An Introduction to Macroeconomics Chapter 5 An Introduction to Macroeconomics Where the telescope ends, the microscope begins. Which of the two has the grander view? VICTOR HUGO

Macroeconomics vs. Microeconomics Decisions of individual units No matter how large Example: GE’s pricing policy Macroeconomics Behavior of entire economies No matter how small Example: inflation in Monaco Economic aggregates: aggregate output, inflation, unemployment, …

Macroeconomics & Aggregation Combine many individual markets into one overall market Why can we aggregate? Composition of demand & supply In various markets Important for microeconomics issues Not important for macroeconomics issues During economic fluctuations, markets move up or down together

Macroeconomics & Microeconomics Assume most details Resource allocation & income distribution Relatively unimportant Microeconomics Ignore macroeconomics issues Focus – individual markets Allocate resources Distribute income

Supply & Demand in Macroeconomics Aggregate demand (AD) curve Quantity of domestic product – demanded Each possible value of price level Aggregate supply (AS) curve Quantity of domestic product – supplied

Figure 1 Two interpretations of a shift in the demand curve D1 Price Q0 Quantity Quantity (a) (b)

Supply & Demand in Macroeconomics Inflation Sustained increase in price level Outward shift of aggregate demand curve Recession – period of time Total output – declines Production falls People lose jobs Inward shift of aggregate demand curve

Figure 2 An economy slipping into a recession S E P0 Price Level B P2 D0 Price Level D2 E P0 Q0 B P2 Q2 Domestic Product

Supply & Demand in Macroeconomics Macroeconomists study Inflation Recession & unemployment (Business Cycles) Economic growth

Figure 3 Economic growth S0 S1 C Price Level E D1 D0 Q0 Q1 Domestic Product

Gross Domestic Product Gross domestic product (GDP) Sum: money values All final goods & services Produced - domestic economy (Toyota car produced in the US vs. Ford pick-up produced in Japan) Sold – organized markets (gambling in Vegas vs. gambling in Chicago) Specified period of time Usually a year

Gross Domestic Product Nominal GDP GDP in current dollars Value outputs – current prices Real GDP Value outputs of different years at common prices GDP in constant dollars

What Gets Counted in GDP? GDP - particular year Add up money value of things Goods & services Produced within the year Final goods & services Production: geographic boundaries of U.S. Organized markets

Gross Domestic Product Final goods and services Purchased by their ultimate users Intermediate good - purchased For resale For use in producing another good

Gross Domestic Product Limitations of GDP Not measure: nation’s economic well-being Includes only market activity Housework, yard work, … Places no value on leisure Counted: “Bads” and “Goods” Hurricane Katrina might increase GDP Ecological costs Not deducted from GDP Needed: “Green GDP”

The Economy on a Roller Coaster U.S. economy Growth – with fluctuations Macroeconomic fluctuations Business cycles Real GDP per capita Ratio: real GDP divided by population

Figure 4 Nominal GDP, real GDP, real GDP per capita since 1959

Figure 5 The growth rate of U.S. real GDP since 1870

The Economy on a Roller Coaster Inflation Sustained increase General price level Deflation Sustained decrease

Figure 6 The inflation rate in the United States since 1870

The Economy on a Roller Coaster The Great Depression, 1929-1933 Decline in economic activity Rapid deflation Production – declined 30% Unemployment rate Increased from 3% to 25%

The Economy on a Roller Coaster The Great Depression, 1929-1933 Revolution in economic thought Before: economy corrects itself After: decrease in aggregate demand cannot recover by themselves (J. M. Keynes) Monetary & fiscal policy needed Ended: early 1940s (due to WWII) What caused it? Stock bubbles Contractionary monetary policy Unregulated markets

The Economy on a Roller Coaster From WWII to 1973 WWII: increased government spending Increased aggregate demand Accidental fiscal policy Price controls Shortage: consumer goods 1960s – strong growth Vietnam war – increased spending Inflation (5-6%) & high unemployment Wage & price controls by Nixon

The Economy on a Roller Coaster The Great Stagflation, 1973-1980 OPEC – 1973 oil prices quadrupled (1st Oil Shock) Poor harvests in 1973 rose food prices Stagflation Inflation rate: 12% High unemployment (9% in 1st quarter 1975) Inward shift of aggregate supply

The Economy on a Roller Coaster The Great Stagflation, 1973-1980 Economy recovered Government actions Natural economic forces 1979 – OPEC soaring oil prices (2nd Oil Shock) Stagflation again Inflation: 16%

Figure 7 The effects of an adverse supply shift S1 S0 A Price Level E Real GDP

The Economy on a Roller Coaster Reaganomics and its aftermath High inflation Federal Reserve Monetary policy (Paul Volcker) High interest rate to fight inflation Result: high unemployment rate (11% in 1982) Fiscal policy large tax cut Laffer Curve Help recovery beginning in the winter of 1982-1983

The Economy on a Roller Coaster Reaganomics and its aftermath Large budget deficits Recovery started 1982-1983 President Bush continues Regan’s policies Inflation Deficit-reduction package Spike in oil prices triggers 1990-1991 recession

The Economy on a Roller Coaster Clintonomics: deficit reduction Deficit-reduction package, 1993 & 1997 Tax increase & spending cuts Large fiscal surplus Economy boomed (might due to globalization and computerization) Lower inflation Aggregate supply curves Pushed outward – rapid pace, 1996 – 1998

Figure 8 The effects of a favorable supply shift S0 S1 S2 C B D1 S0 S1 Price Level D0 S2 C B E Real GDP

The Economy on a Roller Coaster Tax cuts and the Bush economy 2001 recession First in 10 years Tax cut 2001 Budget deficit Burst of government spending War on terror Aggregate demand – shift outward Federal Reserve Lowered interest rate

The Economy on a Roller Coaster The Great Recession (Dec. 2007 – now) Output falls hard 10% unemployment rate Inflation is modest Triggered by subprime crisis

Problem of Macroeconomic Stabilization Historical record shows US economy has not generally produced steady growth w/o inflation Short-run trade-off b/w unemployment and inflation, sometimes both increase (1970s) Gov policy might contribute to this performance

Problem of Macroeconomic Stabilization Stabilization policy Government programs Prevent or shorten recessions Counteract inflation, stabilize prices

Problem of Macroeconomic Stabilization Fight unemployment Increase aggregate demand Government - Fiscal policy Increase spending Cut taxes Federal Reserve - Monetary policy Lower interest rates Increase output Reduce unemployment Raise prices

Figure 9 Stabilization policy to fight unemployment S0 A Price Level E D1 S0 Price Level D0 A E Increase in output Real GDP

Problem of Macroeconomic Stabilization Fight inflation Decrease aggregate demand Government - Fiscal policy Cut spending Increase taxes Federal Reserve - Monetary policy Increase interest rates Decrease inflation (decrease prices) Decrease output Increase unemployment

Figure 10 Stabilization policy to fight inflation S E Price Level B D0 Price Level D2 E Decrease in prices B Real GDP

Stabilization policy Prewar data Postwar data Fluctuations – unmanaged economy Booms & recessions “Natural” economic reasons Little government intervention Postwar data Economy - managed by government policy Successfully (60s and 90s) or unsuccessfully (70s) Recessions - less severe More inflation-prone

Summary Macro vs. Micro Macro is all about Aggregation AD-AS curve GDP Business Cycles vs. Economic Growth Brief Macroeconomic History of US Stabilization Policy