The Goals of Macroeconomics

Economic growth
Economic growth: is the increase in a country's national income, or the growth of
GDP. GDP growth is essential for improvement of the standard of living, as measured
by GDP per capita. In addition, economic growth is a general sign that a country's
economic activity is successful.

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Economic Growth and Inflation in the AS-AD Model
Figure illustrates economic growth.
- Because the quantity of labor grows, capital is accumulated, and technology
advances, potential GDP increases.
- The LAS curve shifts rightward.
Figure also illustrates inflation.
- If the quantity of money grows faster than potential GDP, aggregate demand
increases by more than long-run aggregate supply.
- The AD curve shifts rightward faster than the rightward shift of the LAS curve.

Technology and Economic Growth

- Models of economic growth differ in their assumptions about the role of
technology.
The new growth theory directly links economic growth and advances in technology
by focusing on the decisions of profit-maximizing firms and the high (expected)
profits from new technology discoveries. In this view, innovation becomes a main
source of economic growth, shifting the labor productivity curve upward.
Capital growth occurs, and income and consumption rise, leading to more
innovation. This will move the labor productivity curve upward even further. The
economic growth will continue as long as technological innovation takes place. This
new growth model is important because its explanation of the role of technology
within the economic model is distinctly different from that of the classical and
neoclassical growth models that have dominated thinking about economic growth.
- The classical growth model considered technology a factor that could not be
explained by the economic model itself. Therefore, technology is an exogenous
variable, that is, one that is outside the classical economic model.
The classical growth thinking tied any increases in GDP per capita (i.e., wages
above the minimum subsistence level) to a rise in population. The extra population
(or increased labor supply) would lower wage rates again, back to the original
minimum wage rate. Therefore, changes in GDP per capita would always be
temporary. Empirical studies have shown that population growth is usually
independent of economic growth, contradicting a key assumption of classical
growth theory.
- The neoclassical growth model linked higher GDP per capita to technology
progress that increases saving and investment, and thus capital growth. This would
allow capital per hour of labor to grow (and therefore labor productivity). As in
classical thinking, technological development is a factor outside of the neoclassical
model. The neoclassical growth model predicts that nations will ultimately
converge to identical GDP per capita incomes. The numbers in Fig. 8-1 indicate that
we are not yet at that point.

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Global Economics and Economic Growth
- In determining domestic economic growth objectives, the U.S. government's fiscal
/and monetary policies need to take global economics into account.
- In theory, free international trade is a major contributor to a nation's economic
growth. Comparative advantage indicates the goods and services that would lead
to mutually beneficial international trade. The U.S. government historically has
been a staunch supporter of international free trade, and the United States is a
member of the World Trade Organization (WTO), whose stated objective is the
worldwide removal of trade barriers.
- In practice, when certain domestic industries are under siege from effective foreign
low-cost producers, industry lobbies may pressure members of Congress to pursue
trade restrictions. For example, U.S. textile industry representatives asked for
protective tariffs to limit the impact of Chinese imports resulting from the full
removal of quotas in 2005. Ultimately, no formal tariffs were imposed, and China
agreed to voluntary trade restrictions in the form of a self-imposed U.S. export
quota.

Price stability
The stability of prices is critical to economic growth because people make decision
based on expected future prices. If those expected prices become unstable this causes
uncertainly that will have negative impact on all economic activity.
The Price Level
- Inflation is a sustained increase in the general level of prices in the economy.
The scope of price increases during inflation is significant because inflation is
neither a persistent price increase for just one single product nor a one-time
increase in the average price level.
Inflation is an ongoing price increase, across the board, with a significant impact on
the economy.
- The importance of sustained price increases is that they influence people's
expectations about future prices.
In addition, inflation has a self-fulfilling nature: Once certain prices change and
people are uncertain whether the inflation will stop, there can be a "domino" effect,
leading to a continuous string of increases.
- In the long run, inflation occurs if the quantity of money grows faster than potential
GDP.
- In the short run, many factors can start an inflation, and real GDP and the price
level interact.

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- To study these interactions, we distinguish between two sources of inflation:
o Demand-pull inflation
o Cost-push inflation.
Demand-Pull Inflation
An inflation that starts because aggregate demand increases is called demand-pull
inflation.
Demand-pull inflation can begin with any factor that increases aggregate demand.
Examples are a cut in the interest rate, an increase in the quantity of money, an
increase in government expenditure, a tax cut, an increase in exports, or an increase in
investment stimulated by an increase in expected future profits.
Initial Effect of an Increase in Aggregate Demand

Figure 29.3(a) illustrates the start of a demand-pull inflation.

- Starting from full employment, an increase in aggregate demand shifts the AD
curve rightward.
- The price level rises, real GDP increases, and an inflationary gap arises.
- The rising price level is the first step in the demand-pull inflation.

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Money Wage Rate Response

- The money wage rate rises and the SAS curve shifts leftward.
- The price level rises and real GDP decreases back to potential GDP.
A Demand-Pull Inflation Process

Figure 29.4 illustrates a demand-pull inflation spiral.

- Aggregate demand keeps increasing and the process just described repeats
indefinitely.
- Although any of several factors can increase aggregate demand to start a
demand-pull inflation, only an ongoing increase in the quantity of money can
sustain it.
- Demand-pull inflation occurred in the United States during the late 1960s.
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Aggregate Demand Response

- The initial increase in costs creates a one-time rise in the price level, not inflation.
- To create inflation, aggregate demand must increase.
- That is, the Fed must increase the quantity of money persistently.
- Figure illustrates an aggregate demand response.
- Suppose that the Fed stimulates aggregate demand to counter the higher
unemployment rate and lower level of real GDP.
- Real GDP increases and the price level rises again.

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A Cost-Push Inflation Process

- If the oil producers raise the price of oil to try to keep its relative price higher, ...
- and the Fed responds by increasing the quantity of money, ...
- a process of cost-push inflation continues.
- The combination of a rising price level and a decreasing real GDP is called
stagflation.
- Cost-push inflation occurred in the United States during the 1970s when the Fed
responded to the OPEC oil price rise by increasing the quantity of money

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Expected Inflation
- Figure 29.7 illustrates an expected inflation.
- Aggregate demand increases, but the increase is expected, so its effect on the
price level is expected.
- The money wage rate rises in line with the expected rise in the price level.
- The AD curve shifts rightward and the SAS curve shifts leftward
- so that the price level rises as expected and real GDP remains at potential GDP.
Forecasting Inflation
- To expect inflation, people must forecast it.
- The best forecast available is one that is based on all the relevant information and
is called a rational expectation.
- A rational expectation is not necessarily correct, but it is the best available.
Deflation
An economy experiences deflation when it has a persistently falling price level.
What Causes Deflation
- The price level falls persistently if aggregate demand increases at a persistently
slower rate than aggregate supply.
- The Quantity Theory and Deflation
Inflation rate = Money growth rate + Rate of velocity change – Real GDP growth
rate
Deflation occurs if
o Money growth rate < Real GDP growth rate – Rate of velocity change.
For example in Japan, real GDP growth rate was 0.8 percent a year, the
money growth rate was 2.5 percent a year, and the rate of velocity change
was –3 percent a year.
- Inflation rate = Money growth rate + Rate of velocity change – Real GDP growth
rate
Inflation rate = [2.5 + (– 3) – 0.8] percent a year.
Deflation rate = 1.3 percent a year.
What are the Consequences of Deflation?
- Unanticipated deflation redistributes income and wealth, lowers real GDP and
employment, and diverts resources from production.
How can deflation be ended?
- By increasing the growth rate of money.
- Make the money growth rate exceed the growth rate of real GDP minus the rate of
velocity change.

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The Phillips Curve
A Phillips curve is a curve that shows the relationship between the inflation rate and
the unemployment rate.
There are two time frames for Phillips curves:
- The short-run Phillips curve
- The long-run Phillips curve
The Short-Run Phillips Curve
The short-run Phillips curve shows the tradeoff between the inflation rate and
unemployment rate, holding constant
 The expected inflation rate
 The natural unemployment rate

Figure illustrates a short-run Phillips curve (SRPC)—a downward-sloping curve.

- It passes through the natural unemployment rate and the expected inflation rate.
- With a given expected inflation rate and natural unemployment rate:
- If the inflation rate exceeds the expected inflation rate, the unemployment rate
decreases.
- If the inflation rate is below the expected inflation rate, the unemployment rate
increases.

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The Long-Run Phillips Curve

The long-run Phillips curve shows the relationship between inflation and
unemployment when the actual inflation rate equals the expected inflation rate.
Figure illustrates the long-run Phillips curve (LRPC), which is vertical at the natural
unemployment rate.
Along LRPC, a change in the inflation rate is expected, so the unemployment rate
remains at the natural unemployment rate.

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The SRPC intersects the LRPC at the expected inflation rate—10 percent a year in the
figure.
Change in Expected Inflation
If expected inflation falls to 6 percent a year, ...
the short-run Phillips curve shifts downward by an amount equal to the fall in the
expected inflation rate.
Change in the Natural Unemployment Rate
A change in the natural unemployment rate shifts both the long-run and short-run
Phillips curves.

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