Chapter 4: A First Look at Macroeconomics Origins and issues of macroeconomics Trends and fluctuations in economic growth Benefits and costs of economic growth Trends and fluctuations in unemployment & inflation and associated problems Trends and fluctuations in surpluses, deficits, and debts and why they matter Identify the macroeconomic policy challenges and list the tools available for meeting them

What Will Your World Be Like? Will tomorrow’s world be more prosperous than today? Will jobs be plentiful? Will the cost of living be stable? Will the government’s and the nation’s deficit continue to increase? What macroeconomic policy tools does the government have to steer the course of the economy?

Origins and Issues of Macroeconomics Economists began to study economic growth, inflation, and international payments during the 1750s. Modern macroeconomics dates from the Great Depression, a decade (1929-1939) of high unemployment and stagnant production throughout the world economy. John Maynard Keynes’ book, The General Theory of Employment, Interest, and Money, began the subject. While you will not grab the attention of many students, here is a wonderful opportunity to encourage some informed leisure reading. Tell your students about the novels of F. Scott Fitzgerald, Ernest Hemingway, John Dos Passos, and John Steinbeck. Encourage them to read a novel set in the 1930s to experience the anxiety and poverty of that period. The odd student will be moved into a new world. 

Origins and Issues of Macroeconomics Short-Term Versus Long-Term Goals Keynes focused on the short-term—on unemployment and lost production. “In the long run,” said Keynes, “we’re all dead.” During the 1970s and 1980s, macroeconomists became more concerned about the long-term—inflation and economic growth.

Economic Growth and Fluctuations the expansion of the economy’s production possibilities outward shifting Production possibilities frontier (PPF). results from more resources (land, labor, capital) or improved technology Real Gross Domestic Product (GDP) total market value of all the goods and services produced by domestically located factors of producing during a year, measured using a fixed prices. inflation alone does not cause an increase in real GDP Economic Growth is measured by growth in Real GDP

Economic Growth and Fluctuations Potential GDP is GDP if economy operates at “full employment” Real GDP<Potential GDP economy is operating below full employment A recession occurs when real GDP declines.

Economic Growth and Fluctuations Growth of Potential GDP During the 1970s, the growth of output per person slowed—a phenomenon called the productivity growth slowdown. Fluctuations of Real GDP Around Trend Real GDP fluctuates around potential GDP in a business cycle

Economic Growth and Fluctuations Fluctuations of Real GDP Around Trend Real GDP fluctuates around potential GDP in a business cycle—a periodic but irregular up-and-down movement in production.

Economic Growth and Fluctuations Every business cycle has two phases: 1. A recession 2. An expansion and two turning points: 1. A peak 2. A trough

Economic Growth and Fluctuations Most recent business cycle in the United States You might want to note that recessions begin when real GDP is at an all time high and even as the recession takes hold, real GDP remains above potential GDP. Also, for a while after an expansion begins, real GDP remains below its previous peak. Here is a lesson in the distinction between level and direction of change.

Economic Growth and Fluctuations A recession is a period during which real GDP decreases for at least two successive quarters NBER officially designates beginning and ending of recession -- above definition is not exact. An expansion is a period during which real GDP increases.

Economic Growth and Fluctuations

Economic Growth and Fluctuations The Lucas Wedge and Okun Gap How costly are the growth slowdown and the lost output over the business cycle? To answer that question we measure: The Lucas wedge The Okun gap

Economic Growth and Fluctuations The Lucas Wedge the accumulated loss of output from the productivity growth slowdown of the 1970s (4.3 percent from 1960s versus actual growth realized). $72 trillion or 6.5 times the real GDP in 2005. You might want to tell your students that the growth rate projection from the 1960s is 4.3 percent per year. If starting in 1973 we project a growth rate of 3.5 percent per year, the Lucas wedge decreases to $28 trillion—still a huge loss of output.

Economic Growth and Fluctuations The Okun Gap Real GDP minus potential GDP is the output gap (Okun gap) Okun gap from recessions since 1973 is $3.3 trillion or about 30 percent of real GDP in 2005. Pain of an Okun gap not equally distributed across society. You might want to refer forward to the interview with Ricardo Caballero—see p. 712 of Economics and p. 340 of Macroeconomics and note unequal sharing of the Okun gap.

Determinants of Economic Growth Rate of growth in resources (land, labor, capital) Tax policy Social Insurance programs Immigration Environmental regulations Government spending Technological change Education policy

Jobs and Unemployment Jobs In 2006, 143 million people in the United States had jobs. This number is 16 million more than in 1996 and 33 million more than in 1986. But the pace of job creation fluctuates. During the recession, the number of jobs shrinks. During the 19901991 recession, more than 1 million jobs were lost and during the 2001 recession, 2 million jobs disappeared.

Jobs and Unemployment Unemployment On an average day in a normal year, 7 million people in the U.S. are unemployed (not employed, but searching for a job). Labor force statistics: Civilian Labor force = employed + unemployed (excludes military) Unemployment rate = unemployed/Civilian labor force

Source: http://www.bls.gov/news.release/pdf/empsit.pdf

Jobs and Unemployment The unemployment rate is not a perfect measure of the underutilization of labor. For two reasons: The unemployment rate 1. Excludes discouraged workers. 2. Excludes “under-employment” – e.g. it does not tells us about the number of part-time workers who want full-time jobs.

Jobs and Unemployment During the 1930s, the unemployment rate hit 25 percent.

Jobs and Unemployment

Jobs and Unemployment Unemployment Around the World The U.S. unemployment rate has been lower than that in Western Europe and Canada but higher than that in Japan.

Why Unemployment Is a Problem Unemployment is a serious economic, social, and personal problem for two main reasons: Lost production and incomes Lost human capital The loss of a job brings an immediate loss of income and production—a temporary problem. A prolonged spell of unemployment can bring permanent damage through the loss of human capital.

Inflation and the Dollar We measure the price level as the average of the prices that people pay for all the goods and services that they buy. Consumer Price Index (CPI) is a common measure of the price level. Inflation rate: percentage change in the price level. Inflation occurs when the price level is rising persistently. Deflation occurs when inflation is negative and prices are falling.

Inflation and the Dollar Inflation in the United States Was low in the 1960s. Increased in the 1970s and early 1980s. Fell during the 1980s and 1990s. Increased after 2002.

Inflation Around the World U.S. inflation is similar to that in other industrial countries.

Inflation Around the World The inflation rate in industrial countries has been much lower than that in developing countries.

Inflation Hyperinflation The most serious type of inflation is hyperinflation -- an inflation rate that exceeds 50 percent a month. Why Inflation is a Problem Inflation is a problem for many reasons, but the main one is that once it takes hold, it is unpredictable. Unpredictable inflation is a problem because it Redistributes income and wealth Diverts resources from production

Costs of Inflation Unpredictable changes in the inflation rate redistribute income in arbitrary ways Employers and workers Borrowers and lenders Taxpayers and government High inflation diverts resources from productive activities to inflation forecasting High inflation makes contracts more complicated. Eradicating inflation is costly because it brings a period of greater than average unemployment.

Value of the dollar The Value of the Dollar in terms of other currencies is called the exchange rate —a measure of how much your dollar will buy in other parts of the world. An example is the number of pesos that 1 U.S. dollar will buy (pesos/dollar)

Value of the dollar When value of the dollar decreases, the U.S. dollar depreciates against other currencies. When value of the dollar increases, the U.S. dollar appreciates against other currencies.

Inflation and the Dollar Why the Exchange Rate Matters When the U.S. dollar appreciates, U.S. consumers pay less for imported goods more imports and less demand for domestic goods. Foreign consumers pay more for U.S. exports fewer exports and less demand for domestic goods. When the U.S. dollar depreciates, the opposite occurs.

Surpluses, Deficits, and Debts Government Budget Balance If a government collects more in taxes than it spends, it has a government budget surplus. If a government spends more than it collects in taxes, it has a government budget deficit.

Surpluses, Deficits, and Debts The budget deficit as a percentage of GDP increases in recessions and shrinks in expansions

Surpluses, Deficits, and Debts International Surplus and Deficit If a nation imports more than it exports, it has a trade deficit. If a nation exports more than it imports, it has a trade surplus. The balance on the current account equals U.S. exports minus U.S. imports but also takes into account interest payments paid to and received from the rest of the world.

Surpluses, Deficits, and Debts During the 1980s expansion, a large deficit appeared but it almost disappeared during the 1990–1991 recession. The current account deficit in 2005 was 6.3 percent of GDP.

Surpluses, Deficits, and Debts Deficits Bring Debts A debt is the amount that is owed. When a government or a nation has a deficit, its debt grows. A government’s or a nation’s debt equals the sum of all past deficits minus past surpluses. A government’s debt is called national debt.

Surpluses, Deficits, and Debts

Surpluses, Deficits, and Debts Until 1986, the United States was a net lender to the world. But with increased deficits, the United States is now a net borrower from the world.

Macroeconomic Policy Challenges and Tools Classical and Keynesian Views Economists’ views fall into two broad schools: Classical view: The economy behaves best if the government leaves people free to pursue their own self-interest. Attempts by the government to improve macroeconomic performance will not succeed. Keynesian view: The economy behaves badly if left alone and that government action is needed to achieve and maintain full employment.

Macroeconomic Policy Challenges and Tools Five widely agreed policy challenges for macroeconomics are to: 1. Boost economic growth 2. Keep inflation low 3. Stabilize the business cycle 4. Reduce unemployment 5. Reduce government and international deficits

Macroeconomic Policy Challenges and Tools Two broad groups of macroeconomic policy tools are Fiscal policy changes in tax rates and government spending Conducted by government Monetary policy changing interest rates and the amount of money in the economy Conducted by Federal Reserve