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a. What is the equilibrium level of aggregate demand?
b. At that level , what would be i,s,g-t, m-x
c. If the economy were closed, what would be the equilibrium level of aggregate demand?
d. Opening the economy increases, decreases or leaves unchanged aggregate demand?
e. What is the MPC?
f. What is the multiplier?
g. If investment increased by $250, what would happen to AD if the economy were closed?
h. If the economy were ope, AD would increase by how much?
i. Verify your approach by determining GDP, i, s, g-t, m-x?
h. Suppose x falls to 0 would AD increase/ decrease/remain the same? By how much?
i. Suppose x increase by 100 and imports decrease by 30, what has happend to the currecny?
j. The new equilbrium would be?) defined in two quite different ways. It can be thought of as changes over time in aggregate or total real output an economy produces or it can be thought of in terms of a change over time in per capita real output. Even seemingly small rates of growth lead to substantial effects on the level of GDP when the growth rates are compounded over a number of years. It is these are compounded over a number of years. It is these small, but persistent, rates of economic grwoth that have allowed the industrialized countries of the world to achieve their present economic positions. Similarly, it is the small, but persistent, growth rates in per capita income that have created the high standard of living enjoyed, on average, by people living within these economies.
Several factors determine the rate of growth in an economy. Historically, the growth of inputs--capital, land, and labor--have been quite important. More recently, economic growth has largely been accounted for by increases in productivity. is determined by the resources available to an economy. Changes in these resources will change the _________. of an economy. Thus, increases or improvements in natural resources, the capital stock, the labor supply, or in the technologies that combine these inputs in productive ways will increase potential real output.
The effect of labor on potential real output is both straightforward and subtle. Any change in the number of people actually employed will change the amount of people actually employed will change the amount the economy actually produces. However, the number of people actually employed will be determined by the demand for labor, the supply of labor, expectations that demanders and suppliers have about price levels and real wages, and contracts between suppliers and demanders. When households and firms have the same expectations and contracts have fully adjusted to market conditions, the labor market will be in equilibrium. The amount of labor provided to the economy when this amount of labor is employed will determine the potential real output for the economy. Changes in the equlibrium level of employment in the labor market will lead to changes in potential real output. Not all persons will be employed when the labor market is in equilibrium, only those willing to work at the equilibrium real wage. When the labor market is in equilibrium, however, actual output and potential real output coincide. The important difference between an economy's response in the short run and the long run is that, in the long run, wages and prices are flexible and can respond to changes in market supplies and demands as well as to changes in the overall price level. In the short run, wages are sticky and cannot adjust fully to changes in supply and demand or to changes in the overall price level. The failure of prices and wages to adjust immediately in the short run and wages to adjust immediately in the short run means that adjustments occur in the actual output produced and, hence, in the the actual output produced and, hence, in the employment of labor and other resources. At times, therefore, actual real output will deviate from potential real output. Hence, both changes in output as well as changes in prices are an important part of the macroeconomic adjustment process. The frictional rate of unemployment represents a kind of natural rate to which the economy returns. It appears, however, that the natural unemployment rate increased from 1970 to 1990, and then, perhaps, decreased. Several reasons have been suggested for these changes: First, the composition of the labor force has shifted in the 1970s and 1980s toward younger workers and more women: both groups have traditionally had higher unemployment rates. Second, unemployment compensation has increased over time, thereby reducing the costs of being unemployed somewhat and increasing the rate of frictional unemployment as a consequence. Third, the increase in dual-income households has reduced the costs for one of the income earners to be unemployed. As a consequence, the frictional unemployment rate increased. Its apparent decline in the 1990s is more puzzling. Although fiscal and monetary policy appear to solve the problems of unemployment and inflation quite nicely, they are not simple to implement.
1. Shocks to the economy are not always easy to predict. As a consequence, it takes time to discover that an aggregate demand or aggregate supply shock has occurred.
2. Designing an appropriate policy requires knowledge of both the size of the shock to the economy and the magnitude of the effect on the economy that the policy response will have.
3. Appropriate stabilization policies must affect aggregate demand reasonably quickly and in predictable ways. In this regard, monetary policy, which can be implemented rapidly, affects the economy indirectly and slowly over time. Fiscal policy, which is usually difficult to implement rapidly, affects the economy directly and quickly.
Even if the appropriate responses to an economic shock are understood and are "in principle" possible, they may do little good in practice. The economy may be able to move to full employment more rapidly than a policy can be designed, implemented, and have an effect. Indeed, if the timing of countercyclical monetary and fiscal policy is off, they may actually exacerbate economic cycles. An individual's production possibilities depend upon individual skill, the tools available to the individual, training and acquired skills, work effort, and the technology that combines ability, skills, tools, and resources. Because these differ for different individuals, individuals will typically have different opportunity costs.
The ability to produce, the possible choices, and their costs can be represented by a production possibilities frontier. A PPF indicates the maximum amount that can be produced of any particular mix of goods and services. Teams are often more productive than individuals working alone. However, team production creates opportunities for individual workers to shirk. Shirking can be reduced, and the substantial gains from team production realized, if some people monitor the work effort of others. Since these monitors have, in turn, incentives to shirk ,firms are organized where there is a hierarchy of monitors. Thus, the typical pyramidal organization of a firm evolved to reduce or minimize the shirking problem. Likewise, the rich array of compensation schemes (e.g., wages, salaries, commissions, tips, bonuses, stock options, etc.) evolved as ways to eliminate or reduce the costs of shirking and monitoring. If the quantity demanded is greater than the quantity supplied at a particular price, there is excess demand. If the quantity demanded is less than the quantity supplied at a particular price, however, there is excess supply. If the market price increaes when there is excess demand, and decreases when there is excess supply, a market coordinates the differing interests of demanders and suppliers. Specifically, the price moves to equate the quantity that suppliers willingly provide to the market with the quantity that demanders want to purchase. When the price is such that there is neither excess demand nor excess supply, the amount that demanders wish to purchase will be equal to the amount that suppliers wish to sell: the market is in equilibrium at that price.
Changes in the desires of either suppliers or demanders will lead to predictable changes in price:
1. An increase in demand, if nothing else happens, will lead to an increase in the market price.
2. An increase in supply if nothing else happens will lead to a decrease in the market price.
3. A decrease in demand, if nothing else happens, will lead to a decrease in the market price.
4. A decrease in supply, if nothing else happens, will lead to an increase in the market price. An appreciation of an economy's currency in foreign exchange markets will make its exports appear more costly to foreigners and, generally, its exports will fall. Also, as just noted, an appreciation also makes imports from abroad appear less costly to domestic citizens, and, as a consequence, imports will increase. The combined effects of an appreciation, then, is that net exports will fall. If a country has balanced trade--that is, net exports are zero--then it will find itself with a trade deficit (net exports will be less than zero). If a country has a trade surplus--that is, its net exports are positive--the effect of the appreciation will be to reduce the size of the surplus.
A depreciation of an economy's currency in foreign exchange markets will have the opposite effect: net exports will increase. In this case, an economy with balanced trade will find that now has a trade surplus; one with a trade deficit will find that the deficit falls or is eliminated.
It follows that if a country's currency appreciates when it is running a trade surplus, the appreciation will tend to eliminate the surplus and if depreciation occurs when there is a trade deficit, the depreciation will tend to eliminate the deficit. For this reason, net exports can be persistently different from zero (e.g., negative) only if individuals in one economy choose to hold the currency or assets of another economy. When too little is produced because of a monopoly, the government can provide an incentive for the monopolist to increase its output, thereby moving the market toward the efficient level of output, by regulating the monopolist's prices.
Setting the maximum price that a monopoly can charge below what it would set on its own will force the monopolist to increase its output, as long as the marginal cost curve is below the demand curve. The maximum price is set below the point at which the marginal cost curve is equal to the demand curve, a monopolist will decrease its output and the quantity demanded will increase, thus creating a shortage. The efficient outcome can be obtained if the regulated price is set equal to marginal cost, as long as marginal cost is greater than or equal to average total cost.
For a natural monopoly, setting price equal to marginal cost will lead to losses because, in this case, marginal cost is less than average total cost. In this case, a regulatory agency has no choice but to set price at or above average total cost. If the regulated price is set equal to average total cost, a regulated natural monopoly will break even, but will not operate at the efficient scale.
Setting the regulated price equal to either marginal cost or average total cost is, in general, a difficult matter because a regulated firm's costs are not easy to observe. Externlaities arise because property rights are not clearly defined. If transaction costs are low, strategic bargaining problems avoidable, and private valulations accurate, then once property rights are clearly defined resources will move to the highest-valued use, thus eliminating externalities, regardless of to whom the property rights are assigned. Or, conversely, even when property rights are clearly defined, if transaction costs are high, strategic bargaining problems serious, or private valuations inaccurate, resources might not move to the highest-valued use. In this case, externalities might not be eliminated without more, direct public policy responses. When information is imperfect, either inherently or because searching is too costly, decisions will bem ade in partial ignorance. This creates uncertainty or risk. The degree to which individuals prefer less risk will be reflected by a demand for insurance against the risk. A supply of insurance is possible if some people are tolerant of risks and become speculators who are willing to assume risks for some payment. A supply of insurance is also possible if risks can be pooled so that firms can take advantage of the law of large numbers. However, certain kinds of risks, notably those that are not independent, and certain kinds of behavior, notably moral-hazard or adverse-selection, make it more difficult to supply insurance. In some cases, these difficulties can be overcome by selecting risk pools carefully, by offering contracts with deductibles, by requiring coinsurance, or by all-or-nothing insurnace pools. Not everyone who is out of work is unemployed. In order to be counted as unemployed you have to be out of work, looking for work, and able to accept a job if one is offered to you. If you are out of work and not looking, then you are considered "not in the labor force" rather than unemployed.
We tend to think of unemployment as an undesirable thing, but a certain amount of unemployment is actually part of a healthy economy. Structural unemployment occurs when new industries are created and old industries become obsolete. For example, when we moved from using horses and buggies to using cars to get around, this put a lot of buggy makers in the structurally unemployed category
.
Frictional unemployment might not seem very fun, but consider what it means to have zero unemployment—nobody ever looks for a job, they just remain in whatever job they are given! In fact, a number of dystopian novels have been written in which everyone in a society is automatically assigned a fixed career (such as the Divergent series). Those societies have zero frictional unemployment, but they are also quite unpleasant if you are unhappy with that career!
A decrease in the unemployment rate isn't necessarily a sign of an improving economy. When people stop looking for jobs and drop out of the labor force as discouraged workers, the unemployment rate will decrease even though the true employment situation hasn't gotten any better. This is why it is important to look at both changes in the unemployment rate and changes in the labor force participation rate. Looking at both changes let's you get a more complete idea about changes in the employment situation. Think of this formula this way—any rate of change (such as the rate of change of prices, which is what the inflation rate is measuring) can be calculated as: "new minus old, over old":
\text{Rate of change} = \dfrac{\text{new value}-\text{old value}}{\text{old value}} \times 100\%Rate of change=
old value
new value−old value
​ ×100%R, a, t, e, space, o, f, space, c, h, a, n, g, e, equals, start fraction, n, e, w, space, v, a, l, u, e, minus, o, l, d, space, v, a, l, u, e, divided by, o, l, d, space, v, a, l, u, e, end fraction, times, 100, percent.
Suppose that you had previously calculated that the CPI in 2015 is 175 and the CPI in 2016 is 183. We calculate the rate of inflation between 2015 and 2016 as
\begin{aligned} \text{Rate of inflation} &= \dfrac{183-175}{175}\\\\ & = 4.57\%\end{aligned}
Rate of inflation
​
=
175
183−175
​
=4.57%
​ Real variables are nominal variables deflated by the price level. Examples of real variables are a real wage or a real interest rate. For instance, the sign at the bank says that they are paying 8\%8%8, percent interest, but what are really earning?
If we want to find the real interest rate (the one that reflects what people are actually earning on money deposited in the bank), then we want to take away the effect of inflation. We do so because inflation reduces the purchasing power of the money deposited.
If the interest rate the bank gives us (the nominal interest rate) is 8\%8%8, percent, but the rate of inflation is 5\%5%5, percent, we are really earning 8\%-5\%=3\%8%−5%=3%8, percent, minus, 5, percent, equals, 3, percent on the money that we put in the bank. Why? Because that is how much more we can buy when we take our money out after a year. If there is 2\%2%2, percent inflation every year for five years, then after ten years the price level has gone up to 20\%20%20, percent, right? No! Inflation compounds over time. For example, suppose a chicken coop costs \$100$100dollar sign, 100 and there is 2\%2%2, percent inflation, that means that after a year the chicken coop will cost \$102$102dollar sign, 102. If inflation continues at 2\%2%2, percent for another year, the \$102$102dollar sign, 102 grows by 2\%2%2, percent, not the original price. In fact, if there is 2\%2%2, percent inflation every year for 10 years, the chicken coop will cost \$121.90$121.90dollar sign, 121, point, 90, 21.9\%21.9%21, point, 9, percent more than the original price.
The term "index" might sound strange, but an index is simply any measure that compares a value in one period to the value in a base year.
Another common misperception is that once we calculate the CPI, we have the rate of inflation between any two years. That is a necessary step, but it is not the final step. We must then use the CPI in both years to calculate the rate of inflation.
There are actually several different price indices used to calculate the rate of inflation. The CPI is the one that is used to calculate the official rate of inflation, which is why you'll often hear it reported in the news. Nominal GDP is a measure of how much is spent on output. For example, in Canada during 2015, \text{CAN }\$1,994.9\text{ billion}CAN $1,994.9 billionC, A, N, space, dollar sign, 1, comma, 994, point, 9, space, b, i, l, l, i, o, n was spent on the goods and services produced in Canada. Nominal GDP measures aggregate output (meaning the value of all of the final goods and services produced) using current prices. In other words, these figures reflect the amount spent on Canada's output in the country's prices in 2015. Real GDP is a measure of how much is actually produced. Real GDP measures aggregate output using constant prices, thus removing the effect of changes in the overall price level. For example, in 2015 the value of Canada's output expressed in constant 2010 prices was \text{CAN }\$1,857\text{ bilion}CAN $1,857 bilionC, A, N, space, dollar sign, 1, comma, 857, space, b, i, l, i, o, n.
Here's another way to think about Real GDP: if we add up all of the output that was produced in Canada during 2015 by using the prices that these goods sold for in 2010, the value of GDP in Canada is \$1,857\text{ billion}$1,857 billiondollar sign, 1, comma, 857, space, b, i, l, l, i, o, n. But if we add up all of the output that was produced in Canada during 2015, using the prices that they sold for in 2015, the value of GDP in Canada is \$1,995\text{ billion}$1,995 billiondollar sign, 1, comma, 995, space, b, i, l, l, i, o, n. This means prices must have increased between 2010 and 2015.
However, there is a slight problem with the method above. Calculating real GDP by weighting final goods and services by their prices in a base year can lead to an overstatement of real GDP growth because the prices of some goods decrease over time. Therefore, this method overstates growth in real GDP because it makes it seem like goods make up a bigger share of spending than they really do. Another method of calculating real GDP involves converting nominal GDP to real GDP by using the GDP deflator, which tracks price changes of a nation's output over time. Canada's GDP deflator for its base year of 2010 was 100100100 since this is the year against which prices are compared. By 2015 the deflator had increased to 107.4107.4107, point, 4, indicating that the average prices of Canada's output had increased by 7.4\%7.4%7, point, 4, percent.
By expressing 2015's output in 2015 prices, therefore, Canada's output would appear to have increased by 7.4 more than it actually did. Canada's nominal GDP, which has been "inflated" by higher prices, can be "deflated" by dividing the country's nominal GDP of \text{CAN }\$1,994 \text{ billion}CAN $1,994 billionC, A, N, space, dollar sign, 1, comma, 994, space, b, i, l, l, i, o, n by the deflator expressed in hundredths. The output gap is the difference between actual output and potential output in the business cycle. Potential output is what a nation could be producing if all of its resources were being used efficiently. In the business cycle model, a nation's potential output at any given time is represented as the long-run growth trend.
Output gaps exist whenever the current amount that a nation is producing is more or less than potential output. In the business cycle model, whenever the business cycle curve is above the growth trend that means an economy is experiencing a positive output gap. Whenever the business cycle curve is below the growth trend that means the economy is experiencing a negative output gap.
When actual output is above the potential output, aggregate demand has grown faster than aggregate supply, causing the economy to overheat. Overheating in this instance means output is occurring at an unsustainably high level, at which the unemployment rate is lower than the natural rate of unemployment. Eventually, the business cycle will reach a peak and enter a recession.
When actual output is below the potential output, aggregate demand or aggregate supply have fallen, causing a fall in employment and output. When a negative output gap exists, the unemployment rate will be higher than the natural rate of unemployment. Eventually, the business cycle will reach a trough and enter a recovery and expansion. An expansion is not necessarily economic growth. When an economy is recovering from a recession, it is in the expansion phase of the business cycle, but it is not experiencing economic growth. Economic growth occurs when the potential and actual output of a nation increases over time. That growth is either shown by the dashed, upward-sloping trend line (the growth trend) in the business cycle model, or by an outward shift of the PPC. [Explain]
\$2dollar sign, 233\$1.9dollar sign, 1, point, 9
\$2dollar sign, 2
An economy can produce beyond its full employment level of output. Resources can be overutilized, such as workers working very, very long hours. However, as any student who has ever pulled an all-night study session for an exam knows, you can't sustain that kind of effort for long. Think of something that is stuck. It's fixed in place and, if it's moving, it's doing so really slowly! When things don't move or adjust quickly, economists will often refer to them as "sticky." For instance, if market prices or wages don't adjust quickly to changes in the economy, they are called sticky prices. And when faced with things like sticky wages and prices, an economy might not produce its full employment output.
The short-run aggregate supply curve (SRAS) lets us capture how all of the firms in an economy respond to price stickiness. When prices are sticky, the SRAS curve will slope upward. The SRAS curve shows that a higher price level leads to more output.
There are two important things to note about SRAS. For one, it represents a short-run relationship between price level and output supplied. Aggregate supply slopes up in the short-run because at least one price is inflexible. Second, SRAS also tells us there is a short-run tradeoff between inflation and unemployment. Because higher inflation leads to more output, higher inflation is also associated with lower unemployment in the short run. Why would producers see inflation and think, "let's all make more stuff"? After all, during inflation, shouldn't producers be scared to produce more?
Let's start with the first reason producers might continue despite deflation: sticky input prices. Economists used to believe that all prices were flexible. That means that if conditions change, like a recession happens, prices will quickly adapt to that change. For example, if there is a recession, high unemployment will quickly drive down wages. Lower wages make firms more willing to hire more workers. More workers mean more output, so flexible prices (like wages) mean that recessions should mostly fix themselves. Or so the thinking was at the time!
The Great Depression made us question the idea that all prices are flexible. After all, if prices adjust so well, why wasn't the depression going away? Economists had to rethink what they thought they knew about how well prices adjust. Price adjustment might work well in the long run, but the short run is a different story altogether. This developed into an idea called "short-run nominal price rigidity," which is just an economist's way of saying "prices don't adjust quickly."
Today, most economists believe that prices are sticky (at least in the short run). After all, wages are usually set for long time periods because of labor contracts. Businesses might lock themselves into long-term purchase agreements for other resources too. If there is unanticipated inflation, firms benefit from those long-term contracts because they are paying wages (and other resource prices) using dollars that aren't worth as much, so the real wages they are paying decrease. The SRAS curve tells us that firms will respond to inflation by producing more. If you want to produce more, you will need to hire more workers, so the unemployment rate decreases. In this way, the SRAS captures the tradeoff between inflation and unemployment.
When the price level increases, producers are willing to make more and hire more workers because sticky wages make them a better bargain. On the other hand, when the price level decreases, producers are willing to make less because sticky wages make workers not as good of a deal and producers sell less.
The SRAS curve shows that as the price level increases and you move along the SRAS, the amount of real GDP that will be produced in an economy increases.
An increase in the SRAS is shown as a shift to the right.
Remember the importance of labeling this model: price level (PLPLP, L) is on the vertical axis, and real GDP (or rGDPrGDPr, G, D, P) is on the horizontal axis. SRAS shows that the short-run relationship between price level and aggregate output is positive, so this should always be an upward sloping curve. the ratio of the total change in real GDP caused by a change in taxes; for example, if the tax multiplier is -4−4minus, 4, then a \$100$100dollar sign, 100 tax increase will decrease real GDP by \$400$400dollar sign, 400. For example, if the government has an output gap of \$400$400dollar sign, 400 million and the tax multiplier is -4−4minus, 4, then the government can close that gap by decreasing taxes by only \$100$100dollar sign, 100 million. The expenditure multiplier shows what impact a change in autonomous spending will have on total spending and aggregate demand in the economy. To find the expenditure multiplier, divide the final change in real GDP by the change in autonomous spending.
For example, if the government spends \$1\text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n to send the first gerbil into space, and this increase in government spending results in a \$4 \text{ million}$4 milliondollar sign, 4, space, m, i, l, l, i, o, n increase in real GDP, then the multiplier is 444.
How does that happen? The government buys a rocket from Rocket's R Us for \$1 \text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n, which gets counted in government spending. Rocket's R Us uses this to pay their employees. Those employees will save some of that \$1 \text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n, but spend the rest on t-shirts. The t-shirt sellers then spend the income earned selling t-shirt on kayaking lessons, and so on. A change in taxes also results in a multiplier effect. The tax multiplier tells you just how big of a change you will see in real GDP as a result of a change in taxes. For example, imagine government gives out a total of \$1 \text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n in tax refunds. As a result, there is a \$3\text{ million}$3 milliondollar sign, 3, space, m, i, l, l, i, o, n increase real GDP. Therefore, the tax multiplier is -3−3minus, 3. The tax multiplier is always one less in magnitude than the expenditure multiplier, and it is always a negative number.
We can see how this plays out in the table shown below. Suppose of spending \$1\text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n on gerbil rockets, the government gave out \$1\text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n dollars in tax rebates to the employees at Rockets R Us.
Why is it less? Notice that there is a round missing here: the initial \$1\text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n in tax rebates themselves are not counted. The impact of the tax is indirect, not direct. That missing initial amount is why the tax multiplier is always 1 less than the expenditure multiplier. The marginal propensity to consume is the change in spending that occurs when income changes, divided by that change in disposable income. If someone spends \$75$75dollar sign, 75 when they have \$100$100dollar sign, 100 more in income, the MPCMPCM, P, C is .75.75point, 75.
There are only two things you can do with money: spend it or save it. That means whatever proportion not spent must be saved. Economists call this the marginal propensity to save (MPSMPSM, P, S). So if the MPCMPCM, P, C is 0.750.750, point, 75, the MPSMPSM, P, S is 0.250.250, point, 25. The sum of MPCMPCM, P, C and MPSMPSM, P, S is always 111. The intuition behind the interest rate effect is that when the price level decreases, you need less money in your pocket to buy stuff. The less money you need to keep on hand to buy stuff, the more money you are going to keep in a bank. Banks pay interest to try to lure people to deposit their money in banks. So, if you are going to keep more money in the bank anyway, banks don't have to offer as much interest in order to convince you; that drives interest rates down. As a result, businesses and households spend more money on investment and "big ticket" items that are interest sensitive, like X, Y, and Z. So, once again, a decrease in the price level will increase real GDP.
On the other hand, a higher price level will drive up interest rates. Remember how a higher price level would make everyone's dollars are worth less, and they cut back on consumption? Well, what if they didn't want to cut back on consumption. Instead, maybe they sell off some other asset like a bond to try to get more money. The problem is, every other bondholder is also trying to sell off their bonds, so there are no buyers! Anyone who wants to issue a new bond is going to have to do something to try to attract buyers. The way to do that is to raise the interest rate that is offered. All of that excess demand for money leads to an increase in the interest rate. Finally, the intuition behind the exchange rate effect is that a decrease in the price level in country A makes its goods cheaper to country B, so country B buys more of country A's exports. When the price level in one country goes down, its goods are suddenly more attractive to every other country. It's like the whole country is on sale! Since that country's goods are suddenly cheaper, their exports go up.
Of course, as with the other explanations for the downward-sloping aggregate demand curve, the opposite will happen when the price level increases. Country A's goods will be less attractive to Country B's consumers and the quantity of aggregate output demanded will decrease.
One important note: in all three of these effects, the changes in the amount of AD are brought about by a change in the price level. But if wealth, interest, or exports change for some reason besides a change in the price level, this would actually represent a shift in AD, not a movement along the curve. [got it!] The aggregate demand curve shows the inverse relationship between the price level spending on real GDP. Figure 1 shows an economy that responds to a decrease in the price level by increasing the amount of aggregate demand. The price level decreases from 120120120 to 102102102 and, in response, spending on output increases from \$16 \text{ trillion}$16 trilliondollar sign, 16, space, t, r, i, l, l, i, o, n to \$17 \text{ trillion}$17 trilliondollar sign, 17, space, t, r, i, l, l, i, o, n. The LRAS represents a point on a country's PPC, translated into the AD-AS model. Every point on the PPC represents the maximum sustainable capacity for production in an economy. This value of real GDP represents the economy's maximum sustainable capacity given its current stock of resource
The LRAS is vertical because, in the long-run, the potential output an economy can produce isn't related to the price level. There are only two things that matter for potential output: 1) the quantity and the quality of a country's resources, and 2) how it can combine those resources to produce aggregate output. When an economy is producing exactly its full employment output, the rate of unemployment is equal to the natural rate of unemployment.
The LRAS curve is also vertical at the full-employment level of output because this is the amount that would be produced once prices are fully able to adjust. In the short-run, some prices are sticky. This means that producers might respond to changes in the price level by changing their output. However, in the long-run, those prices get "unstuck," and once they have fully adjusted the economy will produce the efficient, full employment output.
Economists tended to assume that prices were fully flexible before the Great Depression. In times of high unemployment, they believed, wages will go down and restore full employment. There was just a slight problem: that didn't happen during the Great Depression! High unemployment and output persisted for a long time. The logical conclusion is that wages (and other prices) are temporarily rigid. The LRAS curve represents the potential output (Y_fY
f
​ Y, start subscript, f, end subscript) that an economy can produce
LRAS and the PPC
Remember the PPC? In that model, an economy was using all of its resources efficiently if it was operating at a point on the PPC, as shown in Figure 3.
This economy is producing the combination of capital and consumption goods Y_fY
f
​ Y, start subscript, f, end subscript. Why did we label it Y_fY
f
​ Y, start subscript, f, end subscript? Because this combination of output represents full employment output. You can think of the LRAS curve as taking that dot (which represents a certain amount of capital goods and a certain amount of consumption goods), figuring out the real value of that output, and then graphing the real value of that output in a new model. Imagine you can take that single dot on the PPC and then stretch it out into a vertical line . . . that is the LRAS!
What determines the An economy is in short-run equilibrium when the aggregate amount of output demanded is equal to the aggregate amount of output supplied. In the AD-AS model, you can find the short-run equilibrium by finding the point where AD intersects SRAS. The equilibrium consists of the equilibrium price level and the equilibrium output. A good practice is to think of the short-run equilibrium as "how much real GDP is this economy creating right now, and what is the CPI an economy has right now?"
In our analysis of markets, an economy in disequilibrium results in price adjusting until the market finds an equilibrium. The same general idea applies to a short-run macroeconomic equilibrium as well, but with a minor modification. If the amount of output demanded is greater than the amount of output produced, people chase after the limited goods available and drive up the price level. In response to the increase in the price level, producers create more goods and services. This continues until the amount of aggregate production equals the amount of aggregate demand.
Suppose the aggregate output demanded and the aggregate output supplied at different price levels are as shown in the table below:
Real output demanded price level real output supplied
\$400$400dollar sign, 400 125125125 \$500$500dollar sign, 500
\$430$430dollar sign, 430 120120120 \$480$480dollar sign, 480
\$460$460dollar sign, 460 115115115 \$460$460dollar sign, 460
\$490$490dollar sign, 490 110110110 \$440$440dollar sign, 440
If the price level in this economy is only 110, for example, aggregate demand will exceed aggregate supply, leading to shortages. Buyers will compete with each other to get output, driving the price level up. Higher price levels will induce producers to increase their output. This price level adjustment will keep occurring until there is no incentive to change. After all, the definition of an equilibrium is "no tendency to change"!
The opposite happens when the amount of output demanded is less than the amount produced. The amount of output supplied will be greater than aggregate demand. Prices will begin to fall to eliminate the surplus output. As prices fall, the amount of aggregate demand increases and the economy returns to equilibrium. AD shocks have a short-run impact on the three macroeconomic variables
We can summarize the impact of an AD shock as described in the table below:
Demand shock impact on rGDP impact on unemployment impact on price level
↑ AD ↑ rGDP ↓ UR ↑ PL
↓ AD ↓ rGDP ↑ UR ↓ PL
A change in any of the components of aggregate demand will cause AD to shift, creating a new short-run macroeconomic equilibrium. In other words, in our AD=C+I+G+NXAD=C+I+G+NXA, D, equals, C, plus, I, plus, G, plus, N, X equation, anything that increases C, I, G, or NX will shift AD to the right. Anything that decreases C, I, G, or NX will shift AD to the left.
For example, suppose an economy is initially in long-run equilibrium. If the economy experiences a positive AD shock, it would be in the expansion phase of the business cycle and have a positive output gap. Increases in AD are the most frequent cause of increases in aggregate output in the business cycle. Positive output gaps are frequently called inflationary gaps because increases in AD also cause an increase in the price level. We can summarize the impact of a shock to SRAS as described in the table below:
Supply shock impact on rGDP impact on unemployment impact on price level
↑SRAS ↑rGDP ↓ UR ↓ PL
↓SRAS ↓rGDP ↑ UR ↑ PL
Remember the mnemonic "SPITE" to summarize the things that can cause a shift in SRAS: Subsidies for businesses Productivity Input prices Taxes on businesses Expectations about future inflation
For example, suppose an economy is initially in long-run equilibrium (current output is equal to full employment output). If the economy then experiences a positive SRAS shock, such as a decrease in Input prices. Now it would be in the expansion phase of the business cycle and experiences a positive output gap.
On the other hand, if the economy starts in long-run equilibrium and then experiences a negative SRAS shock, it would be in the recession phase of the business cycle and experience a negative output gap. The combination of low output and high inflation that is caused by a decrease in SRAS is so unusual that it gets its a special name: stagflation. This word is a mashup of "stagnation" and "inflation."
Shifts in SRAS represent the best and the worst outcomes for an economy. If SRAS increases, we end up with lower prices, less unemployment, and more output! On the other hand, decreases in SRAS give us more of what we like the least: less stuff, more unemployment, and higher prices. Shocks are unanticipated changes in economic conditions. Demand shocks are unanticipated changes that impact the Aggregate Demand (AD) curve. The basic idea of the self-correction mechanism is that shocks only really matter in the short run. If AD changes, then output and unemployment will change in the short run, but not in the long run. Output gaps due to a change in AD exist in the short run only because prices haven't had a chance to fully adjust to that change yet. Once those prices have fully adjusted in the long run, the output gap will close.
Let's walk through how a shock to AD in the short run can be corrected in the long run.
First, the shock:
Everyone in Hamsterville woke up one morning filled with optimism and confidence that incomes were going to increase, and that this increase will be permanent. ¡Viva Hamsterville! This optimism triggers an increase in consumer spending, causing a positive shock to AD. An increase in consumer spending will cause the AD curve to increase. As a result, output increases and unemployment decreases. Unfortunately, this positive AD shock also means that inflation increases. An increase in AD leads to an increase in real GDP and the price level.
How is shock corrected in the long run?
Inflation has made everyone's real wages decrease. Boo! As a result, workers demand higher wages. This drives up the cost of labor. Rising labor costs causes SRAS to decrease. This happens because expectations of further inflation and higher resource costs lead firms to produce less and charge higher prices. Output decreases and the price level increases. Output keeps falling and price level keeps rising until real GDP returns to full employment output. As long as output is higher than full employment output, an unemployment rate that is higher than the natural rate will put upward pressure on wages and prices. The long-run outcome is that real GDP returns to the full employment level of output and the unemployment rate is equal to the natural rate. The price level, however, is now permanently higher. We can better understand how the self-adjustment mechanism plays out by thinking about all of the coffee shops in Hamsterville. An increase in AD means coffee shops can sell more goods at higher prices. Coffee shops raise the price of a latte 10\%10%10, percent from \5 to \$5.50$5.50dollar sign, 5, point, 50.
At the same time, the baristas making those lattes see the prices all around them rising too. But their paycheck hasn't changed. They are able to buy less stuff, so effectively their real wages have decreased. At the same time, they see help wanted ads all over the place from other firms desperate to hire workers because the unemployment rate is so low. The baristas all quit and find better-paying jobs.
Now the coffee shop owners have to hire more workers. In order to attract workers, they have to raise wages too. Eventually, every firm in Hamsterville is paying higher wages. At the national level, increases in wages and other input costs mean the SRAS will decrease (because SRAS decreases when input prices increase or are expected to increase). Output returns to full employment output, and unemployment returns to the natural rate of unemployment. However, the economy also ends up with a higher price level. In the long-run, the price level increased, but output didn't and the unemployment rate is once again equal to the natural rate of unemployment. Supply shocks are a little different from demand shocks. In this case, the long run impact will depend on whether those shocks are temporary or permanent. For example, suppose an increase in the price of oil leads to a negative supply shock (because an increase in input prices will cause SRAS to decrease). Here's what will happen: As a result of the negative supply shock, output goes down, but inflation and unemployment go up.
The increase in unemployment will theoretically lead to lower wages (because their is less competition for labor, so firms do not have to compete for workers with higher wages). SRAS increases once wages have adjusted, because a decrease in the price of a input to production will lead to an increase in SRAS. Output returns to the full employment output.
On the other hand, if a shock is permanent, there is an entirely different impact. Suppose that there is a permanent negative supply shock that makes the entire economy less productive, such as stricter regulations on production. Here's what will happen: The capacity of the economy has decreased, so LRAS shifts to the left. Because such regulations make the cost of production higher, SRAS will also decrease until output has returned to the full employment output. In this case, output is permanently lower and the price level permanently higher. It's not all about shocks! How much you can produce sustainably has more to do with your resources than with shocks. The self-adjustment mechanism occurs because the amount of output that a country can sustainably produce ultimately depends on its stock of resources, not on AD or SRAS.
Recall that the LRAS is vertical at the full employment output. This is the amount of output associated with any point on the PPC. Unless the amount of resources a country changes, that maximum sustainable output won't change either.
For example, if a country has 100100100 workers working 8-hour shifts every day, that's 800800800 hours worth of labor being used to produce. You might be able to temporarily make everyone work overtime and squeeze out 1{,}0001,0001, comma, 000 hours worth of effort, but that isn't sustainable. Unless the number of workers increases, you are stuck with however much output 800800800 hours worth of labor will produce. If you did get more workers, then the PPC would shift out and the LRAS curve would also shift out. That shift in LRAS represents economic growth. Temporarily pushing output past that amount doesn't count as economic growth. The actual unemployment rate equals the natural rate of unemployment when an economy is in long-run equilibrium. An economy is in long-run equilibrium when the output it produces is equal to the full employment output. The current output is the short-run equilibrium: where the aggregate demand (AD) curve intersects the short-run aggregate supply (SRAS) curve, and in this graph the output currently produced is Y_1Y
1
​ Y, start subscript, 1, end subscript. The full employment output is the output where LRAS is vertical, and in this graph that is Y_fY
f
​ Y, start subscript, f, end subscript. Since Y_1Y
1
​ Y, start subscript, 1, end subscript is equal to Y_fY
f
​ Y, start subscript, f, end subscript, the economy is in long-run equilibrium. Consider a tale of two economies. Marthlandia has an economic boom which has been going on for awhile. But as a result, Marthlandia struggles with high inflation.
Burginville, on the other hand, has been in a recession for quite some time, with high unemployment causing widespread suffering. But the self-correction mechanism isn't kicking in for either country. Is there anything that can be done?
Yes! Both governments can use fiscal policy as a tool to bring their countries back to "normal." For example, they can use fiscal policy (changes in government spending or taxes), which will impact output, unemployment, and inflation.
Burginville needs to increase output to end its recession. Their government can increase output by using expansionary fiscal policy. Expansionary fiscal policy tools include increasing government spending, decreasing taxes, or increasing government transfers. Doing any of these things will increase aggregate demand, leading to a higher output, higher employment, and a higher price level.
Marthlandia's inflation is caused by producing more than is sustainable, so reducing output would fix its problem. Instead, they can draw on contractionary fiscal policy tools, such as increasing taxes or decreasing government spending or government transfers.
Doing any of these things will decrease Marthlandia's aggregate demand, which leads to lower output, lower employment, and a lower price level. Usually, governments engage in expansionary fiscal policy during recessions, and contractionary fiscal policy when they are concerned about inflation.
Altogether, this lesson is about how government spending and taxes have different impacts on aggregate demand (AD). Government spending impacts AD directly, while taxes impact AD indirectly. Because government spending immediately impacts AD, but some fraction of a change in taxes will be saved rather than spent, there is a difference in impact.
If we want to know the amount of taxes that will close an output gap, we need to use the tax multiplier to figure that out. If we want to use government spending to close an output gap, we need to use the spending multiplier to figure that out. transfer payments payments made to groups or individuals when no good or service is received in return; transfers are the opposite of a tax (you receive transfers from the government, but pay taxes to the government).
lag another way of saying "delay"; fiscal policy is associated with data lags, recognition lags, decision lags, and implementation lags.
data lag the time it takes to get macroeconomic data such as real GDP or the unemployment rate
recognition lag the delay in fiscal policy caused by the time that it takes to realize that there is a problem to be corrected
decision lag the delay in fiscal policy caused by the time that it takes to decide on a course of action
implementation lag the time it takes to put action into practice
balanced budget when expenditures equal income; a government has a balanced budget when tax revenue collected exceeds government spending.
deficit when expenditures exceed income; when the government spends \$10\text{m}$10mdollar sign, 10, m more than it collects in tax revenue in a year, it has a $10mdollar sign, 10, m deficit that year.
debt the accumulated deficits over time; when the government runs a \$10\text{m}$10mdollar sign, 10, m deficit every year for three years, it accumulates \$30\text{m}$30mdollar sign, 30, m in debt.
balanced budget multiplier the spending multiplier that will exist when any change in government spending is offset entirely by an equal change in taxes; the balanced budget multiplier is always equal to one. Imagine a government wants to fix a recession or dial back an expansion. Its concrete goals would be to return the economy to full employment, or to control inflation, respectively. Fiscal policy can help them achieve their goals.
The tools of fiscal policy are government spending and taxes (or transfers, which are like "negative taxes"). You want to expand an economy that is producing too little, so expansionary fiscal policy is used to close negative output gaps (recessions). Expansionary fiscal policy includes either increasing government spending or decreasing taxes.
An economy that is producing too much needs to be contracted. In that case, contractionary fiscal policy (either decreasing government spending or increasing taxes) is the correct choice.
For example, if Burginville is experiencing a recession, the government might give everyone a tax refund (an example of expansionary fiscal policy). Here's what will play out: the tax refund leads to an increase in disposable income An increase in disposable income causes an increase in consumption, the increase in consumption increases aggregate demand An increase in aggregate demand leads to an increase in output and a decrease in unemployment As a side effect of the decrease in unemployment and the increase in output, inflation will increase.
Marthlandia is experiencing a boom and inflation. They cut government spending. Here's what will play out in Marthlandia: First, the cut in government spending leads to a decrease in aggregate, because government spending is a component of AD. The decrease in AD leads to a decrease in output, because the decrease in AD will lead to a new short-run equilibrium with a lower output, higher unemployment rate, and lower price level. How are the effects of government spending and taxes different? When a government engages in fiscal policy using government spending, the effect is immediate because government spending is itself a component of AD. For example, if the government buys 600600600 pounds of rice for \$1000$1000dollar sign, 1000 from a farmer in Burginville, that \$1000$1000dollar sign, 1000 counted in the G component of AD and real GDP, and then the spending multiplier kicks in.
But when government spending engages in fiscal policy by using taxes or transfers, the impact is indirect. If the government of Burginville gives that farmer a \$1000$1000dollar sign, 1000 tax refund instead of buying something from him directly, the impact of that action won't have any effect until the farmer actually does something with that refund. In fact, if he puts all of that refund under his mattress, there would be no impact at all!
But, if the farmer saves \$200$200dollar sign, 200 and spends the rest on airline tickets to Florida, the \$800$800dollar sign, 800 is counted in consumption spending. The purchase of the plane ticket then triggers the multiplier effect.
Remember: the tax multiplier is always less than the spending multiplier because some of that amount is saved, and not spent, in the first step. When a gap is negative, you want output to get bigger, and so expansionary fiscal policy the right choice. When a gap is positive, you want output to get smaller, and so contractionary fiscal policy is the right choice. Once you decide on the type of policy (expansionary or contractionary), you can then decide on which tool to use (taxes or spending).
Policymakers also have to be careful to "mind the gap." If they want to close an output gap, they need to know how much stimulus is necessary. Too little stimulus and you won't close the gap. Too much stimulus and you may cause a different kind of gap.
For example, suppose that the economy of Burginville has an output gap of \$20$20dollar sign, 20 billion. They need to take a policy action that causes exactly the amount of change. The good news is that they don't actually have to spend \$20$20dollar sign, 20 billion to close that gap. Why? Because they can count on multipliers.
Recall that the spending multiplier gave us the final impact on AD of an increase in any category of spending. If the spending multiplier is 4, then an increase in government spending of \$20$20dollar sign, 20 billion would increase real GDP by 4x\$20=\$804x$20=$804, x, dollar sign, 20, equals, dollar sign, 80 billion.
The tax multiplier is always one less than the spending multiplier (and is negative). If the spending multiplier is 444, the tax multiplier must be -3−3minus, 3. That means that if the government cuts taxes by \$20$20dollar sign, 20 billion, the final impact will be -3x-\$20=\$60−3x−$20=$60minus, 3, x, minus, dollar sign, 20, equals, dollar sign, 60 billion. In either of these cases, increasing output by too much will cause output to be higher than full employment output. A government has a balanced budget when its expenditures are equal to its revenues. In other words, if a government wants to spend \$20$20dollar sign, 20, but it also wants to maintain a balanced budget, then it needs to take in \$20$20dollar sign, 20 in taxes. Governments run deficits when spending is higher than tax revenue, and they run surpluses when spending is lower than tax revenue. Over time, those deficits accumulate into national debt.
What if a government wants to use expansionary fiscal policy, but it also wants to maintain a balanced budget? If Burginvlle is in a recession and has a \$100$100dollar sign, 100 million negative output gap, it needs to use expansionary fiscal policy to close that gap. Because it has a spending multiplier of 101010, it decides to increase government spending by \$10$10dollar sign, 10 million to close that gap:
10 \times \$10 \text{million}=\$100 \text{million}10×$10million=$100million10, times, dollar sign, 10, m, i, l, l, i, o, n, equals, dollar sign, 100, m, i, l, l, i, o, n.
However, to maintain a balanced budget, it also raises taxes by \$10$10dollar sign, 10 million. But wait . . . that will have its own multiplier effect! Remember that the tax multiplier is always one less than the spending multiplier, and negative.Therefore, if the spending multiplier is 101010, the tax multiplier is -9−9minus, 9. The impact of the tax increase will be:
-9 \times \$10 \text{million} = \$-90\text{ million}−9×$10million=$−90 millionminus, 9, times, dollar sign, 10, m, i, l, l, i, o, n, equals, dollar sign, minus, 90, space, m, i, l, l, i, o, n.
To find the final impact of these actions, we add them together:
\$100 \text{million} + -\$90 \text{million} = \$10 \text{million}$100million+−$90million=$10milliondollar sign, 100, m, i, l, l, i, o, n, plus, minus, dollar sign, 90, m, i, l, l, i, o, n, equals, dollar sign, 10, m, i, l, l, i, o, n.
Notice that the final impact is exactly equal to the increase in government spending. The balanced budget multiplier will always be equal to one. Why? Because if you increase spending by \$10$10dollar sign, 10 million, but then increase taxes by \$10$10dollar sign, 10 million to pay for that spending, the final impact on real GDP is only \$10$10dollar sign, 10 million. When first learning about stabilization policies, some people think that the objective of stabilization policies is to eliminate the business cycle. But that is not the case. The objective of stabilization policy is not to "fine-tune" the economy. The goal of stabilization isn't to make the business cycle go away completely, but to make the ups and downs less dramatic. In other words, we don't want to make the budget cycle a flat line, just less "bumpy".
Some people mistakenly assume that fiscal policy (or any kind of discretionary policy) is as easy as some simple calculations. Unfortunately, that isn't very realistic. Lags make active stabilization policy tricky. For one, the self-correction mechanism may be working in the background, so by the time a policy is finally implemented, it might not be the correct action anymore. Another problem is they make it longer before a corrective action kicks in. One potential solution is to have some form of passive, or automatic, stabilizers that will kick in automatically when a problem arises. We learn more about those in the next lesson.
Some learners confuse two important types of stabilization policy: fiscal policy and monetary policy. Fiscal policy is the domain of governments. Monetary policy is the domain of central banks (which are usually independent of government budgetary actions).
Another common misperception is that if government spending increases by the same amount as a tax increase, they completely cancel each other out. A \$100$100dollar sign, 100 million increase in government spending that is paid for by increasing taxes by \$100$100dollar sign, 100 million won't completely cancel each other out. The balanced budget multiplier is equal to one, not zero. When there is a balanced budget, the final impact on real GDP is a \$100$100dollar sign, 100 million increase as a result of the balanced budget multiplier.
When first learning about discretionary stabilization policies, it can be tricky to remember what specific actions are expansionary and what are contractionary. The table below can be your guide: Are the lags, or delays, in discretionary fiscal policy frustrating you Don't worry, if lags are causing policymakers to be slow to act, automatic stabilizers will help in the meantime.
In a previous lesson, we learned that policymakers can use discretionary fiscal policy as a tool to end recessions or inflationary booms. But delays in putting those plans in place are common, and may even destabilize an economy even more. Luckily, there are mechanisms in place called automatic stabilizers. These mechanisms will kick in immediately to soften the swings of the business cycle, even if policymakers can't act quickly.
Automatic stabilizers are tools built into federal budgets that reduce the impact of the business cycle. They are "automatic" because they happen without requiring anyone to take any action. When aggregate demand decreases, two actions kick in automatically. First, income taxes will go down because the amount of income has decreased. At the same time, transfer payments like unemployment compensation and welfare benefits will increase. As a result, consumption will not decrease by as much as it would have. Taxes work as an automatic stabilizer by increasing disposable income in downturns and decreasing disposable income during booms.
Let's think about this at the individual level. Suppose you make \$1000$1000dollar sign, 1000 per week and pay 20\%20%20, percent in income taxes, so you have to pay \$200$200dollar sign, 200 in taxes and have \$800$800dollar sign, 800 to spend. All of a sudden there is a serious recession.
The bad news is your pay got cut in half, so now you only make \$500$500dollar sign, 500 per week. The good news is that your take-home pay did not get cut in half! It turns out that you live with a progressive tax system, so when your pay got cut, your tax rate fell to 10\%10%10, percent. So instead of your disposable income falling to \$400$400dollar sign, 400, it only falls to \$450$450dollar sign, 450.
The same concept works in reverse. Suppose there is a positive shock to aggregate demand, and you get a \$1000$1000dollar sign, 1000 bonus. However, that pushes you to a higher tax rate of 30\%30%30, percent, so even though your paycheck doubles, your take-home pay does not. Imagine two countries that have the same tax revenues and government spending.
Salvania starts out in long-run equilibrium and a balanced budget, with \$500$500dollar sign, 500 million in government outlays paid for with \$500$500dollar sign, 500 million in tax revenues collected every year. Suddenly, the stock market crashes in Salvania causing widespread panic and decreased consumption. Luckily, the automatic stabilizers kick-in. Tax revenues decrease to \$300$300dollar sign, 300 million, while the government is now paying for \$700$700dollar sign, 700 million in government spending and transfer payments. Salvania is now facing a budget deficit of \$400$400dollar sign, 400 million.
On the other hand, Nadyaland's long-run equilibrium is interrupted by a boom. When the automatic stabilizers kick in, tax revenues increase to \$600$600dollar sign, 600 million and spending falls to \$400$400dollar sign, 400 million. As a result of the stabilizers, Nadyaland has a budget surplus of \$200$200dollar sign, 200 million.
In the real world, there are a lot of other reasons that a country might run a budget deficit or a budget surplus. But, automatic stabilizers contribute to those deficits and surpluses too. For example, the United States was in a recession during 1982. That year it ran a deficit of around \$182$182dollar sign, 182 billion. But if you remove the effect of automatic stabilizers that had kicked in, the deficit was actually only \$72$72dollar sign, 72 billion. Similarly, during the expansion in 1999, the United States had a budget surplus of around \$126$126dollar sign, 126 billion, but if you remove the effect of automatic stabilizers, the surplus was actually around \$39$39dollar sign, 39 billion. [Source: CBO] How does a bank decide what interest rate to charge? It needs to consider two important things: How much interest is enough to make it worthwhile for the bank to loan the money (the real interest rate they earn)? How much of the interest's purchasing power might be lost to inflation?
For example, suppose a bank wants to earn 10\%10%10, percent interest, but it thinks there will be 3\%3%3, percent inflation. If they don't factor that inflation into what they change in interest, they will effectively earn only 7\%7%7, percent (because they will lose 3\%3%3, percent of the purchasing power of an interest rate of 10\%10%10, percent). Instead, banks factor inflation into their interest rates. To account for inflation, this bank would charge 13\%13%13, percent interest.
Remember from a previous lesson that inflation results in winners and losers? Suppose the bank thought inflation would be 3\%3%3, percent, but inflation turned out to be 4\%4%4, percent. We can figure out the real inflation that the bank actually earned in retrospect:
\begin{aligned}\text{real interest rate}&=\text{nominal interest rate}-\text{inflation}\\\\ &=13\%-9\%\\\\ &=9\%\end{aligned}
real interest rate
​
=nominal interest rate−inflation
=13%−9%
=9%
​
The bank was hurt by the unexpected inflation because they only got a return of 9\%9%9, percent, not the 10\%10%10, percent they hoped for. On the other hand, the borrower ended up only paying 9\%9%9, percent real interest. The borrower got the better deal!
This is an important takeaway: it was the unanticipated aspect of the inflation that hurt the bank and helped the borrower. If the bank had anticipated the higher rate of inflation, they would have simply charged a higher nominal interest rate to ensure they got the real interest rate.
This is the basic idea behind something called the Fisher Effect. When expected inflation changes, the nominal interest rate will increase. However, inflation will not effect the real interest rate. Monetary aggregates might be easy to confuse with each other. An easy way to remember them is that the higher the number on the aggregate is, the less liquid that kind of money is. M2 is less liquid than M1.
It might be confusing that checking accounts are considered narrow money, but savings accounts are considered near money. The reason for this is that savings accounts tend to have some limitations on them that checking accounts usually do not. Most checking accounts are demand deposit. Savings accounts frequently will have limitations such as being only able to make five withdrawals per month or having to wait ten days after you deposit money to get them.
You might see a reference to an even broader monetary aggregate in your textbook or class and be confused why it isn't here. The monetary aggregate M3 is tracked in some countries, but not others (the U.S. stopped tracking this category in 2006). If you see M3 elsewhere, the most important thing to remember about it is that M3 is less liquid than M2. In fact, you might even see a broader category called L, which is even less liquid than M3. -Are cryptocurrencies money? There is actually some debate about whether cryptocurrencies (such as bitcoin) are money or just a financial asset. In fact, central banks around the world are grappling with this question right now, and there isn't any consensus on this issue. A main sticking point to argue that cryptocurrencies aren't money is that they generally cannot be used as legal tender (in other words, to buy stuff). Not a lot of stores are equipped to take cryptocurrencies to buy goods and services, at least not yet. As of right now, cryptocurrencies aren't included in either the narrow or broad definition of the money supply. Banks, like any other business, need to keep track of their assets and liabilities. T-accounts are tables that banks use to keep track of assets and liabilities.
Let's create a T-account for a bank that has just opened for business, First Bank of Pulitzer. Nobody has deposited any money yet, so other than its obligations to the bank owners and the real assets that the bank has (like the bank building itself), the bank's T-account is empty:
Assets Liabilities
\$0$0dollar sign, 0 \$0$0dollar sign, 0
Now suppose you win \$100$100dollar sign, 100 in a poetry writing competition. Congratulations! You deposit your winnings in a First Bank of Pulitzer checking account. That deposit creates two entries on the bank's balance sheet. The \$100$100dollar sign, 100 in cash creates an entry on the asset side because the money is an asset for the bank (because they can put that money to use by loaning it out). But, the bank must give you back that money as well. That obligation is a liability, so there is a \$100$100dollar sign, 100 entry on the liabilities side as well.
The bank's balance sheet now looks like this:
Assets Liabilities
Cash \$100$100dollar sign, 100 \$100$100dollar sign, 100 Your Deposit Banks are more than just a vault to keep money in. If banks just acted as a storage facility for money, that wouldn't be a very profitable business. The \$100$100dollar sign, 100 you deposited from your groundbreaking verses will be used to make loans. Banks profit from making loans by charging interest.
But the new First Bank of Pulitzer has a problem. They want to make loans (because that is how they earn a profit). But at some point, they also need to pay back the money that people have deposited into the bank. This is where reserves come in.
Reserves are the amount of money that banks keep in vaults, and they are a fraction of all deposits made. In most countries, banks are heavily regulated and are required to keep a minimum percentage of all deposits, just in case someone wants to withdraw some money. This minimum percent is the reserve requirement.
For example, suppose the reserve requirement is 20\%20%20, percent. The bank would need to keep \$20$20dollar sign, 20 of your \$100$100dollar sign, 100 on hand. We can break this down in our T-account:
Assets Liabilities
Required reserves \$20$20dollar sign, 20 \$100$100dollar sign, 100 Your Deposit
The rest of the cash \$80$80dollar sign, 80 To understand how banks create money, let's take a step back. What if that poetry competition money was the only money that existed in the economy. Before you deposit the money in the bank, let's calculate the money supply:
\begin{aligned} M1&=\text{currency in circulation} + \text{deposits}\\\\ &=\$100 + \$0\end{aligned}
M1
​
=currency in circulation+deposits
=$100+$0
​
Once you deposit your money in the bank, M1 doesn't change; only the composition of the money supply changes:
M1=\$0 + \$100M1=$0+$100M, 1, equals, dollar sign, 0, plus, dollar sign, 100
How does the First Bank of Pulitzer bank create more money out of this \$100$100dollar sign, 100? Our bank now has \$80$80dollar sign, 80 just sitting around. This is the bank's excess reserves - the extra money beyond what they must keep in required reserves. The bank can do one of two things with that money:
Keep it in the bank (just in case you want to withdraw more than \$20$20dollar sign, 20)
Loan it out
In the real world, your deposit wouldn't be the only deposit in the bank. Usually, only a small number of people want to withdraw their money on a given day. So, the bank might want to loan out that money to earn a profit.
Now, suppose Sylvia shows up at the bank and wants to borrow \$50$50dollar sign, 50. Let's see how the bank's loan to Sylvia impacts their T-account and the money supply:
Assets Liabilities
Required reserves \$20$20dollar sign, 20 \$100$100dollar sign, 100 Your Deposit
Loan to Sylvia \$50$50dollar sign, 50
Excess reserves \$30$30dollar sign, 30
M1 has changed as well. Remember, your \$100$100dollar sign, 100 deposit is still your money. If you check your account balance, it still says you have \$100$100dollar sign, 100. But Sylvia now has \$50$50dollar sign, 50 in cash in her pocket, too:
\begin{aligned} M1 &= \text{cash in circulation} + \text{deposits}\\\\ &=\$50 + \$100\\\\ &=\$150\end{aligned}
M1
​
=cash in circulation+deposits
=$50+$100
=$150
​
By loaning out from excess reserves, the bank has added to the money supply. ome learners get confused about what the simple money multiplier represents. The simple multiplier \dfrac{1}{rr}
rr
1
​ start fraction, 1, divided by, r, r, end fraction is the maximum change in the money supply. In all probability, the final increase in the money supply will be far smaller due to leakages from the financial system.
Printing money and creating money is not the same thing. Printing money creates currency, but the amount of money that exists at any point in time (in other words, the money supply) is cash and deposits. The pivotal moment in the creation of money is lending: when loans are made, money is created.
It might seem strange that a bank account is a liability. To you, the owner of the account, the account is an asset. But to the bank, who has to return that money to you on demand, it is a liability. -As a new learner, it might be confusing about which stage in this process creates money. It is the loan. If a bank does not loan out from a deposit, no new money is created. If we want to buy things, we need money to do so. But, by keeping our wealth in the form of money, we give up the opportunity to earn interest by keeping our wealth in the form of some other asset. This tradeoff is the source of the demand for money: as interest rates decrease, it makes more sense for us to keep money in the form of money and not other assets.
At the same time, there is only so much money that exists at any given time. The money supply (M1M1M, 1) is a fixed amount that doesn't change just because interest rates have changed. The money supply changes when either the monetary base changes or banks make loans.
If you are thinking to yourself, "Wait, supply and demand for something sounds a lot like a market," you are absolutely correct! Just like every other market we have seen, there are four important elements:
equilibrium price
equilibrium quantity
supply
demand.
The price of money is the nominal interest rate, the quantity is how much money people hold, supply is the money supply, and demand is the demand for money. Suppose you live in a world where you can only store your wealth in bonds or cash, and you have \$1000$1000dollar sign, 1000 in cash. You can earn a 10\%10%10, percent return if you buy a bond, but the return to holding your wealth in the form of money is zero. That bond sounds pretty attractive, so you spend all of your money buying bonds.
Now you have a slight problem: all of your wealth is in the form of bonds and you are hungry. You take the bonds to the donut shop but they only accept cash. The donut shop holder wants to be paid now, not a year from now when those bonds mature!
So you have a choice: sell your bonds and eat, or keep your bonds and earn interest. The tradeoff between keeping your assets liquid (in the form of cash) or in some other asset (bonds) is called liquidity preference. The amount you are willing to hold in the form of cash is going to depend on a lot of things, such as the price of donuts, how hungry you are, and how easy it is to move wealth between cash and bonds.
Your liquidity preference will also depend on the interest rate. If the interest rate suddenly went down to less than 1\%1%1, percent, then holding onto these bonds doesn't make as much sense as it did at 10\%10%10, percent. This inverse relationship between liquidity preference and the interest rate means that the demand for money is downward sloping. The central bank controls the money supply, so it can take actions to increase the money supply and decrease the money supply. Changes in the money supply lead to changes in the interest rate.
But what about the demand for money, can it change? Absolutely! There are a few reasons why the demand for money might change:
Changes in national income - when real GDP increases, there are more goods and services to be bought. More money will be needed to purchase them. On the other hand, a decrease in real GDP will cause the money demand curve to decrease.
Changes in the price level (inflation or deflation) - if the price of everything increases by 20\%20%20, percent, you need 20\%20%20, percent more money in order to buy things. When there is an increase in the price level, the demand for money increases. Conversely, when there is a decrease in the price level, the demand for money decreases.
Changes in money technology - the demand for money is driven by the transactions motive (we want money so we can buy things). When new technologies make it easier to convert wealth into money, we keep less of it on hand. Key Terms
Key term Definition
monetary policy the use of the money supply to influence macroeconomic aggregates, such as output, inflation, and unemployment
dual mandate the two objectives of most central banks, to 1) control inflation and 2) maintain full employment
contractionary monetary policy monetary policy designed to decrease aggregate demand, decrease output, and increase unemployment
expansionary monetary policy monetary policy designed to increase aggregate demand, increase output, and decrease unemployment;
open market operations the buying and selling of securities, such as bonds, by a central bank to change the money supply
Federal Reserve (nicknamed the "Fed") the central bank of the United States of America; the Federal Reserve is responsible for the maintaining the health of the financial system and conducting monetary policy.
discount rate the name given to the interest rate that the Federal Reserve sets on loans that the Fed makes to banks; changing the discount rate is a tool of monetary policy, but it is not the primary tool that central banks use.
reserve ratio the amount of reserves that banks are required to keep on hand by a central bank; changing the reserve ratio is a tool of monetary policy, but it is rarely changed and is rarely used to conduct monetary policy.
Fed Funds rate the interest rate that banks charge each other for short-term loans; when the Federal Reserve changes the money supply, it changes the Fed Funds rate The tools and outcomes of monetary policy
The table below summarizes the tools and outcomes of monetary policy:
Recessionary gaps (Y<Y_f \text{ and }UR>UR_n)(Y<Y
f
​ and UR>UR
n
​ )left parenthesis, Y, is less than, Y, start subscript, f, end subscript, space, a, n, d, space, U, R, is greater than, U, R, start subscript, n, end subscript, right parenthesis Inflationary gaps (Y>Y_f\text{ and } UR<UR_n)(Y>Y
f
​ and UR<UR
n
​ )left parenthesis, Y, is greater than, Y, start subscript, f, end subscript, space, a, n, d, space, U, R, is less than, U, R, start subscript, n, end subscript, right parenthesis
Why full employment price stability
How increase money supply decrease the money supply
Tools used (primary tool in bold) 1) open market purchases (buy bonds), 2) decrease discount rate, 3) decrease reserve ratio 1) open market sales (sell bonds), 2) increase discount rate, 3) increase reserve ratio
Impact on interest rates decrease nominal interest rate increase the nominal interest rate
Impact on output increase Y decrease Y
Impact on unemployment UR decreases UR increases
Impact on price level/inflation inflation increases inflation decreases When a central bank performs an open market operation, such as buying bonds, they pay for those bonds by depositing money into a bank's reserves. For example, suppose that the central bank buys \$1{,}000$1,000dollar sign, 1, comma, 000 worth of bonds. The central bank then increases bank's reserve balances by \$1{,}000$1,000dollar sign, 1, comma, 000. Remember that money in vaults is counted as part of the monetary base, but not as part of the money supply.
Now the bank has \$1{,}000$1,000dollar sign, 1, comma, 000 in excess reserves. Central banks either pay no interest on those reserves, or they pay such a low interest rate that makes it not worthwhile to a bank to keep excess reserves. That means a bank will usually not want to leave money idle in bank vaults unless it absolutely has to.
Instead, banks will make loans using that money. In fact, it can loan the entire \$1{,}000$1,000dollar sign, 1, comma, 000 because the \$1{,}000$1,000dollar sign, 1, comma, 000 is not part of a demand deposit liability. As soon as it makes the loan, the money is now in circulation and is counted in M1M1M, 1.
We can use the money multiplier to predict the maximum change in the money supply that will occur as a result of the OMO. If the money multiplier is 4, then the money supply will increase by up to \$4{,}000$4,000dollar sign, 4, comma, 000. Monetary policy, like fiscal policy, suffers from lags that might hamper how effective it can be at closing an output gap. First of all, it takes time to recognize that there is a problem in the economy and react appropriately. Second, even if the interest rate changes quickly when OMOs are carried out, the impact of the interest rate change takes time.
Recall that OMOs impact the overnight rate. It takes time for changes in the overnight rate to pass through to other interest rates. Even once other interest rates have adjusted, the investment response to a new interest rate takes time
For example, suppose Inigo is thinking about buying a new home, but banks aren't willing to lend any money right now because they are fully loaned out. Then, the central bank of Florin buys bonds, which increases the amount of funds available to loan out and decreases the interest rate banks charge each other.
Eventually, this changes the interest rate charged for home loans, too. Inigo sees that his local mortgage lender is offering lower interest rates. He takes out a loan and hires a builder to build his dream home. Only once he pays the builderwill real GDP change. It might seem like a time-saver to skip steps when describing the chain of events involved in monetary policy, but taking an extra minute or two is worth it. If you want to save time, use abbreviations and arrows rather than skipping steps. For example, if you want to communicate this: "*An increase in the money supply will lower interest rates, which will increase investment and aggregate demand. As a result, output will increase, the price level will increase, and the unemployment rate will decrease." You could write instead: "Ms ↑ → n.i.r. ↓ → I ↑ → AD ↑ → (Y ↑ PL ↑ UR ↓)"
If a question asks you for an open market operation, you might think it's a good idea to list all of the tools of monetary policy. This is not a good idea, because you haven't answered the question that was asked and you won't get any credit. Instead, only give an answer to the question you are asked so you get full credit. In a closed economy, national savings is the sum of private saving and the public saving. In an open economy, national saving is the sum of private savings, the public saving, and net capital inflows.
For example, suppose the nation of Florin has:
a national income of \$100$100dollar sign, 100 million,
taxes of \$10$10dollar sign, 10 million,
consumption spending of \$30$30dollar sign, 30 million
government spending of \$8$8dollar sign, 8 million,
and net capital inflows of \$4$4dollar sign, 4 million.
The national savings that they have available is therefore:
\begin{aligned}\text{National savings}&=Private savings + Public savings + NCI\\\\ &=(\$100 \text{ million income} - \$10 \text{ million taxes} - \$60 \text{ million consumption}) + (\$10 \text{ million taxes} - \$8 \text{ million government spending}) + \$4 \text{ million NCI}\\\\ &=\$30 \text{ million} + \$2 \text{ million} + \$4 \text{ million} \\\\ &=\$36 \text{ million} \end{aligned}
National savings
​
=Privatesavings+Publicsavings+NCI
=($100 million income−$10 million taxes−$60 million consumption)+($10 million taxes−$8 million government spending)+$4 million NCI
=$30 million+$2 million+$4 million
=$36 million
​
National savings would be \$36$36dollar sign, 36 million in Florin. That means there is \$36$36dollar sign, 36 million in savings that could be turned into loans that could fund investment spending. Recall that the relationship between nominal and real interest rates is:
\text{Nominal interest rate} = \text{real interest rate} + \text{expected inflation}Nominal interest rate=real interest rate+expected inflationN, o, m, i, n, a, l, space, i, n, t, e, r, e, s, t, space, r, a, t, e, equals, r, e, a, l, space, i, n, t, e, r, e, s, t, space, r, a, t, e, plus, e, x, p, e, c, t, e, d, space, i, n, f, l, a, t, i, o, n
For example, suppose that initially the real interest rate is 4% and the expected rate of inflation is 2%, resulting in a nominal interest rate of 6%:
\begin{aligned}\text{Nominal interest rate} &= \text{real interest rate} + \text{expected inflation} \\\\ &= 4\%+2\%\\\\ &=6\%\end{aligned}
Nominal interest rate
​
=real interest rate+expected inflation
=4%+2%
=6%
​
Now, suppose that a government increased its spending. This expansionary fiscal policy would increase aggregate demand, which leads to more output, a lower rate of unemployment, and higher inflation. If people adjust their expectations, and expected inflation increases from 2% to 5%, then the nominal interest rate becomes:
\begin{aligned} \text{nominal interest rate} &=\text{real interest rate} + \text{expected inflation}\\\\ &= 4\%+5\%\\\\ &=9\%\end{aligned}
nominal interest rate
​
=real interest rate+expected inflation
=4%+5%
=9%
​
Uh-oh! An increase in interest rates might undo some of the intended effects of the expansionary fiscal policy-so the central bank might simultaneously engage in expansionary monetary policy to lower the nominal interest rate back to its initial level. The quantity theory of money
M \times V = P \times YM×V=P×YM, times, V, equals, P, times, Y
Where V, the velocity of money, is constant.
The quantity theory of money has these important implications:
If output (YYY) is increasing and velocity is constant, the money supply will have to increase to keep the price level from decreasing; and
An increase in the money supply (MMM) without an increase in output (YYY) causes the price level to change by the same change in the money supply. In other words, output doesn't change, but when the money supply doubles, the price level also doubles.
For example, suppose we had a really simple economy that only produced mangoes. The velocity of money is 5 and there are 100 mangoes:
M \times 5 = P \times YM×5=P×YM, times, 5, equals, P, times, Y
What will the price be if there is \$20$20dollar sign, 20 in the money supply?
\begin{aligned} \$20 \times 5 &= P \times 100\\\\ \$100 &= P \times \$100\\\\ \$1 &= P\end{aligned}
$20×5
$100
$1
​
=P×100
=P×$100
=P
​
So, according to this theory, each mango will cost \$1$1dollar sign, 1. What if instead there is \$40$40dollar sign, 40 in the money supply?
\begin{aligned}\$40 \times 5 &= P \times 100\\\\ \$200 &= P \times 100\\\\ P&=\$2\end{aligned}
$40×5
$200
P
​
=P×100
=P×100
=$2
​
When there was no accompanying increase in output, the price level doubled. Previously, we learned that a central bank can influence output by increasing the money supply. At first glance, it might seem like the quantity theory of money contradicts this, because when the money supply increases only the price level change.
The important assumption that drives this result is that output (YYY) is fixed. This might be true in the long-run, but not in the short-run. In the short-run, an increase in the money supply decreases the nominal interest rate, which increases investment and real output. However, according to the self-correcting mechanism, the accompanying inflation will eventually lead to a decrease in short-run aggregate supply (SRASSRASS, R, A, S). The decrease in SRASSRASS, R, A, S returns the economy to full employment and a new, permanently higher price level.
The impact of a change in the money supply on real output ultimately depends on the shape of the aggregate supply curve. If the aggregate supply curve is vertical (as it is assumed to be in the long run) then an increase in the money supply will only impact inflation. If the aggregate supply curve is relatively flat, then there might be large increases in output that result from an increase in the money supply and relatively little impact on the price level. The quantity theory of money treats money as neutral. That doesn't mean that changes in the money supply have no impact. Rather, "neutral" means that changes in the money supply have no impact on one variable in particular: real output. In the long run, real output will depend on resources and technology, not the money supply.
This means that changes in the price level (and therefore the rate of inflation) depend primarily on changes in the money supply. We can summarize the relationship between increases in the money supply and economic growth as: ## Key misperceptions
Some people assume that money neutrality means monetary policy is pointless.In fact, Milton Friedman, the father of monetarism, believed that the lack of monetary policy contributed to the severity of the Great Depression. Rather, money neutrality states that monetary policy has limits to its appropriate uses. The money supply should grow enough to support any increase in the natural rate of output (in other words, support economic growth), and during severe downturns. However, the money supply shouldn't be used to attempt to smooth out the business cycle Key equations
The government budget
\begin{aligned} \text{Budget Balance} &= T-G, \text{where}\\\\ T&=\text{ tax revenue}\\\\ G&= \text {government spending}\end{aligned}
Budget Balance
T
G
​
=T−G,where
= tax revenue
=government spending
​
For example, if a country collects \$100$100dollar sign, 100 million in taxes and spends \$100$100dollar sign, 100 million, the budget balance is zero. Sometimes you will also see this referred to being "in balance" rather than "the budget balance is zero." In either case, this is the formula:
\$100 \text{ million} - \$100 \text{ million} = 0$100 million−$100 million=0dollar sign, 100, space, m, i, l, l, i, o, n, minus, dollar sign, 100, space, m, i, l, l, i, o, n, equals, 0
But, if a government spends more than it takes in, it has a deficit. So if tax revenue is \$100$100dollar sign, 100 million, but government spending is \$120$120dollar sign, 120 million:
\$100 \text{ million} - \$120 \text{ million} = -\$20 \text{ million}$100 million−$120 million=−$20 milliondollar sign, 100, space, m, i, l, l, i, o, n, minus, dollar sign, 120, space, m, i, l, l, i, o, n, equals, minus, dollar sign, 20, space, m, i, l, l, i, o, n
The budget is short \$20$20dollar sign, 20 million, so the government will need to borrow that money. If the government runs the same deficit every year for three years, it will accrue a debt of \$60$60dollar sign, 60 million:
\begin{aligned}\text{Debt} &= Deficit_{yr1} + Deficit_{yr2} +Deficit_{yr3}\\\\ &= \$20 \text{ million} + \$20 \text{ million} + \$20 \text{ million}\\\\ &=\$60 \text{ million}\end{aligned}
Debt
​
=Deficit
yr1
​ +Deficit
yr2
​ +Deficit
yr3
​
=$20 million+$20 million+$20 million
=$60 million
​ If you want to spend \$50$50dollar sign, 50 on pizzas, but you only have \$10$10dollar sign, 10, you can't afford it unless you take out a loan. Governments have an advantage you do not, though, in that they can print money. However, this is a tactic that governments rarely take because it leads to inflation or even hyperinflation. Instead, just like you, governments borrow money.
What if you want to borrow \$40$40dollar sign, 40 and the government wants to borrow \$50$50dollar sign, 50, but there is only \$60$60dollar sign, 60 available to borrow? Now you and the government are competing to buy something that is scarce, which will drive prices up. As the real interest rate goes up, you decide you don't really need a pizza that much. As a result of the government competing with you, and with any other private borrower, the interest rate goes up, and there is less private spending.
Your pizza dilemma illustrates the crowding out effect: when governments borrow it crowds out private sector borrowing. Less of that borrowing means less investment spending and interest-sensitive consumption in the short run.
Ultimately, the extent of crowding out depends on whether the economy can accommodate additional borrowing. If an economy is in a recession, there is less private investment spending to compete with, and crowding out is less of a concern. On the other hand, if an economy is near full employment output, there is likely to be more private investment; as a result, there is more potential for crowding out. Government policies play a big part in encouraging (or discouraging) economic growth. Some examples of economic policies that contribute to economic growth are:
Investing in infrastructure: infrastructure, like highways or bridges, are physical capital that is available to everyone. By investing in infrastructure, governments add to the capital stock of a country. But infrastructure depreciates, just like any other capital. That means governments must replace depreciated infrastructure to maintain it.
Policies that affect productivity and labor force participation - Encouraging a higher labor force participation rate, such as tax incentives on labor for participation, can lead to more economic growth.
Policies that encourage capital accumulation and technological change - Policies that encourage savings, and therefore investment in capital, lead to higher economic growth. Similarly, policies that encourage technological change, such as tax credits for research and development, also lead to more economic growth.