Macroeconomic Issues: Economic Growth and The Business Cycle
After reading Chapter 11, MACROECONOMIC ISSUES: ECONOMIC GROWTH AND THE BUSINESS CYCLE, you should be able to:
• Explain the difference between Economic Growth and the Business Cycle. • Discuss Capital Accumulation and Technological Progress as the two basis sources of economic growth. • Understand Production Functions and the difference between Extensive and Intensive growth. • Be able to express the production function in terms of annual growth rates. • Understand the Law of Diminishing Returns and its relation to growth.
• Explain how technological progress can overcome the problem of diminishing returns. • Explain different growth policies.
• Discuss the four phases of the business cycle. • Define Gross Domestic Product (GDP) and its four expenditure categories.
• Relate Gross National Product, GNP, and the various measures of income to GDP.
• Explain the relationship between the Natural Level of Real GDP and the natural rate of unemployment.
T Outline
I. Economic Growth
A) Economic Growth consists of rightward shifts in the production possibilities frontier, since this
means that more of all goods and services can be produced. B) There are two sources of economic growth: Increases in the nation’s productive resources,
which often takes the form of Capital Accumulation (investment in new capital stock) and technological progress. C) A Production Function shows the relationship between inputs and output. It shows how much
output can be produced from different amounts of labor and capital with a given state of technology. 1. Extensive Growth results from the expansion of factor inputs. 2. Intensive Growth results from increases in output per unit factor of input. Advances in technology is a source of intensive growth. D) The production function can be expressed in terms of annual growth rates, where the growth rate
of output depends on the growth rates of labor and capital (each weighted by its share of income) and by technological improvements.
112 Gregory • Essentials of Economics, Sixth Edition
E) The shape of the production function is determined by the Law of Diminishing Returns. The
Output-per-Worker Production Function shows that output per worker depends on the amount of capital per worker and upon technological progress. Holding technology fixed, output per worker increases but at a decreasing rate as capital per worker increases. F) Technological advances will shift the entire production function up: for any given amount of
capital per worker, output per worker increases. As long as technology improves, diminishing returns can be avoided, and a nation’s standard of living can continue to increase. G) Advanced nations grow primarily through intensive growth. Hence, government policies that are
designed to increase productivity can raise a nation’s growth rate. II.
Business Cycles
A) The Business Cycle is the pattern of upward and downward movement in the general level of
real economic activity. B) The business cycle is divided into four phases:
1. Recession: downturn when output declines for six months or more. Unemployment rises and economic activity declines. A depression is a prolonged recession.
2. Trough: occurs when output stops falling—when output reaches its low point. 3. Recovery or Expansion: the period after the trough, when the output increases, unemployment falls and economic activity increases.
4. Peak: the final stage of the business cycle and precedes a recession. Output growth ceases. C) Since 1924 business cycles average about 5 years in length: recessions one year and recoveries
four years. III. Gross Domestic Product and National Income
A) Gross Domestic Product (GDP) is the market value of all final goods and services produced by
the factors of production located in a country in one year’s time. B) GDP can be divided into four final use categories:
1. Persona Consumption Expenditures are the goods and services purchased by households for their consumption.
2. Government Expenditures for Goods and Services are the goods and services purchased by the government at all levels (federal, state and local). Government Transfer Payments are not included because they do not (directly) purchase a good or service. 3. Investment are the goods purchased, mainly by business firms, to add to the nation’s capital stock. Depreciation is the value of the existing capital stock that has been used up in the process of producing output.
4. Net Exports are the domestically produced goods purchased by foreigners minus domestic purchases of foreign produced goods. C) Real GDP measures the volume of real goods and services produced by the economy by
removing the effect of changing prices from nominal GDP. Nominal GDP is the value of the output of final goods and services expressed using prevailing prices; D) Gross National Product (GNP) measures the production of the factors of production supplied
by residents of the country, whether that production took place at home or abroad. It is
calculated as GDP plus income generated by U.S.-owned factors located in other nations minus income paid in the United States to foreign-owned factors of production.
Chapter 11 Macroeconomic Issues: Economic Growth and The Business Cycle 113
E) National Income equals GNP minus depreciation and indirect business taxes (such as sales
taxes). National income also equals the sum of payments made to the factors of production. F) Personal Income equals the sum of all income people actually receive. Personal Disposable
Income equals personal income minus personal income tax payments. Thus, personal disposable income is all the income people actually have to spend or save. G) Since GDP equals the sum of total expenditures on consumption investment, government
spending, and net exports, and also equals the amount of income that can be spent on
consumption, savings and taxes investment must be equal to saving. The amount of investment is limited by both household saving and public saving. H) The Natural Level of Real GDP is the output associated with the natural rate of unemployment
(see Chapter 8).
T Review Questions
True/False
If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question give a short statement that supports your answer.
_____ 1. Extensive economic growth can occur if more people decide to work rather than retire early
or continue in school. _____ 2. A government policy that encourages investment in human capital, such as providing below-cost college educations, can help increase a nation’s growth rate. _____ 3. Intensive growth refers to economic growth that is the result of increases in the amount of a
nation’s productive inputs. _____ 4. Real GDP can fall even if nominal GDP rises.
_____ 5. The business cycle refers to the upward and downward movements in the general level of
economic activity. _____ 6. The average business cycle has a length of about fifteen years.
_____ 7. At the natural rate of unemployment, the inflation rate is high and rising.
114 Gregory • Essentials of Economics, Sixth Edition
Multiple Choice Questions
Circle the letter corresponding to the correct answer. 1.
The stage of the business cycle during which output is at its lowest point is
(a) the recession.
(b) when the stock market is falling. (c) the peak. (d) the recovery. (e) the trough. Which of the following is not a final use of GDP? (a) Consumption expenditures
(b) Government expenditures for goods and services
(c) Government expenditures for transfer payments to individuals (d) Investment
(e) Net exports of goods and services
Which of the following is an example of intensive growth?
(a) Growth caused by an increase in technology that allows more output to be produced without any
change in the inputs utilized
(b) Growth caused by an expansion of the nation’s capital stock that takes place as a result of changes
in the nation’s tax laws
(c) Growth caused by an increase in the nation’s labor force (d) All of the above (e) None of the above
The amount of goods and services produced by an economy is measured by (a) national income. (b) depreciation. (c) consumption. (d) the business cycle. (e) real GDP.
At the natural rate of unemployment, real GDP _________ the natural level of real GDP and the inflation rate is _________. (a) is greater than; rising (b) is greater than; rising
(c) is equal to; rising, constant, or falling, depending on other factors (d) is equal to; not changing (e) is less than; falling
The production function says that
(a) real GDP depends on the economy’s capital stock.. (b) real GDP should increase when labor inputs increase.
(c) real GDP rises when there are technological improvements. (d) (a), (b), and (c). (e) None of the above
2.
3.
4.
5.
6.
Chapter 11 Macroeconomic Issues: Economic Growth and The Business Cycle 115
7.
The Law of Diminishing Returns states that growth will (a) decline no matter what.
(b) increase as the labor force expands.
(c) increase as the capital stock expands and labor contracts. (d) eventually fall if there are no technological improvements. (e) None of the above
Essay Questions
Write a short essay or otherwise answer each question. 1. 2. 3. 4.
What is the difference between real and nominal GDP? What are the four final use categories of GDP? What are the four phases of the business cycle?
Use the production function analysis, where the production function is expressed in terms of rates of growth, to calculate the rate of growth of technological change when real GDP is growing at 5% per year, and capital and labor are both growing at 2% per year.
T Answers to Review Questions
True/False
1. 2. 3. 4.
True. Extensive growth occurs when productive inputs increase. By retiring later or leaving school earlier, people increase the nation’s labor force and so labor, a productive resource, increases. True. This sort of productivity-enhancing policy can raise intensive growth.
False. The definition of intensive growth is growth caused by more output per input, not growth caused by possessing more inputs.
True. Even if the number of goods and services produced in an economy declines (so that real GDP falls), it is possible for the inflation rate to be high enough so that nominal GDP, which includes both the effects of higher prices and lower output, rises. True. This is the definition of the business cycle.
False. The average business cycle has a duration of about five years.
False. At the natural rate of unemployment, the inflation rate neither increases nor decreases.
5. 6. 7.
Multiple Choice Questions
1.
(e) The trough is the moment when the economy is at the bottom of the business cycle, passing from
the recession phase into the recovery phase.
116 Gregory • Essentials of Economics, Sixth Edition
2.
(c) The final use breakdown of GDP depends on who or what purchases the goods and services.
Transfer payments are given to people, but nothing—that is, no good or service—is received in exchange. Thus, transfer payments are not part of the government expenditure on goods and services. (Transfer payments can be spent by the recipients to help finance some of the consumption part of GDP.) (a) This is virtually the definition of intensive growth: Growth that occurs when more output can be
produced from the same amount of inputs. (e) Real GDP measures the number of goods and services produced by an economy.
(d) When the economy is at the natural rate of unemployment, employment is not changing and so
there is no wage pressure either upwards or downwards. Because employment does not change, the economy is producing at the natural level of real GDP. And, because there is no wage pressure, the inflation rate is constant. (d) The production function says output depends on labor, capital, and technology. (d) The law states that output growth will decline unless technology improves.
3. 4. 5.
6. 7.
Essay Questions
1.
Real GDP measures the number of goods and services produced by an economy. Nominal GDP is the market value of these goods and services. Nominal GDP depends on the quantities produced as well as on their prices. Real GDP depends on only the quantities.
The four final use categories of GDP depend on the sector that purchases the good. (a) Consumption: Goods purchased by the household sector.
(b) Government purchases of goods and services: Goods purchased by the government sector. (c) Investment: Goods purchased by firms to add to their capital stock.
(d) Net exports of goods and services: Goods purchased by foreign residents less the purchase of
foreign goods by domestic residents. The four phases of the business cycle are the recovery (when the economy is growing most rapidly), the peak (when the economy is poised at its highest level of output), the recession (when the economy is declining) and the trough (when the economy is at its lowest point).
The production function, expressed in annual rates of growth, says that the growth of output will equal the growth rate of inputs plus the growth rate of technology. With inputs both rising at 2% per year, this means that technology is growing at the rate of 3% per year.
2.
3.
4.
T Additional Questions
1.
Suppose an economy’s production function is given by:
Y = 0.75L + 0.25K + T,
where the italics denote annual growth rates. Output grows at 5% per year, labor grows at 4% per
year, and capital grows at 6% per year. How much of the growth in output is explained by technology?
Chapter 11 Macroeconomic Issues: Economic Growth and The Business Cycle 117
2.
Explain whether the following statement is true or false?
Sustained economic growth will only occur if there are continual improvements in technology and not if there is an ever increasing amount of capital.
Consider the amount of investment expenditure an economy has in a given year. Is it possible to have a positive amount of investment spending even though the economy’s capital stock is falling? Explain.
Suppose that you have the following information for the U.S. economy:
Item Amount
Consumption Expenditure $67 million
Depreciation $10 million Exports $22 million Government Expenditure $31 million
Imports $25 million Investment $35 million Transfer Payments $8 million (a) What is the value of GDP?
(b) Is there a trade surplus of deficit? By how much?
3.
4.
5.
Suppose that in the previous problem you are told the following. U.S. residents living abroad received $18 million in factor income payments from foreigners. Foreigners living in the U.S. received $27 million in factor income payments. (a) What is the value of GNP? (b) How much is national income?
Answers
1.
Plugging the information into the growth formula:
5% = 0.75 × 4% + .25 × 6% + T 5% – 3% – 1.5% = T T = 0.5% 2.
The statement is true due to the law of diminishing marginal returns. Although an increase in the
capital labor ratio will increase output per worker and a nation’s standard of living there are limits to how high it can go. Eventually, diminishing returns sets in and output per worker increases but at a smaller and smaller rate. Technological advances allow an economy to increase output per worker for any amount of capital per worker, and therefore, avoids the problem of diminishing returns. Yes. Investment is expenditure on not only new capital but also expenditure on existing capital that is depreciating. It is possible that in a given year all investment spending is on replacing some of the old worn out capital. Since some of the capital may still be depreciating the economy’s capital stock would be shrinking. A better measure of the increase in an economy’s capital stock would be net investment which is gross investment minus depreciation.
3.
118 Gregory • Essentials of Economics, Sixth Edition
4. (a) GDP = C + I + G + X – M = 67 + 35 + 31 + 22 – 25 = $130 million
(b) There is a trade deficit since imports are larger than exports. The deficit is $3 million. 5. (a) GNP = GDP + US income earned abroad + Foreign income earned in the US
GNP = $130 + $18 – $27 = $121 million (b) National Income = GNP – Depreciation
NI = $121 – $10 = $111 million
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