Macro Discussion Board 3

1. Explain the meanings of the following terms: equilibrium level of GDP, full employment level of GDP, inflationary gap, and recessionary gap. How would you characterize our current economy?

In the Keynesian/Neo-Keynesian Model, the equilibrium of GDP occurs when aggregate demand is equal to aggregate supply. Aggregate demand, or, equal to aggregate expenditures, is calculated by adding a nation’s consumption, investment, government expenditures, and net exports (exports less imports). Aggregate supply is the total goods and services supplied by the national economy. Additionally, leakages must be equal to injections. Articulated formulaically, the total savings, taxes and imports (where money is removed from the economic flow), must be equal to the total consumption, investments, government spending, and exports (where money is put into the economic flow).

The full employment level of GDP would occur when everybody that wants to be employed is. In other words, full employment exists when all of those who are willing and able to work under current market wage rates are employed. Full employment is one of the primary goals desired by national governments as they set out to intervene in the market. This is a tough goal to achieve when there is rampant intervention in the economy, particularly as it relates to wage controls.

An inflationary gap is said to exist when aggregate demand exceeds the level of economic activity (total production).  To overcome this gap, the amount of economic activity would have to increase until equilibrium is achieved. But if the economy is at its capacity level of total production, real output does not increase. Thus, the expansion is merely one of prices, and not production. The end result is inflation (Pg. 116 of text).  A recessionary gap exists when the opposite occurs. Aggregate demand is less than it must be with current total production. Thus, production must contract to reach equilibrium.

In the Keynesian sense, our current economy appears to be in a recessionary gap. Production outran demand, and now prices are depressing. Now governments and monetary authorities are doing everything they can to encourage consumption, and keep prices artificially high. This has included a slew of costly bailouts, and money being injected into the economy as fast as the central banks can print it. The veil will come off soon enough, and it will be realized that we are indeed in the recessionary phase of the business cycle.

2. Why is the classical/neoclassical tradition in macroeconomics often referred to as supply side macro, while the Keynesian tradition is referred to as demand side macro?

The Classical tradition in macroeconomics is often referred to as “supply-side” economics because of its adherence to Say’s Law, summarized by many as “supply creates its own demand.” What this means is that the economy will be most efficient when productive resources are induced to produce goods and services. The key focus is production by firms.

“Demand-side” economics would refer to those that adhere to the Keynesian tradition, who believe that consumers ought to be induced to consume goods and services. The key focus is consumption by households.

An example of how these two factions differ is best displayed by their respective view of tax cuts. To the supply-sider, tax cuts should be tailored to encourage more production, e.g. cutting corporate taxes in order to convince firms to stay domestic and not flee overseas. To the demand-sider, tax cuts should be tailored to encourage people to go out and consume more, e.g. spend more on goods and services. The recent “rebates” that certain households received is an example of demand-side thought.

3. What is the meaning of the natural rate of employment and contrast it with the current meaning of full employment?

Full employment occurs when everyone who is willing and able to work is employed. On the other hand, the natural rate of employment is the lowest possible rate the overall economy can sustain in the long-run. It will take into account unemployment caused by frictions, structural issues (re-sizing, etc), and wage controls (minimum wage laws, unions, etc).