MACROECONOMICS II

VERY LONG RUN GROWTH 

The very long run behavior of the economy is the domain of growth theory. In studying growth theory, we ask how the accumulation of inputs investment in machinery, for example and improvements in technology lead to an increased standard of living. We ignore recessions and booms and related short run fluctuations in employment of people and other resources. We assume that labor, capital, raw materials, and so on are all fully employed.   

Question: How can a model that ignores fluctuations in the economy possibly tell us anything sensible? 

Answer: Fluctuations in the economy the ups and downs of unemployment, for example tend to average out over the years. Over very long periods, all that matters is how quickly the economy grows on average. Growth theory seeks to explain growth rates averaged over many years or decades. 

Models and the Real World

Models are simplified representations of the real world. A good model accurately explains the behaviors that are most important to us and omits details that are relatively unimportant. The notion that the earth revolves around the sun on an elliptical path and that the moon similarly revolves around the earth is an example of a model. The exact behavior of sun, earth, and moon is much more complicated, but this model enables us to understand the phases of the moon. For this purpose, it is a good model. Even though the real orbits are not simple ellipses, the model works.

 In economics, the complex behavior of millions of individuals, firms, and markets is represented by one, two, a dozen, a few hundred, or a few thousand mathematical relations in the form of graphs or equations or computer programs. The intellectual problem in model building is that humans can understand the interactions between, at most, only a handful of relations. So usable macro theory relies on a toolbox of models, each consisting of two or three equations. A particular model is a tool based on a set of assumptions for example, that the economy is at full employment that are reasonable in some world circumstances. Understanding the macroeconomy requires a rich toolbox and the application of sound judgment regarding when to deploy a particular model. We cannot overemphasize this point: The only way to understand the very complicated world in which we live is to master a toolbox of simplifying models and to then make quite explicit decisions as to which model is best suited for analyzing a given problem. As an illustration consider three very specific economic questions. 

(1) Question: How will your grand children’s standard of living compare to yours? 

Answer: Over a time span a couple of generations long, we want a model of very long run growth. Nothing matters much for per capita growth except the development of new technology and the accumulation of capital (assuming you live in a developed economy). At growth rates between 4 and 8 percent, income will more than double and less than quintuple within two generations. Your grandchildren will certainly live much better than you do. They will certainly not be as rich as "Elon Musk" is today. 

(2) Question: What caused the great inflation of the past world War I German Weimar Republic?

Answer: Huge inflations have one cause great outward sweeps of the aggregate demand curve caused by the government’s printing too much money. Small changes in the price level may have many contributing factors. But huge changes in prices are the domain of the long run aggregate supply aggregate demand model, in which a vertical aggregate supply curve remains relatively motionless while the aggregate demand curve moves outward. 

(3)Question: Why did the U.S. unemployment rate, which had been below 6 percent during parts of 1979, reach nearly 11 percent by the end of 1982?

Answer: Big changes over short time spans in the level of economic activity, and thus in unemployment, are explained by the short run aggregate supply aggregate demand model with a horizontal aggregate supply curve. At the beginning of the 1980s the Federal Reserve clamped down on aggregate demand, driving the economy into a deep recession. The Fed’s intention was to reduce inflation eventually this is just what happened. But as the short run model explains, over very short periods cutting back aggregate demand reduces output, increasing unemployment. 

THE BUSINESS CYCLE AND THE OUTPUT GAP 

Inflation, growth, and unemployment are related through the business cycle   .  The business cycle is the more or less regular pattern of expansion (recovery) and contraction (recession) in economic activity around the path of trend growth.  At a cyclical peak, economic activity is high relative to trend; at a cyclical    trough, the low point in economic activity is reached. Inflation, growth, and unemployment all have clear cyclical patterns. For the moment we concentrate on measuring the behavior of output or GDP relative to trend over the business cycle. The trend path of GDP is the path GDP would take if factors of production were fully employed.  Over time, GDP changes for the two reasons we already noted. First, more resources become available: The size of the population increases, firms acquire machinery or build plants, land is improved for cultivation, the stock of knowledge increases as new goods and new methods of production are invented and introduced. This increased availability of resources allows the economy to produce more goods and services, resulting in a rising trend level of output. But, second, factors are not fully employed all the time. Full employment of factors of production is an economic, not a physical, concept. Physically, labor is fully employed if everyone is working 16 hours per day all year. In economic terms, there is full employment of labor when everyone who wants a job can find one within a reasonable amount of time. Because the economic definition is not precise, we typically define full employment of labor by some convention, for example, that labor is fully employed when the unemployment rate is 5 percent. Capital similarly is never fully employed in a physical sense; for example, office buildings or lecture rooms, which are part of the capital stock, are used only part of the day. Output is not always at its trend level, that is, the level corresponding to (economic) full employment of the factors of production. Rather, output fluctuates around the trend level. During an    expansion (or recovery) the    employment  of factors of production increases, and that is a source of increased production. Output can rise above trend because people work overtime and machinery is used for several shifts. Conversely, during a    recession unemployment increases and less output is produced than could in fact be produced with the existing resources and technology. Deviations of output from trend are referred to as the    output gap. The output gap measures the gap between actual output and the output the economy could produce at full employment given the existing resources.  Full employment output is also called potential output. 

Output gap = actual output - potential output 

The output gap allows us to measure the size of the cyclical deviations of output from potential output or trend output (we use these terms interchangeably). A positive gap means that there is over employment, overtime for workers, and more than the usual rate of utilization of machinery. It is worth noting that the gap is sometimes very sizable. For example, in 1982 it amounted to as much as 10 percent of output.   

INFLATION AND THE BUSINESS CYCLE

Increases in inflation are positively related to the output gap. Expansionary aggregate demand policies tend to produce inflation, unless they occur when the economy is at high levels of unemployment. Protracted periods of low aggregate demand tend to reduce the inflation rate.

Inflation, like unemployment, is a major macroeconomic concern. However, the costs of inflation are much less obvious than those of unemployment. In the case of unemployment, potential output is going to waste, and it is therefore clear why the reduction of unemployment is desirable. In the case of inflation, there is no obvious loss of output. It is argued that inflation upsets familiar price relationships and reduces the efficiency of the price system. Whatever the reasons, policymakers have been willing to increase unemployment in an effort to reduce inflation that is, to trade off some unemployment for less inflation.