Mr. Sadow



Chapter 17- Macroeconomics: The Big Picture

In microeconomics, we’ll study market structures, which are the organizational structures in markets where sellers and buyers interact: perfect competition, monopolistic competition, oligopoly, and monopoly.

But first we will study Macroeconomics, the study of the whole market economy. Instead of focusing mainly on the profit or loss of one firm or market (prefect competition, monopolistic competition, monopoly, or oligopoly), macroeconomics focuses on the economy as a whole, the big picture, every firm and every market in one country. Macroeconomics focuses on a country's money supply, aggregate (total) demand (AD), aggregate supply (AS), and gross domestic product (GDP). Economists define the money supply (M) as the total amount of currency (coin and paper money) and deposits in banks in a country. Currency and checking are referred to as M1 and are considered demand deposits (currency that you deposit into a bank account from which you can withdraw "on demand"- at any time without any advance notice to the bank, which is liquidity).

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GDP (gross domestic product) is the most important economic variable to macroeconomists. Nominal or current GDP, or just GDP, is the total value of all new goods and services produced in an economy during a specified period of time without a change in the price level (inflation or deflation) taken into account. GDP includes spending by consumers (C) + business investments (I) + the government (G) + foreigners (X) (net exports: exports-imports). For example, if a country makes only watches and sold 100 in 2019 at $10.00 each, the country's GDP for 2017 would be $1,000 (100 x $10). Inflation is the percentage increase in the average price (P) level of all goods and services from one year to the next. But because the quantities of goods and services as well as their prices (P) change over time, economists prefer to use real gross domestic product (real GDP) (Y), which is also called real output or output of production, to calculate economic growth from year to year. Real GDP only calculates/focuses on any change in quantities purchased, whether it be goods or services, from year to year. Any other increase in the value of a country's economy from year to year is inflation and any decrease is deflation.

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Real GDP is a country's GDP that is adjusted to take into account the general change in the price level (inflation or deflation) over time (from year to year). Real GDP allows an equal comparison between years, apples to apples.

nominal GDP= consumer consumption (C) + business investments (I)

+ government spending/expenditures (G)

+ net exports (X) (net exports: exports-imports)

real GDP = nominal GDP +/- change in the price level (inflation or deflation)

For example, imagine a country with a GDP of $100 in a given year. In the next year the GDP rises to $105 and the inflation rate is 3%. Roughly, we can say that real GDP rose 2% to only $102 when the inflation rate is accounted for.

Real GDP focuses on the changes in quantity from year to year, not the price change. As we'll soon learn, decreases or increases in a country's money supply doesn't change real output (real GDP). An increase in aggregate supply (AS) (a country's total supply of resources (inputs)) increases real output, as does an initial decrease in workers' wages, while a decrease in AS, a recession, or a depression, decreases real output.

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The velocity of money is the average frequency with which a unit of money is spent in an economy. For example, assume a very small economy that has a money supply of $100 and has only two people. Bob sells pencils and Jane sells paper. Bob starts with the $100 and buys $100 worth of paper from Jane. Jane turns around and buys $100 worth of pencils from Bob. Bob and Jane's economy now has a GDP/nominal GDP/current GDP of $200 even though the money supply is only $100. The equation for velocity is:

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Velocity of money is an incredibly important component/part of an economy's GDP calculation. GDP cannot be controlled through the money supply alone. If the money supply is increased, but velocity decreases, GDP may stay the same or even decline. Price levels will also rise because of the abundance of money. Along the same idea, the quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. The theory states that the quantity of money is positively related to nominal output and nominal GDP. An increase in the money supply causes prices to rise (inflation). A decrease in the money supply first causes disinflation (when the rate of inflation slows down) which then leads to deflation (a declining inflation rate). Just think of how a cell phone charges... fast at first, then charges slower when nearing 100%, then loses charge when on.

If you met someone in college and they told you that they had $100,000 and that they had invested money for only one year at 5% to earn it, how much did they start with/originally invest? Would you rather have $100 today or $200 in two years? You can determine how much your money someone has or will have if you know the interest rate and the number of years. Future value= A present value of $100 at 5% interest for one year would equal $105: $100 (1.05). As a general rule, today's money is more valuable than the same money in the future.

When you look at real GDP (Y) in the long-run (LR) (4-5 years out), when real GDP indicates an upward trend in an economy it is called economic growth. Real GDP per capita (per person) is the best indicator of this. In the short-run (SR) (up to one year out), economic fluctuations occur, which are small increases or decreases in real GDP, and are sometimes called business cycles. Sometimes real GDP fluctuates above potential GDP, like when a country is in expansion/with inflation, and sometimes it fluctuates below it, like when a country is in a recession/in contraction.

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The 45-degree upward growth trend line in real GDP (Y) is called potential GDP.  Potential GDP represents the long-run (LR) tendency of the economy to grow over time.  It is also called aggregate supply (AS) because as the potential total supply of a country increases of decreases so does the potential GDP line. Although no one knows exactly where potential GDP lies nor its growth rate, it has the same long-term increase as real GDP, and since it intersects real GDP in several places, it is probably a good estimate.  Potential GDP is more like the average or normal level of real GDP and where real GDP should be around.

Because strong economic growth raises the living standards of people in an economy, and because increases in unemployment occur during recessions, two goals of economic policy are to raise long-term growth and to reduce the size of short-term economic fluctuations.  Macroeconomic theory is divided into two branches.  Economic growth theory aims to explain the long-term upward rise of real GDP over time.  Economic fluctuations theory tries to explain the short-term fluctuations in real GDP.  Economic growth theory and economic fluctuations theory combine to form macroeconomic theory, which explains why the economy both grows and fluctuates over time.

A key assumption of the theory of economic fluctuations is that real GDP (GDP) fluctuates around potential GDP. This is because most of the determinants of potential GDP (labor + capital + technology) change rather smoothly, not sharply.  Populations, factories, and equipment all change over time, but there is typically no sudden increase or decrease.

Over time, real GDP (Y) increases and decreases and economic fluctuations, or business cycles, occur. When real GDP falls, economists say that there is a recession, and again, recessions do not happen regularly, but real GDP (a country's economy) will eventually decrease at some time. The rule of thumb says that the fall in real GDP must last for six months or more before the decline is considered a recession.

The highest point before the start of a recession is called the peak. The recession (contraction of the economy) comes next. The lowest point at the end of the recession is called the trough. This is where a depression might be.  The period between recessions, from the trough to the next peak, is called an expansion, the early part of which is called a recovery because the economy is just recovering from the recession. An essential fiscal (Congressional) tactic is to cut taxes in a recession to free up more money for consumers to spend, increasing AD.

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The graph shows the increase percent of real GDP (Y) growth compared from year to year. For example, real GDP increased around 4.1% in 1992 as compared to 1991 and almost -3% in 2009 compared to 2008. Yes, the growth rate can also be a negative number. The most recent recession, the Great Recession of 2008-2010, technically ended in 2010, but most people still feel that the economic picture has only slightly improved in America. A recession's impact is felt much quicker than a recovery or expansion.

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Let’s look at three years, 2017-2019. To calculate the real GDP growth rate between years, we need to see the percentage increase or decrease.

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The real GDP growth rate from 2017 to 2018 was:

and the real GDP growth rate from 2018 to 2019 was:

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100% (growth from 2017-2018) + 50% (growth from 2018-2019) = 150% / 2 = 75%. The annual growth rate from 2017 to 2019 was 75%. The growth rate is said to be in "chained 2017 dollars" for the three years from 2017 to 2019 to emphasize that the final number is calculated by combining years together with growth rates. 2017 would be the base year because that is the year we started the calculation with. But, the base year chosen must be a year where nominal and real GDP were at the same at one point during that year.

The economic well-being of individuals society cannot occur without an increase in real GDP (Y) and their real income, which is their income adjusted for changes in prices (inflation or deflation). For example, if someone earns $100,000 a year, but inflation is at 10%, their real income is only $90,000. To get a better measure of how individuals benefit from increases in real GDP (Y), we consider average production per person, or real GDP per capita.  Real GDP per capita is a country's real GDP divided by the number of people in the country's population.  It is the total production of all food, clothes, cars, computers, etc., per person, their individual productivity. Employee skills are critical for this, and education is the #1 factor in growth per capita. Even if a country's population expands, the unskilled numbers don't help real GDP grow. Output must also increase, not just the number of workers.

If a country's real GDP is $1 billion and their population is 1 million, then the country's real GDP per capita (per person) is $1,000. ($1 billion / $1 million). The annual growth rate of real GDP per capita is the percentage increase in the real GDP per capita each year. Again, this is the best indicator of a country's economic growth and status. To see a country's percent change from one year to another, figure out the per capita for each year and then figure out the percentage change between the years. If the first year's per capita was $1,000 and the second year's is $1,099, the percent change is 9.9% (100% x $1,099 / $1,000= 109.9%, then 109.9%-100%).

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1. 1st yr. per capita= $100 and 2nd yr. per capita= $112 12% ann. growth rate

2. 1st yr. per capita= $200 and 2nd yr. per capita= $220 10% ann. growth rate

Real GDP per capita (labor productivity) also indicates a country's standard of living. An increase in real GDP per capita shifts aggregate supply (SRAS) right (increases) while a decrease shifts SRAS left. Increased productivity occurs because of increased demand. An increase in demand leads suppliers to produce more to maximize their profit.

real income per capita = country's real GDP / country's population

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The annual short-run (SR) economic growth rate is the percentage increase in real GDP (Y) each year from the previous year.  This is a good measure of economic growth in an economy between two years. Over time though, we look at the long-run (LR) economic growth rate, which looks at the growth of the economy from 4-5 years and beyond. In America, for the last 40+ years, on average, the growth rate has been about 3% each year. The best way to promote long-run economic growth in a country is to take care of the unemployed and enhance technology, but once again, education is the key factor. Employees are the human capital in a country, and investing in their education/skills and raising their stock (value), is critical.

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A depression is a huge recession.  The last depression in the United States was the Great Depression, from 1929-1940.  Real GDP (Y) fell by 32.6% from 1929-1933. In comparison, the Great Recession of 2008-2010 saw real GDP fall by only 5.1%, but it was devastating to many.  Because any recession rivets attention on people’s hardship and suffering, there is always a tendency to view a current recession as worse than all previous recessions.

As real GDP (Y) (spending by consumers (C) + businesses (I) + the government (G) + foreigners (X) (net exports: exports-imports) changes over time, so do other economic variables, such as inflation, interest rates, and unemployment.  In turn, the impact of an economy on these variables leads to an impact on CIGX. It is the story of the chicken or the egg.

Just as real GDP and unemployment have fluctuated over time, so has inflation.  The inflation rate is the percentage increase in the average price (P) level of all goods and services from one year to the next. Often the expected rate of inflation impacts consumer decisions. If prices are expected to go up, some will buy earlier rather than later, and vice versa. The inflation rate is included in nominal GDP. Inflation occurs when nominal GDP grows quicker than real GDP; when price levels increase. An inflation rate of around 2% is the target.

Stagflation is persistent high inflation combined with high unemployment and stagnant demand for goods in a country's economy. Demand-pull inflation occurs when inflation is caused by an excess of aggregate demand (AD) vs. supply, (AS), like after natural disasters occur. Finally, a sticky price is a price for goods or services that does not respond immediately to changing economic conditions. Sticky price situations can occur when business leaders make production decisions that do not create equilibrium in the market. It can also occur because of the cost and time to communicate the price change in society, like price tags or advertising. Because of this, sticky prices have been used to explain the shape of the short-run aggregate supply (SRAS) curve because the quantity of goods supplied (Qs) does depend on the price level.

Increases in aggregate demand (AD) causes the inflation rate to increase and vice versa. This occurs because of the demand which then leads to price increases over time. Higher inflation rates make your money worthless. After WW I, Germany's money was worthless because their inflation skyrocketed. Prices for goods went up tremendously. The same happened to the South during the American Civil War. A rapid increase in a country's money supply creates hyperinflation, which explains why governments just can't print more money. Cost-push inflation is inflation caused by an increase in prices of inputs like labor, raw material, etc. The increased price of the factors of production, like labor and materials, leads to a decreased aggregate supply (AS) of the goods being made, and we know that when supply (S) decreases prices (P) increase, which causes inflation.

A low and stable inflation rate has not been a feature of the U.S.  There are some useful facts to know about inflation.  First, inflation is closely correlated with the ups and downs in real GDP (Y) and employment: inflation increased prior to every recession of the last 40 years. Think of a bike going downhill and picking up speed, just like an economy does as it improves. Prices become inflated because firms know people have more money and will pay more in the short-run (SR).

Second, there are long-term trends with inflation. Disinflation occurs when the inflation rate is slowing down. When inflation is falling and the average price (P) level falls, economists call it deflation, something that sounds good but is very bad. Third, there is no reason to expect the inflation rate to be zero.  The inflation rate has averaged around 2% or 3% since the 1990's, and that is the rate goal of most economies. The lower and more stable inflation is in a country, the greater the chance for economic growth, because high inflation puts more goods and services out of reach for some who make less.

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The interest rate also fluctuates over time. The interest rate is the amount lenders charge when they lend money, expressed as a percentage of the amount loaned.  For example, if you borrow $100 for a year from a friend and the interest rate on the loan is 6%, at the end of the year you must pay your friend back $6 in interest in addition to the $100 you borrowed.  Not a nice friend!! The interest rate is another key economic variable that is related to the growth and change in real GDP (Y) of a country's economy over time.

When interest rates are down, people borrow and spend more because it is cheaper to. When interest rates are up or rising, people spend less, which can lead to a recession and usually higher unemployment because less is purchased. This leads to companies laying off employees. Laid off, the former employees then spend less which leads to less purchases, and so on. An interest rate that does not change, such as a 5-year car loan at 2%, is referred to as a fixed interest rate, while those that can change are referred to as flexible interest rates.

The fluctuations in interest rates are intimately connected with the trends and fluctuations in inflation and real GDP (Y).  When inflation rises, people who lend money will be paid back in the long-run (LR) with funds that are worth less because the average price of goods rises more quickly than inflation.  To compensate for this decline in the value of funds, lenders require a higher interest rate just in case inflation rises during the loan.  For example, if a bank lends someone $10,000 for a year at 6%, but inflation unexpectedly pushes the interest rate to 9%, then the bank is actually at -3% interest. The bank loses and the borrower gains because inflation was higher than expected; the borrower paid less for the loan. Interest rates influence people’s economic behavior.  When interest rates rise, it is more expensive to borrow money or to buy a house or a car, so many people postpone such purchases.

Economists define the term nominal interest rate as the interest rate on a loan, making no adjustments for inflation (a loan at 9%, including 5% inflation). The real interest rate is the nominal interest rate minus the inflation rate (9% - 5% = 4%). The real interest rate is adjusted for the growth rate of the economy.

real interest rate = nominal interest rate - the inflation rate or anticipated inflation rate

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Fully anticipated increases in inflation lead to increased nominal rates, like when the government spends money during a recession to grow the economy. Deficit spending by a country also leads to an increase in the nominal interest rate. If nominal interest rates are low, people and businesses borrow and spend more. The chance of inflation and recession then grow. If rates are high, there is less chance of inflation or recession.

There are many different interest rates in the economy. The mortgage interest rate is the rate on loans to buy a house.  The Treasury bill rate is the interest rate the government pays when it borrows money from people for a year or less.  The federal funds rate is the short-term interest rate banks charge other banks on overnight loans; this rate can be adjusted up or down by actions taken by the Federal Reserve (the "Fed") to grow the economy and slow down inflation. To increase the money supply and grow the economy, the government buys bonds from banks to increase the amount of money banks can loan. Bonds (securities) are loans that people give out with their money to a company or government and they promise to pay you back in full, with regular interest payments. When the Fed buys or sell bonds it is called monetary policy, and it is critical in making an economy stable. When the Fed sets higher interest rates, the banks pass along the higher rates to borrowers, and vice versa when rates go down.

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The theory of economic fluctuations emphasizes fluctuations in the total demand for goods and services as the reason for the ups and downs in the economy.  Because the focus is on the total of the demand for all goods and services in the economy and not just one industry, like when we learned about demand (D) in microeconomics, we use the term aggregate demand (AD). More precisely, aggregate demand is the total amount that consumers (C), businesses (I), the government (G), and foreigners (net exports-imports) (X) spend on all goods and services in an economy... in other words AD is GDP. AD is referred to as a demand-side policy because it deals with the total demand of goods and services in an economy. Any change in AD can impact the wealth in a society.

The inflation rate is not the only thing that affects aggregate demand (AD). Changes in government purchases, monetary policy, foreign demand for U.S. exports, taxes, and consumer confidence can affect aggregate demand and cause a shift in the AD line.

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According to the economic fluctuations theory, the increases in real GDP over potential GDP are caused by increases in aggregate demand and decreases in real GDP (Y) below potential GDP during recessions are caused by declines in aggregate demand (AD).  Government military spending during (increased) and after (decreased) the Cold War is an example of both. Increases in C, I, G, or X can cause increase in real GDP (Y) and a rightward shift.

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An increase in AD increases the price level. When income taxes decrease, AD increases. A decrease in the money supply can decrease AD. If a decrease in AD creates a recession, the price level and real output will both decrease. Unemployment will also increase and the inflation rate will decrease if AD decreases and price and wages don't quickly adjust to the change.

Economic growth theory states that the potential GDP of an economy is best calculated by what it makes, its aggregate (total) supply (AS).  There are two types of aggregate supply. Short-run aggregate supply (SRAS) is all of the goods and services produced in the short-run (SR) (up to one year out) by all of the firms in an economy using the available labor, capital, and technology. The curve is sloped because of the law of supply.

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SRAS is referred to as a supply-side policy because it deals with the total supply of goods and services in an economy. SRAS assumes that there are fixed costs (FC) that cannot be changed in the short-run (SR), but the variable costs (VC) can be changed.

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When the level of short-run aggregate supply (SRAS) is the same as aggregated demand (AD), short-run (SR) equilibrium occurs. Short-run equilibrium is a state where aggregate supply (AS) equals aggregate demand (AD) in the short-run (SR) (less than one year). The price level is the measurement of current prices of goods and services produced in the economy in a specific region or country at a specific time.

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The equilibrium price level and equilibrium output level are the price level and output where the quantity of goods supplied (Qs) is equal to the quantity of goods demanded (Qd). Expansionary monetary policy increases the price level and a continual increase in the price level causes inflation. A decrease in the money supply decreases the price level but doesn't change output levels; only a decrease in demand will.

The SRAS curve shifts right (increases) if the stock (worth) of physical capital (trucks, factories) increases. An increase in government expenditures (spending) will also shift the SRAS right as will increased numbers of workers entering the labor force. A decrease in input resource prices for AS increases SRAS but decreases the price level (prices). Real output will then increase but not inflation until demand itself increases.

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An increase in SRAS will lead to increases in income and possibly, in the long-run, less unemployment. Unanticipated increases in SRAS can cause hyperinflation because the excess supply will increase demand because prices will decrease.

SRAS can also shift left (decrease.) A decrease in labor productivity and an increase in production costs/per unit costs both decrease SRAS. If SRAS decreases and aggregate demand (AD) increases, the price level will increase.

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When SRAS decreases but AD stays the same, stagflation occurs. When SRAS decreases rapidly but AD increases, like with a natural disaster, the price level goes up and real wages decline. This is referred to as demand-pull inflation.

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The second type of aggregate supply (AS) is long-run aggregate supply (LRAS). LRAS is all of the goods and services produced in the long-run (LR- four to five years out) by all of the firms in an economy using the available labor, capital, and technology. The curve is perfectly vertical because it reflects economists' belief that changes in aggregate demand (AD) have only a temporary change on the economy's total output and because it indicates immediate adjustments between wages and the price level as they fluctuate over time. The LRAS curve is determined by all of the factors of production since none are fixed in the long-run.

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Long-run equilibrium (left) is a state where long-run aggregate supply (LRAS) equals aggregate demand (AD) in the long-run (LR) (four to five years and beyond). Long-run equilibrium is where real GDP (Y) equals potential GDP. When both the LRAS and AD shift right (increase), output increases but the new price level is unknown at first. This is known as a double-shift (right).

Anywhere on the LRAS curve represents an economy where all inputs: land, labor, and capital, are used to full efficiency. The LRAS curve indicates where full employment and full output are in an economy and also the natural rate of unemployment occurs. If there was an increase in investment, growth in size of a skilled labor force, a right shift in the production possibilities curve/frontier, or consumer confidence in the economy grows, LRAS shifts to the right. When LRAS shifts to the right, it's an indicator of positive economic growth.

The LRAS also shows wages over time shifting to the prevailing price level. Classical economists believe that the close alignment of wages and the price level allow a country to naturally return to long-run equilibrium, even when unemployment or inflation occurs. They feel that during a recession (left graph), wages will decrease which will increase SRAS and AD and the economy will return to long-run equilibrium. During an expansion (right graph), wages will increase which will decrease SRAS and AD and the economy will return to long-run equilibrium.

Long-run aggregate supply (LRAS) can be impacted by changes in input or output costs, taxes, subsidies, government regulations, and the production of capital goods (goods created in order to produce other goods, like a robot for a car factory) and consumer goods (goods created for consumer purchase, like twinkies).  Labor is the total number of hours that workers are available to work in producing real GDP.  Capital is the total number of factories, machines, computers, human workers, etc., available.  Technology is the total amount of know-how available.

As seen below, the difference between potential GDP and real GDP (Y) is called the recessionary gap (potential GDP minus real GDP) because real GDP in a country is lower than potential GDP at the full employment level. Classical economists feel that the economy will work itself out: wages and the price level will drop and the economy will get back to full employment in the long-run (LR).

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The difference between potential GDP and real GDP (Y) is called the inflationary gap (real GDP minus potential GDP) because real GDP in a country is higher than potential GDP at the full employment level. When GDP increases over two years disproportionately, the price level and GDP are increasing.

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We can summarize the relationship between the three determinants of real GDP as:

real GDP = F(labor + capital + technology)

The function F means that there is a general relationship between the three variables in the parentheses.  It is safe to assume that the higher the variables, the higher the real GDP, and vice versa.  We call this relationship the production function because it tells us how much production (real GDP) of goods and services can be obtained from a certain amount of labor, capital, and technology inputs. Growth theory focuses on increasing the available supply of labor, capital, and technology.  The growth rate of capital depends on how much businesses (I) invest in new capital in each year.  Incentives help businesses to do so.  The amount invested depends on the amount of taxing, spending, and borrowing by the government (G).  Government policy can affect the incentives to invest and thereby stimulate long-term economic growth.

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