1 Macroeconomics Midterm Study Notes Ch 6 10 Chapter 6 NOTE when referring to variables term sub is the subscript i e Id I sub d Long run economic growth is the persistent increase in the potential of the economy Long run economic growth is an ongoing process measured over to produce goods and services decades generations centuries Long run economic growth is about potential not actual growth The economic constraints on a nation that determine its production possibilities are the quantity and the quality of its resources and the production technologies that are available for turning the resources into goods and services In order for an economy to continue the quantity and quality must always be increasing and more productive technologies must be invented Investment is the key to increasing the standard of living investment in physical capital plant and equipment human capital education and housing More investment this year to promote economic growth implies less consumption this year future generations benefit from more rapid economic growth made possible by higher level of investment The Rule of 72 indicates how quickly something that grows at a certain annual percentage rate doubles in value Divide 72 by the annual growth rate g 72 g Example If the annual growth rate g were 4 the economy would double every 18 years 72 4 There are two methods to estimate the rate of growth in potential output One uses the actual rate of growth in output over a long period of time as measure of long run economic growth the other measures long run economic growth by building a simple model of the entire economy and then using the model to estimate what the level of national product income would be if the economy were operating on its production possibilities frontier Third method begins with growth in labor productivity over time Small changes in the rate of long run economic growth have an impact on a nation s standard of living over the long run that dwarfs any other factor affecting the standard of living An economy can grow faster than its rate of long run economic growth by hiring previously unemployed employees and using inventory and machines that were lying idle improvising with current resources Long run economic growth is only half the prescription of a healthy economy its about potential as mentioned previously Employed who have worked at least one hour during survey week Unemployed actively seeking employment but cannot find job Labor force sum of people age 16 who are either employed or unemployed Unemployment rate U ratio of unemployed to the labor force Unemployment rate cycles inversely with the performance of the economy rises when circular flow of economic activity declines and falling when circular flow increases obvious 2 Underemployed discouraged workers How much does the unemployment rate respond to fiscal and monetary policies To answer this question divide unemployment in three categories Cyclical unemployment highly responsive to performance of economy and as a result is very responsive to fiscal and monetary policies Cyclical arises because labor markets do not always operate according to the Laws of Supply and Demand fluctuates with state of economy and occurs because of sticky wages NOTE sticky wages exist Insider outsider theory of wage setting the older more experienced insiders have the decision making power and use it to place all risks of a business downturn on the younger less experienced outsiders i e bosses put risk on new employees Efficiency wages more money for more experienced employees makes them happier raises morale keeps them on team productive will not ignore duties Profitable from a firm s point of view i e pay employees more to ensure allegiance Frictional unemployment refers to the unemployment that inevitably exists in a large diverse economy New job opp s jobs eliminated consumers taste changes Frictional unemployment has to do with the amount that the demand for labor shifts from product to product and how quickly workers can move to new employment opportunities composed of job losers who have been let go against their wishes and job leavers who quit voluntarily to seek a better job in an expanding sector Search unemployment we are always trying to improve ourselves in all aspects of our lives people with jobs are looking for better jobs as a result unemployment caused by employees who leave their jobs voluntarily and are looking for other better jobs or by re entrants or new entrants to the labor force who are looking for a job Structural unemployment refers to severe and lasting mismatches between the people looking for work and the jobs that are available to them not very sensitive to state of economy usually skills or land based issue Government fights unemployment through fiscal and monetary policies As a result the goal is not zero rate of unemployment Reach natural rate of employment says gov t Natural rate of employment recognizes that market economy will naturally experience TOTAL RATE OF UNEMPLOYMENT IS sum of cyclical frictional and search and unemployment structural unemployment Natural rate of unemployment the sum of frictional and search unemployment and structural unemployment the rate of unemployment that corresponds to production on the production possibilities frontier and that cannot be reduced very much by fiscal and monetary policies Also called the non accelerating inflationary rate of unemployment Just for understanding search and frictional are associated together because they both have to do with leaving job for a reason Frictional is about the demand for jobs in certain fields and is unemployment because people are getting fired or are leaving to look for better jobs which is search we are always looking to better ourselves and therefore even though we may be happy with our job will take the CEO position at another company and we constantly subconsciously seek this upgrade 3 The natural rate of employment U sub frictional search U sub structural So if these are small then the federal government can drive cyclical unemployment down with fiscal and monetary policies U sub nair non accelerating inflationary rate of unemployment brings together the twin goals of full employment and prices stability with reference to PPF All resources including labor are fully employed when economy is on PPF Gov t doesn t want accelerating inflation because it exponentially increases quickly So they use fiscal and monetary policies to bring