Chapter III: National Income and Macroeconomic Policies

Chapter III: National income
and macroeconomic policies

A. Global production potentials
B. Supply-side orientation
C. Business cycles and
macroeconomic policies
D. Demand management
Goethe Business School
GDP by country (2005)
Source: Students of the World/

Worldbank
Source: The Worldbank
Correction for PPP leads

to dramatic change
12000
10000
8000
6000
4000
2000
0
PPP
In 2004 dollars
In 2004 dollars
PPP
Source: Worldbank;
CIA - World Facts
Shares of world GDP

according to PPP
Regional Distribution of World GDP 2004 (est.)
World GDP (est.) = $55.5 trillion PPP

Source: CIA - World Facts
4
GDP per capita 2005

Luxembourg
Norway
Switzerland
Denmark
Iceland
United States
Sweden
Ireland
Japan
United Kingdom
Finland
Austria
High income: OECD
Netherlands
Belgium
High income
France
Germany
Canada
Australia
European Monetary Union
Italy
Source: Students of the World/

Worldbank
Hong Kong, China

Singapore
New Zealand
Spain
10000
20000
30000
40000
50000
60000
70000
Growth competitiveness
index ranking 2004
Source: World Economic Forum
Example: the United States
7
Reading
Reading 3-1
The quest for prosperity,
Extract from a Special Report on the EU
The Economist, March 2007
8
Production function
Traditionally macroeconomic analysis

has emphasized the supply side
(Adam Smith: The Wealth of the Nations)
The focus is on the production function
and its various inputs
A typical production function looks as follows:
GDPs = f (Labor, Capital, Energy | Environmt, )
Production functions must be interpreted
in a dynamic fashion ( is here for technological
and organizational innovations and change)
9
A simple production function

100 billion hours of
labor can produce
$10 trillion of real
GDP at point A
300 billion hours of

labor can produce
$12 trillion of real
GDP at point C
10
Production function and

marginal productivity of labor
From the production function, we can

derive the marginal product of labor
(marginal productivity) for a fixed amount
of capital and other inputs
It is defined as the additional product
obtained from increasing a given amount
of labor by one hour
GDP = f (Labor;Capital)
11
Marginal product
of labor
For fixed capital,

the marginal product
of labor must fall
12
Marginal product and

the demand for labor
From the marginal product of labor, we derive

the quantity of labor demand, all other influences
on firms plans remaining the same
Other inputs and technology being fixed,
an employer will only hire an hour of labor
if the output from that hour (the last hour of labor
input) is at least as great as the cost of hiring
that hour of labor the real wage
The lower the real wage rate (W/P = ),
the greater is the quantity of labor demanded
13
The demand
for labor function
14
The labor supply function
The labor supply function determines the

relationship between the quantity of labor
supplied and the real wage rate when all
other influences on work plans remain the
same
Labor supply hinges on two effects:
A price (or substitution) effect
An income effect
15
Price and income effects
Price effect:
If the real wage increases, leisure (not working)
has become more expensive, so we expect
people to consume less leisure, work more,
i.e. supply more labor hours
Income effect:
With a higher real wage, people have a higher
income. If leisure is a normal good, we expect
people consuming more of it,
i.e. work less, supply fewer labor hours
In the aggregate the price effect dominates
16
The supply for labor function
17
The labor market
18
Reading
Abel, Bernanke, Croushore, Chapter 3

(only 3.1 through 3.3, including Application)
19
Real and nominal GDP
Macroeconomists divide the variables

describing macroeconomic performance
into two lists:
Real variables
Nominal variables
Real GDP is measured

in constant prices of a base period
Nominal GDP is measured
in current prices
20
Price deflator
The ratio
GDPnominal / GDPreal = Price deflator
The price deflator is an aggregate
measure of the price level
The measurement of price development
will be dealt with later when discussing
inflation
For the time being we shall focus on real
GDP supply and demand
21
The supply side orientation is also

relevant for the firm as it explains
its demand for factors of production
In addition the firm has to focus on
its market and observe its evolution
Business cycles
and macroeconomic policies
Having sketched the macroeconomic

constraints in real terms and its financing,
we now turn to macroeconomic policies
GDP can be seen from two sides:
GDPs (supply) and GDPd (demand)
Ex post, GDPs must always equal GDPd
(inventories are part of investment,
whether voluntary or involuntary)
23
Potential and effective GDP
Economic potential is measured assuming

full employment of resources
GDPpot = f (Laborfully employed, Capitalfully employed)
The term fully employed must be interpreted
and is highly controversial
The could be full employment
side by side with structural unemployment
Economists therefore prefer to speak
of natural employment and natural output
24
Economic fluctuations
When the economy is operating at full

potentials, the forces determining the real
variables are independent of those
determining the nominal variables
Away from the natural rate of employment,
real and monetary forces interact to bring
economic fluctuations
25
Potential GDP in the U.S.

Potential GDP
provides the
anchor
around
which real
GDP
fluctuates in
a business
cycle
26
The output gap

The output gap is
the difference between
actual and potential
GDP relative to GDP
27
AS-AD model
The AS-AD model explains the fluctuations

around potential GDP. This is a very broad,
metaphor-like, model that gives us a story to
understand the macro economys behavior
The AS-AD model has three components:
Aggregate supply
Aggregate demand
Macroeconomic equilibrium
28
Structure
of the macro economy
Money
market
Product
markets
Keynes
Modell
Aggreg.
demand
Macro
model
Business
cycle
Aggreg.
supply
29
The AS-AD Model (1)

Aggregate supply
It shows the relationship between the quantity of

real GDP supplied and the price level all other
influences on production plans remain the same
Other things remaining the same, the higher
the price level, the greater is the quantity of real
GDP supplied, and the lower the price level,
the smaller is the quantity of real GDP supplied
30
The monetarist supply curve
An extreme position renders supply totally

dependent on available resource
potentials using the production function
Given that potential, the supply of goods
and services is then fixed
This position is taken by many
economists, at least for the longer term
31
The supply curve

in the short run
Profits on a unit of output equal

the price for the unit minus costs
In the short run, these costs are often fixed
(wages, raw materials)
An increase of the price level therefore
leads to an expansion of profits
This encourages entrepreneurs to expand output
in the short run
The aggregate supply curve is upward sloping
32
Aggregate supply
in the short run
33
GDP supply and potential

Potential
GDP is $10
trillion and
when the
price level
is 110,
real GDP
equals
potential
GDP
34
Deviation from potential (1)

If the price
level is above
110, real
GDP exceeds
potential
GDP
35
Deviation from potential (2)

If the price
level is below
110, real
GDP is less
than potential
GDP
36
Changes in aggregate supply
Aggregate supply changes

when potential GDP changes
As potential GDP increases, aggregate supply
increases and the AS curve shifts rightward
Aggregate supply also changes when the money
wage rate or any other input cost in money
terms, such as the price of oil, changes
A rise in the money wage rate or in the price of
oil raises firms costs, decreases aggregate
supply, and shifts the AS curve leftward
37
Aggregate supply and costs

Price level
An increase of costs
will shift the aggregate
supply curve to the left
Aggregate output
38
Supply shocks
Example: The oil crisis
In the fall of 1973 the Organization of Petroleum

Exporting Countries (OPEC) imposed an oil
embargo and increased the price of crude oil
by a factor of four
It lead to a shortage of energy and
(given the technology of production at that time) to a
suboptimal allocation of factors of production
This entailed severe productivity losses
39
Effects
of a supply shock (1)
A
GDP0
Y(L | K0, E0)

Y(L | K0, E1)
GDP2
The short run

production function
GDP1
L
B
Ls ( )
Ld 0( )
Ld1 ( )
D
L1
L2
L0
L
40
Effects
The reduction of energy consumption

from E0 to E1 will toss the production function
downwards
With less energy, the factor labor will become
less productive
The marginal product of labor falls for every
level of output, and the demand for labor
function shifts to the left
41
Effects
The supply shock will also lower the equilibrium real

wage rate
If the original real wage 0is maintained, it must entail
unemployment as large as U (or L0 - L1)
Production is now at point C and employment at L1
But in the longer run, goods prices will increase, which
lowers the real wage ( = W/P) even though the nominal
wage W is sticky
It leads to the new long run equilibrium at point D with
employment L2, and a lower production level GDP2 (point
E)
42
Long term equilibrium

after the shock
P
AS1
AS0
In the long run:
Output falls.
As prices increase,
(W/P) will fall
even if W = constant
P1
P0
Y1
Y0
Y
43
Dynamic adjustment
of growth path
GDP
Growth path of GDP
without restriction
New growth path

after oil shock
1973
Time
44
Oil crisis and thereafter
During the 1970s, all members of the Organization

for Economic Cooperation and Development (OECD)
experienced large public budget deficits

(expansionary fiscal policy)
There was worldwide inflation,

which indicates that monetary policy was
accommodating (expansionary monetary policy)
These policies would soften the hard budget
constraint, and were financed through the
recycling of petro-dollars and debt
45
Oil crisis and

structural adjustment
Expansionary fiscal and monetary policies are however

not sustainable
OECD economies had to adjust to the new conditions in
the global economy
As this structural adjustment takes place, the production
function changes
This will compensate some of the static losses of the oil
shock, and could even be beneficial in that a higher
dynamic growth path is obtained
So shocks are often healthy as they incite creativity
and innovation
46
The AS-AD Model (2)

Aggregate demand
Aggregate demand is the relationship between

the quantity of real GDP demanded and the
price level when all other influences on
expenditure plans remain the same
Other things remaining the same the higher
the price level, the smaller is the quantity of real
GDP demanded, and the lower the price level,
the greater is the quantity of real GDP
demanded
47
Aggregate demand
This figure
shows
aggregate
demand
schedule and
aggregate
demand
curve
48
Changes
in aggregate demand
Changes in the following factors will

change aggregate demand:
The interest rate

The quantity of money
Government purchases
Taxes
Real GDP in the rest of the world
Changes in sentiment or expectations
49
exists when the quantity of real
GDP demanded equals the
quantity of real GDP supplied at
the point of intersection of the
AD curve and the AS curve
50
If the economy was at point A,
firms would increase
production and raise prices
If the economy was at point E,
firms would decrease
production and cut prices
The economy moves to
macroeconomic equilibrium
51
Three types of
macro equilibrium
Natural employment equilibrium
When equilibrium real GDP
equals potential GDP or natural output
Above natural employment equilibrium

exceeds potential GDP or natural output
Below natural employment equilibrium

falls short of potential GDP or natural output
52
The business cycle

As the AD curve
fluctuates,
macroeconomic
equilibrium moves
along the AS curve and
traces out
three types of
macroeconomic
equilibrium
53
The business cycle

Recovery
log GDP
Boom
Trend
Recession
Depression
Time
54
The business cycle and fiscal

policy in Europe
55
Reading

(all, but excluding Application)
56
What could generate deviations

from GDP potential, and hence
business cycles?
57
Financing
and the real economy
Does financing have an impact

on the real economy?
Not, if we follow the classical theory
But this wisdom was put to severe test
During the Roaring Twenties
the US economy had expanded largely
on an expansion of credits
58
The Roaring Twenties

and the Fed
I generated a stock market boom (1928/29)

that created a dilemma for the Fed:
tempering the boom would have required
a higher discount rate;
the Fed hesitated to do that because
of legitimate credit needs
When the discount rate was finally raised

(August 1929), it was too late
59
Development
of Stock Market Index
60
The Bank Panic of 1930-33
Substantial withdrawals from banks ended

in a full-fledged panic toward the end of 1930
One bank after the other closed, but the Fed
did not perform its role as lender of last resort
It did not understand the impact of bank failures
on money supply and economic activity
Moreover there was political haggling that
entailed general policy inactivity
61
Repercussions
on the real economy
US Unemployment rate, 1929-1942
official series
25
Quelle: M.R.
Darby, Threeand-a-half
Million
Employees Have
been mislaid,
Journal of
political
Economy,
1976
20
15
10
Adjusted
series
1930
1935
Where have real resources gone?
1940
62
Impact on peoples life (1)

The Depression had
tremendous
repercussions
on peoples life:
Unemployment
Social hardship
Deprivation
Stress
63
Impact on peoples life (2)
Top CEOs had a especially hard time !

64
What dragged
the economy down?
Causes were
Increase of personal savings (and hence
a reduction of consumer spending) due to
a perceived reduction of personal wealth
Change in consumer behavior
due to higher unemployment
Reduction of housing investment
due to prior over-investment
Credit implosion with an induced reduction
of demand, notably fixed investment
65
Further problems ...
...resulted from second-round effects:

A general loss in consumers
and investors confidence
Change in spending behavior
due to insolvencies and bankruptcies
Disintermediation due to a lack of liquidity
Negative impact on public investment
due to a fall in tax revenue
Negative multiplier effects through
strategic trade policies (Smoot-Hawley)
66
Reading
(only 4.3)
Reading 3-2
J. Bradford DeLong,
Slouching Towards Utopia?:
Economic History of the Twentieth Century:
The Great Crash and the Great Slump,
February 1997 (not mandatory, but interesting)
67
A shift of emphasis
In macroeconomics, the Great Depression

caused a dramatic shift in emphasis
from the supply to the demand side
A new macroeconomic policy was initiated
by Roosevelts New Deal
Its theoretical foundations were laid
by Keynes in his famous General Theory
68
The New Deal
President Franklin D. Roosevelt

and his wife Eleanore
69
Two famous projects

of the New Deal
70
Manage demand!
JMK
71
The macroeconomic
policy framework
Fiscal policy
Monetary policy
Money
market
Product
markets
Keynes
Modell
Aggreg.
demand
Aggreg.
supply
Macro
model
Management
of the
macro
economy
72
How does
demand management function?
Keynes focuses
on two essential variables:
Income (GDP) and
The interest rate (cost of capital)
He neglects
The price level
The wage rate (cost of labor)
This was perfectly adequate for his time

73
Keynes
and the supply curve
If the AS
curve is
flat, a
variation
of the AD
changes
GDP at
constant
prices
74
Managing income:
an intuitive approach
For the market of goods and services,

Keynes looks at the fundamental identity:
Saving = Investment,
whereby
Saving = f1(Income)
Investment = f2(Interest rate)
Lets assume we start in equilibrium

with I = S
75
Initial macro equilibrium
I=
f2(Interest rate)
S=
f1(Income)
Lets assume there is a negative shock on I:

What will happen ex ante?
76
Disturbed equilibrium
I = -I
f2(Interest rate)
S=
f1(Income)
What will happen next if we do nothing?

77
Long run adjustment
As investment demand breaks away,

supply and demand of GDP
are no longer in balance
If we do nothing,
there will be a contraction of GDP supply,
hence income, which would reduce S
there will also be pressures on interest rates
as long as S > I, which would redress I
But these adjustments take time,

and they may be rather painful
78
Fiscal policy
Keynes proposal 1:
Wouldnt it be simpler if the government
compensates the shock by increasing
its expenditures by G ?
Compensation could also take the form
of a tax reduction -T to stimulate private
consumption C
In both instances there is a multiplier,
so that Y = mGG (or Y = -mTT),
where mG,mT > 1
79
Equilibrium restored (1)
Y( G)
I = -I
f2(Interest rate)
S=
f1(Income)
80
Monetary policy
Keynes proposal 2:
Wouldnt it be simpler if the central bank
compensates the shock by lowering
interest rates ?
How can the central bank do this?
By increasing the money supply !
Couldnt this trigger inflation?
Not during a depression !
81
Equilibrium restored
I = -I
f2(Interest rate)
S=
f1(Income)
82
Reading
Reading 3-3
A stimulating notion:
The idea of giving flagging economies
a fiscal boost is back in fashion
The Economist, Feb 14th 2008
83
Keynesianism and
econometric modeling
This intuitive approach to Keynesian

thinking is extremely simplified
But it is sufficient to understand demand
management in a nutshell
In practice there are complex multiplier
and reaction functions which are explored
through statistical analysis and
macro econometric modeling
84
Economic policy:
The Tinbergen approach
Econometric
Policy variable
MODEL Target variable
Taxes,
public outlays;
money supply
Income
level;
employment
;
price
stability
85
Reading
For a more formal analysis of the

macroeconomic model (IS-LM Model) read
This chapter is more rigorous than the
presentation in the course and is part of the
standard wisdom of economists
Nevertheless I consider it only voluntary
reading for those with a good intuition
88
What about
the labor market?
Keynes links the

demand for labor to the
production of goods and
services using the
production function
Once GDP is
determined via demand
management, the
quantity of labor demand
is obtained
89
Anticyclical policy
Anti-cyclical fiscal and monetary policies

use demand management to compensate
a business cycle that might result from
private sector economic activities
In a boom phase, the policy will become
restrictive, in a recession or depression it
will be expansionary
90
Anti-cyclical fiscal policy

Y
Hypothetical cycle
Multiplier effect
dG
Compensating fiscal policy
Compound result
Time
91
Anti-cyclical policies:
criticism
The following is said against fiscal and

monetary policies for managing demand:
Keynes assumptions are not realistic
Effective demand and employment are
disconnected (there are structural problems
in the labor market)
Practical problems of policy implementation
(reaction lags, behavioral changes)
Flaws in the political system, which is unable
to maintain fiscal discipline in the long run
92
Discussion 3:
Economic crises and the global firm
Could a crisis such as the Great

Depression reoccur in the global
economy?
Are there similarities with the crash
of the New Economy?
Do global firms need a global crisis
management?
93

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Chapter III: National Income and Macroeconomic Policies

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Chapter III: National income

and macroeconomic policies

GDP by country (2005)

Source: Students of the World/

Source: The Worldbank

Goethe Business School

Correction for PPP leads

Goethe Business School

Shares of world GDP

World GDP (est.) = $55.5 trillion PPP

GDP per capita 2005

Source: Students of the World/

Hong Kong, China

Goethe Business School

Source: World Economic Forum

Goethe Business School

Example: the United States

Traditionally macroeconomic analysis

A simple production function

300 billion hours of

Production function and

From the production function, we can

For fixed capital,

Marginal product and

From the marginal product of labor, we derive

The labor supply function

The labor supply function determines the

Price and income effects

The supply for labor function

The labor market

Abel, Bernanke, Croushore, Chapter 3

Real and nominal GDP

Macroeconomists divide the variables

Real GDP is measured

The supply side orientation is also

Having sketched the macroeconomic

Potential and effective GDP

Economic potential is measured assuming

When the economy is operating at full

Potential GDP in the U.S.

The output gap

The AS-AD model explains the fluctuations

The AS-AD Model (1)

It shows the relationship between the quantity of

The monetarist supply curve

An extreme position renders supply totally

The supply curve

Profits on a unit of output equal

GDP supply and potential

Deviation from potential (1)

Deviation from potential (2)

Changes in aggregate supply

Aggregate supply changes

Aggregate supply and costs

In the fall of 1973 the Organization of Petroleum

Y(L | K0, E0)

The short run

The reduction of energy consumption

The supply shock will also lower the equilibrium real

Long term equilibrium

New growth path

Oil crisis and thereafter

During the 1970s, all members of the Organization