1. 1 Introduction to Macroeconomics CHAPTER 5 © 2003 South-Western/Thomson Learning

2. 2 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

3. 3 Flow and Stock Variables Flow Variable An amount per period of time Average spending per week, hours worked per month, etc. Stock Variable An amount measured at a particular point in time Amount of cash on hand you have now Number of housing units in existence today

4. 4 Economic Fluctuations Economic fluctuations The rise and fall of economic activity relative to the long-term growth trend of the economy

5. 5 Components of Business Cycles Two phases Periods of expansion Periods of contraction Depression Severe contraction Lasting longer than one year and accompanied by high unemployment Recession Milder contraction Decline in total output lasting at least two consecutive quarters

6. 6 Exhibit 1: Hypothetical Business Fluctuations A recession begins after the previous expansion has reached its peak, or high point and continues until the economy reaches a trough, or low point. Peak Trough

7. 7 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

8. 8 Exhibit 2: Annual Percentage Change in U.S. Real GDP from 1929 to 2003

9. 9 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

10. 10 Leading Economic Indicators Declines in leading economic indicators 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

11. 11 Aggregate Output Aggregate output Total amount of goods and services produced in the economy during a given period Best 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

12. 12 Price Level Average price of aggregate output is called the price level The 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

13. 13 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 index Shows how the economy’s general price level changes over time Can be used to convert production in different years into dollars of constant purchasing power

14. 14 Aggregate Demand Curve Aggregate demand curve shows the relationship between the price level in the economy and the real GDP demanded, other things constant Among the factors held constant along a given aggregate demand curve are The price levels in other countries The exchange rates between the U.S. dollar and foreign currencies

15. 15 Exhibit 4: Aggregate Demand Curve The inverse relationship depicted by the aggregate demand curve reflects the fact that as the price level increases, other things constant, the purchases of the four major decision makers decline AD

16. 16 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 constant Assumed constant along an aggregate supply curve are Resource prices, including wage rates The state of technology The rules of the game that provide production incentives

17. 17 Exhibit 5:Aggregate Demand & Supply 150 109 100 50 09.3 Real GDP (trillions of 1996 dollars) AD AS P r i c e l e v e l ( 1 9 96 = 1 0 0 ) Equilibrium in the national economy occurs where the AD and AS curves intersect.

18. 18 Equilibrium 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 economy More people are employed

19. 19 Short History of U.S. Economy History 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

20. 20 Exhibit 6: Decrease in Aggregate AS AD 1929 12.6 822 Real GDP (billions of 1996 dollars) P r i c e l e v e l ( 1 9 96 = 1 0 0 ) AD 1933 9.3 603 0 The Great Depression can be viewed as a shift to the left of the aggregate demand curve. This resulted in a drop of both the price level and real GDP. Demand between 1929 and 1933

21. 21 Great Depression and Before Why did aggregate demand decline so much during this period? Stock market crash of 1929 Grim business expectations Drop in consumer spending Widespread bank failures Sharp decline in the nation’s money supply Severe restrictions on world trade

22. 22 Great Depression and Before Prior to the Great Depression, macroeconomic policy was based primarily on the laissez-faire policy

23. 23 Age of Keynes Keynes 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

24. 24 Age of Keynes Keynes proposed that the government jolt the economy out of its depression by increasing aggregate demand Direct stimulus by increasing its own spending Indirect stimulus by cutting taxes to stimulate the primary components of private-sector demand, consumption and investment Federal budget deficit Flow variable that measures, for a particular period, the amount by which total federal outlays exceed total federal revenues

25. 25 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

26. 26 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

27. 27 Exhibit 7: Stagflation Between 1973-1975 AD AS 1973 33.6 4.12 Real GDP (trillions of 1996 dollars) P r i c e l e v e l ( 1 9 96 = 1 0 0 ) 0 AS 1975 40.0 4.08 The stagflation of the mid-1970s can be represented as a reduction in aggregate supply.

28. 28 Experience Since 1980 The stagflation of the 70s shifted policy maker’s attention from aggregate demand to aggregate supply Supply-side economics The 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

29. 29 Experience Since 1980 In 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

30. 30 Experience Since 1980 However, during this period, the growth in federal spending exceeded the growth in tax revenues  federal budget deficits swelled resulting in a huge federal debt Government debt Stock variable Measures the net accumulation of prior deficits Nearly doubled in the period of 1980 to 1992 relative to GDP

31. 31 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 before slipping into a recession.