Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 19 What Macroeconomics Is All About

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 1. Describe the meaning and importance of the key macroeconomic variables, including national income, unemployment, inflation, interest rates, exchange rates, and trade flows. 2. Explain that most macroeconomic issues are about long- run trends or short-run fluctuations, and that government policy is relevant for both.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Output and Income This gives nominal national income (in current dollars). Using base-period prices, we get real national income (in constant dollars). The production of output generates income. To measure total output in dollars, we add up the values of the many different goods produced. Key Macroeconomic Variables

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 19.1 Growth and Fluctuations in Real GDP, 1962–2005

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Real GDP fluctuates around a rising trend: - the trend shows long-run economic growth - the short-run fluctuations show the business cycle APPLYING ECONOMIC CONCEPTS 19.1 The Terminology of Business Cycles Movements in Real GDP

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The output gap measures the difference between potential output and actual output. Output Gap = Y-Y* When Y > Y*, there is an inflationary gap. When Y < Y*, there is a recessionary gap. Potential output is what the economy could produce if all resources were employed at their normal levels of utilization - often called full-employment output Potential Output and the Output Gap

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 19.2 Potential GDP and the Output Gap, 1971–2005

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Employment, Unemployment, and the Labor Force Employment: the number of workers (16+) who hold jobs. Unemployment: the number who are not employed but are actively looking for a job. Labor force: the total number of employed + unemployed. The unemployment rate is the number of unemployed expressed as a percentage of the labour force.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Unemployment Rate = Number of people unemployed Number of people in the labor force X 100 frictional unemployment Even when Y = Y*, some unemployment exists: structural unemployment Unemployment Rate

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The unemployment rate when Y=Y* is called full employment. Cyclical unemployment is neither structural or frictional - changes with the ebb and flow of the business cycle Why Does Unemployment Matter? Some unemployment is desirable, as it reflects the time required for workers and firms to “find” each other so that good matches are made. But some unemployment is associated with human hardship, especially for those individuals with skills that are not in high demand by firms. Full and Cyclical Unemployment

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 19.3 Labor Force, Employment, and Unemployment, 1960–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Productivity Productivity: a measure of output per unit of input - often measured as GDP per worker (labor productivity) - or GDP per hour of work Increases in productivity are probably the single largest determinant of long-run increases in material living standards.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 19.4 Labor Productivity, 1960–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Inflation and the Price Level The price level: the average level of all prices in the economy. Inflation: the rate at which the price level is changing. The CPI is based on the price of a typical “consumption basket,” relative to the price in some base year:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved APPLYING ECONOMIC CONCEPTS 19.2 How the CPI Is Constructed Why Inflation Matters The purchasing power of money is negatively related to the price level. Also, because it is hard to forecast accurately, inflation adds to the uncertainties of economic life. Inflation Matters

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 19.1 Expenditure Behavior in 1997

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table Expenditure Behavior at 2007 Prices

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 19.5 The Price Level and the Inflation Rate,1960–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Interest Rates The interest rate is the price of borrowing funds — the percentage amount per period. The burden of borrowing depends on the real interest rate. Nominal interest rate: the rate expressed in money terms. Real interest rate: the rate expressed in terms of purchasing power.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 19.6 Real and Nominal Interest Rates, 1960–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The International Economy Exchange rate: the number of U.S. dollars required to purchase one unit of foreign currency. A depreciation of the U.S. dollar means that a U.S. dollar buys less foreign currency - a fall in the exchange rate Foreign exchange: foreign currencies or claims on foreign currencies. An appreciation of the U.S. dollar means that a U.S. dollar buys more foreign currency - a rise in the exchange rate

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 19.7 U.S. Dollars Needed to Purchase A Euro, 1999–2007

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The balance of payments accounts record all payments made in international transactions — goods, services, and assets: - trade balance (exports – imports) - current account balance - capital account balance For the U.S., the increasing role of international trade is an important aspect of globalization. Exports and Imports

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 19.8 Imports, Exports, and Net Exports, 1960–2006

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Growth Versus Fluctuations Long-Term Economic Growth Long-term growth is considerably more important for a society’s living standards from decade to decade than short- term fluctuations. There is considerable debate regarding the ability of government to influence the economy’s long-run growth rate.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Short-term fluctuations are often called business cycles. Economists debate the effectiveness of monetary and fiscal policy in influencing these fluctuations. Some economists argue that despite the power of policy to affect the economy, governments should not attempt “fine- tuning.” Short-Term Fluctuations

Copyright © 2008 Pearson Addison-Wesley. All rights reserved To organize our thinking about macroeconomics, we must develop some tools. These will include: discussing the measurement of national income building a simple model of the economy modifying the model to make it more realistic using our model to analyze some pertinent economic issues What Lies Ahead?