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 1Hypothetical 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 2Annual percentage change, US real GDP since 1929

9

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 3US 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 4Aggregate demand curve

16

Real GDP

(trillions of 2000 dollars)0 2 4 6 8 10 12 14 16

50

150

100

Pric

e le

vel (

2000

= 1

00)

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 5Aggregate Demand and Supply in 2006

18

Real GDP

(trillions of 2000 dollars)0 11.3

50

150

116.6

Pric

e le

vel (

2000

= 1

00)

AD

ASThe 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 Depression2. 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• 1929 - 1933: 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 6The decrease in AD from 1929 to 1933

23

8.9

12.0

Pric

e le

vel (

2000

= 1

00)

AD1929

AS

Real GDP

(billions of 2000 dollars)0 865636

AD1933

The Great Depression of the 1930s can be represented by the shift to the left of the AD curve, from AD1929 to AD1933.

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 1946• 1950s: 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 1980

• 1970 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 1980

• 1973 - 1975: Decrease in AS– Stagflation

• Stagnation or contraction in output• Inflation

– Real GDP decreased– Unemployment increased to 8.5%– Price level increased 19%

• 1979 - 1980: Stagflation; decrease AS– OPEC cutbacks

•28

Exhibit 7Stagflation from 1973 to 1975

29

38.0

31.9

Pric

e le

vel (

2000

= 1

00)

AD

AS1973

Real GDP

(trillions of 2000 dollars)0 4.344.31

AS1975

The stagflation of the mid-1970s can be represented as a leftward shift of the AS curve from AS1973 to AS1975.

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 1980

• 1981: 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 1980

• 1998: Federal budget surplus• Longest expansion: 1991-2001

– 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