Chapter III: National income
and macroeconomic policies
A. Global production potentials
B. Supply-side orientation
C. Business cycles and
macroeconomic policies
D. Demand management
Goethe Business School
GDP by country (2005)
Source: Students of the World/
Worldbank
Source: The Worldbank
2
Goethe Business School
Correction for PPP leads
to dramatic change
Source: Worldbank;
CIA - World Facts
3
Goethe Business School
Shares of world GDP
according to PPP
World GDP (est.) = $55.5 trillion PPP
Source: CIA - World Facts
4
Goethe Business School
GDP per capita 2005
Lux embourg
Norw ay
Sw itzerland
Denmark
Iceland
United States
Sw eden
Ireland
Japan
United Kingdom
Finland
Austria
High inc ome: OECD
Netherlands
Belgium
High inc ome
France
Germany
Canada
Australia
European Monetary Union
Italy
Source: Students of the World/
Worldbank
Hong Kong, China
Singapore
New Zealand
Spain
0
10000
20000
30000
40000
50000
60000
70000
5
Goethe Business School
Growth competitiveness
index ranking 2004
Source: World Economic Forum
6
Goethe Business School
Example: the United States
7
Goethe Business School
Reading
Reading 3-1
“The quest for prosperity“,
Extract from a Special Report on the EU
The Economist, March 2007
8
Goethe Business School
Production function




Traditionally macroeconomic analysis
has emphasized the supply side
(Adam Smith: “The Wealth of the Nations”)
The focus is on the “production function”
and its various inputs
A typical production function looks as follows:
GDPs = f (Labor, Capital, Energy | Environm’t, )
Production functions must be interpreted
in a dynamic fashion ( is here for technological
and organizational innovations and change)
9
Goethe Business School
A simple production function
100 billion hours of
labor can produce
$10 trillion of real
GDP at point A
300 billion hours of
labor can produce
$12 trillion of real
GDP at point C
10
Goethe Business School
Production function and
marginal productivity of labor


From the production function, we can
derive the “marginal product of labor”
(marginal productivity) for a fixed amount
of capital and other inputs
It is defined as the additional product
obtained from increasing a given amount
of labor by one hour
GDP  f (Labor;Capital)
11
Goethe Business School
Marginal product
of labor
dGDP
dGDP

dLabor
dLabor
For fixed capital,
the marginal product
of labor must fall

12
Goethe Business School
Marginal product and
the demand for labor



From the marginal product of labor, we derive
the quantity of labor demand, all other influences
on firms’ plans remaining the same
Other inputs and technology being fixed,
an employer will only hire an hour of labor
if the output from that hour (the last hour of labor
input) is at least as great as the cost of hiring
that hour of labor – the real wage 
The lower the real wage rate (W/P = ),
the greater is the quantity of labor demanded
13
Goethe Business School
The demand
for labor function
14
Goethe Business School
The labor supply function


The labor supply function determines the
relationship between the quantity of labor
supplied and the real wage rate  when all
other influences on work plans remain the
same
Labor supply hinges on two effects:
 A price (or substitution) effect
 An income effect
15
Goethe Business School
Price and income effects



Price effect:
If the real wage increases, leisure (not working)
has become more expensive, so we expect
people to consume less leisure, work more,
i.e. supply more labor hours
Income effect:
With a higher real wage, people have a higher
income. If leisure is a normal good, we expect
people consuming more of it,
i.e. work less, supply fewer labor hours
In the aggregate the price effect dominates
16
Goethe Business School
The supply for labor function
17
Goethe Business School
The labor market
18
Goethe Business School
Reading
Abel, Bernanke, Croushore, Chapter 3
(only 3.1 through 3.3, including Application)
19
Goethe Business School
Real and nominal GDP

Macroeconomists divide the variables
describing macroeconomic performance
into two lists:
 Real variables
 Nominal variables


Real GDP is measured
in constant prices of a base period
Nominal GDP is measured
in current prices
20
Goethe Business School
Price deflator




The ratio
GDPnominal / GDPreal = Price deflator
The price deflator is an aggregate
measure of the price level
The measurement of price development
will be dealt with later when discussing
inflation
For the time being we shall focus on real
GDP supply and demand
21
Goethe Business School
The supply side orientation is also
relevant for the firm as it explains
its demand for factors of production
In addition the firm has to focus on
its market and observe its evolution
Goethe Business School
Business cycles
and macroeconomic policies



Having sketched the macroeconomic
constraints in real terms and its financing,
we now turn to macroeconomic policies
GDP can be seen from two sides:
GDPs (supply) and GDPd (demand)
Ex post, GDPs must always equal GDPd
(inventories are part of investment,
whether voluntary or involuntary)
23
Goethe Business School
Potential and effective GDP





Economic potential is measured assuming
full employment of resources
GDPpot = f (Laborfully employed, Capitalfully employed)
The term “fully employed” must be interpreted
and is highly controversial
The could be “full employment”
side by side with “structural unemployment”
Economists therefore prefer to speak
of “natural employment” and “natural output”
24
Goethe Business School
Economic fluctuations


When the economy is operating at full
potentials, the forces determining the real
variables are independent of those
determining the nominal variables
Away from the natural rate of employment,
real and monetary forces interact to bring
economic fluctuations
25
Goethe Business School
Potential GDP in the U.S.
Potential GDP
provides the
anchor
around
which real
GDP
fluctuates in
a business
cycle
26
Goethe Business School
The “output gap”
The “output gap” is
the difference between
actual and potential
GDP relative to GDP
27
Goethe Business School
AS-AD model


The AS-AD model explains the fluctuations
around potential GDP. This is a very broad,
metaphor-like, model that gives us a story to
understand the macro economy’s behavior
The AS-AD model has three components:
 Aggregate supply
 Aggregate demand
 Macroeconomic equilibrium
28
Goethe Business School
Structure
of the macro economy
Money
market
Product
markets
Keynes
Modell
Aggreg.
demand
Macro
model
Business
cycle
Aggreg.
supply
29
Goethe Business School
The AS-AD Model (1)
Aggregate supply


It shows the relationship between the quantity of
real GDP supplied and the price level all other
influences on production plans remain the same
Other things remaining the same, the higher
the price level, the greater is the quantity of real
GDP supplied, and the lower the price level,
the smaller is the quantity of real GDP supplied
30
Goethe Business School
The monetarist supply curve



An extreme position renders supply totally
dependent on available resource
potentials using the production function
Given that potential, the supply of goods
and services is then fixed
This position is taken by many
economists, at least for the longer term
31
Goethe Business School
The supply curve
in the short run





Profits on a unit of output equal
the price for the unit minus costs
In the short run, these costs are often fixed
(wages, raw materials)
An increase of the price level therefore
leads to an expansion of profits
This encourages entrepreneurs to expand
output in the short run
The aggregate supply curve is upward sloping
32
Goethe Business School
Aggregate supply
in the short run
33
Goethe Business School
GDP supply and potential
Potential
GDP is $10
trillion and
when the
price level
is 110,
real GDP
equals
potential
GDP
34
Goethe Business School
Deviation from potential (1)
If the price
level is above
110, real
GDP
exceeds
potential
GDP
35
Goethe Business School
Deviation from potential (2)
If the price
level is below
110, real
GDP is less
than potential
GDP
36
Goethe Business School
Changes in aggregate supply




Aggregate supply changes
when potential GDP changes
As potential GDP increases, aggregate supply
increases and the AS curve shifts rightward
Aggregate supply also changes when the money
wage rate or any other input cost in money
terms, such as the price of oil, changes
A rise in the money wage rate or in the price of
oil raises firms’ costs, decreases aggregate
supply, and shifts the AS curve leftward
37
Goethe Business School
Aggregate supply and costs
Price level
An increase of costs
will shift the aggregate
supply curve to the left
2
1
2
4
Aggregate output
38
Goethe Business School
Supply shocks
Example: The oil crisis



In the fall of 1973 the Organization of Petroleum
Exporting Countries (OPEC) imposed an oil
embargo and increased the price of crude oil
by a factor of four
It lead to a shortage of energy and
(given the technology of production at that time) to a
suboptimal allocation of factors of production
This entailed severe productivity losses
39
Goethe Business School
Effects
of a supply shock (1)
A
GDP0
Y(L | K0, E0)
Y(L | K0, E1)
GDP2
The short run
production function
E
GDP1
C
0
L
B
U
Ls ()
Ld 0()
1
Ld1 ()
D
L1
L2
L0
L
40
Goethe Business School
Effects
of a supply shock (2)



The reduction of energy consumption
from E0 to E1 will toss the production function
downwards
With less energy, the factor labor will become
less productive
The marginal product of labor falls for every
level of output, and the demand for labor
function shifts to the left
41
Goethe Business School
Effects
of a supply shock (3)





The supply shock will also lower the equilibrium real
wage rate
If the original real wage 0 is maintained, it must entail
unemployment as large as U (or L0 - L1)
Production is now at point C and employment at L1
But in the longer run, goods prices will increase, which
lowers the real wage ( = W/P) even though the nominal
wage W is “sticky”
It leads to the new long run equilibrium at point D with
employment L2, and a lower production level GDP2 (point
E)
42
Goethe Business School
Long term equilibrium
after the shock
P
AS1
AS0
In the long run:
Output falls.
As prices increase,
(W/P) will fall
even if W = constant
P1
P0
Y1
Y0
Y
43
Goethe Business School
Dynamic adjustment
of growth path
GDP
Growth path of GDP
without restriction
New growth path
after oil shock
1973
Time
44
Goethe Business School
Oil crisis and thereafter

During the 1970s, all members of the Organization
for Economic Cooperation and Development (OECD)
experienced large public budget deficits
(expansionary fiscal policy)


There was worldwide inflation,
which indicates that monetary policy was
accommodating (expansionary monetary policy)
These policies would “soften” the hard budget
constraint, and were financed through the
recycling of petro-dollars and debt
45
Goethe Business School
Oil crisis and
structural adjustment





Expansionary fiscal and monetary policies are however
not sustainable
OECD economies had to adjust to the new conditions in
the global economy
As this structural adjustment takes place, the production
function changes
This will compensate some of the “static” losses of the oil
shock, and could even be “beneficial” in that a higher
dynamic growth path is obtained
So shocks are often “healthy” as they incite creativity
and innovation
46
Goethe Business School
The AS-AD Model (2)
Aggregate demand


Aggregate demand is the relationship between
the quantity of real GDP demanded and the
price level when all other influences on
expenditure plans remain the same
Other things remaining the same the higher
the price level, the smaller is the quantity of real
GDP demanded, and the lower the price level,
the greater is the quantity of real GDP
demanded
47
Goethe Business School
Aggregate demand
This figure
shows
aggregate
demand
schedule
and
aggregate
demand
curve
48
Goethe Business School
Changes
in aggregate demand

Changes in the following factors will
change aggregate demand:






The interest rate
The quantity of money
Government purchases
Taxes
Real GDP in the rest of the world
Changes in sentiment or expectations
49
Goethe Business School
Macroeconomic equilibrium
Macroeconomic equilibrium
exists when the quantity of real
GDP demanded equals the
quantity of real GDP supplied at
the point of intersection of the
AD curve and the AS curve
50
Goethe Business School
Macroeconomic equilibrium
If the economy was at point A,
firms would increase
production and raise prices
If the economy was at point E,
firms would decrease
production and cut prices
The economy moves to
macroeconomic equilibrium
51
Goethe Business School
Three types of
macro equilibrium
Natural employment equilibrium
When equilibrium real GDP
equals potential GDP or natural output
Above natural employment equilibrium
When equilibrium real GDP
exceeds potential GDP or natural output
Below natural employment equilibrium
When equilibrium real GDP
falls short of potential GDP or natural output
52
Goethe Business School
The business cycle
As the AD curve
fluctuates,
macroeconomic
equilibrium moves
along the AS curve and
traces out
three types of
macroeconomic
equilibrium
53
Goethe Business School
The business cycle
Recovery
log GDP
Boom
Trend
Recession
Depression
Time
54
Goethe Business School
The business cycle and fiscal
policy in Europe
55
Goethe Business School
Reading
Abel, Bernanke, Croushore, Chapter 8
(all, but excluding Application)
56
Goethe Business School
What could generate deviations
from GDP potential, and hence
business cycles?
57
Goethe Business School
Financing
and the real economy




Does financing have an impact
on the real economy?
Not, if we follow the classical theory
But this wisdom was put to severe test
During the “Roaring Twenties”
the US economy had expanded largely
on an expansion of credits
58
Goethe Business School
The “Roaring Twenties”
and the Fed

I generated a stock market boom (1928/29)
that created a dilemma for the Fed:
 tempering the boom would have required
a higher discount rate;
 the Fed hesitated to do that because
of “legitimate credit needs”

When the discount rate was finally raised
(August 1929), it was too late
59
Goethe Business School
Development
of Stock Market Index
60
Goethe Business School
The Bank Panic of 1930-33




Substantial withdrawals from banks ended
in a full-fledged panic toward the end of 1930
One bank after the other closed, but the Fed
did not perform its role as lender of last resort
It did not understand the impact of bank failures
on money supply and economic activity
Moreover there was political haggling that
entailed general policy inactivity
61
Goethe Business School
Repercussions
on the real economy
US Unemployment rate, 1929-1942
25
official series
20
Quelle: M.R.
Darby, Threeand-a-half
Million
Employees Have
been mislaid,
Journal of
political
Economy,
1976
15
10
Adjusted
series
5
1930
1935
Where have real resources gone?
1940
62
Goethe Business School
Impact on people’s life (1)
The Depression had
tremendous
repercussions
on people’s life:
•Unemployment
•Social hardship
•Deprivation
•Stress
63
Goethe Business School
Impact on people’s life (2)
Top CEOs had a especially hard time !
64
Goethe Business School
What dragged
the economy down?

Causes were
 Increase of personal savings (and hence
a reduction of consumer spending) due to
a perceived reduction of personal wealth
 Change in consumer behavior
due to higher unemployment
 Reduction of housing investment
due to prior over-investment
 Credit implosion with an induced reduction
of demand, notably fixed investment
65
Goethe Business School
Further problems ...

...resulted from “second-round” effects:
 A general loss in consumers’
and investors’ confidence
 Change in spending behavior
due to insolvencies and bankruptcies
 Disintermediation due to a lack of liquidity
 Negative impact on public investment
due to a fall in tax revenue
 Negative multiplier effects through
“strategic trade policies” (Smoot-Hawley)
66
Goethe Business School
Reading
Abel, Bernanke, Croushore, Chapter 4
(only 4.3)
Reading 3-2
J. Bradford DeLong,
“Slouching Towards Utopia?:
Economic History of the Twentieth Century:
The Great Crash and the Great Slump”,
February 1997 (not mandatory, but interesting)
67
Goethe Business School
A shift of emphasis



In macroeconomics, the Great Depression
caused a dramatic shift in emphasis
from the supply to the demand side
A new macroeconomic policy was initiated
by Roosevelt’s “New Deal”
Its theoretical foundations were laid
by Keynes in his famous “General Theory”
68
Goethe Business School
The “New Deal”
President Franklin D. Roosevelt
and his wife Eleanore
69
Goethe Business School
Two famous projects
of the “New Deal”
70
Goethe Business School
Manage demand!
JMK
71
Goethe Business School
The macroeconomic
policy framework
Fiscal policy
Monetary policy
Money
market
Product
markets
Keynes
Modell
Aggreg.
demand
Aggreg.
supply
Macro
model
Management
of the
macro
economy
72
Goethe Business School
How does
demand management function?

Keynes focuses
on two essential variables:
 Income (GDP) and
 The interest rate (cost of capital)

He neglects
 The price level
 The wage rate (cost of labor)

This was perfectly adequate for his time
73
Goethe Business School
Keynes
and the supply curve
If the AS
curve is
flat, a
variation
of the AD
changes
GDP at
constant
prices
74
Goethe Business School
Managing income:
an intuitive approach


For the market of goods and services,
Keynes looks at the fundamental identity:
Saving = Investment,
whereby
 Saving = f1(Income)
 Investment = f2(Interest rate)

Let’s assume we start in equilibrium
with I = S
75
Goethe Business School
Initial macro equilibrium
I=
f2(Interest rate)
S=
f1(Income)
Let’s assume there is a negative shock on I:
What will happen ex ante?
76
Goethe Business School
Disturbed equilibrium
I = -I
f2(Interest rate)
S=
f1(Income)
What will happen next if we do nothing?
77
Goethe Business School
Long run adjustment


As investment demand breaks away,
supply and demand of GDP
are no longer in balance
If we do nothing,
 there will be a contraction of GDP supply,
hence income, which would reduce S
 there will also be pressures on interest rates
as long as S > I, which would redress I

But these adjustments take time,
and they may be rather painful
78
Goethe Business School
Fiscal policy



Keynes proposal 1:
Wouldn’t it be simpler if the government
compensates the shock by increasing
its expenditures by G ?
Compensation could also take the form
of a tax reduction -T to stimulate private
consumption C
In both instances there is a multiplier,
so that Y = mGG (or Y = -mTT),
where mG,mT > 1
79
Goethe Business School
Equilibrium restored (1)
Y(G)
I = -I
f2(Interest rate)
S=
f1(Income)
80
Goethe Business School
Monetary policy



Keynes proposal 2:
Wouldn’t it be simpler if the central bank
compensates the shock by lowering
interest rates ?
How can the central bank do this?
 By increasing the money supply !
Couldn’t this trigger inflation?
 Not during a depression !
81
Goethe Business School
Equilibrium restored
I = -I
f2(Interest rate)
S=
f1(Income)
82
Goethe Business School
Reading
Reading 3-3
“A stimulating notion:
The idea of giving flagging economies
a fiscal boost is back in fashion”
The Economist, Feb 14th 2008
83
Goethe Business School
Keynesianism and
econometric modeling



This intuitive approach to Keynesian
thinking is extremely simplified
But it is sufficient to understand demand
management “in a nutshell”
In practice there are complex multiplier
and reaction functions which are explored
through statistical analysis and
macro econometric modeling
84
Goethe Business School
Economic policy:
The Tinbergen approach
Policy variable
Taxes,
public outlays;
money supply
Econometric
MODEL
Target variable
Income level;
employment;
price stability
85
Goethe Business School
Reading




For a more formal analysis of the
macroeconomic model (IS-LM Model) read
Abel, Bernanke, Croushore, Chapter 9
This chapter is more rigorous than the
presentation in the course and is part of
the standard wisdom of economists
Nevertheless I consider it only voluntary
reading for those with a good intuition
88
Goethe Business School
What about
the labor market?


Keynes links the
demand for labor to the
production of goods and
services using the
production function
Once GDP is
determined via demand
management, the
quantity of labor demand
is obtained
89
Goethe Business School
Anticyclical policy


Anti-cyclical fiscal and monetary policies
use demand management to compensate
a business cycle that might result from
private sector economic activities
In a boom phase, the policy will become
restrictive, in a recession or depression it
will be expansionary
90
Goethe Business School
Anti-cyclical fiscal policy
Y
Hypothetical cycle
Multiplier effect
dG
Compensating fiscal policy
Y
Compound result
Time
91
Goethe Business School
Anti-cyclical policies:
criticism

The following is said against fiscal and
monetary policies for managing demand:
 Keynes‘ assumptions are not realistic
 Effective demand and employment are
disconnected (there are structural problems
in the labor market)
 Practical problems of policy implementation
(reaction lags, behavioral changes)
 Flaws in the political system, which is unable
to maintain fiscal discipline in the long run
92
Goethe Business School
Discussion 3:
Economic crises and the global firm



Could a crisis such as the Great
Depression reoccur in the global
economy?
Are there similarities with the crash
of the “New Economy”?
Do global firms need a global crisis
management?
93
Goethe Business School