MACROECONOMICS Andrew B. Abel Ben S. Bernanke Dean Croushore Authorized adaptation from the United States edition, entitled, Macroeconomics, Eighth Edition, ISBN 9780132992282, by Andrew B. Abel, Ben S. Bernanke, Dean Croushore, published by Pearson Education Inc.© 2014, Pearson Education Inc. Indian Subcontinent Version © 2014 Dorling Kindersley (India) Pvt. Ltd All rights reserved. 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Table of Contents (cid:18)(cid:15)(cid:1)(cid:42)(cid:79)(cid:85)(cid:83)(cid:80)(cid:69)(cid:86)(cid:68)(cid:85)(cid:74)(cid:80)(cid:79)(cid:1)(cid:85)(cid:80)(cid:1)(cid:46)(cid:66)(cid:68)(cid:83)(cid:80)(cid:70)(cid:68)(cid:80)(cid:79)(cid:80)(cid:78)(cid:74)(cid:68)(cid:84) 1 (cid:19)(cid:15)(cid:1)(cid:49)(cid:83)(cid:80)(cid:69)(cid:86)(cid:68)(cid:85)(cid:74)(cid:87)(cid:74)(cid:85)(cid:90)(cid:13)(cid:1)(cid:48)(cid:86)(cid:85)(cid:81)(cid:86)(cid:85)(cid:13)(cid:1)(cid:66)(cid:79)(cid:69)(cid:1)(cid:38)(cid:78)(cid:81)(cid:77)(cid:80)(cid:90)(cid:78)(cid:70)(cid:79)(cid:85) 23 (cid:20)(cid:15)(cid:1)(cid:36)(cid:80)(cid:79)(cid:84)(cid:86)(cid:78)(cid:81)(cid:85)(cid:74)(cid:80)(cid:79)(cid:13)(cid:1)(cid:52)(cid:66)(cid:87)(cid:74)(cid:79)(cid:72)(cid:13)(cid:1)(cid:66)(cid:79)(cid:69)(cid:1)(cid:42)(cid:79)(cid:87)(cid:70)(cid:84)(cid:85)(cid:78)(cid:70)(cid:79)(cid:85) 71 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(cid:18)(cid:20)(cid:15)(cid:1)(cid:46)(cid:80)(cid:79)(cid:70)(cid:85)(cid:66)(cid:83)(cid:90)(cid:1)(cid:49)(cid:80)(cid:77)(cid:74)(cid:68)(cid:90)(cid:1)(cid:66)(cid:79)(cid:69)(cid:1)(cid:85)(cid:73)(cid:70)(cid:1)(cid:39)(cid:70)(cid:69)(cid:70)(cid:83)(cid:66)(cid:77)(cid:1)(cid:51)(cid:70)(cid:84)(cid:70)(cid:83)(cid:87)(cid:70)(cid:1)(cid:52)(cid:90)(cid:84)(cid:85)(cid:70)(cid:78) 519 (cid:18)(cid:21)(cid:15)(cid:1)(cid:40)(cid:80)(cid:87)(cid:70)(cid:83)(cid:79)(cid:78)(cid:70)(cid:79)(cid:85)(cid:1)(cid:52)(cid:81)(cid:70)(cid:79)(cid:69)(cid:74)(cid:79)(cid:72)(cid:1)(cid:66)(cid:79)(cid:69)(cid:1)(cid:42)(cid:85)(cid:84)(cid:1)(cid:39)(cid:74)(cid:79)(cid:66)(cid:79)(cid:68)(cid:74)(cid:79)(cid:72) 567 (cid:42)(cid:79)(cid:69)(cid:70)(cid:89) 607 Introduction to Macroeconomics 1 What Macroeconomics Is About Summarize the Macroeconomics is the study of the structure and performance of national primary issues economies and of the policies that governments use to try to affect economic addressed in performance. The issues that macroeconomists address include the following: macroeconomics. (cid:81)(cid:3) What determines a nation’s long-run economic growth? In 1890, income per capita was smaller in Norway than in Argentina. But today, income per capita is almost three times as high in Norway as in Argentina. Why do some nations’ economies grow quickly, providing their citizens with rapidly improving living standards, while other nations’ economies are relatively stagnant? (cid:81)(cid:3) What causes a nation’s economic activity to fluctuate? The 1990s exhibited the longest period of uninterrupted economic growth in U.S. economic history, but economic performance in the 2000s was much weaker. A mild recession in 2001 was followed by a weak recovery that lasted only until December 2007. The recession that began at the end of 2007 was worsened by the finan- cial crisis in 2008, which contributed to a sharp decline in output at the end Learning Objectives of 2008 and in early 2009. Why do economies sometimes experience sharp 1 Summarize the short-run fluctuations, lurching between periods of prosperity and periods of hard times? primary issues (cid:81)(cid:3) What causes unemployment? During the 1930s, one-quarter of the work force in addressed in the United States was unemployed. A decade later, during World War II, less macroeconomics. than 2% of the work force was unemployed. Why does unemployment some- 2 Describe the times reach very high levels? Why, even during times of relative prosperity, is a significant fraction of the work force unemployed? activities and (cid:81)(cid:3) What causes prices to rise? The rate of inflation in the United States crept objectives of steadily upward during the 1970s, and exceeded 10% per year in the early macroeconomists. 1980s, before dropping to less than 4% per year in the mid 1980s and drop- 3 Differentiate ping even further to less than 2% per year in the late 1990s. Germany’s infla- tion experience has been much more extreme: Although Germany has earned between the classical a reputation for low inflation in recent decades, following its defeat in World and Keynesian War I Germany experienced an eighteen-month period (July 1922–December approaches to 1923) during which prices rose by a factor of several billion! What causes macroeconomics. inflation, and what can be done about it? From Chapter 1 of Macroeconomics, Eighth Edition. Andrew B. Abel, Ben S. Bernanke, Dean Croushore. Copyright © 2014 by Pearson Education, Inc. All rights reserved. 2 Introduction to Macroeconomics (cid:81)(cid:3) How does being part of a global economic system affect nations’ economies? In the late 1990s, the U.S. economy was the engine of worldwide economic growth. The wealth gained by Americans in the stock market led them to increase their spending on consumer goods, including products made abroad, spur- ring greater economic activity in many countries. How do economic links among nations, such as international trade and borrowing, affect the perfor- mance of individual economies and the world economy as a whole? (cid:81)(cid:3) Can government policies be used to improve a nation’s economic performance? In the 1980s and 1990s, the U.S. economy’s output, unemployment rate, and inflation rate fluctuated much less than in the 1960s and 1970s. Some econo- mists credit good government policy for the improvement in economic per- formance. In the financial crisis of 2008, the Federal Reserve and the federal government used extraordinary measures to keep banks and other financial institutions from failing. But some economists criticized these measures for going too far in trying to stabilize the economy, at the expense of creating incentives for increased risk taking by financial firms. Other economists criti- cize the Federal Reserve for not going far enough because the unemployment rate remained persistently high for years after the end of the recession in 2009. How should economic policy be conducted to keep the economy as prosper- ous and stable as possible? Macroeconomics seeks to offer answers to such questions, which are of great practical importance and are constantly debated by politicians, the press, and the public. In the rest of this section, we consider these key macroeconomic issues in more detail. Long-Run Economic Growth If you have ever traveled in a developing country, you could not help but observe the difference in living standards relative to those of countries such as the United States. The problems of inadequate food, shelter, and health care experienced by the poorest citizens of rich nations often represent the average situation for the people of a developing country. From a macroeconomic perspective, the difference between rich nations and developing nations may be summarized by saying that rich nations have at some point in their history experienced extended periods of rapid economic growth but that the poorer nations either have never experienced sustained growth or have had periods of growth offset by periods of economic decline. Figure 1 summarizes the growth in output of the U.S. economy since 1869.1 The record is an impressive one: Over the past 142 years, the annual output of U.S. goods and services has increased by more than 125 times. The performance of the U.S. economy is not unique, however; other industrial nations have had similar, and in some cases higher, rates of growth over the same period of time. This mas- sive increase in the output of industrial economies is one of the central facts of modern history and has had enormous political, military, social, and even cultural implications. In part, the long-term growth of the U.S. economy is the result of a rising pop- ulation, which has meant a steady increase in the number of available workers. 1Output is measured in Fig. 1 by two very similar concepts, real gross national product (real GNP) until 1929 and real gross domestic product (real GDP) since 1929, both of which measure the physical volume of production in each year. Introduction to Macroeconomics 3 MyEconLab Real-time data FIGURE 1 Output of the U.S. uts) 14 2007–2009 economy, 1869–2011 par recession Ionf tthheis U g.rSa.p ehc othneo mouyt pisu t eal out05 doll 12 rec2e0s0s1ion R0 measured by real gross 2 domestic product (real d) 1990–1991 e 10 n recession GDP) for the period ai h 1929–2011 and by real c 1981–1982 gross national product of ( 8 recession (real GNP) for the period ns 1973–1975 o panrido rs etorv 1ic9e2s9 ,v waliuthed g oaot ds (trilli 6 recession their 2005 prices in both World War II cases. Note the strong 4 Great Depression (1941–1945) REAL (1929–1940) upward trend in output OUTPUT over time, as well as World War I 2 (1917–1918) sharp fluctuations during the Great Depression (1929–1940), World 0 1860187018801890190019101920193019401950196019701980199020002010 War II (1941–1945), Year and the recessions of 1973–1975, 1981–1982, 1990–1991, 2001, and But another significant factor is the increase in the amount of output that can be 2007–2009. produced with a given amount of labor. The amount of output produced per unit Sources: Real GNP 1869–1928 of labor input—for example, per worker or per hour of work—is called average from Christina D. Romer, “The Prewar Business Cycle labor productivity. Figure 2 shows how average labor productivity, defined in Reconsidered: New Estimates this case as output per employed worker, has changed since 1900. In 2011, the of Gross National Product, average U.S. worker produced more than seven times as much output as the 1869–1908,” Journal of Political Economy, 97, 1 (February 1989), average worker at the beginning of the twentieth century, despite working fewer pp. 22–23; real GDP 1929 hours over the course of the year. Because today’s typical worker is so much more onward from FRED database, productive, Americans enjoy a significantly higher standard of living than would Federal Reserve Bank of St. Louis, research.stlouisfed.org/ have been possible a century ago. fred2/series/GDPCA. Data from Although the long-term record of productivity growth in the U.S. economy is Romer were rescaled to 2005 excellent, productivity growth slowed from the early 1970s to the mid-1990s and prices. only recently has picked up. Output per worker grew about 2.5% per year from 1949 to 1973, but only 1.1% per year from 1973 to 1995. More recently, from 1995 to 2011, output per worker has increased 1.7% per year, a pace that has improved the health of the U.S. economy significantly. Because the rates of growth of output and, particularly, of output per worker ultimately determine whether a nation will be rich or poor, understanding what determines growth is one of the most important goals of macroeconomics. Unfortunately, explaining why economies grow is not easy. Why, for example, did resource-poor Japan and Korea experience growth rates that transformed them in a generation or two from war-torn nations into industrial powers, whereas several resource-rich nations of Latin America have had erratic or even negative growth in recent years? Although macroeconomists have nothing close to a complete answer to the question of what determines rates of economic growth, they do have some ideas to offer. For example, most macroeconomists believe that rates of saving and investment are important for growth. Another key determinant of growth we discuss is the rate at which technological change and other factors help increase the productivity of machines and workers. 4 Introduction to Macroeconomics MyEconLab Real-time data FIGURE 2 Average labor ers)100 pSrtoadteusc, t1iv9i0t0y– i2n0 t1h1e United workollar 90 d Average labor productiv- ed 05 ity (output per employed oy20 80 worker) has risen over mpled) tWinimgo reiln,d wc rWietaahsr ae Id Ip reweafaklre tdcitmu-rein g put per eof (chain 6700 production. Productivity utds 50 World War II on gstrroowngth i nw tahse p 1a9r5ti0csu alanrdly Real housa 40 GDerepartession 1p9ro7d0usctivity 1960s, slowed in the (t slowdown 30 1970s, and picked up again in the mid 1990s. 1950s–1960s 20 productivity For the calculation of speedup productivity, output is 10 AVERAGE LABOR measured as in Fig. 1. PRODUCTIVITY 0 Sources: Employment in thou- 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 sands of workers 14 and older Year for 1900–1947 from Historical Statistics of the United States, Colonial Times to 1970, pp. 126–127; workers 16 and Business Cycles older for 1948 onward from FRED database, Federal If you look at the history of U.S. output in Fig. 1, you will notice that the growth Reserve Bank of St. Louis, research.stlouisfed.org/fred2/ of output isn’t always smooth but has hills and valleys. Most striking is the period series/ CE16OV. Average labor between 1929 and 1945, which spans the Great Depression and World War II. productivity is output divided During the 1929–1933 economic collapse that marked the first major phase of the by employment, where output is from Fig. 1. Great Depression, the output of the U.S. economy fell by nearly 30%. Over the pe- riod 1939–1944, as the United States entered World War II and expanded produc- tion of armaments, output nearly doubled. No fluctuations in U.S. output since 1945 have been as severe as those of the 1929–1945 period. However, during the postwar era there have been periods of unusually rapid economic growth, such as during the 1960s and 1990s, and times during which output actually declined from one year to the next, as in 1973–1975, 1981–1982, 1990–1991, and 2007–2009. Macroeconomists use the term business cycle to describe short-run, but some- times sharp, contractions and expansions in economic activity.2 The downward phase of a business cycle, during which national output may be falling or perhaps growing only very slowly, is called a recession. Even when they are relatively mild, recessions mean hard economic times for many people. Recessions are also a major political concern because almost every politician wants to be reelected and the chances of reelection are better if the nation’s economy is expanding rather than declining. Macroeconomists put a lot of effort into trying to figure out what causes business cycles and deciding what can or should be done about them. Macroeconomics can describe a variety of features of business cycles, com- pare alternative explanations for cyclical fluctuations, and evaluate the policy options that are available for affecting the course of the cycle. 2Business cycles do not include fluctuations lasting only a few months, such as the increase in activity that occurs around Christmas. Introduction to Macroeconomics 5 MyEconLab Real-time data FIGURE 3 The U.S. unemployment rate, 1890–2011 nte) 30 The figure shows the oymer forc DeGprreeassti on percentage of the civilian plbo lptahebaootp rwl efao isrn cu etnh (eeem xmcpliulloidtyainerydg) Unemvilian la 25 1d8e9p0resssion in each year since 1890. f ci 20 UNEMPLOYMENT o RATE Unemployment peaked nt 1990–1991 during the depression ce 1981–1982 recession of the 1890s and the per 15 recession Great Depression of ( 1973–1975 2007–2009 recession recession the 1930s, and reached low points in 1920 and 10 World War II 2001 recession during World War II. Since World War II, the highest unemployment 5 rates occurred during the 1981–1982 and 2007–2009 recessions. 0 Sources: Civilian unemploy- 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 ment rate (people aged 14 and Year older until 1947, aged 16 and older after 1947) for 1890–1947 from Historical Statistics of the United States, Colonial Times to Unemployment 1970, p. 135; for 1948 onward from FRED database Federal Reserve Bank of St. Louis, One important aspect of recessions is that they usually are accompanied by an research.stlouisfed.org/fred2/ increase in unemployment, or the number of people who are available for work series/UNRATE. and are actively seeking work but cannot find jobs. Along with growth and business cycles, the problem of unemployment is a third major issue in macroeconomics. The best-known measure of unemployment is the unemployment rate, which is the number of unemployed divided by the total labor force (the number of people either working or seeking work). Figure 3 shows the unemployment rate in the United States over the past century. The highest and most prolonged period of unemployment occurred during the Great Depression of the 1930s. In 1933, the unemployment rate was 24.9%, indicating that about one of every four potential workers was unable to find a job. In contrast, the tremendous increase in economic activity that occurred during World War II significantly reduced unemployment. In 1944, at the peak of the wartime boom, the unemployment rate was 1.2%. Recessions have led to significant increases in unemployment in the postwar period. For example, during the 1981–1982 recession the U.S. unemployment rate reached 10.8%.3 Even during periods of economic expansion, however, the unem- ployment rate remains well above zero, as you can see from Fig. 3. In 2000, after nine years of economic growth with no recession, the unemployment rate was still about 4%. Why the unemployment rate can remain fairly high even when the econ- omy as a whole is doing well is another important question in macroeconomics. 3The unemployment rate was 10.8% in November and December 1982. The unemployment rate plotted in Fig. 3 is not this high because the graph only shows annual data—the average unemployment rate over the 12 months of each year—which was 9.7% in 1982.