. 22
( 33)


and Practices Web site at epp.glencoe.com and
click on Chapter 16”Chapter Overviews to pre-
view chapter information.

The mental and social health of society is
an important concern for economists.
The Cost of Economic Instability
Main Idea Key Terms
Economic instability leads to social as well as eco- stagflation, GDP gap, misery (discomfort) index
nomic problems.
Reading Strategy After studying this section, you will be able to:
Graphic Organizer As you read the section, use a 1. Explain the economic costs of instability.
graphic organizer similar to the one below to 2. Describe the social costs of instability.
describe the GDP gap.
Applying Economic Concepts
Misery Index Do you know someone who has suf-
GDP Gap fered from the problems associated with unemploy-
ment and inflation at the same time? Many people
do, which is why economists have invented a measure
called the misery index. Read to find out how the
What causes the GDP
misery index got its name.
gap to fluctuate?

Cover Stor y ecession, high unemployment, and inflation
are forms of economic instability that hinder
long-term economic growth. Sometimes the
Inflation Fears Punish Do economy experiences these problems separately, and
stocks opened with a sometimes they occur at the same time. In the early
arket™s worst fears 1970s, for example, the economy experienced
iday after one of the m
tumble Fr umer level posted stagflation”a period of stagnant growth combined
d”inflation at the cons
with inflation.
its biggest increase
Even when the economy is relatively healthy, or
more than eight years
when there is a hint of problems on the horizon, as
At around 10 A.M. the you just saw in the cover story, we still worry about
Dow-Jones Industria inflation”and even our worries have real conse-
Average lost 128.58, quences. These fears are not unfounded, because eco-
1.1 percent, to 10,987.6 nomic instability carries an enormous cost”one that
as investors exited th can be measured in human as well as economic terms.
market in droves am
surging bond yields an
intensifying speculatio
The Economic Costs
that official interest rate ck
Instability can affect the sto
gher market.
could soon head hi
On one level, unemployment and infla-
as well.
s on the New York
rs overwhelmed gainer tion are simply numbers that are collected,
stocks falling and 435
Exchange, with 2,035 reported in the press, or plotted on a graph. At
another level, they represent enormous economic
rising. . . .
”CNNfn, May 14, 1999 failures that waste the resources of the nation and
its people.

ECONOMICS In a more dynamic sense, business cycles or fluc-
Figure 16.1
AT A GLANCE tuations cause the size of this gap to vary over time.
The scale of GDP is such that if GDP declines even
The GDP Gap and the a fraction of a percentage point, the amount of lost
production and income can be enormous.
Production Possibilities In 1999, for example, the GDP of the United
Frontier States economy was approximately $9 trillion. If a
$9 trillion economy declines just one-fourth of
one percentage point, $22.5 billion of production
would be lost. This amount is more than the fed-
as 15 guns and approxi-
110 eral government spent on agriculture or general sci-
mately 130 units of butter
not produced, or . . .
ence, space, and technology during the entire 1999
The GDP gap
fiscal budget year.
90 b
can be expressed
Quantity of Guns

Described in other terms, this amount would be
80 as 35 guns not
produced, or . . .
equal to 750,000 workers losing jobs that paid
70 c
$30,000 each for an entire year. In practice, the
effects of a decline in GDP generally are spread out
over a large area rather than being concentrated in
just one spot, but they are still enormous by any
as 200 units measure.
20 of butter not

The Misery Index

The misery index, sometimes called the
Quantity of Butter
discomfort index, is the sum of the monthly infla-
tion and unemployment rates. Figure 16.2 shows
Using Graphs The GDP gap is the differ-
the misery index for a period beginning in 1965.
ence between the actual production at point
Although it is not an official government statis-
a and the potential production as indicated
tic, the misery index is a comprehensive measure of
by points b, c, or d. What happens to
consumer suffering during periods of high inflation
production when some resources are
and unemployment. The index is relevant only
idle or are not employed efficiently?
over long periods because of the wide month-to-
month swings in some of the numbers.

The GDP Gap
One measure of the cost of stagnation is the
GDP gap”the difference between the actual GDP When the economy is unstable, a great deal of
and the potential GDP that could be produced if uncertainty exists. A worker may not buy some-
all resources were fully employed. In other words, thing because of concern over his or her job. This
the gap is a type of opportunity cost”a measure of uncertainty translates into purchases that are not
output not produced because of unemployed made, causing some unemployment to rise and
resources. jobs to be lost.
The GDP gap, illustrated in Figure 16.1, shows The worker is not the only one the uncertainty
the production possibilities curve in the classic affects. For example, the owner of a business pro-
guns-versus-butter example. Note that the output ducing at capacity may decide against an expan-
not produced because of resources that lie idle can sion although new orders are arriving daily.
be measured in either guns, butter, or a combina- Instead, the producer may try to raise prices,
tion of the two items. which increases inflation.

The Social Costs fails to satisfy the basic human need to be a useful
and productive member of society. This labor situ-
The cost of instability can be measured in ation is particularly acute in inner cities where
dollars rather easily, but it is harder to meas- unemployment rates run high among minority
ure in terms of human suffering. In human terms, groups.
the costs are almost beyond comprehension. Wasted resources are not limited to just human
Because of these social costs, everyone agrees that resources. Idle factories waiting to be utilized are
stability must be achieved. Economists are inter- another wasted resource. Natural resources may
ested not only in society™s production, but in its also lie unused or go to waste.
mental and social health as well.

Political Instability
Wasted Resources Politicians also suffer from the consequences of
Human suffering during periods of instability economic instability. When times are hard, voters
goes beyond not having more goods and services are dissatisfied, and incumbents are often thrown
that raise the standard of living. The labor resource out of office. For example, most experts agree that
is wasted, with people wanting work but not being Bill Clinton™s victory over President George Bush
able to find it. When this happens, the economy in 1992 was due in part to the 1991 recession.

Figure 16.2

The Misery Index
Annual Percentage Rate





1965 1970 1975 1980 1985 1990 1995 2000
Recession years
Source: Bureau of Economic Analysis, United States Department of Commerce

Using Graphs The misery index is the sum of the monthly inflation
Visit epp.glencoe.com and click on
and unemployment rates. When did the misery index reach its Textbook Updates”Chapter 16 for
highest point? an update of the data.

If too much economic instability Economics and Society
exists, as during the Great Depression
of the 1930s, voters are often willing
to vote for radical change. As a result,
economic stability adds to the politi-
cal stability of our nation.

Crime and Family Values
High crime rates, too few eco-
nomic and social opportunities for
minorities, the loss of individual
freedoms, and the lack of economic
stability for many Americans are all
grounds for concern. Many people
believe that some of these social ills
cannot be cured without the help of
a strong and stable economy.
When the economy is healthy,
Family Values A vibrant economy means that people will be
the citizens of a society can more
more certain of their ability to provide for themselves and their
easily deal with its social problems. families. What are some benefits of a healthy economy?
People have jobs and can provide
for themselves and their families.
A healthy economy means that people will be
Communities can take advantage of higher tax col-
more certain of their ability to provide for them-
lections, which can be used to increase police pro-
selves and their families. When people can do
tection and other municipal services. Companies
this, they are more positive about the future in
are more willing to hire disadvantaged persons and
provide on-the-job training.

Checking for Understanding economic times help prolong an economic
downturn? Provide at least one example with
1. Main Idea Using your notes from the graphic
your answer.
organizer activity on page 437, explain what
the GDP gap measures.
2. Key Terms Define stagflation, GDP gap, mis-
ery (discomfort) index.
6. Making Generalizations If the GDP gap in
3. Explain how economists measure the eco- a given year rose dramatically, what do you
nomic cost of instability. think would happen to unemployment and
4. Describe the social cost of instability. inflation?
7. Making Comparisons How does stagflation
Applying Economic Concepts
differ from the traditional business cycle?
5. Misery Index How might the psychological
strains that many people feel in difficult Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

Applying the Writing Process
Researching and writing allows you to organize your ideas in a logical man-
ner. The writing process involves using skills you have already learned, such
as taking notes, outlining, and synthesizing information.

Practicing the Skill
Learning the Skill
Suppose you are writing a report on the role political
Use the following guidelines to help you apply
turmoil plays in economic instability. Answer the following
the writing process.
questions about the writing process.
• Select an interesting topic. As you identify possi-
1. How could you narrow this topic?
ble topics, focus on resources that would be avail-
able. Do preliminary research to determine 2. Write a thesis statement.
whether your topic is too broad or too narrow.
3. What are three main ideas?
• Write a thesis statement that defines what you
4. What are three possible sources of information?
want to prove, discover, or illustrate in your writ-
ing. This will be the focus of your entire
• Prepare and do research on your topic. First
formulate a list of main idea questions; then
do research to answer those questions.
Prepare note cards on each main-idea ques-
tion, listing the source information.
• Organize your information by building an
outline or another kind of organizer. Then
follow your outline or organizer in writing a
rough draft of your report.
• A report should have three main parts: the
introduction, the body, and the conclusion.
The introduction briefly presents the topic
and gives your topic statement. In the body,
follow your outline to develop the important
ideas in your argument. The conclusion sum-
marizes and restates your findings. A systematic approach facilitates the writing process.
• Each paragraph should express one main
idea in a topic sentence. Additional sen-
tences support or explain the main idea by
using details and facts.
Use research resources in your library to find infor-
• Revise the draft into a final report. Wait for a day, mation on political instability during the Great
then reread and revise it. Depression. Write a short report on the topic.
Practice and assess key social studies skills with the
Glencoe Skillbuilder Interactive Workbook, Level 2.
Macroeconomic Equilibrium
Main Idea Key Terms
Aggregate supply is the total quantity of goods and aggregate supply, aggregate supply curve, aggregate
services produced at different price levels. Aggregate demand, aggregate demand curve, macroeconomic
demand is the total quantity purchased at different equilibrium
price levels.
Reading Strategy After studying this section, you will be able to:
Graphic Organizer As you read the section, complete 1. Explain the concept of aggregate supply.
a graphic organizer similar to the one below by list- 2. Describe the importance of aggregate demand.
ing at least three factors that could lower production 3. Examine the nature of macroeconomic equilibrium.
costs leading to an increase in aggregate supply.
Applying Economic Concepts
Equilibrium Have you ever experienced one of those
Ca Ca
us us rare moments when you feel completely satisfied and
e e
do not want to change anything that you are doing?
Effect: Increase in aggregate supply
This is called a state of equilibrium. Read to find out

how the economy, too, reaches a state of equilibrium


rom a historical perspective, the state of affairs
Cover Stor y described in the cover story is relatively rare.
g... We would like to see these conditions prevail
It Keeps Going and Growin more often, but something always seems to happen
g. Strong economic to prevent it. As a result, economists study markets in
keeps going and growin
It just
s and services, and
stable prices for good an attempt to find out how they work, and how they
growth, stable lending rates
w unemployment and can be made to work even better.
have made the U.S. ec
to the
look remarkably similar
Energizer Bunny on ste
Aggregate Supply
s able
Absolutely nothing seem
to stop it. When we study markets, we often use the
The Dow-Jones Industr tools of supply and demand to show how
Average is now within the equilibrium price and quantity of output are
distance of the dizzying determined. When we study the economy as a
mark. The economy is
whole, we can use the concepts of supply and
sive 4.5 Economy continues
ging along at an impres
demand in much the same way.
tion is growth
percent pace, . . . infla
. . . and One approach is to study aggregate supply,
practically non-existent t, a 29-year low, while
oyment rests at 4.2 percen the total value of goods and services that all
e robust than ever. . . .
d for labor remains mor firms would produce in a specific period of time
e economy keep going at
what gives? How can th at various price levels. If the period was exactly
me point, slowing down?
zzying pace without, at so one year, and if production took place within a
this di
”CNNfn, April 30, 1999 country™s borders, then aggregate supply would
be the same as GDP.

The Aggregate Supply Curve However, any expansion of real GDP beyond
point b, which has an output of Q1, is not possible
The concept of aggregate supply assumes that the
without some increase in the price level. By the
money supply is fixed and that a given price level
time the economy has reached point c, the price
prevails. However, if prices should change, then
level has risen to P1 because firms have been com-
individual firms would adjust their profit-maximiz-
peting for increasingly scarce resources. Q2 is the
ing quantities of output, producing a slightly differ-
level of output where all resources are fully
ent level of GDP. If it were somehow possible to
employed, because firms merely drive up prices if
keep adjusting the price level to see how total out-
they try to expand production beyond point c.
put changed, we could then construct an aggregate
The aggregate supply curve, like the supply curve
supply curve, which shows the amount of real GDP
of the individual firm, can increase or decrease.
that could be produced at various price levels.
Most of the increases in aggregate supply are tied to
Figure 16.3 shows how an aggregate supply
the cost of production for the individual firm. If the
curve, AS, for the whole economy might look. It is
cost goes down for some or all firms, aggregate sup-
shown as upward sloping, but with a horizontal as
ply increases, which shows as a shift to the right.
well as vertical range. The horizontal range repre-
Factors that tend to increase the cost of pro-
sents various levels of output that coexist with
duction for an individual firm tend to decrease
large amounts of unemployed resources. If the
aggregate supply. These factors include higher
economy is producing at point a, for example, out-
prices for foreign oil, higher interest rates, and
put could be expanded to point b by putting some
lower labor productivity. Any increase in cost that
unemployed resources to work, without causing
causes firms to offer fewer goods and services for
any change in the general price level.

Figure 16.3

The Aggregate Supply Curve
Price Level

Price Level


a b

Q0 Q1 Q2
Real GDP Real GDP

Using Graphs The aggregate supply curve shows the amount of real GDP that could be produced
at various price levels. An increase in aggregate supply comes about when production costs for all
the individual producers fall. What causes a decrease in aggregate supply?

sale at each and every price would shift the aggre- The primary reason for the negative slope is the
gate supply curve to the left. underlying assumption that the economy can have
only one money supply at a time. The size of this
supply is fixed and has a different purchasing
Aggregate Demand power at every possible price level. When prices are
very high, a given money supply will purchase a
Aggregate demand is the total quantity of
limited amount of output, such as that represented
goods and services demanded at different
by point a. When prices are much lower, everyone
price levels. It is like aggregate supply in that it is a
will be able to buy relatively more GDP, putting
summary measure of all demand in the economy;
output purchased at point b. If the price level
it can be represented in the form of a graph; and it
dropped further, even more GDP could be pur-
can either increase or decrease over time.
chased, which is why the curve tends to slope
downward and to the right.
The Aggregate Demand Curve The aggregate demand curve, like the aggregate
Figure 16.4 illustrates the aggregate demand supply curve, can increase or decrease depending
curve, a graph showing the quantity of real GDP on certain conditions. One factor that affects the
that would be purchased at each possible price level aggregate demand curve is a change in the amount
in the economy. This curve, labeled AD, represents of money that people save. If consumers collec-
the sum of consumer, business, and government tively save less and spend more, the increase in
demands at various price levels. It slopes downward consumer spending would increase aggregate
and to the right like the demand curve for individ- demand, shifting the aggregate demand curve to
uals, but for entirely different reasons. the right.

Figure 16.4

The Aggregate Demand Curve


Price Level

Price Level



Q0 Q1
Real GDP Real GDP

Using Graphs The aggregate demand curve shows the amount of real GDP the economy would
demand at all possible price levels. What causes the aggregate demand curve to shift?

A decrease in aggregate demand can be caused that things will change, but they do not yield exact
by the same factors behaving in an opposite fash- predictions. Even so, they are becoming increasingly
ion. For example, an increase in saving”leaving important when analyzing macroeconomic issues.
consumers less money to spend”will cause the
aggregate demand curve to shift to the left.
Higher taxes and lower transfer payments could
Figure 16.5
also reduce aggregate spending. Such decisions AT A GLANCE
shift the aggregate demand curve to the left
because all sectors of the economy collectively buy
Macroeconomic Equilibrium
less GDP at all price levels.

Macroeconomic Equilibrium AS

Macroeconomic equilibrium is the level of
real GDP consistent with a given price level,

Price Level
as determined by the intersection of the aggregate
supply and demand curves. This equilibrium is
shown in Figure 16.5 where Q is the level of real
GDP that is consistent with the price level P. This
is a static equilibrium because it represents a situa- P
tion at a particular point in time.
If the economy is growing, the price level may or
may not change, depending on changes in produc-
tivity and the money supply. This is one of the
Real GDP
dilemmas facing economic policy makers”how to
make real GDP grow without unduly increasing the Using Graphs The economy is at equili-
price level and thereby the rate of inflation. brium when the quantity of real GDP
Aggregate supply and demand curves are useful demanded is equal to the real GDP supplied
concepts, providing a framework for analyzing equi- at a given price level. What happens to
librium, economic growth, and price stability. They the price level when output increases?
can be used to give an idea of the way and direction

Checking for Understanding Applying Economic Concepts
1. Main Idea What factors might cause 6. Equilibrium Define macroeconomic equilib-
aggregate demand to increase? rium, then discuss how a decrease in business
investments would affect the macroeconomic
2. Key Terms Define aggregate supply,
aggregate supply curve, aggregate demand,
aggregate demand curve, macroeconomic
3. Describe the concept of aggregate supply. 7. Analyzing Information What kind of effect
4. Explain the importance of aggregate demand. would higher taxes have on aggregate sup-
ply? Explain your reasoning.
5. Describe the nature of macroeconomic
equilibrium. Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

From Rags
to Riches
Rags to riches. The expression
is clich©, but it captures the imagi-
nations of millions of Americans
who dream of success in the coun-
try™s free market economy. They
find inspiration in the stories of
individuals who started what
would some day become giant
global corporations”individuals,
perhaps, not unlike themselves.
the poor quality of American gun-
powder, he thought he could suc-
ceed by making one of higher
The DuPont Company is a
quality. In 1802, he constructed a
He started a food company, selling
multi-billion dollar enterprise, one
small powder works on Brandywine
ketchup, pickles, jams, jellies and
of the largest corporations in the
Creek near Wilmington, Delaware.
condiments. Clever marketing
world. It has about 125 plants in
From these humble beginnings, the
(“It™s not so much what you say,”
the United States and elsewhere,
DuPont giant grew.
said Heinz, “but how, when and
manufacturing more than 40,000
where.”) and aggressive sales were
distinct products. Most are chemi-
key to company growth. By 1896,
cal products”anything from poly-
The J. Heinz Company markets when Heinz was 52, his company
ester to pesticides to camera film.
5,000 varieties of food in 200 coun- had made him a millionaire. Its
In addition, DuPont controls
tries. The company is named for its growth since then has been even
many subsidiaries, including
founder, Henry John Heinz. Heinz more impressive.
Conoco, the petroleum giant.
was born in Pittsburgh in 1844. He
DuPont™s official name is
started his selling career at age 12,
E.I. DuPont de Numours &
hawking produce from his family™s
Company, a tribute to Èleuthère
Examining the Profile
garden. At 25, he sold his mother™s
Ir©n©e du Pont (1771“1834), its
1. Making Comparisons How are the
grated horseradish. He called it
founder. At 17, du Pont was a
individuals profiled alike? How are
“pure and superior,” and sold it in
worker at the French royal gunpow-
they different?
clear glass jars to prove his claim.
der works. At 19, he and his family
The company went bankrupt after
were forced by the revolution to 2. Synthesizing Information Explain
a few years, but Heinz persevered.
come to the United States. Noting why you think the companies du Pont
and Heinz founded are typical or

Stabilization Policies
Main Idea Key Terms
Government can promote economic growth through fiscal policy, Keynesian economics, multiplier, accelera-
demand-side and supply-side policies. tor, automatic stabilizer, unemployment insurance,
supply-side economics, Laffer curve, monetarism,
Reading Strategy wage-price controls
Graphic Organizer As you read the section, complete
graphic organizers similar to the ones below by
describing the role of government under demand- After studying this section, you will be able to:
side and supply-side policies. 1. Explain the operations and impact of fiscal policy.
2. Distinguish between supply-side economics and
fiscal policy.
Demand-side Supply-side
3. State the basic assumptions of monetary policy.
policies policies

Applying Economic Concepts
Automatic Stabilizers You may know someone who
Role of Role of
collects unemployment insurance, Social Security, or
government government
medicare. Read to find out why these programs are
some of the key fiscal policy measures used today.

Cover Stor y
conomic growth, full employment, and price
stability are three of the seven major eco-
nomic goals of the American people. In order
e of
ard to Find the Funny Sid to reach these goals, sound economic policies must
be designed and implemented.
Gridlock Economic stability can be achieved in several ways.
acrimony common
by the high standards of Some people favor policies that stimulate aggregate
agenda has fallen prey
hington, the legislative demand, while others favor ones that stimulate aggre-
in Was
over the government™s
cularly bitter wrangling
to parti gate supply. While these two approaches have their
ted at $3,000 billion
dget surpluses”projec
big bu supporters, Congressional gridlock, as we just saw in
over the next 10 years. the cover story, makes them increasingly more diffi-
Both Republican and cult to implement. As a result, a third approach that
Democratic leaders ar
favors monetary policy has filled the void.
under pressure from
rank-and-file members
to avoid compromise
Demand-Side Policies
this year.
Congress in session
Many candidates for
Demand-side policies are federal policies
Congress and the presi- s,
on party-defining issue designed to increase or decrease total
y would prefer to run
ises or cross-over votes.
uded by messy comprom demand in the economy by shifting the aggregate
Republicans have been
result, Democrats and demand curve to the right or to the left. One
As a
to reach agreement on
le”or are unwilling” approach is known as fiscal policy”the federal
many routine bills. government™s attempt to stabilize the economy
August 6, 1999
”The Financial Times, through taxing and government spending.

Keynesian Economics

The Role of Government
According to Keynesian eco-
nomics, economic activity will
be stimulated if the federal
government invests in projects
such as hydroelectric plants.
What is the role of government
deficits according to Keynesian

Fiscal policies are derived from Keynesian their jobs. These workers in turn would spend less
economics, a set of actions designed to lower and pay fewer taxes. Soon, the amount of spending
unemployment by stimulating aggregate demand. by all sectors in the economy would be down by
John Maynard Keynes put forth these theories in more than the initial decline in investment. This
1936 and they dominated the thinking of econo- effect is called the multiplier, and it says that a
mists until the 1970s. change in investment spending will have a magni-
fied effect on total spending. The multiplier is
believed to be about 2 in today™s economy, so if
The Keynesian Framework investment spending goes down by $50 billion, the
Keynes provided the basic framework with the decline in overall spending could reach $100 billion.
output-expenditure model, GDP = C + I + G + F. Conditions are likely to be made even worse by
According to this model, any change in GDP on the the accelerator”the change in investment spending
left side of the equation could be traced to changes caused by a change in total spending. After a decline
on the right side of the equation. The question was, in overall spending begins, it causes investment
which of the four components caused the instability? spending to be reduced even further. Before long,
According to Keynes, the net impact of the for- the economy is trapped in a downward spiral. The
eign sector (F) was so small that it could be ignored. combined multiplier-accelerator effect is important
The government sector (G) was not the problem because it contributes to the instability of GDP.
either, because its expenditures were normally stable
over time. Spending by the consumer sector (C),
The Role of Government
stated Keynes, was the most stable of all. Ruling out
F, G, and C, it then appeared that the business, or Keynes argued that only the government was big
investment, sector (I) was to blame for the instability. enough to step in and offset changes in investment-
In Keynes™s theory, investment sector spending sector spending. The government could take a
was not only unstable, but had a magnified effect on direct role and undertake its own spending to off-
other spending. If investment spending declined by set the decline in spending by businesses. Or, it
$50 billion, for example, many workers would lose could play an indirect role by lowering taxes and

enacting other measures to encourage businesses Figure 16.6
and consumers to spend more.
Suppose the government wanted to take direct
Fiscal Policy and the
steps quickly to offset a $50 billion decline in busi-
Aggregate Demand Curve
ness spending. To do this, it could spend $10 billion
to build a dam, give $20 billion in grants to cities to
fix up poor neighborhoods, and spend another $20
billion in other ways. Thus, the $50 billion that
business does not spend would be replaced by the
$50 billion the government spends. Thus, the over-

Price Level
all sum of C + I + G + F would remain unchanged.
Or, instead of spending the $50 billion, the gov-
P3 d
ernment could reduce tax rates by that amount and c
give investors and consumers more purchasing b
power. If the $50 billion not collected in taxes were
spent, the initial decline in investment spending AD0 AD1 AD2 AD3
would be offset, and the sum for C + I + G + F Q0 Q1 Q2 Q3
again would remain the same. Real GDP
Either way, the government would run the risk
of a growing federal deficit. In Keynes™s view, the Using Graphs Fiscal policies are designed to
deficit was unfortunate, but necessary to stop fur- increase aggregate demand. Successive
ther declines in economic activity. When the econ- increases in aggregate demand”or moving
omy recovered, tax collections would rise, the the economy from a to d”put increasing
government would run a surplus, and the debt pressure on the price level as the unemployed
could be paid back. The justification for temporary resources in the economy find employment.
federal deficits was one of the lasting contributions Which point on the graph represents the
lowest aggregate demand?
of Keynesian economics, and a major departure
from the economic thinking of the time.

threaten income. Three important stabilizers are
Automatic Stabilizers unemployment insurance, federal entitlement pro-
Another key component of fiscal policy is the grams, and the progressive income tax.
role of automatic stabilizers, programs that auto- Unemployment insurance is insurance that
matically trigger benefits if changes in the economy workers who lose their jobs through no fault of
their own can collect for a limited amount of time.
Unemployment insurance cannot be collected by
people who are fired because of misconduct or
who quit their jobs without good reason.
INFOBYTE Federal entitlement programs and many social
welfare programs designed to provide minimum
health, nutritional, and income levels for selected
The Employment Report The Employment
groups of people also work as automatic stabilizers.
Report, released monthly by the Bureau of Labor
They include federal programs such as welfare, gov-
Statistics, provides the unemployment rate, num-
ernment pensions, medicare, medicaid, and Social
ber of nonfarm payrolls, average workweek, and
Security. The availability of these programs is a
average hourly earnings figures. It is the broadest
guarantee that economic instability or some other
and most timely indicator of economic activity.
factor will not cause demand to fall below a certain
level for selected individuals.

Figure 16.7

Supply-Side and Demand-Side Economics
Supply-Side Policies Demand-Side Policies

Stimulate consumption of goods
Stimulate production (supply)
and services (demand)
to spur output
to spur output

Cut taxes and government Cut taxes or increase federal
regulations to increase spending to put money
incentives for businesses into people™s hands
and individuals

Businesses invest and expand, With more money,
creating jobs; people work, people buy more
save, and spend more

Increasing investment and Businesses increase output
productivity lead to to meet growing demand
increased output

With output increasing, the
economy grows and
unemployment goes down

Making Comparisons Supply-side policies and demand-side policies have the same goal:
continuous and stable economic growth without price inflation. How does the role of
government differ under supply-side and demand-side policies?

The progressive income tax is the third auto- shows a single aggregate supply curve and several
matic stabilizer. For example, if someone loses his aggregate demand curves. When aggregate
or her job, or ends up working fewer hours because demand is very low, as during the Great
of cutbacks, that person will earn less. If the reduc- Depression or other periods of severe economic
tion in income is significant, that person is likely to downturn, the economy would be at point a,
fall into a lower tax bracket, which cushions the where AD0 intersects AS. Increases in government
decline in income. spending”public works projects, transfer pay-
ments, or even tax reductions”could be used to
increase aggregate demand to AD1. Because many
Fiscal Policy and Aggregate Demand resources are not employed, the movement of
The impact of fiscal policies can be illustrated the economy from a to b causes very little price
with the aggregate demand curve AD. Figure 16.6 inflation.

Further attempts to increase aggregate demand approval or tax reduction is not needed when the
to AD2 and AD3 produce successively less output economy enters a recession, or when people lose
with increasingly higher price levels. Eventually, all jobs and need unemployment insurance coverage.
attempts the government sector makes to increase
aggregate demand only increase the price level
without increasing the production of real GDP.
Supply-Side Policies
Supply-side economics are policies designed
Limitations of Fiscal Policy to stimulate output and lower unemployment
by increasing production rather than demand. The
Keynes envisioned the role of government spend-
supply-side view gained support in the late 1970s
ing as a counterbalance to changes in investment
because demand-side policies did not seem to be
spending. Ideally, the government would increase its
controlling the nation™s growing unemployment and
spending to offset declines in business spending, and
inflation. In the 1980s, supply-side policies became
conversely government would decrease spending
the hallmark of President Reagan™s administration.
whenever business spending recovered. In practice,
The differences between supply-side economics
however, the federal government has been generally
and demand-side economics are smaller than most
unable to bring its spending under control, even
people realize. Both policies, which are summa-
when it ran enormous budget deficits in the 1980s.
rized in Figure 16.7, have the same goal”that of
As a result, the most effective counter-cyclical fis-
increasing production and decreasing unemploy-
cal policies used today are the automatic stabilizers.
ment without increasing inflation.
The advantage of the stabilizers is that spending

Figure 16.8

The Laffer Curve
A The Laffer Curve B Tax Receipts
Real Individual Real Corporate
According to Laffer, lower tax
Total tax collections

Tax Receipts Tax Receipts
rates produced higher revenues . . .
1981 $362,379 $77,487
in billions

1982 355,303 58,720
1983 331,351 42,456
1984 327,929 62,520
. . . because high
1985 354,376 64,969
tax rates slowed
1986 360,123 65,163
economic growth
1987 392,557 83,926
1988 386,122 90,961
0 100
1989 410,774 95,199
Tax Rates %

Sequencing Information Proponents used the Laffer curve to argue that lower tax rates would
generate higher economic growth as well as higher tax collections. In retrospect, lower tax rates
generated lower tax receipts. After adjusting for inflation, federal tax revenues declined after taxes
were reduced in 1981. What happened to tax revenues after taxes were raised in 1986?

Smaller Role for Government believe that if taxes are too high, people will not
want to work, and businesses will produce less.
A key issue for supply-siders is that of reducing
Lower tax rates, they argue, allow individuals and
government™s role in the economy. One way to do
businesses to keep more of the money they earn,
this is to reduce the number of federal agencies.
which encourages them to work harder. This
Another way to make government™s role smaller is
would give workers more money to spend in the
through deregulation”removing established regula-
long run. Government would also gain as total tax
tions with which industries must comply.
collections go up because of the extra activity.
Deregulation is a major objective of supply-
In the 1980s, somewhat optimistic supply-siders
siders and is favored by some demand-siders as
even argued that lower tax rates would stimulate
well. Under the administration of President Jimmy
the economy so much that eventually even more
Carter, major steps were taken to deregulate the
taxes could be collected than before. This was for-
energy, airline, and trucking industries. The Reagan
malized in the Laffer curve”a hypothetical rela-
administration continued deregulation efforts in
tionship between federal tax rates and tax
the savings and loan industry, hoping to bring
revenues”shown in Panel A of Figure 16.8. This
about more competition.
proposition was the basis for President Reagan™s
1981 tax cut, which reduced income taxes 25 per-
Lower Federal Taxes cent over a three-year period.
As it turned out, either the interpretation or the
Another target of supply-siders is the federal tax
assumptions of the Laffer curve were invalid, as the
burden on individuals and businesses. They
increased revenue collections never materialized. As
Panel B in Figure 16.8 shows, after adjusting for
inflation, both individual income tax receipts and
corporate tax receipts were lower in 1986 than they
ECONOMICS were in 1981. Because tax collections never went up,
Figure 16.9
AT A GLANCE the federal budget showed a deficit instead. In fact,
real tax collections did not surpass their 1981 levels
Supply-Side Policies and the until after the 1986 tax revisions took effect in 1987.
Aggregate Supply Curve
Supply-Side Policies and Aggregate
AD AS0 AS1 AS2 Supply
The impact of supply-side policies can be illus-
Price Level

trated in terms of the aggregate supply and
demand curves shown in Figure 16.9. When
P3 aggregate supply is very low, the economy would
P2 c be at point a, where AS0 intersects AD. If supply-
side policies were successfully instituted, the
aggregate supply curve would shift to AS1 , moving
the point of macroeconomic equilibrium to b.
Q0 Q1 Q2
Without any corresponding change in aggregate
Real GDP
demand, real output would grow, and the price
level would come down.
Analyzing Graphs Supply-side policies are
Further attempts to increase aggregate supply to
designed to increase aggregate supply.
move the economy to c has even less impact on the
What happens to the price level when
price level. If the aggregate supply curve does have
the aggregate supply curve shifts to the
a horizontal range then the price level could never
be reduced below P0.

leaders increasingly realized that they would have
to find answers to Africa™s problems without much
STABILIZING EFFORTS IN outside help. To break their reliance on foreign

AFRICA countries, some African nations formed regional
associations to promote trade and economic coop-
eration. Governments that had once adopted social-
Beginning in the 1970s, droughts, growing popu-
ist policies increasingly encouraged free enterprise.
lations, lack of capital, and falling world prices
for their exports weakened many African
Critical Thinking
Relying on foreign help to remedy these prob-
lems, African countries south of the Sahara took on 1. Analyzing Information What policies helped
$130 billion worth of debt by the 1980s. African create the large debt?
2. Analyzing Information Why did many African
nations form regional associations?

Limitations of Supply-Side Policies Monetary Policies
One limitation of supply-side policies is a lack of Both demand-side economics and supply-side
enough experience with them to know how they economics are concerned with stimulating
affect the economy. Even the concepts of aggregate production and employment. Neither policy assigns
supply and aggregate demand are largely concep- much importance to the money supply. A doctrine
tual, making it difficult to predict, based on the called monetarism, however, places primary impor-
shapes of the two curves, the exact consequence of tance on the role of money and its growth.
any particular supply-side policy. Monetarists believe that fluctuations in the
In the case of the Laffer curve, total tax collec- money supply can be a destabilizing element that
tions, when adjusted for inflation, actually declined leads to unemployment and inflation. Because of
after the 1981 tax reductions were implemented. this, they favor policies that lead to stable, long-term
The result was that one of the main foundations of monetary growth at levels low enough to control
the supply-side school was found to be invalid. inflation.
Even so, policies that promote productivity, reduce
unnecessary paperwork, or otherwise allow the
Interest Rates and Inflation
economy to grow to its maximum potential are cer-
In the short run, expansionist monetary policy
tainly worthwhile. Almost everyone, including
can lower interest rates. This action would reduce
demand-siders, favors these policies.
the cost of consumer and business borrowing and
Finally, supply-side economic policies are
shift the aggregate supply curve to the right. Real
designed more to promote economic growth
GDP would tend to increase, but so would the
rather than to remedy economic instability. No
possibility of future inflation. The money supply
matter how fast or slow the economy grows, it
can grow over time, but how fast should the
seems to have a tendency to fluctuate around its
money supply be allowed to grow?
trend line. Supply-side policies during the Reagan
Most monetarists believe that inflation can be
presidency tended to weaken the automatic stabi-
controlled if the money supply is allowed to grow
lizers by making the federal tax structure less pro-
at a slow but steady rate. The rates of growth of
gressive and by reducing many of the “safety net”
real GDP and productivity would determine the

rate at which the money supply grows. For exam- When rates eventually do go up, the cost of bor-
ple, if the rate of growth of real GDP were 3 per- rowing for businesses increases, which shifts the
cent, and that of productivity 1 percent, the aggregate supply curve to the left. The larger
money supply would grow at about 4 percent money supply also shifts the aggregate demand
without causing inflation. At this rate, there curve to the right. The result is that real GDP
would be just enough extra money each year to would fall back to its original level”but at a differ-
buy the additional goods and services the economy ent and much higher price level. The final result
produces. would appear as if the aggregate supply and
This approach to inflation control is in sharp con- demand curves shifted up together.
trast to those tried earlier. In the early 1970s, for An overly expansionist monetary policy, then,
example, President Richard Nixon tried to stop infla- will only cause long-term inflation. Monetary policy
tion by imposing wage-price controls”regulations is not a long-term cure for unemployment.
that make it illegal for businesses to give workers
raises”or to raise prices without the explicit permis-
sion of the government. Most monetarists at the
time said the controls would not work. The econ-
omy ultimately proved the economists correct: the Deregulation and New Growth
controls did little to stop inflation. The deregulation of the telecommunications
industry and the breakup of AT&T have helped
turn the telephone into an important compo-
Monetary Policy and Unemployment nent of the economy. The telephone is respon-
sible for helping Sioux Falls, South Dakota, and
Monetarists argue that attempts to cut unem-
Omaha, Nebraska, become major centers for
ployment by expanding the money supply provide
the credit-card processing and telemarketing
only temporary relief. They argue that excessive
rates of monetary growth eventually drive up prices
and interest rates.

Checking for Understanding Applying Economic Concepts
1. Main Idea Compare the views of supply-side 6. Automatic Stabilizers Fiscal policy is one of
economists and demand-side economists the tools designed to stabilize the economy.
regarding the role of government in the First, define fiscal policy in your own words.
economy. Then, explain its role in shifting the aggregate
demand curve.
2. Key Terms Define fiscal policy, Keynesian
economics, multiplier, accelerator, automatic
stabilizer, unemployment insurance, supply-
side economics, Laffer curve, monetarism,
wage-price controls.
7. Making Comparisons How do demand-side
3. Describe the objectives of demand-side policies and supply-side policies differ from
policies. one another?
4. Identify the main assumptions of supply-side 8. Analyzing Information According to mone-
policies. tarists, how do fluctuations in the money
supply affect the economy?
5. Explain how monetary policy could be
destabilizing. Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

MARCH 29, 1999
Using two measures of pay dispersion,
Wages are determined basically the same
Bloom analyzed how they affected both indi-
way other prices are”by demand and
vidual player performance and final team
supply. People work and earn money.
standings for 29 teams from 1985 to 1993.
The amount they earn usually depends on
Adjusting for such factors as past performance,
the value of their labor. Those who pos- age, experience, and pay levels, he found that
sess a unique skill or ability may receive unequal pay distributions translated into poorer
stats for lower-paid players on a number of per-
very high wages.
formance measures”and into lower standings
for their teams.
The proof of the pudding: Bloom notes that
Unequal Pay three of [1998™s] division winners, the New York
Yankees, the San Diego Padres, and the Cleveland
Strikes Out Indians, each had
one of the small-
est pay spreads in
Economists and psychologists who have
their respective
studied the impact of pay differentials on cor-
porate performance seem to be of two minds on
the subject. Some experts argue that unequal
pay is beneficial”inspiring greater individual
effort and productivity. Others claim that large
Successful teams like
pay differences often gener- the San Diego Padres
ate dissatisfaction and and Cleveland Indians
tend to have relatively
poorer quality work.
smaller pay spreads.
Both views may be
valid, depending on
”Reprinted from March 29, 1999 issue of Business Week, by special
the degree of inequal- permission, copyright © 1999 by The McGraw-Hill Companies, Inc.
ity and the nature of
a business and its
workers. But in a
Examining the Newsclip
team sport such as
baseball, unequal pay 1. Synthesizing Information What are the
doesn™t seem to pay two theories presented in the article regard-
off. That™s the finding ing large pay differentials?
of an intriguing study 2. Finding the Main Idea Which theory does
in the Academy of Management the Bloom theory support?
Journal by Matt Bloom of 3. Drawing Conclusions In your opinion,
Purdue University. are the study™s findings valid? Explain your

Economics and Politics
Main Idea Key Term
Monetary policy is becoming more important because Council of Economic Advisers
discretionary fiscal policy is difficult to implement.
After studying this section, you will be able to:
Reading Strategy
1. Explain why monetary policy sometimes conflicts
Graphic Organizer As you read the section, complete
with other economic policies.
a graphic organizer similar to the one below by
2. Recognize that economists have differing views.
identifying and describing the different kinds of
3. Understand the way that politics and economics
fiscal policy.

Applying Economic Concepts
Fiscal policy
Diversity of Opinion Well-meaning friends often dis-
agree over how something should be done. Read to
find out why the same thing happens to economists.

s we look at the economic history of the
Cover Stor y United States, it is clear that times are better
now than at any time in our past. Inflation is
largely under control and unemployment, while it
Charades on the Hill still goes up and down, is less painful than ever.
with the American
ress is playing charades Business cycles have turned into fluctuations, and
has been rigged guar-
, and the way the game the decade of the 1990s contained the longest period
ust of government.
even greater public distr of economic expansion in history.
s] a $792 billion reduc-
e tax cut bill . . . [promise If anything, the task before us is to manage pros-
. . . the “projected”
federal levies . . . [but]
tion in perity in a way that is fair to everyone, and in a way
to pay for these tax
surplus that is supposed
budget that lays the foundation for improved economic
cuts rests on the assu health. Fortunately, economic literacy has never been
. . . in
that the spending caps higher among Americans than it is today”despite


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