1. Introduction to Macroeconomics
CHAPTER 20
© 2003 South-Western/Thomson Learning

2. The National Economy
Recall that macroeconomics concerns the overall performance of the economy
The term economy describes the structure of economic life, or economic activity, in a community, a region, a country, a group of countries or the world
Gross product
Most commonly used measure of an economy’s size
Measures the market value of final goods and services produced in a particular geographical region during a given period

3. Gross Domestic Product
GDP = Gross Domestic Product
Focuses on the U.S. economy
Measures the market value of all final goods and services produced in the United States during a given period
Helps us keep track of the economy’s incredible variety of goods and services

4. The National Economy
Macroeconomic policy typically focuses on the performance of the national economy, including how the national economy interacts with other economic countries around the world
Economy continually renewing itself
Money circulates throughout the economy, facilitating the exchange of resources and products among individual economic units
Money is called a medium of exchange

5. Flow and Stock Variables
Flow Variable
An amount per period of time
Average spending per week, hours worked per month, etc.
Stock Variable
An amount measured at a particular point in time
Amount of cash on hand you have now
Number of housing units in existence today

6. Knowledge and Performance
As long as the economy functions smoothly, policy makers need not understand how it works
However, when problems occur – high inflation, severe unemployment – we must understand how a healthy economy works before we can consider how the problem can be corrected
In order to do this, we must understand the essential relationships among key economic variables

7. Mercantilism
National policy makers have sometimes implemented the wrong economic prescription because of a flawed theory about how the economy works
Mercantilism
Belief that a nation’s economic vitality was thought to spring from the stock of precious metals accumulated in the public treasury
One way of accumulating gold and silver is for a nation to sell more output to foreigners than it bought from them  tariffs and quotas were popular

8. Economic Fluctuations
The rise and fall of economic activity relative to the long-term growth trend of the economy
Business cycles
Vary in length and intensity but have some features in common
Easiest way to understand economic fluctuations is to examine their components

9. Components of Business Cycles
Two phases
Periods of expansion
Periods of contraction
Depression
Severe contraction
Lasting longer than one year and accompanied by high unemployment
Recession
Milder contraction
Decline in total output lasting at least two consecutive quarters

10. U.S. Growth
U.S. economy in 2001 was more than eleven times larger than in 1929 as measured by real gross domestic product – real GDP
Real GDP means the effects of changes in the economy’s price level have been stripped away  the remaining changes reflect real changes in the value of goods and services produced

11. Increases in Production
Production tends to increase over the long run because of
Increases in the amount and quality of resources, especially labor and capital
Better technology
Improvements in the rules of the game that facilitate production and exchange

12. Business Cycle
Turning points – peaks and troughs – are defined as officially occurring by the NBER only after the fact
Since a recession means that output declines for at least two consecutive quarters, a recession is not so designated until six months after it begins and a recovery is officially underway after two consecutive quarters of growth

13. Leading Economic Indicators
Months before a recession is fully underway, changes in these leading economic indicators point to the coming storm
All these activities are called leading economic indicators because they usually predict, or lead to, a downturn and upturns point to an economic recovery
For example, in the early stages of a recession firms reduce overtime and new hiring, machinery orders slip, and the stock market turns down

14. Aggregate Output Aggregate output
Total amount of goods and services produced in the economy during a given period
Unit of aggregate output is a composite measure of all output in the same sense that a unit of food is a composite measure of all food
Best measure of aggregate output is real gross domestic product, or real GDP
Aggregate demand is the relationship between the average price of aggregate output and the quantity of aggregate output demanded

15. Price Level
Average price of aggregate output is called the price level
The price level in any year is an index number, or reference number, comparing average prices that year to average prices in some base, or reference, year
When we say that the price level is higher, we mean compared to where it was
Average price of all goods and services produced in the economy relative to the price level in some base year

16. Price Level
The price level in the base year has a benchmark value of 100
Price levels in other years are expressed relative to the base-year price level
Price level or price index used to make
Comparisons in prices across time
Accurate comparisons of real aggregate output over time

17. GDP Price Index
After adjusting GDP for price changes, we end up with what is called the real gross domestic product, or real GDP
The GDP price index
Shows how the economy’s general price level changes over time
Can be used to convert production in different years into dollars of constant purchasing power

18. Aggregate Demand Curve
Aggregate demand curve shows the relationship between the price level in the economy and the real GDP demanded, other things constant
Sums demands of the four economic decision makers: households, firms, governments, and the rest of the world
Among the factors held constant along a given aggregate demand curve are
The price levels in other countries
The exchange rates between the U.S. dollar and foreign currencies

19. Aggregate Supply Curve
Aggregate supply curve shows how much output U.S. producers are willing and able to supply at each price level, other things quantity
Assumed constant along an aggregate supply curve are
Resource prices, including wage rates
The state of technology
The rules of the game that provide production incentives

20. Equilibrium
Although employment is not measured directly along the horizontal axis in Exhibit 5
Firms usually must hire more workers to produce more output  higher levels of real GDP can be beneficial because
More goods and services are available in the economy
More people are employed

21. Short History of U.S. Economy
History of the U.S. economy can be crudely divided into four economic eras
Prior to and including the Great Depression
These contractions were often accompanied by a falling price level
After the Great Depression to the early 1970s
Was an era of generally strong economic growth
Moderate increases in the price level
From the early 1970s to the early 1980s
High unemployment and high inflation
Since the early 1980s
Good economic growth

22. Great Depression and Before
Why did aggregate demand decline so much during this period?
Stock market crash of 1929
Grim business expectations
Drop in consumer spending
Widespread bank failures
Sharp decline in the nation’s money supply
Severe restrictions on world trade

23. Great Depression and Before
Prior to the Great Depression, macroeconomic policy was based primarily on the laissez-faire policy
If people were allowed to pursue their self-interest in free markets, resources would e guided as if by an “invisible hand” to produce the greatest, most efficient level of aggregate output  contractions were essentially self-correcting

24. Age of Keynes
Keynes argued that aggregate demand was inherently unstable
In part, this instability occurs because business investment decisions were often guided by unpredictable “animal spirits” of business expectations
Keynes saw no natural forces operating to ensure that the economy, even if allowed a reasonable time to adjust, would return to a high level of employment and output

25. Age of Keynes
Keynes proposed that the government jolt the economy out of its depression by increasing aggregate demand
Direct stimulus by increasing its own spending
Indirect stimulus by cutting taxes to stimulate the primary components of private-sector demand, consumption and investment
Federal budget deficit
Flow variable that measures, for a particular period, the amount by which total federal outlays exceed total federal revenues

26. Age of Keynes
To visualize what Keynes had in mind, federal policies would be designed to shift the aggregate demand back to its original position in Exhibit 6 with the result that equilibrium real GDP and employment would increase
The Keynesian approach can be though of as demand-side economics because it focused on how changes in aggregate demand could promote full employment

27. Age of Keynes
Trying to avoid another depression, Congress approved the Employment Act of 1946
Which imposed a clear responsibility on the federal government to foster
Maximum employment
Maximum production
Maximum purchasing power
Created the Council of Economic Advisers
Required the president to report annually on the state of the economy

28. The Great Stagflation: 1973 - 1980
The combined stimulus of federal spending on both the war in Vietnam and social programs in the late 1960s increased aggregate demand enough that the inflation rate began to increase
The high inflation rates induced President Richard Nixon to introduce ceilings on prices and wages in 1971
To compound these problems, OPEC reduced the supply of oil with the resulting increase in world prices

29. The Great Stagflation
The combination reduced aggregate supply as shown in Exhibit 7 with the result that we had the stagflation of the 1970s
Stagflation
Stagnation, or a contraction in the economy’s aggregate output combined with
Inflation, a rise in the economy’s price level
Primarily a supply side problem  the demand-management policies of Keynes were relatively ineffective

30. Experience Since 1980
The stagflation of the 70s shifted policy maker’s attention from aggregate demand to aggregate supply
Supply-side economics
The federal government, by lowering tax rates, would increase after-tax earnings, which would provide incentives to increase the supply of labor and other resources
The resulting increase in aggregate supply would achieve the goals of expanding real GDP and reducing the price level

31. Experience Since 1980
In 1981 President Reagan and Congress cut personal income tax rates by an average of 23% to be phased in over 3 years
Before the tax cut was fully implemented, recession hit in 1982 and the unemployment rate shot up to 10%
After the recession, the economy began what was at the time the longest peacetime expansion on record

32. Experience Since 1980
However, during this period, the growth in federal spending exceeded the growth in tax revenues  federal budget deficits swelled
The huge deficits that occurred during this period accumulated as a huge federal debt
Government debt
Stock variable
Measures the net accumulation of prior deficits
Nearly doubled in the period of 1980 to 1992 relative to GDP

33. Experience Since 1980
The huge federal deficits led both Presidents George H.W. Bush and William Clinton to increase taxes
When combined with the Republican Congress reductions in federal spending, the deficit problem turned to surpluses
By early 2001 the U.S. economic expansion became the longest on record and has only recently began to slow