clones turned out to be fairly easy things to manufacture. As shown in Table 4.1 “Personal Computer Shipments, Market Percentage Shares by Vendors, World and United States”, the top five personal computer manufacturers produced only 48% of the personal computers sold in the world in 2005, and the largest manufacturer, Dell, sold only about 19% of the total in that year. This is a far cry from the more than 90% of the mainframe computer market that IBM once held. The market has become far more competitive.
Table 4.1 Personal Computer Shipments, Market Percentage Shares by Vendors, World and United States
Company % of World Shipments Company % of U.S. Shipments
Dell 18.9 Dell 34
Hewlett-Packard 15.4 Hewlett-Packard 18.2
IBM 5.1 Gateway 5.7
Fujitsu Seimens 4.6 IBM 4.3
Acer 4 Apple 3.9
Others 52 Others 34
Total 100.0 Total 100.0
Figure 4.1 illustrates the changes that have occurred in the computer market. The horizontal axis shows the quantity of quality-adjusted personal computers. Thus, the quantity axis can be thought of as a unit of computing power. Similarly, the price axis shows the price per unit of computing power. The rapid increase in the number of firms, together with dramatic technological improvements, led to an increase in supply, shifting the supply curve in Figure 4.1 to the right from S1 to S2.
Demand also shifted to the right from D1 to D2, as incomes rose and new uses for computers, from e-mail and social networking to Voice over Internet Protocol (VoIP) and Radio Frequency ID (RFID) tags (which allow wireless tracking of commercial shipments via desktop computers), altered the preferences of consumer and business users. Because we observe a fall in equilibrium price and an increase in equilibrium quantity, we conclude that the rightward shift in supply has outweighed the rightward shift in demand. The power of market forces has profoundly affected the way we live and work.
The Markets for Crude Oil and for Gasoline
The market for crude oil took a radical turn in 1973. The price per barrel of crude oil quadrupled in 1973 and 1974. Price remained high until the early 1980s but then fell back drastically and remained low for about two decades. In 2004, the price of oil began to move upward and by 2008 had reached \$147 per barrel.
What caused the dramatic increase in gasoline and oil prices in 2008? It appeared to be increasing worldwide demand outpacing producers’ ability—or willingness—to increase production much. This increase in demand is illustrated in Figure 4.2.
Higher oil prices also increase the cost of producing virtually every good or service, as at a minimum, the production of most goods requires transportation. These costs inevitably translate into higher prices for nearly all goods and services. Supply curves of the goods and services thus affected shift to the left, putting downward pressure on output and upward pressure on prices.
Graphically, the impact of higher gasoline prices on businesses that use gasoline is illustrated in Figure 4.3. Because higher gasoline prices increase the cost of doing business, they shift the supply curves for nearly all businesses to the left, putting upward pressure on prices and downward pressure on output. In the case shown here, the supply curve in a typical industry shifts from S1 to S2. This increases the equilibrium price from P1 to P2 and reduces the equilibrium quantity from Q1 to Q2.
Then, as the world economy slowed dramatically in the second half of 2008, the demand curve for oil shifted back to the left. By November 2008, the price per barrel had dropped back to below \$60 per barrel. As gas prices also subsided, so did the threat of higher prices in other industries.
The Stock Market
The circular flow model suggests that capital, like other factors of production, is supplied by households to firms. Firms, in turn, pay income to those households for the use of their capital. Generally speaking, however, capital is actually owned by firms themselves. General Motors owns its assembly plants, and Wal-Mart owns its stores; these firms therefore own their capital. But firms, in turn, are owned by people—and those people, of course, live in households. It is through their ownership of firms that households own capital.
A firm may be owned by one individual (a sole proprietorship), by several individuals (a partnership), or by shareholders who own stock in the firm (a corporation). Although most firms in the United States are sole proprietorships or partnerships, the bulk of the nation’s total output (about 90%) is produced by corporations. Corporations also own most of the capital (machines, plants, buildings, and the like).
This section describes how the prices of shares of corporate stock, shares in the ownership of a corporation, are determined by the interaction of demand and supply. Ultimately, the same forces that determine the value of a firm’s stock determine the value of a sole proprietorship or partnership.
When a corporation needs funds to increase its capital or for other reasons, one means at its disposal is to issue new stock in the corporation. (Other means include borrowing funds or using past profits.) Once the new shares have been sold in what is called an initial public offering (IPO), the corporation receives no further funding as shares of its stock are bought and sold on the secondary market. The secondary market is the market for stocks that have been issued in the past, and the daily news reports about stock prices almost always refer to activity in the secondary market. Generally, the corporations whose shares are traded are not involved in these transactions.
The stock market is the set of institutions in which shares of stock are bought and sold. The New York Stock Exchange (NYSE) is one such institution. There are many others all over the world, such as the DAX in Germany and the Bolsa in Mexico. To buy or sell a share of stock, one places an order with a stockbroker who relays the order to one of the traders at the NYSE or at some other exchange.
The process through which shares of stock are bought and sold can seem chaotic. At many exchanges, traders with orders from customers who want to buy stock shout out the prices those customers are willing to pay. Traders with orders from customers who want to sell shout out offers of prices at which their customers are willing to sell. Some exchanges use electronic trading, but the principle is the same: if the price someone is willing to pay matches the price at which someone else is willing to sell, the trade is made. The most recent price at which a stock has traded is reported almost instantaneously throughout the world.
Figure 4.4 applies the model of demand and supply to the determination of stock prices. Suppose the demand curve for shares in Intel Corporation is given by D1 and the supply by S1. (Even though the total number of shares outstanding is fixed at any point in time, the supply curve is not vertical. Rather, the supply curve is upward sloping because it represents how many shares current owners are prepared to sell at each price, and that number will be greater at higher prices.) Suppose that these curves intersect at a price of \$25, at which Q1 shares are traded each day. If the price were higher, more shares would be offered for sale than would be demanded, and the price would quickly fall. If the price were lower, more shares would be demanded than would be supplied, and the price would quickly rise. In general, we can expect the prices of shares of stock to move quickly to their equilibrium levels.
The intersection of the demand and supply curves for shares of stock in a particular company determines the equilibrium price for a share of stock. But what determines the demand and supply for shares of a company’s stock?
The owner of a share of a company’s stock owns a share of the company, and, hence, a share of its profits; typically, a corporation will retain and reinvest some of its profits to increase its future profitability. The profits kept by a company are called retained earnings. Profits distributed to shareholders are called dividends. Because a share of stock gives its owner a claim on part of a company’s future profits, it follows that the expected level of future profits plays a role in determining the value of its stock.
Of course, those future profits cannot be known with certainty; investors can only predict what they might be, based on information about future demand for the company’s products, future costs of production, information about the soundness of a company’s management, and so on. Stock prices in the real world thus reflect estimates of a company’s profits projected into the future.
The downward slope of the demand curve suggests that at lower prices for the stock, more people calculate that the firm’s future earnings will justify the stock’s purchase. The upward slope of the supply curve tells us that as the price of the stock rises, more people conclude that the firm’s future earnings do not justify holding the stock and therefore offer to sell it. At the equilibrium price, the number of shares supplied by people who think holding the stock no longer makes sense just balances the number of shares demanded by people who think it does.
What factors, then, cause the demand or supply curves for shares of stocks to shift? The most important factor is a change in the expectations of a company’s future profits. Suppose Intel announces a new generation of computer chips that will lead to faster computers with larger memories. Current owners of Intel stock would adjust upward their estimates of what the value of a share of Intel stock should be. At the old equilibrium price of \$25 fewer owners of Intel stock would be willing to sell. Since this would be true at every possible share price, the supply curve for Intel stock would shift to the left, as shown in Figure 4.5. Just as the expectation that a company will be more profitable shifts the supply curve for its stock to the left, that same change in expectations will cause more people to want to purchase the stock, shifting the demand curve to the right. In Figure 4.5, we see the supply curve shifting to the left, from S1 to S2, while the demand curve shifts to the right, from D1 to D2.
Other factors may alter the price of an individual corporation’s share of stock or the level of stock prices in general. For example, demographic change and rising incomes have affected the demand for stocks in recent years. For example, with a large proportion of the U.S. population nearing retirement age and beginning to think about and plan for their lives during retirement, the demand for stocks has risen.
Information on the economy as a whole is also likely to affect stock prices. If the economy overall is doing well and people expect that to continue, they may become more optimistic about how profitable companies will be in general, and thus the prices of stocks will rise. Conversely, expectations of a sluggish economy, as happened in the fall of 2008, could cause stock prices in general to fall.
The stock market is bombarded with new information every minute of every day. Firms announce their profits of the previous quarter. They announce that they plan to move into a new product line or sell their goods in another country. We learn that the price of Company A’s good, which is a substitute for one sold by Company B, has risen. We learn that countries sign trade agreements, launch wars, or make peace. All of this information may affect stock prices because any information can affect how buyers and sellers value companies.
Key Takeaways
• Technological change, which has caused the supply curve for computing power to shift to the right, is the main reason for the rapid increase in equilibrium quantity and decrease in equilibrium price of personal computers.
• The increase in crude oil and gasoline prices in 2008 was driven primarily by increased demand for crude oil, an increase that was created by economic growth throughout the world. Crude oil and gas prices fell markedly as world economic growth subsided later in the year.
• Higher gasoline prices increased the cost of producing virtually every good and service, shifting supply curves for most goods and services to the left. This tended to push prices up and output down.
• Demand and supply determine prices of shares of corporate stock. The equilibrium price of a share of stock strikes a balance between those who think the stock is worth more and those who think it is worth less than the current price.
• If a company’s profits are expected to increase, the demand curve for its stock shifts to the right and the supply curve shifts to the left, causing equilibrium price to rise. The opposite would occur if a company’s profits were expected to decrease.
• Other factors that influence the price of corporate stock include demographic and income changes and the overall health of the economy.
Try It!
Suppose an airline announces that its earnings this year are lower than expected due to reduced ticket sales. The airline spokesperson gives no information on how the company plans to turn things around. Use the model of demand and supply to show and explain what is likely to happen to the price of the airline’s stock.
Case in Point: 9/11 and the Stock Market
Figure 4.6
The hijacking of four airplanes and the steering of them into buildings is perhaps the only disaster that has become universally known by its date: September 11, 2001—hence, 9/11. “9/11” will remain etched in our collective memory for a great many generations.
Disasters such as 9/11 represent the kind of complete surprises that dramatically affect stock prices, if only temporarily. The New York Stock Exchange was closed on the day of the attack and remained closed for six days. On the day the market opened, the Dow Jones Industrial Average (the “DOW”, a widely used gauge of stock prices) fell nearly 685 points to 8,920. It was one of the biggest one-day decline in U.S. history.
Why did the attacks on September 11, 2001, have such a dramatic short-term impact on the stock market? The attacks of 9/11 plunged the United States and much of the rest of the world into a very frightening war against terrorism. The realization that terrorists could strike anytime and in any place sapped consumer and business confidence alike and affected both the demand and supply of most stocks. The attacks on 9/11 provoked fear and uncertainty—two things that are certain to bring stock prices down, at least until other events and more information cause expectations to change again in this very responsive market.
Answer to Try It! Problem
The information given in the problem suggests that the airline’s profits are likely to fall below expectations. Current owners of the airline’s stock and potential buyers of the stock would adjust downward their estimates of what the value of the corporation’s stock should be. As a result the supply curve for the stock would increase, shifting it to the right, while the demand curve for the stock would decrease, shifting it to the left. As a result, equilibrium price of the stock falls from P1 to P2. What happens to equilibrium quantity depends on the extent to which each curve shifts. In the diagram, equilibrium quantity is shown to decrease from Q1 to Q2.
Figure 4.7 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/04%3A_Applications_of_Demand_and_Supply/4.1%3A_Putting_Demand_and_Supply_to_Work.txt |
Learning Objective
1. Use the model of demand and supply to explain what happens when the government imposes price floors or price ceilings.
2. Discuss the reasons why governments sometimes choose to control prices and the consequences of price control policies.
So far in this chapter and in the previous chapter, we have learned that markets tend to move toward their equilibrium prices and quantities. Surpluses and shortages of goods are short-lived as prices adjust to equate quantity demanded with quantity supplied.
In some markets, however, governments have been called on by groups of citizens to intervene to keep prices of certain items higher or lower than what would result from the market finding its own equilibrium price. In this section we will examine agricultural markets and apartment rental markets—two markets that have often been subject to price controls. Through these examples, we will identify the effects of controlling prices. In each case, we will look at reasons why governments have chosen to control prices in these markets and the consequences of these policies.
Agricultural Price Floors
Governments often seek to assist farmers by setting price floors in agricultural markets. A minimum allowable price set above the equilibrium price is a price floor. With a price floor, the government forbids a price below the minimum. (Notice that, if the price floor were for whatever reason set below the equilibrium price, it would be irrelevant to the determination of the price in the market since nothing would prohibit the price from rising to equilibrium.) A price floor that is set above the equilibrium price creates a surplus.
Figure 4.8 shows the market for wheat. Suppose the government sets the price of wheat at PF. Notice that PF is above the equilibrium price of PE. At PF, we read over to the demand curve to find that the quantity of wheat that buyers will be willing and able to purchase is W1 bushels. Reading over to the supply curve, we find that sellers will offer W2 bushels of wheat at the price floor of PF. Because PF is above the equilibrium price, there is a surplus of wheat equal to (W2W1) bushels. The surplus persists because the government does not allow the price to fall.
Why have many governments around the world set price floors in agricultural markets? Farming has changed dramatically over the past two centuries. Technological improvements in the form of new equipment, fertilizers, pesticides, and new varieties of crops have led to dramatic increases in crop output per acre. Worldwide production capacity has expanded markedly. As we have learned, technological improvements cause the supply curve to shift to the right, reducing the price of food. While such price reductions have been celebrated in computer markets, farmers have successfully lobbied for government programs aimed at keeping their prices from falling.
While the supply curve for agricultural goods has shifted to the right, the demand has increased with rising population and with rising income. But as incomes rise, people spend a smaller and smaller fraction of their incomes on food. While the demand for food has increased, that increase has not been nearly as great as the increase in supply. Figure 4.9 shows that the supply curve has shifted much farther to the right, from S1 to S2, than the demand curve has, from D1 to D2. As a result, equilibrium quantity has risen dramatically, from Q1 to Q2, and equilibrium price has fallen, from P1 to P2.
On top of this long-term historical trend in agriculture, agricultural prices are subject to wide swings over shorter periods. Droughts or freezes can sharply reduce supplies of particular crops, causing sudden increases in prices. Demand for agricultural goods of one country can suddenly dry up if the government of another country imposes trade restrictions against its products, and prices can fall. Such dramatic shifts in prices and quantities make incomes of farmers unstable.
The Great Depression of the 1930s led to a major federal role in agriculture. The Depression affected the entire economy, but it hit farmers particularly hard. Prices received by farmers plunged nearly two-thirds from 1930 to 1933. Many farmers had a tough time keeping up mortgage payments. By 1932, more than half of all farm loans were in default.
Farm legislation passed during the Great Depression has been modified many times, but the federal government has continued its direct involvement in agricultural markets. This has meant a variety of government programs that guarantee a minimum price for some types of agricultural products. These programs have been accompanied by government purchases of any surplus, by requirements to restrict acreage in order to limit those surpluses, by crop or production restrictions, and the like.
To see how such policies work, look back at Figure 4.8. At PF, W2 bushels of wheat will be supplied. With that much wheat on the market, there is market pressure on the price of wheat to fall. To prevent price from falling, the government buys the surplus of (W2W1) bushels of wheat, so that only W1 bushels are actually available to private consumers for purchase on the market. The government can store the surpluses or find special uses for them. For example, surpluses generated in the United States have been shipped to developing countries as grants-in-aid or distributed to local school lunch programs. As a variation on this program, the government can require farmers who want to participate in the price support program to reduce acreage in order to limit the size of the surpluses.
After 1973, the government stopped buying the surpluses (with some exceptions) and simply guaranteed farmers a “target price.” If the average market price for a crop fell below the crop’s target price, the government paid the difference. If, for example, a crop had a market price of \$3 per unit and a target price of \$4 per unit, the government would give farmers a payment of \$1 for each unit sold. Farmers would thus receive the market price of \$3 plus a government payment of \$1 per unit. For farmers to receive these payments, they had to agree to remove acres from production and to comply with certain conservation provisions. These restrictions sought to reduce the size of the surplus generated by the target price, which acted as a kind of price floor.
What are the effects of such farm support programs? The intention is to boost and stabilize farm incomes. But, with price floors, consumers pay more for food than they would otherwise, and governments spend heavily to finance the programs. With the target price approach, consumers pay less, but government financing of the program continues. U.S. federal spending for agriculture averaged well over \$22 billion per year between 2003 and 2007, roughly \$70 per person.
Help to farmers has sometimes been justified on the grounds that it boosts incomes of “small” farmers. However, since farm aid has generally been allotted on the basis of how much farms produce rather than on a per-farm basis, most federal farm support has gone to the largest farms. If the goal is to eliminate poverty among farmers, farm aid could be redesigned to supplement the incomes of small or poor farmers rather than to undermine the functioning of agricultural markets.
In 1996, the U.S. Congress passed the Federal Agriculture Improvement and Reform Act of 1996, or FAIR. The thrust of the new legislation was to do away with the various programs of price support for most crops and hence provide incentives for farmers to respond to market price signals. To protect farmers through a transition period, the act provided for continued payments that were scheduled to decline over a seven-year period. However, with prices for many crops falling in 1998, the U.S. Congress passed an emergency aid package that increased payments to farmers. In 2008, as farm prices reached record highs, Congress passed a farm bill that increased subsidy payments to \$40 billion. It did, however, for the first time limit payments to the wealthiest farmers. Individual farmers whose farm incomes exceed \$750,000 (or \$1.5 million for couples) would be ineligible for some subsidy programs.
Rental Price Ceilings
The purpose of rent control is to make rental units cheaper for tenants than they would otherwise be. Unlike agricultural price controls, rent control in the United States has been largely a local phenomenon, although there were national rent controls in effect during World War II. Currently, about 200 cities and counties have some type of rent control provisions, and about 10% of rental units in the United States are now subject to price controls. New York City’s rent control program, which began in 1943, is among the oldest in the country. Many other cities in the United States adopted some form of rent control in the 1970s. Rent controls have been pervasive in Europe since World War I, and many large cities in poorer countries have also adopted rent controls.
Rent controls in different cities differ in terms of their flexibility. Some cities allow rent increases for specified reasons, such as to make improvements in apartments or to allow rents to keep pace with price increases elsewhere in the economy. Often, rental housing constructed after the imposition of the rent control ordinances is exempted. Apartments that are vacated may also be decontrolled. For simplicity, the model presented here assumes that apartment rents are controlled at a price that does not change.
Figure 4.10 shows the market for rental apartments. Notice that the demand and supply curves are drawn to look like all the other demand and supply curves you have encountered so far in this text: the demand curve is downward-sloping and the supply curve is upward-sloping.
The demand curve shows that a higher price (rent) reduces the quantity of apartments demanded. For example, with higher rents, more young people will choose to live at home with their parents. With lower rents, more will choose to live in apartments. Higher rents may encourage more apartment sharing; lower rents would induce more people to live alone.
The supply curve is drawn to show that as rent increases, property owners will be encouraged to offer more apartments to rent. Even though an aerial photograph of a city would show apartments to be fixed at a point in time, owners of those properties will decide how many to rent depending on the amount of rent they anticipate. Higher rents may also induce some homeowners to rent out apartment space. In addition, renting out apartments implies a certain level of service to renters, so that low rents may lead some property owners to keep some apartments vacant.
Rent control is an example of a price ceiling, a maximum allowable price. With a price ceiling, the government forbids a price above the maximum. A price ceiling that is set below the equilibrium price creates a shortage that will persist.
Suppose the government sets the price of an apartment at PC in Figure 4.10. Notice that PC is below the equilibrium price of PE. At PC, we read over to the supply curve to find that sellers are willing to offer A1 apartments. Reading over to the demand curve, we find that consumers would like to rent A2 apartments at the price ceiling of PC. Because PC is below the equilibrium price, there is a shortage of apartments equal to (A2A1). (Notice that if the price ceiling were set above the equilibrium price it would have no effect on the market since the law would not prohibit the price from settling at an equilibrium price that is lower than the price ceiling.)
If rent control creates a shortage of apartments, why do some citizens nonetheless clamor for rent control and why do governments often give in to the demands? The reason generally given for rent control is to keep apartments affordable for low- and middle-income tenants.
But the reduced quantity of apartments supplied must be rationed in some way, since, at the price ceiling, the quantity demanded would exceed the quantity supplied. Current occupants may be reluctant to leave their dwellings because finding other apartments will be difficult. As apartments do become available, there will be a line of potential renters waiting to fill them, any of whom is willing to pay the controlled price of PC or more. In fact, reading up to the demand curve in Figure 4.11 from A1 apartments, the quantity available at PC, you can see that for A1 apartments, there are potential renters willing and able to pay PB. This often leads to various “backdoor” payments to apartment owners, such as large security deposits, payments for things renters may not want (such as furniture), so-called “key” payments (“The monthly rent is \$500 and the key price is \$3,000”), or simple bribes.
In the end, rent controls and other price ceilings often end up hurting some of the people they are intended to help. Many people will have trouble finding apartments to rent. Ironically, some of those who do find apartments may actually end up paying more than they would have paid in the absence of rent control. And many of the people that the rent controls do help (primarily current occupants, regardless of their income, and those lucky enough to find apartments) are not those they are intended to help (the poor). There are also costs in government administration and enforcement.
Because New York City has the longest history of rent controls of any city in the United States, its program has been widely studied. There is general agreement that the rent control program has reduced tenant mobility, led to a substantial gap between rents on controlled and uncontrolled units, and favored long-term residents at the expense of newcomers to the city (Arnott, R., 1995). These distortions have grown over time, another frequent consequence of price controls.
A more direct means of helping poor tenants, one that would avoid interfering with the functioning of the market, would be to subsidize their incomes. As with price floors, interfering with the market mechanism may solve one problem, but it creates many others at the same time.
Key Takeaways
• Price floors create surpluses by fixing the price above the equilibrium price. At the price set by the floor, the quantity supplied exceeds the quantity demanded.
• In agriculture, price floors have created persistent surpluses of a wide range of agricultural commodities. Governments typically purchase the amount of the surplus or impose production restrictions in an attempt to reduce the surplus.
• Price ceilings create shortages by setting the price below the equilibrium. At the ceiling price, the quantity demanded exceeds the quantity supplied.
• Rent controls are an example of a price ceiling, and thus they create shortages of rental housing.
• It is sometimes the case that rent controls create “backdoor” arrangements, ranging from requirements that tenants rent items that they do not want to outright bribes, that result in rents higher than would exist in the absence of the ceiling.
Try It!
A minimum wage law is another example of a price floor. Draw demand and supply curves for unskilled labor. The horizontal axis will show the quantity of unskilled labor per period and the vertical axis will show the hourly wage rate for unskilled workers, which is the price of unskilled labor. Show and explain the effect of a minimum wage that is above the equilibrium wage.
Case in Point: Corn: It Is Not Just Food Any More
Figure 4.12
Government support for corn dates back to the Agricultural Act of 1938 and, in one form or another, has been part of agricultural legislation ever since. Types of supports have ranged from government purchases of surpluses to target pricing, land set asides, and loan guarantees. According to one estimate, the U.S. government spent nearly \$42 billion to support corn between 1995 and 2004.
Then, during the period of rising oil prices of the late 1970s and mounting concerns about dependence on foreign oil from volatile regions in the world, support for corn, not as a food, but rather as an input into the production of ethanol—an alternative to oil-based fuel—began. Ethanol tax credits were part of the Energy Act of 1978. Since 1980, a tariff of 50¢ per gallon against imported ethanol, even higher today, has served to protect domestic corn-based ethanol from imported ethanol, in particular from sugar-cane-based ethanol from Brazil.
The Energy Policy Act of 2005 was another milestone in ethanol legislation. Through loan guarantees, support for research and development, and tax credits, it mandated that 4 billion gallons of ethanol be used by 2006 and 7.5 billion gallons by 2012. Ethanol production had already reached 6.5 billion gallons by 2007, so new legislation in 2007 upped the ante to 15 billion gallons by 2015.
Beyond the increased amount the government is spending to support corn and corn-based ethanol, criticism of the policy has three major prongs:
1. Corn-based ethanol does little to reduce U.S. dependence on foreign oil because the energy required to produce a gallon of corn-based ethanol is quite high. A 2006 National Academy of Sciences paper estimated that one gallon of ethanol is needed to bring 1.25 gallons of it to market. Other studies show an even less favorable ratio.
2. Biofuels, such as corn-based ethanol, are having detrimental effects on the environment, with increased deforestation, stemming from more land being used to grow fuel inputs, contributing to global warming.
3. The diversion of corn and other crops from food to fuel is contributing to rising food prices and an increase in world hunger. C. Ford Runge and Benjamin Senauer wrote in Foreign Affairs that even small increases in prices of food staples have severe consequences on the very poor of the world, and “Filling the 25-gallon tank of an SUV with pure ethanol requires over 450 pounds of corn—which contains enough calories to feed one person for a year.”
Some of these criticisms may be contested as exaggerated: Will the ratio of energy-in to energy-out improve as new technologies emerge for producing ethanol? Did not other factors, such as weather and rising food demand worldwide, contribute to higher grain prices? Nonetheless, it is clear that corn-based ethanol is no free lunch. It is also clear that the end of government support for corn is nowhere to be seen.
Answer to Try It! Problem
A minimum wage (Wmin) that is set above the equilibrium wage would create a surplus of unskilled labor equal to (L2L1). That is, L2 units of unskilled labor are offered at the minimum wage, but companies only want to use L1 units at that wage. Because unskilled workers are a substitute for a skilled workers, forcing the price of unskilled workers higher would increase the demand for skilled labor and thus increase their wages.
Figure 4.13 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/04%3A_Applications_of_Demand_and_Supply/4.2%3A_Government_Intervention_in_Market_Prices_-_Price_Floors_and_Price_Ceilings.txt |
Learning Objective
1. Use the model of demand and supply to explain the effects of third-party payers on the health-care market and on health-care spending.
There has been much discussion over the past three decades about the health-care problem in the United States. Much of this discussion has focused on rising spending for health care. In this section, we will apply the model of demand and supply to health care to see what we can learn about some of the reasons behind rising spending in this important sector of the economy.
Figure 4.14 shows the share of U.S. output devoted to health care since 1960. In 1960, about 5% of total output was devoted to health care; by 2004 this share had risen to 15.4%. That has meant that we are devoting more of our spending to health care, and less to other goods and services, than we would be had health-care spending not risen so much.
Why were Americans willing to increase their spending on health care so dramatically? The model of demand and supply gives us part of the answer. As we apply the model to this problem, we will also gain a better understanding of the role of prices in a market economy.
The Demand and Supply for Health Care
When we speak of “health care,” we are speaking of the entire health-care industry. This industry produces services ranging from heart transplant operations to therapeutic massages; it produces goods ranging from X-ray machines to aspirin tablets. Clearly each of these goods and services is exchanged in a particular market. To assess the market forces affecting health care, we will focus first on just one of these markets: the market for physician office visits. When you go to the doctor, you are part of the demand for these visits. Your doctor, by seeing you, is part of the supply.
Figure 4.15 shows the market, assuming that it operates in a fashion similar to other markets. The demand curve D1 and the supply curve S1 intersect at point E, with an equilibrium price of \$30 per office visit. The equilibrium quantity of office visits per week is 1,000,000.
We can use the demand and supply graph to show total spending, which equals the price per unit (in this case, \$30 per visit) times the quantity consumed (in this case, 1,000,000 visits per week). Total spending for physician office visits thus equals \$30,000,000 per week (\$30 times 1,000,000 visits). We show total spending as the area of a rectangle bounded by the price and the quantity. It is the shaded region in Figure 4.15.
The picture in Figure 4.15 misses a crucial feature of the market. Most people in the United States have health insurance, provided either by private firms, by private purchases, or by the government. With health insurance, people agree to pay a fixed amount to the insurer in exchange for the insurer’s agreement to pay for most of the health-care expenses they incur. While insurance plans differ in their specific provisions, let us suppose that all individuals have plans that require them to pay \$10 for an office visit; the insurance company will pay the rest.
How will this insurance affect the market for physician office visits? If it costs only \$10 for a visit instead of \$30, people will visit their doctors more often. The quantity of office visits demanded will increase. In Figure 4.16, this is shown as a movement along the demand curve. Think about your own choices. When you get a cold, do you go to the doctor? Probably not, if it is a minor cold. But if you feel like you are dying, or wish you were, you probably head for the doctor. Clearly, there are lots of colds in between these two extremes. Whether you drag yourself to the doctor will depend on the severity of your cold and what you will pay for a visit. At a lower price, you are more likely to go to the doctor; at a higher price, you are less likely to go.
In the case shown, the quantity of office visits rises to 1,500,000 per week. But that suggests a potential problem. The quantity of visits supplied at a price of \$30 per visit was 1,000,000. According to supply curve S1, it will take a price of \$50 per visit to increase the quantity supplied to 1,500,000 visits (Point F on S1). But consumers—patients—pay only \$10.
Insurers make up the difference between the fees doctors receive and the price patients pay. In our example, insurers pay \$40 per visit of insured patients to supplement the \$10 that patients pay. When an agent other than the seller or the buyer pays part of the price of a good or service, we say that the agent is a third-party payer.
Notice how the presence of a third-party payer affects total spending on office visits. When people paid for their own visits, and the price equaled \$30 per visit, total spending equaled \$30 million per week. Now doctors receive \$50 per visit and provide 1,500,000 visits per week. Total spending has risen to \$75 million per week (\$50 times 1,500,000 visits, shown by the darkly shaded region plus the lightly shaded region).
The response described in Figure 4.16 holds for many different types of goods and services covered by insurance or otherwise paid for by third-party payers. For example, the availability of scholarships and subsidized tuition at public and private universities increases the quantity of education demanded and the total expenditures on higher education. In markets with third-party payers, an equilibrium is achieved, but it is not at the intersection of the demand and supply curves. The effect of third-party payers is to decrease the price that consumers directly pay for the goods and services they consume and to increase the price that suppliers receive. Consumers use more than they would in the absence of third-party payers, and providers are encouraged to supply more than they otherwise would. The result is increased total spending.
Key Takeaways
• The rising share of the output of the United States devoted to health care represents a rising opportunity cost. More spending on health care means less spending on other goods and services, compared to what would have transpired had health-care spending not risen so much.
• The model of demand and supply can be used to show the effect of third-party payers on total spending. With third-party payers (for example, health insurers), the quantity of services consumed rises, as does spending.
Try It!
The provision of university education through taxpayer-supported state universities is another example of a market with a third-party payer. Use the model of demand and supply to discuss the impact this has on the higher education market. Specifically, draw a graph similar to Figure 4.16. How would you label the axes? Show the equilibrium price and quantity in the absence of a third-party payer and indicate total spending on education. Now show the impact of lower tuition As a result of state support for education. How much education do students demand at the lower tuition? How much tuition must educational institutions receive to produce that much education? How much spending on education will occur? Compare total spending before and after a third-party payer enters this market.
Case in Point: The Oregon Plan
Figure 4.17
The health-care industry presents us with a dilemma. Clearly, it makes sense for people to have health insurance. Just as clearly, health insurance generates a substantial increase in spending for health care. If that spending is to be limited, some mechanism must be chosen to do it. One mechanism would be to require patients to pay a larger share of their own health-care consumption directly, reducing the payments made by third-party payers. Allowing people to accumulate tax-free private medical savings accounts is one way to do this. Another option is to continue the current trend to use insurance companies as the agents that limit spending. A third option is government regulation; this Case in Point describes how the state of Oregon tried to limit health-care spending by essentially refusing to be a third-party payer for certain services.
Like all other states, Oregon has wrestled with the problem of soaring Medicaid costs. Its solution to the problem illustrates some of the choices society might make in seeking to reduce health-care costs.
Oregon used to have a plan similar to plans in many other states. Households whose incomes were lower than 50% of the poverty line qualified for Medicaid. In 1987, the state began an effort to manage its Medicaid costs. It decided that it would no longer fund organ transplants and that it would use the money saved to give better care to pregnant women. The decision turned out to be a painful one; the first year, a seven-year-old boy with leukemia, who might have been saved with a bone marrow transplant, died. But state officials argued that the shift of expenditures to pregnant women would ultimately save more lives.
The state gradually expanded its concept of determining what services to fund and what services not to fund. It collapsed a list of 10,000 different diagnoses that had been submitted to its Medicaid program in the past into a list of more than 700 condition-treatment pairs. One such pair, for example, is appendicitis-appendectomy. Health-care officials then ranked these pairs in order of priority. The rankings were based on such factors as the seriousness of a particular condition and the cost and efficacy of treatments. The state announced that it would provide Medicaid to all households below the poverty line, but that it would not fund any procedure ranked below a certain level, initially number 588 on its list. The plan also set a budget limit for any one year; if spending rose above that limit, the legislature must appropriate additional money or drop additional procedures from the list of those covered by the plan. The Oregon Health Plan officially began operation in 1994.
While the Oregon plan has been applied only to households below the poverty line that are not covered by other programs, it suggests a means of reducing health-care spending. Clearly, if part of the health-care problem is excessive provision of services, a system designed to cut services must determine what treatments not to fund.
Professors Jonathan Oberlander, Theodore Marmor, and Lawrence Jacobs studied the impact of this plan in practice through the year 2000 and found that, in contrast to initial expectations, excluded procedures were generally ones of marginal medical value, so the “line in the sand” had little practical significance. In addition, they found that patients were often able to receive supposedly excluded services when physicians, for example, treated an uncovered illness in conjunction with a covered one. During the period of the study, the number of people covered by the plan expanded substantially and yet rationing of services essentially did not occur. How do they explain this seeming contradiction? Quite simply: state government increased revenues from various sources to support the plan. Indeed, they argue that, because treatments that might not be included were explicitly stated, political pressure made excluding them even more difficult and may have inadvertently increased the cost of the program.
In the early 2000s, Oregon, like many other states, confronted severe budgetary pressures. To limit spending, it chose the perhaps less visible strategy of reducing the number of people covered through the plan. Once serving more than 100,000 people, budget cuts reduced the number served to about 17,000. Whereas in 1996, 11% of Oregonians lacked health insurance, in 2008 16% did.
Trailblazing again, in 2008 Oregon realized that its budget allowed room for coverage for a few thousand additional people. But how to choose among the 130,000 eligibles? The solution: to hold a lottery. More than 90,000 people queued up, hoping to be lucky winners.
Answer to Try It! Problem
Without a third-party payer for education, the graph shows equilibrium tuition of P1 and equilibrium quantity of education of Q1. State support for education lowers tuition that students pay to P2. As a result, students demand Q2 courses per year. To provide that amount of education, educational institutions require tuition per course of P3. Without a third-party payer, spending on education is 0P1EQ1. With a third-party payer, spending rises to 0P3FQ2.
Figure 4.18 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/04%3A_Applications_of_Demand_and_Supply/4.3%3A_The_Market_for_Health-Care_Services.txt |
Summary
In this chapter we used the tools of demand and supply to understand a wide variety of market outcomes. We learned that technological change and the entry of new sellers has caused the supply curve of personal computers to shift markedly to the right, thereby reducing equilibrium price and increasing equilibrium quantity. Market forces have made personal computers a common item in offices and homes.
Crude oil and gasoline prices soared in 2008 and then fell back. We looked at the causes of these increases as well as their impacts. Crude oil prices rose in large part As a result of increased demand, particularly from China. Higher prices for crude oil led to higher prices for gasoline. Those higher prices not only hurt consumers of gasoline, they also put upward pressure on the prices of a wide range of goods and services. Crude oil and gasoline prices then decreased dramatically in the last part of 2008, as world growth declined.
The model of demand and supply also explains the determination of stock prices. The price per share of corporate stock reflects the market’s estimate of the expected profitability of the firm. Any information about the firm that causes potential buyers or current owners of corporate stock to reevaluate how profitable they think the firm is, or will be, will cause the equilibrium price of the stock to change.
We then examined markets in which some form of government price control keeps price permanently above or below equilibrium. A price floor leads to persistent surpluses because it is set above the equilibrium price, whereas a price ceiling, because it is set below the equilibrium price, leads to persistent shortages. We saw that interfering with the market mechanism may solve one problem but often creates other problems at the same time. We discussed what some of these unintended consequences might be. For example, agricultural price floors aimed at boosting farm income have also raised prices for consumers and cost taxpayers dearly, and the bulk of government payments have gone to large farms. Rent controls have lowered rents, but they have also reduced the quantity of rental housing supplied, created shortages, and sometimes led to various forms of “backdoor” payments, which sometimes force the price of rental housing above what would exist in the absence of controls.
Finally, we looked at the market for health care and a special feature behind demand and supply in this market that helps to explain why the share of output of the United States that is devoted to health care has risen. Health care is an example of a market in which there are third-party payers (primarily private insurers and the government). With third-party payers the quantity of health-care services consumed rises, as does health-care spending.
Concept Problems
1. Like personal computers, digital cameras have become a common household item. Digital camera prices have plunged in the last 10 years. Use the model of demand and supply to explain the fall in price and increase in quantity.
2. Enron Corp. was one of several corporations convicted of fraud in its accounting practices during the early part of this decade. It had created dummy corporations to hide massive borrowing and to give it the appearance of extraordinary profitability. Use the model of demand and supply to explain the likely impact of such convictions on the stocks of other corporations.
3. During World War II there was a freeze on wages, and corporations found they could evade the freeze by providing other fringe benefits such as retirement funds for their employees. The Office of Price Administration, which administered the wage freeze, ruled that the offer of retirement funds was not a violation of the freeze. The Internal Revenue Service went along with this and ruled that employer-financed retirement plans were not taxable income. Was the wage freeze an example of a price floor or a price ceiling? Use the model of demand and supply to explain why employers began to offer such benefits to their employees.
4. The text argues that political instability in potential suppliers of oil such as Iraq and Venezuela accounts for a relatively steep supply curve for crude oil such as the one shown in Figure 4.2 Suppose that this instability eases considerably and that the world supply curve for crude oil becomes much flatter. Draw such a curve, and explain its implications for the world economy and for typical consumers.
5. Suppose that technological change affects the dairy industry in the same way it has affected the computer industry. However, suppose that dairy price supports remain in place. How would this affect government spending on the dairy program? Use the model of demand and supply to support your answer.
6. People often argue that there is a “shortage” of child care. Using the model of demand and supply, evaluate whether this argument is likely to be correct.
7. “During most of the past 50 years the United States has had a surplus of farmers, and this has been the root of the farm problem.” Comment.
8. Suppose the Department of Agriculture ordered all farmers to reduce the acreage they plant by 10%. Would you expect a 10% reduction in food production? Why or why not?
9. The text argues that the increase in gasoline prices had a particularly strong impact on low-income people. Name some other goods and services for which a sharp increase in price would have a similar impact on people with low incomes.
10. Suppose that the United States and the European Union impose a price ceiling on crude oil of \$25 per barrel. Explain, and illustrate graphically, how this would affect the markets for crude oil and for gasoline in the United States and in the European Union.
11. Given that rent controls can actually hurt low-income people, devise a housing strategy that would provide affordable housing for those whose incomes fall below the poverty line (in 2004, this was about \$19,000 for a family of four).
12. Using the model of demand and supply, show and explain how an increase in the share individuals must pay directly for medical care affects the quantity they consume. Explain how this would address the total amount of spending on health care.
13. Given that people pay premiums for their health insurance, how can we say that insurance lowers the prices people pay for health-care services?
14. Suppose that physicians now charge \$30 for an office visit and insurance policies require patients to pay 33 1/3% of the amount they pay the physicians, so the out-of-pocket cost to consumers is \$10 per visit. In an effort to control costs, the government imposes a price ceiling of \$27 per office visit. Using a demand and supply model, show how this policy would affect the market for health care.
15. Do you think the U.S. health-care system requires reform? Why or why not? If you think reform is in order, explain the approach to reform you advocate.
Numerical Problems
Problems 1–4 are based on the following demand and supply schedules for corn (all quantities are in millions of bushels per year).
Price per bushel Quantity demanded Quantity supplied
\$0 6 0
1 5 1
2 4 2
3 3 3
4 2 4
5 1 5
6 0 6
1. Draw the demand and supply curves for corn. What is the equilibrium price? The equilibrium quantity?
2. Suppose the government now imposes a price floor at \$4 per bushel. Show the effect of this program graphically. How large is the surplus of corn?
3. With the price floor, how much do farmers receive for their corn? How much would they have received if there were no price floor?
4. If the government buys all the surplus wheat, how much will it spend?
Problems 5–9 are based on the following hypothetical demand and supply curves for apartments
Rent/Month
Number of Apts.
Demanded/Month
Number of Apts.
Supplied/Month
\$0 120,000 0
200 100,000 20,000
400 80,000 40,000
600 60,000 60,000
800 40,000 80,000
1000 20,000 100,000
1200 0 120,000
1. Draw the demand and supply curves for apartments.
2. What is the equilibrium rent per month? At this rent, what is the number of apartments demanded and supplied per month?
3. Suppose a ceiling on rents is set at \$400 per month. Characterize the situation that results from this policy.
4. At the rent ceiling, how many apartments are demanded? How many are supplied?
5. How much are people willing to pay for the number of apartments supplied at the ceiling? Describe the arrangements to which this situation might lead. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/04%3A_Applications_of_Demand_and_Supply/4.4%3A_Review_and_Practice.txt |
Thumbnail: https://pixabay.com/illustrations/usa-map-dollar-america-money-1026228/
05: Macroeconomics: The Big Picture
Learning Objective
1. Define real gross domestic product and explain how its calculation avoids both double-counting and the effects of changes in the price level.
2. Identify the phases of a business cycle.
3. Relate business cycles to the overall long-run trend in real GDP in the United States.
To determine whether the economy of a nation is growing or shrinking in size, economists use a measure of total output called real GDP. Real GDP, short for real gross domestic product, is the total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices. Let us break that definition up into parts.
Notice that only “final” goods and services are included in GDP. Many goods and services are purchased for use as inputs in producing something else. For example, a pizza parlor buys flour to make pizzas. If we counted the value of the flour and the value of the pizza, we would end up counting the flour twice and thus overstating the value of total production. Including only final goods avoids double-counting. If the flour is produced during a particular period but has not been sold, then it is a “final good” for that period and is counted.
We want to determine whether the economy’s output is growing or shrinking. If each final good or service produced, from hammers to haircuts, were valued at its current market price, and then we were to add the values of all such items produced, we would not know if the total had changed because output changed or because prices changed or both. The market value of all final goods and services produced can rise even if total output falls. To isolate the behavior of total output only, we must hold prices constant at some level. For example, if we measure the value of basketball output over time using a fixed price for valuing the basketballs, then only an increase in the number of basketballs produced could increase the value of the contribution made by basketballs to total output. By making such an adjustment for basketballs and all other goods and services, we obtain a value for real GDP. In contrast, nominal GDP, usually just referred to as gross domestic product (GDP), is the total value of final goods and services for a particular period valued in terms of prices for that period. For example, real GDP fell in the third quarter of 2008. But, because the price level in the United States was rising, nominal GDP rose 3.6%.
We will save a detailed discussion of the computation of GDP for another chapter. In this section, our goal is to use the concept of real GDP to look at the business cycle—the economy’s pattern of expansion, then contraction, then expansion again—and at growth of real GDP.
Phases of the Business Cycle
Figure 20.1 shows a stylized picture of a typical business cycle. It shows that economies go through periods of increasing and decreasing real GDP, but that over time they generally move in the direction of increasing levels of real GDP. A sustained period in which real GDP is rising is an expansion; a sustained period in which real GDP is falling is a recession. Typically, an economy is said to be in a recession when real GDP drops for two consecutive quarters, but in the United States, the responsibility of defining precisely when the economy is in recession is left to the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The Committee defines 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, and wholesale-retail sales” (National Bureau of Economic Research, 2008).
At time t1 in Figure 20.1, an expansion ends and real GDP turns downward. The point at which an expansion ends and a recession begins is called the peak of the business cycle. Real GDP then falls during a period of recession. Eventually it starts upward again (at time t2). The point at which a recession ends and an expansion begins is called the trough of the business cycle. The expansion continues until another peak is reached at time t31. A complete business cycle is defined by the passage from one peak to the next.
Because the Business Cycle Dating Committee dates peaks and troughs by specific months, and because real GDP is estimated only on a quarterly basis by the Bureau of Economic Analysis, the committee relies on a variety of other indicators that are published monthly, including real personal income, employment, industrial production, and real wholesale and retail sales. The committee typically determines that a recession has happened long after it has actually begun and sometimes ended! In large part, that avoids problems when data released about the economy are revised, and the committee avoids having to reverse itself on its determination of when a recession begins or ends, something it has never done. In December 2008, the Committee announced that a recession in the United States had begun in December 2007. Interestingly, real GDP fell in the fourth quarter of 2007, grew in the first and second quarters of 2008, and shrank in the third quarter of 2008, so clearly the Committee was not using the two consecutive quarters of declining GDP rule-of-thumb. Rather, it was taking into account the behavior of a variety of other variables, such as employment and personal income.
Business Cycles and the Growth of Real GDP in the United States
Figure 20.2 shows movements in real GDP in the United States from 1960 to 2010. Over those years, the economy experienced eight recessions (including the current one), shown by the shaded areas in the chart. Although periods of expansion have been more prolonged than periods of recession, we see the cycle of economic activity that characterizes economic life.
Real GDP clearly grew between 1960 and 2010. While the economy experienced expansions and recessions, its general trend during the period was one of rising real GDP. The average annual rate of growth of real GDP was about 3.2%.
During the post–World War II period, the average expansion has lasted 58 months, and the average recession has lasted about 11 months. The 2001 recession, which lasted eight months, was thus slightly shorter than the average. The 2007-2009 recession lasted 18 months; it was the longest of the post-World War II period.
Economists have sought for centuries to explain the forces at work in a business cycle. Not only are the currents that move the economy up or down intellectually fascinating but also an understanding of them is of tremendous practical importance. A business cycle is not just a movement along a curve in a textbook. It is new jobs for people, or the loss of them. It is new income, or the loss of it. It is the funds to build new schools or to provide better health care—or the lack of funds to do all those things. The story of the business cycle is the story of progress and plenty, of failure and sacrifice.
During the recent recession, the job outlook for college graduates deteriorated. According to a National Association of Colleges and Employers study, 20% of college graduates seeking jobs had one waiting after graduation in 2009. In 2010, that percent rose to 24% but the average salary had slipped 1.7% from the previous year. The unemployment rate for college graduates under age 25 rose from 3.7% in April 2007 to 8% in April 2010. The unemployment rate for high school graduates who never enrolled in college went from 11.4% to 24.5% over the same two-year period (Greenhouse, S., 2010).
The effects of recessions extend beyond the purely economic realm and influence the social fabric of society as well. Suicide rates and property crimes—burglary, larceny, and motor vehicle theft tend to rise during recessions. Even popular music appears to be affected. Terry F. Pettijohn II, a psychologist at Coastal Carolina University, has studied Billboard No. 1 songs from 1955–2003. He finds that during recessions, popular songs tend to be longer and slower, and to have more serious lyrics. “It’s ‘Bridge over Troubled Water’ or ‘That’s What Friends Are For’,” he says. During expansions, songs tend to be faster, shorter, and somewhat sillier, such as “At the Hop” or “My Sharona” (Lewin, T., 2008).
In our study of macroeconomics, we will gain an understanding of the forces at work in the business cycle. We will also explore policies through which the public sector might act to make recessions less severe and, perhaps, to prolong expansions. We turn next to an examination of price-level changes and unemployment.
Key Takeaways
• Real gross domestic product (real GDP) is a measure of the value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of price changes.
• The economy follows a path of expansion, then contraction, then expansion again. These fluctuations make up the business cycle.
• The point at which an expansion becomes a recession is called the peak of a business cycle; the point at which a recession becomes an expansion is called the trough.
• Over time, the general trend for most economies is one of rising real GDP. On average, real GDP in the United States has grown at a rate of over 3% per year since 1960.
Try It!
The data below show the behavior of real GDP in Turkey from the first quarter of 2001 through the third quarter of 2002. Use the data to plot real GDP in Turkey and indicate the phases of the business cycle.
Period Real GDP (billions of New Turkish lira, 1987 prices)
First quarter, 2001 24.1
Second quarter, 2001 26.0
Third quarter, 2001 33.1
Fourth quarter, 2001 27.1
First quarter, 2002 24.6
Second quarter, 2002 28.3
Third quarter, 2002 35.7
Case in Point: The Art of Predicting Recessions
Figure 20.3
Reynermedia – Numbers And Finance – CC BY 2.0.
People who make a living tracking the economy and trying to predict its future do not do a very good job at predicting turning points in economic activity. The 52 economists surveyed by the Wall Street Journal each month did predict that the economy would slip into a recession in the third quarter of 2008. They made that prediction, however, in October—after the third quarter had ended. In September, the last month of the third quarter, the average forecast among the 52 economists had the economy continuing to grow through the third and fourth quarters of 2008. That September survey was taken before the financial crisis hit, a crisis that took virtually everyone by surprise. Of course, as we have already noted, the third-quarter downturn had not been identified as a recession by the NBER’s Business Cycle Dating Committee as of November of 2008.
Predicting business cycle turning points has always been a tricky business. The experience of the recession of 2001 illustrates this. As the accompanying table shows, even as late as September 10, 2001, only 13 out of the 100 Blue Chip forecasters had answered in the affirmative to the question, “Has the United States slipped into a recession?” even though we now know the recession had begun the previous March. Comparing the data that were originally released by the U.S. Bureau of Economic Analysis shortly after the end of each quarter with the revised data that were released after July 2002 provides an important insight into explaining why the forecasters seem to have done so badly. As the graph on pre-revision and post-revision estimates of real GDP growth shows, the data released shortly after the end of each quarter showed an economy expanding through the second quarter of 2001, whereas the revised data show the economy contracting modestly in the first quarter of 2001 and then more forcefully in the second quarter. Only after the attacks on the World Trade Center in New York City and the Pentagon in Washington, D.C., on September 11, 2001, did most of the Blue Chip forecasters realize the economy was in recession.
The National Bureau of Economic Research (NBER) Business Cycle Dating Committee in November 2001 released a press announcement dating the onset of the recession as March 2001. The committee argued that “before the attacks of September 11, it is possible that the decline in the economy would have been too mild to qualify as a recession. The attacks clearly deepened the contraction and may have been an important factor in turning the episode into a recession.” While surprising at the time, the revised data suggest that the committee made a good call.
This episode in economic history also points out the difference between the common definition of a recession as two consecutive quarters of declining real GDP and the NBER Dating Committee’s continued insistence that it does not define a recession in this way. Rather the committee looks not only at real GDP but also at employment, income, and other factors. The behavior of employment during 2001 seems to have been an important factor in the November 2001 decision to proclaim March 2001 as the peak despite the misleading information on real GDP coming out of the Bureau of Economic Analysis at the time. The slow pickup in employment may also, though, have made it hesitate to call November 2001 the trough until July 2003.
Question posed: “Has the United States slipped into a recession?”
Date Percent of Blue Chip responders answering “Yes” Percent of Blue Chip responders answering “No”
February 2001 5 95
June 2001 7 93
July 2001 13 87
August 2001 5 85
September 10, 2001 13 87
September 19, 2001 82 18
Figure 20.4 Real GDP Growth: Pre- and Post-July, 2002
Answer to Try It! Problem
Figure 20.5
1Some economists prefer to break the expansion phase into two parts. The recovery phase is said to be the period between the previous trough and the time when the economy achieves its previous peak level of real GDP. The “expansion” phase is from that point until the following peak. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/05%3A_Macroeconomics%3A_The_Big_Picture/5.1%3A_Growth_of_Real_GDP_and_Business_Cycles.txt |
Learning Objective
1. Explain how unemployment is measured in the United States.
2. Define three different types of unemployment.
3. Define and illustrate graphically what is meant by the natural level of employment. Relate the natural level of employment to the natural rate of unemployment.
For an economy to produce all it can and achieve a solution on its production possibilities curve, the factors of production in the economy must be fully employed. Failure to fully employ these factors leads to a solution inside the production possibilities curve in which society is not achieving the output it is capable of producing.
In thinking about the employment of society’s factors of production, we place special emphasis on labor. The loss of a job can wipe out a household’s entire income; it is a more compelling human problem than, say, unemployed capital, such as a vacant apartment. In measuring unemployment, we thus focus on labor rather than on capital and natural resources.
Measuring Unemployment
The Bureau of Labor Statistics defines a person as unemployed if he or she is not working but is looking for and available for work. The labor force is the total number of people working or unemployed. The unemployment rate is the percentage of the labor force that is unemployed.
To estimate the unemployment rate, government surveyors fan out across the country each month to visit roughly 60,000 households. At each of these randomly selected households, the surveyor asks about the employment status of each adult (everyone age 16 or over) who lives there. Many households include more than one adult; the survey gathers information on about roughly 100,000 adults. The surveyor asks if each adult is working. If the answer is yes, the person is counted as employed. If the answer is no, the surveyor asks if that person has looked for work at some time during the previous four weeks and is available for work at the time of the survey. If the answer to that question is yes, the person is counted as unemployed. If the answer is no, that person is not counted as a member of the labor force. Figure 20.8 shows the survey’s results for the civilian (nonmilitary) population for November 2010. The unemployment rate is then computed as the number of people unemployed divided by the labor force—the sum of the number of people not working but available and looking for work plus the number of people working. In November 2010, the unemployment rate was 9.8%.
There are several difficulties with the survey. The old survey, designed during the 1930s, put the “Are you working?” question differently depending on whether the respondent was a man or woman. A man was asked, “Last week, did you do any work for pay or profit?” A woman was asked, “What were you doing for work last week, keeping house or something else?” Consequently, many women who were looking for paid work stated that they were “keeping house”; those women were not counted as unemployed. The BLS did not get around to fixing the survey—asking women the same question it asked men—until 1994. The first time the new survey question was used, the unemployment rate among women rose by 0.5 percentage point. More than 50 million women are in the labor force; the change added more than a quarter of a million workers to the official count of the unemployed 1.
The problem of understating unemployment among women has been fixed, but others remain. A worker who has been cut back to part-time work still counts as employed, even if that worker would prefer to work full time. A person who is out of work, would like to work, has looked for work in the past year, and is available for work, but who has given up looking, is considered a discouraged worker. Discouraged workers are not counted as unemployed, but a tally is kept each month of the number of discouraged workers.
The official measures of employment and unemployment can yield unexpected results. For example, when firms expand output, they may be reluctant to hire additional workers until they can be sure the demand for increased output will be sustained. They may respond first by extending the hours of employees previously reduced to part-time work or by asking full-time personnel to work overtime. None of that will increase employment, because people are simply counted as “employed” if they are working, regardless of how much or how little they are working. In addition, an economic expansion may make discouraged workers more optimistic about job prospects, and they may resume their job searches. Engaging in a search makes them unemployed again—and increases unemployment. Thus, an economic expansion may have little effect initially on employment and may even increase unemployment.
Types of Unemployment
Workers may find themselves unemployed for different reasons. Each source of unemployment has quite different implications, not only for the workers it affects but also for public policy.
Figure 20.9 applies the demand and supply model to the labor market. The price of labor is taken as the real wage, which is the nominal wage divided by the price level; the symbol used to represent the real wage is the Greek letter omega, ω. The supply curve is drawn as upward sloping, though steep, to reflect studies showing that the quantity of labor supplied at any one time is nearly fixed. Thus, an increase in the real wage induces a relatively small increase in the quantity of labor supplied. The demand curve shows the quantity of labor demanded at each real wage. The lower the real wage, the greater the quantity of labor firms will demand. In the case shown here, the real wage, ωe, equals the equilibrium solution defined by the intersection of the demand curve D1 and the supply curve S1. The quantity of labor demanded, Le, equals the quantity supplied. The employment level at which the quantity of labor demanded equals the quantity supplied is called the natural level of employment. It is sometimes referred to as full employment.
Even if the economy is operating at its natural level of employment, there will still be some unemployment. The rate of unemployment consistent with the natural level of employment is called the natural rate of unemployment. Business cycles may generate additional unemployment. We discuss these various sources of unemployment below.
Frictional Unemployment
Even when the quantity of labor demanded equals the quantity of labor supplied, not all employers and potential workers have found each other. Some workers are looking for jobs, and some employers are looking for workers. During the time it takes to match them up, the workers are unemployed. Unemployment that occurs because it takes time for employers and workers to find each other is called frictional unemployment.
The case of college graduates engaged in job searches is a good example of frictional unemployment. Those who did not land a job while still in school will seek work. Most of them will find jobs, but it will take time. During that time, these new graduates will be unemployed. If information about the labor market were costless, firms and potential workers would instantly know everything they needed to know about each other and there would be no need for searches on the part of workers and firms. There would be no frictional unemployment. But information is costly. Job searches are needed to produce this information, and frictional unemployment exists while the searches continue.
The government may attempt to reduce frictional unemployment by focusing on its source: information costs. Many state agencies, for example, serve as clearinghouses for job market information. They encourage firms seeking workers and workers seeking jobs to register with them. To the extent that such efforts make labor-market information more readily available, they reduce frictional unemployment.
Structural Unemployment
Another reason there can be unemployment even if employment equals its natural level stems from potential mismatches between the skills employers seek and the skills potential workers offer. Every worker is different; every job has its special characteristics and requirements. The qualifications of job seekers may not match those that firms require. Even if the number of employees firms demand equals the number of workers available, people whose qualifications do not satisfy what firms are seeking will find themselves without work. Unemployment that results from a mismatch between worker qualifications and the characteristics employers require is called structural unemployment.
Structural unemployment emerges for several reasons. Technological change may make some skills obsolete or require new ones. The widespread introduction of personal computers since the 1980s, for example, has lowered demand for typists who lacked computer skills.
Structural unemployment can occur if too many or too few workers seek training or education that matches job requirements. Students cannot predict precisely how many jobs there will be in a particular category when they graduate, and they are not likely to know how many of their fellow students are training for these jobs. Structural unemployment can easily occur if students guess wrong about how many workers will be needed or how many will be supplied.
Structural unemployment can also result from geographical mismatches. Economic activity may be booming in one region and slumping in another. It will take time for unemployed workers to relocate and find new jobs. And poor or costly transportation may block some urban residents from obtaining jobs only a few miles away.
Public policy responses to structural unemployment generally focus on job training and education to equip workers with the skills firms demand. The government publishes regional labor-market information, helping to inform unemployed workers of where jobs can be found. The North American Free Trade Agreement (NAFTA), which created a free trade region encompassing Mexico, the United States, and Canada, has created some structural unemployment in the three countries. In the United States, the legislation authorizing the pact also provided for job training programs for displaced U.S. workers.
Although government programs may reduce frictional and structural unemployment, they cannot eliminate it. Information in the labor market will always have a cost, and that cost creates frictional unemployment. An economy with changing demands for goods and services, changing technology, and changing production costs will always have some sectors expanding and others contracting—structural unemployment is inevitable. An economy at its natural level of employment will therefore have frictional and structural unemployment.
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. In a later chapter we will explore what happens when the economy generates employment greater or less than the natural level. Cyclical unemployment is unemployment in excess of the unemployment that exists at the natural level of employment.
Figure 20.10 shows the unemployment rate in the United States for the period from 1960 through November 2010. We see that it has fluctuated considerably. How much of it corresponds to the natural rate of unemployment varies over time with changing circumstances. For example, in a country with a demographic “bulge” of new entrants into the labor force, frictional unemployment is likely to be high, because it takes the new entrants some time to find their first jobs. This factor alone would raise the natural rate of unemployment. A demographic shift toward more mature workers would lower the natural rate. During recessions, highlighted in Figure 20.10, the part of unemployment that is cyclical unemployment grows. The analysis of fluctuations in the unemployment rate, and the government’s responses to them, will occupy center stage in much of the remainder of this book.
Key Takeaways
• People who are not working but are looking and available for work at any one time are considered unemployed. The unemployment rate is the percentage of the labor force that is unemployed.
• When the labor market is in equilibrium, employment is at the natural level and the unemployment rate equals the natural rate of unemployment.
• Even if employment is at the natural level, the economy will experience frictional and structural unemployment. Cyclical unemployment is unemployment in excess of that associated with the natural level of employment.
Try It!
Given the data in the table, compute the unemployment rate in Year 1 and in Year 2. Explain why, in this example, both the number of people employed and the unemployment rate increased.
Year Number employed (in millions) Number unemployed (in millions)
1 20 2
2 21 2.4
Case in Point: Might Increased Structural Unemployment Explain the “Jobless Recovery” Following the 2001 Recession?
Figure 20.11
Kathryn Decker – The grindstone – CC BY 2.0.
The U.S. 2001 recession was mild by historical standards, but recovery in terms of increased employment seemed painfully slow in coming. Economists Erica Goshen and Simon Potter at the Federal Reserve Bank of New York think the reason for the slow recovery in jobs may have actually reflected structural changes in the U.S. economy. They argue that during the recession permanent rather than temporary layoffs predominated and that it takes longer for firms to hire workers into new positions than to hire them back into former jobs.
What is their evidence? When the layoff is temporary, the employer “suspends” the job, due to slack demand, and the employee expects to be recalled once demand picks up. With a permanent layoff, the employer eliminates the job. So, they looked at the contribution of temporary layoffs to the unemployment rate during the recent recession compared to the situation in the four recessions before 1990. In the earlier recessions, unemployment from temporary layoffs rose when the economy was shrinking and fell after the economy began to recover. In both the 1991 and 2001 recessions, temporary layoffs were minor. Then, the authors examined job flows in 70 industries. They classified layoffs in an industry as being cyclical in nature if the job losses during the recession were reversed during the recovery but structural if job losses for the industry continued during the recovery. Their analysis revealed that during the recession of the early 1980s, job losses were about evenly split between cyclical and structural changes. In the 1991 recession and then more strongly in the 2001 recession, structural changes dominated. “Most of the industries that lost jobs during the [2001] recession—for example, communications, electronic equipment, and securities and commodities brokers—[were] still losing jobs” in 2003. “The trend revealed . . . is one in which jobs are relocated from some industries to others, not reclaimed by the same industries that lost them earlier.”
The authors suggest three possible reasons for the recent increased role of structural change: (1) The structural decline in some industries could be the result of overexpansion in those industries during the 1990s. The high tech and telecommunications industries in particular could be examples of industries that were overbuilt before the 2001 recession. (2) Improved government policies may have reduced cyclical unemployment. Examination of macroeconomic policy in future chapters will return to this issue. (3) New management strategies to reduce costs may be promoting leaner staffing. For firms adopting such strategies, a recession may provide an opportunity to reorganize the production process permanently and reduce payrolls in the process.
Goshen and Potter point out that, for workers, finding new jobs is harder than simply returning to old ones. For firms, making decisions about the nature of new jobs is time consuming at best. The uncertainty created by the war in Iraq and the imposition of new accounting standards following the “Enron”-like scandals may have further prolonged the creation of new jobs.
Answer to Try It! Problem
In Year 1 the total labor force includes 22 million workers, and so the unemployment rate is 2/22 = 9.1%. In Year 2 the total labor force numbers 23.4 million workers; therefore the unemployment rate is 2.4/23.4 = 10.3%. In this example, both the number of people employed and the unemployment rate rose, because more people (23.4 − 22 = 1.4 million) entered the labor force, of whom 1 million found jobs and 0.4 million were still looking for jobs.
1For a description of the new survey and other changes introduced in the method of counting unemployment, see Janet L. Norwood and Judith M. Tanur, “Unemployment Measures for the Nineties,” Public Opinion Quarterly 58, no. 2 (Summer 1994): 277–94. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/05%3A_Macroeconomics%3A_The_Big_Picture/5.3%3A_Unemployment.txt |
Summary
In this chapter we examined growth in real GDP and business cycles, price-level changes, and unemployment. We saw how these phenomena are defined and looked at their consequences.
Examining real GDP, rather than nominal GDP, over time tells us whether the economy is expanding or contracting. Real GDP in the United States shows a long upward trend, but with the economy going through phases of expansion and recession around that trend. These phases make up the business cycle. An expansion reaches a peak, and the economy falls into a recession. The recession reaches a trough and begins an expansion again.
Inflation is an increase in the price level and deflation is a decrease in the price level. The rate of inflation or deflation is the percentage rate of change in a price index. We looked at the calculation of the consumer price index (CPI) and the implicit price deflator. The CPI is widely used in the calculation of price-level changes. There are, however, biases in its calculation: the substitution bias, the new-product bias, the quality-change bias, and the outlet bias.
Inflation and deflation affect economic activity in several ways. They change the value of money and of claims on money. Unexpected inflation benefits borrowers and hurts lenders. Unexpected deflation benefits lenders and hurts borrowers. Both inflation and deflation create uncertainty and make it difficult for individuals and firms to enter into long-term financial commitments.
The unemployment rate is measured as the percentage of the labor force not working but seeking work. Frictional unemployment occurs because information about the labor market is costly; it takes time for firms seeking workers and workers seeking firms to find each other. Structural unemployment occurs when there is a mismatch between the skills offered by potential workers and the skills sought by firms. Both frictional and structural unemployment occur even if employment and the unemployment rate are at their natural levels. Cyclical unemployment is unemployment that is in excess of that associated with the natural level of employment.
Concept Problems
1. Describe the phases of a business cycle.
2. On the basis of recent news reports, what phase of the business cycle do you think the economy is in now? What is the inflation or deflation rate? The unemployment rate?
3. Suppose you compare your income this year and last year and find that your nominal income fell but your real income rose. How could this have happened?
4. Suppose you calculate a grocery price inflation rate. Using the arguments presented in the chapter, explain possible sources of upward bias in the rate you calculate, relative to the actual trend of food prices.
5. Name three items you have purchased during the past year that have increased in quality during the year. What kind of adjustment would you make in assessing their prices for the CPI?
6. Why do some people gain and other people lose from inflation and deflation?
7. Suppose unemployed people leave a state to obtain jobs in other states. What do you predict will happen to the unemployment rate in the state experiencing the out-migration? What might happen to the unemployment rates in the states experiencing in-migration?
8. Minority teenagers have the highest unemployment rates of any group. One reason for this phenomenon is high transportation costs for many minority teens. What form of unemployment (cyclical, frictional, or structural) do high transportation costs suggest?
9. Welfare reforms enacted in 1996 put more pressure on welfare recipients to look for work. The new law mandated cutting off benefits after a certain length of time. How do you think this provision might affect the unemployment rate?
10. American workers work more hours than their European counterparts. Should Congress legislate a shorter workweek?
Numerical Problems
1. Plot the quarterly data for real GDP for the last two years. (You can find the data in the Survey of Current Business or in Current Economic Indicators in the current periodicals section of your library. Alternatively, go to the White House, Economic Statistics Briefing Room at www.whitehouse.gov/fsbr/esbr.html. Relate recent changes in real GDP to the concept of the phases of the business cycle.)
2. Suppose that in 2009, the items in the market basket for our movie price index cost \$53.40. Use the information in the chapter to compute the price index for that year. How does the rate of movie price inflation from 2008 to 2009 compare with the rate from 2007 to 2008?
3. Recompute the movie price indexes for 2007 and 2008 using 2008 as the base year. Now compute the rate of inflation for the 2007–2008 period. Compare your result to the inflation rate calculated for that same period using 2007 as the base year.
4. Here are some statistics for August 2006. Compute the unemployment rate for that month (all figures are in thousands).
Population (Civilian, noninstitutional) 229,167
Civilian Labor Force 151,698
Participation Rate 66.2%
Not in Labor Force 77,469
Employed 144,579
Unemployed 7,119
5. Suppose an economy has 10,000 people who are not working but looking and available for work and 90,000 people who are working. What is its unemployment rate? Now suppose 4,000 of the people looking for work get discouraged and give up their searches. What happens to the unemployment rate? Would you interpret this as good news for the economy or bad news? Explain.
6. The average price of going to a baseball game in 2008, based on the observations in the Case in Point, was \$191.92. Using this average as the equivalent of a base year, compute fan price indexes for:
1. The New York Yankees.
2. The Chicago Cubs.
3. The Boston Red Sox.
4. The Tampa Bay Rays.
5. The team of your choice.
7. Suppose you are given the following data for a small economy:
Number of unemployed workers: 1,000,000.
Labor force: 10,000,000.
Based on this data, answer following:
1. What is the unemployment rate?
2. Can you determine whether the economy is operating at its full employment level?
3. Now suppose people who had been seeking jobs become discouraged, and give up their job searches. The labor force shrinks to 900,500 workers, and unemployment falls to 500,000 workers. What is the unemployment rate now? Has the economy improved?
8. Nominal GDP for an economy is \$10 trillion. Real GDP is \$9 trillion. What is the value of the implicit price deflator?
9. Suppose you are given the following data for an economy:
Month Real GDP Employment
1 \$10.0 trillion 100 million
2 \$10.4 trillion 104 million
3 \$10.5 trillion 105 million
4 \$10.3 trillion 103 million
5 \$10.2 trillion 102 million
6 \$10.3 trillion 103 million
7 \$10.6 trillion 106 million
8 \$10.7 trillion 107 million
9 \$10.6 trillion 106 million
1. Plot the data for real GDP, with the time period on the horizontal axis and real GDP on the vertical axis.
2. There are two peaks. When do they occur?
3. When does the trough occur?
10. The Consumer Price Index in Period 1 is 107.5. It is 103.8 in Period 2. Is this a situation of inflation for deflation? What is the rate? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/05%3A_Macroeconomics%3A_The_Big_Picture/5.4%3A_Review_and_Practice.txt |
Thumbnail: https://pixabay.com/illustrations/dollar-money-us-dollar-arrangement-1071788/
06: Measuring Total Output and Income
Learning Objective
1. Define gross domestic product and its four major spending components and illustrate the various flows using the circular flow model.
2. Distinguish between measuring GDP as the sum of the values of final goods and services and as the sum of values added at each stage of production.
3. Distinguish between gross domestic product and gross national product.
An economy produces a mind-boggling array of goods and services. In 2007, for example, Domino’s Pizza produced 400 million pizzas. The United States Steel Corporation, the nation’s largest steel company, produced 23.6 million tons of steel. Strong Brothers Lumber Co., a Colorado firm, produced 2.1 million board feet of lumber. The Louisiana State University football team drew 722,166 fans to its home games—and won the national championship. Leonor Montenegro, a pediatric nurse in Los Angeles, delivered 387 babies and took care of 233 additional patients. A list of all the goods and services produced in any year would be virtually endless.
So—what kind of year was 2007? We would not get very far trying to wade through a list of all the goods and services produced that year. It is helpful to have instead a single number that measures total output in the economy; that number is GDP.
The Components of GDP
We can divide the goods and services produced during any period into four broad components, based on who buys them. These components of GDP are personal consumption (C), gross private domestic investment (I), government purchases (G), and net exports (Xn). Thus
Equation 21.1
or
We will examine each of these components, and we will see how each fits into the pattern of macroeconomic activity. Before we begin, it will be helpful to distinguish between two types of variables: stocks and flows. A flow variable is a variable that is measured over a specific period of time. A stock variable is a variable that is independent of time. Income is an example of a flow variable. To say one’s income is, for example, \$1,000 is meaningless without a time dimension. Is it \$1,000 per hour? Per day? Per week? Per month? Until we know the time period, we have no idea what the income figure means. The balance in a checking account is an example of a stock variable. When we learn that the balance in a checking account is \$1,000, we know precisely what that means; we do not need a time dimension. We will see that stock and flow variables play very different roles in macroeconomic analysis.
Personal Consumption
Personal consumption is a flow variable that measures the value of goods and services purchased by households during a time period. Purchases by households of groceries, health-care services, clothing, and automobiles—all are counted as consumption.
The production of consumer goods and services accounts for about 70% of total output. Because consumption is such a large part of GDP, economists seeking to understand the determinants of GDP must pay special attention to the determinants of consumption. In a later chapter we will explore these determinants and the impact of consumption on economic activity.
Personal consumption represents a demand for goods and services placed on firms by households. In the chapter on demand and supply, we saw how this demand could be presented in a circular flow model of the economy. Figure 21.1 presents a circular flow model for an economy that produces only personal consumption goods and services. (We will add the other components of GDP to the circular flow as we discuss them.) Spending for these goods flows from households to firms; it is the arrow labeled “Personal consumption.” Firms produce these goods and services using factors of production: labor, capital, and natural resources. These factors are ultimately owned by households. The production of goods and services thus generates income to households; we see this income as the flow from firms to households labeled “Factor incomes” in the exhibit.
In exchange for payments that flow from households to firms, there is a flow of consumer goods and services from firms to households. This flow is shown in Figure 21.1 as an arrow going from firms to households. When you buy a soda, for example, your payment to the store is part of the flow of personal consumption; the soda is part of the flow of consumer goods and services that goes from the store to a household—yours.
Similarly, the lower arrow in Figure 21.1 shows the flow of factors of production—labor, capital, and natural resources—from households to firms. If you work for a firm, your labor is part of this flow. The wages you receive are part of the factor incomes that flow from firms to households.
There is a key difference in our interpretation of the circular flow picture in Figure 21.1 from our analysis of the same model in the demand and supply chapter. There, our focus was microeconomics, which examines individual units of the economy. In thinking about the flow of consumption spending from households to firms, we emphasized demand and supply in particular markets—markets for such things as blue jeans, haircuts, and apartments. In thinking about the flow of income payments from firms to households, we focused on the demand and supply for particular factors of production, such as textile workers, barbers, and apartment buildings. Because our focus now is macroeconomics, the study of aggregates of economic activity, we will think in terms of the total of personal consumption and the total of payments to households.
Private Investment
Gross private domestic investment is the value of all goods produced during a period for use in the production of other goods and services. Like personal consumption, gross private domestic investment is a flow variable. It is often simply referred to as “private investment.” A hammer produced for a carpenter is private investment. A printing press produced for a magazine publisher is private investment, as is a conveyor-belt system produced for a manufacturing firm. Capital includes all the goods that have been produced for use in producing other goods; it is a stock variable. Private investment is a flow variable that adds to the stock of capital during a period.
Heads Up!
The term “investment” can generate confusion. In everyday conversation, we use the term “investment” to refer to uses of money to earn income. We say we have invested in a stock or invested in a bond. Economists, however, restrict “investment” to activities that increase the economy’s stock of capital. The purchase of a share of stock does not add to the capital stock; it is not investment in the economic meaning of the word. We refer to the exchange of financial assets, such as stocks or bonds, as financial investment to distinguish it from the creation of capital that occurs as the result of investment. Only when new capital is produced does investment occur. Confusing the economic concept of private investment with the concept of financial investment can cause misunderstanding of the way in which key components of the economy relate to one another.
Gross private domestic investment includes three flows that add to or maintain the nation’s capital stock: expenditures by business firms on new buildings, plants, tools, equipment, and software that will be used in the production of goods and services; expenditures on new residential housing; and changes in business inventories. Any addition to a firm’s inventories represents an addition to investment; a reduction subtracts from investment. For example, if a clothing store stocks 1,000 pairs of jeans, the jeans represent an addition to inventory and are part of gross private domestic investment. As the jeans are sold, they are subtracted from inventory and thus subtracted from investment.
By recording additions to inventories as investment and reductions from inventories as subtractions from investment, the accounting for GDP records production in the period in which it occurs. Suppose, for example, that Levi Strauss manufactures 1 million pairs of jeans late in 2007 and distributes them to stores at the end of December. The jeans will be added to inventory; they thus count as investment in 2007 and enter GDP for that year. Suppose they are sold in January 2008. They will be counted as consumption in GDP for 2008 but subtracted from inventory, and from investment. Thus, the production of the jeans will add to GDP in 2007, when they were produced. They will not count in 2008, save for any increase in the value of the jeans resulting from the services provided by the retail stores that sold them.
Private investment accounts for about 16% of GDP and at times even less. Despite its relatively small share of total economic activity, private investment plays a crucial role in the macroeconomy for two reasons:
1. Private investment represents a choice to forgo current consumption in order to add to the capital stock of the economy. Private investment therefore adds to the economy’s capacity to produce and shifts its production possibilities curve outward. Investment is thus one determinant of economic growth, which is explored in another chapter.
2. Private investment is a relatively volatile component of GDP; it can change dramatically from one year to the next. Fluctuations in GDP are often driven by fluctuations in private investment. We will examine the determinants of private investment in a chapter devoted to the study of investment.
Private investment represents a demand placed on firms for the production of capital goods. While it is a demand placed on firms, it flows from firms. In the circular flow model in Figure 21.2, we see a flow of investment going from firms to firms. The production of goods and services for consumption generates factor incomes to households; the production of capital goods for investment generates income to households as well.
Figure 21.2 shows only spending flows and omits the physical flows represented by the arrows in Figure 21.1. This simplification will make our analysis of the circular flow model easier. It will also focus our attention on spending flows, which are the flows we will be studying.
Government Purchases
Government agencies at all levels purchase goods and services from firms. They purchase office equipment, vehicles, buildings, janitorial services, and so on. Many government agencies also produce goods and services. Police departments produce police protection. Public schools produce education. The National Aeronautics and Space Administration (NASA) produces space exploration.
Government purchases are the sum of purchases of goods and services from firms by government agencies plus the total value of output produced by government agencies themselves during a time period. Government purchases make up about 20% of GDP.
Government purchases are not the same thing as government spending. Much government spending takes the form of transfer payments, which are payments that do not require the recipient to produce a good or service in order to receive them. Transfer payments include Social Security and other types of assistance to retired people, welfare payments to poor people, and unemployment compensation to people who have lost their jobs. Transfer payments are certainly significant—they account for roughly half of all federal government spending in the United States. They do not count in a nation’s GDP, because they do not reflect the production of a good or service.
Government purchases represent a demand placed on firms, represented by the flow shown in Figure 21.3. Like all the components of GDP, the production of goods and services for government agencies creates factor incomes for households.
Net Exports
Sales of a country’s goods and services to buyers in the rest of the world during a particular time period represent its exports. A purchase by a Japanese buyer of a Ford Taurus produced in the United States is a U.S. export. Exports also include such transactions as the purchase of accounting services from a New York accounting firm by a shipping line based in Hong Kong or the purchase of a ticket to Disney World by a tourist from Argentina. Imports are purchases of foreign-produced goods and services by a country’s residents during a period. United States imports include such transactions as the purchase by Americans of cars produced in Japan or tomatoes grown in Mexico or a stay in a French hotel by a tourist from the United States. Subtracting imports from exports yields net exports.
Equation 21.2
In the third quarter of 2010, foreign buyers purchased \$1,847.0 billion worth of goods and services from the United States. In the same year, U.S. residents, firms, and government agencies purchased \$2,339.1 billion worth of goods and services from foreign countries. The difference between these two figures, −\$552.2 billion, represented the net exports of the U.S. economy in the third quarter of 2010. Net exports were negative because imports exceeded exports. Negative net exports constitute a trade deficit. The amount of the deficit is the amount by which imports exceed exports. When exports exceed imports there is a trade surplus. The magnitude of the surplus is the amount by which exports exceed imports.
The United States has recorded more deficits than surpluses since World War II, but the amounts have typically been relatively small, only a few billion dollars. The trade deficit began to soar, however, in the 1980s and again in the 2000s. We will examine the reasons for persistent trade deficits in another chapter. The rest of the world plays a key role in the domestic economy and, as we will see later in the book, there is nothing particularly good or bad about trade surpluses or deficits. Goods and services produced for export represent roughly 13% of GDP, and the goods and services the United States imports add significantly to our standard of living.
In the circular flow diagram in Figure 21.4, net exports are shown with an arrow connecting firms to the rest of the world. The balance between the flows of exports and imports is net exports. When there is a trade surplus, net exports are positive and add spending to the circular flow. A trade deficit implies negative net exports; spending flows from firms to the rest of the world.
The production of goods and services for personal consumption, private investment, government purchases, and net exports makes up a nation’s GDP. Firms produce these goods and services in response to demands from households (personal consumption), from other firms (private investment), from government agencies (government purchases), and from the rest of the world (net exports). All of this production creates factor income for households. Figure 21.5 shows the circular flow model for all the spending flows we have discussed. Each flow is numbered for use in the exercise at the end of this section.
The circular flow model identifies some of the forces at work in the economy, forces that we will be studying in later chapters. For example, an increase in any of the flows that place demands on firms (personal consumption, private investment, government purchases, and exports) will induce firms to expand their production. This effect is characteristic of the expansion phase of the business cycle. An increase in production will require firms to employ more factors of production, which will create more income for households. Households are likely to respond with more consumption, which will induce still more production, more income, and still more consumption. Similarly, a reduction in any of the demands placed on firms will lead to a reduction in output, a reduction in firms’ use of factors of production, a reduction in household incomes, a reduction in income, and so on. This sequence of events is characteristic of the contraction phase of the business cycle. Much of our work in macroeconomics will involve an analysis of the forces that prompt such changes in demand and an examination of the economy’s response to them.
Figure 21.6 shows the size of the components of GDP in 2010. We see that the production of goods and services for personal consumption accounted for about 70% of GDP. Imports exceeded exports, so net exports were negative.
Final Goods and Value Added
GDP is the total value of all final goods and services produced during a particular period valued at prices in that period. That is not the same as the total value of all goods and services produced during a period. This distinction gives us another method of estimating GDP in terms of output.
Suppose, for example, that a logger cuts some trees and sells the logs to a sawmill. The mill makes lumber and sells it to a construction firm, which builds a house. The market price for the lumber includes the value of the logs; the price of the house includes the value of the lumber. If we try to estimate GDP by adding the value of the logs, the lumber, and the house, we would be counting the lumber twice and the logs three times. This problem is called “double counting,” and the economists who compute GDP seek to avoid it.
In the case of logs used for lumber and lumber produced for a house, GDP would include the value of the house. The lumber and the logs would not be counted as additional production because they are intermediate goods that were produced for use in building the house.
Another approach to estimating the value of final production is to estimate for each stage of production the value added, the amount by which the value of a firm’s output exceeds the value of the goods and services the firm purchases from other firms. Table 21.1 “Final Value and Value Added” illustrates the use of value added in the production of a house.
Table 21.1 Final Value and Value Added
Good Produced by Purchased by Price Value Added
Logs Logger Sawmill \$12,000 \$12,000
Lumber Sawmill Construction firm \$25,000 \$13,000
House Construction firm Household \$125,000 \$100,000
Final Value \$125,000
Sum of Values Added \$125,000
If we sum the value added at each stage of the production of a good or service, we get the final value of the item. The example shown here involves the construction of a house, which is produced from lumber that is, in turn, produced from logs.
Suppose the logs produced by the logger are sold for \$12,000 to a mill, and that the mill sells the lumber it produces from these logs for \$25,000 to a construction firm. The construction firm uses the lumber to build a house, which it sells to a household for \$125,000. (To simplify the example, we will ignore inputs other than lumber that are used to build the house.) The value of the final product, the house, is \$125,000. The value added at each stage of production is estimated as follows:
1. The logger adds \$12,000 by cutting the logs.
2. The mill adds \$13,000 (\$25,000 − \$12,000) by cutting the logs into lumber.
3. The construction firm adds \$100,000 (\$125,000 − \$25,000) by using the lumber to build a house.
The sum of values added at each stage (\$12,000 + \$13,000 + \$100,000) equals the final value of the house, \$125,000.
The value of an economy’s output in any period can thus be estimated in either of two ways. The values of final goods and services produced can be added directly, or the values added at each stage in the production process can be added. The Commerce Department uses both approaches in its estimate of the nation’s GDP.
GNP: An Alternative Measure of Output
While GDP represents the most commonly used measure of an economy’s output, economists sometimes use an alternative measure. Gross national product (GNP) is the total value of final goods and services produced during a particular period with factors of production owned by the residents of a particular country.
The difference between GDP and GNP is a subtle one. The GDP of a country equals the value of final output produced within the borders of that country; the GNP of a country equals the value of final output produced using factors owned by residents of the country. Most production in a country employs factors of production owned by residents of that country, so the two measures overlap. Differences between the two measures emerge when production in one country employs factors of production owned by residents of other countries.
Suppose, for example, that a resident of Bellingham, Washington, owns and operates a watch repair shop across the Canadian–U.S. border in Victoria, British Columbia. The value of watch repair services produced at the shop would be counted as part of Canada’s GDP because they are produced in Canada. That value would not, however, be part of U.S. GDP. But, because the watch repair services were produced using capital and labor provided by a resident of the United States, they would be counted as part of GNP in the United States and not as part of GNP in Canada.
Because most production fits in both a country’s GDP as well as its GNP, there is seldom much difference between the two measures. The relationship between GDP and GNP is given by
Equation 21.3
GDP + net income received from abroad by residents of a nation = GNP
In the third quarter of 2010, for example, GDP equaled \$14,750.2 billion. We add income receipts earned by residents of the United States from the rest of the world of \$706.0 billion and then subtract income payments that went from the United States to the rest of the world of \$516.1 billion to get GNP of \$14,940.0 billion for the third quarter of 2010. GNP is often used in international comparisons of income; we shall examine those later in this chapter.
Key Takeaways
• GDP is the sum of final goods and services produced for consumption (C), private investment (I), government purchases (G), and net exports (Xn). Thus GDP = C + I + G + Xn.
• GDP can be viewed in the context of the circular flow model. Consumption goods and services are produced in response to demands from households; investment goods are produced in response to demands for new capital by firms; government purchases include goods and services purchased by government agencies; and net exports equal exports less imports.
• Total output can be measured two ways: as the sum of the values of final goods and services produced and as the sum of values added at each stage of production.
• GDP plus net income received from other countries equals GNP. GNP is the measure of output typically used to compare incomes generated by different economies.
Try It!
Here is a two-part exercise.
1. Suppose you are given the following data for an economy:
Personal consumption \$1,000
Home construction 100
Increase in inventories 40
Equipment purchases by firms 60
Government purchases 100
Social Security payments to households 40
Government welfare payments 100
Exports 50
Imports 150
Identify the number of the flow in Figure 21.5 to which each of these items corresponds. What is the economy’s GDP?
2. Suppose a dairy farm produces raw milk, which it sells for \$1,000 to a dairy. The dairy produces cream, which it sells for \$3,000 to an ice cream manufacturer. The ice cream manufacturer uses the cream to make ice cream, which it sells for \$7,000 to a grocery store. The grocery store sells the ice cream to consumers for \$10,000. Compute the value added at each stage of production, and compare this figure to the final value of the product produced. Report your results in a table similar to that given in Table 21.1 “Final Value and Value Added”.
Case in Point: The Spread of the Value Added Tax
Figure 21.7
401(K) 2012 – Tax – CC BY-SA 2.0.
Outside the United States, the value added tax (VAT) has become commonplace. Governments of more than 120 countries use it as their primary means of raising revenue. While the concept of the VAT originated in France in the 1920s, no country adopted it until after World War II. In 1948, France became the first country in the world to use the VAT. In 1967, Brazil became the first country in the Western Hemisphere to do so. The VAT spread to other western European and Latin American countries in the 1970s and 1980s and then to countries in the Asia/Pacific region, central European and former Soviet Union area, and Africa in the 1990s and early 2000s.
What is the VAT? It is equivalent to a sales tax on final goods and services but is collected at each stage of production.
Take the example given in Table 21.1 “Final Value and Value Added”, which is a simplified illustration of a house built in three stages. If there were a sales tax of 10% on the house, the household buying it would pay \$137,500, of which the construction firm would keep \$125,000 of the total and turn \$12,500 over to the government.
With a 10% VAT, the sawmill would pay the logger \$13,200, of which the logger would keep \$12,000 and turn \$1,200 over to the government. The sawmill would sell the lumber to the construction firm for \$27,500—keeping \$26,200, which is the \$25,000 for the lumber itself and \$1,200 it already paid in tax. The government at this stage would get \$1,300, the difference between the \$2,500 the construction firm collected as tax and the \$1,200 the sawmill already paid in tax to the logger at the previous stage. The household would pay the construction firm \$137,500. Of that total, the construction firm would turn over to the government \$10,000, which is the difference between the \$12,500 it collected for the government in tax from the household and the \$2,500 in tax that it already paid when it bought the lumber from the sawmill. The table below shows that in the end, the tax revenue generated by a 10% VAT is the same as that generated by a 10% tax on final sales.
Why bother to tax in stages instead of just on final sales? One reason is simply record keeping, since it may be difficult to determine in practice if any particular sale is the final one. In the example, the construction firm does not need to know if it is selling the house to a household or to some intermediary business.
Also, the VAT may lead to higher revenue collected. For example, even if somehow the household buying the house avoided paying the tax, the government would still have collected some tax revenue at earlier stages of production. With a tax on retail sales, it would have collected nothing. The VAT has another advantage from the point of view of government agencies. It has the appearance at each stage of taking a smaller share. The individual amounts collected are not as obvious to taxpayers as a sales tax might be.
Good Price Value Added Tax Collected − Tax Already Paid = Value Added Tax
Logs \$12,000 \$12,000 \$1,200 − \$0 = \$1,200
Lumber \$25,000 \$13,000 \$2,500 − \$1,200 = \$1,300
House \$125,000 \$100,000 \$12,500 − \$2,500 = \$10,000
Total \$16,200 −\$3,700 = \$12,500
Answer to Try It! Problem
1. GDP equals \$1,200 and is computed as follows (the numbers in parentheses correspond to the flows in Figure 21.5):
Personal consumption (1) \$1,000
Private investment (2) 200
Housing 100
Equipment and software 60
Inventory change 40
Government purchases (3) 100
Net exports (4) −100
GDP \$1,200
Notice that neither welfare payments nor Social Security payments to households are included. These are transfer payments, which are not part of the government purchases component of GDP.
2. Here is the table of value added.
Good Produced by Purchased by Price Value Added
Raw milk Dairy farm Dairy \$1,000 \$1,000
Cream Dairy Ice cream maker 3,000 2,000
Ice cream Ice cream manufacturer Grocery store 7,000 4,000
Retail ice cream Grocery store Consumer 10,000 3,000
Final Value \$10,000
Sum of Values Added \$10,000 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/06%3A_Measuring_Total_Output_and_Income/6.1%3A_Measuring_Total_Output.txt |
Learning Objective
1. Define gross domestic income and explain its relationship to gross domestic product.
2. Discuss the components of gross domestic income.
3. Define disposable personal income and explain how to calculate it from GDP.
We saw in the last section that the production of goods and services generates factor incomes to households. The production of a given value of goods and services generates an equal value of total income. Gross domestic income (GDI) equals the total income generated in an economy by the production of final goods and services during a particular period. It is a flow variable. Because an economy’s total output equals the total income generated in producing that output, GDP = GDI. We can estimate GDP either by measuring total output or by measuring total income.
Consider a \$4 box of Cheerios. It is part of total output and thus is part of GDP. Who gets the \$4? Part of the answer to that question can be found by looking at the cereal box. Cheerios are made from oat flour, wheat starch, sugar, salt, and a variety of vitamins and minerals. Therefore, part of the \$4 goes to the farmers who grew the oats, the wheat, and the beets or cane from which the sugar was extracted. Workers and machines at General Mills combined the ingredients, crafted all those little O’s, toasted them, and put them in a box. The workers were paid part of the \$4 as wages. The owners of General Mills and the capital it used received part of the \$4 as profit. The box containing the Cheerios was made from a tree, so a lumber company somewhere received part of the \$4. The truck driver who brought the box of cereal to the grocery store got part of the \$4, as did the owner of the truck itself and the owner of the oil that fueled the truck. The clerk who rang up the sale at the grocery store was paid part of the \$4. And so on.
How much of the \$4 was income generated in the production of the Cheerios? The answer is simple: all of it. Some of the money went to workers as wages. Some went to owners of the capital and natural resources used to produce it. Profits generated along the way went to the owners of the firms involved. All these items represent costs of producing the Cheerios and also represent income to households.
Part of the \$4 cost of the Cheerios, while it makes up a portion of GDI, does not represent ordinary income actually earned by households. That part results from two other production costs: depreciation and taxes related to the production of the Cheerios. Nevertheless, they are treated as a kind of income; we will examine their role in GDI below.
As it is with Cheerios, so it is with everything else. The value of output equals the income generated as the output is produced.
The Components of GDI
Employee compensation is the largest among the components of factor income. Factor income also includes profit, rent, and interest. In addition, GDI includes charges for depreciation and taxes associated with production. Depreciation and production-related taxes, such as sales taxes, make up part of the cost of producing goods and services and must be accounted for in estimating GDI. We will discuss each of these components of GDI next.
Employee Compensation
Compensation of employees in the form of wages, salaries, and benefits makes up the largest single component of income generated in the production of GDP. In the second quarter of 2008, employee compensation represented 57% of GDI.
The structure of employee compensation has changed dramatically in the last several decades. In 1950, virtually all employee compensation—95% of it—came in the form of wages and salaries. The remainder, about 5%, came in the form of additional benefits such as employer contributions to retirement programs and health insurance. In 2008, the share of benefits was roughly 20% of total employee compensation.
Profits
The profit component of income earned by households equals total revenues of firms less costs as measured by conventional accounting. Profits amounted to about 16% of GDI, or \$2,332.2 billion in 2010, down sharply from five decades earlier, when profits represented about 25% of the income generated in GDI1.
Profits are the reward the owners of firms receive for being in business. The opportunity to earn profits is the driving force behind production in a market economy.
Rental Income
Rental income, such as the income earned by owners of rental housing or payments for the rent of natural resources, is the smallest component of GDI (about 2%); it is the smallest of the income flows to households. The meaning of rent in the computation of GDI is the same as its meaning in conventional usage; it is a charge for the temporary use of some capital asset or natural resource2.
Net Interest
Businesses both receive and pay interest. GDI includes net interest, which equals interest paid less interest received by domestic businesses, plus interest received from foreigners less interest paid to foreigners. Interest payments on mortgage and home improvement loans are counted as interest paid by business, because homeowners are treated as businesses in the income accounts. In 2010 net interest accounted for 6.3% of GDI.
Depreciation
Over time the machinery and buildings that are used to produce goods and services wear out or become obsolete. A farmer’s tractor, for example, wears out as it is used. A technological change may make some equipment obsolete. The introduction of personal computers, for example, made the electric typewriters used by many firms obsolete. Depreciation is a measure of the amount of capital that wears out or becomes obsolete during a period. Depreciation is referred to in official reports as the consumption of fixed capital.
Depreciation is a cost of production, so it represents part of the price charged for goods and services. It is therefore counted as part of the income generated in the production of those goods and services. Depreciation represented about 13% of GDI in 2008.
Indirect Taxes
The final component of the income measure of GDI is indirect business taxes3. Indirect taxes are taxes imposed on the production or sale of goods and services or on other business activity. (By contrast, a direct tax is a tax imposed directly on income; the personal income and corporate income taxes are direct taxes.) Indirect taxes, which include sales and excise taxes and property taxes, make up part of the cost to firms of producing goods and services. Like depreciation, they are part of the price of those goods and services and are therefore treated as part of the income generated in their production. Indirect business taxes amounted to 7.7% of GDI in 2010.
Table 21.2 “GDP and GDI, 2010” shows the components of GDI in 2010. Employee compensation represented the largest share of GDI. The exhibit also shows the components of GDP for the same year.
In principle, GDP and GDI should be equal, but their estimated values never are, because the data come from different sources. Output data from a sample of firms are used to estimate GDP, while income data from a sample of households are used to estimate GDI. The difference is the statistical discrepancy shown in the right-hand column of Table 21.2 “GDP and GDI, 2010”. Some of the difficulties with these data are examined in the Case in Point feature on discrepancies between GDP and GDI.
Table 21.2 GDP and GDI, 2010
Gross domestic product \$14,750.2 Gross Domestic Income \$14,584.8
Personal Consumption Expenditures 10,383.6 Compensation of Employees 8,040.8
Gross Private Domestic Investment 1,895.3 Profits4 2,332.3
Government consumption expenditures and gross investment 3,023.5 Rental income of persons 304.7
Net exports of goods and services – 552.2 Net interest 913.9
Taxes on production and imports5 1,121.0
Consumption of fixed capital (depreciation) 1872.1
Statistical discrepancy 165.4
The table shows the composition of GDP and GDI in the third quarter of 2010 (in billions of dollars at an annual rate). Notice the rough equality of the two measures. (They are not quite equal because of measurement errors; the difference is due to a statistical discrepancy and is reduced significantly over time as the data are revised.)
Tracing Income from the Economy to Households
We have seen that the production of goods and services generates income for households. Thus, the value of total output equals the value of total income in an economy. But we have also seen that our measure of total income, GDI, includes such things as depreciation and indirect business taxes that are not actually received by households. Households also receive some income, such as transfer payments, that does not count as part of GDP or GDI. Because the income households actually receive plays an important role in determining their consumption, it is useful to examine the relationship between a nation’s total output and the income households actually receive.
Table 21.3 “From GDP to Disposable Personal Income” traces the path we take in going from GDP to disposable personal income, which equals the income households have available to spend on goods and services. We first convert GDP to GNP and then subtract elements of GNP that do not represent income received by households and add payments such as transfer payments that households receive but do not earn in the production of GNP. Disposable personal income is either spent for personal consumption or saved by households.
Table 21.3 From GDP to Disposable Personal Income
GDP + net factor earnings from abroad = gross national product (GNP)
GNP − depreciation (consumption of fixed capital) = net national product (NNP)
NNP − statistical discrepancy = national income (NI)
NI − income earned but not received [e.g., taxes on production and imports, social security payroll taxes, corporate profit taxes, and retained earnings] + transfer payments and other income received but not earned in the production of GNP = personal income (PI)
PI − personal income taxes = disposable personal income (DPI)
GDP, a measure of total output, equals GDI, the total income generated in the production of goods and services in an economy. The chart traces the path from GDP to disposable personal income, which equals the income households actually receive. We first convert GDP to GNP. Then, we subtract depreciation to obtain net national product and subtract the statistical discrepancy to arrive at national income (i.e., gross national income [GNI] net of depreciation and the statistical discrepancy). Next, we subtract components of GNP and GNI that do not represent income actually received by households, such as taxes on production and imports, corporate profit and payroll taxes (contributions to social insurance), and corporate retained earnings. We add items such as transfer payments that are income to households but are not part of GNP and GNI. The adjustments shown are the most important adjustments in going from GNP and GNI to disposable personal income; several smaller adjustments (e.g., subsidies, business current transfer payments [net], and current surplus of government enterprises) have been omitted.
Key Takeaways
• Gross domestic product, GDP, equals gross domestic income, GDI, which includes compensation, profits, rental income, indirect taxes, and depreciation.
• We can use GDP, a measure of total output, to compute disposable personal income, a measure of income received by households and available for them to spend.
Try It!
The following income data refer to the same economy for which you had output data in the first part of the previous Try It! Compute GDI from the data below and confirm that your result equals the GDP figure you computed in the previous Try It! Assume that GDP = GNP for this problem (that is, assume all factor incomes are earned and paid in the domestic economy).
Employee compensation \$700
Social Security payments to households 40
Welfare payments 100
Profits 200
Rental income 50
Net interest 25
Depreciation 50
Indirect taxes 175
Case in Point: The GDP–GDI Gap
Figure 21.8
Jorge Franganillo – Calculator – CC BY 2.0.
GDP equals GDI; at least, that is the way it is supposed to work. But in an enormously complex economy, the measurement of these two variables inevitably goes awry. Estimates of the two are never quite equal. In recent years, the absolute value of the gap has been quite sizable. For 2007 and 2008, for example, GDI has differed from GDP by −\$81.4 and \$160.5 billion per year, respectively.
Although the gap seems large, it represents a remarkably small fraction of measured activity—around 1% or less. Of course, 1% of a big number is still a big number. But it is important to remember that, relative to the size of the economy, the gap between GDI and GDP is not large. The gap is listed as a “statistical discrepancy” in the Department of Commerce reporting of the two numbers.
Why does the gap exist? From an accounting point of view, it should not. The total value of final goods and services produced must be equal to the total value of income generated in that production. But output is measured from sales and inventory figures collected from just 10% of commercial establishments. Preliminary income figures are obtained from household surveys, but these represent a tiny fraction of households. More complete income data are provided by income tax returns, but these are available to the economists who estimate GDI only after a two- to four-year delay.
The Department of Commerce issues revisions of its GDP and GDI estimates as more complete data become available. With each revision, the gap between GDP and GDI estimates is significantly reduced.
While GDP and GDI figures cannot provide precise measures of economic activity, they come remarkably close. Indeed, given that the numbers come from entirely different sources, the fact that they come as close as they do provides an impressive check of the accuracy of the department’s estimates of GDP and GDI.
Answer to Try It! Problem
GDI equals \$1,200. Note that this value equals the value for GDP obtained from the estimate of output in the first part of the previous Try It! Here is the computation:
Employee compensation \$700
Profits 200
Rental income 50
Net interest 25
Depreciation 50
Indirect taxes 175
GDI \$1,200
Once again, note that Social Security and welfare payments to households are transfer payments. They do not represent payments to household factors of production for current output of goods and services, and therefore are not included in GDI.
1Although reported separately by the Department of Commerce, we have combined proprietors’ income (typically independent business owners and farmers) with corporate profits to simplify the discussion.
2If you have studied microeconomics, you know that the term “rent” in economics has a quite different meaning. The national income and product accounts use the accounting, not the economic, meaning of “rent.”
3The adjustment for indirect business taxes includes two other minor elements: transfer payments made by business firms and surpluses or deficits of government enterprises.
4Profit is corporate profit (\$1,274.7) plus proprietors’ income (\$1,057.6), both with inventory valuation and capital consumption adjustment.
5Indirect taxes include taxes on production and imports of \$1,060.6 plus business transfer payments (\$133.1) less subsidies (\$58.5) and current surplus of government enterprise (\$14.1). Prior to the 2003 National Income and Product Accounts (NIPA) revisions, the category “taxes on production and imports” was, with some technical and other minor adjustments, referred to as “indirect business taxes.” See Brent R. Moulton and Eugene P. Seskin, “Preview of the 2003 Comprehensive Revision of the National Income and Product Accounts,” Bureau of Economic Analysis, Survey of Current Business, June 2003, pp. 17-34. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/06%3A_Measuring_Total_Output_and_Income/6.2%3A_Measuring_Total_Income.txt |
Learning Objective
1. Discuss and give examples of measurement and conceptual problems in using real GDP as a measure of economic performance and of economic well-being.
2. Explain the use of per capita real GNP or GDP to compare economic performance across countries and discuss its limitations.
GDP is the measure most often used to assess the economic well-being of a country. Besides measuring the pulse of a country, it is the figure used to compare living standards in different countries.
Of course, to use GDP as an indicator of overall economic performance, we must convert nominal GDP to real GDP, since nominal values can rise or fall simply as a result of changes in the price level. For example, the movie Titanic, released in 1997, brought in \$601 million—the highest amount ever in gross box office receipts, while Gone with the Wind, released in 1939, earned only \$199 million and ranks 49th in terms of nominal receipts. But does that mean that Titanic actually did better than Gone with the Wind? After all, the average price of a movie ticket in 1939 was 25 cents. At the time of Titanic, the average ticket price was about \$5. A better way to compare these two movies in terms of popularity is to control for the price of movie tickets—the same strategy that economists use with real GDP in order to determine whether output is rising or falling. Adjusting the nominal box-office receipts using 1998 movie prices to obtain real revenue reveals that in real terms Gone with the Wind continues to be the top real grosser of all time with real box-office receipts of about \$1.3 billion. As illustrated by this example on revenues from popular movies, we might draw erroneous conclusions about performance if we base them on nominal values instead of on real values. In contrast, real GDP, despite the problems with price indexes that were explained in another chapter, provides a reasonable measure of the total output of an economy, and changes in real GDP provide an indication of the direction of movement in total output.
We begin this section by noting some of the drawbacks of using real GDP as a measure of the economic welfare of a country. Despite these shortcomings, we will see that it probably remains our best single indicator of macroeconomic performance.
Measurement Problems in Real GDP
There are two measurement problems, other than those associated with adjusting for price level changes, in using real GDP to assess domestic economic performance.
Revisions
The first estimate of real GDP for a calendar quarter is called the advance estimate. It is issued about a month after the quarter ends. To produce a measure so quickly, officials at the Department of Commerce must rely on information from relatively few firms and households. One month later, it issues a revised estimate, and a month after that it issues its final estimate. Often the advance estimate of GDP and the final estimate do not correspond. The recession of 2001, for example, began in March of that year. But the first estimates of real GDP for the second and third quarters of 2001 showed output continuing to rise. It was not until later revisions that it became clear that a recession had been under way.
But the revision story does not end there. Every summer, the Commerce Department issues revised figures for the previous two or three years. Once every five years, the department conducts an extensive analysis that traces flows of inputs and outputs throughout the economy. It focuses on the outputs of some firms that are inputs to other firms. In the process of conducting this analysis, the department revises real GDP estimates for the previous five years. Sometimes the revisions can paint a picture of economic activity that is quite different from the one given even by the revised estimates of GDP. For example, revisions of the data for the 1990–1991 recession issued several years later showed that the recession had been much more serious than had previously been apparent, and the recovery was more pronounced.
The Service Sector
Another problem lies in estimating production in the service sector. The output of goods in an economy is relatively easy to compute. There are so many bushels of corn, so many pounds of beef. But what is the output of a bank? Of a hospital? It is easy to record the dollar value of output to enter in nominal GDP, but estimating the quantity of output to use in real GDP is quite another matter. In some cases, the Department of Commerce estimates service sector output based on the quantity of labor used. For example, if this technique were used in the banking industry and banking used 10% more labor, the department would report that production has risen 10%. If the number of employees remains unchanged, reported output remains unchanged. In effect, this approach assumes that output per worker—productivity—in those sectors remains constant when studies have indicated that productivity has increased greatly in the service sector. Since 1990 progress has been made in measurement in this area, which allows in particular for better estimation of productivity changes and price indexes for different service sector industries, but more remains to be done in this large sector of the U.S. economy (Triplett & Bosworth, 2008).
Conceptual Problems with Real GDP
A second set of limitations of real GDP stems from problems inherent in the indicator itself. Real GDP measures market activity. Goods and services that are produced and exchanged in a market are counted; goods and services that are produced but that are not exchanged in markets are not1.
Household Production
Suppose you are considering whether to eat at home for dinner tonight or to eat out. You could cook dinner for yourself at a cost of \$5 for the ingredients plus an hour or so of your time. Alternatively, you could buy an equivalent meal at a restaurant for perhaps \$15. Your decision to eat out rather than cook would add \$10 to the GDP.
But that \$10 addition would be misleading. After all, if you had stayed home you might have produced an equivalent meal. The only difference is that the value of your time would not have been counted. But surely your time is not worthless; it is just not counted. Similarly, GDP does not count the value of your efforts to clean your own house, to wash your own car, or to grow your own vegetables. In general, GDP omits the entire value added by members of a household who do household work themselves.
There is reason to believe this omission is serious. Economists J. Steven Landefeld and Stephanie H. McCulla of the U.S. Bureau of Economic Analysis estimated in a 2000 paper the value of household output from 1946 to 1997. Their estimate of household output in 1946 was 50% of reported GDP. Since then, that percentage has fallen, because more women have entered the workforce, so that more production that once took place in households now occurs in the market. Households now eat out more, purchase more prepared foods at the grocery store, hire out child-care services they once performed themselves, and so on. Their estimate for 1997, for example, suggests that household production amounted to 36% of reported GDP (Landefeld & McCulla, 2000).
This problem is especially significant when GDP is used to make comparisons across countries. In low-income countries, a much greater share of goods and services is not exchanged in a market. Estimates of GDP in such countries are adjusted to reflect nonmarket production, but these adjustments are inevitably imprecise.
Underground and Illegal Production
Some production goes unreported in order to evade taxes or the law. It is not likely to be counted in GDP. Legal production for which income is unreported in order to evade taxes generally takes place in what is known as the “underground economy.” For example, a carpenter might build a small addition to a dentist’s house in exchange for orthodontic work for the carpenter’s children. Although income has been earned and output generated in this example of bartering, the transaction is unlikely to be reported for income tax or other purposes and thus is not counted in GDP. Illegal activities are not reported for income taxes for obvious reasons and are thus difficult to include in GDP.
Leisure
Leisure is an economic good. All other things being equal, more leisure is better than less leisure.
But all other things are not likely to be equal when it comes to consuming leisure. Consuming more leisure means supplying less work effort. And that means producing less GDP. If everyone decided to work 10% fewer hours, GDP would fall. But that would not mean that people were worse off. In fact, their choice of more leisure would suggest they prefer the extra leisure to the goods and services they give up by consuming it. Consequently, a reduction in GDP would be accompanied by an increase in satisfaction, not a reduction.
The GDP Accounts Ignore “Bads”
Suppose a wave of burglaries were to break out across the United States. One would expect people to respond by buying more and louder burglar alarms, better locks, fiercer German shepherds, and more guard services than they had before. To the extent that they pay for these by dipping into savings rather than replacing other consumption, GDP increases. An epidemic might have much the same effect on GDP by driving up health-care spending. But that does not mean that crime and disease are good things; it means only that crime and disease may force an increase in the production of goods and services counted in the GDP.
Similarly, the GDP accounts ignore the impact of pollution on the environment. We might produce an additional \$200 billion in goods and services but create pollution that makes us feel worse off by, say, \$300 billion. The GDP accounts simply report the \$200 billion in increased production. Indeed, some of the environmental degradation might itself boost GDP. Dirtier air may force us to wash clothes more often, to paint buildings more often, and to see the doctor more often, all of which will tend to increase GDP!
Conclusion: GDP and Human Happiness
More GDP cannot necessarily be equated with more human happiness. But more GDP does mean more of the goods and services we measure. It means more jobs. It means more income. And most people seem to place a high value on these things. For all its faults, GDP does measure the production of most goods and services. And goods and services get produced, for the most part, because we want them. We might thus be safe in giving two cheers for GDP—and holding back the third in recognition of the conceptual difficulties that are inherent in using a single number to summarize the output of an entire economy.
International Comparisons of Real GDP and GNP
Real GDP or GNP estimates are often used in comparing economic performance among countries. In making such comparisons, it is important to keep in mind the general limitations to these measures of economic performance that we noted earlier. Further, countries use different methodologies for collecting and compiling data.
Three other issues are important in comparing real GDP or GNP for different countries: the adjustment of these figures for population, adjusting to a common currency, and the incorporation of nonmarket production.
In international comparisons of real GNP or real GDP, economists generally make comparisons not of real GNP or GDP but of per capita real GNP or GDP, which equals a country’s real GNP or GDP divided by its population. In 2009, for example, Japan had a real GDP of about \$4,000 billion and Luxembourg had a real GDP of about \$29 billion. We can conclude that Japan’s economy produced far more goods and services than did Luxembourg’s. But Japan had almost 300 times as many people as did Luxembourg. Japan’s per capita real GDP in 2009 was \$33,280; Luxembourg’s was \$57,640, the highest in the world that year.
Figure 21.9 compares per capita real GNP for 11 countries in 2009. It is based on data that uses a measure called “international dollars” in order to correct for differences in the purchasing power of \$1 across countries. The data also attempt to adjust for nonmarket production (such as that of rural families that grow their own food, make their own clothing, and produce other household goods and services themselves).
The disparities in income are striking; Luxembourg, the country with the highest per capita real GNP, had an income level more than 200 times greater than Liberia, the country with the lowest per capita real GNP.
What can we conclude about international comparisons in levels of GDP and GNP? Certainly we must be cautious. There are enormous difficulties in estimating any country’s total output. Comparing one country’s output to another presents additional challenges. But the fact that a task is difficult does not mean it is impossible. When the data suggest huge disparities in levels of GNP per capita, for example, we observe real differences in living standards.
Key Takeaways
• Real GDP or real GNP is often used as an indicator of the economic well-being of a country.
• Problems in the measurement of real GDP, in addition to problems encountered in converting from nominal to real GDP, stem from revisions in the data and the difficulty of measuring output in some sectors, particularly the service sector.
• Conceptual problems in the use of real GDP as a measure of economic well-being include the facts that it does not include nonmarket production and that it does not properly adjust for “bads” produced in the economy.
• Per capita real GDP or GNP can be used to compare economic performance in different countries.
Try It!
What impact would each of the following have on real GDP? Would economic well-being increase or decrease as a result?
1. On average, people in a country decide to increase the number of hours they work by 5%.
2. Spending on homeland security increases in response to a terrorist attack.
3. The price level and nominal GDP increase by 10%.
Case in Point: Per Capita Real GDP and Olympic Medal Counts
Figure 21.10
Aurelien Guichard – Olympics – CC BY-SA 2.0.
In the popular lore, the Olympics provide an opportunity for the finest athletes in the world to compete with each other head-to-head on the basis of raw talent and hard work. And yet, contenders from Laos tend to finish last or close to it in almost any event in which they compete. One Laotian athlete garnered the unenviable record of having been the slowest entrant in the nearly half-century long history of the 20-kilometer walk. In contrast, U.S. athletes won 103 medals at the 2004 Athens Olympics and 110 medals at the 2008 Beijing Olympics. Why do Laotians fare so poorly and Americans so well, with athletes from other countries falling in between?
Economists Daniel K. N. Johnson and Ayfer Ali have been able to predict with astonishing accuracy the number of medals different countries will win on the basis of a handful of factors, including population, climate, political structure, and real per capita GDP. For example, they predicted that the United States would win 103 medals in Athens and that is precisely how many the United States won. They predicted 103 medals for the United States in Beijing; 110 were won. They did not expect the Laotians to win any medals in either Athens or Beijing, and that was indeed the outcome.
Johnson and Ali estimated that summer game participant nations average one more medal per additional \$1,000 of per capita real GDP. With per capita real GDP in Laos less than the equivalent of \$500 compared to per capita real GDP in the United States of about \$38,000, the results for these two nations could be considered a foregone conclusion. According to Johnson and Ali, “High productive capacity or income per person displays an ability to pay the costs necessary to send athletes to the Games, and may also be associated with a higher quality of training and better equipment.” For example, a Laotian swimmer at Athens, Vilayphone Vongphachanh, had never practiced in an Olympic-size pool, and a runner, Sirivanh Ketavong, had worn the same running shoes for four years.
The good news is that as the per capita real GDP in some relatively poor countries has risen, the improved living standards have led to increased Olympic medal counts. China, for instance, won 28 medals in 1988 and 63 in 2004. As the host for the 2008 games, it won an impressive total of 100 medals.
While not a perfect measure of the well-being of people in a country, per capita real GDP does tell us about the opportunities available to the average citizen in a country. Americans would surely find it hard to imagine living at the level of consumption of the average Laotian. In The Progress Paradox: How Life Gets Better While People Feel Worse, essayist Gregg Easterbrook notes that a higher material standard of living is not associated with higher reported happiness. But, he concludes, the problems of prosperity seem less serious than those of poverty, and prosperity gives people and nations the means to address problems. The Olympic medal count for each nation strongly reflects its average standard of living and hence the opportunities available to its citizens.
Answer to Try It! Problem
1. Real GDP would increase. Assuming the people chose to increase their work effort and forgo the extra leisure, economic well-being would increase as well.
2. Real GDP would increase, but the extra expenditure in the economy was due to an increase in something “bad,” so economic well-being would likely be lower.
3. No change in real GDP. For some people, economic well-being might increase and for others it might decrease, since inflation does not affect each person in the same way.
1There are two exceptions to this rule. The value of food produced and consumed by farm households is counted in GDP. More important, an estimate of the rental values of owner-occupied homes is included. If a family rents a house, the rental payments are included in GDP. If a family lives in a house it owns, the Department of Commerce estimates what the house would rent for and then includes that rent in the GDP estimate, even though the house’s services were not exchanged in the marketplace. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/06%3A_Measuring_Total_Output_and_Income/6.3%3A_GDP_and_Economic_Well-Being.txt |
Summary
This chapter focused on the measurement of GDP. The total value of output (GDP) equals the total value of income generated in producing that output (GDI). We can illustrate the flows of spending and income through the economy with the circular flow model. Firms produce goods and services in response to demands from households (personal consumption), other firms (private investment), government agencies (government purchases), and the rest of the world (net exports). This production, in turn, creates a flow of factor incomes to households. Thus, GDP can be estimated using two types of data: (1) data that show the total value of output and (2) data that show the total value of income generated by that output.
In looking at GDP as a measure of output, we divide it into four components: consumption, investment, government purchases, and net exports. GDP equals the sum of final values produced in each of these areas. It can also be measured as the sum of values added at each stage of production. The components of GDP measured in terms of income (GDI) are employee compensation, profits, rental income, net interest, depreciation, and indirect taxes.
We also explained other measures of income such as GNP and disposable personal income. Disposable personal income is an important economic indicator, because it is closely related to personal consumption, the largest component of GDP.
GDP is often used as an indicator of how well off a country is. Of course, to use it for this purpose, we must be careful to use real GDP rather than nominal GDP. Still, there are problems with our estimate of real GDP. Problems encountered in converting nominal GDP to real GDP were discussed in the previous chapter. In this chapter we looked at additional measurement problems and conceptual problems.
Frequent revisions in the data sometimes change our picture of the economy considerably. Accounting for the service sector is quite difficult. Conceptual problems include the omission of nonmarket production and of underground and illegal production. GDP ignores the value of leisure and includes certain “bads.”
We cannot assert with confidence that more GDP is a good thing and that less is bad. However, real GDP remains our best single indicator of economic performance. It is used not only to indicate how any one economy is performing over time but also to compare the economic performance of different countries.
Concept Problems
1. GDP is used as a measure of macroeconomic performance. What, precisely, does it measure?
2. Many economists have attempted to create a set of social accounts that would come closer to measuring the economic well-being of the society than does GDP. What modifications of the current approach would you recommend to them?
3. Every good produced creates income for the owners of the factors of production that created the product or service. For a recent purchase you made, try to list all the types of factors of production involved in making the product available, and try to determine who received income as a result of your purchase.
4. Explain how the sale of used textbooks in your campus bookstore affects the GDP calculation.
5. Look again at the circular flow diagram in Figure 21.5 and assume it is drawn for the United States. State the flows in which each of the following transactions would be entered.
1. A consumer purchases fresh fish at a local fish market.
2. A grocery store acquires 1,000 rolls of paper towels for later resale.
3. NASA purchases a new Saturn rocket.
4. People in France flock to see the latest Brad Pitt movie.
5. A construction firm builds a new house.
6. A couple from Seattle visits Guadalajara and stays in a hotel there.
7. The city of Dallas purchases computer paper from a local firm.
6. Suggest an argument for and an argument against counting in GDP all household-produced goods and services that are not sold, such as the value of child care or home-cooked meals.
7. Suppose a nation’s firms make heavy use of factors of production owned by residents of foreign countries, while foreign firms make relatively little use of factors owned by residents of that nation. How does the nation’s GDP compare to its GNP?
8. Suppose Country A has the same GDP as Country B, and that neither nation’s residents own factors of production used by foreign firms, nor do either nation’s firms use factors of production owned by foreign residents. Suppose that, relative to Country B, depreciation, indirect business taxes, and personal income taxes in Country A are high, while welfare and Social Security payments to households in Country A are relatively low. Which country has the higher disposable personal income? Why?
9. Suppose that virtually everyone in the United States decides to take life a little easier, and the length of the average workweek falls by 25%. How will that affect GDP? Per capita GDP? How will it affect economic welfare?
10. Comment on the following statement: “It does not matter that the value of the labor people devote to producing things for themselves is not counted in GDP; because we make the same ‘mistake’ every year, relative values are unaffected.”
11. Name some of the services, if any, you produced at home that do get counted in GDP. Are there any goods you produce that are not counted?
12. Marijuana is sometimes estimated to be California’s largest cash crop. It is not included in estimates of GDP. Should it be?
Numerical Problems
1. Given the following nominal data, compute GDP. Assume net factor incomes from abroad = 0 (that is, GDP = GNP).
Nominal Data for GDP and NNP \$ Billions
Consumption 2,799.8
Depreciation 481.6
Exports 376.2
Gross private domestic investment 671.0
Indirect taxes 331.4
Government purchases 869.7
Government transfer payments 947.8
Imports 481.7
2. Find data for each of the following countries on real GDP and population. Use the data to calculate the GDP per capita for each of the following countries:
1. Mozambique
2. India
3. Pakistan
4. United States
5. Canada
6. Russia
7. Brazil
8. Iran
9. Colombia
3. Now construct a bar graph showing your results in the previous problem, organizing the countries from the highest to the lowest GNP per capita, with countries on the horizontal axis and GNP per capita on the vertical axis.
4. Suppose Country A has a GDP of \$4 trillion. Residents of this country earn \$500 million from assets they own in foreign countries. Residents of foreign countries earn \$300 million from assets they own in Country A. Compute:
1. Country A’s net foreign income.
2. Country A’s GNP.
5. Suppose a country’s GDP equals \$500 billion for a particular year. Economists in the country estimate that household production equals 40% of GDP.
1. What is the value of the country’s household production for that year?
2. Counting both GDP and household production, what is the country’s total output for the year?
6. A miner extracts iron from the earth. A steel mill converts the iron to steel beams for use in construction. A construction company uses the steel beams to make a building. Assume that the total product of these firms represents the only components of the building and that they will have no other uses. Complete the following table:
Company Product Total Sales Value Added
Acme Mining iron ore \$100,000 ?
Fuller Mill steel beams \$175,000 ?
Crane Construction building \$1,100,000 ?
Total Value Added ?
7. You are given the data below for 2008 for the imaginary country of Amagre, whose currency is the G.
Consumption 350 billion G
Transfer payments 100 billion G
Investment 100 billion G
Government purchases 200 billion G
Exports 50 billion G
Imports 150 billion G
Bond purchases 200 billion G
Earnings on foreign investments 75 billion G
Foreign earnings on Amagre investment 25 billion G
1. Compute net foreign investment.
2. Compute net exports.
3. Compute GDP.
4. Compute GNP. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/06%3A_Measuring_Total_Output_and_Income/6.4%3A_Review_and_Practice.txt |
Thumbnail: https://pixabay.com/illustrations/up-down-graph-arrow-market-figure-3765610/
07: Aggregate Demand and Aggregate Supply
Learning Objective
1. Define potential output, also called the natural level of GDP.
2. Define aggregate demand, represent it using a hypothetical aggregate demand curve, and identify and explain the three effects that cause this curve to slope downward.
3. Distinguish between a change in the aggregate quantity of goods and services demanded and a change in aggregate demand.
4. Use examples to explain how each component of aggregate demand can be a possible aggregate demand shifter.
5. Explain what a multiplier is and tell how to calculate it.
Firms face four sources of demand: households (personal consumption), other firms (investment), government agencies (government purchases), and foreign markets (net exports). Aggregate demand is the relationship between the total quantity of goods and services demanded (from all the four sources of demand) and the price level, all other determinants of spending unchanged. The aggregate demand curve is a graphical representation of aggregate demand.
The Slope of the Aggregate Demand Curve
We will use the implicit price deflator as our measure of the price level; the aggregate quantity of goods and services demanded is measured as real GDP. The table in Figure 22.1 gives values for each component of aggregate demand at each price level for a hypothetical economy. Various points on the aggregate demand curve are found by adding the values of these components at different price levels. The aggregate demand curve for the data given in the table is plotted on the graph in Figure 22.1. At point A, at a price level of 1.18, \$11,800 billion worth of goods and services will be demanded; at point C, a reduction in the price level to 1.14 increases the quantity of goods and services demanded to \$12,000 billion; and at point E, at a price level of 1.10, \$12,200 billion will be demanded.
The negative slope of the aggregate demand curve suggests that it behaves in the same manner as an ordinary demand curve. But we cannot apply the reasoning we use to explain downward-sloping demand curves in individual markets to explain the downward-sloping aggregate demand curve. There are two reasons for a negative relationship between price and quantity demanded in individual markets. First, a lower price induces people to substitute more of the good whose price has fallen for other goods, increasing the quantity demanded. Second, the lower price creates a higher real income. This normally increases quantity demanded further.
Neither of these effects is relevant to a change in prices in the aggregate. When we are dealing with the average of all prices—the price level—we can no longer say that a fall in prices will induce a change in relative prices that will lead consumers to buy more of the goods and services whose prices have fallen and less of the goods and services whose prices have not fallen. The price of corn may have fallen, but the prices of wheat, sugar, tractors, steel, and most other goods or services produced in the economy are likely to have fallen as well.
Furthermore, a reduction in the price level means that it is not just the prices consumers pay that are falling. It means the prices people receive—their wages, the rents they may charge as landlords, the interest rates they earn—are likely to be falling as well. A falling price level means that goods and services are cheaper, but incomes are lower, too. There is no reason to expect that a change in real income will boost the quantity of goods and services demanded—indeed, no change in real income would occur. If nominal incomes and prices all fall by 10%, for example, real incomes do not change.
Why, then, does the aggregate demand curve slope downward? One reason for the downward slope of the aggregate demand curve lies in the relationship between real wealth (the stocks, bonds, and other assets that people have accumulated) and consumption (one of the four components of aggregate demand). When the price level falls, the real value of wealth increases—it packs more purchasing power. For example, if the price level falls by 25%, then \$10,000 of wealth could purchase more goods and services than it would have if the price level had not fallen. An increase in wealth will induce people to increase their consumption. The consumption component of aggregate demand will thus be greater at lower price levels than at higher price levels. The tendency for a change in the price level to affect real wealth and thus alter consumption is called the wealth effect; it suggests a negative relationship between the price level and the real value of consumption spending.
A second reason the aggregate demand curve slopes downward lies in the relationship between interest rates and investment. A lower price level lowers the demand for money, because less money is required to buy a given quantity of goods. What economists mean by money demand will be explained in more detail in a later chapter. But, as we learned in studying demand and supply, a reduction in the demand for something, all other things unchanged, lowers its price. In this case, the “something” is money and its price is the interest rate. A lower price level thus reduces interest rates. Lower interest rates make borrowing by firms to build factories or buy equipment and other capital more attractive. A lower interest rate means lower mortgage payments, which tends to increase investment in residential houses. Investment thus rises when the price level falls. The tendency for a change in the price level to affect the interest rate and thus to affect the quantity of investment demanded is called the interest rate effect. John Maynard Keynes, a British economist whose analysis of the Great Depression and what to do about it led to the birth of modern macroeconomics, emphasized this effect. For this reason, the interest rate effect is sometimes called the Keynes effect.
A third reason for the rise in the total quantity of goods and services demanded as the price level falls can be found in changes in the net export component of aggregate demand. All other things unchanged, a lower price level in an economy reduces the prices of its goods and services relative to foreign-produced goods and services. A lower price level makes that economy’s goods more attractive to foreign buyers, increasing exports. It will also make foreign-produced goods and services less attractive to the economy’s buyers, reducing imports. The result is an increase in net exports. The international trade effect is the tendency for a change in the price level to affect net exports.
Taken together, then, a fall in the price level means that the quantities of consumption, investment, and net export components of aggregate demand may all rise. Since government purchases are determined through a political process, we assume there is no causal link between the price level and the real volume of government purchases. Therefore, this component of GDP does not contribute to the downward slope of the curve.
In general, a change in the price level, with all other determinants of aggregate demand unchanged, causes a movement along the aggregate demand curve. A movement along an aggregate demand curve is a change in the aggregate quantity of goods and services demanded. A movement from point A to point B on the aggregate demand curve in Figure 22.1 is an example. Such a change is a response to a change in the price level.
Notice that the axes of the aggregate demand curve graph are drawn with a break near the origin to remind us that the plotted values reflect a relatively narrow range of changes in real GDP and the price level. We do not know what might happen if the price level or output for an entire economy approached zero. Such a phenomenon has never been observed.
Changes in Aggregate Demand
Aggregate demand changes in response to a change in any of its components. An increase in the total quantity of consumer goods and services demanded at every price level, for example, would shift the aggregate demand curve to the right. A change in the aggregate quantity of goods and services demanded at every price level is a change in aggregate demand, which shifts the aggregate demand curve. Increases and decreases in aggregate demand are shown in Figure 22.2.
What factors might cause the aggregate demand curve to shift? Each of the components of aggregate demand is a possible aggregate demand shifter. We shall look at some of the events that can trigger changes in the components of aggregate demand and thus shift the aggregate demand curve.
Changes in Consumption
Several events could change the quantity of consumption at each price level and thus shift aggregate demand. One determinant of consumption is consumer confidence. If consumers expect good economic conditions and are optimistic about their economic prospects, they are more likely to buy major items such as cars or furniture. The result would be an increase in the real value of consumption at each price level and an increase in aggregate demand. In the second half of the 1990s, sustained economic growth and low unemployment fueled high expectations and consumer optimism. Surveys revealed consumer confidence to be very high. That consumer confidence translated into increased consumption and increased aggregate demand. In contrast, a decrease in consumption would accompany diminished consumer expectations and a decrease in consumer confidence, as happened after the stock market crash of 1929. The same problem has plagued the economies of most Western nations in 2008 as declining consumer confidence has tended to reduce consumption. A survey by the Conference Board in September of 2008 showed that just 13.5% of consumers surveyed expected economic conditions in the United States to improve in the next six months. Similarly pessimistic views prevailed in the previous two months. That contributed to the decline in consumption that occurred in the third quarter of the year.
Another factor that can change consumption and shift aggregate demand is tax policy. A cut in personal income taxes leaves people with more after-tax income, which may induce them to increase their consumption. The federal government in the United States cut taxes in 1964, 1981, 1986, 1997, and 2003; each of those tax cuts tended to increase consumption and aggregate demand at each price level.
In the United States, another government policy aimed at increasing consumption and thus aggregate demand has been the use of rebates in which taxpayers are simply sent checks in hopes that those checks will be used for consumption. Rebates have been used in 1975, 2001, and 2008. In each case the rebate was a one-time payment. Careful studies by economists of the 1975 and 2001 rebates showed little impact on consumption. Final evidence on the impact of the 2008 rebates is not yet in, but early results suggest a similar outcome. In a subsequent chapter, we will investigate arguments about whether temporary increases in income produced by rebates are likely to have a significant impact on consumption.
Transfer payments such as welfare and Social Security also affect the income people have available to spend. At any given price level, an increase in transfer payments raises consumption and aggregate demand, and a reduction lowers consumption and aggregate demand.
Changes in Investment
Investment is the production of new capital that will be used for future production of goods and services. Firms make investment choices based on what they think they will be producing in the future. The expectations of firms thus play a critical role in determining investment. If firms expect their sales to go up, they are likely to increase their investment so that they can increase production and meet consumer demand. Such an increase in investment raises the aggregate quantity of goods and services demanded at each price level; it increases aggregate demand.
Changes in interest rates also affect investment and thus affect aggregate demand. We must be careful to distinguish such changes from the interest rate effect, which causes a movement along the aggregate demand curve. A change in interest rates that results from a change in the price level affects investment in a way that is already captured in the downward slope of the aggregate demand curve; it causes a movement along the curve. A change in interest rates for some other reason shifts the curve. We examine reasons interest rates might change in another chapter.
Investment can also be affected by tax policy. One provision of the Job and Growth Tax Relief Reconciliation Act of 2003 was a reduction in the tax rate on certain capital gains. Capital gains result when the owner of an asset, such as a house or a factory, sells the asset for more than its purchase price (less any depreciation claimed in earlier years). The lower capital gains tax could stimulate investment, because the owners of such assets know that they will lose less to taxes when they sell those assets, thus making assets subject to the tax more attractive.
Changes in Government Purchases
Any change in government purchases, all other things unchanged, will affect aggregate demand. An increase in government purchases increases aggregate demand; a decrease in government purchases decreases aggregate demand.
Many economists argued that reductions in defense spending in the wake of the collapse of the Soviet Union in 1991 tended to reduce aggregate demand. Similarly, increased defense spending for the wars in Afghanistan and Iraq increased aggregate demand. Dramatic increases in defense spending to fight World War II accounted in large part for the rapid recovery from the Great Depression.
Changes in Net Exports
A change in the value of net exports at each price level shifts the aggregate demand curve. A major determinant of net exports is foreign demand for a country’s goods and services; that demand will vary with foreign incomes. An increase in foreign incomes increases a country’s net exports and aggregate demand; a slump in foreign incomes reduces net exports and aggregate demand. For example, several major U.S. trading partners in Asia suffered recessions in 1997 and 1998. Lower real incomes in those countries reduced U.S. exports and tended to reduce aggregate demand.
Exchange rates also influence net exports, all other things unchanged. A country’s exchange rate is the price of its currency in terms of another currency or currencies. A rise in the U.S. exchange rate means that it takes more Japanese yen, for example, to purchase one dollar. That also means that U.S. traders get more yen per dollar. Since prices of goods produced in Japan are given in yen and prices of goods produced in the United States are given in dollars, a rise in the U.S. exchange rate increases the price to foreigners for goods and services produced in the United States, thus reducing U.S. exports; it reduces the price of foreign-produced goods and services for U.S. consumers, thus increasing imports to the United States. A higher exchange rate tends to reduce net exports, reducing aggregate demand. A lower exchange rate tends to increase net exports, increasing aggregate demand.
Foreign price levels can affect aggregate demand in the same way as exchange rates. For example, when foreign price levels fall relative to the price level in the United States, U.S. goods and services become relatively more expensive, reducing exports and boosting imports in the United States. Such a reduction in net exports reduces aggregate demand. An increase in foreign prices relative to U.S. prices has the opposite effect.
The trade policies of various countries can also affect net exports. A policy by Japan to increase its imports of goods and services from India, for example, would increase net exports in India.
The Multiplier
A change in any component of aggregate demand shifts the aggregate demand curve. Generally, the aggregate demand curve shifts by more than the amount by which the component initially causing it to shift changes.
Suppose that net exports increase due to an increase in foreign incomes. As foreign demand for domestically made products rises, a country’s firms will hire additional workers or perhaps increase the average number of hours that their employees work. In either case, incomes will rise, and higher incomes will lead to an increase in consumption. Taking into account these other increases in the components of aggregate demand, the aggregate demand curve will shift by more than the initial shift caused by the initial increase in net exports.
The multiplierThe ratio of the change in the quantity of real GDP demanded at each price level to the initial change in one or more components of aggregate demand that produced it. is the ratio of the change in the quantity of real GDP demanded at each price level to the initial change in one or more components of aggregate demand that produced it:
Equation 22.1
We use the capital Greek letter delta (Δ) to mean “change in.” In the aggregate demand–aggregate supply model presented in this chapter, it is the number by which we multiply an initial change in aggregate demand to obtain the amount by which the aggregate demand curve shifts as a result of the initial change. In other words, we can use Equation 22.1 to solve for the change in real GDP demanded at each price level:
Equation 22.2
Suppose that the initial increase in net exports is \$100 billion and that the initial \$100-billion increase generates additional consumption of \$100 billion at each price level. In Panel (a) of Figure 22.3, the aggregate demand curve shifts to the right by \$200 billion—the amount of the initial increase in net exports times the multiplier of 2. We obtained the value for the multiplier in this example by plugging \$200 billion (the initial \$100-billion increase in net exports plus the \$100-billion increase that it generated in consumption) into the numerator of Equation 22.1 and \$100 billion into the denominator. Similarly, a decrease in net exports of \$100 billion leads to a decrease in aggregate demand of \$200 billion at each price level, as shown in Panel (b).
Key Takeaways
• Potential output is the level of output an economy can achieve when labor is employed at its natural level. When an economy fails to produce at its potential, the government or the central bank may try to push the economy toward its potential.
• The aggregate demand curve represents the total of consumption, investment, government purchases, and net exports at each price level in any period. It slopes downward because of the wealth effect on consumption, the interest rate effect on investment, and the international trade effect on net exports.
• The aggregate demand curve shifts when the quantity of real GDP demanded at each price level changes.
• The multiplier is the number by which we multiply an initial change in aggregate demand to obtain the amount by which the aggregate demand curve shifts at each price level as a result of the initial change.
Try It!
Explain the effect of each of the following on the aggregate demand curve for the United States:
1. A decrease in consumer optimism
2. An increase in real GDP in the countries that buy U.S. exports
3. An increase in the price level
4. An increase in government spending on highways
Case in Point: The Multiplied Economic Impact of SARS on China’s Economy
Figure 22.4
Zervas – wrong face mask – CC BY-NC-ND 2.0.
Severe Acute Respiratory Syndrome (SARS), an atypical pneumonia-like disease, broke onto the world scene in late 2002. In March 2003, the World Health Organization (WHO) issued its first worldwide alert and a month later its first travel advisory, which recommended that travelers avoid Hong Kong and the southern province of China, Guangdong. Over the next few months, additional travel advisories were issued for other parts of China, Taiwan, and briefly for Toronto, Canada. By the end of June, all WHO travel advisories had been removed.
To estimate the overall impact of SARS on the Chinese economy in 2003, economists Wen Hai, Zhong Zhao, and Jian Want of Peking University’s China Center for Economic Research conducted a survey of Beijing’s tourism industry in April 2003. Based on findings from the Beijing area, they projected the tourism sector of China as a whole would lose \$16.8 billion—of which \$10.8 billion came from an approximate 50% reduction in foreign tourist revenue and \$6 billion from curtailed domestic tourism, as holiday celebrations were cancelled and domestic travel restrictions imposed.
To figure out the total impact of SARS on China’s economy, they argued that the multiplier for tourism revenue in China is between 2 and 3. Since the SARS outbreak only began to have a major economic impact after March, they assumed a smaller multiplier of 1.5 for all of 2003. They thus predicted that the Chinese economy would be \$25.3 billion smaller in 2003 as a result of SARS:
Answer to Try It! Problem
1. A decline in consumer optimism would cause the aggregate demand curve to shift to the left. If consumers are more pessimistic about the future, they are likely to cut purchases, especially of major items.
2. An increase in the real GDP of other countries would increase the demand for U.S. exports and cause the aggregate demand curve to shift to the right. Higher incomes in other countries will make consumers in those countries more willing and able to buy U.S. goods.
3. An increase in the price level corresponds to a movement up along the unchanged aggregate demand curve. At the higher price level, the consumption, investment, and net export components of aggregate demand will all fall; that is, there will be a reduction in the total quantity of goods and services demanded, but not a shift of the aggregate demand curve itself.
4. An increase in government spending on highways means an increase in government purchases. The aggregate demand curve would shift to the right. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/07%3A_Aggregate_Demand_and_Aggregate_Supply/7.1%3A_Aggregate_Demand.txt |
Learning Objective
1. Distinguish between the short run and the long run, as these terms are used in macroeconomics.
2. Draw a hypothetical long-run aggregate supply curve and explain what it shows about the natural levels of employment and output at various price levels, given changes in aggregate demand.
3. Draw a hypothetical short-run aggregate supply curve, explain why it slopes upward, and explain why it may shift; that is, distinguish between a change in the aggregate quantity of goods and services supplied and a change in short-run aggregate supply.
4. Discuss various explanations for wage and price stickiness.
5. Explain and illustrate what is meant by equilibrium in the short run and relate the equilibrium to potential output.
In macroeconomics, we seek to understand two types of equilibria, one corresponding to the short run and the other corresponding to the long run. The short run in macroeconomic analysis is a period in which wages and some other prices do not respond to changes in economic conditions. In certain markets, as economic conditions change, prices (including wages) may not adjust quickly enough to maintain equilibrium in these markets. A sticky price is a price that is slow to adjust to its equilibrium level, creating sustained periods of shortage or surplus. Wage and price stickiness prevent the economy from achieving its natural level of employment and its potential output. In contrast, the long run in macroeconomic analysis is a period in which wages and prices are flexible. In the long run, employment will move to its natural level and real GDP to potential.
We begin with a discussion of long-run macroeconomic equilibrium, because this type of equilibrium allows us to see the macroeconomy after full market adjustment has been achieved. In contrast, in the short run, price or wage stickiness is an obstacle to full adjustment. Why these deviations from the potential level of output occur and what the implications are for the macroeconomy will be discussed in the section on short-run macroeconomic equilibrium.
The Long Run
As explained in a previous chapter, the natural level of employment occurs where the real wage adjusts so that the quantity of labor demanded equals the quantity of labor supplied. When the economy achieves its natural level of employment, it achieves its potential level of output. We will see that real GDP eventually moves to potential, because all wages and prices are assumed to be flexible in the long run.
Long-Run Aggregate Supply
The long-run aggregate supply (LRAS) curve relates the level of output produced by firms to the price level in the long run. In Panel (b) of Figure 22.5, the long-run aggregate supply curve is a vertical line at the economy’s potential level of output. There is a single real wage at which employment reaches its natural level. In Panel (a) of Figure 22.5, only a real wage of ωe generates natural employment Le. The economy could, however, achieve this real wage with any of an infinitely large set of nominal wage and price-level combinations. Suppose, for example, that the equilibrium real wage (the ratio of wages to the price level) is 1.5. We could have that with a nominal wage level of 1.5 and a price level of 1.0, a nominal wage level of 1.65 and a price level of 1.1, a nominal wage level of 3.0 and a price level of 2.0, and so on.
In Panel (b) we see price levels ranging from P1 to P4. Higher price levels would require higher nominal wages to create a real wage of ωe, and flexible nominal wages would achieve that in the long run.
In the long run, then, the economy can achieve its natural level of employment and potential output at any price level. This conclusion gives us our long-run aggregate supply curve. With only one level of output at any price level, the long-run aggregate supply curve is a vertical line at the economy’s potential level of output of YP.
Equilibrium Levels of Price and Output in the Long Run
The intersection of the economy’s aggregate demand curve and the long-run aggregate supply curve determines its equilibrium real GDP and price level in the long run. Figure 22.6 depicts an economy in long-run equilibrium. With aggregate demand at AD1 and the long-run aggregate supply curve as shown, real GDP is \$12,000 billion per year and the price level is 1.14. If aggregate demand increases to AD2, long-run equilibrium will be reestablished at real GDP of \$12,000 billion per year, but at a higher price level of 1.18. If aggregate demand decreases to AD3, long-run equilibrium will still be at real GDP of \$12,000 billion per year, but with the now lower price level of 1.10.
The Short Run
Analysis of the macroeconomy in the short run—a period in which stickiness of wages and prices may prevent the economy from operating at potential output—helps explain how deviations of real GDP from potential output can and do occur. We will explore the effects of changes in aggregate demand and in short-run aggregate supply in this section.
Short-Run Aggregate Supply
The model of aggregate demand and long-run aggregate supply predicts that the economy will eventually move toward its potential output. To see how nominal wage and price stickiness can cause real GDP to be either above or below potential in the short run, consider the response of the economy to a change in aggregate demand. Figure 22.7 shows an economy that has been operating at potential output of \$12,000 billion and a price level of 1.14. This occurs at the intersection of AD1 with the long-run aggregate supply curve at point B. Now suppose that the aggregate demand curve shifts to the right (to AD2). This could occur as a result of an increase in exports. (The shift from AD1 to AD2 includes the multiplied effect of the increase in exports.) At the price level of 1.14, there is now excess demand and pressure on prices to rise. If all prices in the economy adjusted quickly, the economy would quickly settle at potential output of \$12,000 billion, but at a higher price level (1.18 in this case).
Is it possible to expand output above potential? Yes. It may be the case, for example, that some people who were in the labor force but were frictionally or structurally unemployed find work because of the ease of getting jobs at the going nominal wage in such an environment. The result is an economy operating at point A in Figure 22.7 at a higher price level and with output temporarily above potential.
Consider next the effect of a reduction in aggregate demand (to AD3), possibly due to a reduction in investment. As the price level starts to fall, output also falls. The economy finds itself at a price level–output combination at which real GDP is below potential, at point C. Again, price stickiness is to blame. The prices firms receive are falling with the reduction in demand. Without corresponding reductions in nominal wages, there will be an increase in the real wage. Firms will employ less labor and produce less output.
By examining what happens as aggregate demand shifts over a period when price adjustment is incomplete, we can trace out the short-run aggregate supply curve by drawing a line through points A, B, and C. The short-run aggregate supply (SRAS) curve is a graphical representation of the relationship between production and the price level in the short run. Among the factors held constant in drawing a short-run aggregate supply curve are the capital stock, the stock of natural resources, the level of technology, and the prices of factors of production.
A change in the price level produces a change in the aggregate quantity of goods and services supplied and is illustrated by the movement along the short-run aggregate supply curve. This occurs between points A, B, and C in Figure 22.7.
A change in the quantity of goods and services supplied at every price level in the short run is a change in short-run aggregate supply. Changes in the factors held constant in drawing the short-run aggregate supply curve shift the curve. (These factors may also shift the long-run aggregate supply curve; we will discuss them along with other determinants of long-run aggregate supply in the next chapter.)
One type of event that would shift the short-run aggregate supply curve is an increase in the price of a natural resource such as oil. An increase in the price of natural resources or any other factor of production, all other things unchanged, raises the cost of production and leads to a reduction in short-run aggregate supply. In Panel (a) of Figure 22.8, SRAS1 shifts leftward to SRAS2. A decrease in the price of a natural resource would lower the cost of production and, other things unchanged, would allow greater production from the economy’s stock of resources and would shift the short-run aggregate supply curve to the right; such a shift is shown in Panel (b) by a shift from SRAS1 to SRAS3.
Reasons for Wage and Price Stickiness
Wage or price stickiness means that the economy may not always be operating at potential. Rather, the economy may operate either above or below potential output in the short run. Correspondingly, the overall unemployment rate will be below or above the natural level.
Many prices observed throughout the economy do adjust quickly to changes in market conditions so that equilibrium, once lost, is quickly regained. Prices for fresh food and shares of common stock are two such examples.
Other prices, though, adjust more slowly. Nominal wages, the price of labor, adjust very slowly. We will first look at why nominal wages are sticky, due to their association with the unemployment rate, a variable of great interest in macroeconomics, and then at other prices that may be sticky.
Wage Stickiness
Wage contracts fix nominal wages for the life of the contract. The length of wage contracts varies from one week or one month for temporary employees, to one year (teachers and professors often have such contracts), to three years (for most union workers employed under major collective bargaining agreements). The existence of such explicit contracts means that both workers and firms accept some wage at the time of negotiating, even though economic conditions could change while the agreement is still in force.
Think about your own job or a job you once had. Chances are you go to work each day knowing what your wage will be. Your wage does not fluctuate from one day to the next with changes in demand or supply. You may have a formal contract with your employer that specifies what your wage will be over some period. Or you may have an informal understanding that sets your wage. Whatever the nature of your agreement, your wage is “stuck” over the period of the agreement. Your wage is an example of a sticky price.
One reason workers and firms may be willing to accept long-term nominal wage contracts is that negotiating a contract is a costly process. Both parties must keep themselves adequately informed about market conditions. Where unions are involved, wage negotiations raise the possibility of a labor strike, an eventuality that firms may prepare for by accumulating additional inventories, also a costly process. Even when unions are not involved, time and energy spent discussing wages takes away from time and energy spent producing goods and services. In addition, workers may simply prefer knowing that their nominal wage will be fixed for some period of time.
Some contracts do attempt to take into account changing economic conditions, such as inflation, through cost-of-living adjustments, but even these relatively simple contingencies are not as widespread as one might think. One reason might be that a firm is concerned that while the aggregate price level is rising, the prices for the goods and services it sells might not be moving at the same rate. Also, cost-of-living or other contingencies add complexity to contracts that both sides may want to avoid.
Even markets where workers are not employed under explicit contracts seem to behave as if such contracts existed. In these cases, wage stickiness may stem from a desire to avoid the same uncertainty and adjustment costs that explicit contracts avert.
Finally, minimum wage laws prevent wages from falling below a legal minimum, even if unemployment is rising. Unskilled workers are particularly vulnerable to shifts in aggregate demand.
Price Stickiness
Rigidity of other prices becomes easier to explain in light of the arguments about nominal wage stickiness. Since wages are a major component of the overall cost of doing business, wage stickiness may lead to output price stickiness. With nominal wages stable, at least some firms can adopt a “wait and see” attitude before adjusting their prices. During this time, they can evaluate information about why sales are rising or falling (Is the change in demand temporary or permanent?) and try to assess likely reactions by consumers or competing firms in the industry to any price changes they might make (Will consumers be angered by a price increase, for example? Will competing firms match price changes?).
In the meantime, firms may prefer to adjust output and employment in response to changing market conditions, leaving product price alone. Quantity adjustments have costs, but firms may assume that the associated risks are smaller than those associated with price adjustments.
Another possible explanation for price stickiness is the notion that there are adjustment costs associated with changing prices. In some cases, firms must print new price lists and catalogs, and notify customers of price changes. Doing this too often could jeopardize customer relations.
Yet another explanation of price stickiness is that firms may have explicit long-term contracts to sell their products to other firms at specified prices. For example, electric utilities often buy their inputs of coal or oil under long-term contracts.
Taken together, these reasons for wage and price stickiness explain why aggregate price adjustment may be incomplete in the sense that the change in the price level is insufficient to maintain real GDP at its potential level. These reasons do not lead to the conclusion that no price adjustments occur. But the adjustments require some time. During this time, the economy may remain above or below its potential level of output.
Equilibrium Levels of Price and Output in the Short Run
To illustrate how we will use the model of aggregate demand and aggregate supply, let us examine the impact of two events: an increase in the cost of health care and an increase in government purchases. The first reduces short-run aggregate supply; the second increases aggregate demand. Both events change equilibrium real GDP and the price level in the short run.
A Change in the Cost of Health Care
In the United States, most people receive health insurance for themselves and their families through their employers. In fact, it is quite common for employers to pay a large percentage of employees’ health insurance premiums, and this benefit is often written into labor contracts. As the cost of health care has gone up over time, firms have had to pay higher and higher health insurance premiums. With nominal wages fixed in the short run, an increase in health insurance premiums paid by firms raises the cost of employing each worker. It affects the cost of production in the same way that higher wages would. The result of higher health insurance premiums is that firms will choose to employ fewer workers.
Suppose the economy is operating initially at the short-run equilibrium at the intersection of AD1 and SRAS1, with a real GDP of Y1 and a price level of P1, as shown in Figure 22.9. This is the initial equilibrium price and output in the short run. The increase in labor cost shifts the short-run aggregate supply curve to SRAS2. The price level rises to P2 and real GDP falls to Y2.
A reduction in health insurance premiums would have the opposite effect. There would be a shift to the right in the short-run aggregate supply curve with pressure on the price level to fall and real GDP to rise.
A Change in Government Purchases
Suppose the federal government increases its spending for highway construction. This circumstance leads to an increase in U.S. government purchases and an increase in aggregate demand.
Assuming no other changes affect aggregate demand, the increase in government purchases shifts the aggregate demand curve by a multiplied amount of the initial increase in government purchases to AD2 in Figure 22.10. Real GDP rises from Y1 to Y2, while the price level rises from P1 to P2. Notice that the increase in real GDP is less than it would have been if the price level had not risen.
In contrast, a reduction in government purchases would reduce aggregate demand. The aggregate demand curve shifts to the left, putting pressure on both the price level and real GDP to fall.
In the short run, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. Recall, however, that the short run is a period in which sticky prices may prevent the economy from reaching its natural level of employment and potential output. In the next section, we will see how the model adjusts to move the economy to long-run equilibrium and what, if anything, can be done to steer the economy toward the natural level of employment and potential output.
Key Takeaways
• The short run in macroeconomics is a period in which wages and some other prices are sticky. The long run is a period in which full wage and price flexibility, and market adjustment, has been achieved, so that the economy is at the natural level of employment and potential output.
• The long-run aggregate supply curve is a vertical line at the potential level of output. The intersection of the economy’s aggregate demand and long-run aggregate supply curves determines its equilibrium real GDP and price level in the long run.
• The short-run aggregate supply curve is an upward-sloping curve that shows the quantity of total output that will be produced at each price level in the short run. Wage and price stickiness account for the short-run aggregate supply curve’s upward slope.
• Changes in prices of factors of production shift the short-run aggregate supply curve. In addition, changes in the capital stock, the stock of natural resources, and the level of technology can also cause the short-run aggregate supply curve to shift.
• In the short run, the equilibrium price level and the equilibrium level of total output are determined by the intersection of the aggregate demand and the short-run aggregate supply curves. In the short run, output can be either below or above potential output.
Try It!
The tools we have covered in this section can be used to understand the Great Depression of the 1930s. We know that investment and consumption began falling in late 1929. The reductions were reinforced by plunges in net exports and government purchases over the next four years. In addition, nominal wages plunged 26% between 1929 and 1933. We also know that real GDP in 1933 was 30% below real GDP in 1929. Use the tools of aggregate demand and short-run aggregate supply to graph and explain what happened to the economy between 1929 and 1933.
Case in Point: The U.S. Recession of 2001
Figure 22.11
Simon Cunningham – Recession – CC BY 2.0.
What were the causes of the U.S. recession of 2001? Economist Kevin Kliesen of the Federal Reserve Bank of St. Louis points to four factors that, taken together, shifted the aggregate demand curve to the left and kept it there for a long enough period to keep real GDP falling for about nine months. They were the fall in stock market prices, the decrease in business investment both for computers and software and in structures, the decline in the real value of exports, and the aftermath of 9/11. Notable exceptions to this list of culprits were the behavior of consumer spending during the period and new residential housing, which falls into the investment category.
During the expansion in the late 1990s, a surging stock market probably made it easier for firms to raise funding for investment in both structures and information technology. Even though the stock market bubble burst well before the actual recession, the continuation of projects already underway delayed the decline in the investment component of GDP. Also, spending for information technology was probably prolonged as firms dealt with Y2K computing issues, that is, computer problems associated with the change in the date from 1999 to 2000. Most computers used only two digits to indicate the year, and when the year changed from ’99 to ’00, computers did not know how to interpret the change, and extensive reprogramming of computers was required.
Real exports fell during the recession because (1) the dollar was strong during the period and (2) real GDP growth in the rest of the world fell almost 5% from 2000 to 2001.
Then, the terrorist attacks of 9/11, which literally shut down transportation and financial markets for several days, may have prolonged these negative tendencies just long enough to turn what might otherwise have been a mild decline into enough of a downtown to qualify the period as a recession.
During this period the measured price level was essentially stable—with the implicit price deflator rising by less than 1%. Thus, while the aggregate demand curve shifted left as a result of all the reasons given above, there was also a leftward shift in the short-run aggregate supply curve.
Answer to Try It! Problem
All components of aggregate demand (consumption, investment, government purchases, and net exports) declined between 1929 and 1933. Thus the aggregate demand curve shifted markedly to the left, moving from AD1929 to AD1933. The reduction in nominal wages corresponds to an increase in short-run aggregate supply from SRAS1929 to SRAS1933. Since real GDP in 1933 was less than real GDP in 1929, we know that the movement in the aggregate demand curve was greater than that of the short-run aggregate supply curve.
Figure 22.12 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/07%3A_Aggregate_Demand_and_Aggregate_Supply/7.2%3A_Aggregate_Demand_and_Aggregate_Supply%3A_The_Long_Run_and_the_Short_Run.txt |
Learning Objective
1. Explain and illustrate graphically recessionary and inflationary gaps and relate these gaps to what is happening in the labor market.
2. Identify the various policy choices available when an economy experiences an inflationary or recessionary gap and discuss some of the pros and cons that make these choices controversial.
The intersection of the economy’s aggregate demand and short-run aggregate supply curves determines equilibrium real GDP and price level in the short run. The intersection of aggregate demand and long-run aggregate supply determines its long-run equilibrium. In this section we will examine the process through which an economy moves from equilibrium in the short run to equilibrium in the long run.
The long run puts a nation’s macroeconomic house in order: only frictional and structural unemployment remain, and the price level is stabilized. In the short run, stickiness of nominal wages and other prices can prevent the economy from achieving its potential output. Actual output may exceed or fall short of potential output. In such a situation the economy operates with a gap. When output is above potential, employment is above the natural level of employment. When output is below potential, employment is below the natural level.
Recessionary and Inflationary Gaps
At any time, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. If employment is below the natural level of employment, real GDP will be below potential. The aggregate demand and short-run aggregate supply curves will intersect to the left of the long-run aggregate supply curve.
Suppose an economy’s natural level of employment is Le, shown in Panel (a) of Figure 22.13. This level of employment is achieved at a real wage of ωe. Suppose, however, that the initial real wage ω1 exceeds this equilibrium value. Employment at L1 falls short of the natural level. A lower level of employment produces a lower level of output; the aggregate demand and short-run aggregate supply curves, AD and SRAS, intersect to the left of the long-run aggregate supply curve LRAS in Panel (b). The gap between the level of real GDP and potential output, when real GDP is less than potential, is called a recessionary gapThe gap between the level of real GDP and potential output, when real GDP is less than potential..
Just as employment can fall short of its natural level, it can also exceed it. If employment is greater than its natural level, real GDP will also be greater than its potential level. Figure 22.14 shows an economy with a natural level of employment of Le in Panel (a) and potential output of YP in Panel (b). If the real wage ω1 is less than the equilibrium real wage ωe, then employment L1 will exceed the natural level. As a result, real GDP, Y1, exceeds potential. The gap between the level of real GDP and potential output, when real GDP is greater than potential, is called an inflationary gapThe gap between the level of real GDP and potential output, when real GDP is greater than potential.. In Panel (b), the inflationary gap equals Y1YP.
Restoring Long-Run Macroeconomic Equilibrium
We have already seen that the aggregate demand curve shifts in response to a change in consumption, investment, government purchases, or net exports. The short-run aggregate supply curve shifts in response to changes in the prices of factors of production, the quantities of factors of production available, or technology. Now we will see how the economy responds to a shift in aggregate demand or short-run aggregate supply using two examples presented earlier: a change in government purchases and a change in health-care costs. By returning to these examples, we will be able to distinguish the long-run response from the short-run response.
A Shift in Aggregate Demand: An Increase in Government Purchases
Suppose an economy is initially in equilibrium at potential output YP as in Figure 22.15. Because the economy is operating at its potential, the labor market must be in equilibrium; the quantities of labor demanded and supplied are equal.
Now suppose aggregate demand increases because one or more of its components (consumption, investment, government purchases, and net exports) has increased at each price level. For example, suppose government purchases increase. The aggregate demand curve shifts from AD1 to AD2 in Figure 22.15. That will increase real GDP to Y2 and force the price level up to P2 in the short run. The higher price level, combined with a fixed nominal wage, results in a lower real wage. Firms employ more workers to supply the increased output.
The economy’s new production level Y2 exceeds potential output. Employment exceeds its natural level. The economy with output of Y2 and price level of P2 is only in short-run equilibrium; there is an inflationary gap equal to the difference between Y2 and YP. Because real GDP is above potential, there will be pressure on prices to rise further.
Ultimately, the nominal wage will rise as workers seek to restore their lost purchasing power. As the nominal wage rises, the short-run aggregate supply curve will begin shifting to the left. It will continue to shift as long as the nominal wage rises, and the nominal wage will rise as long as there is an inflationary gap. These shifts in short-run aggregate supply, however, will reduce real GDP and thus begin to close this gap. When the short-run aggregate supply curve reaches SRAS2, the economy will have returned to its potential output, and employment will have returned to its natural level. These adjustments will close the inflationary gap.
A Shift in Short-Run Aggregate Supply: An Increase in the Cost of Health Care
Again suppose, with an aggregate demand curve at AD1 and a short-run aggregate supply at SRAS1, an economy is initially in equilibrium at its potential output YP, at a price level of P1, as shown in Figure 22.16. Now suppose that the short-run aggregate supply curve shifts owing to a rise in the cost of health care. As we explained earlier, because health insurance premiums are paid primarily by firms for their workers, an increase in premiums raises the cost of production and causes a reduction in the short-run aggregate supply curve from SRAS1 to SRAS2.
As a result, the price level rises to P2 and real GDP falls to Y2. The economy now has a recessionary gap equal to the difference between YP and Y2. Notice that this situation is particularly disagreeable, because both unemployment and the price level rose.
With real GDP below potential, though, there will eventually be pressure on the price level to fall. Increased unemployment also puts pressure on nominal wages to fall. In the long run, the short-run aggregate supply curve shifts back to SRAS1. In this case, real GDP returns to potential at YP, the price level falls back to P1, and employment returns to its natural level. These adjustments will close the recessionary gap.
How sticky prices and nominal wages are will determine the time it takes for the economy to return to potential. People often expect the government or the central bank to respond in some way to try to close gaps. This issue is addressed next.
Gaps and Public Policy
If the economy faces a gap, how do we get from that situation to potential output?
Gaps present us with two alternatives. First, we can do nothing. In the long run, real wages will adjust to the equilibrium level, employment will move to its natural level, and real GDP will move to its potential. Second, we can do something. Faced with a recessionary or an inflationary gap, policy makers can undertake policies aimed at shifting the aggregate demand or short-run aggregate supply curves in a way that moves the economy to its potential. A policy choice to take no action to try to close a recessionary or an inflationary gap, but to allow the economy to adjust on its own to its potential output, is a nonintervention policyA policy choice to take no action to try to close a recessionary or an inflationary gap, but to allow the economy to adjust on its own to its potential output.. A policy in which the government or central bank acts to move the economy to its potential output is called a stabilization policyA policy in which the government or central bank acts to move the economy to its potential output..
Nonintervention or Expansionary Policy?
Figure 22.17 illustrates the alternatives for closing a recessionary gap. In both panels, the economy starts with a real GDP of Y1 and a price level of P1. There is a recessionary gap equal to YPY1. In Panel (a), the economy closes the gap through a process of self-correction. Real and nominal wages will fall as long as employment remains below the natural level. Lower nominal wages shift the short-run aggregate supply curve. The process is a gradual one, however, given the stickiness of nominal wages, but after a series of shifts in the short-run aggregate supply curve, the economy moves toward equilibrium at a price level of P2 and its potential output of YP.
Panel (b) illustrates the stabilization alternative. Faced with an economy operating below its potential, public officials act to stimulate aggregate demand. For example, the government can increase government purchases of goods and services or cut taxes. Tax cuts leave people with more after-tax income to spend, boost their consumption, and increase aggregate demand. As AD1 shifts to AD2 in Panel (b) of Figure 22.17, the economy achieves output of YP, but at a higher price level, P3. A stabilization policy designed to increase real GDP is known as an expansionary policyA stabilization policy designed to increase real GDP..
Nonintervention or Contractionary Policy?
Figure 22.18 illustrates the alternatives for closing an inflationary gap. Employment in an economy with an inflationary gap exceeds its natural level—the quantity of labor demanded exceeds the long-run supply of labor. A nonintervention policy would rely on nominal wages to rise in response to the shortage of labor. As nominal wages rise, the short-run aggregate supply curve begins to shift, as shown in Panel (a), bringing the economy to its potential output when it reaches SRAS2 and P2.
A stabilization policy that reduces the level of GDP is a contractionary policyA stabilization policy designed to reduce real GDP.. Such a policy would aim at shifting the aggregate demand curve from AD1 to AD2 to close the gap, as shown in Panel (b). A policy to shift the aggregate demand curve to the left would return real GDP to its potential at a price level of P3.
For both kinds of gaps, a combination of letting market forces in the economy close part of the gap and of using stabilization policy to close the rest of the gap is also an option. Later chapters will explain stabilization policies in more detail, but there are essentially two types of stabilization policy: fiscal policy and monetary policy. Fiscal policyThe use of government purchases, transfer payments, and taxes to influence the level of economic activity. is the use of government purchases, transfer payments, and taxes to influence the level of economic activity. Monetary policyThe use of central bank policies to influence the level of economic activity. is the use of central bank policies to influence the level of economic activity.
To Intervene or Not to Intervene: An Introduction to the Controversy
How large are inflationary and recessionary gaps? Panel (a) of Figure 22.19 shows potential output versus the actual level of real GDP in the United States since 1960. Real GDP appears to follow potential output quite closely, although you see some periods where there have been inflationary or recessionary gaps. Panel (b) shows the sizes of these gaps expressed as percentages of potential output. The percentage gap is positive during periods of inflationary gaps and negative during periods of recessionary gaps. The economy seldom departs by more than 5% from its potential output.
Panel (a) gives a long-run perspective on the economy. It suggests that the economy generally operates at about potential output. In Panel (a), the gaps seem minor. Panel (b) gives a short-run perspective; the view it gives emphasizes the gaps. Both of these perspectives are important. While it is reassuring to see that the economy is often close to potential, the years in which there are substantial gaps have real effects: Inflation or unemployment can harm people.
Some economists argue that stabilization policy can and should be used when recessionary or inflationary gaps exist. Others urge reliance on the economy’s own ability to correct itself. They sometimes argue that the tools available to the public sector to influence aggregate demand are not likely to shift the curve, or they argue that the tools would shift the curve in a way that could do more harm than good.
Economists who advocate stabilization policies argue that prices are sufficiently sticky that the economy’s own adjustment to its potential will be a slow process—and a painful one. For an economy with a recessionary gap, unacceptably high levels of unemployment will persist for too long a time. For an economy with an inflationary gap, the increased prices that occur as the short-run aggregate supply curve shifts upward impose too high an inflation rate in the short run. These economists believe it is far preferable to use stabilization policy to shift the aggregate demand curve in an effort to shorten the time the economy is subject to a gap.
Economists who favor a nonintervention approach accept the notion that stabilization policy can shift the aggregate demand curve. They argue, however, that such efforts are not nearly as simple in the real world as they may appear on paper. For example, policies to change real GDP may not affect the economy for months or even years. By the time the impact of the stabilization policy occurs, the state of the economy might have changed. Policy makers might choose an expansionary policy when a contractionary one is needed or vice versa. Other economists who favor nonintervention also question how sticky prices really are and if gaps even exist.
The debate over how policy makers should respond to recessionary and inflationary gaps is an ongoing one. These issues of nonintervention versus stabilization policies lie at the heart of the macroeconomic policy debate. We will return to them as we continue our analysis of the determination of output and the price level.
Key Takeaways
• When the aggregate demand and short-run aggregate supply curves intersect below potential output, the economy has a recessionary gap. When they intersect above potential output, the economy has an inflationary gap.
• Inflationary and recessionary gaps are closed as the real wage returns to equilibrium, where the quantity of labor demanded equals the quantity supplied. Because of nominal wage and price stickiness, however, such an adjustment takes time.
• When the economy has a gap, policy makers can choose to do nothing and let the economy return to potential output and the natural level of employment on its own. A policy to take no action to try to close a gap is a nonintervention policy.
• Alternatively, policy makers can choose to try to close a gap by using stabilization policy. Stabilization policy designed to increase real GDP is called expansionary policy. Stabilization policy designed to decrease real GDP is called contractionary policy.
Try It!
Using the scenario of the Great Depression of the 1930s, as analyzed in the previous Try It!, tell what kind of gap the U.S. economy faced in 1933, assuming the economy had been at potential output in 1929. Do you think the unemployment rate was above or below the natural rate of unemployment? How could the economy have been brought back to its potential output?
Case in Point: Survey of Economists Reveals Little Consensus on Macroeconomic Policy Issues
Figure 22.20
Wikimedia Commons – CC BY-SA 3.0.
“An economy in short-run equilibrium at a real GDP below potential GDP has a self-correcting mechanism that will eventually return it to potential real GDP.”
Of economists surveyed, 36% disagreed, 33% agreed with provisos, 25% agreed, and 5% did not respond. So, only about 60% of economists responding to the survey agreed that the economy would adjust on its own.
“Changes in aggregate demand affect real GDP in the short run but not in the long run.”
On this statement, 36% disagreed, 31% agreed with provisos, 29% agreed, and 4% did not respond. Once again, about 60% of economists accepted the conclusion of the aggregate demand–aggregate supply model.
This level of disagreement on macroeconomic policy issues among economists, based on a fall 2000 survey of members of the American Economic Association, stands in sharp contrast to their more harmonious responses to questions on international economics and microeconomics. For example,
“Tariffs and import quotas usually reduce the general welfare of society.”
Seventy-two percent of those surveyed agreed with this statement outright and another 21% agreed with provisos. So, 93% of economists generally agreed with the statement.
“Minimum wages increase unemployment among young and unskilled workers.”
On this, 45% agreed and 29% agreed with provisos.
“Pollution taxes or marketable pollution permits are a more economically efficient approach to pollution control than emission standards.”
On this environmental question, only 6% disagreed and 63% wholeheartedly agreed.
The relatively low degree of consensus on macroeconomic policy issues and the higher degrees of consensus on other economic issues found in this survey concur with results of other periodic surveys since 1976.
So, as textbook authors, we will not hide the dirty laundry from you. Fortunately, though, the model of aggregate demand–aggregate supply we present throughout the macroeconomic chapters can handle most of these disagreements. For example, economists who agree with the first proposition quoted above, that an economy operating below potential has self-correcting mechanisms to bring it back to potential, are probably assuming that wages and prices are not very sticky and hence that the short-run aggregate supply curve will shift rather easily to the right, as shown in Panel (a) of Figure 22.17. In contrast, economists who disagree with the statement are saying that the movement of the short-run aggregate supply curve is likely to be slow. This latter group of economists probably advocates expansionary policy as shown in Panel (b) of Figure 22.17. Both groups of economists can use the same model and its constructs to analyze the macroeconomy, but they may disagree on such things as the slopes of the various curves, on how fast these various curves shift, and on the size of the underlying multiplier. The model allows economists to speak the same language of analysis even though they disagree on some specifics.
Answer to Try It! Problem
To the graph in the previous Try It! problem we add the long-run aggregate supply curve to show that, with output below potential, the U.S. economy in 1933 was in a recessionary gap. The unemployment rate was above the natural rate of unemployment. Indeed, real GDP in 1933 was about 30% below what it had been in 1929, and the unemployment rate had increased from 3% to 25%. Note that during the period of the Great Depression, wages did fall. The notion of nominal wage and other price stickiness discussed in this section should not be construed to mean complete wage and price inflexibility. Rather, during this period, nominal wages and other prices were not flexible enough to restore the economy to the potential level of output. There are two basic choices on how to close recessionary gaps. Nonintervention would mean waiting for wages to fall further. As wages fall, the short-run aggregate supply curve would continue to shift to the right. The alternative would be to use some type of expansionary policy. This would shift the aggregate demand curve to the right. These two options were illustrated in Figure 22.18.
Figure 22.21 | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/07%3A_Aggregate_Demand_and_Aggregate_Supply/7.3%3A_Recessionary_and_Inflationary_Gaps_and_Long-Run_Macroeconomic_Equilibrium.txt |
Summary
In this chapter, we outlined the model of aggregate demand and aggregate supply. We saw that the aggregate demand curve slopes downward, reflecting the tendency for the aggregate quantity of goods and services demanded to rise as the price level falls and to fall as the price level rises. The negative relationship between the price level and the quantity of goods and services demanded results from the wealth effect for consumption, the interest rate effect for investment, and the international trade effect for net exports. We examined the factors that can shift the aggregate demand curve as well. Generally, the aggregate demand curve shifts by a multiple of the initial amount by which the component causing it to shift changes.
We distinguished between two types of equilibria in macroeconomics—one corresponding to the short run, a period of analysis in which nominal wages and some prices are sticky, and the other corresponding to the long run, a period in which full wage and price flexibility, and hence market adjustment, have been achieved. Long-run equilibrium occurs at the intersection of the aggregate demand curve with the long-run aggregate supply curve. The long-run aggregate supply curve is a vertical line at the economy’s potential level of output. Short-run equilibrium occurs at the intersection of the aggregate demand curve with the short-run aggregate supply curve. The short-run aggregate supply curve relates the quantity of total output produced to the price level in the short run. It is upward sloping because of wage and price stickiness. In short-run equilibrium, output can be below or above potential.
If an economy is initially operating at its potential output, then a change in aggregate demand or short-run aggregate supply will induce a recessionary or inflationary gap. Such a gap will be closed in the long run by changes in the nominal wage, which will shift the short-run aggregate supply curve to the left (to close an inflationary gap) or to the right (to close a recessionary gap). Policy makers might respond to a recessionary or inflationary gap with a nonintervention policy, or they could use stabilization policy.
Concept Problems
1. Explain how the following changes in aggregate demand or short-run aggregate supply, other things held unchanged, are likely to affect the level of total output and the price level in the short run.
1. An increase in aggregate demand
2. A decrease in aggregate demand
3. An increase in short-run aggregate supply
4. A reduction in short-run aggregate supply
2. Explain why a change in one component of aggregate demand will cause the aggregate demand curve to shift by a multiple of the initial change.
3. Use the model of aggregate demand and short-run aggregate supply to explain how each of the following would affect real GDP and the price level in the short run.
1. An increase in government purchases
2. A reduction in nominal wages
3. A major improvement in technology
4. A reduction in net exports
4. How would an increase in the supply of labor affect the natural level of employment and potential output? How would it affect the real wage, the level of real GDP, and the price level in the short run? How would it affect long-run aggregate supply? What kind of gaps would be created?
5. Give three reasons for the downward slope of the aggregate demand curve.
6. “When the price level falls, people’s wealth increases. When wealth increases, the real volume of consumption increases. Therefore, a decrease in the price level will cause the aggregate demand curve to shift to the right.” Do you agree? Explain.
7. Suppose the economy has a recessionary gap. We know that if we do nothing, the economy will close the gap on its own. Alternatively, we could arrange for an increase in aggregate demand (say, by increasing government spending) to close the gap. How would your views about the degree of price stickiness in the economy influence your views on whether such a policy would be desirable?
8. The cost of hiring workers includes not only payments made directly to workers, that is, wages, but payments made on behalf of workers as well, such as contributions by employers to pension plans and to health-care insurance for employees. How would a decrease in the cost of employer-provided health insurance affect the economy? Using Figure 22.9 as a guide, draw a graph to illustrate your answer.
9. Suppose nominal wages never changed. What would be the significance of such a characteristic?
10. Suppose the minimum wage were increased sharply. How would this affect the equilibrium price level and output level in the model of aggregate demand and aggregate supply in the short run? In the long run?
11. Explain the short-run impact of each of the following.
1. A discovery that makes cold fusion a reality, greatly reducing the cost of producing energy
2. An increase in the payroll tax
Numerical Problems
1. Suppose the aggregate demand and short-run aggregate supply schedules for an economy whose potential output equals \$2,700 are given by the table.
Aggregate Quantity of Goods and Services
Price Level Demanded Supplied
0.50 \$3,500 \$1,000
0.75 3,000 2,000
1.00 2,500 2,500
1.25 2,000 2,700
1.50 1,500 2,800
1. Draw the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves.
2. State the short-run equilibrium level of real GDP and the price level.
3. Characterize the current economic situation. Is there an inflationary or a recessionary gap? If so, how large is it?
4. Now suppose aggregate demand increases by \$700 at each price level; for example, the aggregate quantity of goods and services demanded at a price level of 0.50 now equals \$4,200. Show the new aggregate demand curve, state the new short-run equilibrium price level and real GDP, and state whether there is an inflationary or a recessionary gap and give its size.
2. An economy is characterized by the values in the table for aggregate demand and short-run aggregate supply. Its potential output is \$1,500.
Aggregate Quantity of Goods and Services
Price Level Demanded Supplied
0.50 \$2,500 \$1,500
0.75 2,000 2,000
1.00 1,500 2,300
1.25 1,000 2,500
1.50 500 2,600
1. Draw the aggregate demand, short-run aggregate supply, and long-run aggregate supply curves.
2. State the equilibrium level of real GDP and the price level.
3. Characterize the current economic situation. Is there an inflationary or a recessionary gap? If so, how large is it?
4. Now suppose that nominal wages rise and that the price level required to induce a particular level of total output rises by 0.50. For example, a price level of 1.00 is now required to induce producers to produce a real GDP of \$1,500. Show the new short-run aggregate supply curve, state the new equilibrium price level and real GDP, and state whether there is an inflationary or a recessionary gap and give its size. Why might such a change occur?
3. Suppose the price level in a particular economy equals 1.3 and that the quantity of real GDP demanded at that price level is \$1,200. An increase of 0.1 point in the price level reduces the quantity of real GDP demanded by \$220, and a reduction of 0.1 point would produce an increase in the quantity of real GDP demanded of \$220. Draw the aggregate demand curve and show the price level and quantity of real GDP demanded at three points.
4. Suppose an economy is described by the following aggregate demand and short-run aggregate supply curves. The potential level of output is \$10 trillion.
Aggregate Quantity of Goods and Services
Price Level Demanded Supplied
3.0 \$11.0 trillion \$9.0 trillion
3.4 \$10.8 trillion \$9.2 trillion
3.8 \$10.6 trillion \$9.4 trillion
4.2 \$10.4 trillion \$9.6 trillion
4.6 \$10.2 trillion \$9.8 trillion
5.0 \$10.0 trillion \$10.0 trillion
5.4 \$9.8 trillion \$10.2 trillion
5.8 \$9.6 trillion \$10.4 trillion
6.2 \$9.4 trillion \$10.6 trillion
6.6 \$9.2 trillion \$10.8 trillion
7.0 \$9.0 trillion \$11.0 trillion
1. Draw the aggregate demand and short-run aggregate supply curves.
2. What is the initial real GDP?
3. What is the initial price level?
4. What kind of gap, if any, exists?
5. After the increase in health-care costs, each level of real GDP requires an increase in the price level of 0.8. For example, producing \$9.0 trillion worth of goods and services now requires a price level of 3.8. What is the short-run equilibrium level of real GDP?
6. After the health-care cost increase, what is the new equilibrium price level in the short run?
7. What sort of gap, if any, now exists?
5. According to Alaskan state economist Mark Edwards, the multiplier effect of Alaska’s trade with Japan is such that for every \$1 billion exported from Alaska to Japan another \$600 million is added to the state’s economy (Volz, M., 2004). Calculate the size of the export multiplier.
6. The Nottinghamshire Research Observatory in England calculated that students who attend Nottingham Technical University spend about £2,760 each in the local economy for a total of £50.45 million. In total, the impact of their spending on the local economy is £63 million (Nottingham Evening Post, 2004). Calculate the size of the student spending multiplier.
7. In Goa, India, the multiplier effect of iron ore exports is calculated to be 1.62 (Ta, V. K., 2003). Calculate the impact of an additional 1,000 rupees of iron ore exports on the economy of Goa. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/07%3A_Aggregate_Demand_and_Aggregate_Supply/7.4%3A_Review_and_Practice.txt |
Thumbnail: https://pixabay.com/illustrations/chart-business-concept-success-up-5061484/
08: Economic Growth
Learning Objective
1. Define economic growth and explain it using the production possibilities model and the concept of potential output.
2. State the rule of 72 and use it to show how even small differences in growth rates can have major effects on a country’s potential output over time.
3. Calculate the percentage rate of growth of output per capita.
To demonstrate the impact of economic growth on living standards of a nation, we must start with a clear definition of economic growth and then study its impact over time. We will also see how population growth affects the relationship between economic growth and the standard of living an economy is able to achieve.
Defining Economic Growth
Economic growth is a long-run process that occurs as an economy’s potential output increases. Changes in real GDP from quarter to quarter or even from year to year are short-run fluctuations that occur as aggregate demand and short-run aggregate supply change. Regardless of media reports stating that the economy grew at a certain rate in the last quarter or that it is expected to grow at a particular rate during the next year, short-run changes in real GDP say little about economic growth. In the long run, economic activity moves toward its level of potential output. Increases in potential constitute economic growth.
Earlier we defined economic growth as the process through which an economy achieves an outward shift in its production possibilities curve. How does a shift in the production possibilities curve relate to a change in potential output? To produce its potential level of output, an economy must operate on its production possibilities curve. An increase in potential output thus implies an outward shift in the production possibilities curve. In the framework of the macroeconomic model of aggregate demand and aggregate supply, we show economic growth as a shift to the right in the long-run aggregate supply curve.
There are three key points about economic growth to keep in mind:
1. Growth is a process. It is not a single event; rather, it is an unfolding series of events.
2. We define growth in terms of the economy’s ability to produce goods and services, as indicated by its level of potential output.
3. Growth suggests that the economy’s ability to produce goods and services is rising. A discussion of economic growth is thus a discussion of the series of events that increase the economy’s ability to produce goods and services.
Figure 23.1 shows the record of economic growth for the U.S. economy over the past century. The graph shows annual levels of actual real GDP and of potential output. We see that the economy has experienced dramatic growth over the past century; potential output has soared more than 30-fold. The figure also reminds us of a central theme of our analysis of macroeconomics: real GDP fluctuates about potential output. Real GDP sagged well below its potential during the Great Depression of the 1930s and rose well above its potential as the nation mobilized its resources to fight World War II. With the exception of these two periods, real GDP has remained close to the economy’s potential output. Since 1950, the actual level of real GDP has deviated from potential output by an average of less than 2%.
Figure 23.1 A Century of Economic Growth
At the start of the 21st century, the level of potential output reached a level nearly 30 times its level a century earlier. Over the years, actual real GDP fluctuated about a rising level of potential output.
We urge you to take some time with Figure 23.1. Over the course of the last century, it is economic growth that has taken center stage. Certainly, the fluctuations about potential output have been important. The recessionary gaps—periods when real GDP slipped below its potential—were often wrenching experiences in which millions of people endured great hardship. The inflationary gaps—periods when real GDP rose above its potential level—often produced dramatic increases in price levels. Those fluctuations mattered. It was the unemployment and/or the inflation that came with them that made headlines. But it was the quiet process of economic growth that pushed living standards ever higher. We must understand growth if we are to understand how we got where we are, and where we are likely to be going during the 21st century.
Figure 23.2 tells us why we use changes in potential output, rather than actual real GDP, as our measure of economic growth. Actual values of real GDP are affected not just by changes in the potential level of output, but also by the cyclical fluctuations about that level of output.
Given our definition of economic growth, we would say that the hypothetical economy depicted in Figure 23.2 grew at a 2.5% annual rate throughout the period. If we used actual values of real GDP, however, we would obtain quite different interpretations. Consider, for example, the first decade of this period: it began with a real GDP of \$900 billion and a recessionary gap, and it ended in year 10 with a real GDP of \$1,408 billion and an inflationary gap. If we record growth as the annual rate of change between these levels, we find an annual rate of growth of 4.6%—a rather impressive performance.
Now consider the second decade shown in Figure 23.2. It began in year 10, and it ended in year 20 with a recessionary gap. If we measure the growth rate over that period by looking at beginning and ending values of actual real GDP, we compute an annual growth rate of 0.5%. Viewed in this way, performance in the first decade is spectacular while performance in the second is rather lackluster. But these figures depend on the starting and ending points we select; the growth rate of potential output was 2.5% throughout the period.
By measuring economic growth as the rate of increase in potential output, we avoid such problems. One way to do this is to select years in which the economy was operating at the natural level of employment and then to compute the annual rate of change between those years. The result is an estimate of the rate at which potential output increased over the period in question. For the economy shown in Figure 23.2, for example, we see that real GDP equaled its potential in years 5 and 15. Real GDP in year 5 was \$1,131, and real GDP in year 15 was \$1,448. The annual rate of change between these two years was 2.5%. If we have estimates of potential output, of course, we can simply compute annual rates of change between any two years.
The Rule of 72 and Differences in Growth Rates
The Case in Point on presidents and growth at the end of this section suggests a startling fact: the U.S. growth rate began slowing in the 1970s, did not recover until the mid-1990s, only to slow down again in the 2000s. The question we address here is: does it matter? Does a percentage point drop in the growth rate make much difference? It does. To see why, let us investigate what happens when a variable grows at a particular percentage rate.
Suppose two economies with equal populations start out at the same level of real GDP but grow at different rates. Economy A grows at a rate of 3.5%, and Economy B grows at a rate of 2.4%. After a year, the difference in real GDP will hardly be noticeable. After a decade, however, real GDP in Economy A will be 11% greater than in Economy B. Over longer periods, the difference will be more dramatic. After 100 years, for example, income in Economy A will be nearly three times as great as in Economy B. If population growth in the two countries has been the same, the people of Economy A will have a far higher standard of living than those in Economy B. The difference in real GDP per person will be roughly equivalent to the difference that exists today between Great Britain and Mexico.
Over time, small differences in growth rates create large differences in incomes. An economy growing at a 3.5% rate increases by 3.5% of its initial value in the first year. In the second year, the economy increases by 3.5% of that new, higher value. In the third year, it increases by 3.5% of a still higher value. When a quantity grows at a given percentage rate, it experiences exponential growthWhen a quantity grows at a given percentage rate.. A variable that grows exponentially follows a path such as those shown for potential output in Figure 23.1 and Figure 23.2. These curves become steeper over time because the growth rate is applied to an ever-larger base.
A variable growing at some exponential rate doubles over fixed intervals of time. The doubling time is given by the rule of 72A variable’s approximate doubling time equals 72 divided by the growth rate, stated as a whole number., which states that a variable’s approximate doubling time equals 72 divided by the growth rate, stated as a whole number. If the level of income were increasing at a 9% rate, for example, its doubling time would be roughly 72/9, or 8 years1.
Let us apply this concept of a doubling time to the reduction in the U.S. growth rate. Had the U.S. economy continued to grow at a 3.5% rate after 1970, then its potential output would have doubled roughly every 20 years (72/3.5 = 20). That means potential output would have doubled by 1990, would double again by 2010, and would double again by 2030. Real GDP in 2030 would thus be eight times as great as its 1970 level. Growing at a 2.4% rate, however, potential output doubles only every 30 years (72/2.4 = 30). It would take until 2000 to double once from its 1970 level, and it would double once more by 2030. Potential output in 2030 would thus be four times its 1970 level if the economy grew at a 2.4% rate (versus eight times its 1970 level if it grew at a 3.5% rate). The 1.1% difference in growth rates produces a 100% difference in potential output by 2030. The different growth paths implied by these growth rates are illustrated in Figure 23.3.
Growth in Output per Capita
Of course, it is not just how fast potential output grows that determines how fast the average person’s material standard of living rises. For that purpose, we examine economic growth on a per capita basis. An economy’s output per capitaReal GDP per person. equals real GDP per person. If we let N equal population, then
Equation 23.1
In the United States in the third quarter of 2010, for example, real GDP was \$13,277.4 billion (annual rate). The U.S. population was 311.0 million. Real U.S. output per capita thus equaled \$42,693.
We use output per capita as a gauge of an economy’s material standard of living. If the economy’s population is growing, then output must rise as rapidly as the population if output per capita is to remain unchanged. If, for example, population increases by 2%, then real GDP would have to rise by 2% to maintain the current level of output per capita. If real GDP rises by less than 2%, output per capita will fall. If real GDP rises by more than 2%, output per capita will rise. More generally, we can write:
Equation 23.2
For economic growth to translate into a higher standard of living on average, economic growth must exceed population growth. From 1970 to 2004, for example, Sierra Leone’s population grew at an annual rate of 2.1% per year, while its real GDP grew at an annual rate of 1.4%; its output per capita thus fell at a rate of 0.7% per year. Over the same period, Singapore’s population grew at an annual rate of 2.1% per year, while its real GDP grew 7.4% per year. The resultant 5.3% annual growth in output per capita transformed Singapore from a relatively poor country to a country with the one of the highest per capita incomes in the world.
Key Takeaways
• Economic growth is the process through which an economy’s production possibilities curve shifts outward. We measure it as the rate at which the economy’s potential level of output increases.
• Measuring economic growth as the rate of increase of the actual level of real GDP can lead to misleading results due to the business cycle.
• Growth of a quantity at a particular percentage rate implies exponential growth. When something grows exponentially, it doubles over fixed intervals of time; these intervals may be computed using the rule of 72.
• Small differences in rates of economic growth can lead to large differences in levels of potential output over long periods of time.
• To assess changes in average standards of living, we subtract the percentage rate of growth of population from the percentage rate of growth of output to get the percentage rate of growth of output per capita.
Try It!
Suppose an economy’s potential output and real GDP is \$5 million in 2000 and its rate of economic growth is 3% per year. Also suppose that its population is 5,000 in 2000, and that its population grows at a rate of 1% per year. Compute GDP per capita in 2000. Now estimate GDP and GDP per capita in 2072, using the rule of 72. At what rate does GDP per capita grow? What is its doubling time? Is this result consistent with your findings for GDP per capita in 2000 and in 2072?
Case in Point: Presidents and Economic Growth
Figure 23.4
Wikimedia Commons – public domain; Wikimedia Commons – public domain.
President Annual Increase in Real GDP (%) Growth Rate (%)
Truman 1949–1952 5.4 4.4
Eisenhower 1953–1960 2.4 3.4
Kennedy-Johnson 1961–1968 5.1 4.3
Nixon-Ford 1969–1976 2.7 3.4
Carter 1977–1980 3.2 3.1
Reagan 1981–1988 3.5 3.1
G. H. W. Bush 1989–1992 2.4 2.7
Clinton 1992–2000 3.6 3.2
G. W. Bush 2001–2008 (Q3) 2.1 2.7
Presidents are often judged by the rate at which the economy grew while they were in office. This test is unfair on two counts. First, a president has little to do with the forces that determine growth. And second, such tests simply compute the annual rate of growth in real GDP over the course of a presidential term, which we know can be affected by cyclical factors. A president who takes office when the economy is down and goes out with the economy up will look like an economic star; a president with the bad luck to have reverse circumstances will seem like a dud. Here are annual rates of change in real GDP for each of the postwar presidents, together with rates of economic growth, measured as the annual rate of change in potential output.
The presidents’ economic records are clearly affected by luck. Presidents Truman, Kennedy, Reagan, and Clinton, for example, began their terms when the economy had a recessionary gap and ended them with an inflationary gap or at about potential output. Real GDP thus rose faster than potential output during their presidencies. The Eisenhower, Nixon-Ford, H. W. Bush, and G. W. Bush administrations each started with an inflationary gap or at about potential and ended with a recessionary gap, thus recording rates of real GDP increase below the rate of gain in potential. Only Jimmy Carter, who came to office and left it with recessionary gaps, presided over a relatively equivalent rate of increase in actual GDP versus potential output.
Answer to Try It! Problem
GDP per capita in 2000 equals \$1,000 (\$5,000,000/5,000). If GDP rises 3% per year, it doubles every 24 years (= 72/3). Thus, GDP will be \$10,000,000 in 2024, \$20,000,000 in 2048, and \$40,000,000 in 2072. Growing at a rate of 1% per year, population will have doubled once by 2072 to 10,000. GDP per capita will thus be \$4,000 (= \$40,000,000/10,000). Notice that GDP rises by eight times its original level, while the increase in GDP per capita is fourfold. The latter value represents a growth rate in output per capita of 2% per year, which implies a doubling time of 36 years. That gives two doublings in GDP per capita between 2000 and 2072 and confirms a fourfold increase.
1Notice the use of the words roughly and approximately. The actual value of an income of \$1,000 growing at rate r for a period of n years is \$1,000 × (1 + r)n. After 8 years of growth at a 9% rate, income would thus be \$1,000 (1 + 0.09)8 = \$1,992.56. The rule of 72 predicts that its value will be \$2,000. The rule of 72 gives an approximation, not an exact measure, of the impact of exponential growth. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_(LibreTexts)/08%3A_Economic_Growth/8.1%3A_The_Significance_of_Economic_Growth.txt |
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