THEORY AND POLICY 2nd Edition William H.Branson Princeton Untversity HARPER & ROW, PUBLISHERS New York, Harerstown, Phiizdeiphia, Sin Fran 6, LandesMacrocconorie Tory snd Policy, Second Edition opps 1978 by Wa sen nin Rep 1085 Second adi Rein 988 ‘Piedndan Ree 1088 LUMIVERSAL BOOK STALL. aout Ro ew Det 10 002 soe anda Pt Li, 48, adsl Ae, su 20 O10, Dit Chasibns (UP)x“ exes ‘The Static Equilibrium Model ” 4 Deman-Sde Egle: Fcome a he Tater te 3 gui nee a he It Rane Prods Maret Baan Income the oe teeth Mn Mate lla Fre sd Beny Maret Ime othe Lo Bad v 5. Anlntodetin to Motard Fc Polley n cal Foc een Donat Mosetary Ply Beton Demat (Toe 6 Sept Sd gira: Outpt ed the Pe Leet : 3 ‘Tae Sim Daren Moe The Da fi aor Te Seve. {ater Bqatromin Us Later Mk epee ‘Sip inte ho Hon nt Loe Ro / Sup Se Dstt 7. Byline State Moe 1B ‘exit Egultown rant) Rtion Demos Dostana Rel aera Avge (A ‘ign Recents Sept Dances 1 serch, Wage Rig, a Unemlormen M46 Labor Mate Serhan pom Egan Unmet in be ‘Gree eps Motel Wap sy be Apu Labor rit] {onl Wee Ried Aspe Unepest Suey AN Eae ‘iowa ernest 9 Monetary Fs an Tacs Paley te Stale Model 16h ene nF aya te State Mae Fe ad Meaty Matern te Ste Manco Ply the Ste Model {asomes Poyant Ens Den Canon at 5CONTENTS vu Part Sectoral Demand Functions and Extensions of the Static Model 181 ©10_ Consumption and Consumer Expenditure 183 VY _, _ Background: Cross Sections, Cycles, and Trends / Three Theories of the a Consumption Function / Choice Structure and Disequilibrium / The MPS , wae Model / The Wealth Effect in the Static Model / Conclusion: Some : Implications for Stabilization Policy — 11 Investment Demand DET. 214 ‘The Present Value Criterion for Investment / The Marginal Efficiency of Investment / Investment Demand and Output Growth / The User Cost and Liquidity Effects / Lags in Investment Demand / Investment in the Static Model / Stability and the Slope of the IS Curve / Conélusion: Investment Demand and Monetary and Fiscal Policy 12 The Demand for Money 243 ‘The Regressive Expectations Model / The Portfolio Balance Approach / ‘The Transactions Demand for Money / Money as a Consumer's and Producer’s Good / Empirical Estimates of Income and Interest Elasticities Liste Supply of Money 267 ‘The Instruments of Monetary Policy / The Mechanism of Monetary Expansion / The Determinants of the Money Supply / Empirical Estimates of Interest Elasticity / The Money Supply in the Static Model / Conclusion: ‘The Relevance of Interest Sensitivity of the Money Supply 14. Monetary and Fiscal Policy in the Extended Model 281 ‘The Static Model Extended / The Effects of Fiscal Policy Changes / The Effectiveness of Monetary and Fiscal Policy: Monetarists and Fiscalists / Tax Rate Changes and the Budget Deficit / Fiscal Stimulus and Deficit Financing \ ay 15. The Foreign Sector and the Balance of Payments 311 ‘The Current Account and Product Market Equilibrium / The Capital Account and Balance-of-Payments Equilibrium / Balance-of-Payments Adjustmentnde LA Cane / ace Pa Aisne! ay wh Ft $s Pi ce Dac Enya ee 16. Maceecnomis When Maret De Net Char + by Joba Meelinue abd Richard Pots ar “Te Repyi f he Fratton of Macononc Some Asie lina fe be "Resta Mo Manon Fund (be Repeal Mode Te Cone Mot ae atin Sol (Opes zeny The nga Tne nthe ona Cparne Sts Mehr, rd Dc The Mail an tal noe Part 1V ‘Medium-Term Dynat Between Static Bquilibrom and Long-Rin Growth 373 17 eto, Madey an name Dison 375 enn he Ste Mat Was Pan rd The Wag ce Gusta swe Diebson/ Arps Chane The Unt Lopate he toute a Topline Fouts 20d Usenloymet inthe 197 7 “The elton fee Co Unt: Tips Cane Inti See et Atif ae) 19 tnredction to Stack Adsnet Dynal as Moy Fe he at Ot (ted oath Bf [inset etn Cota Oa ten Btren be ‘Genes ade ec aay] A GeV o ‘eect Adee 29. ‘Tro Gromhia the State Mode 29 Asani Unehin Tr GrothTeet GowthfOntpat ant ‘Ten iowa Mowry Spt Pou Met Eom ~ {de ade he Merry ial ee Mw Ag Tod Fi Dag ‘ne Fuleagayment e/a Det wi Tend OeCONTENTS c ix Part V Long-Run Growth with Full Employment 457 21. Introduction to Growth Models 459 The Stylized Facts of Growth / Basic Assumptions of One-Sector Growth Models / The Harrod-Domar Condition for Equilibrium Growth 22 The Basic Neoclassical Growth Model 472 The Constant Returns Production Function / Equilibrium Growth in the ‘Neoclassical Model / The Neoclassical Model with Technical Progress / ‘Multiple Equilibria in the Neoclassical Model 23. The Basic Model Extended: Varying Savings Assumptions 491 The Classical Saving Function / The Characteristic Equations of a One-Sector Growth Model / The Kaldor Saving Fanction / The Ando-Modigliani (A-M) Consumption Function 24 The Golden Rule and an Introduction to Optimal Growth Models 506 The Basic, Neoclassical Model Once More / Saving and Consumption in Growth Equilibrium / Phelps’ Golden Rule of Accumulation / Optimal Growth Turnpikes / Conclusion 25 Medium-Term Growth and “The Measure of Our Ignorance” 523 Output Growth, Input Growth, and the Constant-Returns-to-Scale Production Function / Neutral Disembodied Technical Progress / Labor-Augmenting Disembodied Technical Progress / Capital-Embodied Technical Progress Index 539Preface The first edition of Macroeconomic Theory and Policy grew out of my lec tures to the advanced undergraduate and graduate levels, in the late 1960s, at Princeton University. Similarly, the new and revised material in this second edition has been developed as a result of teaching macroeconomic courses at Princeton, and as a visitor at the University of Stockholm and the Institute for Advanced Studies in the Social Sciences in Vienna during the turbulent period since 1972. The basic objectives and methodology of * the first edition are retained, but the second edition has been thoroughly revised, with three new chapters added, to reflect the macroeconomic events and theoretical advances in the 1970s. In this second edition, I still try to meet three objectives concerning substance (what material is presented), while adhering to three principles concerning methodology (ow the material is presented). Concerning sub- stance, I want first to give the reader a fairly thorough discussion of the structure of the macroeconomic system and the theoretical questions and controversies concerning this basic structure before getting down to the details of empirical estimates of the precise shape of the economy. So the first substantive objective is to display to the reader the skeleton of the macroeconomy and how its parts interact, before we get into controversies concerning the precise measurement of the body. This basic theoretical overview is accomplished in Part II, after three brief introductory chapters deal with the national income accounts and basic multiplier models from the principles course. The second substantive objective is to provide a fairly thorough review of the empirical work that has been done to date on the various sectors of = the economy that we discuss ‘in skeletal form in Part I. This review in- xites dope! of abr eri necig conse be, ise tate Sal a se ae ee ae Piseortrerserp ep eee teeter Seance ots ese Tr ae peal svn eke Serotec ie ya oak nists Seas eeteegeed ee uly Re incped esa hey fice denon ith anther eih teem Cok ween eines Ieee Fin toca mam wo hacker ar fealas nocias cee faethe eeepc oh Han Pha Vine dened rv of hs cota Vocus ae Finesse ingen wef path ce Sas oe Slaw crop poh seas waved ren ere teri ate ated cea nana woe Seong one pee og he Sal pow noes Seg towed dectedame aie Weller ay Si deen entaie beayr ae ecenat omer Belin wanda ot ne pot hy Chcrningebodalg. ay fs ping tyres poeta sprue coer ER i te Beamyeyctiicg pce keno coe aso Sj ta pli p a st lo ‘SSelieca ot MecPeh tata esay ta ally NE Ging’ ms pst SU an the ne men Econ pen dedagesmteanst oie Kereta SS epoletthinar pels eerie ot Tica mel htm oc sy, and kor mt Selsle seaeplacnsemanene tect Baeipar ae ee ne “estos mtd peace ftw ode the geet marietta noe ee tal weeconae rela ee SINC Sperloaearceonaanicetan seep! hot Snag aan tee Rapes eats SSS pir i i aoe te we li em Sorcb eation wo Shetelnii Gvas o e e eee eee ee acon "RoR achalcpe,or eosin, pas i 0 jxagse vetulerlinesy pekinese dt dea Eas Sie Seat Rete ce eos fedigousd Bo tu nate nd seal Space aie ona lf ori ef el ae Retestoemeheny sccee mee sid ea at a ee ey ae SS ies ie of Sa’ ei soePREFACE xiii students with a mathematical background to develop new insights into “feal-world” economics. ___The book focuses on policy questions and the current “state of the art” in macroeconomics, bringing in doctririal controversies only where thiey are relevant to current problems. I have not footnoted references in the text; whenever theories or results associated with particular individuals are dis- cussed, the appropriate references are included in the selected readings. Revisions in the second edition reflect both advances in macroeconomic theory and macroeconomic events since the first edition went into produc- tion in 1971. The major macroeconomic events were the deep worldwide recession of 1974-1975 and the subsequent “stagflation"—persistence of inflation with high unemployment. This has led macroeconomic research to shift to an emphasis on the supply side of the economy. This shift is re- flected in Part II of the second edition, which has been thoroughly revised to incorporate the role of expectations and shifting availability of raw materials on the aggregate supply curve, and in a new Chapter 18 on in- flation and unemployment in the 1970s that has been added to Part IV. The Part II revisions include a complete renovation of Chapter 6 to include the role of price expectations; incorporation of search theories of unem- ployment in Chapter 8; and analysis of incomes policy in Chapter 9. Throughout Part II we pay attention to shifts of aggregate supply as well as demand. ‘An important theoretical development in macroeconomics during the last ten years has been the reinterpretation of the static equilibrium model of Part II as a short-run model of general equilibrium with price rigidities, nonclearing markets, and quantity rationing. While most of Parts IT and HI] remain within the framework of general equilibrium with flexible prices, and wages, wage rigidity is explicitly discussed in Chapter 8, and the effects of rationing are discussed in the sectoral chapters of Part III. A complete exposition of the model when markets do not clear is provided in new Chapter 16 of Part HII, adapted by John Muellbauer and Richard Portes from their paper published in the Economic Journal. 1 want to thank them for the care they took in integrating this new approach into the text. Another niajor revision in the second edition reflects current research in macroeconomics on the medium-term dynamics between short-run equi- librium and the long-run growth path. This movement from short-run to long-run is the focus of Part IV, especially in new Chapters 18 and 19. Of course, throughout the second edition, the data, examples, empirical esti- mates, and suggested readings are all updated. In preparing the second edition, I have incorporated suggestions from correspondents too numerous to mention here. I want to thank them all, and for particularly extensive comments, I should thank Ruben Almonacid, Daniel Christman, Rolf Clark, Carl Gambs, Ray Lewis, James Price, Bruce Rettig, Case Sprenkle, and Ronald Sutherland. Robert Schiller at the Uni- versity of Pennsylvania kindly.provided runs on the MPS model for Part IIL. I have, of course, learned a lot from colleagues and students at Princetonho have ued the text, AmoEE my colegu, para hacks 19 See ll i A A ak tf Chapter 6 Among sede epaly waa oak Lovia aeh ‘apatites sow acting St Ye, fr toh pot comments td & orgpcal dans ae gos Seta area ope te tte condos, ato recon prune Soden ute Neon Sho Rotaniteg the povided ny our of rar strc on ‘eine tt fevlon fhe fi enya the inex eon Firper tod Row ve ho bern heigl an expert Tris edice Tel folow Pal Sumac dum 4 ese 0 ss ly and Emily. the oer cle Wiliam H. BransonAn Introduction to MacroeconomicsActual and Potential GHP: Fluctuations and Growth In microeconomic theory, full employment of resources is generally assumed, so that the focus of the analysis is on the determination of relative prices and the allocation of scarce resources among alternative uses. On the other hand, in its now traditional form, macroeconomics focuses on the level of utilization of resources—especially the level of employment—and the general level of prices. In addition, macroeconomics is turning more toward the question of what determines the rate of growth.of resources—the growth of potential output—as well as the determinants of their level of utilization at any one time. The focus of classical microeconomics on the allocation of scarce re- sources for their best uses implicitly assumed that full employment—scarcity of resources—is the normal state of the economy. If the economy is operating at substantially less than full employment, resources are, at least temporarily, really not scarce, and the opportunity cost of additional output of almost any kind is about zero—more total output can be produced by simply reducing unemployment. Because the U.S. economy, for example, suffered major recessions or depressions with high unemployment in the years 1907-1908. 1920-1921, and 1930-1939, the relevance of classical microeconomics was bound to be questioned by more than just the hard-core skeptics. The Development of Macroeconomics Partly as a reaction to the Great Depression—that's what the historians call it, even though one suspects the people living then didn’t think it was so great—of the 1930s, and with the publication of Keynes’ The General 3neeanaoucnon To mcnaxeonoues Toro Em meet nt Mon 9 mater ani Sheen ea imi supe rang soe Ig af Tones pled feat nh el oes or 80h Sy it po erin mecene ish fgged teen sey on os fatten ont ta tie og fucose dea px sce ‘ric sein snd ional pear ganatan ots feta att habe hike ely recey esg Tt iri Outten we ered ton Wt artle ia teconoey marten eng uence te Sakipmen tet inenshons sos kon 0 oe ‘cg c een eting sate. com Sect lhyitenanomn eel Sopra ee ih tts dup cen devo ong a it in sas py spo rey prey pr enero SpE We ene she ces Hea ne Eeritieni nee engesmmisentwt ar Hehnc oda pace inst oma deo ‘edgy drsne ene fennel ‘oe apn one he Senn of at corns tha uapntaseniywcikee cramer. Soc awa toc mel meses a Tepes by hers ket een ttn seal eon ya ek St Safe cies kt epprySatreage SSRs autaeenna tote isometries opr rade oyna nha aco om ‘Peseoy domes Saeco ony canon ma Sah ae el otal any te ro cone cma aa een ‘Mat move ee enon fo ell equiv ova» growth BEADS tore Guu log secure taka decrmane TSUSEGICG ate cts or segenee soe Mebane indjamtasele Reb mchenas wad es ye ‘Sept pce oe ak east ay ine derma ha sept ce arena noe ene Sean meg ram me gabe aacpe ae cheng apse bce noe eee SSELSAOTRy, Sas ae seeps a tse[ACTUAL AND POTENTIAL GNP: FLUCTUATIONS AND GROWTH 5 \ But it seems clear that the theories of medium-term dynamics and growth and their applications are now at the frontier of macroeconomic theory; that is why this book departs from the usual format of macroeconomics texts or treatises to offer a fairly thorough treatment of some issues in medium-term dynamics and aggregate one-sector growth models and to examine the empirical evidence we do have concerning the dynamic process. While we may not be able, at this level, to take the student right to the front lines of macro theory, the least we can do is give him a brief tour of the intellectual combat zone. Actual and Potential Output Most of macroeconomic theory in its current stage of development focuses on two main questions: 1. What determines the path—level and rate of growth—of full-employ- ment or potential output? This is the question of growth theory. 2. What determines the level of actual output relative to potential at any one time? This is the question of income determination or stabilization theory. A third question concerning the behavior of the price level—the rate of infiation—can be added to the second of these two central questions, and it too occupies a good deal of space here. THEORY AND POLICY Implicit in these two questions, and inextricably bound up with them, are questions of policy. If depends, ateast.in part; on the level of the moni at least in part, how, to.change.the level of.outpu unsatisfactorily low. ‘Thus, it is almost impossible to talk about theory without implying possi- bilities for policy, and the best way to approach policy is probably by studying theory and its empirical applications. In this book we deal with the two main questions in inverse order, mostly because, as is suggested earlier, much more is known about stabilization theory and, especially, policy than about growth theory and its applications. For this reason, the traditional macroeconomics course focuses on the . problem of income determination and its implications fér stabilization policy. Before we go on to a brief preview of the methods we use in Parts II-IV, it should be useful to review the movement of actual and potential gross national product (GNP), unemployment, and prices in the U.S. economy since 1960. This is to give the reader a feeling for the relationships between these variables and also for the context in which this book is set.Movements of asa pte outpt—or real GNPare shown in Figur lay the pero B80-1998 The moval of he nergy {tee ration a he bo fret oneal soca Ppa To, Fully. Fgue (fel wesbon thera ofl the comer eine (CPI, “The pel real GNP ne a Fiat -() sbons the ral GNP at would be roduc! with at aerplymet ate tender 3 percent THs tteCotnatonEaonomteAdvier teuphestnaealtewnenoloymentte ‘eset oh clog, Gn the at tat al elon Feat inpossble Theatr oLONBntaslapetnetens fate Ege pe Teco 33 pen ay ee iti the seag Bw ae abo aly 18 erent ding The st Sout, and sbiaction the anil 3 pent dene he work wet ‘ing tons 20 pera growth reins peony ves le oF {Stereo grow of potent utp ‘Treacut ONP hneimFigue 1) yest thatthe el GNP actly produ drenc tetocen pena an cial GND i the GNP Se Sa ac ach ea eared eee eer eaten eer gure) ete, rete GNP. pp the peter the on alors Silt Ace can cence A at SEEMS OP ATT Otom, ouphte Otic tata peter Suerese el ONP wil sida | peenapepa deere nthe on SRS ed rg sows herent tna ene cnge “Hite CPt iterate of inianan-corciponding tothe GNP esp end ‘plement ae een Connrean of Fgwes 0) sn 1) sam tat mseea Sethe ennai rede the ate aoe fat ae he Spee elarensty Coreen eeepc SIS Eischatig watdacncalnChoper era arcane tron Tat tocsry 80s, x hewnenployment te gral ce down ere vad to erie ince inthe eof fii Dl the fair dpa ake teoyn fer ea 1948 196 ough a shaepipereas in the te oF ‘Mali andthe shen of eat dnd sre at eet nempleyment elo 4 pccet om 1986 ous 10) generated 3 com ‘ug ton tha on sone at nn long by 190 "Te beds opened wh emlayent tact ra of 67 pent iauhescend quater of 19961 than caesponingy ntl NP Stagg opt tha GNP gapot 83a fy 1972 dirs. The re ‘elumneerysubiema coh theraienan otek dmand condos sine 1994 The usplyment ate pea 071 percent 1988 and fh tt poet 3) te teagan hn rig og? n "The padual clon af the GNP pap and reduction of woeplyment ‘om TET om 1868 a duet ates dean or up NESFigure 1-1 The GNP gap, un- employment, and inflation, 1960-1970. 1,300) 1,100} Potential GNP Actual GNP $ Billions (1972 prices) ob 1960 196219641983 «19681970 1972-1974 1978 (a) Actual and potential GNP 90 70 Percent 50 30 ee er 1960 1962 1964 1968 1968 1970 1972 1974 1970 (6) Unemployment rate 120 80 Percent 40 0 vos) 1962-1861 +1965 1965 1970 lo72 1074 1876 (ce) Rateof inflationty» sees of expansionary Hcl pic ations combed with amily ‘gnsonary row afte money Soply that eveaped 3 pen pe Ser fom 196 Tip 1965 1p oat te Asmisitaian ered de Sovemmenl epee toatl the economy adn reson {Senne ae ae econ ans os ‘Wheninife 9ehheratcalgonhandtbeumlayoentrteatoed ‘out the Adminstration proposed 9 ta ut anany TOES fo ge he ‘Sconomya rhe Boo Th a at na pad io Maoh 39546 0 cert demu Th sol long wha coed experi the ‘ney sap tok theca amon upto lemloyt by mi 188, eae sere ire “At hsp 108 the tory of stbiation pi in he 16 seas sues story Fea nd monetary policy ad eed he GNP gp om $55 bin in 1961 torr by IEE, unemployment Was ee fo [eee ahd the ate of tio, whe beng tte, mat Sl wader ‘ipseet Tobe rr. the sallenon probe tr 961 ary ee sna an wth the svanige of inde Wit sable pcs tse GN {ips and igh enemploymen thet Secon fr oly as Sv Exfond Te eager nar cad oat a grees rannftonsy way: {a ont rea dnc of olin that appeared bas wheter te cal ‘nla prope 18 shoud cme tsa a ct boc costes ‘endig’ rom an eres pb pending on Kea Bethy aad ‘lhe prem decison cme dow on hese ota paaly pelts cp, Conc Sin tt he Admin Interhagin ie seas to propane een eng Corrs tops ata Ieee when roan mand spear aces ato haut hat bt sed eng roxas np ahd td ‘ein apf eainon po ee nmi 1565 expansion he Video War began acne ape xynson of oda porta gos abd servis the ens Sate {nts ik atesecnpendirer toss Ssbahony 19661 ty ad ren {1230 ballon andy 167 lth ood at 3 6ien-on eens of ery ‘25 tion or grent ts two yen Ts pesto to demand wat fet nnd by oun cos pee dome ect Seals cit Gere né pene rom he pam hs EFeconami pti ater) ire ip dana rom needa bane Snemploynet below & psn i 1864 anne ate onan one 16 ey pret az shom fn Fgue 1.1) “Renta he ante 196th Fer Reser ali he rte of grown SOSSGW ect tn cee (FE) woe ented Cad eqns {tue Houses demand strata by reste morse ere snd ‘tion: fvement if te ST das to bah ci thoes and ‘sperson ofthe TC Tee step redone ron emo rat ‘ti andthe adcn ye demand pret bgt he unemployetACTUAL AND POTENTIAL GNP: FLUCTUATIONS AND GROWTH “9 rate up slightly in late 1967. The rate of inflation also flattened as a result of eased demand pressure. With the economy slowing in late 1966, the Federal Reserve permitted the money supply to resume its growth at.an annual rate of 7.0 percent from January to June 1967, and the investment tax credit was restored in March 1967. To balance these expansioriary moves, in January 1967 the Administra- tion requested a temporary income tax increase, to become effective in July od 1967, to slow down the growth in consurher demand. However, the tax increase was not passed until July 1968, and by then the combination of continued money supply growth of 6.4 percent from June 1967 to June 1968 and the further increase in Federal government purchases of $5.8 billion in “ defense and $3.7 billion in nondefense areas from 1967 III to 1968 HI had pushed the unemployment rate back down to 3.6 percent and raised the rate of inflation to 5.1 percent. Passage of the explicitly temporary income tax increase of about.2 percent in July 1968 did little to dampen demand. while + money supply growth continued into early 1969. Finally, in late 1968 and early 1969 the growth of government purchases slowed; there was almost no increase in purchases from 1968 III into 1970. At the same time the growth of the money supply was again slowed in early 1969 and held to 1 percent in the last half of 1970. Even with the expiration of the income tax increase—half in January 1970 and half in July 1970—this shift to a restrictive monetary and fiscal policy slowed the growth of demand in late 1969, and during 1970 a GNP gap of about $30 billion reappeared. The unemployment rate was up to 6 percent at the end of 1970, and the first signs of a slowdown in the rate of inflation were appearing. Thus, in early 1971, it appeared that the economy, in a way, was coming back toa position’ similar to its starting point in 1960, but with a smaller GNP gap relative to potential GNP, and an unemployment rate around 6-6.5 percent instead of the 65-7 percent of 1961. The reduction in demand seemed to be slowing the rate of inflation, so that in 1971 the economy might begin another gradual expansion with stable prices and slowly falling unemployment. However, this pleasant scenario, written in early 1971, did not describe the actual developments that followed. The inflation, recession, and recovery of the 1970s are analyzed in detail in Chapter 18; here we conclude this narrative with a short summary. In mid-1971 the unemployment rate peaked at 5.7 percent. The rate of inflation was falling from 5.5 percent in the first quarter of 1971 to 4.7 percent in the second quarter, and 3.6 percent in the third. This steady fall in the inflation rate was not apparent at the time, and in August 1971 the Adminis- tration began the first phase of wage and price controls, which continued into 1974, With the controls in place, the Administration provided a substantial stimulus to demand in 1972 (an election year). Federal purchases, which had been in the $97-99 billion range from {968 through 1971, jumped to $105 billion in 1972. The money supply grew 8.8 percent from the end of 1971 to the end of 1972. The result, with a lag, was a drop in the unemployment ratefrom 7 paket percent thee of 97nd esata 1046 percent "ht arin at wma ree on arto aan {otsand 97a ina sodden emp inthe sation re Monstary ahd fal poi shied ome 1973 and were date that {974m reauon to tejumpm Exton In eats government parce JeyyS erect tom 972 ound here owt he ate sock ‘taeda vers poret in 17 ines an aiaton ater TS pct by the end the yen, "Toeedec af the monetary) and cal sqnee a 197 was aparnt inthe scempioyment ate mish rtsto9 pram ad nthe tection vhs sees abode Perr mil-97R At that pot howeey, he eesion oto sd gradual eeasion began Gace aia ‘Ahaoeh economic eeovery sed athe senna 17S he 1973 ages MP nest oh cone pu Semcon and 8 percent Gang 16 sed lly nde? prea by mie [B77 Ws armere sable of pa he te ofiation a about pest Bytheend 37 ‘Contac economic gonth should be gost or the remainder of the eens stoning wcetiunan ot grea esnery dang =, ‘it iempionment by 19000 1981 foot peta ‘SOME IMPLICATIONS FOR MACROECONOMIC THEORY ‘ype btn of hemi maceemonicvae erin ‘grep some eae head be spare ane te esos ‘ebeen stl uted an the wena te suas the eel a ‘ctat na fntnn of employment The potucton farina ‘Spe n Caper and wsed rong the et ebook ‘Sedona an sugested shove. thre ape to bea nts eaoship ‘escent el af nemo ed feat ft the conan cats bese of demand siseditartanes Tht Paigecure rene ‘hips neduied tm Caper 18 as an inpora pt of be ceonanys elamiem djmems inne tae the nin of stl onpa opted bythe evel of dead, Sik otra soon weed by monetary and Bsa poli ‘langa-moveens the money supply, goverment puchses and tt eid ha aaa it eno ane te {hep inelWetegnanasfite ces feats oy ‘ia ei fener asi Chapter Sand tency tat ‘shut incense comply Capes 8,808 14ACTUAL AND POTENTIAL GNP: FLUCTUATIONS AND GROWTH ui An Analytical Approach to Macroeconomics In Parts II and Ill, we use an aggregate general equilibrium approach to build a theory explaining movements in output, employment, and the price level. We introduce, in turn, a product market for goods and services, a money market, and a labor market. Together with the production function linking output and employment, demand-and-supply equilibrium conditions in these three markets jointly determine the equilibrium levels of four key variables— output, employment, the price level. and the interest rate. In general, what happens in one market affects all markets in a general equilibrium framework; so in Part IT, where we focus on the skeletal analytic framework of the system. the emphasis is on simultaneity and interaction between markets. AN EXAMPLE OF SIMULTANEITY BETWEEN MARKETS Consider a major increase in the efficiency of a transactions mechanis introduction of a widely held and accepted credit card system. This is “I an increase in the money supply in that a given stock of money will finance an increase in annual transactions. This will tend to reduce interest rates, since people can reduce cash holdings and buy interest-earning bonds. The increase in bond demand bids bond prices up and interest rates down. The drop in interest rates essentially raises investment demand by making borrowing cheaper. Increased investment demand raises sales and income and pulls the price level up. The increase in output and the price level raises employment. In the meantime, higher income and price levels tend to raise the demand for money, so that to a certain extent the effect of the original stimulus of the credit card is offset. Eventually, the system settles to a new equilibrium with higher levels of output, prices, and employment, and a lower interest rate. The initial disturbance in the money market has spread through the other markets in the “model,” as it would spread through the entire economy in the real world. The important point in Part II is developing an intuitive under- standing of this kind of simultaneity. CONNECTION TO THE “REAL WORLD” THROUGH EMPIRICAL RESULTS The discussion of empirical findings in Part III is designed to add richness or texture to the analytical framework of Part II. We see what both theory and practical experience with economic data tell us, for example, about how long it takes for one variable, say, investment demand. to react to changes in another variable, say, the interest rate. We also discuss whether temporary tax changes have different effects on the level of consumer spending than permanent ones.a sncermoouoan vo mscnoecovonc While Pari is meat to ep dovlon a8 ndertaning ofthe Bae nahi of he maroon tem, Pa should help event Mind queedtre iatulton conning the reams beter the Sic marecconomic arable How long d hinge tse 2d Mo [ings witbe rectors et SF bette Cig we nee a ri review of tenon income counts, hh both deine many feu Key maroon vary ‘Sormpion, ineseat. ard s0 o2--and prove sacl Sevag Sfamewotk ir ber taps Ths rvcw petted Chapter Poe) {hen elves wth ra tevewinChaper of ebilncone tein ‘Star ro the ni egnamc pops coe Selected Readings ‘coum of Bonnie Aanien, Anal Ret she, DC: Gonna ‘Roce Oe nay sey ety Dea ey Gong -h New nm of tal GP, Cool of Ens Ai, WW. Her Ne Dramas Pea! Emp (Cate, Mas Menard Usman 06 capes ‘AMC Oke Te el Eton 6f Pp Yk Cape and anne ‘A.Me Olan "Tie Gop Bec Actes Ftp The oe set Cm, hao eon WW. Noy Er pt ap ad Dt Dag Ro Boe rom 1A Review of the National income and Product Accounts The National Income and Product Accounts—frequently referred to as NIA—are the official measurement of the flow of product and income in the economy. The accounts are maintained by the Office of Business Eco- nomics (OBE) of the Department of Commerce and are published in a monthly OBE publication called the Survey of Current Business. Many of the economic aggregates, such as consumer expenditure, business invest- ment, and so on, that this book deals with, are defined in the accounts, which also provide a framework for analyzing the level of economic activity. So we begin our analysis of income determination with a brief review of the accounts. The product side of the national accounts measures the flow of currently produced goods and services in the economy. The income side of the accounts measures the factor incomes that are earned by U.S. workers in current production. On the product side, the flow of goods and services currently produced by U.S, workers is measured by expenditures on these goods and services by consumers, businesses, government, and foreigners. The counter- part to this flow of expenditures on final product is national income, which measures income received by factors of production—compensation of employees, profits paid to owners of capital, earnings of proprietors, and so on—in compensation for producing the final product. This means that the product and income sides are two different measures of the same continuous flow. The product side measures expenditures on output, These expenditures then become payments compensating the factors that produced the output. These factor incomes then are disposed of in consumer expenditure, tax payments, saving, and transfer payments to 13cy foragers Thus, we ean view pes atonal product (GNE) es hee di feet waival means Mealy the stne Rowe The bre GND rpeswed ty een nal proc: he spond 8 GNP nestor by the ype of terme generated in earn the id e GNP mented byte ay he ocome edo apt "Te fit aa hs of he ‘euros pv or he baie GNE wey tat fans ote $y ofecners on an ageepte—or aco" CHECHEN SONPECHSST HR, = ‘The Left side of ts ientey measres GNP by expenditure 02 Solent He neon fre nhononn tegument, ented reelection. sie {nto som fiat dorsi bene: oa fier at, nd os ‘oveamet parses of goods end serves (F ~My inet eos Te opt mod of) meanes GNP ty the way come cae in ‘rotations dpe of Hee Capa consume expends {et eving by consumers ad by banners nthe fom of deren ‘towsoa and teed earning 7 is ett pent ot a ops tes rans, tees ad subd pent yl ects poverht Ie is tranaer payment oles by pte stuns, ea, ae peopl or dents to ineratoal eat eos "Md of this enaptrshowe how expendares on Sn pode, the ethan idea ae ranted it he depoon fete eos Protection the dgtetand side of 1 ough the ae pest TRS Free seven several pron Past esp jibes he Ney ( ‘ie is Soe to ail te areceonomc teary ht felon by shone ‘Berend bowie eto ice ag pretax “hag toner Secon it dened to give the eae tt forthe gate sealed Macrrconomi thon el teary, inves great deal attain, andl bs wt fr the ender to eae o tate Se Seo, more forks eatnuney. ck ito he tlt aaona cove exec. Flan» review ofthe sconts oduct ene Tote cept Economie raves commen deal wisn uceesomomts teary Te ‘beoy dels with apres vals atv hvough the beaks aes Nera these peg eps a "Ie next sete of hs caper Gora ame Basie ponte wader ‘ying te eros We then troduced er fow of pode ‘odin tied the GRP eat Net we Gere the mar ‘Sendhare sarees cathe product Se of the toute abd ace he ‘come font bak tothe income ne We fish tw esrition of he ‘pms ooing tbo te tang nesta! alte The eon Sethe datnaon betwen nator mney, GNP mesure cure Epes RF ae nyc rs Ne sah ft ‘ne ok mt the govenet tor ef the acon an compe ‘heed eis Bt tha he reset esbneanual Yo Congres]‘A REVIEW OF THE NATIONAL INCOME AND PRODUCT ACCOUNTS. 15 Finally, we end the chapter by raising some questions about the use of GNP as a measure of national welfare. Some Principles Behind the Accounts There are a few basic ideas underlying the construction of the accounts that should be kept in mind as we go through them. Here, four of these ideas, which seem particularly relevant to our purposes, are briefly discussed. Keeping an eye or them will help prevent confusion in the later discussion. ‘The first point is that the accounts should aggregate economic variables in a way that is useful for economic analysis. In general, this means “like” expenditures, or incomes, should be ageregated together, and “un- like” expenditures should be separated. On the product side of the accounts, this principle means that sectors of expenditure should be aggregated by who does the spending, that is, into expenditures by consumers, businesses, governments, and foreigners. This is a useful way to agerepate, since pre- sumably each of these different kinds of expenditure is related to a different set of motivations, and thus to a different set of other economic variables. For example, consumer spending is probably related to consumer income and perhaps wealth, as we see in some detail in Chapter 10; business in- vestment may be related to such variables as expected sales, profits, and the cost of capital, as Chapter 11 shows; government spending is determined by a political process only distantly related to consumer and business spending decisions, and net exports depend to a great extent on foreign incomes and prices. Second, the accounts measure the expenditure and income stream that comes from current production of goods and services. Transactions that transfer ownership of existing assets are, in general, not reflected in the accounts because they do not involve currerit production. For example, an individual’s purchase of a used car will enter the accounts only insofar as the purchase price exceeds the sale price of the previous owner, reflecting some value added to the car by the services and facilities of the used car dealer, which presumably facilitate trading and thus add to output. In a case where the owner sells directly, the transaction involves only the trade of one existing asset—the car—for another, presumably cash or checking account deposits, with no value added by a used car dealer. The transaction involving purely an asset exchange has no direct effect on current production and thus does not enter-into the national income accounts. Of course, it may have indirect effects on consumer expenditure since the mixture of assets on both sides has changed. The seller now has liquid funds that may increase his spending, while the buyer may reduce spending for just the opposite reason. But these are indirect effects that would be observed, to the degree they occur, in current consumer expenditure items. ‘The last two points are related to the orientation of the accounts toward the measurement of total output as an (obviously imperfect) indicator of