1 Introduction to Macroeconomics CHAPTER 20 © 2003 South-Western/Thomson Learning

2 The National Economy Recall 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 product Most commonly used measure of an economy’s size Measures the market value of final goods and services produced in a particular geographical region during a given period

3 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

4 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

5 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

6 Knowledge and Performance As 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

7 Mercantilism National policy makers have sometimes implemented the wrong economic prescription because of a flawed theory about how the economy works Mercantilism Belief that a nation’s economic vitality was thought to spring from the stock of precious metals accumulated in the public treasury One 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

8 Economic Fluctuations Economic fluctuations The rise and fall of economic activity relative to the long-term growth trend of the economy Business cycles Vary in length and intensity but have some features in common Easiest way to understand economic fluctuations is to examine their components

9 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

10 Exhibit 1: Hypothetical Business Fluctuations The long-term growth trend is shown by the upward sloping straight line. Economic fluctuations reflect movements along this growth trend. 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. Period between a peak and a trough is a recession and the period between a trough and subsequent peak is an expansion. Peak Trough

11 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

12 Exhibit 2: Annual Percentage Change in U.S. Real GDP from

13 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

14 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

15 Leading Economic Indicators Months before a recession is fully underway, changes in these leading economic indicators point to the coming storm All 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

16 Aggregate Output Aggregate output Total 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 food 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

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

18 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 time Accurate comparisons of real aggregate output over time

19 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

20 Aggregate Demand Curve Aggregate demand curve shows the relationship between the price level in the economy and the real GDP demanded, other things constant Sums demands of the four economic decision makers: households, firms, governments, and the rest of the world 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

21 Exhibit 4: Aggregate Demand Curve The vertical axis measures an index of the economy’s price level relative to a 1996 base year price level of 100. The horizontal axis shows real GDP, which measures output in dollars of constant purchasing power, using 1996 prices 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

22 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 rates The state of technology The rules of the game that provide production incentives

23 Exhibit 5:Aggregate Demand & Supply Real GDP (trillions of 1996 dollars) AD AS P r i c e l e v e l ( = ) Wage rates are typically assumed to be constant along the aggregate supply curve  firms find a higher price level more profitable so they increase real GDP supplied. Equilibrium in the national economy occurs where the AD and AS curves intersect. Equilibrium real GDP in 2001 was about $9.3 trillion at a price level of 109. At any other price level, quantity demanded would not match quantity supplied.

24 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 economy More people are employed

25 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

26 Exhibit 6: Decrease in Aggregate AS AD Real GDP (billions of 1996 dollars) P r i c e l e v e l ( = ) AD 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

27 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

28 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

29 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

30 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

31 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

32 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

33 The Great Stagflation: 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

34 The Great Stagflation The combination reduced aggregate supply as shown in Exhibit 7 with the result that we had the stagflation of the 1970s Stagflation Stagnation, or a contraction in the economy’s aggregate output combined with Inflation, a rise in the economy’s price level Primarily a supply side problem  the demand-management policies of Keynes were relatively ineffective

35 Exhibit 7: Stagflation Between AD AS Real GDP (trillions of 1996 dollars) P r i c e l e v e l ( = ) 0 AS The stagflation of the mid-1970s can be represented as a reduction in aggregate supply.

36 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

37 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

38 Experience Since 1980 However, during this period, the growth in federal spending exceeded the growth in tax revenues  federal budget deficits swelled The huge deficits that occurred during this period accumulated as 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

39 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