Chapter 5 – Macroeconomy Foundations ECONOMICS THEORY AND PRACTICE Seventh Edition Copyright © 2004 John Wiley & Sons, Inc. All rights reserved. Patrick J. Welch St. Louis University Gerry F. Welch St. Louis Community College at Meramec & PowerPoint Presentation by: Dr. Ray Everett Pima Community College

Foundations of the Macroeconomy Contents Macroeconomic Activity Changes Total Spending & Activity Household Sector Business Sector Government Sector Foreign Sector Summary of Total Spending & Activity Multiplier Effect Macroeconomic Policies

Foundations of the Macroeconomy Chapter Objectives To define and explain business cycles. To understand how total spending drives the economy’s levels of employment and production, and influences prices. To examine the spending behavior of households, businesses, government units, and the foreign sector. To identify the macroeconomy’s “leakages” and “injections” and show how they affect economic activity. To introduce the multiplier effect. To discuss how expectations affect the economy’s output and price levels. To identify the role of total spending in macroeconomic policies.

Overview of Activity Changes in Macroeconomic Activity 5-1a FIGURE 5-1 Real Gross Domestic Product and the Unemployment Rate for 1985 through 2001

Business Cycles  Recurring periods of growth and decline in an economy’s real output, or real GDP.  Composed of four phases: Recovery –Expansionary phase during which real GDP increases. Peak –Where maximum output occurs. Recession –Phase during which GDP falls. Trough –Where GDP reaches its minimum. Changes in Macroeconomic Activity 5-1b

Business Cycles (cont.) Changes in Macroeconomic Activity 5-1c

Cyclical Behavior of the U.S. Economy Changes in Macroeconomic Activity 5-1d FIGURE 5-3 Economic Activity (1900–1984)

Cyclical Behavior of the U.S. Economy (cont.) Changes in Macroeconomic Activity 5-1e FIGURE 5-3 (continued)

Total Spending  Also called aggregate spending.  Total combined spending of all units in the economy for new goods and services. Includes households, businesses, government, and foreign. Spending & Macroeconomic Activity 5-2 FIGURE 5-4 Total Spending and the Level of Economic Activity

Personal Consumption Expenditures  Household spending on new goods and services. Household Sector 5-3a FIGURE 5-5 Real Personal Consumption Expenditures for 1970–2001

Household Sector & the Circular Flow  Income-Determined Spending Household spending on new goods and services that comes from income earned from providing resources to producers. Household Sector 5-3b FIGURE 5-6 Household Spending, Borrowing, Transfers, Saving, and Taxes

Household Sector & the Circular Flow (cont.)  Transfer Payments Money from the government for which no direct work is performed in return.  Nonincome-Determined Spending Spending that is not generated from household earned income.  Injections into the Spending Stream Spending that comes from a source other than household earned income.  Leakages from the Spending Stream Uses for earned income other than spending, such as taxes and saving. Household Sector 5-3c

Investment Spending  Also considered nonincome-determined spending.  Business spending on new goods, such as machinery, equipment, buildings, and inventories. Business Sector 5-4a FIGURE 5-7 Real Gross Investment for 1970–2001

Business Sector & the Circular Flow  Retained Earnings Portion of a business’s accumulated profits that has been retained for investment or other purposes. Business Sector 5-4b FIGURE 5-8 Business Investment Spending, Saving, and Taxes

Saving-Borrowing Relationship  Relationship between the amount saved by households and businesses and the amount returned to the spending stream through business and household borrowing. Business Sector 5-4c FIGURE 5-9 Saving, Investing, and Borrowing by Households and Businesses

Government Purchases of Goods & Services  Also considered nonincome-determined spending.  Government spending on new goods and services. Government Sector 5-5a FIGURE 5-10 Real Government Purchases of Goods and Services for 1970–2001

Government Sector & the Circular Flow Government Sector 5-5b FIGURE 5-11 The Government Sector and the Circular Flow

Exports  Goods and services that are sold abroad. Imports  Goods and services purchased from abroad. Net Exports  Exports minus imports. Foreign Sector 5-6a FIGURE 5-12 Real U.S. Exports, Imports, and Net Exports of Goods and Services for 1970–2001

Exports, Imports, & Net Exports (cont.) Foreign Sector 5-6b FIGURE 5-12 (continued)

Foreign Sector & the Circular Flow Foreign Sector 5-6c FIGURE 5-13 The Foreign Sector and the Circular flow

Total Spending  Drives the economy’s production, employment, and income levels. Summary of Total Spending & Activity 5-7

Multiplier Effect  Change in total output and income generated by a change in nonincome-determined spending is larger than, or a multiple of, the spending change itself. Multiplier Effect 5-8a TABLE 5-2 Effect on Total Output and Income from a Nonincome-Determined Spending Injection of $10,000,000

Calculating the Multiplier Effect  Initial change in nonincome-determined spending divided by the percentage of additional income not spent will yield the total change in output and income. $2,000,000 (what was not spent) / $10,000,000 = 0.20 $10,000,000 / 0.20 = $50,000,000 Multiplier Effect 5-8b

Fiscal Policy  Influencing the levels of aggregate output and employment or prices through changes in federal government purchases, transfer payments, and/or taxes. Monetary Policy  Influencing levels of aggregate output and employment or prices through changes in interest rates and the money supply. Macroeconomic Policies 5-9

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