Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by

6-2 © 2016 McGraw ‐ Hill Education Limited LEARNING OBJECTIVES LO6.1Explain why economists focus on GDP, unemployment, and inflation when assessing the health of an entire economy and what policy to pursue. LO6.2Discuss why sustained increases in living standards are historically recent phenomena. LO6.3Identify why saving and investment are key factors in promoting rising living standards. LO6.4Describe why expectations, shocks, and sticky prices are responsible for short-run fluctuations in output and employment. LO6.5Characterize the degree to which various prices in the economy are sticky. LO6.6Explain why the greater flexibility of prices as time passes causes economists to use different macroeconomic models for different time horizons. 6 An Introduction to Macroeconomics

In assessing the health and development of an economy, macroeconomists focus on: Real GDP Unemployment Inflation LO1 © 2016 McGraw ‐ Hill Education Limited 6.1 Assessing the Health of the Economy: Performance and Policy 6-3

Real GDP (real gross domestic product) measures the value of final goods and services produced within the borders of a given country during a given time period, typically a year. To calculate real GDP, nominal GDP must first be calculated LO1 © 2016 McGraw ‐ Hill Education Limited 6.1 Assessing the Health of the Economy: Performance and Policy 6-4

Unemployment A failure of the economy to fully employ its labour force Occurs when a person cannot get a job despite being willing to work and actively seeking work LO1 © 2016 McGraw ‐ Hill Education Limited 6.1 Assessing the Health of the Economy: Performance and Policy 6-5

Inflation An increase in the overall level of prices. Can cause decreases in standard of living surprise jump in inflation reduces the purchasing power of people’s savings LO1 © 2016 McGraw ‐ Hill Education Limited 6.1 Assessing the Health of the Economy: Performance and Policy 6-6

Macroeconomics Models Help Clarify Government Economic Policies Can governments promote long-run economic growth? Can governments reduce the severity of recessions? Are certain government policy tools, more effective than others, e.g. monetary policy versus fiscal policy? Is there a trade-off between lower rates of unemployment and higher rates of inflation? Does government policy work best when it is announced in advance or when it is a surprise? LO1 © 2016 McGraw ‐ Hill Education Limited 6.1 Assessing the Health of the Economy: Performance and Policy 6-7

Modern economic growth refers to an increase in output per person as compared with earlier times in which output (but not output per person) increased. The vast differences in living standards seen today between rich and poor countries are almost entirely the result of the fact that only some countries have experienced modern economic growth. LO2 © 2016 McGraw ‐ Hill Education Limited 6.2 The Miracle of Modern Economics Growth 6-8

6.1 GLOBAL PERSPECTIVE GDP per Person, Selected Countries © 2016 McGraw ‐ Hill Education Limited LO2 6-9

To raise living standards over time an economy must devote at least some fraction of its current output to increasing future output Savings The accumulation of funds that results when people in an economy spend (consume) less than their incomes during a given time period Savings fund Investment LO3 © 2016 McGraw ‐ Hill Education Limited 6.3 Savings, Investment, and Modern Economics Growth 6-10

Investment refers to spending for the production and accumulation of capital and additions to inventories. Economists distinguish between financial investment and economic investment. Financial investment refers to the purchasing of financial assets (stocks, bonds, mutual funds) or real assets (houses, land, factories), or building such assets, in the expectation of financial gain. Economic investment refers to spending for the production and accumulation of capital and additions to inventories. LO3 © 2016 McGraw ‐ Hill Education Limited 6.3 Savings, Investment, and Modern Economics Growth 6-11

Banks and Other Financial Institutions Households are the principal source of savings, but businesses are the main economic investors. These institutions collect the savings of households, rewarding savers with interest and dividends and sometimes capital gains (increases in asset values). The banks and other financial institutions then lend the funds to businesses, which invest in equipment, factories, and other capital goods. LO3 © 2016 McGraw ‐ Hill Education Limited 6.3 Savings, Investment, and Modern Economics Growth 6-12

The Importance of Expectations and Shocks Expectations The anticipations of consumers, firms, and others about future economic conditions. Expectations have a large effect on economic growth Expectations can become unmet due to shocks LO4 © 2016 McGraw ‐ Hill Education Limited 6.4 Uncertainty, Expectations, Shocks, and Short-Run Fluctuations 6-13

The Importance of Expectations and Shocks Shocks Situations in which one thing is expected to occur but in reality something different occurs. Demand shocks Sudden, unexpected changes in demand. Supply shocks Sudden, unexpected changes in aggregate supply Economists believe that most short-run fluctuations are the result of demand shocks FULL EMPLYMENT IF THERE ARE NO SHOCKS LO4 © 2016 McGraw ‐ Hill Education Limited 6.4 Uncertainty, Expectations, Shocks, and Short-Run Fluctuations 6-14

LO4 © 2016 McGraw ‐ Hill Education Limited 6-15 Cars per week Price DMDM DLDL DHDH 900 $40,000 $37,000 $35,000 Flexible Prices FIGURE 6-1(a) The Effect of Unexpected Changes in Demand under Flexible Prices

LO4 © 2016 McGraw ‐ Hill Education Limited 6-16 Cars per week DMDM DLDL DHDH $37,000 Fixed Prices Price FIGURE 6-1(b) The Effect of Unexpected Changes in Demand under Fixed Prices

Demand Shocks and Flexible Prices If the prices of goods and services could always adjust quickly to unexpected changes in demand, then the economy could always produce at its optimal capacity since prices would adjust to ensure that the quantity demanded of each good and service would always equal the quantity supplied. LO4 © 2016 McGraw ‐ Hill Education Limited 6.4 Uncertainty, Expectations, Shocks, and Short-Run Fluctuations 6-17

Demand Shocks and Sticky Prices In reality, many prices in the economy are inflexible and do not change rapidly when demand changes unexpectedly. Manufacturing firms typically attempt to deal with unexpected changes in demand by maintaining an inventory. Inventory Goods that have been produced but remain unsold. If demand falls for many goods and services across the entire economy for an extended period of time, then many firms will find inventories piling up and will be forced to cut production resulting in recession, with GDP falling and unemployment rising. If demand is unexpectedly high for a prolonged period of time, the economy will boom and unemployment will fall. LO4 © 2016 McGraw ‐ Hill Education Limited 6.4 Uncertainty, Expectations, Shocks, and Short-Run Fluctuations 6-18

Inflexible prices (sticky prices) Product prices that remain in place (at least for a while) even though supply or demand has changed. Flexible prices Product prices that react within seconds to changes in supply and demand. LO5 © 2016 McGraw ‐ Hill Education Limited 6.5 How Sticky Are Prices? 6-19

LO5 © 2016 McGraw ‐ Hill Education Limited 6-20 ItemMonths Coin-operated laundry machines46.4 Newspapers29.9 Haircuts25.5 Taxi fare19.7 Veterinary services14.9 Magazines11.2 Computer software5.5 Beer4.3 Microwaves ovens3.0 Milk2.4 Electricity1.8 Airline tickets1.0 Gasoline0.6 Source: Mark Bils and Peter J. Klenow, “Some Evidence on the Importance of Sticky Prices”, Journal of Political Economy, October 2004, pp , Used with permission of The University of Chicago Press. TABLE 6-1 Average Number of Months Between price Changes for Selected Goods and Services

What Causes Sticky Prices? Companies selling final goods and services know that consumers prefer stable, predictable prices that do not fluctuate rapidly with changes in demand. In certain situations a firm may be afraid that cutting its price may be counterproductive because its rivals might simply match the price cut - a situation often referred to as a price war. LO5 © 2016 McGraw ‐ Hill Education Limited How Sticky Are Prices?

Price stickiness moderates over time. If unexpected changes in demand begin to look permanent, many firms will allow their prices to change so that price changes (in addition to quantity changes) can help to equalize quantities supplied with quantities demanded. Prices go from stuck in the extreme short run to fully flexible in the long run. LO6 © 2016 McGraw ‐ Hill Education Limited 6.6 Categorizing Macroeconomic Models Using Price Stickiness 6-22

Economists Disagreed Vigorously About Both the Causes of the Great Recession and the Best Ways to Speed a Recovery. The Minksy Explanation: Euphoric Bubbles The Austrian Explanation: Excessively Low Interest Rates The Stimulus Solution The Structural Solution The LAST WORD Debating the Great Recession © 2016 McGraw ‐ Hill Education Limited 6-23

LO6.1Explain why economists focus on GDP, Inflation, and unemployment when assessing the health of an entire economy and what policy to pursue. LO6.2Discuss why sustained increases in living standards are historically recent phenomena. LO6.3Identify why saving and investment are key factors in promoting rising living standards. LO6.4Describe why expectations, shocks, and sticky prices are responsible for short-run fluctuations in output and employment. LO6.5Characterize the degree to which various prices in the economy are sticky. LO6.6Explain why the greater flexibility of prices as time passes causes economists to use different macroeconomic models for different time horizons. Chapter Summary © 2016 McGraw ‐ Hill Education Limited 6-24