Economics is defined as the study of the "efficient use of scarce resources" for the production of goods and services that "achieve the maximum satisfaction of economic wants." Economic perspective is founded on resource scarcity and choice, the assumption of rational behavior, and marginalism. Knowledge of economics for the non-economist adds to good citizenship and is thus valuable for consumers, workers, and politicians.
Economists use the scientific method to form and test hypotheses of cause-effect relationships. Economists do this to formulate theories, laws, and principles that help them explain real-world relationships and predict real-world outcomes. Good economic policy is designed to identify and solve economic problems to the fullest extent possible, while protecting society's shared goals of economic growth and efficiency, full employment, price-level stability, economic freedom, equitable distribution of income, economic security, and a reasonable balance in international trade and finance. Some of these goals are compatible while others require trade-offs to accomplish.
Macroeconomics supports these goals as they relate to the examination of the economy as a whole, while microeconomics supports these goals as they relate to the examination of specific units and institutions. Both macroeconomics and microeconomics issue positive and normative statements. Positive statements state "facts" (what is) while normative statements express "value judgments" (what ought to be). The study of both macroeconomics and microeconomics encounters pitfalls in the way of biases and preconceptions, vague use of terminology, difficulty in establishing clear cause-effect relationships, and fallacy of composition, which is the logical error of believing that what is true for the individual is also true for the group.
Graphs employing variables that are positively (or directly) related and variables that are negatively (or indirectly) related are used in economics to represent economic relationships. Directly related relationships show a rising upward slope, while indirectly related relationships show a dropping downward slope.
The slope of a curve expresses the cause-effect relationship between variables, with an upslope showing a positive relationship and a downslope showing a negative relationship. A straight line curve shows no relationship as it represents the ratio of the vertical (cause) change to the horizontal (effect) change between any two variable sets, or points. The slope of a vertical line is infinite and the slope of a horizontal line is zero. The slope of a curved relationship line is determined by calculating the slope of a straight line tangent to the curve at a given point.
Economics is grounded in two facts: (1) economic wants are unlimited, and (2) economic resources are scare. Economics is concerned with the problem of using scarce resources to maximize production of goods and services in order to satisfy the economic wants of society. There are two classes of economic resources, both of which are recognized as scarce: (1) property resources, which are raw materials and capital, and (2) human resources, which are labor and entrepreneurial ability. Maximum production requires efficient use of scarce resources, whether property resources or human resources, and full employment, which will result in productive efficiency and allocative efficiency. Productive efficiency is defined as producing all output combinations in the least costly way. Allocative efficiency is defined as producing the specific output mix most desired by a society.
Technological advances allow for the production of more goods and services, which, by definition, is economic growth. A society's choice to produce both consumer goods and capital goods is a major determinant of future economic growth. In the market system, consumers own most resources and are said to determine the product mix, while markets coordinate most economic activity. In the command system, governments own most resources and therefore determine the product mix and coordinate most economic activity. The former (market system) is called capitalism, while the later (command system) is called socialism or communism.
The circular flow model tracks major real flow and money flow between businesses and households in relation to the resource market and the producer market.
A market is defined as an institution or arrangement that brings buyers and sellers together with demands and supplies. Demand is a graph curve (or schedule) representing buyers' willingness to purchase a particular good or service at a particular price. The law of demand therefore implies that consumers will buy more at a lower price than at a higher one. The relationship between price and demand is inverse, or negative, and results in a downsloping curve. Changes in the willingness to purchase result in a shift in the graphed demand curve: a shift to the right means an increase in demand at a particular price; a shift to the left means a decrease in demand.
The supply graph works in a similar fashion. Supply is a graph curve (or schedule) representing the quantity of a particular good or service that producers, or sellers, are willing to make available at a particular price. The law of supply therefore implies that producers will offer more at a higher price than at a lower one. The relationship between price and quantity supplied is direct, or positive, and results in an upsloping curve. Changes in the willingness to produce results in a shift in the graphed supply curve: a shift to the right means an increase in supply; a shift to the left means a decrease in supply.
The equilibrium price and the equilibrium quantity are determined by the intersection of the demand curve and the supply curve. It is theorized that with all things being equal and with consumers and producers acting rationally (requirements that may not be true) the intersection of the market demand curve with the market supply curve adjusts the price to the point at which the quantity demanded and the quantity supplied are equal. The point of intersection represents the equilibrium price, and the corresponding quantity is the equilibrium quantity. Increases in demand raise equilibrium price and equilibrium quantity, while decreases in demand lower both equilibrium price and equilibrium quantity.
The market system is also known as the private enterprise system and the capitalist system. It is characterized by private ownership of resources, which includes capital, and the freedom of individuals to choose to participate in economic activities for their own material well-being. A market economy faces the Four Fundamental Questions of what to produce, how to produce it, who will get the product, and how will the market system accommodate changes in technology, resources, and consumer taste. In a market economy, markets and prices organize what is produced, the methods of production, and how output is shared, while self-interest is the driving force and competition is said to be the regulatory or control mechanism. A monetary medium of exchange eliminates barter and encourages specialization of product while permitting easy trade domestically and internationally.
A healthy market system produces products by which production costs and sales yield total revenue sufficient to cover all costs including normal profit, as profit is figured as a cost of production. Economic profit indicates a prosperous industry and promotes industry expansion. Economic loss indicates an industry that lacks prosperity and promotes industry contraction. Competition forces lowest-cost production as well as efficient production techniques and technology. Demand-supply curve theory communicates market changes, thereby promoting appropriate adjustments and encouraging technological advances and capital accumulation.
Consumer sovereignty indicates that businesses and resource suppliers must be responsive to the economic wants of consumers who theoretically use their "dollar votes" to determine the composition of product output. Households are holders and suppliers of resources. The price the household receives for its resources determines that household's income and therefore its claim on the economy's output and its level of participation in the market economy. Competition is said to promote equality between self-interests, which drives a market economy, and social interests, which includes individual households' income and market participation. It is theorized that competition acts as an invisible hand that directs and harnesses the self-interest motivating businesses and resource suppliers, thus furthering social interest.
Distribution and ownership of income pertains to households and businesses and is affected by government policy on the federal, state, and local levels. Functional distribution of income shows how society's total income is divided between wages, rents, interest, and profit. Personal distribution of income shows how society's total income is divided between households, which use their income to pay personal taxes, to buy consumer goods and services, and for savings.
Businesses can express ownership and contribute to functional distribution of income through sole proprietorships (single owner), partnerships (two or more individual owners), and corporations (legal entities distinct from the individuals who own them).
Government participates in the market system by improving its operation through (1) providing appropriate legal and social frameworks and by (2) acting to maintain competition, for example by attempting to disallow monopolization, as was intended with the Whole Foods merger with Wild Oates. Government also corrects spillovers, or "externalities," by legislation and taxation or by subsidies. Spillovers disrupt equilibrium output and may be spillover costs or spillover benefits. Spillover costs are regulated by legislation and specific taxation that limits use, whereas spillover benefits are regulated by subsidies that limit production.
Government provides public services that those in the private sector do not choose to provide, such as public education and health care for the disadvantaged. Government also reduces unemployment and inflation by altering taxation, spending, and interest-rate policies. Government spending can exhaust capital resources by making payments or can transfer capital by making transfer payments. The main categories of Federal government spending are pension and income security, national defense, health, and interest on public debt. These categories are offset by Federal government revenue derived from personal income taxes, payroll taxes, and corporate income taxes.
Global trade links the world together through goods and services flows, capital and labor flows, information flows, and financial flows. World trade has significance for the United States because the U.S. absolute volume of trade exceeds that of any other nation and because the U.S. is completely dependent on trade for certain goods that cannot be acquired domestically. Global trade has been greatly facilitated by advances that allow for economic growth. Advances have occurred in the general decline in protective tariffs, in transportation technology, and in communications technology. In addition, the total volume of trade has increased because of the contributions of new trade participants from Asian countries and Eastern European countries as well as some Southern hemisphere developing countries.
Global trade is enhanced by specialization within a nation's comparative advantages whereby products and services are produced at the lowest domestic opportunities costs. Global trade is impeded by the implementation of protective tariffs, quotas, non-tariff trade barriers, and export subsidies. Such impediments result from misunderstandings about free trade and from political agendas. The World Trade Organization (WTO) rules on trade disagreements, implements WTO trade agreements, and provides forums for discussions on the liberalization of global trade. Free-trade zones, also called trade blocs, liberalize trade within defined regions. However, they simultaneously impede trade with non-bloc nations. The European Union is an example of a free-trade zone and is one which is growing annually. The European Union has implemented a uniform currency called "the Euro," which is utilized by many E.U. member nations. The North American Free Trade Agreement (NAFTA) is an example of a free-trade bloc that consists of Canada, Mexico, and the United States.
Gross domestic product (GDP) is defined as the basic measure of an economy's economic performance and is equal to the market value of all final goods and services produced within the borders of a nation within a year. GDP calculations intentionally exclude intermediate goods, non-production transactions, and second-hand sales. To calculate GDP by using the expenditures approach, find the sum of total expenditures on all final output. To calculate GDP by using the income (or allocations) approach, find the sum of the income derived from the production of all final output.
Using the expenditures approach, GDP is determined by adding consumer purchases of goods and services, gross investment spending by businesses, government purchases, and net exports: GDP = C + I + G + X. Using the income (or allocations) approach, GDP is determined by adding compensation to employees, interest, proprietors' income, and corporate profit, plus consumption of fixed capital, indirect business taxes, and net foreign factor income earned in the United States.
Other national accounts are derived from the GDP calculations. These others are the net domestic product (NDP), national income (NI), personal income (PI), and disposable income (DI). Price indexes, like the GDP index, are calculated by multiplying a particular market "basket" of output by 100. Two other measures are the nominal GDP, which is the current-year valuation of output in comparison to prevailing prices for that year. The consumer price index (CPI) measures changes in the price of a market basket (selected types of goods or services) of approximately 300 goods and services purchased by urban consumers, making the CPI a fixed-weight index in which the market basket items remain the same in all years, though the valuation of the items changes over time.
Economic growth is defined as (1) an increase to the GDP (gross domestic product) over time or as (2) an increase to the GDP per capita over time. Economic growth provides the advantages of lessening the burden caused by scarcity of resources, as growth is tied to an increase in resource supplies or quantities, and of providing increases in real GDP, which can be used to resolve socioeconomic problems. Economic growth is tied to economic cycles and business cycles.
Economic cycles have periods of fluctuation in terms of real GDP, employment, and price levels. Business cycles have similar fluctuations and share phases of fluctuation in common with economic fluctuations, both experiencing phases of peak, recession, trough, and recovery, although business cycle phases vary greatly in duration and intensity. Economists explain business cycle fluctuations in terms of causal determinants. The most significant and most immediate causal determinant is the level of total spending. Other determinants in business cycle fluctuations are major innovations, political events, and money creation.
Business cycles affect all sectors of the economy, although in varying ways. The greatest affect is on output and employment in the capital (e.g., banking, finance) and durable consumer goods (that is, use expectancy of three or more years) industries. The business cycles' least affect is on the services (e.g., doctors) and non-durable goods (that is, use expectancy of less than three years) industries. The business cycle affects employment in all of these industries.
Economists distinguish three kinds of unemployment: (1) frictional, (2) structural, and (3) cyclical unemployment. Full employment is defined as including a natural rate of unemployment comprising frictional and structural unemployment. The GDP gap measures the cost of unemployment—over and above the natural rate of unemployment—in terms of the loss of goods and services forgone by society, a loss that has ramifications for the GDP and for future economic growth. The GDP gap is the amount that the actual gross domestic product falls below potential product output. Okun's law suggests that every 1 percentage point rise over the full employment unemployment rate creates a 2 percentage point increase in the GDP gap between actual GDP and potential GDP.
Unemployment is also linked to inflation. Economists distinguish two kinds of inflation: (1) demand-pull inflation and (2) cost-push inflation. With demand-pull inflation, total spending increases as a result of product demand increases. This demand and total spending increase pulls prices higher causing inflation. With cost-push inflation, real output is reduced and unemployment is increased as supplies become more scarce and more costly, which pushes supply prices up, lessens product output, increases unemployment, and causes supply-side cost-push inflation.
The aggregate expenditures model shows the various amounts that households intend to consume and save as well as showing what firms plan to invest at various income and output levels. The tools upon which the aggregate expenditures model is built are consumption, saving, and investment schedules (graphs). The end objectives of the aggregate expenditures model is to determine the aggregate propensity to consume (APC), the aggregate propensity to save (APS), the marginal propensity to consume (MPC), and the marginal propensity to save (MPS). Recall that marginal means the cost or benefit/value of one unit of the property, propensity, or product being considered.
The aggregate propensities to consume and save show the fraction of any total income that is consumed or saved: APC + APS = 1. Similarly, although with a significant difference, the marginal propensities to consume and save show the fraction of change in any total income that is consumed or saved: MPC + MPS = 1. In other words, aggregate propensity shows the fraction of the total income consumed or saved, while marginal propensity shows the change in total income consumed or saved, assuming changes occur over time since income nor price levels nor inflation are static. The locations of these consumption and saving schedules (the location of the graphed curves) are determined by (1) the amount of household wealth; (2) expectations regarding future income, future prices, and future product availability; (3) the relative size of household debt; and (4) taxation. Even with these variables, the consumption and saving schedules--showing the fraction, or ratio, of the total or the total change--are relatively stable. These schedules are significant to the economy in that they affect potential unplanned changes to business inventories.
The immediate determinants to firms' investment are (1) expected rate of return and (2) the real rate of interest. Firms' investments are profitable up until the real interest rate equals the rate of return. The investment demand curve shows an inverse (negative) relationship between the interest rate and the level of aggregate investment. Shifts in the location of the investment demand curve occur when there is a change in (1) the cost of capital goods (e.g., loans), (2) in business taxes, (3) in technology, (4) in stocks of capital goods on hand, and (5) in future expectations. The investment schedule, resulting from calculations of the investment demand curve, shows the amount of investment expected at each income level of real GDP. The variables relative to the investment demand curve and thus the investment schedule show instability in investment spending.
Both the aggregate schedules and investment schedules affect business inventories. Equilibrium of GDP occurs when aggregate expenditures (from the aggregate expenditures schedule) and real output are equal. On a graph, this is where consumption (C) + investment (I) intersects the 45 degree line. When GDP is greater than equilibrium, or intersects above the 45 degree line, then real output exceeds aggregate spending, which results in unintended investment in, or unplanned accumulation of, inventory which leads over time to a decline in output and a decline in GDP. When GDP is less than equilibrium, or intersects below the 45 degree line, then aggregate expenditures exceed output, which results in unintended declines in, or unplanned loss of, inventory which leads over time to an increase in output and a rise in GDP.
Changes in expected rate of return and interest shift the investment schedule left or right. This shift in investment schedule causes a correlated shift in the aggregate expenditures curve and alters the equilibrium level of real GDP. Real GDP is defined as GDP adjusted for that year's inflation, divided by the price index, and expressed as a decimal. The change in real GPD is always more than the precipitating change in the investment schedule. This is known as the multiplier effect. The multiplier effect applies to investments and accompanies both increases and decreases in aggregate expenditures. The multiplier effect also applies to changes in net exports and government expenditures.
The multiplier relevant to the multiplier effect is equal to the reciprocal of the marginal propensity to save (MPS). Therefore, as the MPS increases (gains), the multiplier decreases (lessens). Thus the effect of the multiplier on real GDP correlates inversely to MPS. In addition, as the the marginal propensity to consume (MPC) increases, the multiplier also increases: the effect of the multiplier on real GDP thus correlates directly to MPC.
The net export schedule relates net exports to GDP. In this relationship, positive net exports increase aggregate expenditures and raise equilibrium real GDP by a multiple of net exports. On the other hand, negative net exports decrease aggregate expenditures and decrease equilibrium real GDP, also by a multiple of net exports. Therefore, increases in exports have an expansionary effect on real GDP, which is also true for a decrease in imports. Conversely, decreases in exports have a contractionary effect on real GDP, which is also true for an increase in imports.
Government purchases have the effect of shifting the aggregate expenditures schedule upwards and of raising GDP, which is why government spending contributes to expanding the economy. On the other hand, taxation shifts the aggregate expenditures schedule downward and lowers GDP. This is because taxation reduces disposable income, lowers savings, and lowers consumption; thus, equilibrium GDP is reduced.
The aggregate demand–aggregate supply model (AD-AS) is a variable price model. It enables economists to analyze simultaneous changes of real GPD and the price level. The aggregate price curve in the AD-AS shows each possible price level and it shows the level of product output that the economy will purchase at each of the price levels.
The corresponding aggregate demand curve, which relates price level to product output purchase quantity level, is a downsloping curve. The factors that make it a downsloping curve are the real-balances effect, the interest-rate effect, and the foreign purchases effect.
The real-balances effect indicates that inflation reduces the real value of financial assets held by households. The resultant reduction in purchasing power causes cutbacks in consumer spending. The interest-rate effect means that a higher price level in the general market place increases the demand for money and thus interest rates are increased in response, which leads to a reduction in investment purchases. The foreign purchase effect means that as a foreign country's price level increases in comparison to other countries', the net export component of its aggregate demand relative to the demand from other countries is reduced, thus curtailing the level of outgoing exports.
The aggregate supply curve, which relates price level to businesses' real product output production levels, is a variable curve, the shape of which depends upon per-unit production costs. The aggregate supply curve regulates how much the firm must receive to cover costs and make a profit.
Relevant to the aggregate supply curve, a horizontal curve indicates substantial unemployment that results in increased production without increased prices. A curve in the intermediate range indicates inefficient equipment and less unemployment. These intermediate range factors together create a production bottleneck resulting in increased prices to cover costs as real product is expanded. A curve in the vertical range indicates employment is at full capacity and real output has reached a maximum and cannot be increased. This means prices will rise in a response to rising demand resulting from full employment.
As prescribed in the Employment Act of 1946, the United States Federal government has the responsibility for achieving and maintaining full employment. The Council of Economic Advisors (CEA) was established to council the president as he or she directs policy aimed at fulfilling the goals of the Employment Act while aided by the careful tracking and frequent reporting of the unemployment rate.
Government increases in spending tend to expand aggregate demand and equilibrium GDP, whereas decreases in government spending tend to contract aggregate demand and equilibrium GDP. On the other hand, increases in taxes reduce aggregate demand and equilibrium GDP, while decreases in taxes expand aggregate demand and equilibrium GDP. To correct for demand-pull inflation (i.e., consumer spending demand creating an upward pull on prices), government fiscal policy calls for decreases in government spending and increases in taxation thus creating a budget surplus.
Due to these measures, fiscal policy has a measure of built-in stability because policy determines that during recession the Federal budget automatically moves toward building a stabilizing deficit. During inflation, the Federal budget automatically moves toward creating a stabilizing anti-inflationary surplus. The full-employment budget, also called the standardized budget, measures the hypothetical Federal budget deficit or budget surplus that would be expected if the economy operated at full employment for a year. On the other hand, cyclical deficits or surpluses that might occur during a fiscal year are tied to GDP and indicate consumer spending and saving as well as business investment and production output.
Money is defined as (1) a recognized medium of exchange, (2) a unit of monetary account, and (3) a store of value. The Federal Reserve System recognizes three measures of the supply of money: M1, M2, M3. M1 is available currency and checkable deposits, the money of which is available upon demand. M2 consists of M1 added to savings deposits, which includes (a) money market deposit accounts, (b) small (less than $100,000) time deposits, and (c) money market mutual fund balances. Time deposits are defined as deposits that may be withdrawn without penalty to the principle at the end of a specified time period. M3 consists of M2 (which encompasses M1) and large ($100,000 or more) time deposits. Therefore M1 represents liquid money while M2 and M3 add two categories of savings to liquid money.
Maintaining the purchasing power of money largely depends on the government's ability to manage the M1, M2, and M3 money supply. Money represents the debts of the government and the institutions (commercial banks and thrift institutions) that offer checkable deposits. Money has value because of the goods, services, and resources it commands in the market.
The total demand for money comprises the transaction demand for money and the asset demand for money. Transaction demand is defined as the demand that varies directly with the nominal GDP. Nominal GDP is GDP related to price level at the time of the measurement; it is not adjusted for inflation. Conversely, asset demand varies inversely with the interest rate. The total demand for money (transaction demand plus asset demand) is combined with M1, M2, and M3 money supply to produce the equilibrium interest rate. At the equilibrium interest rate, the amounts of money demanded and supplied are equal.
Interest rates tend to rise when there is a decrease in the supply of money. On the other hand, interest rates tend to decrease when there is an increases in the supply of money. The relationship between interest rates and the supply of money is an inverse relationship. Conversely, the relationship between interest rates and bond prices is a direct relationship so that when interest rise, bond prices rise; when interest rates decrease, bond prices decrease. At the equilibrium interest rate, bond prices tend to be stable.
The United States banking system consists of (1) the Board of Governors of the Federal Reserve System, (2) the twelve Federal Reserve Banks, and (3) approximately 8,600 commercial banks and 12,500 thrift institutions. The Board of Governors of the Federal Reserve System is the body most responsible for making banking fiscal policy decisions (e.g., interest rate levels), which are carried out by the twelve Federal Reserve Banks. In addition, the Federal Reserve issues Federal Notes. The Federal Reserve Banks are (1) quasi-public banks, (2) central banks, and (3) bankers' banks from which banks borrow money.
Modern commercial banks are a function of their balance sheets, which detail assets and liabilities. A balance sheet is defined as a statement of assets, liabilities, and net worth at a given time. Assets are defined as being equal to liabilities plus net worth. Modern banks back only a fraction of checkable deposits with currency. This is known as a fractional reserve system.
Banks keep three kinds of reserves: (1) required reserves, (2) actual reserves, and (3) excess reserves. Required reserves are defined as a fixed percentage of checkable deposits and are kept on deposit in a Federal Reserve Bank or they may be kept at the bank as part of its vault cash. Actual reserves are defined as required reserves plus vault cash; vault cash may include required reserves if not kept in a Federal Reserve Bank. Excess reserves are defined as the amount by which actual reserves exceed required reserves and are calculated as actual reserves minus required reserves. When checks are drawn against a bank, it loses both checkable deposits and actual reserves.
Checkable deposits, or checkable-deposit money, when originating from bank loans, are money created by the bank. The creation of checkable-deposit money through bank lending is the most important source of money in the United States economy. When lenders pay back loans, money is destroyed. This is because M1, M2, and M3 measure the supply of money based on checkable deposits and two categories of savings deposits; when the money is repaid it exits the M money supply. The assets of a bank are reduced when a borrower draws a check against deposited borrowed checkable-deposit money. This is because that, in all likelihood, the amount will be newly deposited in another bank and not the borrower's bank. This causes a loss of reserves, due to a lessened fixed percentage, and deposits at the borrower's bank. The ability of a bank to create money through lending depends on the size of its excess reserve.
A second way for banks to create money is to buy bonds, in which case the purchase money is deposited to the bond seller as checkable-deposit money. Money vanishes when the bank later acts as the bond seller and sells bonds to the public. This is because public bond buyers must draw down their checkable-deposit balances to pay for the bonds, an action which transfers the money out of the M measured money supply and into the market place.
As is true for fiscal policy, monetary policy is intended to achieve price stability, full employment within the full employment-unemployment rate definition, and economic growth. Monetary policy is largely decided by the Governors of the Board of the Federal Reserve Bank. The Federal Reserve Banks' most important assets are stock securities and loans to commercial banks. The Federal Reserve Banks' main liabilities are the reserves of member banks, Federal Treasury Deposits, and Federal Reserve Notes.
The three instruments of Federal Reserve monetary policy are (1) open-market operations, (2) the reserve ratio, and (3) the discount rate. Monetary policy implemented through these instruments operates in a complex cause-effect chain whereby (1) policy affects commercial bank reserves, (2) bank reserve changes affect changes to M money supply through changes in lending, (3) changes in money supply alter the interest rate, (4) changes in the interest rate affect business investment, (5) changes in business investment affect aggregate demand, and (6) changes in aggregate demand affect real GDP and price level. In addition, the Federal Reserve may directly state new target levels for the interest rate by stating the target level for the federal funds rate (overnight discount rate).
The advantages of Federal Reserve monetary policy are that the Fed can use monetary policy to stem rapid inflation and to steer the economy away from recession. Nearly all economists consider Fed monetary policy an important tool for economic stability. The limitations of Federal Reserve monetary policy are that global economy considerations make monetary policy more difficult to administer and the outcome much less certain. Another disadvantage is that the velocity of money (the rate at which a dollar changes hands for goods and services in a year) may partially alter the changes in money supply that are aimed at by monetary policy. Also, in a recession, firms may be reluctant to spend on capital goods, thus limiting the effectiveness of an expansionary monetary policy as implemented by the Fed.
The aggregate supply curve is related to price level and nominal wages. The short-run aggregate supply curve reflects a short term period of time during which nominal wages are fixed because they have not had time to respond to changes in price level. The long-run aggregate supply curve reflects extended time periods over which nominal wages have had time to adjust to changes in price level. The short-run aggregate supply curve is upward sloping because price level changes determine changes in profits and real output. Since they have a direct relationship, increases in price level results in increases in profit and real output. Decreases in price level result in decreases in profit and real output.
On the other hand, the long-run aggregate supply curve is a vertical line because over time price level changes theoretically result in changes in nominal wages. Following sufficient time for economic and policy adjustment, nominal wages theoretically respond in a direct relationship with the rise and fall of price levels, thus moving the economy along the vertical line of the long-run aggregate supply curve.
The relationship between price level and inflation is a complicated one. In the short-run, demand-pull inflation (consumer-driven demand for more output) raises price level and raises real output. In the long-run, following sufficient time and adjustments after which nominal wages reflect the long-run vertical line change related to price level, the temporary inflationary increase in real output is reversed and output decreases to original levels.
Conversely, in the short-run, when cost-push inflation (raise in cost of supplies, use of inefficient technology) occurs price level increases and real output decreases in an inverse relationship. This is because supplies are more scarce with the result that real output becomes more scarce. In the long-run, following sufficient time and adjustments, nominal wages will decrease under conditions of a recession and the short-run aggregate supply curve will shift away from the vertical line back to its original position as an upsloping curve. Profits and real output will also eventually shift back to their original positions, which will then reestablish a long-run aggregate supply curve as a vertical line.
Government policy can alter the outcome of cost-push inflation by expanding aggregate demand. On the other hand, if prices and nominal wages are flexible downward, then to alter the outcome of demand-pull inflation, decreasing aggregate demand lowers real output and lowers price level, resulting in a decline in nominal wages. These declines shift the aggregate supply curve rightward resulting in a restoration of full-employment output.
Economic growth is measured as an increase in real product output or as an increase in real product output per capita. Supply-side factors, aggregate demand factors, and economic efficiency factors all are necessary for economic growth. One area of economic growth is the New Economy and is defined as rapid technological change derived from the microchip and information technology. This results in increasing profit returns and lower per-unit costs, which is complemented by an increasing global market participation that helps hold down prices.
The supply-side factors in economic growth are (1) quantity and quality of national resources, (2) quantity and quality of human resources, (3) health of stock and capital facilities, and (4) the economy's technology. Economic growth potential is met when these supply factors combine with sufficient aggregate demand and with economic efficiency to produce growth.
A graph of the growth of production capacity is shown as an upward shift of the national production possibilities curve. Or it may be shown as a rightward shift of the long-run aggregate supply curve. Realization of economic growth occurs when total spending rises to match with total production capacity. United States production experienced economic growth due to increased input of labor and increased productivity of labor resulting from technological progress and increased capital per laborer in addition to improved quality of labor and improved allocations of labor.
Proponents of the New Economy, which is technology-based, say the advantages are (1) that it has a lower natural rate of unemployment than has the old economy, (2) that it can grow more rapidly than the old without producing inflation, (3) and that it generates higher tax revenues because it generates faster growth of personal income. Skeptics who advise a wait-and-see attitude toward the New Economy point out that previous surges of growth during expansionary periods have not translated into long-lived trends.
The public debt is the total accumulation over time of government deficit minus surpluses. A government budget deficit is defined as excess government expenditures over receipts. A government budget surplus is defined as excess government revenues over expenditures. The public debt comprises various public instruments of debt requiring government payment on demand or at the expiration of a specified time period. These instruments are Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds.
There are varying philosophies pertaining to government budget management. Three such philosophies are (1) the annually balanced budget, (2) the balanced budget based on business cycles, and (3) functional finance. Each philosophy has intrinsic problems attached to it. The problem with the annually balanced budget is that it promotes swings in the business cycle rather than countering them and stabilizing the economy. A balanced budget based on business cycles has a similar problem in that it may be difficult to balance the budget if the business cycle's upswings and alternate downswings are not of a comparable magnitude. The problem with functional finance is that it emphasizes the function of government to stabilize the economy while recognizing deficits and surpluses as a secondary problem.
The public debt has historically grown from deficit financing of wars, declines in revenues occurring during recessions, and tax-rate reductions that were not accompanied by reductions in government spending. The public concern that a large public debt may bankrupt the government is considered a false worry by economists because the debt needs only to be refinanced rather than refunded (paid off) and the government has the power if needed to increase taxes to raise revenue to make interest payments on the public debt. In addition, each generation of Americans inherits not only the public debt, but it also inherits the asset of the U.S. securities that finance the debt.
The goal of economic theory is to advance the stabilization of the economy, which comprises price and wage stability as well as full real output and economic growth. There are several economic philosophies that offer theories on how to achieve economic stability. Some of these philosophies are classical economics, Keynesian economics, macro economics, monetarianism economics, rational expectation economic theory, and new classical economics.
In classical economics theory, the aggregate supply curve is vertical and establishes the value of real output. The aggregate demand curve tends to stability and establishes price level. By this model, the economy is predicted to be fairly stable. On the other hand, in Keynesian theory the aggregate supply curve is horizontal when employment is at less than the full employment level. Further, the aggregate demand curve is inherently unstable. By this model, the economy is predicted to be unstable.
Macro economics finds that macro instability is caused by the volatility of investment spending because investment spending shifts the demand curve causing instability. However, this instability of the demand curve is due to investments volatility rather than aggregate demand. Monetarianism, on the other hand, ties instability to monetary policy based on the perception that velocity (rate at which a dollar changes hands for goods and services in a year) is stable and that changes in money supply M create changes in nominal GDP.
Rational expectations theory (RET) predicates economic instability and is tied to (1) inherently flexible price and wage markets that move easily upward or downward and (2) the knowledge level of consumers who will push the market in the direction of known future expectations. Similarly, new classical economists, comprised of RET and monetarists, find that instability in the economy is automatically self-correcting when disturbed from the stability of the full-employment level of real output. During automatic self-corrections producers respond by a short-run increase of output. Then, when they see that all prices including nominal wages are changing in reaction to inflation or deflation, they adjust output back to previous levels leading to long-run stability.
The crux of debate between proponents of economic philosophies is over fiscal policy and monetary policy and whether or not policy helps achieve full employment and stabilize the economy. The greater question is which policies help establish full employment and stabilize the economy. The goal of economic theory and policy is to achieve full employment, economic stability via price and wage stability, and economic growth.
Consumer responsiveness to price change varies. Responsiveness may also vary at different price ranges. Price elasticity of demand measures consumer response to price changes. If consumers respond well to price changes, then demand is said to be elastic. On the other hand, if consumers do not respond well to price changes, then demand is said to be inelastic. The degree of elasticity or inelasticity of demand is measured by the price elasticity coefficient. Percentage changes in price and quantity is determined by the use of the average of prices and the average of quantities being considered in relation to price elasticity of demand.
On a graph, perfectly inelastic demand is a vertical line parallel to the vertical axis line, whereas perfectly elastic demand is a horizontal line above and parallel to the horizontal axis line. At various price ranges on a demand curve, demand elasticity varies. It tends to be elastic in the upper left segment of a graph while it tends to be inelastic in the lower right segment.
Demand elasticity changes according to total revenue and price because revenue and price are in relationship to each other. If total revenue and prices change in opposite directions from each other (one rises while one declines), then demand is elastic, or responsive to price changes. If total revenue and prices change in the same direction (both rise or both decline), then demand is inelastic. On the other hand, price change will correspond to an unchanged total revenue when demand is of unit elasticity, which is defined as occurring when the percentage change in the quantity demanded is equal to the change in price. Demand elasticity is determined (1) by the number of available substitutes, (2) by price relative to budget, and (3) by whether the product is a deemed a necessity or a luxury.
Elasticity applies to supply just as it applies to demand. Equally, unit elasticity applies to supply just as to demand. Elasticity of supply varies directly with how much time producers have for responding to a particular price level change because elasticity of supply depends on the ease of shifting producers' resources between alternate product uses.
Changes in income varies the responsiveness of consumers' purchases. Income elasticity measures the responsiveness of consumers to price changes. Government-set prices, or legally fixed prices, result in product shortages when there is a price ceiling and product surpluses when there is a price floor. In this way the rationing function of equilibrium prices is stifled because prices are limited from being in a functioning relationship to income. When there is product shortage, a distribution of product commensurate with income requires government policy to ration product to consumers. When there is a product surplus, elimination of surpluses must occur through government purchases or by policy imposing restrictions on production or increasing private demand.
Economics assumes consumers are rational and that they act on the basis of well-defined needs and preferences. Since income is limited and products have prices, consumers must make decisions about goods and services to purchase. Consumer selection is made to maximize utility and satisfaction. Maximization of utility is when the last dollar spent on a product brings the same amount of extra satisfaction as others spent.
Since consumers are assumed to be rational, (1) the income effect, (2) the substitution effect, and (3) the law of diminishing marginal utility help explain the relationship between purchase quantity and product price. This relationship is that consumers buy more of a given product when the price changes downward and buy less of it when the price changes upward.
The income effect implies that a decline in price in effect correlates to an increase in a consumer's real income, which is defined as the amount of product that can be purchased with minimal income. An increase in real income allows a consumer to purchase more product with a fixed income. The substitution effect implies that a lower price increases a given product's attractiveness among alternative substitute products so that the consumer is more willing to substitute it for alternative products. The law of diminishing marginal utility states that beyond a certain quantity, additional quantities of a given product will yield declining units of added satisfaction.
The utility-maximizing rule (consumer utility maximization is related to the same extra satisfaction yielded from last dollar spent) is consistent with the logic behind the demand curve. Therefore, since marginal utility declines commensurate with the law of diminishing marginal utility, a lower price is needed to motivate a consumer to buy more of a particular product.