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

Contents 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 Copyright © 2006 South-Western/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.

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.

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.

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).

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

FIGURE 1: Two Interpretations of a Shift in the Demand Curve Price Price P P D 1 S S D D Q Quantity (a) Quantity (a) Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 2: An Economy Slipping into a Recession D0 S D 2 E Price Level B D0 S D2 Domestic Product Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 3: Economic Growth S0 D 1 S 1 D0 C E Price Level D 1 S0 S 1 D0 Q Q 1 Domestic Product Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Supply and Demand in Macroeconomics Major concerns of macroeconomics Inflation Unemployment Growth  AD   price level

Supply and Demand in Macroeconomics Recession and Unemployment  AD/AS  unemployment Recession = a period of time during which production falls and people lose jobs

Supply and Demand in Macroeconomics Economic Growth Economic growth =  GDP  AD and/or AS  growth

Gross Domestic Product 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 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

GDP Example 2005 2006 Pounds Produced Price per lb. Beef 15 20 13 Corned Beef 5 10 2 12 Beef Jerky 3 8

GDP Example 2005 Nominal Output Pounds Produced Price per lb. Beef 15   Beef 15 Corned Beef 5 10 Beef Jerky 3 20 Nominal GDP =

GDP Example 2005 Nominal Output Pounds Produced Price per lb. Beef 15   Beef 15 225 Corned Beef 5 10 50 Beef Jerky 3 20 60 Nominal GDP = 335

GDP Example 2006 2005 Nominal Output Real Output in 2005 Dollars Pounds Produced Price per lb.   Beef 20 13 15 Corned Beef 2 12 10 Beef Jerky 8  Nominal GDP =  xxxxxxxxxxxxxxxx Real GDP in 2005 Dollars = xxxxxxxxxxxxxxxxxx 

GDP Example 2006 2005 Nominal Output Real Output in 2005 Dollars Pounds Produced Price per lb.   Beef 20 13 15 260 300 Corned Beef 2 12 10 24 Beef Jerky 8 64 160  Nominal GDP = 348 Real GDP in 2005 Dollars = 480

FIGURE 4: Nominal GDP, Real GDP, and Real GDP per Capita $40,000 Nominal GDP (right scale) Real GDP per capita (left scale) $11,000 35,000 Real GDP (right scale) $10,000 30,000 $9,000 8,000 25,000 7,000 20,000 6,000 Dollars per Year Billions of Dollars per Year 5,000 15,000 4,000 Dollars per Year 10,000 3,000 2,000 Billions of Dollars per Year 5,000 1,000 2004 1955 1960 1965 1970 1975 1980 1985 1990 199 5 2000 Year NOTE: Real GDP figures are in 2000 dollars. Copyright © 2006 South-Western/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

Gross Domestic Product 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

Well-Being? If national income is a good measure of well-being, why is Switzerland's Gross Domestic Product so much lower than India's GDP or China's GDP? What measures would better compare the well-being for residents of different countries? How do you expect these direct measures to correlate with per capita GDP?

Well Being? If national income is a good measure of well-being, why is Switzerland's Gross Domestic Product so much lower than India's GDP or China's GDP? What measures would better compare the well-being for residents of different countries? How do you expect these direct measures to correlate with per capita GDP?

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.

FIGURE 5: The Growth Rate of U.S. Real GDP, 1870-2004 Post–1950 Pre–1940 Rapid industrialization Railroad prosperity Depression of 1890s Panic of 1907 Postwar depression Great recession World War I War II Korean War Expansion of 1960s 1974–75 Recession 1982–83 Roaring Twenties 1990–91 1980s Boom 1990s 20 15 10 5 –5 –10 –15 Percentage Growth Rate of Real GDP 2004 –20 1 87 1 88 1 89 1 90 1 91 1 92 1 93 1 94 1 95 1 96 1 97 1 98 1 99 2000 Year Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 6: The Inflation Rate in the United States, 1870-2004 Post–1950 Pr e –1940 2004 Postwar deflation Post-Civil War Great Depression World War I War II adjustment Inflation of the 1970s Vietnam War inflation Disinflation of the 1980s 25 20 15 10 5 Percentage Inflation Rate –5 –10 –15 1 87 1 88 1 89 1 90 1 91 1 92 1 93 1 94 1 95 1 96 1 97 1 98 1 99 2000 Year Copyright © 2006 South-Western/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 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 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 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 Economy on a Roller Coaster 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 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.

The Economy on a Roller Coaster The Great Stagflation, 1973-1980 The international price of oil was raised sharply in 1973 and again in 1979. For that reason and some others, the period saw the emergence of stagflation, both unemployment and inflation increasing together.

FIGURE 7: The Effects of an Adverse Supply Shift 1 D S A Price Level E Real GDP Copyright © 2006 South-Western/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 1990-91, recession hit.

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.

FIGURE 8: The Effects of a Favorable Supply Shift D 1 S 1 S 2 D C B E Price Level Real GDP Copyright © 2006 South-Western/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 1999. Strong economic growth continued through the late 1990s. Inflation remained low.

The Economy on a Roller Coaster The Bush Economy and the 2004 Election Real GDP grew very slowly then declined slightly in 2nd half of 2001 1st recession in 10 years Recession ended November 2001

The Economy on a Roller Coaster The Bush Economy and the 2004 Election Policies that helped shift AD curve, mitigating recession 2001-2003 tax cuts war of terrorism, burst of government spending consumers spending remained strong, despite 9/11 low interest rates encouraged spending

The Problem of Macroeconomic Stabilization Combating Unemployment When recessions are caused by too low aggregate demand, governments can try to stimulate demand.

FIGURE 9 Stabilization Policy to Fight Unemployment D 1 S D A E Price Level Increase in output Real GDP Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

The Problem of Macroeconomic Stabilization Combating Inflation When inflation is caused by too high aggregate demand, governments can try to restrain aggregate demand.

FIGURE 10: Stabilization Policy to Fight Inflation D D 2 E Price Level Decrease in prices B Real GDP Copyright © 2006 South-Western/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.

FIGURE 5: The Growth Rate of U.S. Real GDP, 1870-2004 Post–1950 Pre–1940 Rapid industrialization Railroad prosperity Depression of 1890s Panic of 1907 Postwar depression Great recession World War I War II Korean War Expansion of 1960s 1974–75 Recession 1982–83 Roaring Twenties 1990–91 1980s Boom 1990s 20 15 10 5 –5 –10 –15 Percentage Growth Rate of Real GDP 2004 –20 1 87 1 88 1 89 1 90 1 91 1 92 1 93 1 94 1 95 1 96 1 97 1 98 1 99 2000 Year Copyright © 2006 South-Western/Thomson Learning. All rights reserved.