Chapter 19 Introduction to Macroeconomics © 2009 South-Western/ Cengage Learning

The National Economy Gross domestic product GDP – Market value – All final goods and services – Produced in U.S., regardless of ownership of resources – During a given period, usually one year – Real versus nominal GDP 2

The National Economy Composed of millions of decision makers Some independence, yet connected with the economy Money flows through the economy Circular flow – Money – Products – Resources 3

The National Economy Flow variable – Amount per unit of time Stock variable – Amount at a particular point in time Testing new theories Knowledge and performance – Essential relationships – Key variables 4

Economic Fluctuations and Growth Rise and fall of economic activity Business cycles – Expansions: Output increases – Contractions: Output decreases Depression – Sharp reduction in output – Lasts > 1 year – High unemployment Recession – Lasts > 6 months 5

Economic Fluctuations and Growth Inflation – Economy’s average price level increase U.S. economic fluctuations – 14 times more output than in 1929 – Increased production—growth in real output— increased standard of living Quantity and quality of resources Better technology Rules of the game—government intervention 6

Exhibit 1 Hypothetical business cycles 7

Economic Fluctuations and Growth Business cycle – Peak-to-trough-to-peak – Contraction Between peak and trough – Expansion Between trough and peak Longest – 10 years (March 1991 to March 2001) 8

Exhibit 2 Annual percentage change, US real GDP since

The global economy Business cycles –Linked among economies—increased globalization Slump in a major economy spills over to other economies Economic strength in major economies leads to improvement in other economies 10

Exhibit 3 US and UK annual growth rates in output are similar 11

Leading Economic Indicators Leading economic indicators – Predict a change in economy Recovery Downturn Coincident economic indicators – Reflect changes as they occur Lagging economic indicators – Follow changes in economy 12

Aggregate Demand; Aggregate Supply Aggregate output – Total amount of goods and services – Produced in economy – Given period – Real GDP Aggregate demand – Price level – Quantity of aggregate output demanded 13

Aggregate Demand; Aggregate Supply Price level – Index number – Base year = 100 Nominal GDP—this year output valued in current prices Real GDP – GDP adjusted for price level changes 14

Aggregate Demand Curve Sum of demand of economic decision makers Households; Firms; Governments; Rest of the world Inverse relationship Price level Real GDP demanded – Other things constant Price levels in other countries Exchange rates 15

Exhibit 4 Aggregate demand curve 16 Real GDP (trillions of 2000 dollars) Price level (2000 = 100) AD The quantity of aggregate output demanded is inversely related to the price level, other things constant. This inverse relationship is reflected by the aggregate demand curve AD.

Aggregate Supply Curve Positive relationship Price level Real GDP supplied – Other things constant Resource prices State of technology Rules of the game 17

Exhibit 5 Aggregate Demand and Supply in Real GDP (trillions of 2000 dollars) Price level (2000 = 100) AD AS The total output of the economy and its price level are determined at the intersection of the Ad and AS curves. This point reflects real GDP and the price level for 2006 using 2000 as the base year.

Equilibrium AD curve intersects AS curve – Equilibrium price level – Equilibrium real GDP Higher real GDP – More goods and services – Higher employment – Generally higher standard of living 19

Short History of the US Economy 1.Before and during Great Depression 2.After Great Depression to early 1970s – The Age of Keynes 3.From early 1970s to early 1980s – Stagflation 4.Since early 1980s – Normal times 20

The Great Depression and Before 1873 – 1879: Longest contraction – 80 railroads – bankrupt 1890s – Contractions – 18% unemployment rate 1929: The Great Depression—see next slide 21

The Great Depression and Before : Deepest economic contraction – Stock market crashed; – Investment dropped – Consumer spending fell; – Banks failed – Money supply dropped by 1/3 – High tariffs – restricted trade – Big decline in AD Real GDP dropped 27% Price level dropped 26% Unemployment rate 33% 22

Exhibit 6 The decrease in AD from 1929 to Price level (2000 = 100) AD 1929 AS Real GDP (billions of 2000 dollars) AD 1933 The Great Depression of the 1930s can be represented by the shift to the left of the AD curve, from AD 1929 to AD In the resulting depression, real GDP fell from $865 billion to $636 billion, and the price level dropped from 11.9 to 8.9, measured relative to a price level of 100 in the base year 2000.

The Age of Keynes After the Great Depression to early 1970s 1936 John Maynard Keynes – The general theory of employment, interest, and money – AD – inherently unstable – Government - increase AD Expansionary fiscal policy – Increase government spending – Cut taxes Federal budget deficit 24

The Age of Keynes Increase in AD – Increase real GDP Increase employment Demand-side economics WWII – Increased employment – Increased government spending – Federal deficits 25

The Age of Keynes Employment act of s: Prosperity, no fiscal policy 1960s: Golden age Keynesian economics Fiscal policy ‘ fine tune’ Low unemployment; Healthy growth Modest inflation Early 1970s Recession High inflation 26

Stagflation: 1973 to Inflation rate: 5.3% 1971 Ceilings: prices, wages 1973 Crop failures – Soaring grain prices OPEC cut oil supply – Increased oil prices 27

Stagflation: 1973 to : Decrease in AS – Stagflation Stagnation or contraction in output Inflation – Real GDP decreased – Unemployment increased to 8.5% – Price level increased 19% : Stagflation; decrease AS – OPEC cutbacks 28

Exhibit 7 Stagflation from 1973 to Price level (2000 = 100) AD AS 1973 Real GDP (trillions of 2000 dollars) AS 1975 The stagflation of the mid-1970s can be represented as a leftward shift of the AS curve from AS 1973 to AS Aggregate output fell from $4.34 trillion in 1973 to $4.31 trillion in 1975, for a decline of about $30 billion (stagnation). The price level rose from 31.9 to 38.0, for a growth of 19% (inflation).

Normal Times since 1980 Combat stagflation – Increase AS Supply-side economics – Lower price level – Increase output – Increase employment – Through lower taxes – Deregulation 30

Normal Times since : Recession – Unemployment rate 10% – Lower output Economic growth for 10 years – Federal budget deficit 1990: higher taxes 1993: higher taxes 1995: slower growth in federal spending Lower federal deficits 31

Normal Times since : Federal budget surplus Longest expansion: – 22 millions new jobs – Unemployment rate 4.2% – Modest inflation 2001: Recession (8 months) – Slow recovery – 2003, unemployment rate 6.3% Tax cuts – Increased output – Federal budget deficit 32