I. Growth is one of the four central problems of macroeconomics. The others are business cycles, unemployment, and inflation.

A. The benefits and costs of growth.
1. Generally the U.S. economy is growing or expanding.
2. The primary measurement of growth is changes in real gross domestic product (GDP) -the market value of goods and services stated in the prices of a given year.
3. Since 1890, the U.S. economic output has grown at an annual rate of 2.5 to 3.5 per annum. This is called the secular growth trend.
4. Per capita economic growth allows everyone in society, on average to have more.
5. Politically, growth, or predictions of growth, allows governments to avoid hard questions.
a. A growing economy creates jobs, to the joy of politicians.
b. There are costs to material growth: pollution, resource exhaustion, and destruction to natural habitat.
c. Since many believe these environmental costs are important, the result is often an environmental - economic growth stalemate.

B. The sources of growth.
1. Institutions with incentives compatible with growth.
a. Growth compatible institutions - those that foster growth - must have incentives built into them that lead people to work hard and discourage people from activities that inhibit growth.
b. Private ownership of property plays an important role in growth.
c. A corporation is another example of a growth - promoting economic institution because of limited liability.
d. Many developing nations have merchantilistic policies dictating governmental permission before economic activity can take place. This does not foster growth.
2. Technological development.
a. Growth in some ways involves more of the same, a much larger aspect of growth involves changes in technology - changes in the goods we buy and changes in the way we make goods.
b. Society gets people to work on these new developments by:
(1) Providing incentives.
(2) Working with institutions that foster creativity and bold thinking.
(3) Working through institutions that foster hard work.
c. U.S. educational institutions do a good job of fostering creativity but a poor job of fostering hard work.
3. Available resources.
a. What is a resource depends on the technology used.
b. A resource in one time period may not be a resource in another.
4. Investment and accumulated capital.
a. Capital accumulation and investment were once seen as the key elements to growth.
b. This is not longer thought to be true because:
(1) The empirical evidence does not support it.
(2) Products and processes change.
(3) Capital is far more than machines.
(a) Capital also includes human capital - peoples' knowledge, and
(b) Social capital - the habitual way of doing things that guides people in how they approach production.
5. Entrepreneurship.
6. Turning the sources of growth into growth.
a. Even if the five ingredients to growth exist, they may not exist in the right proportion.
b. It is the combination of investing in machines and technological change that plays a central role in the growth of any economy.

II. Business Cycles
A. Although the secular growth trend is a average 2.5 to 3.5 percent increase in GDP, there are numerous fluctuations around that trend called a business cycle -the upward or downward movement of economic activity, or real GDP, that occurs around the growth trend.
B. There are a number of theories regarding business cycles.
1. The Classicals generally favor laissez-faire or non interventionist policies.
2. The Keynesians generally favor activist policies.
3. The rational expectationists argue that expectations about the future based on the best current information is often undermined by the public who anticipate government's actions and do the opposite of what is expected of them.

C. Each business cycle is different. After World War II, however, down turns have been less severe.
1. If prolonged contractions are a type of cold the economy catches, the Great Depression of the 1930s was double pneumonia.
2. If the severity of business fluctuations has been reduced, one reason is that changes in institutional structure were made as a result of the Great Depression.

E. The phases of the business cycle.
1. Since 1945, the average expansion has lasted about 51 months .
2. The four phases of the business cycle are:
a. The peak is the tope of the business cycle. A boom is a very high peak, representing a big jump in output.
b. The downturn -the phenomenon of economic activity starting to fall from a peak. A recession is a decline in output that persists for more than two consecutive quarters in a year. A depression is a large recession.
c. The bottom of the recession or depression is called the trough.
d. As total output starts to expand, the economy comes out of the trough into an upturn, which may turn into an expansion -an upturn that lasts at least two consecutive quarters of a year.

F. Leading indicators are those that tell us what's likely to happen in the economy 12 to 15 months from now.
1. They include:
a. Average workweek for production workers in manufacturing.
b. Unemployment claims.
c. New orders for consumer goods and materials.
d. Vendor performance, measured as a percentage of companies reporting slower deliveries from suppliers.
e. Contracts and orders for plant and equipment.
f. Number of new building permits issued for private housing units.
g. Change in stock prices
h. Change in consumer expectations.
i. Changes in the money supply.
2. The drudge work of sifting through statistical series is the backbone of business economists' work.

III. Unemployment

A. Business cycles and growth are directly related to unemployment in the U.S. economy.
1. Unemployment occurs when people are looking for a job and cannot find one.
2. The unemployment rate is the number of people who cannot find a job as a percent of those people in the economy who are willing and able to work.
3. Cyclical unemployment is that which results from fluctuations in economic activity. It did not exist in pre-industrial society.
4. Structural unemployment -that caused by economic restructuring making some skills obsolete, did exist in pre-industrial society.
5. The Industrial Revolution changed the nature of work and introduced unemployment as a problem for society.
a. It created the possibility of cyclical unemployment.
b. The Industrial Revolution was accompanied by a change in how families dealt with unemployment. What had previously been a family problem, now became a social problem.
c. The early solution for unemployment hunger was not an effective answer to unemployment.
d. In the Employment Act of 1946, government took responsibility for full employment - an economic climate in which just about everyone who wants a job can have one.
6. Initially government regarded 2 percent unemployment as a condition of full employment. The 2 percent was made up of frictional unemployment -unemployment caused by new entrants into the job market and people quitting a job just long enough to look for and find another one.
7. The target rate of unemployment is the lowest sustainable rate of unemployment that policy makers believe is achievable under existing conditions.
8. In the 1980s and 1990s, the target rate of unemployment was been between 5 and 7 percent.
9. The target rate of unemployment has changed over time because:
a. In the 1970s and early 1980s, a low inflation rate seemed to be incompatible with a low unemployment rate.
b. Demographics have changed. Different age groups have different rates of unemployment.
c. Social and institutional structures have changed.
d. The economy has undergone major structural readjustments - modifications in the types of goods produced and the methods of production.
e. Governmental institutions also changed.

B. Whose responsibility is unemployment?
1. The Classicals believe that individuals are responsible for their own employment.
2. Keynesian economists tend to say that society owes a person a job commensurate with the individual's training or past job experience.

C. How is unemployment measured?
1. The unemployment rate is published by the U.S. Department of Labor's Bureau of labor Statistics. visit the Bureau of Labor Statistics on the Internet at : http://stats.bls.gov.]
2. Calculating the unemployment rate.
a. The unemployment rate is calculated by dividing the number of unemployed individuals by the number of people in the civilian labor force and multiplying by 100.
b. The labor force is those people in an economy who are willing and able to work.
3. How accurate is the official unemployment rate?
a. The unemployment rate does not include discouraged workers - people who do not look for a job because they feel they do not have a chance of getting one.
b. The unemployment rate counts as employed those who are underemployed part time workers who would prefer full-time work.
c. Both sides - the Classicals and the Keynesians -for completely different reasons, agree that the unemployment figures are imperfect.

D. Unemployment and potential income.
1. The capacity utilization rate - the rate at which factories and machines are operating compared to the maximum sustainable rate at which they could be used, indicates how much capital is available for economic growth.
2. Potential output is the output that would materialize at the target rate of unemployment and the target rate of capacity utilization.
3. Potential income is defined as the output that will be achieved at the target rate of unemployment and at the target level of capacity utilization.
4. There is debate about where the actual level of potential income is.
5. To determine the effect changes in the unemployment rate will have on income, we use Okum's rule of thumb, which states that a 1 percentage point change in unemployment will cause income to change in the opposite direction by 2.5 percent.

E. Microeconomic categories of unemployment.
1. Macroeconomic measures of unemployment may be too crude. Different types of unemployment are susceptible to different types of products.
2. Some microeconomic categories of unemployment are reason for how people become unemployed, demographic unemployment, duration of unemployment, and unemployment by industry.

V. Inflation
A. Inflation is a continual rise in the price level.
B. Since World War II, the U.S. inflation rate has remained positive and relatively stable.
C. Measurement of inflation.
1. In order to estimate inflation one must first create a price index, or a composite of prices - a series of number that summarizes what happens to prices of a selection of goods (often called a market basket of goods) over time.

2. The Producer Price Index (PPI) is an index or ratio of a composite of prices of a number of important raw materials, such as steel, relative to a composite of the prices of those raw materials in a base year.
a. It does not accurately measure what most consumers are interested in final goods.
b. It does, however, give an early indication as to where inflation is headed.
3. The GDP deflator (gross domestic product deflator) is an index of the price level of aggregate output or the average price of the components in GDP relative to a base year.
a. This is the measure of inflation most economists favor since it includes the widest number of goods.
b. Since it is difficult to compute, it is published only quarterly and with a fairly substantial lag.
4. The Consumer Price Index (CPI) measures the prices of a fixed 'basket' of consumer goods, weighed according to each component's share of an average consumer's expenditures.
a. It is the measure of inflation most often presented in news broadcasts.
b. Many economists believe that the CPI as currently constituted, overstates inflation by one to two percentage points.

D. Real and nominal concepts.
1. Real output is the total amount of goods and services produced, adjusted for price level changes.
Real output = Nominal Output/Price Index X100
2. Nominal output is the total amount of goods and services as measured by current prices.
3. The 'real' amount is the nominal amount divided by the price index. It is the nominal amount adjusted for inflation.

E. Why does inflation occur?
1. The economy has nominal wage- and price-setting institutions in which people set their relative prices by setting a nominal price.
2. When the majority of industries are close to capacity and they experience increases in demand, we say there is demand pull inflation -inflation that occurs when the economy is at or above full employment.
3. Cost-push inflation involves a rise in the price level resulting from restrictions on supply due to some sort of legal or social pressure.

F. Expected and unexpected inflation.
1. Expected inflation is that which people anticipate.
2. Unexpected inflation is that which surprises people.
3. Expectations of inflation play an important role in exacerbating inflation further.

G. Costs of inflation.
1. While inflation may not make the nation poorer, it does cause income to be redistributed from those who do not raise their price to those who do, for example, from lenders to borrowers, and it can reduce the amount of information that prices are supposed to convey.
2. Despite redistributive costs and a blurring of price information, inflation is usually accepted by governments as long as it stays at a low level.
3. The danger is when inflation becomes hyperinflation - exceptionally high levels of inflation of, say, 100 percent or more a year.
4. The U.S. has never experienced a hyperinflation.

V. The Interrelationship of Growth, Inflation, and Unemployment

Irwin/McGraw-Hill Copyright 1998, The McGraw-Hill Companies, Inc.

Lecture Notes Ch. 7   National Income Accounting

G.D.P.
DEFINITIONS:
1. GDP is the sum of the market values of all final goods and services produced during a period of time by the resources located on the country's territory, regardless of who owned those resources.
2. NOMINAL OR CURRENT GDP ( Money value in any year), is the total value of the nation's output, in dollar terms, in prices ruling at the moment. It measures the quantities produced and market prices.
3. REAL OR CONSTANT DOLLAR GDP ( GDP adjusted to the price changes), measures the quantities produced in the year valued in terms of prices ruling in some base year. Measure only the changes in output or total quantities.
4. NATIONAL PRODUCT is the income measure in constant dollars and measures the total quantity of output produced. The common denominator is dollars.
5. POTENTIAL GDP OR FULL EMPLOYMENT GDP tells what the economy would produced if its productive resources were fully employed at their normal intensity use. It is the maximum practical utilization of economic resources not necessarily at a 100% capacity.
6. ACTUAL GDP what the economy in fact is actually producing.
Actual nominal GDP: when measured in current dollar terms
Actual Real GDP: when measured in constant dollars.
7. GDP GAPS  are the differences between Potential GDP and the Actual GDP. There are two important ones: INFLATIONARY GAP AND DEFLATIONARY GAP

NATIONAL INCOME OR SOCIAL ACCOUNTING OF THE GDP
1. Measure or estimates the GDP = the total output all all goods and services produced in the economy within a period of time regardless of ownership.
2. NET NATIONAL PRODUCT: N.N.P. = GDP - DEPRECIATION
The annual output of all the goods and services over and above (in excess of) the stock of capital goods with which the economy began the year.
3. NATIONAL INCOME: N.I. = NNP - ( indirect business taxes + transfer payments) + subsidies.
The total income earned by the owners of the factors of production and suppliers of them during the year.
4. PERSONAL INCOME: PI = NI - (Corporate profits + Soc. sec.) + government transfer payments.
The total income actually received (whether earned or unearned) by the suppliers of resources ( or total income earned or received and unearned income) before payment of personal taxes.
5. DISPOSABLE INCOME: D.I. = PI - personal taxes
Total income available Net income) to resource suppliers after the payment of personal taxes.
6. DI = C + S S = Y - C C = Y - S
7. DEPRECIATION: ( Capital consumption allowance) The decrease in the value of capital stock or the value of a durable input that results from wear and tear and the passage of time.
 

I. National Income Accounting
A. A prelude. Before talking about macroeconomics in depth, the student needs to review to some terminology and the Circular Flow.
1. Macroeconomic statistics such as GDP and its components.
2. The difference between real and nominal statistics.
a. Real concepts are those adjusted for inflation.
b. Nominal concepts are those specified in monetary terms with no adjustments for inflation.
3. In the 1930s it was impossible to talk intelligently about macroeconomics since the discussion lacked rigorous terminology.
4. In the mid-1930s, Keynesians (Simon Kuznets and Richard Stone) began to develop this terminology.
5. They developed national income accounting - a set of rules and definitions for measuring economic activity in the aggregate economy, that is, in the economy as a whole.

B. Measuring total economic output of goods and services.
1. Gross Domestic product (GDP) is the total value of all final goods and services produced in an economy in a one year period. It is the single most used economic measure.
2. Gross national product (GNP) is the aggregate final output of citizens and businesses of an economy in one year. Whereas GDP measures the economic activity that occurs within a country, the economic activity of the citizens and businesses of a country is measured by GNP.
3. To move from GDP to GNP, one must add net foreign factor income to GDP.
a. Net foreign factor income is the income from foreign domestic factor sources minus foreign factor incomes earned domestically.
b. One must add the foreign income of one's citizens and subtract the income of residents who are not citizens.

C. Calculating GDP.
a. All goods and services produced by an economy must be weighted, that is, each good and service must be multiplied by its price.
b. Once quantities of a particular good or service are multiplied by its price, we arrive at a value measure of the good or service.
c. Finally, all the value measures are added to arrive at GDP.
1. GDP is a flow concept.
a. GDP is a flow concept.
b. The store of wealth is a stock concept.
c. The stock equivalent to National Income Accounts is the Wealth Accounts - a balance sheet of an economy's stocks of assets and liabilities.
2. GDP measures final output.
a. When one firm sells products to another firm for use in production of yet another good, the first firm's products are no considered final output but intermediate products - products used as input in the production of some other product.
b. Not accounting for intermediate products would result in double and triple counting.
c. If we did not eliminate intermediate goods, a change in organization, say, a merger would look like a change in output.
3. Two ways of eliminating intermediate goods.
a. The first is to calculate only final output.
b. A second way is to follow the value added approach. Value added is the increase in value that a firm contributes to a product or service. It is calculated by subtracting intermediate goods from the value of its sales.
4. Calculating GDP: some examples.
a. Selling your car to a neighbor does not add to GDP. Selling your car to a used car dealer who sells your car to someone else for a higher price, does add to GDP. The value added is the dealer's services.
b. Selling a stock or bond does not add to GDP. The stock broker's commission for the sales does add to GDP.
c. Social security payments, welfare payments, veterans' benefits, and other government transfer payments are not included in GDP.
d. The work of unpaid house spouses does not appear in GDP calculations.

D. The national income accounting identity is the accounting equality of output and income. There are two approaches to calculating GDP:
1. The income approach.
a. National income is the total income earned by citizens and businesses in a country in one year
b. Firms make payments to households for supplying their services as factors of production.
c. These factors are broken up into employee compensation, rent, interest, and profits.
(1) Employee compensation is payments for labor such as salaries and wages.
(2) Rents are payments for use of land and buildings.
(3) Interest includes payments for loans by households to firms.
(4) Profits are payments to the owners of firms.
d. Businesses often focus on disposable income - that which is roughly equal to national income less taxes paid by individuals plus transfer payments made to individuals.
2. The expenditure approach . Specifically, GDP is equal to the sum of the four categories of expenditures: GDP = C + I + + G + (X - M).

a. Consumption.
(1) When individuals receive income, they can spend it on domestic goods, save it, pay taxes, or buy foreign goods.
(2) This is the largest and most important of the flows.

b. Investment.
(1) The portion of their income that individuals save leaves the income stream and goes into financial markets.
(2) Business spending on equipment, structures, and inventories is counted as investment.

c. Government consumption and investment.
(1) When individuals pay taxes, those taxes are either spent by government on goods and services or are returned to individuals in the form of transfer payments.
(2) The connection drawn between the government and the financial markets is there because if the government runs a deficit, it must borrow from financial markets to make up the difference.

d. Net exports.
(1) Spending on foreign goods escapes the system and does not add to domestic production, thus spending on imports are subtracted from total expenditures.
(2) Exports to foreign nations are added to total expenditures.
(3) These flows are usually combined into net exports.

3. Equality of income and expenditure.
a. Income and expenditures must be equal because of the rules of double entry bookkeeping.
b. Profit is the balancing item.
c. The national income accounting identity allows GDP to be calculated either by adding up all values of final output (the expenditures approach) or by adding up the values of all earnings or income (the income approach).

II. Using GDP Figures
A. Comparing GDP among countries.
1. GDP is important since we can compare one country with another and one year's production with another year's.
2. Per capita GDP is another measure often used to compare nations' GDP.
a. Per capita can be a poor measure of the various living standards in various nations.
b. To get around the problems of per capita GDP, economists use purchasing power parity, which adjusts for different relative prices among nations before making comparisons.

B. Economic welfare over time.
1. A second way in which GDP is used is to compare one year with another.
2. Comparing output over time is best done with real output which is nominal output adjusted for inflation.

C. Real and nominal GDP.
1. Nominal GDP is GDP calculated at existing prices.
2. Real GDP is nominal GDP adjusted for inflation.
a. Real GDP is important to society because it measures what is really produced.
b. By dividing nominal GDP by the GDP deflator, we arrive at real GDP.

II. Some Limitations of National Income Accounting.

A. GDP measures market activity, not welfare.
1. GDP does not measure happiness, nor does it measure economic welfare.
2. Welfare is a complicated idea, very difficult to measure.

B. Measurement errors.
1. GDP figures do not measure all market economic activity. They do not measure the following market activities:
a. Illegal drug sales.
b. Under-the-counter sales of goods to avoid income and sales taxes.
c. Work performed and paid for in cash.
d. Unreported sales.
e. Prostitution, loan sharking, extortion, and other illegal activities.

2. Estimates of the size of the underground economy range from 1.5 to 20 percent of GDP.

3. A second type of measurement error occurs in adjusting GDP for inflation.
a. If the price and the quality of a product go up together, has the price really gone up?
b. Is it possible to measure the value of quality increases?

C. Misinterpretation of subcategories.
1. For example, the line between investment and consumption is often fuzzy.
a. Buying a steam iron would be consumption, and if it is used to iron team T-shirts sold by a home business, it would still be counted as consumption.
b. Investment includes private housing units, but they do not usually add to our stock of productive tools. The garages and spare bedrooms might if they are used in an income producing capacity.
2. Some social scientists have developed alternatives to GDP such as the Gross Process Indicator (GPI). The GPI tries to measure pollution, education, health concerns, as well as GDP.

D. GDP is worth using despite its limitations.
1. National income accounting should be used with sophistication.
2. It is a powerful economic tool that informs average citizens as to which the direction the economy is moving.
 

Irwin/McGraw-Hill Copyright 1998, The McGraw-Hill Companies, Inc.

   Lecture Outline   Ch. 9

I. The Historical Development of Modern Macroeconomics
A. Recent economic history and the debate.
1. In the late 1990s, workers worry about downsizing - the laying off of workers by large firms.
2. Despite this, few policy actions at the federal level focused on unemployment.
3. The focus was on the federal deficit and how to eliminate it, or structural policies that would make the economy more competitive.
4. The policy debate did not focus on fiscal policy and focused less than in the past on monetary policy.
5. The student will be introduced to the macro policy model - one that demonstrates the effects of macro policy on output and prices. For simplicity, only two sides of the debate will be presented:
a. Activist economists are those who believe that the government can create and implement policy proposals that can positively effect the economy. These are sometimes called Keynesian economists since they follow the 'do something' recommendations of John Maynard Keynes.
b. Laissez-faire economists are those who believe that government policies would probably make things worse, so the best policy is (relatively) little government involvement with the economy. These are sometimes called Classical economists.
c. In spite of policy differences, there is much more agreement that disagreement in reference to policy and to the macro policy model.

B. The emergence of Classical Economics.
1. Classical economists built on Adam Smith's Wealth of Nations.
a. The Classical economists' approach was laissez-faire (leave the market alone).
b. They felt the market was self adjusting.
c. They also concentrated on the long run and largely ignored the shorten.
2. When the Great Depression hit with 25 percent unemployment, their response was to refer to supply and demand in the labor market.
a. The problem, as they saw it, was that the real wage - the wage level relative to the price level was too high.
b. Thus, the solution to unemployment was to eliminate labor unions and government policies that held the wages too high.
3. Lay people were not pleased with this argument but believed instead that the Depression was caused by an oversupply of goods that glutted the market.
4. The Classicals argued that an oversupply of goods was impossible.

C. Say's Law.
1. The belief that an oversupply of goods was impossible was first formulated by J.B. Say in his Say's Law - supply creates its own demand.
a. Demand for goods and services as a whole will always be sufficient to buy what is supplied.
b. Thomas Malthus argued that Say's Law was not necessarily true for if people saved, part of their income would be lost to the economy.
c. Another Classical writer, David Ricardo, rejected Malthus' argument and stated that any savings would come back into the circular flow by way of investment.
d. Say's Law did not say unemployment could not exist, only that it was localized wage-price problem.
2. Classical economists believed that frictional and structural unemployment could exist, but they did not believe cyclical unemployment could be caused by a shortage of aggregate demand.

D. The Quantity Theory of Money.
1. In its simplest terms, the quantity theory of money says that the price level varies in response to changes in the quantity of money.
a. The quantity theory of money can be seen in the equation of exchange:      MV = PQ
b. Where:
M = money supply
V = velocity of money (is relatively constant and determined by institutional forces).
P = price level
Q = real output (is relatively constant and determined by real, not monetary forces)
2. This leaves M and P directly related to each other with the arrow of causation going from left to right: MV = PQ.

E. Classicals' view of the Great Depression.
1. While the Classicals were waiting for the long run to kick in, nations were sinking deeper and deeper into the Depression.
2. They reluctantly developed a shorten analysis of why the Depression was lingering so long which centered on the social and political forces that prevented market forces from operating.
a. Stop the measures that governments were passing to hold up wages and prices.
b. Break up labor unions.

F. The emergence of Keynesian Economics.
1. Politicians and economics students as well were not listening to the Classicals' viewpoints.
2. Economists in general had a gut feeling that there had to be a better way.
3. According to Keynes, equilibrium income is not fixed at the economy's long run potential income; it fluctuates. The key is that equilibrium income does not always equal potential income.
a. Equilibrium income is the level of income toward which the economy gravitates in the short run because of cumulative circles of declining production.
b. Potential income is the level of income which the economy is capable of producing without generating accelerating inflation.
c. If there was a persistent gap between equilibrium income and potential income, government had to step in to give the economy a boost.
d. Keynesian economics provided an explanation as to why the economy could find itself caught in a rut with a glut and it offered a way to get the economy moving again through the use of government spending policies.

II. The Macro Policy Model
Economists use the concepts of aggregate demand and aggregate supply to represent the forces that determine the economy's equilibrium GDP and price level. Aggregate demand (AD) is the total quantity of output demanded by all sectors in the economy together at various price levels in a given period of time. The aggregate demand curve slopes downward and to the right, indicating that more real output will be demanded at a lower price level than at a higher price level. There are three reasons for the downward slope of the aggregate demand curve: the real balance effect, the interest rate effect, and the international trade effect. The factors that will shift the aggregate demand curve include changes in the expectations of households and businesses, aggregate wealth, government policy, foreign incomes, and foreign price levels.
Aggregate supply (AS) refers to the quantity of output supplied by all producers in the economy together at various price levels in a given period of time. The aggregate supply curve slopes upward because higher price levels stimulate businesses to expand output. Since wage rates and some other input prices are commonly fixed by contracts, an increase in the price level provides incentive for firms to increase output. A given aggregate supply curve assumes the prevailing wage rates and prices of non labor inputs, the current level of productivity, and the existing supplies of labor and capital. If one or more of these factors change, the AS curve will shift to a new position.
The intersection of the aggregate demand and supply curves simultaneously determines the level of equilibrium real GDP and the equilibrium price level in the economy. Shifts in aggregate demand or supply win tend to alter these equilibrium values. If aggregate demand increases, both real GDP and the price level will tend to increase. The economy enjoys higher levels of output and employment, but it experiences demand-pull inflation. If aggregate demand declines, the levels of output, employment, and prices decline.
Changes in equilibrium can also be caused by changes in aggregate supply. A supply shock, such as an increase in the price of imported oil, will tend to reduce aggregate supply. This will cause cost-push inflation since the higher cos t of oil pushes up prices. When aggregate supply is reduced, the levels of output and employment in the economy also decline. Supply shocks provide one possible explanation for stagflation, high unemployment combined with high inflation. If aggregate supply increases, the results win be doubly beneficial; the levels of output and employment in the economy will tend to increase, whereas the overall price level will decline.
Most modem economists agree that, to some extent, the economy contains a self-correcting mechanism. In the short run, the economy can deviate from potential GDP because certain wages and prices are rigid. In the long run, however, all wages and prices become flexible. As a consequence, reductions in aggregate demand are ultimately met by failing wages and input prices, which cause aggregate supply to expand and return the economy to potential GDP. Increases in aggregate demand eventually lead to higher wages and input prices, which cause aggregate supply to contract and output and employment to fall. Thus, wage and price adjustments ultimately return the economy to potential GDP and full employment.

A. The partial equilibrium supply/demand models - the microeconomic models in which the shapes of supply and demand curves are based on the principle of substitution and opportunity costs cannot be used to model the aggregate economy for two reasons:
1. Macroeconomic models of the economy depend upon macroeconomic relationships between aggregate output and the price level, not upon relationships between a single good and its relative price.
2. In the aggregate, other things do not remain constant.
3. The macro policy model consists of two curves:
a. The curve describing the supply side of the aggregate economy is the aggregate supply path.
b. The curve describing the demand side of aggregate economy is the aggregate equilibrium demand curve.

B. The graphical framework of the macro policy model.
1. The price level (the price of a composite good) is on the vertical axis and the aggregate level of output (GDP) on the horizontal axis.
2. This curve is fundamentally different from the partial equilibrium model which has relative price on the vertical axis and the quantity of a single good on the horizontal axis. The shapes of the macro curves are not based on the principle of substitution.
3. The macro policy model is an historical model - one that starts at a point in time, and tells one what will likely happen when shocks hit the economy.

C. The aggregate equilibrium demand curve components.
1. The aggregate equilibrium demand (AED) curve is one that shows how a change in the price level will change aggregate equilibrium demand after all the dynamic interactive effects between production and expenditures are taken into account.
2. Slope of the AED Curve.
a. The AED is a downward sloping curve. At least two reasons can be given for this :
(1) The wealth effect tells us that as the price level falls, people are richer, so they buy more.
(2) The international effect tells us that as the price level in the U.S. falls, (assuming the exchange rate does not change), the quantity of U.S. goods demanded will increase.
3. Repercussions and the multiplier effect.
a. In order to determine equilibrium in the macro policy model, one must take into account any repercussions that the change in quantity demanded has on production (supply decisions) and subsequently on income and expenditures (demand decisions).
b. These repercussions are called multiplier effects because they multiply the initial effect of the price level change on the quantity of aggregate demand as the economy adjusts to equilibrium.
4. Shifts in the AED Curve. Anything that affects aggregate expenditures, except the price level, shifts the AED curve.
a. Foreign income.
(1) When U.S. trading partners go into a recession, the demand for U.S. goods (exports) will fall, causing the U.S. AED curve to shift to the left.
(2) A rise in foreign income leads to an increase in U.S. exports and a rightward shift of the U.S. AED curve.
b. Expectations.
(1) Expectations about future income.
(a) If businesses expect demand to be high in the future, they will want to increase their capacity to produce, thus, their demand for investment, a component of aggregate equilibrium demand will increase as well. The AED curve will shift to the right.
(b) When consumers expect the economy to do well in the future, they will spend more now, shifting the AED curve to the right.
(2) Expectations of future prices.
(a) If one expects the prices of goods to rise in the future while the current price remains constant, to pays to buy goods now before the prices rise. The AED curve will shift to the right.
(b) The is most acutely felt in a hyperinflation.
(c) It is difficult to specify the exact reason why expectations will cause a shift in the AED curve because of the inter relatedness of various types of expectations.
c. Exchange rates.
(1) When a currency loses value relative to other currencies, the foreign demand for its goods increases and its demand for foreign goods decreases as individuals do their spending at home. The AED curve will shift to the right.
(2) When a currency gains value, the AED curve shifts to the left.
d. Distribution of income. This is based on the observation that people spend a greater percentage of their wage income as compared to their profit income.
(1) As real wages increase, but total income remains constant, it is likely that the AED curve will shift to the right.
(2) As real wages decrease, it is likely that the AED curve will shift to the left.
e. Government aggregate demand policies.
(1) Activist macro policy makers think they can control the AED curve to some extent.
(2) If the federal government spends lots of money without raising taxes, it shifts the AED curve to the right.
(3) Similarly, when the Fed expand money supply, it can often lower interest rates and thereby shift the AED curve to the right.
(4) This deliberate shifting of the AED curve to influence the level of income in the economy is what most policy makers mean by the term macro policy.
(5) Expansionary macro policy shifts the AED curve to the right; contractionary macro policy shifts it to the left.
5. Multiplier effects of shift factors.
a. As mentioned before, an AED curve cannot be treated like a demand curve.
b. When a shift factor of the AED curve causes it to move, it moves by more than the initial shift factor because of the multiplier effect.

D. The aggregate supply (AS) path is a curve that tells us how changes in aggregate equilibrium demand will be split between real output changes and price level changes.
1. Real world pricing: The AS path pricing strategies and quantity adjusting markets.
a. The curve describing the supply-side dimension in the macro policy model is called a supply path rather than a supply curve because it incorporates the institutional realities of seller - set prices.
b. Institutional realities are emphasized because they affect the way the aggregate economy adjusts to aggregate demand shocks.
c. Markets with seller - set prices (about 90-95 percent of retail markets in the U.S.) are sometimes called quantity - adjusted markets - those in which firms modify their supply in order to bring about equilibrium instead of changing prices.
d. In seller - set markets, central pricing decisions are long run, not shorten.
e. Cutting the long-term prices is the exception, not the rule.
f. In quantity - adjusting markets, firms pick a price and quantity strategy, which means that in the short run when they are not selling as much as expected, they prefer to reduce production rather than cut their price sufficiently to sell all they are producing.
g. To say that the U.S. economy is not perfectly competitive is not to say that it is not highly competitive.
h. Firms are hesitant to cut price when demand falls because direct competitors will match their price cut.
2. Slope of the AS path.
a. The slope of the AS path depends on how close the economy is to its potential income.
b. Three ranges are distinguished:
(1) A fixed price - level range (a flat AS path).
(a) Here the price level seems to have a floor.
(b) Downward shifts in aggregate equilibrium demand do not result in falls in the price level.
(c) Rightward shifts in the AED curve do not cause significant rises in the price level.
(2) A partially -flexible price level range (an upward sloping AS path).
(a)  As the economy begins approaching its potential income, the price level rises as aggregate equilibrium demand increases.
(b) This demand tends to split into an increase in the price level and an increase in aggregate real output.
(c) Within this range, the rise in the price level does not start an accelerating inflation.
(3) An unsustainable flexible price level range (a vertical AS path).
(a) Once the economy reaches its potential income, an excess in aggregate equilibrium demand results in unsustainable price level changes.
(b) Once this range is entered, a change in the psychology of the economy occurs: from a stable price level psychology to an inflationary psychology.
(c) Natural resources and labor are in short supply.
(d) Shortages begin occurring, driving prices higher.
(e) This point of no return delineated by the economy's potential income provides the supply-side limit of the economy.
(f) Further expansion will accelerate inflation.
c. Range A or Keynesian or Horizontal Range:
(1) The historically determined price level places a floor on the price level, and any adjustment takes place in real output changes not in price level changes.
(2) Governments would feel that they would have to respond to range A problems by:
(a) Introducing policies to get the economy out of this range.
(b) By prohibiting firms from lowering prices.
(3) Why the asymmetry (the price level tends not to fall but tends to rise) between upward and downward price movements?
(a) Sellers do not want to lower nominal prices and 'ruin the market.'
(b) Government policy undertakes to prevent price declines and sellers build this into their nominal prices.
d. Range B or Classical or Vertical Range.
(1) The economy begins to experience supply bottlenecks .
(2) Raw material prices rise and labor shortages begin to appear.
(3) As firms' cost rise, they raise prices to cover increased costs.
(4) As the economy moves closer to potential income, bottlenecks become more pervasive and the psychology of the market begins to change.
(5) Since prices expect the price level to rise, they build this expectation into their prices until Range C is finally reached.
e. Range C or Intermediate Range.
(1) Range C begins at the economy's potential income.
(2) Since prices expect inflation, increasing their prices becomes a self fulfilling prophecy.
(3) Activist Keynesians see the economy in the fixed price range of the AS path (Range A). Laissez-faire Classicals see the economy in the perfectly flexible range of the AS path (Range B)
f. Where is potential income? There is much debate over this question.
(1) If the price level has remained constant but a small price level rise begins an accelerating inflation, the economy's true potential output is at the beginning  of Range B.
(2) If the price level rise does not start an accelerating inflation, the economy can move into Range B, depending on what type of rise in the price level policy makers are willing to accept.
(3) Thus, the economy's target level of output somewhere within Range B.
(4) This target level of potential output is that which policy makers feel is achievable in the long run without generating accelerating inflation.
3. The macro policy model in an economy with ongoing inflation.
a. The macro policy model allows for the incorporation of inflationary expectations as well as for deflationary expectations.
b. Disinflation is a fall in the rate at which the price level is rising.
c. When the macro policy model is interpreted as having inflation relative to expected inflation on the vertical axis, a movement down the AS path does not represent deflation - a fall in the price level but instead represents disinflation.
4. Shifts of the aggregate supply path. If the price level shifts for some reason other than a shift in aggregate equilibrium demand, the AS path will shift up and down.
a. Up and down shifts of the AS path.
(1) The horizontal portion of the AS path can shift up or down due to nominal price level shocks .
(2) Examples includes the Mexican peso devaluation in late 1994, and the sudden increase in nominal oil prices in the 1970s.
b. Right and left shifts of the AS path.
(1) An increase in productive capacity will shift the AS path to the right; a decrease will shift it to the left.
(2) Productive capacity is determined by technology, available resources (including labor and capital), institutions, and regulations.
(3) Although it is subject to debate, and increase in the first two would move the AS curve to the right; and increase in the latter two would move it to the left.
(4) Expectations of any of the above can also shift the AS curve to the right or left.

E. Equilibrium in the macro policy model.
1. Equilibrium is achieved when the AED curve intersects the AS path. If either of the two curves shift, the equilibrium will change.
2. An initial shift factor will move the AED curve more than the magnitude of the shift factor because of the multiplier effect.

F. Macro policy in the macro policy model.
1. Alternative shifts.
a. In Range A, since the economy is below its potential income, a policy of increasing aggregate equilibrium will expand output and create jobs without inflation b. In Range B, an increase in aggregate equilibrium demand will cause both the price level and real output to rise. The problem in Range B is that by achieving a higher output (a desired goal) you have to move away from another desired goal price level stability.
c. In Range C, the equilibrium of the economy is at its potential income. The AS path is vertical. In this range, any increase in aggregate equilibrium demand will not bring about any increase in real output or additional jobs. It will simply cause the price level to rise.
2. Some additional examples.
a. Shifts in aggregate equilibrium demand and the aggregate supply path can affect the price level and real output.
b. How it does so depends upon the shift as well as where the economy is before the shift

III. Why Macro Policy is More Complicated than This Model Makes It Look

A. The problem is that economists have no way of precisely knowing for sure what range the economy is in, or precisely where the correct target level of potential output is.
1. One way to determine potential income is to take the economy's previous income level and add the normal growth factor of 3 percent (the trend growth rate).
2. This method is problematic if shift factors are changing quickly or dramatically.
3. In some cases, the economy can be undergoing significant structural readjustment in which an economy is trying to change from what it has been doing to something new, not to repeat what it did in the past.
B. Some examples
1. The United States in the mid-1990s.
a. The economy was expanding slowly with structural unemployment rampant.
b. It was thought that 6 percent unemployment was the threshold for inflation to begin, and when the unemployment rate hit 5 percent with no inflation, economists lost face.
2. Canada in the mid-1990s.
a. Unemployment was 9 percent high by normal standards, while inflation was 2 percent.
b. Most economists saw the AS path close to vertical, so that any expansion in the economy would be inflationary.
3. Japan in the late 1990s.
a. Unemployment was 3 percent, while inflation was well below 1 percent.
b. While it would seem the Japanese economy was in Range C, most economists believed their economy had room for expansion since it was in Range B.
4. The EU in the mid-1990s.
a. Unemployment was above 10 percent so it would seem that the economy was in Range A.
b. There was major economic restructuring going on with social welfare programs significantly reducing peoples' willingness to work.
c. Economic theory could not explain what range the EU was actually in.
5. The formerly socialist countries.
a. Structural change in these nations is especially critical.
b. Output has fallen by 40 to 50 percent.
c. As they struggle to create new institutional structures, past data are meaningless.

C. Debates about potential income.
1. Since the problems of estimating the target level of potential income remain, some economists argue that the best estimate of potential income is the actual income in the economy.
2. Their Classical supply-side explanation is called a real business cycle theory, which sees all changes in the economy as real shifts - shifts in potential income, that reflect real causes such as technological changes or shifting tastes.
3. For a real business cycle theorist, the economy is always in Range B.

IV. Conclusion and a Look Ahead

1. Classicals believe:                            Keynesians believe:
a.   In laissez-faire policies.                      In activist policies.
b.   The AS path is vertical.                     The AS path is flat.
2. Most economists are a combination of the two.
 

nbsp; Irwin/McGraw-Hill Copyright 1998, The McGraw-Hill Companies, Inc.

  Lecture Notes Ch. 10

I. The Keynesian Model

A. It was not enough for early Keynesians to know the qualitative direction of a shift in the AED curve, they also wanted to know the quantitative amount of change.
1. In this fashion the early Keynesians could get input into policy.
a. They needed to know the exact induced or multiplier effects that would occur when there was an autonomous shock to aggregate equilibrium.
b. An autonomous shift is one that occurs because of some change that the model does not consider.
2. Aggregate ( income) production/aggregate expenditures (AD/AS or AP/AE model).
a. This is the Keynesian model where aggregate supply is aggregate production. It focuses on total production changes, not on changes in output caused by price level changes.
b. This approach emphasizes the difference between the Keynesian focus and the Classical focus on quantity of aggregate supply and demand changes resulting from changes in the price level.
3. The AP/AE model focuses on induced effects by looking specifically at the relationship between production and aggregate expenditures, and concentrates on the income adjustment mechanism - the process by which initial changes in aggregate expenditures create a cumulative change in aggregate equilibrium income.
4. The Keynesian AP/AE model fills the gap in the macro policy model by determining the size of the multiplier effects.

B. Aggregate production in the Keynesian AP/AE model.
1. Aggregate production, the center of the Keynesian model, is the total amount of actual production of all goods and services in every industry in an economy.
a. Production creates an equal amount of income. Thus, actual production and actual income are always equal.
b. While production and income are equal, that does not necessarily mean that expenditures are equal to production.
c. Expenditures can be higher or lower than planned production.
2. In this view of the economy, expectations play an important role.
a. If businesses expect high expenditures, they produce a lot.
b. If they expect low expenditures, they produce little.
3. Graphically, aggregate production ( Aggregate Supply) in the Keynesian model is represented by a 45 degree; line through the origin, with real production (in dollars) on the vertical axis, and real income (in dollars) on the horizontal axis.
a. The 45 degree; line is the aggregate production curve, or the aggregate income curve.
b. At all points on this curve, income equals production.
c. The model is relevant only when output is below it potential (the Keynesian range).

C. Classical and Keynesian views of production compared.
1. In the Classical model, income equals aggregate expenditures.
2. In the Keynesian model, planned expenditures need not equal production.
3. If they were not in equilibrium, some adjustment mechanism was needed to make planned expenditures and planned production equal if the economy was to move back to equilibrium.

D. Aggregate expenditures  (AD) in the Keynesian model.
1. Aggregate expenditures in the Keynesian model consist of consumption (spending by consumers), investment (spending by business), spending by government, and net foreign spending on U.S. goods (the difference between U.S. exports and U.S. imports). Or:
Y = C + I + G + (X - M).
2. These four components of national income accounting were developed contemporaneously with the Keynesian model.
3. Autonomous and induced expenditures.
a. According to the AD/AS model, as income changes, expenditures change, but not as much as income.
b. Even if income is zero, spending is still taking place.
(1) The money comes from borrowing, or from previous savings.
(2) Expenditures that would exist at a zero level of income are called autonomous expenditures - those that change because something other than income changes.
c. Induced expenditures are those that change as income changes.
d. The relationship between expenditures and income can be expressed more concisely as an expenditures function - a representation of the relationship between expenditures and income as a mathematical function.

C = Ca + mpc Y    mpc = mpe  or  a + bY  where b = mpc
e. Where:
C expenditures
Ca autonomous expenditures
mpc = marginal propensity to consume
Y= income

4. The marginal propensity to consume or expend (mpc) is the ratio of a change in expenditures, E, to a change in income, Y.
a. The mpe is the fraction spent from an additional dollar of income.
b. Remember that the largest component of expenditures is consumption, and that the marginal propensity of individuals to consume out of their income is a key determinant of the marginal propensity to expend.
5. Graphing the expenditures function.
6. The AS/AD model is an historical model in time.
a. It is assumed that within the range around existing income, the mpe remains constant.
b. The autonomous portion of the expenditures is the Y axis intercept that would occur if the expenditures functions was extended to the Y axis.

II. Determining the Level of Aggregate Income

A. In bringing AS and AD together in one framework the following assumptions are made:

1. The economy is in Range A, the Keynesian Range.
2. The price level is constant, i.e. a horizontal line.
3. The AS curve is a 45 degree; line up until the economy reaches its potential income.
4. Expenditures shown on the AD line do not necessarily equal AP or income.
5. To determine income graphically, you find the income level at which AE equals planned AP.

B. Determining the level of aggregate income with the Keynesian equation.
1. Another way to determine the level of income in the model is through the Keynesian equation, one where income equals the multiplier times autonomous expenditures.
2. Y = (multiplier) (autonomous expenditures).

C. The multiplier.
1. The multiplier is the key aspect of the Keynesian model that differentiates it from the Classical model.
2. The multiplier is a number that reveals how much income will change in response to a change in autonomous expenditures.
a. The formula is: Multiplier = 1/(1 - mpc)
b. The multiplier gave policy makers something specific to guide governmental action.
c. It had implications for the following story:
(1) The stock market collapsed in 1929. Frightened consumers and businesses cut back on consumption and investment, both components of expenditures.
(2) AD decreased sending the multiplier into action.
(3) Businesses further decreased production which lowered income and induced a further decrease in AD.
(4) The cumulative downward spiral of expenditures was the multiplier process.
(5) Policy makers saw a way to reverse this downward spiral.
d. To determine equilibrium income using the Keynesian equation, you determine the multiplier and multiple it by the level of autonomous expenditures.
e. As mpe increases, the multiplier increases.

D. A closer look at the income adjustment mechanism.
1. What forces are operating to ensure that the income level we determined is actually the equilibrium income level?
2. The multiplier process works because when expenditures do not equal production, business people change planned production, which changes income, which changes expenditures,
which ...

E. The multiplier and the circular flow injections (J) and withdrawals (W).
1. Expenditures are injections into the circular flow.
2. The mpc measures the percentage of expenditures that get injected back into the economy each round of the circular flow.
3. But there is leakage. Economists use a term that represents leakages from each round.
a. The marginal propensity of withdraw (mpw) is the percentage of income flow that leaks out of the economy for each round of the circular flow.
b. mpc + mpw = 1
c. Alternatively expressed: mpw = 1 - mpc
d. Multiplier = 1/mpw
4. Equilibrium occurs when the leakages equal the autonomous expenditures.

III. Shifts in Autonomous Expenditures
A. The first step in understanding Keynes's analysis is determining the level of income using the multiplier. This was explained above. The second step is to answer the question: how much would a change in autonomous expenditures change the equilibrium level of income?
1. Autonomous expenditures can, and do, shift for a number of reasons.
a. Natural disasters.
b. Sudden climatic changes.
c. Changes in consumption causes by changes in consumer choice.
d. Changes in investment caused by technological developments.
e. Shifts in government expenditures.
f. Shifts in imports and exports.
2. An understanding of these shifts can be enhanced by tying them to the formula:
Y = C + I + G + (X - M).
a. Changes in consumer sentiment affect C.
b. Changes in exchange rates affect X - M.
c. Major technological breakthroughs affect I.
d. Changes in government taxing and spending affect G.

B. Shifts in autonomous expenditures and Keynes's model: an example.
1. A dramatic rise in the Japanese exchange rate cuts Japanese exports.
2. AD falls so that AS is greater than AD.
3. Suppliers cannot sell all they produce.
4. If all producers lay off workers and decrease output, investment, and hence AD, will also fall.
5. As the laid off workers cut their consumption, total AD will decrease further.
6. Producers will lay off still more workers and cut back production even more.
7. Keynes argued that the downward spiral will finally stop.
a. Fired workers will dip into savings and not cut back expenditures by the full amount of their decrease in income.
b. So as income falls, AS and AD will move closer together.
c. At some level of income, AS will equal AD.

IV. Further Examples of the Keynesian Model

A. Keynes' explanation of the 1930s depression: another example.
1. The 1929 stock market crash, which continued into 1930, threw the financial markets into chaos.
2. Frightened business people decreased investment and laid off workers.
3. Frightened consumers decreased autonomous consumption and increased savings, thereby increasing withdrawals from the system.
4. This resulted in a downward shift of the AD curve.
5. Business people responded by decreasing output, which decreased income, starting a downward cycle, thereby confirming the fears of the business people.
6. The process continued until the economy settled at a low level equilibrium, far below the potential level of income.
7. The process caused the paradox of thrift, whereby individuals attempting to save more, spent less, and caused income to decrease. They ended up saving not more, but less.

B. The Keynesian model when the price level is not fixed.
1. The AS/AD model depends on the economy being in Range A, where the price level is fixed.
a. When the price level is not fixed, the changes are divided between real and nominal changes.
b. The relative split is determined by the degree of price level flexibility determined by the AS path.
2. The Keynesian model when the AS path is upward sloping.
a. If we are in Range B, where the AS path begins to slope upward, part of the shift of the AE curve caused by the shift of autonomous expenditures would be offset by a change in the price level.
b. The greater the slope of the AS path, the greater the shift back of the AE curves.
c. Real income increased by a smaller amount when prices are flexible than when they are fixed.
3. The Keynesian model once potential income is reached.
a. If we are in Range C, the AS curve is vertical, and the price level offset is complete.
b. In Range C, all changes must be nominal, not real changes.
c. What happens when AE increase but the economy is in Range C.

V. The Classical Response to Keynes
A. The Keynesian model is not a complete model of the economy.
1. Classical would argue the there is a problem with the model presented thus far.
a. The model does not tell us where the autonomous expenditures came from.
b. The model does not tell us how we go about measuring them.
2. At best, the Keynesian model allows us to estimate direction and rough sizes of autonomous demand or supply shocks.

B. Shifts are not as great as one's intuition suggests.
1. A second criticism the Classicals make is that it leads people to overemphasize the shifts that occur in AD in response to a shift in autonomous expenditures.
2. If one takes a broad view of AD, many of the shifts in expenditures are simply rearrangements from one group of expenditures to another.
a. To resolve this knotty problem, a study of the financial sector is required.
b. Many of these shifts , the Classicals argue, will be much less than might be intuitively expected at first glance.

C. The price level will often change in response to shifts in demand.
1. The Keynesian model assumes that the AS curve is a 45 degree; line.
2. In reality, the price level varies in response to increases in demand.
3. Classicals point out that the economy is in Range B, wherein price level can change, and that change can bring about an adjustment toward equilibrium.

D. People's forward looking expectations make the adjustment process much more complicated.
1. The Keynesian model assumes that people respond to current changes in income.
2. Most people, however, act upon their expectations of the future.
a. Business people may not automatically cut back on production and lay off workers if they think see the fall as a temporary blip.
b. They would begin to build up their inventories or set their workers painting the factory.
3. Some modern Classicals have put forward a rational expectations model of the economy in which all decisions are based upon the expected equilibrium in the economy.

E. Shifts in expenditures might reflect desired shifts in supply and demand.
1. Shifts in demand can occur for many reasons, and many shifts many shifts can reflect desired shifts in aggregate production. and are accompanied by shifts in aggregate demand.
2. Shifts may be simultaneous shifts in supply and demand that do not necessarily reflect suppliers' responding to changes in demand.
3. Expansion of this line of thought has led to the real business cycle theory of the economy - the theory that fluctuations in the economy reflect real phenomena - simultaneous shifts in supply and demand, not simply supply responses to demand shifts.

F. Expenditures depend on much more than current income.
1. If it is true that people base their spending on lifetime income, not yearly income, the mpe out of changes in current income could be very low, even approaching zero.
2. In that case, the expenditures function would essentially by a flat line, and the multiplier would be one, and there would be no secondary effects of an initial shift.
3. This set of arguments is called the permanent income hypothesis - the hypothesis that expenditures are determined by permanent or lifetime income.

VI. Summary of the Differing Views of the Keynesian Model
A. Although, in the real world, there are many overlaps between the Classicals and the Keynesians, it makes sense pedagogically to view them as distinctly different.
1. The Keynesian model.
a. The Keynesian model is an historic model in time.
b. The equilibrium that the economy arrives at is a path - dependent equilibrium - one that is influenced by the adjustment process to that equilibrium.
c. The aggregate economy should be pictured as a pulsating spiral, expanding and contracting in response to unexpected shocks.
d. The model offered a simple way to simultaneously consider equilibrium and disequilibrium adjustment.
e. Keynes asked:
(1) Does AD always equal AS?
(2) If not, what will happen in the economy to make them equal?
2. The Classical school.
a. The circular flow diagram expresses the national income identity - aggregate income equals aggregate output.
b. The Classicals saw forces outside of economics determining the size of the circular flow.

B. Mechanistic and interpretative Keynesians.
1. A mechanistic model is one that pictures the economy as representable by a mechanically determined, timeless model with a determinant equilibrium.
2. An interpretive Keynesian model sees it as a guide to one's common sense, highlighting important dynamic interdependencies. Before apply the model, one must consider other interdependencies.
3. The Keynesian model is not to be taken literally, but only as a guide to our intuition.
C. Mechanistic and interpretive Classicals.
1. A mechanist Classical sees the Classical model as a direct guide for policy.
2. An interpretive Classical see the Classical model as an aid to understanding complicated disequilibrium dynamics with interdependencies.

VII. Conclusion: The AS/AD Model and the Macro Policy Model.

A. The AS/AD model can be used to derive an AD curve by showing the effect of a change in the price level on equilibrium expenditures.
B. The AE/AP model can be used to determine precisely how much the AD curve will shift when autonomous expenditures shift and the economy is in Range A of the Aggregate supply curve.

nbsp;   Irwin/McGraw-Hill Copyright 1998, The McGraw-Hill Companies, Inc.

   Lecture Notes Ch. 11  and Ch. 12

I. Fiscal Policy and Aggregate Demand
A. Introduction.
1. Keynes' initial policy proposals were for public works , i.e., deficit spending by government to 'prime the pump.'
2. Keynesians soon broadened that policy proposal to stimulate the economy to also include:
a. Another way to stimulate the economy - reducing taxes.
b. A way to slow down the economy by decreasing government spending or increasing taxes.
c. Policies to change the money supply as a way of controlling the economy.
d. General policies to influence components of aggregate expenditures.
3. Government policies that change the level of government spending and taxes are termed aggregate demand (expenditure) management policies.
a. One of the best known of these aggregate demand management policies is fiscal policy - the deliberate change in either government spending or taxes to stimulate or slow down the economy.
(1) Expansionary fiscal policy involves decreasing taxes or increasing government spending.
(2) Contractionary fiscal policy involves increasing taxes or decreasing government spending.
b. Keynesians considered fiscal policy the steering wheel for the aggregate economy.
4. The Keynesian model was greeted with great animosity in the political as well as the academic arena.
5. By the 1960s, Keynesian economics had become mainstream economics.

B. The story of Keynesian fiscal policy.
1. The Great Depression needed a countershock - a jolt in the opposite direction of the shift in aggregate demand that started the depression to get the multiplier working in reverse.
2. Individuals, as individuals, were not prepared to do this in spite of pleas from the President: 'We have nothing to fear but fear itself.' Collective action was needed.
3. With fiscal policy, government could provide the needed increased spending by decreasing taxes, increasing government spending, or both.
4. Expansionary fiscal policy stimulated autonomous expenditures, which increased people's income , which increased people's spending even more.
5. Keynesians argued that fiscal policy was the missing steering wheel of the economy. See Added Dimension: 'The Economic Steering Wheel.'
C. Aggregate demand management.
1. The significantly different effects when one person does something rather than everyone doing something plays an important role in economics. This goes under the following names: the public goods problem, the tragedy of the commons, the fallacy of composition, and the multi person dilemma.
2. Keynes argued that, in times of a national emergency such as a depression, spending is a public good that benefits everyone.
D. Keynesian and Classical views of fiscal policy.
1. Expansionary fiscal policy shifts the AD curve up and the AD curve to the right. The effect on prices and output depends upon where the economy is on the AS path .
2. The Classical view of the effect of fiscal policy. There are to major differences to note.
a. In the Classical case, fiscal policy shifts the AD curve out only by the initial increase in spending to AD, that is, there are no repercussive effects. It does not shift it out as far as in the Keynesian case.
b. The AS path is upward sloping or close to vertical and not horizontal.
c. The Classical view of fiscal policy is that it is far less effective than Keynesians believe it is.
3. The same differences are shown in the AD/AS model.
a. The Classical expenditures function is flatter than the Keynesian expenditures function since the multiplier effect is smaller (the Classicals factor in permanent income, not current income).
b. Price level changes are different in the two models. The net increase in income resulting from an increase in government spending in the Classical model is less than the increase in government spending.
4. Fighting recession: Expansionary fiscal policy.
a. The economy is in Range A during a recession.
b. The top panel shows the macro policy model; the bottom panel shows the AD/AS model.
c. The equilibrium income is below potential income, so there is a recessionary gap-the difference between equilibrium income and potential income when potential income exceeds equilibrium income.
d. Assuming that government knows the value of the multiplier, money is pumped into the economy, which, when multiplied, fills the recessioinary gap.
5. Fighting inflation: Contractionary fiscal policy.
a. Fiscal policy can also work in reverse - decreasing expenditures that are too high-, i.e.., when inflation begins to accelerate beyond potential income.
b. If the quantity of aggregate equilibrium demand exceeds potential income at that price level, there will be excess demand and pressures for demand-pull inflation.
c. Temporarily, output may exceed potential output as firms and workers are slow to raise prices and wages.
d. Soon however, shortages and accelerating inflation will drive the economy back to its potential income.
e. Government decrease its expenditures by an amount that reflects the magnitude of the multiplier.
f. This would remove the inflationary gap - the difference between equilibrium income and potential income when equilibrium income exceeds potential income.

E. Applying the models and the questionable effectiveness of fiscal policy.
1. Effectiveness of fiscal policy in reality.
a. The effectiveness of fiscal policy in reality depends on the government's ability to perceive a problem, and react appropriately to it.
b. If the model is correct in describing the economy, and if government acts quickly enough in a countercyclical way, depressions can be avoided.
c. A countercyclical fiscal policy is one in which the government offsets any shock that would create a business cycle.
d. Fine tuning is the term used to describe a fiscal policy designed to keep the economy always at its target or potential level of income.
2. All economists now recognize that the dynamic adjustment in the economy is extraordinarily complicated, especially when taking into account reasonable expectations of future policy.

II. Alternatives to Fiscal Policy
A. Three alternatives to fiscal policy are: directed investment policies, trade policies, and autonomous consumption policies.
1. Changes in any of the above can achieve the same results as fiscal policy.
2. Any policy that can influence autonomous expenditures without having offsetting effects on other expenditures can be used to influence the direction and movement of aggregate income.

B. Directed investment policies: Policy affecting expectations.
1. A numerical example.
2. Rosy scenario: Talking the economy well.
a. Almost invariably, government officials paint optimistic pictures as to where the economy is headed. These have been called rosy scenario policies - government policies of making optimistic predictions and never making gloomy predictions.
b. Upbeat predications must be credible, i.e.,. Bob Dole and Bill Clinton during the 1996 national elections.
c. Another way to influence investment is to protect the financial system by government guarantees or promises of guarantees. Example: preventing bank failures.
d. Still another way in which government can influence investment is through influencing the interest rate. See Chapter 13 on monetary policy.

C. Trade policy and export led growth.
1. Any governmental policy that increases autonomous exports and decreases autonomous imports (and thereby increases autonomous expenditures) will also have multiplied effects on income.
2. These policies are called export led growth policies - those designed to stimulate U.S. exports and increase aggregate expenditures on U.S. goods, and hence have a multiplied effect on U.S. income.
3. Alternatively, any policy that will lower imports, such as tariffs, will have the same expansionary effect on income.
4. A numerical example.
5. Interdependencies in the global economy.
a. Any time the U.S. is pushing an export led growth policy, it is the same as getting another nation to follow an import led decline for its economy.
b. It can reasonably be expected that other nations will retaliate.
c. As a consequence, many economists support free trade agreements such as NAFTA.
d. Trade balance can also be affected through exchange rate policy - a policy of deliberately affecting a nation's exchange rate in order to affect its trade balance.

D. Autonomous consumption policy.
1. A third alternative to fiscal policy is consumption policies.
2. Increasing consumer credit availability to individuals increases consumption.
E. Structural versus passive government budget and trade deficits.
1. Higher tax rates and higher marginal propensities to import decrease the size of the multiplier.
2. The budget deficit and the trade balance will affect aggregate income, but they will also be affected by it.
3. To differentiate between a budget deficit being used as a policy instrument to affect the economy, and a budget deficit that is the result of income being below its potential, economists use a reference income level at which to judge fiscal policy.
a. A structural deficit is one that would exist at potential income.
b. A passive deficit is one that exists because income is below or above potential income.
(1) If the economy is operating above potential, the passive deficit is a positive number and reduces the overall effect.
(2) If the economy is operating below potential, the passive deficit is negative, an adds to the overall effect.
c. Since the economy cannot grow out of a structural budget deficit, they are of more concern to policy makers than are passive budget deficits.
d. Since there is debate about what an economy's potential income level is, there is disagreement about what percentage of a deficit is structural and what percentage is passive.

4. Fiscal policy in World War II.
1. Fiscal Policy:
a. Taxes rose but government expenditures rose still more.
b. The deficit shot up and real income rose by more than the increase in the deficit.
c. But where is the price - level increase one would expect? One would normally expect a huge inflation.
d. The wartime expansion was accompanied by wage and price controls and rationing.

2. Fiscal policy in the 1990s.
a. In order to stimulate a more robust growth in the economy, one would have expected President Clinton, a Democrat surrounded by Keynesian economists, to have suggested a policy of increasing the federal deficit . This would fit in with the model presented above.
b. Instead, he advocated decreasing the deficit in order to stimulate the economy.
(1) This was because of the deficit's effect on long term interest rates and investment.
(2) A smaller deficit means less government borrowing, which means lower interest rates, which leads to higher investment.
c. Thus, applying this simple Keynesian model is not going to give you an understanding of policy discussions today.

III. Problems with Fiscal and Other Activist Keynesian Policy

A. The Keynesian model seems so simple: if the economy contracts, the government runs an expansionary fiscal policy; if there's inflation, the government runs a contractionary fiscal policy.
1. In real life, that is not the way it is.
2. That does not necessarily mean the model is wrong; only that the model must be modified for it to work in the real world.

B. The model makes the following six assumptions:
1. Financing the deficit doesn't have offsetting effects.
2. Knowing what the situation is.

3. Knowing the level of potential income.
4. The government's flexibility in changing taxes and spending.
5. Size of the government debt doesn't matter.
6. Fiscal policy doesn't negatively affect other governmental goals. In reality, it often does.

C. Financing the deficit doesn't have offsetting effects.
1. Classicals argue that government financing of deficit spending will offset the deficit's expansionary effect.
2. Classicals object to the Keynesian assumption that savings and investment are unequal, They believe that the interest rate equilibrates savings and investment, and that borrowing will increase interest rates and crowd out private investment.
a. Crowding out is the offsetting of a change in government expenditures by a change in private expenditures in the opposite direction.
(1) In order to make government debt instruments attractive to investors, interest rates must be higher than they would otherwise be.
(2) Interest rates in the economy are pushed up.
(3) Private businesses are loathe to borrow when interest rates are high.
b. Thus, Interest rate crowding out reduces the effect of increases in government expenditures. Indeed, some Classicals argue that the effect is negative, since they consider private spending to be more productive than government spending.
c. Crowding out also works in reverse in contractionary fiscal policy.
(1) Assume the government is running a surplus and it decides to buy back bonds they have issued in the past.
(2) Interest rates drop, stimulating investment, thereby causing inflation.
d. Some Keynesian argue that often the crowding out will be offset by crowding in.
(1) Crowding in represents the positive effects of government spending on other components of spending.
(2) When there is crowding in, increased government spending will cause investment to increase as businesses prepare to meet the government's demand for goods.

D. Knowing what the situation is.
1. Getting reliable numbers on the economy takes time. We may even be in the middle of a recession and not know it.
2. In order to deal with the problem, the government has large econometric models and leading indicators to predict where the economy will be in the near future.
3. Alas, economic forecasting is still very much an art and not a science.
E. Knowing the level of potential income.
1. What is the level of potential income? No one knows for sure.
2. Any variation in potential income can make an enormous difference in the policy prescription that could be recommended.
a. According to Okun's law - a general rule of thumb economists use to translate the unemployment rate into changes in income.
b. A 1 percent fall in the unemployment rate is associated with a 2.5 percent increase in income.
3. Differences in estimates of potential income often lead to different policy recommendations.
4. In most cases, the U.S. economy is in an ambiguous state where some economists are calling for expansionary policy and others are calling for contractionary policy.

F. The government's flexibility in changing taxes and spending.
1. Even if all economists agree that an expansionary policy is needed, putting fiscal policy into place takes time and has serious implementation problems.
2. Numerous political and institutional realities in the U.S. today make it a difficult task to implement fiscal policy.
3. Squabbles between Congress and the President may delay implementing appropriate fiscal policy for months, even years.

G. Size of the government debt doesn't matter.
1. These is no inherent reason why the adoption of Keynesian policies should have caused the government to run deficits year after year.
2. There are two reasons why Keynesian policy has led to an increase in government debt.
a. Early Keynesians favored large increases in government spending as well as favoring the government's using fiscal policy.
b. Politically, it is much easier for government to increase spending and decrease taxes than vice versa.
3. If one believes that debt is harmful, then there might be a reason not to conduct expansionary fiscal policy, even when the model calls for it.

H. Fiscal policy doesn't negatively affect other government goals.
1. An economy has many goals; achieving potential income is only one of those goals
2. National economic goals often conflict.

I. Fiscal policy in practice: Summary of the problems.
1. While the problems listed above do not necessarily eliminate fiscal policy altogether, they severely restrict it.
2. Fiscal policy is a sledgehammer, not an instrument for fine tuning.

J. Building Keynesian policies into institutions.
1. Economists were quick to realize the political realities of fiscal policy so they attempted to create built-in fiscal policies.
2. These built-in fiscal policies are called automatic stabilizers - any government program or policy that will counteract the business cycle without any new government action. These may include.
a. Welfare payments.
b. Unemployment insurance.
c. The income tax system.
3. Automatic stabilizers have their problems too.
a. When the economy first starts climbing out of a recession, automatic stabilizers may slow down the process.
b. As income increases, automatic stabilizers increase government taxes and decrease government spending, and as they do, the discretionary policy's expansionary effects are decreased.
4. Despite these problems, most Keynesians believe automatic stabilizers have played an important role in reducing fluctuations in the economy.

K. Fiscal policy in perspective.
1. In the 1970s, the Classicals rose out of the ashes and began seriously questioning Keynesian assumptions.
2. They modified the presentation of Keynesian economics so that it focuses on dynamic adjustment and is no longer presented mechanistically.
3. Modern Classical economists argue that expectations of policy can change the dynamic adjustment process, and that any simple dynamic adjustment models are unlikely to describe the aggregate economy.

IV. The Practice of Fiscal Policy in the 1990s
A. Most economists agree that demand management policies are useful for keeping the economy out of a serious recession (Range A) and a hyperinflationary boom (Range C).
B. Died-in-the-wool Keynesians argue that the target unemployment rate should be at a 3.5 percent level, while rabid Classicals argue that a 6 percent range is more realistic.
C. The economy is generally in an ambiguous range (probably Range B); in this range, macro policy is an art, not a science.
 
 

Lecture Outline Chapter 11 Fiscal Policy

I. Introduction
A. The multiplier model presented in the last chapter highlights the role of aggregate demand (expenditure) management
policies, that is, changing the level of government spending and taxes.
B. One of the best known of these aggregate demand management policies is fiscal policy -- the deliberate change in either
government spending or taxes to stimulate or slow down the economy.
1. Expansionary fiscal policy involves decreasing taxes or increasing government spending.
2. Contractionary fiscal policy involves increasing taxes or decreasing government spending.

II. The Story of Fiscal Policy.
A. The Great Depression needed a countershock -- a jolt in the opposite direction of the shift in aggregate demand that started
the Depression -- to get the multiplier working in reverse.
1. Individuals, as individuals, were not prepared to do this in spite of pleas from the President: "We have nothing to fear but fear
itself." Collective action was needed.
2. With fiscal policy, government could provide the needed increased spending by decreasing taxes, increasing government
spending, or both.
3. Expansionary fiscal policy stimulated autonomous expenditures, which increased people's income, which increased people's
spending even more.
B. Aggregate demand management is government's attempt to control the aggregate level of income in the economy.
1. The fact that the effects are significantly different when one person does something rather than everyone doing something
plays an important role in economics. This goes under the following names: the public goods problem, the tragedy of the
commons, the fallacy of composition, and the multiperson dilemma.
2. Keynesians argued that, in times of a national emergency such as a depression, spending is a public good that benefits
everyone.
C. Fighting recession requires expansionary fiscal policy.
1. The economy is below potential income during a recession.
2. The top panel shows the AS/AD model; the bottom panel shows the multiplier model.
3. There is a recessionary gap -- the difference between equilibrium income and potential income when potential income
exceeds equilibrium income.
4. Assuming that government knows the value of the multiplier, money is pumped into the economy, which, when multiplied, fills
the recessionary gap.
D. Fighting inflation requires contractionary fiscal policy. The top panel shows the AS/AD model; the bottom panel shows the
multiplier model.
1. Fiscal policy can also work in reverse -- decreasing expenditures that are too high, that is, when inflation begins to accelerate
beyond potential income.
2. If the quantity of aggregate demand exceeds potential income at that price level, there will be excess demand and pressures
for inflation.
3. Temporarily, output may exceed potential output as firms and workers are slow to raise prices and wages.
4. Soon however, shortages and accelerating inflation will drive the economy back to its potential income.
5. Government would decrease its expenditures by an amount that reflects the magnitude of the multiplier.
6. This would remove the inflationary gap -- the difference between equilibrium income and potential income when equilibrium
income exceeds potential income.
E. The effectiveness of fiscal policy is questionable. There are two ways to think about the effectiveness of fiscal policy - in the
model and in reality.
1. The effectiveness of fiscal policy in reality depends on the government's ability to perceive a problem, and react
appropriately to it.
2. If the model is correct in describing the economy, and if government acts quickly enough in a countercyclical way,
depressions can be avoided.
3. A countercyclical fiscal policy is one in which the government offsets any shock that would create a business cycle.
4. Fine tuning is the term used to describe a fiscal policy designed to keep the economy always at its target or potential level
of income.
5. All economists now recognize that the dynamic adjustment in the economy is extraordinarily complicated, especially when
taking into account reasonable expectations of future policy.

III. Alternatives to Fiscal Policy
A. Three alternatives to fiscal policy are: directed investment policies, trade policies, and autonomous consumption policies.
1. Changes in autonomous C, I, G, X, or M can achieve the same results as fiscal policy.
2. Any policy that can influence autonomous expenditures without having offsetting effects on other expenditures can be used to
influence the direction and movement of aggregate income.
B. Directed investment policies are those affecting expectations to increase investment.
1. Rosy scenario is government talking the economy well.
a. Almost invariably, government officials paint optimistic pictures as to where the economy is headed.
b. Upbeat predications must be credible -- cf. Bob Dole and Bill Clinton during the 1996 national elections.
2. Financial guarantees affect expectations regarding financial institutions..
a. Another way to influence investment is to protect the financial system by government guarantees or promises of guarantees.
Example: preventing bank failures.
b. Still another way in which government can influence investment is through influencing the interest rate.
C. Trade policy and export led growth is another alternative.
1. Any governmental policy that increases autonomous exports and decreases autonomous imports (and thereby increases
autonomous expenditures) will also have multiplied effects on income.
2. These policies are called export led growth policies -- those designed to stimulate U.S. exports and increase aggregate
expenditures on U.S. goods, and hence have a multiplied effect on U.S. income.
3. Alternatively, any policy that will lower imports, such as tariffs, will have the same expansionary effect on income.
5. The global economy is interdependent.
a. Any time the U.S. is pushing an export-led growth policy, it is the same as getting another nation to follow an import led
decline for its economy.
b. It can reasonably be expected that other nations will retaliate.
c. As a consequence, many economists support free trade agreements such as NAFTA.
6. Exchange rate policies can affect new exports.
a. Trade balance can also be affected through exchange rate policy -- a policy of deliberately affecting a nation's exchangerate in order to affect its trade balance.
b. A low value of a nation's currency relative to currencies of other nations encourages exports and discourages imports; a high
value of a nation's currency relative to currencies of other nations discourages exports and encourages imports
D. Autonomous consumption policy is a third alternative. One example is increasing consumer credit availability to individuals
increases consumption.

IV. Real world examples.
A. Fiscal policy in World War II.
1. Taxes rose but government expenditures rose still more.
2. The deficit shot up and real income rose by more than the increase in the deficit.
3. But where is the price-level increase one would expect? One would normally expect a huge inflation.
4. The wartime expansion was accompanied by wage and price controls and rationing.
B. Owing to the death of soldiers and sailors, unemployment was reduced -- not a particularly palatable way of doing so.
C. Recent fiscal policy.
1. The deficit picture in the 1990s changed to a surplus.
a. The budget went from a large deficit to a large surplus. The economy was booming.
b. Did this mean that the government's fiscal policy was slowing the economy down?
2. There are two explanations for this seeming paradox.
a. The first:
(1) The surplus was slowing the economy,
(2) The contractionary effect of the surplus was offset by booms in consumer and investment spending.
b. The second:
(1) Much of the surplus resulted from the booming economy, not from discretionary fiscal policy.
(2) Much of the deficit reduction and movement into budget surplus resulted from an increase in income.
(3) The economy exceeded economists' estimate of potential income, without generating inflation, by far more than any
thought possible.

V. Problems with Fiscal and Other Activist Keynesian Policy
A. Activist government policy seems so simple: if the economy contracts, the government runs an expansionary fiscal policy; if
there's inflation, the government runs a contractionary fiscal policy.
1. In real life, that is not the way it is.
2. That does not necessarily mean the model is wrong; only that the model must be modified for it to work in the real world.
B. The model makes the following six assumptions:
1. Financing the deficit doesn't have offsetting effects.
2. Knowing what the situation is.
3. Knowing the level of potential income.
4. The government's flexibility in changing taxes and spending.
5. Size of the government debt doesn't matter.
6. Fiscal policy doesn't negatively affect other governmental goals. In reality, it often does.
C. Financing the deficit doesn't have offsetting effects.
1. Some economists argue that government financing of deficit spending will offset the deficit's expansionary effect.
2. They object to the multiplier model assumption that savings and investment are unequal. They believe that the interest rate
equilibrates savings and investment, and that borrowing will increase interest rates and crowd out private investment.
a. Crowding out is the offsetting of a change in government expenditures by a change in private expenditures in the opposite
direction.
(1) In order to make government debt instruments attractive to investors, interest rates must be higher than they would
otherwise be.
(2) Interest rates in the economy are pushed up.
(3) Private businesses are loath to borrow when interest rates are high.
b. Thus, interest rate crowding out reduces the effect of increases in government expenditures. Indeed, some economists argue
that the effect is negative, since they consider private spending to be more productive than government spending.
c. Crowding out also works in reverse in contractionary fiscal policy.
(1) Assume the government is running a surplus and it decides to buy back bonds they have issued in the past.
(2) Interest rates drop, stimulating investment, thereby causing inflation.
D. Knowing what the situation is.
1. Getting reliable numbers on the economy takes time. We may even be in the middle of a recession and not know it.
2. In order to deal with the problem, the government has large econometric models and leading indicators to predict where the
economy will be in the near future.
3. Alas, economic forecasting is still very much an art and not a science.
E. Knowing the level of potential income.
1. What is the level of potential income? No one knows for sure.
2. Any variation in potential income can make an enormous difference in the policy prescription that could be recommended.
a. Potential income is also known as full employment level of income.
b. According to Okun's rule of thumb, a 1 percentage point fall in the unemployment rate is associated with a 2 percent
increase in income.
3. Differences in estimates of potential income often lead to different policy recommendations.
4. In most cases, the U.S. economy is in an ambiguous state where some economists are calling for expansionary policy and
others are calling for contractionary policy.
F. The government's flexibility in changing taxes and spending.
1. Even if all economists agree that an expansionary policy is needed, putting fiscal policy into place takes time and has serious
implementation problems.
2. Numerous political and institutional realities in the U.S. today make it a difficult task to implement fiscal policy.
3. Squabbles between Congress and the President may delay implementing appropriate fiscal policy for months, even years.
G. Size of the government debt doesn't matter.
1. These is no inherent reason why the adoption of Keynesian policies should have caused the government to run deficits year
after year.
2. There are two reasons why activist policy of deficit spending has led to an increase in government debt.
a. Early activists favored large increases in government spending as well as favoring the government's using fiscal policy.
b. Politically, it is much easier for government to increase spending and decrease taxes than vice versa.
3. If one believes that debt is harmful, then there might be a reason not to conduct expansionary fiscal policy, even when the
model calls for it.
H. Fiscal policy doesn't negatively affect other government goals.
1. An economy has many goals; achieving potential income is only one of those goals
2. National economic goals often conflict.
I. Fiscal policy in practice: Summary of the problems.
1. While the six problems listed above do not necessarily eliminate fiscal policy altogether, they severely restrict it.
2. Fiscal policy is a sledgehammer, not an instrument for fine tuning.

VI. Fiscal policies are built into institutions.
A. Economists were quick to realize the political realities of fiscal policy so they attempted to create built-in fiscal policies.
B. These built-in fiscal policies are called automatic stabilizers -- any government program or policy that will counteract the
business cycle without any new government action. These may include:
1. Welfare payments.
2. Unemployment insurance.
3. The income tax system.
C. Automatic stabilizers have their problems too.
1. When the economy first starts climbing out of a recession, automatic stabilizers may slow down the process.
2. As income increases, automatic stabilizers increase government taxes and decrease government spending, and as they do,
the discretionary policy's expansionary effects are decreased.
D. Despite these problems, most Keynesians believe automatic stabilizers have played an important role in reducing fluctuations
in the economy.

V. Conclusion
1. The crowding out effect:
a. states that deficit spending financed by borrowing will increase interest rates and thereby crowd out private spending.
b. occurs because when the government runs a deficit it must buy bonds to finance that deficit, . occurs because businesses become more pessimistic about the future whenever government spending rises.
d. gets smaller the closer the economy comes to full employment.
2. Which of the following statements is true?
a. Higher taxes and higher marginal propensities to import increase the size of the real world multiplier.
b. Reducing the deficit during a recession would help keep the recession from getting worse.
c. The purpose of expansionary fiscal policy is to reduce inflationary pressures.
d. Contractionary fiscal policy involves raising taxes and/or reducing government spending - moving in the direction of a budget
surplus.
3. In a simple multiplier model with a mpc of 0.75, if the target level of national income is $3000 billion and the economy is
currently operating at an income level of $3200, then:
a. the recessionary gap is $200 billion and government could close the gap by increasing government spending by $50 billion.
b. the recessionary gap is $200 billion and government could close the gap by reducing taxes by approximately $66.67 billion.
c. the inflationary gap is $200 billion and government could close the gap by reducing taxes by approximately $50 billion.
d. the inflationary gap is $200 billion and government could close the gap by increasing taxes by approximately $66.67 billion.
4. Which of the following statement is true?
a. Keynesian economists argue that an increase in aggregate demand is divided between a rise in the price level and a rise in
real income.

Lecture Outline: Fiscal Policies Chapter 12

I. Introduction
A. After having run budget deficits for many decades, in 1998 the U.S. government began to run surpluses.
B. This chapter considers budget deficits and surpluses from an economist's perspective.
1. In the long run framework, surpluses are good because they provide additional saving for an economy and deficits are bad
because they reduce saving, growth, and income,
2. In a shorten framework, the view of surpluses and deficits depends on the state of the economy relative to its potential.
a. If the economy is running below its potential output, deficits are good and surpluses are bad.
b. Below potential income, deficits increase expenditures, increasing output by a multiple of that amount.
3. Combining the two frameworks gives us the following policy directive:
a. Whenever possible, run surpluses, or at least a balanced budget, to help stimulate longtime growth. This is especially true
when the economy is booming - when it is above its level of potential income.
b. The argument for surpluses is weakened, and likely reversed, when the economy falls into a recession.
C. The situation at the end of 1999:
1. There was a large surplus.
a. The economy was booming.
b. Unemployment was at historic lows.
c. There was general agreement that the economy was at its potential output.
2. Instead of cutting the national debt, a policy both the short- and long-term economic frameworks recommended, both
political parties looked at ways to spend the surplus, either by cutting taxes or by increasing spending.

II. Defining Surpluses and Debt.
A. A surplus is an excess of revenues over payments.
B. A deficit is a shortfall of revenues over payments.
C. Both are flow concepts.
D. The deficit must be financed.
1. The U.S. Treasury finances a deficit by selling bonds - promises to pay back the money in the future.
2. Since the central bank's IOU's are money, the loans can also made by printing money. Potentially, the central bank has an
unlimited source of funds.
3. However, too much money means inflation. that can have a negative effect on the economy.
E. Defining surpluses and deficits can be arbitrary.
1. Whether or not a nation has a deficit depends on what is included as a revenue and what is included as an expenditure.
2. This accounting issue is central to the debate about whether we should be concerned about a deficit.
a. The government's Social Security System - a social insurance program that provides financial benefits to the elderly and
disabled and to their eligible dependents and/or survivors - is based on promises to pay.
b. The accounting procedures used play an important role in whether the government budget has a deficit or surplus.
F. There are many right definitions of revenues and expenditures.
1. All definitions are not necessarily correct.
2. Inconsistent accounting practices - sometimes to measure an income flow one way and sometimes another - are wrong.
G. Surpluses and deficits as summary measures.
1. As a summary, a surplus or deficit figure reduces a complicated set of accounting relationships down to a single figure.
2. What is important is not whether a budget is in surplus or deficit; what is important is the economic health of the economy.

III. Nominal and Real Surpluses and Deficits
A. A nominal deficit is the deficit determined by looking at the difference between expenditures and receipts.
B. A real deficit is the nominal deficit adjusted for inflation.
1. Inflation wipes out debt (accumulated deficits less accumulated surpluses).
2. The larger the debt and the larger the inflation, the more debt will be eliminated by inflation.
3. If inflation is wiping out debt, and the deficit is equal to the increases in debt from one year to the next, inflation also affects
the deficit.
4. To calculate a real deficit:
Real deficit = Nominal deficit - (Inflation X Total debt)
a. The lowering of the real deficit by inflation is not costless to the government.
b. Persistent inflation becomes built into expectations and causes higher interest rates.

IV. Structural and Passive Surpluses and Deficits.
A. It is important to make a distinction between structural and passive deficits.
1. Not all government expenditures are independent of the level of income in the economy.
2. To differentiate between a budget deficit being used as a policy instrument to affect the economy and a budget deficit that is
the result of income deviating from its potential, economists ask the question: would the economy have a budget deficit if it were
at its potential level of income?
a. If it would, that part of the budget deficit is said to be a structural deficit or surplus - the part of the budget deficit or
surplus that would exist even if the economy were at its potential level of income.
b. That part of the total budget deficit or surplus is a passive deficit or surplus - the part of the deficit or surplus that exists because the economy is operating below or above its potential level of output.
(1) When an economy is operating above its potential, it has a passive surplus.
(2) If the economy is operating below its potential, the actual deficit would be larger than the structural deficit.
B. In reality there is a significant debate about what an economy's potential income level is, and hence there is disagreement
about what percentage of a deficit is structural and what part is passive.

V. The definition of debt and assets.
A. Debt is accumulated deficits minus accumulated surpluses .
1. Deficits and surpluses are flow concepts.
2. Debt is a stock concept.
B. The debt must be managed.
1. The U.S. Treasury must continually refinance the bonds that are coming due by selling new bonds, as well as selling new
bonds when running a deficit.
2. If the government is running a surplus, it can either retire some of its previously issued bonds by buying them back, or simply
not replace the previously issued bonds when they come due.
3. In the late 1990s, the U.S. Treasury has done both.
4. Debt needs to be judged relative to assets.
a. Debt is also a summary measure of a nation's financial situation. As a summary measure, debt has even more problems than
deficit. Debt by itself is only half the picture.
b. The other half is assets.
(1) For a nation, assets include:
(a) Its skilled work force.
(b) Natural resources.
(c) Its housing stock.
(d) Holdings of foreign assets.
(2) For a government, assets include:
(a) The buildings and land it owns.
(b) A portion of the assets of the people in the country, since government gets a portion of all earnings of those assets in tax
revenue.
c. When the government runs a deficit, it might be spending on projects that increase its assets. If the assets are valued at more
than their costs, then the deficit is making the society better off.
(1) Business does this and includes such expenditures in a capital budget. These assets earn money in the future for the
business.
(2) Government does not have a capital budget.
(a) Determining what is an investment in government is extraordinarily difficult.
(b) Most government goods earn no income, but are supplied free to individuals and are paid for by taxes.
(c) Thus, government avoids trying to measure the capitalizing aspects of spending.
5. Defining debt and assets can be arbitrary.
a. As was the case with income, revenues, and deficits, there is on perfect answer as to how assets and debt should be valued.
b. Even after assets are taken into account, you still have to be careful when deciding whether or not to be concerned about
debt.
c. Much of the surplus the government is running is being directed into the Social Security Trust Fund.
(1) This fund is managed by the Social Security Administration in order to meet its future obligations.
(2) By law, the trust fund must be held as nonmarketable government bonds.
(a) Thus, one agency of government -the Social Security Administration - is buying the bonds of another agency - the Treasury
Department.
(b) When the government is running a surplus, as in the late 1990s, the Treasury had to buy back bonds that the public owned
and sell additional bonds to the Social Security Administration.
C. Individual and government debt are different.
1. Government debt is difference from an individual's debt for three reasons:
a. Government is ongoing - it does not die.
b. Government can print money to pay off its debt. Unfortunately, individuals can't.
c. Three quarters of government debt is internal debt - debt owed to other government agencies or to its citizens. Paying
interest on the internal debt involves a redistribution among citizens of the country, but it does involve a net reduction in income
of the average citizen.
2. External debt - government debt owed to individuals in foreign countries - is more like an individual's debt.

VI. U. S. Government Deficits and Debt: The Historical Record.
A. Most economists do not look at absolute figures of deficits and debt. They are much more concerned with deficits and debt
relative to GDP.
1. Viewed in this manner, deficits and debt did not rise significantly in the 1970s and 1980s.
2. In the mid-1990s, it stabilized to about 70 percent of GDP, while in the late-1990s, it has been falling.
3. Economists prefer this "relative to GDP measurement" because it better measures the government's ability to handle the
deficit and pay off the debt. It depends on a nation's productive capacity, the asset side of the equation.
4. When GDP grows, the debt the government can reasonable handle also grows.
D. The debt burden.
1. There are two ways in which growth in GDP can occur:
a. Through inflation - a rise in nominal, but not real GDP.
b. Through real growth.
2. When an economy experiences real growth, the ability of the government to incur debt is increased - the economy becomes
richer, and, being richer, it can handle more debt.
a. Real growth in the U.S. has averaged about 2.5 percent a year.
b. This means that U.S. debt can grow at the same rate without increasing the debt-GDP ratio.
E. U.S. debt is not too large relative to other countries.
1. When judged relative to other countries, the U.S. debt burden is not especially large. See Figure 28-3.
2. U.S. government can have trillions of dollars more in debt before there is a significant need for
concern.
F. Interest rates affect debt burden.
1. Economists are also concerned about the interest rate paid on the debt.
a. How much of a burden a given amount of debt imposes depends on the interest rate that must be paid on that debt.
b. It determines annual debt service - the interest rate on debt times the total debt.
c. Ultimately, the interest payments are the burden of the debt.
d. That is what people mean when they say a deficit is burdening future generations. See Figure 28-4.
2. This measure suggests that the debt is more of a problem than the debt to GDP measure, but less of a problem than when
looked at debt as an isolated figure.
3. The U.S. can afford its current debt in the sense that it can afford to pay the interest on that debt.

VII. The Late 1990s Debate About the Surplus
A. Why did the surpluses come about?
1. Keynesian economics made clear that the view that deficits were always bad was too simplistic.
a. At certain troubled times, deficits could serve a positive function.
b. This enlightened view was never fully accepted by politicians, nor by the public.
2. Politicians never acted on their convictions.
a. Democrats enacted new spending programs.
b. Republicans tried to stop the new spending and tried to increase taxes to maintain fiscal responsibility.
3. The 1980s saw a change in the political landscape.
a. Republicans, who opposed large government spending programs, developed a new strategy that focused on cutting taxes.
b. Democrats wanted to expand the government's role in the economy by spending.
c. The point is that both political parties were pushing the economy toward deficits - one by spending, the other by cutting
taxes.
d. This led to the passage of the Budget Enforcement Act of 1990, a law that put caps on certain aspects of federal
spending, and established a "pay-as-you-go" test for new spending or tax cuts. This law had little effect on the surpluses that
began to accelerate in the late 1990s.
(1) What actually brought about these surpluses was the unexpected growth of the U.S. economy coupled with a lack of
inflation.
(2) Interest rates stayed low, holding down government interest payments.
(a) Republicans wanted to eliminate the surplus by cutting taxes.
(b) Democrats wanted to eliminate part of the surplus by increasing spending.
B. What should the government do with the surpluses?
1. Do government statistics adequately describe the actual surplus situation? No, they do not.
2. This is because the government uses a cash flow accounting system - an accounting system entering expenses and
revenues only when cash is received or paid out.
C. The government's cash flow accounting system has a few economic implications.
1. A number of obligations the government incurs do not show up as part of the deficit.
2. An example is the Social Security system, a partially unfounded system.
D. The Social Security System.
1. Because the government uses a cash flow budget, a number of obligations incurred by the government do not show up as
part of expenditures.
2. The Social Security system was set up as a pay-as-you-go system where the payments to current beneficiaries are funded
through current payroll taxes.
a. Recently, the Social Security Administration began to invest its surplus revenue into a Trust Fund. By 2040, the Trust Fund is
expected to be depleted.
b. That means the Social Security system is a partially unfounded pension system.
(1) A funded pension system is one where the contributions plus interest paid by workers are used to fund those workers'
pensions.
(2) As long as the population's age distribution, the annual death rate, and the number of people working do not change much,
an unfounded pension system works smoothly.
(3) But an unfounded system does present a potential problem if the amount paid in, and the amount paid out, differ.
3. The baby boom affects the Social Security System.
a. If there is a baby boom, the size of the three groups, the retired elderly, the workers, and the very young who are not
working, are no longer equal.
b. When the baby boomers retire, there are not enough new entrants into the work place, assuming they have few children, to
pay the benefits of the retired folks.
c. In this case, payments per person must decrease, real contributions per worker coming in must increase, or some
combination of the two must occur. None of these alternatives are politically palatable.
d. This represents the current situation in the U.S. Social Security System.
E. The Social Security Trust Fund was set up to fund future Social Security obligations.
1. In 1983 legislation was passed to aid Social Security.
a. It raised the age of eligibility slightly.
b. Social Security tax rates were raised.
c. Social Security payments became subject to taxation for some beneficiaries.
2. Currently, the Social Security system accounts for nearly all the government surplus.
3. The portion of surpluses held by Social Security is not available for spending - it is saved for the Trust Fund.
4. Medicare is also in a similar bind since the elderly use significantly more medical services than younger people.
F. Why the surplus is not as large as it looks.
1. The U.S. does not have anywhere near as large a spendable surplus as it appears.
2. What we have is a surplus that is serving as a Trust Fund to pay future social security claims.
3. Economic theory suggests that since the economy is doing so well now, the entire surplus should be saved, and possibly even
increased through further spending cuts and increased taxes.
4. If those budget surpluses in excess of what is required to be placed in the Social Security Trust Fund were put into a special
rainy day fund, current surpluses would not be subject to the Budget Enforcement Act that is designed to prevent deficits.
G. The real problem and the real solution are different from the financial problem.
1. Even a fully funded Trust Fund will not solve the Social Security problem.
2. The reason is that the Trust Fund is simply a financial solution - that actual solution must be a "real" solution. This solution
deals with the supply and demand of real resources, not with nominal amounts.
3. The real problem, because of the baby boomers, is that starting in 2030, present workers must produce not only enough
goods for themselves and their families, they must also produce enough goods for the retired baby boomers.
4. Put another way, the output per worker must increase but the consumption of workers much not increase.
5. Starting in 2030, present workers will be taxed heavily.
6. The Trust Fund is an accounting illusion.
a. It backs one government obligation with another government obligation.
b. The Trust Fund has a positive effect on the problem, even if it does not solve the problem completely.
7. Politics affects economic policy.
a. A proposal to help the elderly with their drug expenses will, in 2020, make the situation worse for those still working.
b. Another proposal is to invest the Trust Fund in the stock market. The argument for this is dubious since the market can
always fall.
8. Politically unpopular policies may be needed.
a. The real solution is any policy that brings the real forces of aggregate supply and demand into equilibrium.
b. The real amount baby boomers spend when they retire must be reduced otherwise taxes on those still working must be
increased.
c. There are a number of ways this can be done, none of them politically appetizing.
(1) Increase taxes on those working in 2030.
(2) Cut benefits once baby boomers start retiring.
(3) Make Social Security means tested.
(4) Increase the retirement age to 72.
(a) The elderly now live longer.
(b) They are in better health than in the past.
(c) Many people would work longer thereby paying more into Social Security.
(d) It would decrease the number of people consuming without producing.