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Wk 5 Discussion 1 Aggregate Supply and Economic Growth [WLO: 3] [CLOs: 1, 2] Economic growth may be attained when either aggregate demand or aggregate supply shifts to the right. Prior to beginning work on this discussion, read Chapter 15 from the course text, especially examining Section 15.2, and respond to the following components: What are the different effects between aggregate demand-based growth and aggregate supply-based growth?What may shift aggregate supply to the right? Thoroughly explain its process.As a policy maker, would you prefer the strategies of aggregate supply-based economic growth or aggregate demand-based growth? Why or why not? As a proponent of either aggregate supply-based growth strategies or aggregate demand-based growth strategies, what would you recommend for the current U.S. economy to achieve stable economic growth? Your initial post should be a minimum of 300 words. Wk 5 Discussion 2 The Challenge of Economic Development [WLO: 4] [CLOs: 3, 5] Imagine you oversee a developing country’s growth and have been approached by a multinational corporation interested in locating in your country. Prior to beginning work on this discussion, read Chapter 16, especially examining Section 16.5, and respond to the following components: Describe a multinational corporation and foreign direct investment (FDI).Identify some benefits and costs for the host country from allowing a multinational corporation to locate there, despite its developing economy.Evaluate whether developmental assistance from world developmental agencies, such as the World Bank or the United Nations, would be preferable to private investment. What would you decide between developmental agency assistance or private investment, such as FDI from multinational corporations? Why? Explain. Your initial post should be a minimum of 300 words.
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15
Aggregate Supply,
Economic Growth, and
Macroeconomic Policy
Rawpixel/iStock/Thinkstock
Learning Outcomes
After reading this chapter, you should be able to
• Explain the importance of the slope of demand-based growth strategies.
• Identify sources of economic growth, which are the factors that can shift the aggregate supply curve and
improve productivity.
• Describe how growth in the labor force affects economic growth.
• Understand the supply-side policies relating to taxes, transfers, and regulation.
© 2019 Bridgepoint Education, Inc. All rights reserved. Not for resale or redistribution.
Demand-Based Growth Strategies
Section 15.1
Introduction
In May of 2018, the U.S. Labor Department reported the lowest unemployment rate since the
1960s (3.9%).1 But in a massive survey undertaken across four-year college campuses in the
United States in 2018, only 51% felt that their major would lead to a good job.2 If unemployment is historically low, and the economy is doing well, why do college seniors feel uneasy
about finding a good job? One of the major reasons, which you will read about in Chapter 15,
is a change in the supply curve. According to The Economist, 48% of Americans now have
degrees.3 In 1991 that number was 24%.4 This rise in the supply of college-educated Americans has put downward pressure on the salaries of recent college graduates. More and more
young people now have degrees, and the price for their services has not kept up with inflation.
Additionally, according to The Economist, two-thirds of Americans who have a college degree
(25 million people) are doing work that, 20 years ago, did not require a college degree.5 The
country currently has $1.4 trillion in student loan debt. Are we getting our money’s worth?
Kitroeff, N. (2018, May 4). Unemployment rate hits 3.9%, a rare low, as job market becomes more competitive. The New York Times.
Retrieved from https://www.nytimes.com/2018/05/04/business/economy/jobs-report.html
2
Bauer-Wolf, J. (2018, January 17). Unprepared and confused: a new study says students don’t feel confident they can find a job or succeed
when they land one. Inside Higher Ed. Retrieved from https://www.insidehighered.com/news/2018/01/17/study-college-students
-dont-have-confidence-theyll-land-job
3
All must have degrees: Going to university is more important than ever for young people. (2018, February 3). The Economist. Retrieved
from https://www.economist.com/international/2018/02/03/going-to-university-is-more-important-than-ever-for-young-people
4
All must have degrees. (2018, February 3).
5
All must have degrees. (2018, February 3).
1
15.1 Demand-Based Growth Strategies
A steady rate of economic growth is the most central of macroeconomic goals. Like any goal,
the goal of economic growth involves some trade-offs. Growth is often accompanied by inflation, which redistributes income. Growth may benefit the rich but fail to trickle down to the
poor. Growth may come at a cost in terms of leisure, environmental quality, or security. A society must weigh these costs against the benefits of growth. Growth allows a society to absorb
a growing labor force without rising unemployment. Growth increases the standard of living.
Out of the “growth dividend,” a society can (if it chooses) provide for people who are elderly,
homeless, or poor—needs that can be addressed less painfully out of new resources and new
income. While there are still concerns about environmental effects, leisure, and quality of life,
there appears to be a consensus in favor of encouraging growth by either increasing aggregate demand or increasing aggregate supply.
A demand-based growth strategy is an attempt to create a long-term increase in output
and employment by shifting aggregate demand to the right. Demand-based growth strategies are based on the long-run effects of the lost output during periods when the economy is
operating significantly below its potential. The output that is lost during that time includes
some valuable investment in research and development (R&D), physical capital, and human
capital (both formal education and on-the-job training). These lost investments could be the
inputs into future growth. The usefulness of demand-based growth strategies depends on the
length of the time period that divides the short run from the long run. Thus, the ideas about
the aggregate supply curve discussed in Chapter 14 are important not only for stabilization
policy but also for demand-based growth policies.
© 2019 Bridgepoint Education, Inc. All rights reserved. Not for resale or redistribution.
Demand-Based Growth Strategies
Section 15.1
Revisiting the Aggregate Supply Curve
The debate over aggregate supply has concentrated on the alternatives of vertical versus
upward sloping. Most economists agree that the short-run aggregate supply curve is upward
sloping rather than vertical. The upward slope results from imperfections in the marketplace,
such as immobile resources, imperfect information, long-term contractual agreements, incorrect expectations, or delayed responses to information. Rational expectations suggest that the
short run is not a very long period of actual time and that the long-run aggregate supply curve
is vertical or at least very steep. Adaptive expectations suggest that the short-run aggregate
supply curve could be fairly flat and that the short run itself may be a long period of time.
The Short Run and Long Run
The link between demand management policies and economic growth arises from opportunities for real (short-run) profit created by a rising price level. Workers, entrepreneurs,
investors, and consumers who can respond more quickly than others gain from rising prices.
Suppose, for example, you are a shoe manufacturer. Prices in general are rising, and you can
get a higher price for your shoes. Your contracts with workers and suppliers include prices
that are fixed for 6 months. If during those 6 months you can obtain resources at fixed prices
and sell the shoes for higher prices, you can increase your profits. At the end of 6 months,
your contracts will be up for renewal. You know that wages and prices of materials will rise,
and your temporary profit surge will end in the long run. In the meantime, however, you have
an incentive to expand output. In fact, if you expect more such surges in the future, each with
a short-run profit opportunity, you may respond by investing more in new equipment, more
modern technology, and upgrading employee skills.
The long-run and short-run aggregate supply curves are shown in Figure 15.1. The long-run
aggregate supply curve, LRAS, is vertical at Y*, which is the real output level corresponding to
the natural rate of unemployment. The short-run aggregate supply curve, AS1, is upward sloping. Initially, the economy is in short-run and long-run equilibrium at P1 = 110 and Y* = $18
trillion. Then aggregate demand shifts from AD1 to AD2. Moving along AS1, output increases
to Y2 = $19 trillion, and the price level begins to rise to P2 = 120. Producers raise prices and
expand output in response to increased demand.
Eventually, however, the rising price level affects the prices of productive inputs: workers,
capital, and raw materials. The real value of workers’ earnings falls. As soon as resource owners have an opportunity to renegotiate wages and prices, those wages and prices rise. Rising
costs produce an upward shift in the short-run aggregate supply curve to AS2. Once again the
economy is in short-run and long-run equilibrium at a higher price level, P3 = 130. However,
there has been no permanent increase in the level of output and employment.
The important question is how widespread these short-run profit opportunities are and how
long it takes the market to eliminate them. If imperfections are substantial and it takes a long
time for the market to adapt to change, then an increase in aggregate demand can increase
© 2019 Bridgepoint Education, Inc. All rights reserved. Not for resale or redistribution.
Demand-Based Growth Strategies
Section 15.1
profit opportunities and real output for a fairly long period of time. This higher output represents growth not only of consumption but also of the resource base of human and physical
capital acquired during the interim. Expanding aggregate demand can be a growth strategy
as well as a stabilization strategy.
Figure 15.1: Short-run and long-run aggregate supply
When the AS curve slopes upward in the short run but is vertical in the long run, an increase in aggregate
demand results (the shift from AD1 to AD2). Real output returns to Y*, and only the price level increases.
Price
level
ASlr
AS2
AS1
130
120
110
AD2
AD1
0
$18
trillion
$19
trillion
Output
Once again, economists are faced with this question: How long is the short run? Economists in
the Keynesian tradition argue that the short run is very long indeed, possibly 10 years or even
longer, because these imperfections are large and the market works slowly to overcome them.
Economists of the classical tradition are more optimistic about people’s ability to acquire
and process information and about the ability of buyers and sellers to respond quickly by
changing prices, quantities, or suppliers. Consequently, they see little role for demand-based
growth strategies and concentrate instead on shifting aggregate supply.
© 2019 Bridgepoint Education, Inc. All rights reserved. Not for resale or redistribution.
Demand-Based Growth Strategies
Section 15.1
Policy Focus: Real Business Cycles
A growing economy typically exhibits some instability because innovations resulting from
R&D and investment spending do not occur at a steady pace. Thus, such an economy would
be expected to exhibit business cycles, as described in Chapter 4. The Keynesian model
explains such cyclical fluctuations in output, employment, and the price level in terms of
shifts in aggregate demand combined with a relatively stable aggregate supply curve that
gradually moves rightward over time.
Another explanation of cyclical fluctuations, in the classical tradition, was developed in the
1980s. Its roots go back to such early 20th-century economists as Wesley Clair Mitchell (who
first measured business cycles) and Joseph Schumpeter. This explanation holds that cyclical
economic fluctuations result from changes in aggregate supply rather than in aggregate
demand (or changes that affect both at once). The cyclical pattern is called the real business
cycle. If changes in aggregate supply as a result of technology shocks and other disturbances
occur irregularly in large bursts, the result is cyclical fluctuations in output (Mankiw, 1989).
These cyclical fluctuations arise because workers and owners of firms take advantage of
temporarily high returns to investment, production, and work effort when such shocks
occur. Later, when the returns to such efforts are lower, workers will catch up on leisure and
firms will slack off until the next shock begins. Intertemporal substitutions of effort (shifting
economic activity between periods to take advantage of the time period with higher returns)
will lead to fluctuations in output. Note, however, that in this model, unemployment is largely
voluntary, caused by the substitution of work effort between time periods to take advantage
of the higher wages when productivity is higher.
A supply-induced explanation of fluctuations was a response to the experience of the 1990s
and early 2000s. At that time, supply influences, such as a less-experienced labor force and
higher oil prices, seemed to shift the aggregate supply curve to the left. Such a shift would
result in the usual decline in output and employment that indicates a recession. Unlike
most recessions, however, there would be no fall in the price level (or the inflation rate).
In a supply-induced recession, in contrast to a demand-induced recession, real output can
fall while the price level rises. A subsequent shift of the aggregate supply curve to the right
would expand both employment and real output. What happened to the price level during
such an expansion would depend on whether aggregate demand also shifted to the right
during that period.
In general, a real business cycle—one based on shifts in aggregate supply—implies rising
price levels or higher inflation rates during recessions and lower price levels or lower
inflation rates during expansions. This pattern is somewhat consistent with the experience
of the 1990s but does not generally describe cyclical fluctuations for longer periods or any
of the more recent business cycles, like the one from 2007 to 2009. Evidence to support a
real business cycle on a regular and recurring basis has been weak, but some recessions or
expansions may be triggered by factors shifting the aggregate supply curve.
© 2019 Bridgepoint Education, Inc. All rights reserved. Not for resale or redistribution.
Shifting the Aggregate Supply Curve
Section 15.2
Key Ideas: Growth Strategies—Aggregate Demand or
Aggregate Supply?
• Demand-based growth strategies try to create a long-term increase in output and
employment by shifting aggregate demand to the right. These strategies are particularly useful when the economy is operating significantly below its potential.
• Keynesian economists argue that market imperfections are large, and as a result the
short run can be very long.
• Demand-based growth strategies are appropriate and effective.
• Classical economists claim that the short run is really not very long.
∘∘ Classical economists tend to focus instead on shifting aggregate supply.
15.2 Shifting the Aggregate Supply Curve
Although economists disagree about many things, they do agree about what makes aggregate supply shift. The long-run aggregate supply curve will shift to the right in response to
increases in the capital stock, improvement in the size or quality of the labor force, additional natural resources, improvements in productivity, or technological advances. Increases
in resources or productivity will shift the aggregate supply curve to the right. Encouragement
of production through reduced taxes or regulations that lower costs to firms will also shift the
curve to the right. Anything that shifts the aggregate supply curve to the right is a source of
economic growth because it will produce a rise in real output and income.
The aggregate supply curve can also shift to the left, indicating negative growth or a decline
in a nation’s standard of living. Factors that can shift the curve to the left include resource
depletion, a decline in the size or quality of the labor force, and public policies (taxes or regulations) that discourage productive activity.
Long-term economic growth requires steady rightward shifts of the aggregate supply curve.
Economic growth has been a major concern in the United States for at least 50 years. Economists are constantly examining the growth rate of the U.S. economy to make sure that the
standard of living is rising, and economic journalists are always comparing that growth rate
to economic growth in other nations, such as China. Economists are also concerned that output expands fast enough to create enough jobs for a growing labor force. The antigrowth
voices of the early 1970s became muted when Americans started realizing the costs of not
growing—in terms of inflation, unemployment, and a lower standard of living when the population grew faster than real output. During the 1990s and early 2000s, the continuing debate
has not been over whether to grow but rather how to grow. Economists try to determine what
strategies are most successful for shifting aggregate supply to the right.
Between 1962 and 2011, real output increased over 300% in the United States. Some of that
growth was a result of increased resources, specifically labor and capital. Even though the
economy was coming out of a recession in 2011, gross investment in constant dollars was
© 2019 Bridgepoint Education, Inc. All rights reserved. Not for resale or redistribution.
Shifting the Aggregate Supply Curve
Section 15.2
over 400% higher in 2011 than it was in 1962 (Bureau of Economic Analysis, n.d.). However,
recall from Chapter 5 that a large (and increasing) part of gross private domestic investment
goes to replace worn-out capital. After correcting for depreciation, real net investment in
2011 was only 12% higher than in 1962! Thus, the real growth rate of investment was much
lower than the rate of economic growth from 1962 to 2011.
Because investment is so volatile, year-to-year comparisons must be treated carefully. Figure
15.2 plots both gross and net investment expenditures as percentages of GDP from 1970 to
2016. The growth of gross investment over that whole period was greater than the growth
of total GDP but was very erratic. Net investment—which consists of new plants, equipment,
and housing, as opposed to replacement of worn-out facilities and equipment—actually fell
relative to GDP during several time periods. Note that in recession years, such as 1975, 1982,
1991, and 2009, investment declined even more than GDP, reducing the stock of capital available for future economic growth.
Figure 15.2: Gross investment, 1970–2016
Since 2010 gross investment has averaged about 19.5% of GDP and net investment about 3.7%. Both
drop relative to GDP during recession years, such as in 1975, 1982, 1991, and especially 2009, when net
investment fell to 0%.
22
20
18
Gross investment
Net investment
16
14
12
10
8
6
4
0
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2
Year
From “Table 5.2.5. Gross and Net Domestic Investment,” by Bureau of Economic Analysis, n.d., Retrieved from https://www.bea.gov
/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1921=survey&1903=139.
© 2019 Bridgepoint Education, Inc. All rights reserved. Not for resale or redistribution.
Shifting the Aggregate Supply Curve
Section 15.2
Private Saving
The most commonly used indicator of what is happening to saving is the savings rate, or saving by households, business, and government combined as a percentage of GDP. The current
U.S. rate is low compared to past experience and to savings rates in many other industrial
countries. However, saving has fallen in other industrial countries as well in the past four
decades, due to the emphasis on consumer spending in an effort to bolster the flailing global
economy. From 1960 to 1980, the United States saved 19.6% of GDP, somewhat below the
average for 17 industrial countries, which was 23.4%. (Japan, at 35%, had the highest rate.)
Demographic factors, such as the maturing of the baby boomers, are just now beginning to
contribute to a higher savings rate in the United States. Although the savings rate hit lows of
1.5% in 2005 and nearly zero in early 2008, it surged to 6.9% by 2009. The deep downturn
in the economy and the high unemployment figures were partly the reason that Americans
began saving more (PBS NewsHour, 2009). By 2017 the savings rate was right around 2% and
more stable across years.
Private Investment
A higher level of investment would shift both the aggregate demand curve and the aggregate
supply curve to the right. Such a shift would increase employment without more inflation.
More specifically, business investment in new equipment is a key source of economic growth.
Additional equipment gives each worker more capital with which to work and thus increases
productivity. New equipment embodies new technology, which also increases productivity.
Thus, the slowdown in investment in the 1970s, 1980s, and early 2000s led to a search for
policies that would stimulate investment. Tax incentives of various kinds were proposed and
implemented. Since 1986 numerous efforts have been made to restore the special tax treatment of capital gains. Capital gains are “ …
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