Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 1 Economics THIRD EDITION By John B. Taylor Stanford University

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 2 Chapter 17 (Macro 4) Macroeconomics: The Big Picture

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 3 Overview This chapter introduces the major themes and components of modern macroeconomics. It defines macroeconomics in terms of economic growth and economic fluctuations. It summarizes the recent historical record of a few key macroeconomic variables and emphasizes a set of key facts about economic growth and economic fluctuations. An overview of the major sources of macroeconomic theory is provided to explain these facts. Finally, the role of economic policy is introduced with a brief discussion of fiscal and monetary policy.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 4 Teaching Objectives 1.Explain how economic growth and economic fluctuations occur together, but make clear the difference between the two. 2.Provide an account of the important facts about economic growth and economic fluctuations. 3.Introduce major theoretical perspectives on both economic growth (Solow model) and economic fluctuations (Keynes, monetarism, and rational expectations). 4.Introduce the role that economic policy can play in promoting economic growth and reducing economic fluctuations.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved Economic Output Over Time 1a. Real GDP is the starting point for studying macroeconomics. Figure 17.1 distinguishes economic growth trends from business cycles, or fluctuations. 1b. Economic growth can be measured in terms of individual benefit by using real GDP per capita values, providing an indicator of average well- being in an economy.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 6 Figure 17.1 (Macro 4) Economic Growth and Fluctuations

Copyright © 2001 by Houghton Mifflin Company. All rights reserved Economic Output Over Time 1c. The growth record of the United States over the past 40 years is based on real GDP growth of 3 percent and per capita growth of 1.7 percent. However, these growth rates cover two distinct periods. The first period ( ) growth rate was about 3.25 percent, compared to the second period ( ) rate of 2.5 percent. Explaining this growth slowdown has been a major challenge for economists.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 8 Figure 17.2 (Macro 4) Visualizing Economic Growth

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 9 Economic fluctuations 1d. Economic fluctuations define the parts of a business cycle (see Figures 17.2 and 17.2). Note the irregular duration and variable depth and peak of cycles. This may be related to particular administrations or events. It is important to point out that economic fluctuations differ from cycles in physical sciences. The aftermath of a recession, a recovery, is gradual, and the effect of an improvement in the economy is usually delayed. A comparison between the recession and the Great Depression of the 1930s is made in Figure 17.4.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 10 Economic Fluctuations: Recession / Expansion

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 11 Figure 17.3 (Macro 4) The Phases of Business Cycles

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 12 Figure 17.4 (Macro 4) Growth and Fluctuations Throughout the Twentieth Century

Copyright © 2001 by Houghton Mifflin Company. All rights reserved Jobs, Inflation, and Interest Rates 2a. Job creation, or the net increase in employment, along with measures of labor productivity, are two of several variables used to describe an economy's performance. Figure 17.5 illustrates employment growth over the last 40 years. Labor productivity has increased at about 1.3 percent per year when measured in real GDP per hour. But again there are two periods of productivity growth, reflecting the productivity slowdown of the last 20 years: 2 percent for the period from the mid-1950s to the mid-1970s, compared to 0.7 percent since. Small differences make for large differences over long periods of time.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 14 Figure 17.5 (Macro 4) The Unemployment Rate

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 15 Unemployment 2b. The unemployment rate rises in a recession and falls in a recovery but with a delay, as shown in Figure The contrast in the magnitude between recent rates and the Great Depression is provided by Figure The labor force participation rate, although rising gradually over the last 40 years, also varies over the business cycle as workers are discouraged from further job search or decide to retire early, causing the rate to fall in a recession.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 16 Figure 17.6 (Macro 4) Unemployment During the Great Depression

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 17 Inflation Inflation is closely linked to the business cycle, as seen from the shaded areas in Figure There is a long-term positive trend to inflation over the last 40 years, even though disinflation has been a feature of the last decade. Inflation has never been zero during the period and is expected to remain positive on average in the future. The cost of inflation is the uncertainty about how to determine prices and anticipate future changes in prices. Inflation has not been low or stable, both desirable goals.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 18 Figure 17.7 (Macro 4) The Ups and Downs in Inflation

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 19 Interest rates Interest rates are also linked to business cycles. Interest rates, such as mortgage and savings deposit rates, along with the federal funds rate, are affected by the performance of the economy, as shown in Figure Real interest rates, the difference between nominal interest rates and expected inflation, provide a way of explaining the close relationship between inflation and interest rates.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 20 Figure 17.8 (Macro 4) The Ups and Downs in Interest Rates

Copyright © 2001 by Houghton Mifflin Company. All rights reserved Macroeconomic Theory and Policy 3a. Economic growth theory and economic fluctuations theory are the long- and short- term parts of macroeconomic theory, respectively. The trend line of Figure 19.1 is potential GDP, or the long-run tendency of GDP, and is an average-level GDP that reflects the long-term growth rate, the slope of the trend line.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 22 Aggregate Supply 3b. The term aggregate supply is used to describe potential GDP in the short-run setting of economic fluctuations. Aggregate supply is determined by the available labor, capital, and technology. 3b.1 The concept of the aggregate production function is used to relate real GDP to the inputs: labor, capital, and technology. Because of this long-term relationship between inputs and output, any slowdown in economic growth must be due to a slowdown in the growth of one or more of the inputs.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 23 Economic policies 3c. Policy for long-term economic growth (sometimes called supply side policy) attempts to increase potential GDP, or aggregate supply. Fiscal and monetary policy are other tools to improve economy.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 24 Fiscal policy 3c.1 Fiscal policy can affect aggregate supply through the use of tax changes or changes in spending or borrowing. These incentives alter labor, capital, and technology inputs to the production function.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 25 Monetary policy 3c.2 Monetary policy is concerned primarily with the control of the money supply in order to control inflation. A low and stable rate of inflation is desirable because it reduces the uncertainty associated with determining prices and future inflation when inflation is high or variable.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 26 Final thoughts 3d.1 Changes in aggregate demand are central to the explanation of economic fluctuations, whether due to fluctuations in business spending (Keynes) or the money supply (monetarists). 3d.2 The potential of macroeconomic policy, both fiscal and monetary, to alter the size of economic fluctuations parallels the potential of policy to affect economic growth. These details are pursued in subsequent chapters.