21 The Realm of Macroeconomics Where the telescope ends, the microscope begins. Which of the two has the grander view? VICTOR HUGO The Realm of Macroeconomics Where the telescope ends, the microscope begins. Which of the two has the grander view? VICTOR HUGO

●Drawing a Line Between Macroeconomics and Microeconomics ●Supply and Demand in Macroeconomics ●Gross Domestic Product ●The Economy on a Roller Coaster ●The Problem of Macroeconomic Stabilization: A Sneak Preview ●Drawing a Line Between Macroeconomics and Microeconomics ●Supply and Demand in Macroeconomics ●Gross Domestic Product ●The Economy on a Roller Coaster ●The Problem of Macroeconomic Stabilization: A Sneak Preview Contents Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Drawing a Line Between Macro and Microeconomics ●In macroeconomics, we typically assume that most details of resource allocation and income distribution are of secondary importance to the study of the overall rates of inflation and unemployment.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Drawing a Line Between Macro and Microeconomics ●Aggregation and Macroeconomics ♦An economic aggregate is nothing but an abstraction that people use to describe some important feature of economic life, such as total domestic product. ●Aggregation and Macroeconomics ♦An economic aggregate is nothing but an abstraction that people use to describe some important feature of economic life, such as total domestic product.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Drawing a Line Between Macro and Microeconomics ●The Foundations of Aggregation ♦The composition of demand and supply in various markets is of little consequence for the economy-wide issues of growth, inflation, and unemployment. ♦During economic fluctuations, markets tend to move up or down together. ●The Foundations of Aggregation ♦The composition of demand and supply in various markets is of little consequence for the economy-wide issues of growth, inflation, and unemployment. ♦During economic fluctuations, markets tend to move up or down together.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Supply and Demand in Macroeconomics ●Moving to Macroeconomic Aggregates ♦Aggregate supply and aggregate demand relate domestic product (on the horizontal axis) to the price level (on the vertical axis). ●Moving to Macroeconomic Aggregates ♦Aggregate supply and aggregate demand relate domestic product (on the horizontal axis) to the price level (on the vertical axis).

FIGURE 21-1 Two Interpretations of a Shift in the Demand Curve Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Q 0 Price P 0 D 1 A S D D S E Quantity (a) Price P 0 S D D S E Quantity (a) D 1

FIGURE 21-2 An Economy Slipping into a Recession Copyright © 2003 South-Western/Thomson Learning. All rights reserved. D 2 B Price Level S D0D0 D0D0 S E Domestic Product D2D2

FIGURE 21-3 Economic Growth Copyright © 2003 South-Western/Thomson Learning. All rights reserved. D 1 C Price Level S0S0 D0D0 D0D0 S0S0 E Domestic Product D 1 S 1 S 1 Q 0 Q 1

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Supply and Demand in Macroeconomics ●Moving to Macroeconomic Aggregates ♦Aggregate demand (AD) = quantity of domestic product that is demanded at each possible price level ♦Aggregate supply (AS) = quantity of domestic product that is supplied at each possible price level ●Moving to Macroeconomic Aggregates ♦Aggregate demand (AD) = quantity of domestic product that is demanded at each possible price level ♦Aggregate supply (AS) = quantity of domestic product that is supplied at each possible price level

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Inflation ♦Major concerns of macroeconomics ■Inflation ■Unemployment ■Growth ♦  AD   price level ●Inflation ♦Major concerns of macroeconomics ■Inflation ■Unemployment ■Growth ♦  AD   price level Supply and Demand in Macroeconomics

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Recession and Unemployment ♦  AD  unemployment ♦Recession = a period of time during which production falls and people lose jobs ●Recession and Unemployment ♦  AD  unemployment ♦Recession = a period of time during which production falls and people lose jobs Supply and Demand in Macroeconomics

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Economic Growth ♦Economic growth =  GDP ♦  AD and/or  AS  growth ●Economic Growth ♦Economic growth =  GDP ♦  AD and/or  AS  growth Supply and Demand in Macroeconomics

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Money as the Measuring Rod: Real Versus Nominal GDP ♦GDP = sum of the money values of all final goods and services produced in the domestic economy within the year ♦Nominal GDP (GDP in current dollars) values each good and service at the price at which it was actually sold during the year. ●Money as the Measuring Rod: Real Versus Nominal GDP ♦GDP = sum of the money values of all final goods and services produced in the domestic economy within the year ♦Nominal GDP (GDP in current dollars) values each good and service at the price at which it was actually sold during the year. Gross Domestic Product

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ♦Drawback of Nominal GDP: it changes when prices change even if there is no change in actual production. ♦Solution: calculate real GDP or GDP in constant dollars. ♦Distinction between Nominal and Real GDP  a working definition of a recession as a period in which real GDP declines ♦Drawback of Nominal GDP: it changes when prices change even if there is no change in actual production. ♦Solution: calculate real GDP or GDP in constant dollars. ♦Distinction between Nominal and Real GDP  a working definition of a recession as a period in which real GDP declines Gross Domestic Product

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Gross Domestic Product ●What Gets Counted in GDP? ♦Only goods and services produced within the year ♦Only final goods and services ♦Only production within the geographic boundaries of the United States ●What Gets Counted in GDP? ♦Only goods and services produced within the year ♦Only final goods and services ♦Only production within the geographic boundaries of the United States

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Limitations of the GDP: What GDP Is Not ♦Includes only market activities ♦Places no value on leisure ♦Counts “bads” as well as “goods” ♦Does not deduct ecological costs of economic activity ●Limitations of the GDP: What GDP Is Not ♦Includes only market activities ♦Places no value on leisure ♦Counts “bads” as well as “goods” ♦Does not deduct ecological costs of economic activity Gross Domestic Product

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●Growth, but with Fluctuations ♦The U.S. has seen significant fluctuations in economic growth, unemployment, and inflation. ♦Before WWII, the business cycle was particularly strong, the worst episode being the Great Depression of the 1930s. ●Growth, but with Fluctuations ♦The U.S. has seen significant fluctuations in economic growth, unemployment, and inflation. ♦Before WWII, the business cycle was particularly strong, the worst episode being the Great Depression of the 1930s.

FIGURE 21-4 Nominal GDP, Real GDP, and Real GDP per Capita Copyright © 2003 South-Western/Thomson Learning. All rights reserved Year Nominal GDP (right scale) Billions of Dollars per Year $10,000 $9,000 7,000 5,000 3,000 8,000 6,000 4,000 1,000 2,000 0 Per-capita real GDP (left scale) Dollars per Year $35,000 25,000 15,000 Real GDP (right scale) 30,000 20,000 5,000 10,000 0

FIGURE 21-5 The Growth Rate of U.S. Real GDP, Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Boom of 1990s Expansion of 1980s 1990–91 Recession Roaring Twenties 1982–83 Recession 1974–75 Recession Expansion of 1960s Korean War World War II World War I Postwar recession Great Depression Postwar depression Panic of 1907 Depression of 1890s Railroad prosperity Rapid industrialization Percentage Growth Rate of Real GDP 0 Year –5 –10 –15 –20 Pre–1940 Post–1950

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●The Great Depression ♦A worldwide event ♦Caused a much-needed revolution in economic thinking ♦Until the 1930s, the prevailing economic theory held that a capitalist economy could cure recessions or inflations by itself. ●The Great Depression ♦A worldwide event ♦Caused a much-needed revolution in economic thinking ♦Until the 1930s, the prevailing economic theory held that a capitalist economy could cure recessions or inflations by itself.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●The Great Depression ♦The Great Depression led John Maynard Keynes, one of the world’s most renowned economists, to write The General Theory of Employment, Interest, and Money (1936). ●The Great Depression ♦The Great Depression led John Maynard Keynes, one of the world’s most renowned economists, to write The General Theory of Employment, Interest, and Money (1936).

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●The Great Depression ♦Keynes believed that: ■The economy did not naturally gravitate toward smooth growth and high levels of employment ■A pessimistic outlook could lead business firms and consumers to curtail their spending plans ■The economy could then be condemned to years of stagnation ●The Great Depression ♦Keynes believed that: ■The economy did not naturally gravitate toward smooth growth and high levels of employment ■A pessimistic outlook could lead business firms and consumers to curtail their spending plans ■The economy could then be condemned to years of stagnation

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●The Great Depression ♦In terms of the AD-AS framework, Keynes suggested that there were times when the AD curve shifted inward by large amounts. ♦The consequence would be declining output and deflation. ●The Great Depression ♦In terms of the AD-AS framework, Keynes suggested that there were times when the AD curve shifted inward by large amounts. ♦The consequence would be declining output and deflation.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●The Great Depression ♦Keynes showed how governments can manage their economies so that recessions will not turn into depressions and depressions will not last as long as the Great Depression. ●The Great Depression ♦Keynes showed how governments can manage their economies so that recessions will not turn into depressions and depressions will not last as long as the Great Depression. The Economy on a Roller Coaster

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●From World War II to 1973 ♦During this period, the economy experienced some fairly mild business cycles, but grew considerably. ♦By the end of the period, inflation was rising. ●From World War II to 1973 ♦During this period, the economy experienced some fairly mild business cycles, but grew considerably. ♦By the end of the period, inflation was rising.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●The Great Stagflation, ♦The international price of oil was raised sharply in 1973 and again in ♦For that reason and some others, the period saw the emergence of stagflation, both unemployment and inflation increasing together. ●The Great Stagflation, ♦The international price of oil was raised sharply in 1973 and again in ♦For that reason and some others, the period saw the emergence of stagflation, both unemployment and inflation increasing together.

FIGURE 21-6 The Inflation Rate in the United States, Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Disinflation of the 1980s Vietnam War inflation Inflation of the 1970s Postwar adjustment World War II World War I Great Depression Post-Civil War deflation Postwar deflation –5 Year Percentage Inflation Rate –10 –15 Pre–1940 Post–1950

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●Reaganomics and its Aftermath ♦When Reagan assumed office in 1981, the economy went into a sharp tailspin, and soon the rate of inflation fell. ♦This was followed by a period of steady, non- inflationary growth during most of the 1980s. In , recession hit. ●Reaganomics and its Aftermath ♦When Reagan assumed office in 1981, the economy went into a sharp tailspin, and soon the rate of inflation fell. ♦This was followed by a period of steady, non- inflationary growth during most of the 1980s. In , recession hit.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●Clintonomics: Deficit Reduction and “The Best Economy in 30 Years” ♦Clinton’s initial objectives were spurring growth and increasing public investment. ♦Soon, however, the overriding goal in Washington became deficit reduction. ●Clintonomics: Deficit Reduction and “The Best Economy in 30 Years” ♦Clinton’s initial objectives were spurring growth and increasing public investment. ♦Soon, however, the overriding goal in Washington became deficit reduction.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●Clintonomics: Deficit Reduction and “The Best Economy in 30 Years” ♦A variety of transitory factors pushed the economy’s AS curve outward at an unusually rapid pace between 1996 and ♦Strong economic growth continued through the late 1990s. ♦Inflation remained low. ●Clintonomics: Deficit Reduction and “The Best Economy in 30 Years” ♦A variety of transitory factors pushed the economy’s AS curve outward at an unusually rapid pace between 1996 and ♦Strong economic growth continued through the late 1990s. ♦Inflation remained low.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●The First Year of the Bush Economy ♦Real GDP grew very slowly then declined slightly in 2nd half of 2001 ■1st recession in 10 years ●The First Year of the Bush Economy ♦Real GDP grew very slowly then declined slightly in 2nd half of 2001 ■1st recession in 10 years

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Economy on a Roller Coaster ●The First Year of the Bush Economy ♦Policies that helped shift AD curve, mitigating recession ■tax cut of 2001 ■war of terrorism, burst of government spending ■consumers spending remained strong, despite Sept 11 ♦As of 2002, debate rages over whether recession already over ●The First Year of the Bush Economy ♦Policies that helped shift AD curve, mitigating recession ■tax cut of 2001 ■war of terrorism, burst of government spending ■consumers spending remained strong, despite Sept 11 ♦As of 2002, debate rages over whether recession already over

FIGURE 21-7 The Effects of an Adverse Supply Shift Copyright © 2003 South-Western/Thomson Learning. All rights reserved. S 1 S 1 D D S 0 S 0 Price Level Real GDP A E

FIGURE 21-8 The Effects of a Favorable Supply Shift Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Real GDP Price Level D 0 D 0 S 0 S 0 S 1 S 1 D 1 D 1 S 2 S 2 C B E

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Combating Unemployment ♦When recessions are caused by too low aggregate demand, governments can try to stimulate demand. ●Combating Unemployment ♦When recessions are caused by too low aggregate demand, governments can try to stimulate demand. The Problem of Macroeconomic Stabilization

FIGURE 21-9 Stabilization Policy to Fight Unemployment Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Increase in output Price Level Real GDP S S D 0 D 0 E D 1 D 1 A

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Combating Inflation ♦When inflation is caused by too high aggregate demand, governments can try to restrain aggregate demand. ●Combating Inflation ♦When inflation is caused by too high aggregate demand, governments can try to restrain aggregate demand. The Problem of Macroeconomic Stabilization

FIGURE Stabilization Policy to Fight Inflation Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Decrease in prices Price Level Real GDP S S D 0 D 0 E D 2 D 2 B

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Problem of Macroeconomic Stabilization ●Does It Really Work? ♦Before 1940, the economy endured pronounced business fluctuations and inflation was rare. ♦Since World War II the business fluctuations have been much less severe, but inflation has been a common occurrence. ♦How successful government policy can be is a question to be explored throughout the text. ●Does It Really Work? ♦Before 1940, the economy endured pronounced business fluctuations and inflation was rare. ♦Since World War II the business fluctuations have been much less severe, but inflation has been a common occurrence. ♦How successful government policy can be is a question to be explored throughout the text.