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MAKRO PERBANKAN SEMESTER GENAP 2014-15 Al Muizzuddin Fazaalloh

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Page 1: MAKRO PERBANKAN - mizu.lecture.ub.ac.id · Tugas diberikan sewaktu-waktu 7. Partisipasi adalah presentasi dan diskusi mahasiswa di setiap pertemuan. 8. Ujian Susulan (Quiz, Tugas,

MAKRO PERBANKANSEMESTER GENAP 2014-15 Al Muizzuddin Fazaalloh

Page 2: MAKRO PERBANKAN - mizu.lecture.ub.ac.id · Tugas diberikan sewaktu-waktu 7. Partisipasi adalah presentasi dan diskusi mahasiswa di setiap pertemuan. 8. Ujian Susulan (Quiz, Tugas,

CURRICULUM VITAE

Al Muizzuddin Fazaalloh

Dosen Non-PNS FEB UB (2012-sekarang)

HP. 0812 3005 8998

Email [email protected]

4/15/2015 2

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PENILAIAN

TUGAS = 20%

QUIZ = 15%

PARTISIPASI = 15 %

UTS = 25%

UAS = 25%

4/15/2015 3

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SYLLABUSSYLLABUS

1. Pendahuluan: Review pengantar makroekonomi (chapter 1 dan 2Mankiw)

2. Pengukuran Makroekonomi (chapter 4 Parkin)

3. Pengeluaran Agregat: Konsumsi (chapter 5 Slavin)

4. Pengeluaran Agregat: Investasi (chapter 6 Slavin)

5. Pengeluaran Agregat dan Pendapatan Nasional (chapter 10Parkin)

6. Pemerintah dan Makroekonomi (chapter 7 Slavin)

7. Uang dan Bank (chapter 13 Slavin)

8. UTS

Wednesday, April 15, 2015 4

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SYLLABUS (2)

9. Bunga dan Pasar Uang (chapter 7 Parkin)

10. Uang, Bunga, dan pendapatan nasional (chapter 8 Parkin)

11. Kebijakan Fiskal (chapter 13 Parkin)

12. Kebijakan Monter (chapter 14 Parkin)

13. Nilai Tukar dan Sistem Keuangan Internasional (chapter 19 Slavin)

14. Perdagangan Internasional dan Pendapatan Nasional (chapter 15Parkin)

15. Pemikiran Makroekonomi (chapter 15 Slavin)

16. UAS

Wednesday, April 15, 2015 5

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LITERATURELITERATURE

1. Parkin, 2012, Macroeconomics tenth edition, Boston: PearsonEducation, Inc.

2. Slavin, 2009, Macroeconomics nine edition, New York: Mc GrawHill.

3. Mankiw, 2010, Macroeconomics seventh edition, New York:Worth Publisher.

Wednesday, April 15, 2015 6

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DESAIN PERKULIAHAN

1. Presentasi dan Diskusi Mahasiswa selama 30 menit.2. Berikutnya, 30 menit penjelasan dari dosen.3. Berikutnya, 30 menit diskusi dosen dan mahasiswa.4. Mahasiswa harus absen sendiri. Tidak boleh diwakilkan ke

temannya. Sanksinya harus merangkum 5 halaman folio garis darimateri yang diajarkan dosen pada hari itu.

5. Quiz diberikan sewaktu-waktu6. Tugas diberikan sewaktu-waktu7. Partisipasi adalah presentasi dan diskusi mahasiswa di setiap

pertemuan.8. Ujian Susulan (Quiz, Tugas, UTS, UAS) bisa dilakukan dengan syarat

dan ketentuan yang berlaku dan Nilai Ujian Susulan biasanya tidakseperti Nilai Regular*

4/15/2015 7

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TATA TERTIB KELAS

Ketua Kelas 1 orang (volunteer)

Bila Sakit atau berhalangan hadir di kelas cukup sms kedosen dengan konten sebagai berikut: Nama lengkap: Cristioano Ronaldi Nim: 0812345678 Kelas: XA Program studi: Ilmu Keilmuan Keterangan: Ijin menikah

Jika mahasiswa tidak masukdan tidak ada sms maka

dianggap tidak ijin4/15/2015 8

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KELOMPOK DISKUSI

Buatlah kelompok diskusi sebanyak 3-4 orang

Buatlah powerpoint waktu presentasi dan bagikan powerpointtersebut ke kelompok lain

Penilaian diskusi kelompok:

Wednesday, April 15, 2015 9

A = presentasi sangat jelas dan mampumenjawab semua pertanyaan dengan tepatdan cepat

B = presentasi jelas dan mampu menjawabsemua pertanyaan

C = presentasi cukup jelas

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ADA PERTANYAAN?

4/15/2015 10

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Lecture: Al Muizzuddin F., SE., ME.

WHAT IS ECONOMICS

Page 12: MAKRO PERBANKAN - mizu.lecture.ub.ac.id · Tugas diberikan sewaktu-waktu 7. Partisipasi adalah presentasi dan diskusi mahasiswa di setiap pertemuan. 8. Ujian Susulan (Quiz, Tugas,

Scarcity◦ Our inability to get everything we want is called scarcity

Insentive◦ A reward that encourages an action or a penalty that

discourages one.

2

Economic is the social science that studies thechoices that individuals, businesses, governments,

and entire societies make as they cope with scarcityand the incentives that influence and reconcile those

choices.

Economic is the social science that studies thechoices that individuals, businesses, governments,

and entire societies make as they cope with scarcityand the incentives that influence and reconcile those

choices.

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Mikroekonomi◦ Microeconomics is the study of the choices that individuals

and businesses make, the way these choices interact inmarkets, and the influence of governments. Some examples ofmicroeconomic questions are: Why are people downloadingmore movies? How would a tax on e-commerce affect eBay?

Makroekonomi◦ Macroeconomics is the study of the performance of the

national economy and the global economy. Some examples ofmacroeconomic questions are: Why is the U.S. unemploymentrate so high? Can the Federal Reserve make our economyexpand by cutting interest rates?

3

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How do choices end up determining what, how,and for whom goods and services are produced?

Can the choices that people make in the pursuit oftheir own self-interest also promote the broadersocial interest?

4

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What?◦ What we produce varies across countries and changes

over time.

5

First

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How?◦ Goods and services are produced by using productive

resources that economists call factors of production.◦ Factors of production are grouped into four categories: Land Labor Capital Entrepreneurship

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The “gifts of nature” that we use to produce goodsand services are called land.

In economics, land is what in everyday languagewe call natural resources.

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The work time and work effort that people devote to producinggoods and services is called labor.

The quality of labor depends on human capital, which is theknowledge and skill that people obtain from education, on-the-jobtraining, and work experience.

8

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The tools, instruments, machines, buildings, andother constructions that businesses use to producegoods and services are called capital.

In everyday language, we talk about money,stocks, and bonds as being “capital.” These itemsare financial capital.

9

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The human resource that organizes labor, land,and capital is called entrepreneurship.

10

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Whom?◦ Who consumes the goods and services that are produced

depends on the incomes that people earn.◦ People earn their incomes by selling the services of the factors

of production they own: Land earns rent. Labor earns wages. Capital earns interest. Entrepreneurship earns profit.

◦ Which factor of production earns the most income?◦ Knowing how income is shared among the factors of

production doesn’t tell us how it is shared among individuals.And the distribution of income among individuals is extremelyunequal.

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A choice is in your self-interest if you think thatchoice is the best one available for you.

You make most of your choices in your self-interest.

You use your time and other resources in the waysthat make the most sense to you, and you don’tthink too much about how your choices affectother people.

12

Second

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A choice is in the social interest if it leads to anoutcome that is the best for society as a whole.

The social interest has two dimensions: efficiencyand equity (or fairness). What is best for society isan efficient and fair use of resources.

13

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Can we organize our economic lives so that wheneach one of us makes choices that are in our self-interest, we promote the social interest?◦ Can trading in free markets achieve the social interest?◦ Do we need government action to achieve the social

interest?◦ Do we need international cooperation and treaties to

achieve the global social interest?

14

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We’re going to look at six key ideas that define theeconomic way of thinking. These ideas are:◦ A choice is a tradeoff.◦ People make rational choices by comparing benefits and

costs.◦ Benefit is what you gain from something.◦ Cost is what you must give up to get something.◦ Most choices are “how-much” choices made at the

margin.◦ Choices respond to incentives.

15

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Because we face scarcity, we must make choices. And when we make a choice, we select from the

available alternatives. A tradeoff is an exchange—giving up one thing to

get something else.

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Economists view the choices that people make asrational.

A rational choice is one that compares costs andbenefits and achieves the greatest benefit over costfor the person making the choice.

The idea of rational choice provides an answer tothe first question: What goods and services willbe roduced and in what quantities? The answer isthose that people rationally choose to buy!

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The benefit of something is the gain or pleasurethat it brings and is determined by preferences—by what a person likes and dislikes and theintensity of those feelings.

Economists measure benefit as the most that aperson is willing to give up to get something.

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The opportunity cost of something is the highestvalued alternative that must be given up to get it.

To make the idea of opportunity cost concrete,think about your opportunity cost of being inschool.

It has two components: the things you can’t affordto buy and the things you can’t do with your time.

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You can allocate the next hour between studyingand instant messaging your friends, but the choiceis not all or nothing. You must decide how manyminutes to allocate to each activity. To make thisdecision, you compare the benefit of a little bitmore study time with its cost—you make yourchoice at the margin.

The benefit that arises from an increase in anactivity is called marginal benefit.

The opportunity cost of an increase in an activityis called marginal cost.

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The central idea of economics is that we canpredict the self-interested choices that peoplemake by looking at the incentives they face.People undertake those activities for whichmarginal benefit exceeds marginal cost; and theyreject options for which marginal cost exceedsmarginal benefit.

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Economist as Social Scientist Positive Statements A positive statement is about what is.

Normative Statements A normative statement is about what ought to be.

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Economist as Policy Adviser◦ Economics is useful. It is a toolkit for advising

governments and businesses and for making personaldecisions. Some of the most famous economists workpartly as policy advisers.

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24

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4 MEASURING GDP ANDECONOMIC GROWTH

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© 2014 Pearson Addison-Wesley

After studying this chapter, you will be able to:

Define GDP and explain why GDP equals aggregateexpenditure and aggregate income

Explain how the Bureau of Economic Analysis measuresU.S. GDP and real GDP

Explain the uses and limitations of real GDP as ameasure of economic well-being

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© 2014 Pearson Addison-Wesley

Will the U.S. economy expand more rapidly next year orwill it sink back into another recession?

To assess the state of the economy and to make bigdecisions about business expansion, firms use forecastsof GDP.

What exactly is GDP?

How do we use GDP to tell us how rapidly our economy isexpanding or whether our economy is in a recession?

How do we take the effects of inflation out of GDP toreveal the growth rate of our economic well-being?

And how do we compare economic well-being acrosscountries?

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© 2014 Pearson Addison-Wesley

Gross Domestic Product

GDP DefinedGDP or gross domestic product is the market value ofall final goods and services produced in a country in agiven time period.

This definition has four parts:

Market value Final goods and services Produced within a country In a given time period

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© 2014 Pearson Addison-Wesley

Gross Domestic Product

Market Value

GDP is a market value—goods and services are valued attheir market prices.

To add apples and oranges, computers and popcorn, weadd the market values so we have a total value of outputin dollars.

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© 2014 Pearson Addison-Wesley

Gross Domestic Product

Final Goods and Services

GDP is the value of the final goods and servicesproduced.

A final good (or service) is an item bought by its final userduring a specified time period.

A final good contrasts with an intermediate good, whichis an item that is produced by one firm, bought by anotherfirm, and used as a component of a final good or service.

Excluding the value of intermediate goods and servicesavoids counting the same value more than once.

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© 2014 Pearson Addison-Wesley

Gross Domestic Product

Produced Within a Country

GDP measures production within a country—domesticproduction.

In a Given Time Period

GDP measures production during a specific time period,normally a year or a quarter of a year.

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© 2014 Pearson Addison-Wesley

Gross Domestic Product

GDP and the Circular Flow of Expenditure and IncomeGDP measures the value of production, which also equalstotal expenditure on final goods and total income.

The equality of income and value of production shows thelink between productivity and living standards.

The circular flow diagram in Figure 4.1 illustrates theequality of income and expenditure.

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Gross Domestic Product

The circular flow diagram shows the transactions amonghouseholds, firms, governments, and the rest of the world.

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© 2014 Pearson Addison-Wesley

Gross Domestic Product

Households and Firms

Households sell and firms buy the services of labor,capital, and land in factor markets.

For these factor services, firms pay income to households:wages for labor services, interest for the use of capital,and rent for the use of land. A fourth factor of production,entrepreneurship, receives profit.

In the figure, the blue flow, Y, shows total income paid byfirms to households.

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Gross Domestic Product

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© 2014 Pearson Addison-Wesley

Gross Domestic ProductFirms sell and households buy consumer goods andservices in the goods market.

Consumption expenditure is the total payment forconsumer goods and services, shown by the red flowlabeled C .

Firms buy and sell new capital equipment in the goodsmarket and put unsold output into inventory.

The purchase of new plant, equipment, and buildings andthe additions to inventories are investment, shown by thered flow labeled I.

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Gross Domestic Product

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© 2014 Pearson Addison-Wesley

Gross Domestic ProductGovernments

Governments buy goods and services from firms and theirexpenditure on goods and services is called governmentexpenditure.

Government expenditure is shown as the red flow G.

Governments finance their expenditure with taxes and payfinancial transfers to households, such as unemploymentbenefits, and pay subsidies to firms.

These financial transfers are not part of the circular flow ofexpenditure and income.

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© 2014 Pearson Addison-Wesley

Gross Domestic Product

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Gross Domestic Product

Rest of the World

Firms in the United States sell goods and services to therest of the world—exports—and buy goods and servicesfrom the rest of the world—imports.

The value of exports (X ) minus the value of imports (M) iscalled net exports, the red flow (X – M).

If net exports are positive, the net flow of goods andservices is from U.S. firms to the rest of the world.

If net exports are negative, the net flow of goods andservices is from the rest of the world to U.S. firms.

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Gross Domestic Product

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Gross Domestic ProductThe blue and red flows are the circular flow of expenditureand income.

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Gross Domestic ProductThe sum of the red flows equals the blue flow.

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Gross Domestic ProductThat is: Y = C + I + G + X – M

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Gross Domestic Product

The circular flow shows two ways of measuring GDP.

GDP Equals Expenditure Equals Income

Total expenditure on final goods and services equals GDP.

GDP = C + I + G + X – M.

Aggregate income equals the total amount paid for the useof factors of production: wages, interest, rent, and profit.

Firms pay out all their receipts from the sale of final goods,so income equals expenditure,

Y = C + I + G + (X – M).

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Gross Domestic Product

Why “Domestic” and Why “Gross”?Domestic

Domestic product is production within a country.

It contrasts with national product, which is the value ofgoods and services produced anywhere in the world bythe residents of a nation.

Gross

Gross means before deducting the depreciation of capital.

The opposite of gross is net, which means after deductingthe depreciation of capital.

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Gross Domestic Product

Depreciation is the decrease in the value of a firm’scapital that results from wear and tear and obsolescence.

Gross investment is the total amount spent on purchasesof new capital and on replacing depreciated capital.

Net investment is the increase in the value of the firm’scapital.

Net investment = Gross investment Depreciation.

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Gross Domestic Product

Gross investment is one of the expenditures included inthe expenditure approach to measuring GDP.

So total product is a gross measure.

Gross profit, which is a firm’s profit before subtractingdepreciation, is one of the incomes included in the incomeapproach to measuring GDP.

So total product is a gross measure.

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Measuring U.S. GDP

The Bureau of Economic Analysis uses two approaches tomeasure GDP:

The expenditure approach

The income approach

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Measuring U.S. GDP

The Expenditure ApproachThe expenditure approach measures GDP as the sum ofconsumption expenditure, investment, governmentexpenditure on goods and services, and net exports.

GDP = C + I + G + (X M)

Table 4.1 on the next slide shows the expenditureapproach with data (in billions) for 2012.

GDP = $11,007 + $2,032 + $3,055 $616

= $15,478 billion

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Measuring U.S. GDP

The Income ApproachThe income approach measures GDP by summing theincomes that firms pay households for the factors ofproduction they hire—wages for labor, interest for capital,rent for land, and profit for entrepreneurship.

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Measuring U.S. GDP

The National Income and Expenditure Accounts divideincomes into two broad categories:

1. Compensation of employees2. Net operating surplus

Compensation of employees is the payments for laborservices. It is the sum of net wages plus taxes withheldplus social security and pension fund contributions.

Net operating surplus is the sum of other factor incomes. Itincludes net interest, rental income, corporate profits, andproprietor’s income.

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Measuring U.S. GDP

The sum of all factor incomes is net domestic income atfactor cost.

Two adjustments must be made to get GDP:

1. Indirect taxes less subsidies are added to get fromfactor cost to market prices.

2. Depreciation is added to get from net domestic incometo gross domestic income.

Table 4.2 on the next slide shows the income approachwith data for 2012.

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Measuring U.S. GDP

Nominal GDP and Real GDPReal GDP is the value of final goods and servicesproduced in a given year when valued at the prices of areference base year.

Currently, the reference base year is 2005 and wedescribe real GDP as measured in 2005 dollars.

Nominal GDP is the value of goods and servicesproduced during a given year valued at the prices thatprevailed in that same year.

Nominal GDP is just a more precise name for GDP.

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Measuring U.S. GDP

Calculating Real GDPTable 4.3(a) shows thequantities produced andthe prices in 2005 (thebase year).

Nominal GDP in 2005 is$100 million.

Because 2005 is the baseyear, real GDP equalsnominal GDP and is $100million.

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Measuring U.S. GDP

Table 4.3(b) shows thequantities produced and theprices in 2012.

Nominal GDP in 2012 is$300 million.

Nominal GDP in 2012 isthree times its value in 2005.

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Measuring U.S. GDP

In Table 4.3(c), we calculatereal GDP in 2012.

The quantities are those of2012, as in part (b).

The prices are those in thebase year (2005) as in part(a).

The sum of theseexpenditures is real GDP in2012, which is $160 million.

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The Uses and Limitations of Real GDP

Economists use estimates of real GDP for two mainpurposes:

To compare the standard of living over time

To compare the standard of living across countries

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The Uses and Limitations of Real GDP

The Standard of Living Over TimeReal GDP per person is real GDP divided by thepopulation.

Real GDP per person tells us the value of goods andservices that the average person can enjoy.

By using real GDP, we remove any influence that risingprices and a rising cost of living might have had on ourcomparison.

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The Uses and Limitations of Real GDP

Long-Term Trend

A handy way of comparing real GDP per person over timeis to express it as a ratio of some reference year.

For example, in 1960, real GDP per person was $15,850and in 2012, it was $43,182.

So real GDP per person in 2012 was 2.7 times its 1960level—that is, $43,182 ÷ $15,850 = 2.7.

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The Uses and Limitations of Real GDP

Two features of our expanding living standard are

The growth of potential GDP per person

Fluctuations of real GDP around potential GDP

The value of real GDP when all the economy’s labor,capital, land, and entrepreneurial ability are fullyemployed is called potential GDP.

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The Uses and Limitations of Real GDP

Figure 4.2 shows U.S.real GDP per person.

Potential GDP grows at asteady pace because thequantities of the factorsof production and theirproductivity grow at asteady pace.

Real GDP fluctuatesaround potential GDP.

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The Uses and Limitations of Real GDP

Real GDP per person inthe United States:

Doubled between 1960and 1990.

Was 2.7 times its 1960level in 2012.

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The Uses and Limitations of Real GDP

Productivity Growth Slowdown

The growth rate of real GDP per person slowed after1970. How costly was that slowdown?

The answer is provided by a number that we’ll call theLucas wedge.

The Lucas wedge is the dollar value of the accumulatedgap between what real GDP per person would have beenif the 1960s growth rate had persisted and what real GDPper person turned out to be.

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The Uses and Limitations of Real GDP

Figure 4.3 illustrates theLucas wedge.

The red line is actual realGDP per person.

The thin black line is thetrend that real GDP perperson would have followedif the 1960s growth rate ofpotential GDP hadpersisted.

The shaded area is theLucas wedge.

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The Uses and Limitations of Real GDP

Real GDP Fluctuations— The Business Cycle

A business cycle is a periodic but irregular up-and-downmovement of total production and other measures ofeconomic activity.Every cycle has two phases:1. Expansion2. Recession

and two turning points:1. Peak2. Trough

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The Uses and Limitations of Real GDP

Figure 4.4 illustrates thebusiness cycle.

An expansion is a periodduring which real GDPincreases—from a troughto a peak.

Recession is a periodduring which real GDPdecreases—its growth rateis negative for at least twosuccessive quarters.

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The Uses and Limitations of Real GDP

The Standard of Living Across CountriesTwo problems arise in using real GDP to compare livingstandards across countries:

1. The real GDP of one country must be converted into thesame currency units as the real GDP of the othercountry.

2. The goods and services in both countries must bevalued at the same prices.

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The Uses and Limitations of Real GDP

Using the exchange rate to compare GDP in one countrywith GDP in another country is problematic because …

prices of particular products in one country may be muchless or much more than in the other country.

For example, using the market exchange rate to valueChina’s GDP in U.S. dollars leads to an estimate that in2012, GDP per person in the United States was 8.4 timesGDP per person in China.

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The Uses and Limitations of Real GDP

Figure 4.5 illustrates theproblem.Using the market exchangerate and domestic pricesmakes China look like apoor developing country.

But when GDP is valued atpurchasing power parityprices, U.S. income perperson is only 5.6 timesthat in China.

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The Uses and Limitations of Real GDPLimitations of Real GDPReal GDP measures the value of goods and services thatare bought in markets.

Some of the factors that influence the standard of livingand that are not part of GDP are Household production Underground economic activity Leisure time Environmental quality

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The Uses and Limitations of Real GDPThe Bottom LineDo we get the wrong message about the level and growthof economic well-being and the standard of living bylooking at the growth of real GDP?

The influences that are omitted from real GDP are probablylarge.

It is possible to construct broader measures that combinethe many influences that contribute to human happiness.

Despite all the alternatives, real GDP per person remainsthe most widely used indicator of economic well-being.

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Mathematical Note:Chained-Dollar Real GDP

The BLS uses a measure of real GDP called chained-dollar real GDP.Three steps are needed to calculate this measure: Value production in the prices of adjacent years Find the average of two percentage changes Link (chain) back to the reference year

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Mathematical Note:Chained-Dollar Real GDP

Value Production in Prices ofAdjacent YearsPart (a) shows the quantitiesand prices in 2011.

Part (b) shows the quantitiesand prices in 2012.

Part (c) the quantities of 2012valued at 2011 prices.

Part (d) the quantities of 2011valued at prices of 2012.

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Mathematical Note:Chained-Dollar Real GDP

Parts (a) and (c) value thequantities of both years at2011 prices.

That is, in 2011 prices, realGDP increased from $145million to $160 million.

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Mathematical Note:Chained-Dollar Real GDP

Parts (d) and (b) value thequantities in both years at2012 prices.

That is, in 2012 prices, realGDP increased from $275million to $300 million.

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Mathematical Note:Chained-Dollar Real GDP

Find the Average ofTwo PercentageChangesPart (a) shows that at2011 prices, productionincreased by 10.3%.

Part (b) shows that at2012 prices, productionincreased by 9.1%.

The average increase inproduction is 9.7%.

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Mathematical Note:Chained-Dollar Real GDP

Link (Chain) to the Base YearTo find real GDP in 2012 in base-year prices (2005),we need to know the

1. Real GDP in 2005

2. Average growth rate each year from 2005 to 2012.

The BEA must calculate the percentage change of thegrowth rate in real GDP for each pair of years from thebase year to the most recent year.

To find real GDP for years before the base year, theBEA must calculate the growth rates for each pair ofyears back to the earliest one available.

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Finally, using the percentagechanges that it has calculated,the BEA finds the real GDP ineach year in 2005 prices bylinking them to the GDP in2005.

The figure shows an example.

Mathematical Note:Chained-Dollar Real GDP

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Graphs in Macroeconomics

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After studying this appendix, you will be able to:

Make and interpret a time-series graph

Make and interpret a graph that uses a ratio scale

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Making a Time-SeriesGraph

A time-series graphmeasures

Time on thex-axis and

The variable in whichwe are interested onthe y-axis.

The Time-Series Graph

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Reading a Time-SeriesGraph

A time-series graphshows the

Level of the variable

Change in thevariable

The speed of changein the variable

The Time-Series Graph

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Ratio Scale Reveals TrendA time-series graph also reveals whether a variable has a

Cycle—a tendency for a variable to alternate betweenupward and downward movements

Trend—a tendency for a variable to move in one generaldirection

The Time-Series Graph

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This time-series graphhas

A cycle

No trend

The Time-Series Graph

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A Time-Series with a TrendFigure A4.2(a) shows theaverage prices paid byconsumers since 1972.

In 1972, the price is set at100.

The price in other years ismeasured as a percentage ofthe 1972 level.

Prices look as if they rose at afairly constant rate.

The Time-Series Graph

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© 2014 Pearson Addison-Wesley

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© 2014 Pearson Addison-Wesley

Using a Ratio ScaleOn the y-axis of a normalgraph, the gap between 100and 200 is the same as thatbetween 300 and 400.

On a graph with a ratio scalethe gap between 100 and 200is same as that between 200and 400.

The ratio of 200 to 100 equalsthe ratio of 400 to 200—aconstant ratio gap.

The Time-Series Graph

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© 2014 Pearson Addison-Wesley

Graphing data on a ratioscale reveals the trend.

The steeper the line, thefaster is the growth rate ofprices.

Prices rose rapidly in the1970s and early 1980s andmore slowly in the later1980s, 1990s, and 2000s.

The Time-Series Graph

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Chapter 5

The Consumption Sector

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 5-1

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Chapter Objectives

• The average propensity to consume• The average propensity to save• The marginal propensity to consume• The marginal propensity to save• The consumption function• The saving function• The determinants of consumption• The permanent income hypothesis

5-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Consumption

• Consumption is the nation’s expenditureson all final goods and services producedduring the year at market prices– Consumption will be almost $2 trillion

dollars in 2002• $2,000,000,000,000• $2,000 billion• $2.0 trillion

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 5-3

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Four Parts of GDP

• Consumption ------------ C (this chapter)

• Investment ---------------- I (Chapter 6)

• Government -------------- G (Chapter 7)

• Net Exports --------------- Xn (Chapter 8)

5-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Consumption

• Americans spend over 95% of theirincome after taxes– The total of everyone’s expenditures is called

consumption• Consumption is designated by the letter C

• C is the largest sector of GDP– Now C is just over two-thirds of GDP

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 5-5

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Consumption (Continued)

• The consumption functions states– As income rises, consumption (C) rises, but

not as quickly

– Therefore, consumption varies withdisposable income (DI)

• DI increases . . . C increases but by a smalleramount

• DI decreases . . . C decreases but by a smalleramount

5-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Consumption and DisposableIncome

Disposable Income Consumption

1,000 1,400

2,000 2,200

3,000 3,000

4,000 3,800

5,000 4,600

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Consumption and DisposableIncome (Continued)

Disposable Income Consumption

1,000 1,400

2,000 2,200

3,000 3,000

4,000 3,800

5,000 4,600

+ 1000 + 800

+ 1000 + 800

+ 1000 + 800

+ 1000 + 800

5-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Saving

• Saving is NOT spending• The more we spend, the less we save• A low savings rate leads to a low

productivity growth rate– Without savings ($) to invest in NEW plant

and equipment, we cannot raise ourproductivity fast enough

• Savings includes personal saving,business saving, and a governmentsurplus (if there is one)

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 5-9

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Source: Economic Report of the President, 2001, BusinessCycle Indicators, March 2001

Saving as a Percentage ofDisposable Income

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000

5-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Average Propensity to Consume(APC/The Percent of DI Spent)

APC = -----------------------------------Consumption

Disposable Income

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Disposable Income Consumption Saving

$40,000 $30,000

Table 2

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Table 2 (Continued)

Disposable Income Consumption Saving

$40,000 $30,000 $10,000

APC = ------------ = ------------ = ------ = .75C 30000 3

DI 40000 4

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Table 2 (Continued)

Disposable Income Consumption Saving

$40,000 $30,000 $10,000

APC = ------------ = ------------ = ------ = .75C 30000 3

DI 40000 4

APS = ------------ = ------------ = ------ = .25S 10000 1DI 40000 4

5-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Table 2 (Continued)

Disposable Income Consumption Saving

$40,000 $30,000 $10,000

APC = ------------ = ------------ = ------ = .75C 30000 3

DI 40000 4

APS = ------------ = ------------ = ------ = .25S 10000 1DI 40000 4

+

1.00Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 5-15

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Table 3

Disposable Income Saving

$20,000 $1,500

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Table 3 (Continued)

Disposable Income Saving

$20,000 $1,500

Disposable Income Saving Consumption

$20,000 $1,500 $18,500

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Table 3 (Continued)

Disposable Income Saving

$20,000 $1,500

Disposable Income Saving Consumption

$20,000 $1,500 $18,500

APC = ------------ = ------------ = ------ = .925C 18500 37

DI 20000 40

5-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Table 3 (Continued)

Disposable Income Saving

$20,000 $1,500

Disposable Income Saving Consumption

$20,000 $1,500 $18,500

APC = ------------ = ------------ = ------ = .925C 18500 37

DI 20000 40

APS = ------------ = ------------ = ------ = .075S 1500 3DI 20000 40

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Table 3 (Continued)

Disposable Income Saving

$20,000 $1,500

Disposable Income Saving Consumption

$20,000 $1,500 $18,500

APC = ------------ = ------------ = ------ = .925C 18500 37

DI 20000 40

APS = ------------ = ------------ = ------ = .075S 1500 3DI 20000 40

+

1.005-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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APCs Greater than One

Disposable Income Consumption Saving

$10,000 $12,000

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 5-21

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APCs Greater than One (Continued)

Disposable Income Consumption Saving

$10,000 $12,000 - 2000

Where is this going to come from?

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APCs Greater than One (Continued)

Disposable Income Consumption Saving

$10,000 $12,000 - 2000

APC = ------------ = ------------ = ------ = 1.2C $12,000 12

DI $10,000 10

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APCs Greater than One (Continued)

Disposable Income Consumption Saving

$10,000 $12,000 - 2000

APC = ------------ = ------------ = ------ = 1.2C $12,000 12

DI $10,000 10

APS = ------------ = ------------ = ------ = -0.2S -$2,000 -2

DI $10,000 10

5-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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APCs Greater than One (Continued)

Disposable Income Consumption Saving

$10,000 $12,000 - 2000

APC = ------------ = ------------ = ------ = 1.2C $12,000 12

DI $10,000 10

APS = ------------ = ------------ = ------ = -0.2S -$2,000 -2

DI $10,000 10

+

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Marginal Propensityto Consume (MPC)

MPC =CHANGE in Consumption

CHANGE in Income

5-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Marginal Propensityto Consume (MPC)

Table 4

Year DI C S

1998 $30000 $23000 $7000

1999 $40000 $31000 $9000

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Marginal Propensityto Consume (MPC)

Table 4 (continued)

Year DI C S

1998 $30000 $23000 $7000

1999 $40000 $31000 $9000

10000 8000 2000Change

5-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Table 4 (Continued)Year DI C S

1998 $30000 $23000 $7000

1999 $40000 $31000 $9000

10000 8000 2000Change

MPC =---------------- = ---------- = ------- = .8Change in C 8000 8

Change in DI 10000 10

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Table 4 (Continued)

Year DI C S

1998 $30000 $23000 $7000

1999 $40000 $31000 $9000

10000 8000 2000Change

MPC =---------------- = ---------- = ------- = .8Change in C 8000 8

Change in DI 10000 10

MPS = -------------- = ---------- = -------- = .2Change in S 2000 2

Change in DI 10000 10

+

1.0

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Graphing the Consumption Function

If Consumption rose at the same rate as Disposable Income . . . Agraph of this function would be a 45 % line

Disposable income ($)

45 û

1,000

1,000

2,000

3,000

2,000 3,000

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Graphing the Consumption Function

Consumption is the vertical distance between the bottom(horizontal) axis and the “C” line.

DI C S

3000 1750

5-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

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Graphing the Consumption Function

DI C S

3000 1750 1250

5-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Saving is the vertical distance between the “C” line and the 45degree line

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440

5-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Consumption is the vertical distance between the bottom(horizontal) axis and the “C” line.

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 560

5-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Saving is the vertical distance between the “C” line and the 45degree line

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000

5-36Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Consumption is the vertical distance between the bottom(horizontal) axis and the “C” line.

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000 0

5-37Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Saving is “0” at 1000 DI because there is NO distance between the Cline and the 45 degree line.

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000 00 625

5-38Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Consumption is the vertical distance between the bottom(horizontal) axis and the “C” line.

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000 00 625

5-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

When DI is “0” the level of Consumption is called AutonomousConsumption (AC)

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000 00 625 -625

5-40Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

Saving is the vertical distance between the “C” line and the 45 degree line. Savingis negative to the left of where the C line crosses the 45 degree line

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Autonomous Consumptionversus Induced Consumption

• Autonomous consumption (AC) is the level ofconsumption when disposable income is “0”– It is called autonomous because it is independent of

change in disposable income

• Induce consumption (IC) is that part ofconsumption which varies with the level ofdisposable income– As disposable income rises, induced income rises– As disposable income fall, induced income falls

• IC = C - AC

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000 00 625 -625

5-42Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

DI = 0

What is IC?

IC = C - AC

IC = 625 - 625

IC = 0

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000 00 625 -625

5-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

DI = 1000

What is IC?

IC = C - AC

IC = 1000 - 625

IC = 375

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000 00 625 -625

5-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

DI = 2000

What is IC?

IC = C - AC

IC = 1440 - 625

IC = 815

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Graphing the Consumption Function

DI C S

3000 1750 12502000 1440 5601000 1000 00 625 -625

5-45Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Disposable income ($)

45û

C

1,000 2,000 3,0001,000

1,000

2,000

3,000

DI = 3000

What is IC?

IC = C - AC

IC = 1750 - 625

IC = 1125

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Consumer Spending ($ billions)

The major change in consumer spending has been a massiveshift from nondurables to services

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 5-46

1955

Durables15.2%

Nondurables48.4%

Services36.3%

Total: 1,588

2000

Services58.0%Nondurables

29.8%

Total: 6,759

Durables12.2%

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Determinants of the Level ofConsumption

• Disposable Income– The most important determinant of consumption

• Credit Availability

• Stock of Liquid Assets– in the hands of consumers

• Stock of Durable Goods– in the hands of consumers

• Keeping up with the Jones's

• Consumer Expectations

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Permanent Income Hypothesis(Milton Friedman)

• People gear their consumption totheir expected lifetime averageearnings more than to their currentincome– Apparently there are quite a few deviations

from the behavior predicted by thepermanent income hypothesis

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The Determinants of Saving

• There is no single reason why people save• Some spend virtually all of their

disposable income• Some spend more than they earn• Americans now save less than 5% of

disposable income• Americans used to save 7-10% of

disposable income

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Why Do We Spend So Muchand Save So Little?

• Americans have been on aspending binge the past 20 years–Mottos

• Buy now, pay later.• Shop till you drop.• We want it all, and we want it all

now!

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• The Federal Government has underwrittenAmerica’s spending binge– Until 1987 interest paid on consumer loans was fully

deductible from income taxes• Mortgage interest and property taxes remain fully

deductible

– Credit cards, installment credit, and consumer loanshave expanded tremendously

• 1990 – 2000 household debt doubled to $7 trillion

Why Do We Spend So Muchand Save So Little? (Continued)

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• Two factors have become increasinglyimportant– Social Security causes many to NOT feel a

pressing need to save for their old age

– Home ownership is seen as a form of saving

• Especially during a period of rising realestate prices

Why Do We Spend So Muchand Save So Little? (Continued)

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Total Saving

• Every economy depends on saving forcapital formation

• Individual saving + business saving +government saving = Total Saving– Declines in household saving has been offset

somewhat since 1993 by a sharp rise ingovernment saving and business saving

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Chapter 6

The Business-Investment Sector

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Chapter Objectives

• The three types of business firms

• How investment is carried out

• The difference between gross investmentand net investment

• How capital is accumulated

• The determinants of the level of investment

• The graphing of the C + I line

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Proprietorships, Partnerships,and Corporations

• Proprietorship– Proprietorships are owned by individuals

and are almost always a small businesses• Grocery stores, barbershops, restaurants, family

farms, gas stations, etc

– Advantages of a proprietorship– You can be your own boss– Your income is taxed only once

– Disadvantages of a proprietorship• Unlimited liability

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Proprietorships, Partnerships,and Corporations (Continued)

• Partnership• Partnerships are owned by two or more people

– Some law and accounting firms have hundreds ofpartners

• Advantages of a partnership– It is easier to raise more capital– The work and responsibility can be divided

• Disadvantages– Partnerships must be dissolved when one partner

dies or wants to leave– Unlimited liability

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• Corporation– A corporation is a legal person

– Most corporations are small firms

– Corporations are owned by the stockholders

– It is easier to raise money by selling stock

– Most corporations are not publicly held

Proprietorships, Partnerships,and Corporations (Continued)

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• Corporation• Advantages

– Limited liability– Corporations have potential perpetual life– Corporations may pay lower federal taxes

• Disadvantages–You need a lawyer and have to pay a charter fee– You have to pay federal (perhaps state) corporate

income tax– Double taxation

Proprietorships, Partnerships,and Corporations (Continued)

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Stocks and Bonds

• Stockholders are the OWNERS ofa corporation– Common stock

• Voting rights

– Preferred stock• Receive a stipulated dividend• No voting rights

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• Bondholders are CREDITORSrather than owners– Must be paid a stipulated percent of

the face value of the bond whether ornot the company makes a profit

– If a company goes bankrupt• Bondholders are paid off before

stockholders

Stocks and Bonds (Continued)

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• A corporation’s total capital (capitalization)– Consists of the total value of its stocks and

bonds

– Example• 1,000,000,000 in bonds• 500,000,000 in preferred stock• 2,500,000,000 in common stock• 4,000,000,000 capitalization (capitalized)

Capitalization and Control

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– Theoretically, you would need 50%plus one share to control a corporation

– Practically, holding 5% of the commonstock would probably give you control

• Most economist believe that you need 10% of thecommon stock to be assured of control

• Many stockholders don’t bother to vote or givetheir proxies to others

Capitalization and Control(Continued)

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The Business Population by Form ofLegal Organization, 1997

Form Number of Firms

Proprietorships 17,176,000

Partnerships 1,759,000

Corporations 4,710,000

Source: Statistical Abstract of the United States, 2001

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The Business Population andShares of Total Sales, 1997

Source: Statistical Abstract of the United States, 2000

(a) Percentage of firms (b) Percentage of sales

Proprietorships73%

Partnerships 7%

Corporations20%

Corporations89%

Partnerships 6%Proprietorships 5%

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Investment

• “Investment” is the thing that reallymakes our economy go and grow!

• Investment is any NEW– Plant and equipment

• Investment is any NEW– Additional inventory

• Investment is any NEW– Residential housing

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Inventory Investment

Includes only net changeDate Level of Inventory

Jan. 1, 2003 $120 million

July 1, 2003 145 million

Dec. 31, 2003 130 million

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Inventory InvestmentIncludes only net change

Date Level of Inventory

Jan. 1, 2003 $120 million

July 1, 2003 145 million

Dec. 31, 2003 130 million

Started the year with $120 million

Ended the year with 130 million

The net change is a (+) 10 million

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Inventory Investment (Continued)

Includes only net changeDate Level of Inventory

Jan. 1, 2003 $130 million

July 1, 2003 145 million

Dec. 31, 2003 120 million

Started the year with $130 million

Ended the year with 120 million

The net change is a (-) 10 million

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6-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

75

50

25

0

Ð251960 1965 1970 1975 1980 1985 1990 1995 2000

Inventory Investment, 1960-2000 (inbillions of 1987 dollars)

This is the most volatile sector of investment. Note that investmentwas actually negative during three recessions

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Investment in Plant andEquipment

• Investment in plant and equipment ismore stable than inventory– Even in bad years companies will still

invest a substantial amount in newplant and equipment• This is mainly because old and obsolete

factories, office buildings, and machinerymust be replaced

– This is the depreciation part of investment

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6-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

1960 1965 1970 1975 1980 1985 1990 1995 2000

1200

1100

1000

900

800

7 00

600

500

400

300

200

100

Investment in Plant and Equipment,1960-2000 (in 1987 dollars)

There has been a strong upward trend in this investment sector over the last fourdecades. Note the periodic downturns, especially during recession years

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Residential Construction

• Involves replacing old housing as well asadding to it

• Fluctuates considerably from year to year• Has mortgage interest rates play a

dominant role

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Investment

• Investment is the most volatile sector inour economy– GDP = C + I + G + Xn

• Fluctuations in GDP are largelyfluctuations in investment

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Investment (Continued)

• Recessions are touched off by declines ininvestment

• Recoveries are brought about by risinginvestment

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How Do Savings Get Invested?

• Money saved is put into stocks and bonds• Banks loan money based on their demand

deposits and reserve requirements• Businesses take this money and buy new

plant and equipment, and add to theirinventory

• Corporations also use “retainedearnings” and “depreciation allowances”

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Gross Investment vs Net Investment

• In the equation– GDP = C + I + G + Xn

• The “I” represent gross investment• Gross investment - depreciation = net investment

– Depreciation is taking into account for the factthat plant & equipment wear out and housesdeteriorate

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Gross Investment vs Net Investment(Continued)

• In the equation– GDP = C + I + G + Xn

• the “I” represent Gross Investment• Gross Investment - Depreciation = Net Investment

– Depreciation is taking into account for the fact that plant &equipment wear out and houses deteriorate.

– start the year with 10 machines– bought 6 machines (gross investment)– worn out/obsolete - 4 machines (depreciation)– end the year with 12 machines– actual gain of 2 machines (net investment)

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Calculate Gross Investmentand Net Investment

Date level of inventory

Jan 1 $60 billion

July 1 55 billion

Dec 31 70 billion

Expenditures on new plant & equipment

$120 billion

Expenditures on new residential housing

$ 90 billion

Depreciation on plant & equipment and

residential housing $30 billion

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SolutionDate level of inventory

Jan1 $60 billion

July 1 55 billion

Dec 31 70 billion inventory investment $ 10

Expenditures on new plant & equipment new P & E 120

$120 billion new RH 90

Expenditures on new residential housing gross investment 220

$ 90 billion -depreciation - 30

Depreciation on plant & equipment and net investment $ 190

Residential housing $30 billion

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Building Capital

• Investment involves sacrifice (onsomeone’s part)

• To invest– We must work more

– We must consume less (save)

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Karl Marx“Capital is created by labor but stolen by capitalist”

Assume it takes $3 to keep a person alive for 24hours

Assume that one person can use a machine toproduce $3 worth of cloth in 6 hours

The capitalist owns the machine and pays $3 for12 hours work

12 hours of work produces $6 worth of cloth

Capitalist pays ------------> $3 wages

creates a surplus of ------->$ 3

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Determinants of theLevel of Investment

• Sales outlook

• Capacity utilization rate

• Interest rate

• Expected rate of profit (ERP)

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The Sales Outlook

• You won’t invest if the sales outlook isbad– If sales are expected to be strong the next

few months the business is probably willingto add inventory

– If sales outlook is good for the next fewyears, firms will probably purchase newplant and equipment

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Capacity Utilization Rate• This is the percent of plant and

equipment that is actually being used atany given time

• You won’t invest if you have a lot ofunused capacity– During recessions, why build more when you

are not using all of what you have

• Other factors– Manufacturing is a shrinking part of U.S.

economy due to imports and increasinginvestment overseas by U.S. Companies

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1965

60708090

66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 2001

Capacity Utilization Rate inManufacturing, 1965-2000

Since the mid-1980s, our capacity utilization rate has been in thelow 80s. Note that it fell during each recession

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The Interest Rate

• You won’t invest if interest rates are toohigh

Interest rate = The interest paid / The amount borrowed

Assume you borrow $1000 for one year @ 12 %, howmuch interest do you pay?

.12 =X

$1000

X = $120

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The Interest Rate

• You won’t invest if interest rates are toohigh

Interest rate = The interest paid / The amount borrowed

X =$120

$1000

X = .12 = 12 %

Assume you borrowed $1000 for one year and paid $120interest. What was the interest rate?

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Expected Rate of Profit(ERP)

ERP = -------------------------------------------Expected Profits

Money Invested

How much is the ERP on a $10,000investment if you expect to make a profitof $1,650?

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How much is the ERP on a$10,000 investment if you expectto make a profit of $1,650?

ERP = -------------------------------------------Expected Profits

Money Invested

ERP = -------------------------------------------$1,650

$10,000

ERP = .165 = 16.5 %

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You Won’t InvestIf Interest Rates Are Too High

• In general, the lower the interest rate, themore business firms will borrow

• To know how much they will borrow andwhether they will borrow, you need tocompare the interest rate with theexpected rate of profit

• Even if they are investing their ownmoney they need to make thiscomparison

6-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Why Do Firms Invest?

• Firm’s will only invest if the expectedprofit rate is “high enough”

• Firms invest when– Their sales outlook is good– Their capacity utilization rate is high– Their expected profit rate is high

• Even if firm’s invest their own money, theinterest rate is still a consideration

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What Accounts for our LowRate of Investment?

• The short time horizon of corporateAmerica

• The quality of management in America• The quality of labor in America• The low savings rate in America

– The less we save, the less we can invest– The less we invest, the slower our rate of

economic growth

6-41Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Disposable income ($)

45û

C

1,000

1,000

2,000

3,000

2,000 3,000Disposable income ($)

45û

CC + I

1,000

1,000

2,000

3,000

2,000 3,000

Graphing the C + I Line

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To keep things simple so we can read the graph we’re going toassume the level of investment stays the same for all levels of income

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Disposable income ($)

45û

C

1,000

1,000

2,000

3,000

2,000 3,000Disposable income ($)

45û

CC + I

1,000

1,000

2,000

3,000

2,000 3,000

Graphing the C + I Line

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-43

How much is I when disposable income is 1000, 2000, and 3,000?

The C line and the C+I line are parallel. Therefore I is about 480 atevery level of disposable income.

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Summing Up Investment

• Gross Investment

• 1997 2000

• P & E 845 (68.3%) 1203 (72.9%)

• R H 328 (26.5%) 403 (24.5%)

• Inventory change 65 ( 5.2%) 43 ( 2.6%)

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Gross Investment as aPercentage of GDP

0 10 20 30 40

South Korea

Japan

Mexico

Germany

United States

Canada

France

Britain

Sweden

26.8

26.1

23.2

22.2

20.7

20.2

19.0

17.6

17.0

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5 MONITORING JOBSAND INFLATION

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After studying this chapter, you will be able to:

Explain why unemployment is a problem and how wemeasure the unemployment rate and other labor marketindicators

Explain why unemployment occurs and why it is presenteven at full employment

Explain why inflation is a problem and how we measurethe inflation rate

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Each month, we chart the course of unemployment andinflation as measures of the health of the U.S. economy.

How do we measure the unemployment rate?

How do we measure the inflation rate?

Are they reliable vital signs for the economy?

As the U.S. economy slowly expanded after a recession in2008 and 2009, job growth was weak and questions aboutthe health of the labor market became of vital importanceto millions of Americans.

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Employment and Unemployment

What kind of job market will you enter when you graduate?

The class of 2012 had a tough time:

In July 2012, 25 million Americans wanted a job butcouldn’t find one.

On a typical day, fewer than half that number of Americansare unemployed.

The U.S. economy creates lots of jobs: 139 million peoplehad jobs during the recession of 2009.

But in recent years, the population has grown faster thanthe number of jobs, so unemployment is a serious problem.

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Employment and Unemployment

Why Unemployment Is a ProblemUnemployment results in

Lost incomes and production

Lost human capital

The loss of income is devastating for those who bear it.Employment benefits create a safety net but don’t fullyreplace lost wages, and not everyone receives benefits.

Prolonged unemployment permanently damages aperson’s job prospects by destroying human capital.

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Employment and Unemployment

Current Population SurveyThe U.S. Census Bureau conducts a monthly populationsurvey to determine the status of the U.S. labor force.

The population is divided into two groups:

1. The working-age population—the number of peopleaged 16 years and older who are not in jail, hospital, orsome other institution

2. People too young to work (under 16 years of age) or ininstitutional care

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Employment and Unemployment

The working-age population is divided into two groups:

1. People in the labor force

2. People not in the labor force

The labor force is the sum of employed and unemployedworkers.

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Employment and Unemployment

To be counted as unemployed, a person must be in one ofthe following three categories:

1. Without work but has made specific efforts to find a jobwithin the previous four weeks

2. Waiting to be called back to a job from which he or shehas been laid off

3. Waiting to start a new job within 30 days

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Employment and UnemploymentFigure 5.1 shows the laborforce categories. In June2012:

Population: 314 million

Working-age population:243.4 million

Labor force: 155.0 million

Employed: 142.2 million

Unemployed: 12.8 million

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Employment and Unemployment

Three Labor Market Indicators The unemployment rate

The employment-to-population ratio

The labor force participation rate

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Employment and Unemployment

The Unemployment RateThe unemployment rate is the percentage of the laborforce that is unemployed.

The unemployment rate is(Number of people unemployed ÷ labor force) 100.

In June 2012, the labor force was 155 million and 12.8million were unemployed, so the unemployment rate was8.2 percent.

The unemployment rate increases in a recession andreaches its peak value after the recession ends.

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Employment and UnemploymentFigure 5.2 shows the unemployment rate: 1980–2012.

The unemployment rate increases in a recession.

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Employment and Unemployment

The Employment-to-Population Ratio

The employment-to-population ratio is the percentageof the working-age population who have jobs.

The employment-to-population ratio is(Employment ÷ Working-age population) 100.

In June 2012, the employment was 142.2 million and theworking-age population was 243.4 million.

The employment-to-population ratio was 58.45 percent.

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Employment and Unemployment

The Labor Force Participation RateThe labor force participation rate is the percentage ofthe working-age population who are members of the laborforce.

The labor force participation rate is(Labor force ÷ Working-age population) 100.

In June 2012, the labor force was 155 million and theworking-age population was 243.4 million.

The labor force participation rate was 63.7 percent.

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Employment and UnemploymentFigure 5.3 shows that the labor force participation rateand the employment-to-population ratio both trendedupward before 2000 and downward after 2000.

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Employment and Unemployment

Other Definitions of Unemployment

The purpose of the unemployment rate is to measure theunderutilization of labor resources.

The BLS believes that the unemployment rate gives acorrect measure.

But the official measure is an imperfect measurebecause it excludes

Marginally attached workers

Part-time workers who want full-time jobs

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Employment and Unemployment

Marginally Attached Workers

A marginally attached worker is a person who currentlyis neither working nor looking for work but has indicatedthat he or she wants and is available for a job and haslooked for work sometime in the recent past.

A discouraged worker is a marginally attached workerwho has stopped looking for a job because of repeatedfailure to find one.

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Employment and Unemployment

Part-Time Workers Who Want Full-Time Jobs

Many part-time workers want to work part time, but somepart-time workers would like full-time jobs and can’t findthem.

In the official statistics, these workers are calledeconomic part-time workers and they are partlyunemployed.

Most Costly Unemployment

All unemployment is costly, but the most costly is long-term unemployment that results from job loss.

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Employment and Unemployment

Alternative Measures of Unemployment

The BLS reports six alternative measures of theunemployment rate: two narrower than the officialmeasure and three broader ones.

The narrower measures, U-1 and U-2, focus on thepersonal cost of unemployment.

The broader measures, U-4, U-5, and U-6, focus onassessing the full amount of unused labor resources.

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Figure 5.4 shows sixalternative measures.

U-1: Those unemployedfor 15 or more weeks

U-2: Unemployed joblosers

U-3: The officialunemployment rate

Employment and Unemployment

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Employment and Unemployment

Broader measures are

U-4: U-3 + Discouragedworkers

U-5: U-4 + Othermarginally attachedworkers

U-6: U-4 + Part-timeworkers who wantfull-time jobs

All measures increasetogether in recession.

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Unemployment and Full Employment

Unemployment can be classified into three types:

Frictional unemployment

Structural unemployment

Cyclical unemployment

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Unemployment and Full Employment

Frictional Unemployment

Frictional unemployment is unemployment that arisesfrom normal labor market turnover.

The creation and destruction of jobs requires thatunemployed workers search for new jobs.

Increases in the number of people entering and reenteringthe labor force and increases in unemployment benefitsraise frictional unemployment.

Frictional unemployment is a permanent and healthyphenomenon of a growing economy.

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Unemployment and Full Employment

Structural Unemployment

Structural unemployment is unemployment created bychanges in technology and foreign competition thatchange the skills needed to perform jobs or the locationsof jobs.

Structural unemployment lasts longer than frictionalunemployment.

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Unemployment and Full Employment

Cyclical Unemployment

Cyclical unemployment is the higher than normalunemployment at a business cycle trough and lower thannormal unemployment at a business cycle peak.

A worker who is laid off because the economy is in arecession and is then rehired when the expansion beginsexperiences cyclical unemployment.

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Unemployment and Full Employment

“Natural” UnemploymentNatural unemployment is the unemployment that arisesfrom frictions and structural change when there is nocyclical unemployment.

Natural unemployment is all frictional and structuralunemployment.

The natural unemployment rate is natural unemploymentas a percentage of the labor force.

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Unemployment and Full Employment

Full employment is defined as the situation in which theunemployment rate equals the natural unemployment rate.

When the economy is at full employment, there is nocyclical unemployment or, equivalently, all unemploymentis frictional and structural.

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Unemployment and Full Employment

The natural unemployment rate changes over time and isinfluenced by many factors.

Key factors are

The age distribution of the population

The scale of structural change

The real wage rate

Unemployment benefits

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Unemployment and Full Employment

Real GDP and Unemployment Over the CyclePotential GDP is the quantity of real GDP produced at fullemployment.

Potential GDP corresponds to the capacity of the economyto produce output on a sustained basis.

Real GDP minus potential GDP is the output gap.

Over the business cycle, the output gap fluctuates and theunemployment rate fluctuates around the naturalunemployment rate.

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Figure 5.5 shows theoutput gap and …

the fluctuations ofunemployment around thenatural rate.

When the output gap isnegative, ...

the unemployment rateexceeds the naturalunemployment rate.

Unemployment and Full Employment

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Price Level, Inflation, and Deflation

The price level is the average level of prices and thevalue of money.

A persistently rising price level is called inflation.

A persistently falling price level is called deflation.

We are interested in the price level because we want to

1. Measure the inflation rate or the deflation rate

2. Distinguish between money values and real values ofeconomic variables.

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Price Level, Inflation, and Deflation

Why Inflation and Deflation Are Problems

Low, steady, and anticipated inflation or deflation is not aproblem.

Unpredictable inflation or deflation is a problem because it

Redistributes income and wealth

Lowers real GDP and employment

Diverts resources from production

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Price Level, Inflation, and Deflation

Unpredictable changes in the inflation rate redistributeincome in arbitrary ways between employers and workersand between borrowers and lenders.

A high inflation rate is a problem because it divertsresources from productive activities to inflation forecasting.

From a social perspective, this waste of resources is acost of inflation.

At its worst, inflation becomes hyperinflation—an inflationrate that is so rapid that workers are paid twice a daybecause money loses its value so quickly.

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Price Level, Inflation, and Deflation

The Consumer Price Index

The Consumer Price Index, or CPI, measures theaverage of the prices paid by urban consumers for a“fixed” basket of consumer goods and services.

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Price Level, Inflation, and DeflationReading the CPI NumbersThe CPI is defined to equal 100 for the reference baseperiod.

Currently, the reference base period is 19821984.

That is, for the average of the 36 months from January1982 through December 1984, the CPI equals 100.

In June 2012, the CPI was 228.8.

This number tells us that the average of the prices paid byurban consumers for a fixed basket of goods was 128.8percent higher in June 2012 than it was during 19821984.

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Price Level, Inflation, and Deflation

Constructing the CPIConstructing the CPI involves three stages:

Selecting the CPI basket

Conducting a monthly price survey

Calculating the CPI

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Price Level, Inflation, and Deflation

The CPI Basket

The CPI basket is based on a Consumer ExpenditureSurvey, which is undertaken infrequently.

The CPI basket today is based on data collected in theConsumer Expenditure Survey of 2008.

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Price Level, Inflation, and Deflation

Figure 5.6 illustrates theCPI basket.

Housing is the largestcomponent.

Transportation and foodand beverages are the nextlargest components.

The remaining componentsaccount for 26 percent ofthe basket.

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Price Level, Inflation, and Deflation

The Monthly Price Survey

Every month, BLS employees check the prices of the80,000 goods in the CPI basket in 30 metropolitan areas.

Calculating the CPI

1. Find the cost of the CPI basket at base-period prices.

2. Find the cost of the CPI basket at current-period prices.

3. Calculate the CPI for the current period.

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Price Level, Inflation, and DeflationLet’s work an example ofthe CPI calculation.

In a simple economy,people consume onlyoranges and haircuts.

The CPI basket is 10oranges and 5 haircuts.

The table also shows theprices in the base period.

The cost of the CPI basketin the base period was $50.

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Price Level, Inflation, and Deflation

Table 5.1(b) shows thefixed CPI basket of goods.

It also shows the prices inthe current period.

The cost of the CPI basketat current-period prices is$70.

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Price Level, Inflation, and Deflation

The CPI is calculated using the formula:

CPI = (Cost of basket at current-period prices ÷ Cost ofbasket at base-period prices) 100.

Using the numbers for the simple example,

CPI = ($70 ÷ $50) 100 = 140.

The CPI is 40 percent higher in the current period thanit was in the base period.

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Price Level, Inflation, and Deflation

Measuring the Inflation RateThe major purpose of the CPI is to measure inflation.

The inflation rate is the percentage change in the pricelevel from one year to the next.

The inflation formula is:

Inflation rate = [(CPI this year – CPI last year) ÷ CPI lastyear] 100.

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Price Level, Inflation, and DeflationFigure 5.7 shows therelationship betweenthe price level and theinflation rate.The inflation rate isHigh when the price

level is rising rapidlyandLow when the price

level is rising slowly.Negative when the

price level is falling

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Price Level, Inflation, and Deflation

The Biased CPIThe CPI might overstate the true inflation rate for fourreasons:

New goods bias

Quality change bias

Commodity substitution bias

Outlet substitution bias

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Price Level, Inflation, and Deflation

New Goods Bias

New goods that were not available in the base yearappear and, if they are more expensive than the goodsthey replace, they put an upward bias into the CPI.

Quality Change Bias

Quality improvements occur every year. Part of the rise inthe price is payment for improved quality and is notinflation.

The CPI counts all the price rise as inflation.

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Price Level, Inflation, and Deflation

Commodity Substitution Bias

The market basket of goods used in calculating the CPI isfixed and does not take into account consumers’substitutions away from goods whose relative pricesincrease.

Outlet Substitution Bias

As the structure of retailing changes, people switch tobuying from cheaper sources, but the CPI, as measured,does not take account of this outlet substitution.

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Price Level, Inflation, and Deflation

The Magnitude of the Bias

Estimates say that the CPI overstates inflation by 1.1percentage points a year.

Some Consequences of the Bias

Distorts private contracts.

Increases government outlays (close to a third of federalgovernment outlays are linked to the CPI).

A bias of 1 percent is small, but over a decade adds up toalmost $1 trillion of additional expenditure.

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Price Level, Inflation, and Deflation

Alternative Price IndexesAlternative measures of the price level are

Chained CPI

Personal consumption expenditure deflator

GDP deflator

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Price Level, Inflation, and Deflation

Chained CPIThe chained CPI is a price index that is calculated using asimilar method to that used to calculate chained-dollar realGDP described in Chapter 21.

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Price Level, Inflation, and Deflation

Personal Consumption Expenditure Deflator

The PCE deflator equals

(Nominal consumption expenditure ÷ Real consumptionexpenditure) 100

PCE deflator is a broader measure of the price level thanthe CPI because it includes all consumption expenditure.

GDP Deflator

GDP deflator is like the PCE deflator except it includes theprices of all goods and services that are counted in GDP.

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Price Level, Inflation, and Deflation

Core InflationThe figure shows the CPIinflation rate.

The core inflation rate isthe CPI inflation rateexcluding the volatileelements (of food and fuel).

The core inflation rateattempts to reveal theunderlying inflation trend.

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Price Level, Inflation, and Deflation

The Real Variables in MacroeconomicsWe can use the deflator to deflate nominal variablesto find their real values.

For example,

Real wage rate = (Nominal wage rate ÷ GDP deflator) 100

But not the real interest rate! It is different.

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6 ECONOMICGROWTH

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After studying this chapter, you will be able to:

Define and calculate the economic growth rate andexplain the implications of sustained growth

Describe the economic growth trends in the UnitedStates and other countries and regions

Explain what makes potential GDP grow

Explain the sources of labor productivity growth

Explain the theories of economic growth and policiesto increase its rate

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U.S. real GDP per person and the standard of livingtripled between 1960 and 2010.

We see even more dramatic change in China, whereincomes have tripled not in 50 years but in the 13 yearssince 1999.

Incomes are growing rapidly in some other economiesof Asia, Africa, and South America.

What are the forces that make real GDP grow?

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The Basics of Economic Growth

Economic growth is the sustained expansion of productionpossibilities measured as the increase in real GDP over agiven period.

Calculating Growth Rates

The economic growth rate is the annual percentagechange of real GDP.

The economic growth rate tells us how rapidly the totaleconomy is expanding.

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The Basics of Economic Growth

The standard of living depends on real GDP per person.

Real GDP per person is real GDP divided by thepopulation.

Real GDP per person grows only if real GDP grows fasterthan the population grows.

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The Basics of Economic GrowthEconomic Growth Versus Business Cycle Expansion

Real GDP can increase for two distinct reasons:

1. The economy might be returning to full employment in anexpansion phase of the business cycle.

2. Potential GDP might be increasing.

The return to full employment in an expansion phase of thebusiness cycle isn’t economic growth.

The expansion of potential GDP is economic growth.

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The Basics of Economic GrowthFigure 6.1 illustrates thedistinction.

A return to full employmentin a business cycleexpansion is a movementfrom inside the PPF (pointA) to a point on the PPF(point B).

Economic growth is theoutward shift of the PPFfrom PPF0 to PPF1 and themovement from point B onPPF0 to point C on PPF1.

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The Basics of Economic GrowthThe growth rate of potentialGDP measures the pace ofexpansion of productionpossibilities and …

smoothes out the businesscycle fluctuations in thegrowth rate of real GDP.

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The Basics of Economic Growth

The Magic of Sustained Growth

The Rule of 70 states that the number of years it takes forthe level of a variable to double is approximately 70 dividedby the annual percentage growth rate of the variable.

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The Basics of Economic Growth

Applying the Rule of 70Figure 6.3 shows thedoubling time for growthrates.A variable that grows at7 percent a year doublesin 10 years.A variable that grows at2 percent a year doublesin 35 years.A variable that grows at1 percent a year doublesin 70 years.

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Long-Term Growth Trends

Long-Term Growth in the U.S. EconomyFrom 1912 to 2012, growth in real GDP per person in theUnited States averaged 2 percent a year.Real GDP per person fell precipitously during the GreatDepression and rose rapidly during World War II.Growth was most rapid during the 1960s.Growth slowed during the 1970s and sped up again in the1980s and1990s.Figure 6.4 on the next slide illustrates.

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Long-Term Growth Trends

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Long-Term Growth TrendsReal GDP Growth in theWorld Economy

Figure 6.5(a) shows thegrowth in the richcountries.

Japan grew rapidly inthe 1960s, slower in the1980s, and stagnatedduring the 1990s.

Growth in Europe Big 4,Canada, and the UnitedStates has been similar.

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Economic Growth Trends

Figure 6.5(b) showsthe growth of real GDPper person in a groupof poor countries.

The gaps between realGDP per person in theUnited States and inthese countries havewidened.

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How Potential GDP Grows

Economic growth occurs when real GDP increases.

But a one-shot increase in real GDP or a recovery fromrecession is not economic growth.

Economic growth is the sustained, year-on-year increasein potential GDP.

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How Potential GDP Grows

What Determines Potential GDP?

Potential GDP is the quantity of real GDP produced whenthe quantity of labor employed is the full-employmentquantity.

To determine potential GDP we use a model with twocomponents:

An aggregate production function

An aggregate labor market

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How Potential GDP Grows

Aggregate ProductionFunction

The aggregate productionfunction tells us how realGDP changes as thequantity of labor changeswhen all other influenceson production remain thesame.

An increase in laborincreases real GDP.

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How Potential GDP Grows

Aggregate Labor Market

The demand for labor shows the quantity of labordemanded and the real wage rate.

The real wage rate is the money wage rate dividedby the price level.

The supply of labor shows the quantity of laborsupplied and the real wage rate.

The labor market is in equilibrium at the real wagerate at which the quantity of labor demanded equalsthe quantity of labor supplied.

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How Potential GDP Grows

Figure 6.7 illustrates labormarket equilibrium.

Labor market equilibriumoccurs at a real wage rateof $35 an hour and 200billion hours employed.

At a real wage rate above$35 an hour, there is asurplus of labor and thereal wage rate falls.

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How Potential GDP Grows

At a real wage rate below$35 an hour, there is ashortage of labor and thereal wage rate rises.

At the labor marketequilibrium, the economyis at full employment.

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How Potential GDP Grows

Potential GDP

The quantity of real GDPproduced when the economyis at full employment ispotential GDP.

The economy is at full-employment when 200 billionhours of labor are employed.

Potential GDP is $13 trillion.

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How Potential GDP Grows

What Makes Potential GDP Grow?

We begin by dividing real GDP growth into the forces thatincrease:

Growth in the supply of labor

Growth in labor productivity

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How Potential GDP Grows

Growth in the Supply of LaborAggregate hours, the total number of hours worked by allthe people employed, change as a result of changes in:1. Average hours per worker2. Employment-to-population ratio3. The working-age population growth

Population growth increases aggregate hours and realGDP, but to increase real GDP per person, labor mustbecome more productive.

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How Potential GDP Grows

The Effects of Population GrowthAn increase in population increases the supply of labor.

With no change in the demand for labor, the equilibriumreal wage rate falls and the aggregate hours increase.

The increase in the aggregate hours increases potentialGDP.

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How Potential GDP Grows

Figure 6.9(a) illustrates theeffects of populationgrowth in the labor market.

The labor supply curveshifts rightward.

The real wage rate falls

and aggregate hoursincrease.

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How Potential GDP Grows

The increase in aggregatehours increases potentialGDP.

Because of the diminishingreturns, the increasedpopulation …

increases real GDP,

but decreases real GDPper hour of labor.

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How Potential GDP Grows

Growth of Labor Productivity

Labor productivity is the quantity of real GDP producedby an hour of labor.

Labor productivity equals real GDP divided by aggregatelabor hours.

If labor becomes more productive, firms are willing to paymore for a given number of hours so the demand for laborincreases.

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How Potential GDP Grows

Figure 6.10 shows theeffect of an increase inlabor productivity.

The increase in laborproductivity shifts theproduction functionupward.

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How Potential GDP Grows

In the labor market:An increase in laborproductivity increases thedemand for labor.With no change in thesupply of labor, the realwage rate risesand aggregate hoursincrease.

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How Potential GDP Grows

And with the increase inaggregate hours, potentialGDP increases.

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Why Labor Productivity Grows

Preconditions for Labor Productivity Growth

The fundamental precondition for labor productivity growthis the incentive system created by firms, markets, propertyrights, and money.

The growth of labor productivity depends on

Physical capital growth

Human capital growth

Technological advances

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Why Labor Productivity Grows

Physical Capital Growth

The accumulation of new capital increases capital perworker and increases labor productivity.

Human Capital Growth

Human capital acquired through education, on-the-jobtraining, and learning-by-doing is the most fundamentalsource of labor productivity growth.

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Why Labor Productivity Grows

Technological AdvancesTechnological change—the discovery and the applicationof new technologies and new goods—has contributedimmensely to increasing labor productivity.

Figure 6.11 on the next slide summarizes the process ofgrowth.

It also shows that the growth of real GDP per persondepends on real GDP growth and the population growthrate.

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Why Labor Productivity Grows

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Growth Theories, Evidence,and Policies

We study three growth theories: Classical growth theory Neoclassical growth theory New growth theory

Classical Growth TheoryClassical growth theory is the view that the growth ofreal GDP per person is temporary and that when it risesabove the subsistence level, a population explosioneventually brings real GDP per person back to thesubsistence level.

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Growth Theories, Evidence,and Policies

Modern-Day Malthusians

Many people today are Malthusians.

They say that if today’s global population of 6.9 billionexplodes to 11 billion by 2050 and perhaps 35 billion by2300, we will run out of resources, …

real GDP per person will decline and we will return to aprimitive standard of living.

We must, say Malthusians, contain population growth.

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Growth Theories, Evidence,and Policies

Neoclassical Growth TheoryNeoclassical growth theory is the proposition that realGDP per person grows because technological changeinduces a level of saving and investment that makescapital per hour of labor grow.

Growth ends only if technological change stops becauseof diminishing marginal returns to both labor and capital.

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Growth Theories, Evidence,and Policies

The Neoclassical Theory of Population Growth

The neoclassical view is that the population growth rate isindependent of real GDP and the real GDP growth rate.

Technological Change and Diminishing Returns

In the neoclassical theory, the rate of technologicalchange influences the economic growth rate but economicgrowth does not influence the pace of technologicalchange.

It is assumed that technological change results fromchance.

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Growth Theories, Evidence,and Policies

Technology begins to advance at a more rapid pace.New profit opportunities arise and investment and savingincrease.As technology advances and the capital stock grows, realGDP per person increases.Diminishing returns to capital lower the real interest rateand eventually economic growth slows and just keeps upwith population growth.Capital per worker remains constant.

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Growth Theories, Evidence,and Policies

A Problem with Neoclassical Growth Theory

All economies have access to the same technologies andcapital is free to roam the globe, seeking the highestavailable real interest rate.

These facts imply that economic growth rates and realGDP per person across economies will converge.

Figure 6.5 shows some convergence among richcountries, but convergence doesn’t appear imminent for allcountries.

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Growth Theories, Evidence,and Policies

New Growth TheoryNew growth theory holds that real GDP per person growsbecause of choices that people make in the pursuit ofprofit and that growth can persist indefinitely.

The theory begins with two facts about market economies:

Discoveries result from choices.

Discoveries bring profit and competition destroys profit.

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Growth Theories, Evidence,and Policies

Two further facts play a key role in the new growth theory:

Discoveries are a public capital good.

Knowledge is not subject to diminishing returns.

Increasing the stock of knowledge makes capital and labormore productive.

The central proposition of new growth theory is thatknowledge capital does not experience diminishingreturns.

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Growth Theories, Evidence,and Policies

Figure 6.12summarizesthe ideas ofnew growththeory as aperpetualmotionmachine.

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Growth Theories, Evidence,and Policies

Sorting Out the Theories

Each theory teaches us something of value but not thewhole story.

Classical theory reminds us that our physical resources arelimited and we need technological advances to grow.

Neoclassical theory’s emphasis of diminishing returns tocapital means we need technological advances to grow.

New theory emphasizes the capacity of human resourcesto innovate at a pace that offsets diminishing returns.

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Growth Theories, Evidence,and Policies

The Empirical Evidence on the Causes of EconomicGrowth

Economic growth makes progress by the interplay of theoryand empirical evidence.

Theory makes predictions about what we will observe if it iscorrect.

Empirical evidence provides the data for testing the theory.

Table 6.1 on the next slide summarizes the more robustinfluences on growth that economists have discovered.

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Growth Theories, Evidence,and Policies

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Growth Theories, Evidence,and Policies

Policies for Achieving Faster GrowthGrowth accounting tells us that to achieve faster economicgrowth we must either increase the growth rate of capitalper hour of labor or increase the pace of technologicalchange.

The main suggestions for achieving these objectives are:

Stimulate Saving

Saving finances investment. So higher saving rates mightincrease physical capital growth.

Tax incentives might be provided to boost saving.

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Growth Theories, Evidence,and Policies

Stimulate Research and Development

Because the fruits of basic research and developmentefforts can be used by everyone, not all the benefit of adiscovery falls to the initial discoverer.

So the market might allocate too few resources toresearch and development.

Government subsidies and direct funding might stimulatebasic research and development.

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Growth Theories, Evidence,and Policies

Improve the Quality of Education

The benefits from education spread beyond the personbeing educated, so there is a tendency to under invest ineducation.

Provide International Aid to Developing Nations

If rich countries give financial aid to developing countries,investment and growth will increase.

But data on the effect of aid shows that it has had zero ora negative effect.

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Growth Theories, Evidence,and Policies

Encourage International Trade

Free international trade stimulates growth by extracting allthe available gains from specialization and trade.

The fastest growing nations are the ones with the fastestgrowing exports and imports.