2.2 Macroeconomics

Question 1

Macroeconomics

Answer 1

Macroeconomics is concerned with the economic activities and outcomes of an entire economy, typically an entire nation or region comprising several nations. The most common issues considered, all of which are covered in the following lessons, relate to:
A. Aggregate demand
B. Aggregate supply
C. Business cycles
D. Inflation/deflation
E. Gross measures of activity and status
F. Role of government

Question 2

Flow Model Expanded

In the section on microeconomics we developed a two-sector free-market flow model, which showed the flows of resources and payments between individuals and business firms.

Answer 2

For the purposes of macroeconomic analysis, we need to expand that flow model to incorporate the role of additional entities in the economy, including:

1. Government
2. Financial sector
3. Foreign sector

Because of including the additional sectors, the equality between flows to/from individuals and from/to business firms, which is assumed in the two-sector model, no longer holds.

Question 3

Leakages = The amounts of individual income that are not spent on domestic consumption

Answer 3

These leakages consist of:
savings (from individuals),
taxes (from government),
and indirectly, imports (from foreign sector).

Question 4

Injections = The amounts of expenditures not for domestic consumption added to the domestic production

Answer 4

These injections consist of:
investment expenditures
government spending/subsidies,
and exports (from foreign sector).

Question 5

Nominal Gross Domestic Product (Nominal GDP)

Answer 5

Measures the total output of final goods and services produced for exchange in the domestic market during a period (usually a year).

Question 6

GDP

This output may be quantified (measured) in two ways:

Answer 6

Expenditure approach – This measures GDP using the value of final sales and is derived as the sum of the spending of:

i. Individuals – In the form of consumption expenditures for durable and non-durable goods and for services;
ii. Businesses – In the form of investments in residential and non-residential (e.g., plant and equipment) construction and new inventory;
iii. Governmental entities – In the form of goods and services purchased;
iv. Foreign buyers – In the form of net exports (exports - imports) of U.S. produced goods and services.

Question 7

Income approach – This measures GDP as the value of income and resource costs and is derived as the sum of:

Answer 7

Components Amounts in Billions
1) Compensation to employees $ 7,799
2) Rental income 268
3) Proprietor’s income 1,041
4) Corporate profits 997
5) Net interest 988
6) Taxes on production and inputs 1,024
7) Depreciation (consumption of fixed capital) 1,861
8) Business transfer payments 134
Less: Government enterprise surplus (8)
Plus: Statistical adjustment 209
GROSS DOMESTIC PRODUCT (GDP) $14,256 (Rounded)

Question 8

Real Gross Domestic Product (Real GDP)
measures production in terms of prices that existed at a specific prior period; that is, it adjusts for changing prices using a price index.

Answer 8

Measures the total output of final goods and services produced for exchange in the domestic market during a period (usually a year) at constant prices.

Question 9

Gross Domestic Product (GDP Deflator) – The GDP deflator is a comprehensive measure of price levels used to derive real GDP.

Answer 9

Real GDP = (Nominal GDP/GDP Deflator) × 100

Question 10

Potential Gross Domestic Product (Potential GDP)

• At points within the curve, actual output (i.e., real GDP) is less than potential output (potential GDP). The difference (potential GDP − real GDP) is the (positive) GDP gap, a measure of inefficiency in the economy;
• At points outside the curve, actual output (i.e., real GDP) exceeds potential output and there is a negative GDP gap, which will result in price level increases.

Answer 10

Measures the maximum final output that can occur in the domestic economy at a point in time without creating upward pressure on the general level of prices in the economy. The point of maximum final output will be a point on the production-possibility frontier for the economy.

Question 11

Net Domestic Product (NDP)

Answer 11

Measures GDP less a deduction for “capital consumption” during the period—the equivalent of depreciation. Thus, NDP is GDP less the amount of capital that would be needed to replace capital consumed during the period.

Question 12

Gross National Product (GNP)

Answer 12

Measures the total output of all goods and services produced worldwide using economic resources of U.S. activities. In 1992 GNP was replaced by GDP as the primary measure of the U.S. economy. GNP includes both the cost of replacing capital (the depreciation factor) and the cost of investment in new capital.

Question 13

Net National Product (NNP)

Answer 13

Measures the total output of all goods and services produced worldwide using economic resources of U.S. entities, but unlike GNP, NNP only includes the cost of investment in new capital (i.e., there is no amount included for depreciation).

Question 14

National Income

Answer 14

Measures the total payments for economic resources included in the production of all goods and services, including payments for wages, rent, interest, and profits, but not taxes included in the cost of final output.

Question 15

Personal Income

Answer 15

Measures the amount (portion) of national income, before personal income taxes, received by individuals.

Question 16

Personal Disposable Income

Answer 16

Measures the amount of income individuals have available for spending, after taxes are deducted from total personal income.

Question 17

The labor force, in turn, is comprised of two subgroups:

Answer 17

(1) the employed (employment), and

2) the unemployed (unemployment

Question 18

The official unemployment rate is the percentage of the labor force that is not employed, not the percentage of the population that is not employed.

Answer 18

Unemployment Rate = Unemployed (including all categories)/Size of Labor Force

Question 19

The natural rate of unemployment is the percentage of the labor force that is not employed as a result of frictional, structural and seasonal unemployment.

Answer 19

Natural Rate of Unemployment = Frictional + Structural + Seasonal Unemployed/Size of Labor Force

Officially, full employment is when there is no cyclical unemployment. Even with frictional and structural unemployment, officially full employment can exist. Said another way, if unemployment is due solely to frictional, structural and seasonal causes (i.e., the natural rate of unemployment), the economy is in a state of full employment.

Question 20

Aggregate demand curve – At the macroeconomic (economy) level

The demand curve that results from plotting the aggregate spending (AD) is negatively sloped.

Answer 20

Like its microeconomic counterpart, the aggregate demand curve shows quantity demanded at various prices (aggregate prices = price level), assuming all other variables that affect spending are held constant (ceteris paribus).

Question 21

Components of aggregate demand

Answer 21

Aggregate demand is the total spending by individual consumers (consumption spending), businesses on investment goods, and by governmental entities, and foreign entities on net exports

Question 22

Several ratios – are used to measure the relationship between consumption spending and disposable income:

Answer 22

1. Average propensity to consume (APC): Measures the percent of disposable income spent on consumption goods;
2. Average propensity to save (APS): Measures the percent of disposable income not spent, but rather saved;
   APC + APS = 1 (because each measure is the reciprocal of the other)
3. Marginal propensity to consume (MPC): Measures the change in consumption as a percent of a change in disposable income;
4. Marginal propensity to save (MPS): Measures the change in savings as a percent of a change in disposable income.
   MPC + MPS = 1 (because each measure is the reciprocal of the other)

Question 23

The aggregate demand (AD) curve, as shown above, is negatively sloped because of three significant factors:

Answer 23

A. Interest rate factor – Generally, the higher the price level, the higher the interest rate. As the interest rate increases, interest-sensitive spending (e.g., new home purchases, business investment, etc.) decrease;
B. Wealth-level factor – As price levels (and interest rates) increase, the value of financial assets may decrease. As wealth decreases, so also may spending decrease;
C. Foreign purchasing power factor – As the domestic price level increases, domestic goods become relatively more expensive than foreign goods. Therefore, spending on domestic goods decreases and spending on foreign goods increases.

Question 24

Aggregate Demand Curve Shift

Answer 24

If variables other than price affect total spending in the economy, aggregate demand will change, and the aggregate demand curve will shift to create a new curve. The curve will shift outward (to the right) when demand increases and inward (to the left) when demand decreases.

Question 25

Aggregate demand typically changes as a result of the following kinds of occurrences (among others):

Answer 25

1. Personal taxes (e.g., income taxes) –
2. Consumer confidence –
3. Technological advances –
4. Corporate taxes (e.g., income taxes, franchise taxes, etc.) –
5. Interest rates –
6. Government spending –
7. Exchange rates/net exports –
8. Wealth changes –

Question 26

Multiplier effect – Factors that cause a shift in aggregate demand have a ripple effect through the economy. For example, an increase in investment spending by business results in certain increases in personal disposable income, which further spurs demand. This cascading effect on demand is called “the multiplier effect.” Simply put, a change in a single factor that causes a change in aggregate demand will have a multiplied effect on aggregate demand.

Answer 26

The multiplier effect is caused by, and can be calculated, using the marginal propensity to consume. Recipients of additional income will spend some portion of that new income—their marginal propensity to consume a portion—which will provide income to others, a portion of which they will spend, and so on.

The extent of the multiplier effect can be measured as:
Multiplier Effect = Initial Change in Spending × (1/(1 − MPC))

Question 27

Aggregate supply curve – At the macroeconomic (economy) level

Answer 27

supply measures the total output of goods and services at different price levels. The exact slope of the aggregate supply curve that results from plotting the output depends on which of three theoretical curves is accepted as representing aggregate supply. These possibilities are:

Question 28

Classical Aggregate Supply Curve

Answer 28

This curve is completely vertical, reflecting no relationship between aggregate supply and price level.

Question 29

Keynesian Aggregate Supply Curve

Answer 29

This curve is horizontal up to the (assumed) level of output at full employment, then slopes upward, reflecting that output is not associated with price level until full employment is reached, at which point increased output is associated with higher price levels.

Question 30

Conventional Aggregate Supply Curve

Answer 30

This curve has a continuously positive slope with a steeper slope beginning at the (assumed) level of output at full employment, reflecting that at full employment increased output is associated with proportionately higher increases in price levels.

Question 31

Changes in Variables
Changes other than price level will affect aggregate supply and shift the aggregate supply curve under any of the theoretical assumptions described above. Factors that may change the position of the supply curve include:

Answer 31

A. Resource availability – An increase in economic resources (e.g., increase in working age population) will shift the curve outward (to the right); a decrease would have the opposite effect;
B. Resource cost – A decrease in the cost of economic resources (e.g., lower oil prices) will shift the curve outward (to the right); an increase will have the opposite effect;
C. Technological advances – (e.g., more efficient production processes) will shift the curve outward (to the right). Government prohibitions on the use of an existing technology, in the absence of a comparable alternative, will shift the curve inward (to the left).

Question 32

Aggregate (Economy) Equilibrium

Answer 32

The equilibrium real output and price level for an economy are determined by its aggregate demand and supply curves. Graphically, equilibrium occurs where the aggregate demand and supply curves intersect.
The effect of a shift in the aggregate demand and/or aggregate supply curve(s) on equilibrium output and the price level would depend on:
1. Which of the three theoretical supply curves is assumed; and
2. The degree of shift in the curve(s) relative to prechange equilibrium.

Question 33

Classical Supply Curve

Answer 33

An increase in aggregate demand alone results only in higher price levels.
An increase in aggregate supply alone results in more output at a lower price.

Question 34

Keynesian Supply Curve

Answer 34

An increase in aggregate demand alone results only in more output until output at full employment, at which point output and price level each increase.
An increase in supply alone will not affect either output or price level unless aggregate demand intersects supply where it is positively sloped.

Question 35

Conventional Supply Curve

Answer 35

An increase in aggregate demand alone will increase both the output and the price level.
An increase in supply alone will increase output, but reduce the price level.

Question 36

Cyclical Economic Behavior

Answer 36

Business cycles is the term used to describe the cumulative fluctuations (up and down) in aggregate real GDP, generally that last for two or more years. These increases and decreases in real GDP tend to recur over time, though with no consistent pattern of length (duration) or magnitude (intensity). These increases and decreases also tend to impact individual industries at somewhat different times and with different intensities.

Question 37

Components of Business Cycle

Answer 37

A. Peak – A point in the economic cycle that marks the end of rising aggregate output and the beginning of a decline in output. (the P’s in the graph)
B. Trough – A point in the economic cycle that marks the end of a decline in aggregate output and the beginning of an increase in output. (the T’s in the graph)
C. Economic expansion or expansionary period – Periods during which aggregate output is increasing. (periods from T to P in the graph)
D. Economic contraction or recessionary period – Periods during which aggregate output is decreasing. (periods from P to T in the graph)

Question 38

Recession defined

Answer 38

Quantitative guidelines used frequently by others (but which are not official) include:

a. A period of two or more consecutive quarters in which there is a decline in real GDP growth.
b. An economic downturn in which real GDP declines by 10% or less.

Question 39

Depression defined

Answer 39

Quantitative guidelines used by economists (but which are not official) include:

a. A decline in real GDP exceeding 10%;
b. A decline in real GDP lasting 2 or more years.

Question 40

Primary Cause of Business Cycles

Answer 40

While no single theory fully explains the causes and characteristics of business cycles, a major cause is changes in business investment spending (i.e., on plant, equipment, etc.) and consumer spending on durable goods (i.e., on goods used over multiple periods, like major appliances, automobiles, etc.).

Question 41

As previously noted, declines in consumer and business spending may be caused by such factors as:

Answer 41

1. Tax increases
2. Confidence in the economy declines
3. Interest rates rise and/or borrowing becomes more difficult.

Question 42

Leading Indicators of Business Cycles = These measures of economic activity (which change before the aggregate business cycle)

Answer 42

1. Consumer expectations
2. Initial claims for unemployment
3. Weekly manufacturing hours
4. Stock prices
5. Building permits
6. New orders for consumer goods
7. Real money supply

Question 43

Lagging (Trailing) Indicators of Business Cycles = Measures of economic activity associated with changes in the business cycle, but which occur after changes in the business cycle

Answer 43

1. Changes in labor cost per unit of output
2. Ratio of inventories to sales
3. Duration of unemployment
4. Commercial loans outstanding
5. Ratio of consumer installment credit to personal income

Question 44

Price Indexes

Answer 44

Price indexes convert prices of each period to what those prices would be in terms of prices of a specific prior (or sometimes subsequent) reference period. Mathematically, the price of the reference period is set equal to 100 (100%), and the price of other periods is measured as a percentage of the reference (or base) period.

Question 45

Consumer Price Index (CPI-U) – The Consumer Price Index for All Urban Consumers (published monthly)

Answer 45

relates the prices paid by all urban consumers for a “basket” of goods and services during a period to the price of the “basket” in a prior reference period. The current reference period for CPI-U is the 36-month average of prices for 1982-1984. The average prices in that period are taken as 100. Prices in subsequent periods are measured as percentage changes related to that base period.

Question 46

Purchase Price Index (PPI) – (formerly Wholesale Price Index)

Answer 46

Measures the average change over time in the selling prices received (i.e., revenue received) by domestic producers for their output. The prices included in the PPI are from the first commercial transaction of producers for their domestically produced goods, services and construction output. The calculations are done in essentially the same manner as for the CPI-U index, but because the price changes are from the perspective of the producer/seller, the values used are selling prices of (revenues received by) the first producer rather than the cost to end buyers.

Question 47

Gross Domestic Product (GDP) Deflator

Answer 47

The GDP Deflator relates nominal GDP to real GDP (both as previously defined). It is the most comprehensive measure of price level since GDP includes not only consumer and business spending, but also government spending and net exports.
The calculation is:
(Nominal GDP/Real GDP) × 100 = GDP Deflator

Question 48

Inflation/Deflation

Answer 48

Inflation (or inflation rate) is the annual rate of increase in the price level; deflation (or deflation rate) is the annual rate of decrease in the price level. The most common yardstick used to measure inflation or deflation in the United States is the CPI-U.

Question 49

Demand-induced (demand-pull) inflation

Answer 49

Results when levels of aggregate spending for goods and services exceeds the productive capacity of the economy at full employment. Consequently, the excess demand pulls up prices.

Question 50

Supply-induced (cost-push or supply-push) inflation

Answer 50

Results from increases in the cost of inputs to the production process—raw materials, labor, taxes, etc.—which are passed on to the final buyer in the form of higher prices. To the extent the producer absorbs the increase in cost of inputs and does not pass them on to the final buyer, inflation does not occur (or is deferred).

Question 51

Consequences of Inflation

Answer 51

1. Lower current wealth and lower future real income – Because of inflation, monetary items (those fixed in dollar amount) lose purchasing power. Consumers on fixed incomes, or those with incomes that do not keep pace with inflation, will reduce consumption. Similarly, creditors repaid with a fixed number of dollars will be able to purchase less with those dollars. The effect of less consumption is a reduction in aggregate demand leading to lower output and higher unemployment.
2. Higher interest rates – In order to offset declines in purchasing power derived from loans, creditors increase interest rates. Higher interest rates increase the cost of borrowing, which reduces both consumer spending and business investment in capital goods. Further, lenders may tighten loan requirements, and thereby, squeeze marginal borrowers out of the market, which also would reduce spending.
3. Uncertainty of economic measures – The changing real value of the dollar makes it an uncertain measure for making economic decisions. Price increases create uncertainty about future costs, prices, profitability, and cash flows. Consequently, individuals and businesses are likely to postpone investments, which in turn reduces current demand and future productive capacity.

Question 52

Consequences of deflation—the deflationary spiral

Answer 52

When prices are falling, consumers have an incentive to delay purchases and businesses have an incentive to delay investments, both in anticipation of lower prices in the future. These delays create further decreases in aggregate demand, causing further reductions in prices, increased idle production capacity, increased unemployment, and reductions in wages and in lending and interest rates. This cycle is called a deflationary spiral.

Question 53

Banking System
The United States does not have a central bank, but rather a central banking system, the Federal Reserve System, which consists of:

Individual, business firms, and other entities deal with these financial intermediaries, but not directly with the Federal Reserve Banks.

Answer 53

1. Board of Governors – The seven-member, policy-making body of the Federal Reserve System.
2. Federal Open Market Committee – The 12-member body responsible for implementing monetary policy through open-market operations to affect the money supply (M1).
3. Federal Reserve Banks – The twelve district banks, each responsible for a specific geographical area of the U.S. Within their area, each federal bank supervises, regulates, and examines member institutions, provides currency to and clears checks for those institutions, and holds reserves and lends to those institutions. The Federal Reserve Banks are owned by its member institutions, but they operate under uniform policies of the Federal Reserve System. Member institutions, which function as financial intermediaries, include:
   a. Commercial banks
   b. Savings and loan associations
   c. Mutual savings banks
   d. Credit unions

Question 54

Monetary Policy

Answer 54

Monetary policy is concerned with managing the money supply to achieve national economic objectives, including economic growth and price level stability. The Federal Reserve System can regulate the money supply (exercise monetary policy) in a number of ways:

Question 55

Reserve-requirement changes

Answer 55

A bank’s ability to issue check-writing deposits is limited by a reserve-requirement by the Fed on check-writing deposits. Simply put, loans made by banks are paid to borrowers by checks drawn on the lending bank. For every dollar of such checks issued as loans, the bank must have a required amount held as a reserve, either at the bank or on deposit at a Federal Reserve Bank.

Question 56

Open-market operations

Answer 56

The Fed engages in open-market operations by purchasing and selling U.S. Treasury debt obligations (e.g., Treasury Bonds) from/to banks. The effect of purchasing Treasury obligations is to replace debt held by banks with additional reserves for the banks. The increase in reserves permits additional check-writing deposits (i.e., lending ability) by the banks. Sale of Treasury obligations has the opposite effect. Thus, open-market purchasing implements monetary easing; while open-market sales implement monetary tightening.

Question 57

Discount rate

Answer 57

The rate of interest banks pay when they borrow from a Federal Reserve Bank in order to maintain reserve requirements is called the “discount rate.” Borrowing from a Fed bank increases a bank’s reserves with the Fed because the borrowing is credited to the bank’s reserve with the Fed, not withdrawn from the Fed bank. As a result of increased reserves, banks are able to increase loans. By decreasing or increasing the discount rate, the Fed encourages or discourages borrowing from the Fed, and thereby, eases or tightens the money supply.

Question 58

Fiscal and Monetary Policy Summary
Both fiscal and monetary policy provide means for the government to influence aggregate spending (demand). Fiscal policy is implemented through changes in government spending and/or taxes. Monetary policy is implemented primarily through control of the money supply. Thus, for example, governmental efforts to increase aggregate spending (and reduce unemployment, increase GDP, etc.) would include:

Answer 58

Action Policy Type

Increase government spending Fiscal
Reduce taxes Fiscal
Increase money supply Monetary

Question 59

Lag-time element – There are differences in how quickly the alternative forms of policy can be implemented and how quickly economic activity will be affected. Changes of significant magnitude in fiscal policy, generally require congressional approval and may be delayed (or never approved) if there is not agreement by members of Congress. However, once approved, changes in government spending can be implemented quickly and with an almost immediate impact on demand. Changes in tax rates, once approved, have a less immediate impact and a less certain magnitude of influence.

Answer 59

Generally, changes in monetary policy can be made more quickly than fiscal policy because monetary policy is changed by the Federal Reserve Board, not by Congress. Once approved, monetary policy has an almost immediate effect on the interest rate. However, the full effect on spending may not occur immediately because of the time lags inherent in “ramping-up” (or “ramping-down”) large-scale projects commonly sensitive to changes in the interest rate.

Of the two approaches, monetary policy has been the primary approach to achieving economic objectives. Changes can be approved more quickly to respond to changing economic circumstances, and monetary policy changes have fewer artificial influences on the economy. Fiscal policy, on the other hand, causes a redistribution of output and income.