Chapter 12

Managing the Macroeconomy

• Stagflation: it occurs when recession and inflation takes place simultaneously in the economy.

Five Macroeconomic Objectives

• Stable Prices

• Full employment

• Sustained Economic Growth

• External Balances

• Protection of the Environment

Stable Prices:

Price stability has become the primary objective of most governments that wish to secure long-term growth and full employment.

Inflation is a process of rising prices.

– The inflation rate is measured as a percentage change in the average level of prices or the price level.

– Consumer Price Index (CPI)

Deflation is negative inflation, the price level is falling.

Inflation

In December 1995, the CPI was 153.5

In December 1996, it was 158.6.

How would the inflation rate for 1996 be calculated?

Inflation

The inflation rate for 1996 was:

Inflation = 158.6 – 153.5

153.5

= 3.3%

100

Is Inflation a Problem?

Predictability of inflation rates creates problems:

High, unpredictable inflation causes resources to be diverted to predicting inflation rates.

This is a wasteful use of resources.

Is Inflation a Problem?

Hyperinflation– Inflation in excess of 50% per month– Workers are paid daily

• Money loses value rapidly• Workers spend their incomes quickly

1994• Zaire — 76% per month• Brazil — 40% per month

Is Inflation a Problem?

Policies that reduce the inflation rate increase the unemployment rate.

Sustained Economic Growth

Economic growth is the expansion of the economy’s production possibilities.

Measured by real gross domestic product (Real GDP)

The value of the total production of all the nation’s farms, factories, shops, and offices linked back to the prices of a single year (1992)

The Growth of Potential GDPWhen an economy’s labor, capital, land, and entrepreneurial ability are fully employed.

Real GDP fluctuates around potential GDP

Growth slowed during the 1970sProductivity growth slowdown.

External BalanceDeficits

A government budget deficit exists if the federal government spends more than it collects in taxes.

Deficits

An international deficit exists if our imports exceed our exports.

Current Account Our exports minus our imports; but it also takes interest payment paid to and received from the rest of the world into account.

Do Deficits Matter?

Governments must borrow if it spends more than it earns in tax revenue.

If the borrowed funds are used to purchase assets that earn a profit, the investment may be sound.

Government Policy Instruments

• Fiscal Policy

• Monetary Policy

• Direct Policy

Macroeconomic Policy Challenges and Tools

Policy Tools (cont.)

1) Fiscal policy

Making changes in taxes and government

spending.

• Long-term growth

• Smooth the business cycle

Macroeconomic Policy Challenges and Tools

Policy Tools (cont.)

2) Monetary policy

Changing interest rates and the amount of

money in the economy

• Control inflation

• Smooth business cycle

Coordination of fiscal and monetary policy

• 3) Direct Policy• Many other government economic policies

tend to be more ‘objective specific’ compared with the broad macro fiscal and monetary policy options we have considered so far. We refer to these instruments as direct policy, but it is also known as direct control or direct intervention.

Macroeconomic Management

• Figure 12.2 Business Fluctuations• BUSINESS CYCLE

– The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate, but the money wage does not change rapidly enough to keep real GDP at potential GDP.

– A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP.

– An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP.

– A full-employment equilibrium is an equilibrium in which real GDP equals potential GDP.

Fluctuations Around Potential GDPThe business cycle is the periodic, but irregular up-and-down movement in production.

Phases of the Business Cycle

Recession– Period during which real GDP decreases for

two successive quarters.

Expansion– Period during which real GDP increases.

Economic Growth in theUnited States

Turning Points

Peak– Expansion ends, recession begins.

Trough– Recession ends, expansion begins.

Economic Forecasting

• Exogenous variables are external to the economy in so far as they are determined by world events and policy (i.e oil prices and exchange rates)

• Endogenous variables are dependent on what goes on within an economy (i.e employment and inflation)

Functions of the Construction Sector

• Improving business performance and profitability in construction

• Improving the construction process, technologies and techniques

• Tackling people issues, such as recruitment and development

• Promoting and sponsoring research and development• Improving awareness of the benefits of information

technology• Leading on sustainability in construction• Promoting overseas activities by the construction industry• Engaging the industry in regulation and policy

development