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Introduction to Macroeconomics

CHAPTER

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© 2003 South-Western/Thomson Learning

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The National EconomyRecall that macroeconomics concerns the overall performance of the economy

The term economy describes the structure of economic life, or economic activity, in a community, a region, a country, a group of countries or the world

Gross productMost commonly used measure of an economy’s sizeMeasures the market value of final goods and services produced in a particular geographical region during a given period

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Gross Domestic Product

GDP = Gross Domestic Product

Focuses on the U.S. economy

Measures the market value of all final goods and services produced in the United States during a given period

Helps us keep track of the economy’s incredible variety of goods and services

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The National Economy

Macroeconomic policy typically focuses on the performance of the national economy, including how the national economy interacts with other economic countries around the world

Economy continually renewing itself

Money circulates throughout the economy, facilitating the exchange of resources and products among individual economic units

Money is called a medium of exchange

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Flow and Stock Variables

Flow VariableAn amount per period of timeAverage spending per week, hours worked per month, etc.

Stock VariableAn amount measured at a particular point in timeAmount of cash on hand you have nowNumber of housing units in existence today

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Knowledge and PerformanceAs long as the economy functions smoothly, policy makers need not understand how it works

However, when problems occur – high inflation, severe unemployment – we must understand how a healthy economy works before we can consider how the problem can be corrected

In order to do this, we must understand the essential relationships among key economic variables

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Mercantilism

National policy makers have sometimes implemented the wrong economic prescription because of a flawed theory about how the economy works

MercantilismBelief that a nation’s economic vitality was thought to spring from the stock of precious metals accumulated in the public treasuryOne way of accumulating gold and silver is for a nation to sell more output to foreigners than it bought from them tariffs and quotas were popular

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Economic Fluctuations

Economic fluctuations The rise and fall of economic activity relative to the long-term growth trend of the economyBusiness cyclesVary in length and intensity but have some features in common

Easiest way to understand economic fluctuations is to examine their components

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Components of Business CyclesTwo phases

Periods of expansionPeriods of contraction

DepressionSevere contractionLasting longer than one year and accompanied by high unemployment

RecessionMilder contractionDecline in total output lasting at least two consecutive quarters

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U.S. Growth

U.S. economy in 2001 was more than eleven times larger than in 1929 as measured by real gross domestic product – real GDP

Real GDP means the effects of changes in the economy’s price level have been stripped away the remaining changes reflect real changes in the value of goods and services produced

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Increases in Production

Production tends to increase over the long run because of

Increases in the amount and quality of resources, especially labor and capital

Better technology

Improvements in the rules of the game that facilitate production and exchange

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Business Cycle

Turning points – peaks and troughs – are defined as officially occurring by the NBER only after the fact

Since a recession means that output declines for at least two consecutive quarters, a recession is not so designated until six months after it begins and a recovery is officially underway after two consecutive quarters of growth

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Leading Economic Indicators

Months before a recession is fully underway, changes in these leading economic indicators point to the coming stormAll these activities are called leading economic indicators because they usually predict, or lead to, a downturn and upturns point to an economic recovery

For example, in the early stages of a recession firms reduce overtime and new hiring, machinery orders slip, and the stock market turns down

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Aggregate Output

Aggregate outputTotal amount of goods and services produced in the economy during a given period

Unit of aggregate output is a composite measure of all output in the same sense that a unit of food is a composite measure of all foodBest measure of aggregate output is real gross domestic product, or real GDP

Aggregate demand is the relationship between the average price of aggregate output and the quantity of aggregate output demanded

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Price Level

Average price of aggregate output is called the price levelThe price level in any year is an index number, or reference number, comparing average prices that year to average prices in some base, or reference, year

When we say that the price level is higher, we mean compared to where it wasAverage price of all goods and services produced in the economy relative to the price level in some base year

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Price Level

The price level in the base year has a benchmark value of 100

Price levels in other years are expressed relative to the base-year price level

Price level or price index used to make

Comparisons in prices across timeAccurate comparisons of real aggregate output over time

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GDP Price Index

After adjusting GDP for price changes, we end up with what is called the real gross domestic product, or real GDP

The GDP price indexShows how the economy’s general price level changes over timeCan be used to convert production in different years into dollars of constant purchasing power

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Aggregate Demand Curve

Aggregate demand curve shows the relationship between the price level in the economy and the real GDP demanded, other things constantSums demands of the four economic decision makers: households, firms, governments, and the rest of the worldAmong the factors held constant along a given aggregate demand curve are

The price levels in other countriesThe exchange rates between the U.S. dollar and foreign currencies

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Aggregate Supply Curve

Aggregate supply curve shows how much output U.S. producers are willing and able to supply at each price level, other things quantity

Assumed constant along an aggregate supply curve are

Resource prices, including wage ratesThe state of technologyThe rules of the game that provide production incentives

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Equilibrium

Although employment is not measured directly along the horizontal axis in Exhibit 5

Firms usually must hire more workers to produce more output higher levels of real GDP can be beneficial because

More goods and services are available in the economyMore people are employed

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Short History of U.S. EconomyHistory of the U.S. economy can be crudely divided into four economic eras

Prior to and including the Great Depression• These contractions were often accompanied by

a falling price level

After the Great Depression to the early 1970s• Was an era of generally strong economic

growth• Moderate increases in the price level

From the early 1970s to the early 1980s• High unemployment and high inflation

Since the early 1980s• Good economic growth• Moderate increases in the price level

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Great Depression and Before

Why did aggregate demand decline so much during this period?

Stock market crash of 1929Grim business expectationsDrop in consumer spendingWidespread bank failuresSharp decline in the nation’s money supplySevere restrictions on world trade

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Great Depression and Before

Prior to the Great Depression, macroeconomic policy was based primarily on the laissez-faire policy

If people were allowed to pursue their self-interest in free markets, resources would e guided as if by an “invisible hand” to produce the greatest, most efficient level of aggregate output contractions were essentially self-correcting

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Age of KeynesKeynes argued that aggregate demand was inherently unstable

In part, this instability occurs because business investment decisions were often guided by unpredictable “animal spirits” of business expectations

Keynes saw no natural forces operating to ensure that the economy, even if allowed a reasonable time to adjust, would return to a high level of employment and output

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Age of KeynesKeynes proposed that the government jolt the economy out of its depression by increasing aggregate demand

Direct stimulus by increasing its own spendingIndirect stimulus by cutting taxes to stimulate the primary components of private-sector demand, consumption and investment

Federal budget deficitFlow variable that measures, for a particular period, the amount by which total federal outlays exceed total federal revenues

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Age of Keynes

To visualize what Keynes had in mind, federal policies would be designed to shift the aggregate demand back to its original position in Exhibit 6 with the result that equilibrium real GDP and employment would increase

The Keynesian approach can be though of as demand-side economics because it focused on how changes in aggregate demand could promote full employment

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Age of Keynes

Trying to avoid another depression, Congress approved the Employment Act of 1946

Which imposed a clear responsibility on the federal government to foster • Maximum employment• Maximum production• Maximum purchasing power

Created the Council of Economic Advisers

Required the president to report annually on the state of the economy

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The Great Stagflation: 1973 - 1980

The combined stimulus of federal spending on both the war in Vietnam and social programs in the late 1960s increased aggregate demand enough that the inflation rate began to increase

The high inflation rates induced President Richard Nixon to introduce ceilings on prices and wages in 1971

To compound these problems, OPEC reduced the supply of oil with the resulting increase in world prices

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The Great Stagflation

The combination reduced aggregate supply as shown in Exhibit 7 with the result that we had the stagflation of the 1970s

StagflationStagnation, or a contraction in the economy’s aggregate output combined withInflation, a rise in the economy’s price levelPrimarily a supply side problem the demand-management policies of Keynes were relatively ineffective

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Experience Since 1980The stagflation of the 70s shifted policy maker’s attention from aggregate demand to aggregate supply

Supply-side economicsThe federal government, by lowering tax rates, would increase after-tax earnings, which would provide incentives to increase the supply of labor and other resources

The resulting increase in aggregate supply would achieve the goals of expanding real GDP and reducing the price level

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Experience Since 1980In 1981 President Reagan and Congress cut personal income tax rates by an average of 23% to be phased in over 3 years

Before the tax cut was fully implemented, recession hit in 1982 and the unemployment rate shot up to 10%

After the recession, the economy began what was at the time the longest peacetime expansion on record

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Experience Since 1980

However, during this period, the growth in federal spending exceeded the growth in tax revenues federal budget deficits swelledThe huge deficits that occurred during this period accumulated as a huge federal debtGovernment debt

Stock variableMeasures the net accumulation of prior deficitsNearly doubled in the period of 1980 to 1992 relative to GDP

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Experience Since 1980

The huge federal deficits led both Presidents George H.W. Bush and William Clinton to increase taxes

When combined with the Republican Congress reductions in federal spending, the deficit problem turned to surpluses

By early 2001 the U.S. economic expansion became the longest on record and has only recently began to slow