Lecture 2 – Chapter 5

Review of Supply and Demand in Microeconomics 2 0 Quantity Price (a) D D 0 Quantity Price (b) Q0Q0 S S P0P0 E D0D0 D0D0 S S P0P0 D1D1 D1D1 P1P1 E A

Supply and Demand in Macroeconomics Moving to Macroeconomic Aggregates Aggregate demand curve Quantity of domestic product that is demanded at each possible value of the price level Aggregate supply curve Quantity of domestic product that is supplied at each possible value of the price level 3

Recall the Three macroeconomic concerns 1.Inflation Sustained increase in the general price level 2.Recession - unemployment A period of time during which the total output of the economy declines. Production falls, people lose jobs and are unemployed. Leftward shift of aggregate demand curve 4 Supply and Demand in Macroeconomics

An Economy Slipping into a Recession: Total Demand for Goods and Services Falls 5 0 Domestic Product Price Level D0D0 D0D0 Q0Q0 S S P0P0 D2D2 D2D2 P2P2 Q2Q2 E B

Three macroeconomic concerns 3.Economic growth Over time, both aggregate demand and aggregate supply shift right 6 Supply and Demand in Macroeconomics

Figure 3 Economic Growth 7 0 Domestic Product Price Level D 1995 D0D0 Q0Q0 S 1995 S0S0 D 2015 D1D1 Q1Q1 E S 2015 S1S1 C

Definition of Gross Domestic Product Gross Domestic Product (GDP) Sum of the money values of all final goods and services produced in the domestic economy and sold on organized markets during a specified period of time, usually a year Another way to says this – Total value of all final goods and services produced in the domestic economy and sold on organized markets at current prices during a specified period of time, usually a year 8

Gross Domestic Product Money as a measuring rod How to add apples and oranges Nominal GDP: GDP in current dollars Calculated by valuing all outputs at current prices We will call this NGDP Real GDP: GDP in constant dollars Calculated by valuing outputs of different years at common prices We will call this RGDP 9

Gross Domestic Product Real GDP and recessions A recession is a period of time in which real GDP falls Some say after two consecutive quarters Great Recession :4 – 2009:2 RGDP fell from $14,992 to $14,356 billion RGDP fell 4.24% 10

Gross Domestic Product What gets counted in GDP? For a particular year includes only goods and services produced that year Only includes final goods and services Goods purchased by their ultimate users Intermediate good is a good used in the production of another good Why don’t we include the value of intermediate goods? 11

Intermediate and Final Good Tires taken from that pile and mounted on the wheels of the new car before it is sold are considered intermediate goods. Tires taken from that pile to replace tires on your old car are considered final goods. If we included the value of the tires (an intermediate good) on new cars and the value of new cars (including the tires), we would be double counting.

Gross Domestic Product What gets counted in GDP? Domestic denotes production within the geographic boundaries of the U.S. regardless of who owns the resources Japanese Honda plant in U.S. is part of U.S GDP Includes only goods and services that pass through organized markets 13

What’s Not Included in GDP 14 Non-market goods and services such as chores performed at home by family members (non- market) Underground activities, both legal and illegal such as legal unrecorded activities paid for in cash or illegal gambling (non- market) Sales of used goods (no production) Financial transactions such as trading of stocks and bonds (no production) Government transfer payments: a payment to a person that is not for goods and services currently supplied such as social security (no production)

LIMITATIONS OF THE GDP CONCEPT GDP AND SOCIAL WELFARE If crime levels went down, society would be better off, but a decrease in crime is not an increase in output and is not reflected in GDP. An increase in leisure is also an increase in social welfare, but sometimes associated with a decrease in GDP. Most nonmarket and domestic activities, such as housework and child care, are not counted in GDP even though they amount to real production.

LIMITATIONS OF THE GDP CONCEPT underground economy - the part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP. distribution of income - GDP also has nothing to say about the distribution of output among individuals in a society. pollution – environmental deterioration is not subtracted out.

The Economy on a Roller Coaster Some history of the U.S. economy Growth with booms and recessions 17

The Business Cycle peak trough +3% +4% -2% Long-run upward trend is 3%. In the expansion phase of the cycle, growth is > the trend. When output falls, we are in a recession.

Figure 4 Nominal GDP, Real GDP, and Real GDP per Capita since

The Economy on a Roller Coaster What about the growth rate of real GDP? Macroeconomic fluctuations - the business cycle 20

Figure 5 The Growth Rate of U.S. Real Gross Domestic Product since

Annualized data for GDP, real GDP, and growth rate, by quarters Self test - How do we calculate the 3.8% real GDP growth rate for 2010-II?

The Economy on a Roller Coaster What about the price level over time? Inflation Sustained increase in the general price level Deflation Sustained decrease in the general price level 23

Figure 6 The Inflation Rate in the United States since

The Economy on a Roller Coaster The Great Depression, Significant decline in economic activity and rapid deflation Production declined 26%, and business investment ceased Unemployment rate increased from 3% to 25% World-wide event 25

The Economy on a Roller Coaster The Great Depression, Led to a revolution in economic thought Before: Classical Economists - Economy corrects itself After: John Maynard Keynes Economy does not correct itself quickly Household and business firms can reduce demand Decrease in aggregate demand reducing output and employment Role of monetary and fiscal policy 26

The Economy on a Roller Coaster From WWII to 1973 Great Depression ended when U.S. mobilized for war Fiscal policy – government spending boosted aggregate demand Price controls and shortages 1960’s: period of unprecedented noninflationary growth Keynesian success? Inflation returned starting late 1960s and early 1970s 27

The Economy on a Roller Coaster The Great Stagflation, OPEC – 1973 oil prices quadrupled, poor harvests, and removal of price controls led to more inflation U.S. economy also went into a recession Stagflation Inflation that occurs while the economy is growing slowly or in a recession 28

The Effects of an Adverse Supply Shift - Stagflation 29 0 Real GDP Price Level D D S0S0 S0S0 E S1S1 S1S1 A

The Economy on a Roller Coaster Reaganomics and its aftermath Recovery underway in 1981 but still high inflation Federal Reserve used monetary policy Actions by the Federal Reserve to influence aggregate demand by changing interest rates Recovery that started in long lasting Unemployment fell from 11% to 5.5% Inflation fell from 10% to less than 3% 30

The Economy on a Roller Coaster Reaganomics and its aftermath President Bush Inflation started to rise Congress passed a deficit-reduction package Spike in oil prices recession 31

The Economy on a Roller Coaster Clintonomics: deficit reduction and the “New Economy” Deficit-reduction package, 1993 & 1997: both tax increases and spending cuts Budget deficit became a budget surplus At same time economy boomed, and inflation lower The “New Economy” Globalization and computerization 32

Figure 8 The Effects of a Favorable Supply Shift 33 0 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 D1D1 D1D1 E S1S1 S1S1 C S2S2 S2S2 B

The Economy on a Roller Coaster Tax cuts and the Bush economy 2001 recession, the first in 10 years Tax cut 2001 brought back budget deficit War on terrorism led to an increase in government spending Federal Reserve lowered interest rate The housing bubble and it’s bursting 34

The Economy on a Roller Coaster Obamanomics and the Great Recession January 2009, economy was sinking Jobs - disappearing at a rapid pace More tax cuts A burst of federal spending Large-scale aid to state and local governments 35

The Economy on a Roller Coaster Obamanomics and the Great Recession Bush, Obama administrations, the Fed Variety of unprecedented emergency measures - to rescue the collapsing financial system Summer 2009, the Great Recession was over Economy started growing again but unemployment remained high 36

Problem of Macroeconomic Stabilization Stabilization policy Government programs designed to prevent or shorten recessions and to counteract inflation (stabilize prices) Combating unemployment Suppose output is too low: high unemployment 37

Figure 9 Stabilization Policy to Fight Unemployment 38 0 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 E Current output level at E too low Want to get to point A A

Problem of Macroeconomic Stabilization Combating unemployment Government pushes out aggregate demand using Fiscal policy: increase spending and/or cut taxes Monetary policy: lower interest rates Output increases, unemployment falls, and prices rise 39

Figure 9 Stabilization Policy to Fight Unemployment 40 0 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 D1D1 D1D1 E A Increase in output

Problem of Macroeconomic Stabilization Combating inflation Government would want to decrease aggregate demand Fiscal policy: cut spending and/or increase taxes Monetary policy: increase interest rates Inflation and output decreases, unemployment increases 41

Figure 10 Stabilization Policy to Fight Inflation 42 0 Real GDP Price Level D0D0 D0D0 S S D2D2 D2D2 E Decrease in prices B

Does Stabilization Policy Really Work? Compare economic fluctuations before and after WWII 43

Figure 5 The Growth Rate of U.S. Real Gross Domestic Product since

Does Stabilization Policy Really Work? Compare economic fluctuations before and after WWII Before the war, frequent and sometimes large fluctuations After the war, less recessions and less severe fluctuations 45

Does Stabilization Policy Really Work? Compare inflation before and after WWII 46

Figure 6 The Inflation Rate in the United States since

Does Stabilization Policy Really Work? Compare inflation before and after WWII Before the war, periods of price stability and deflation After the war, only positive inflation so prices increase each year Overall Since WWII, success of government managing economy has been mixed Although recession less severe, economy appears to be more prone to inflation 48