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Chapter 19

ECON 295 Chapter 19: Chapter 19.docx

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ECON 295
Kenneth Ragan

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Chapter 19
Macroeconomics is the study of how the economy behaves in broad outline without dwelling
on much of the detail that occurs in markets for individual products. Macroeconomics is
concerned with the behaviour of economic aggregates (resulting from activities in many
different markets). Studying economic aggregates allows us to view the big picture. (When
aggregate output rises, the output of many commodities and the incomes of many people
rise with it).
Macroeconomics considers two aspects of the economy: short-run behaviour of
macroeconomic variables (business cycles) and the long-run behaviour of the same
variables (study of economic growth). There are also two different steams of research in
macroeconomics. The first based on microeconomic foundations builds models of the
economy that are populated by workers, consumers, and firms all of whom are assumed to
be optimizers. The second group of researchers construct their models using aggregate
relationships for consumption, investment and employment subject to extensive empirical
testing. One of the major differences between these approaches is related with the flexibility
of wages and prices. Contrarily to the first group, the second group of economists believe
prices and wages are slow to adjust because of well-established institutions (labour unions,
long-term employment contracts).
Output and Income
The most comprehensive measure of a nation’s overall level of economic activity is the value
of its production of goods and services, called national product (or national income).
1) Aggregating Total Output
To measure total output, quantities of many goods are aggregated. To do so, we add up the
values of the different products. This gives us the quantity of total output measured in dollars
also called the nominal national income. To determine the extent to which any change is
due to quantities or to prices, economists calculate real national income which tells us the
value of current output measured at constant prices.
2) National Income: Recent History
One of the most commonly used measures of national income is called Gross Domestic
Product. The major movement of GDP is a positive trend that increased real output by
approximately four times since 1965 (long-term economic growth). The second feature of
GDP is the short-term fluctuations around the trend. Because growth dominates, these
fluctuations are hardly visible but are important to understand the current economy in a
country. Business cycles refer to fluctuations of national income around the trend value that
follow more or less wavelike pattern. A cycle may last several years and no two cycles are
the same.
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3) Potential Output and the Output Gap
National Output (Y) represents what the economy actually produces. Potential output (Y*)
is what an economy would produce if all resources were employed at their normal levels of
utilisation. The Output Gap measures the difference between potential output and actual
output (Y-Y*). If this number is negative, then the economy’ resources are not fully employed
and there is a recessionary gap. On the other hand if the output gap is positive it is called an
inflationary gap meaning that temporarily production is in excess of what the economy can
4) Why National Income Matters
National Income is an important measure of economic performance. When actual GDP is
bellow potential GDP there is economic waste and human suffering, resulting from the failure
to use the economy’s resources at their normal intensity of use. When actual GDP exceeds
potential GDP, inflationary pressure usually ensues.
Employment, Unemployment and the Labour Force
National income and employment are closely related. If more is to be produced, there is
either a rise in employment or a rise in productivity. In the short-run, change in productivity is
irrelevant while change in employment is important. Both concepts are important to the long-
Unemployment Rate =
Labour Force100
1) Frictional, Structural and Cyclical Unemployment
When the economy is at potential GDP, economists say there is full employment. There are
still many people unemployed. Frictional unemployment is due to the constant turnover of
individuals in given jobs. Structural unemployment is due to some mismatch between
characteristics of the labour force and the characteristics of the available jobs. Full
employment is said to occur when the only unemployment is frictional and structural.
Unemployment that is neither is called cyclical.
2) Employment and Unemployment: Recent History
Employment has grown roughly in line with the growth in the labour force. The short-term
fluctuation of the unemployment rate has been substantial.
3) Why Unemployment Matters
The social significance of unemployment is enormous because it involves economic waste
and human suffering. Unemployment means a waste of potential output. The loss of income
associated with unemployment is clearly harmful to individuals and in some cases can push
people into poverty.
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