Chapter 5

An Introduction to Macroeconomics

Where the telescope ends, the microscope begins.

Which of the two has the grander view?VICTOR HUGO

Macroeconomics vs. Microeconomics

• Microeconomics– Decisions of individualindividual units

• No matter how large• Example: GE’s pricing policy

• Macroeconomics– Behavior of entireentire economies

• No matter how small• Example: inflation in Monaco

– Economic aggregates: aggregate output, inflation, unemployment, …

2

Macroeconomics & Aggregation

• Aggregation– Combine many individual markets into

one overall market

• Why can we aggregate?– Composition of demand & supply

• In various markets• Important for microeconomics issues• Not important for macroeconomics issues

– During economic fluctuations, markets move up or down together

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Macroeconomics & Microeconomics

• Macroeconomics– Assume most details

• Resource allocation & income distribution• Relatively unimportant

• Microeconomics– Ignore macroeconomics issues

– Focus – individual markets• Allocate resources• Distribute income

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Supply & Demand in Macroeconomics

• Aggregate demand (ADAD) curve– Quantity of domestic product – demanded

– Each possible value of price level

• Aggregate supply (ASAS) curve– Quantity of domestic product – supplied

– Each possible value of price level

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Two interpretations of a shift in the demand curve

Figure 1

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Quantity

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Quantity

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Q0

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A

Supply & Demand in Macroeconomics

• Inflation– Sustained increase in price level

– Outward shift of aggregate demand curve

• Recession – period of time– Total output – declines

• Production falls• People lose jobs

– Inward shift of aggregate demand curve

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An economy slipping into a recession

Figure 2

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Domestic Product

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D0

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Supply & Demand in Macroeconomics

• Macroeconomists study– Inflation

– Recession & unemployment (Business Cycles)

– Economic growth

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Economic growth

Figure 3

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Domestic Product

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Gross Domestic Product

• Gross domestic product (GDP)– Sum: moneymoney values

– All finalfinal goods & services• Produced - domestic economy (Toyota car

produced in the US vs. Ford pick-up produced in Japan)

• Sold – organized markets (gambling in Vegas vs. gambling in Chicago)

– Specified period of time• Usually a year

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Gross Domestic Product

• Nominal GDP– GDP in currentcurrent dollars

– Value outputs – current prices

• Real GDP– Value outputs of different years at

common prices

– GDP in constantconstant dollars

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What Gets Counted in GDP?

• GDP - particular year– Add up money value of things

– Goods & services• Produced within the year

– Final goods & services

– Production: geographic boundaries of U.S.

– Organized markets

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Gross Domestic Product

• Final Final goods and services– Purchased by their ultimate users

• IntermediateIntermediate good - purchased– For resale

– For use in producing another good

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Gross Domestic Product

• Limitations of GDP– Not measure: nation’s economic well-being

– Includes only market activity• Housework, yard work, …

– Places no value on leisure

– Counted: “Bads” and “Goods”• Hurricane Katrina might increase GDP

– Ecological costs• Not deducted from GDP• Needed: “GreenGreen GDP”

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The Economy on a Roller Coaster

• U.S. economy– Growth – with fluctuations

• Macroeconomic fluctuations– Business cycles

• Real GDP per capita– Ratio: real GDP divided by population

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Nominal GDP, real GDP, real GDP per capita since 1959

Figure 4

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The growth rate of U.S. real GDP since 1870

Figure 5

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The Economy on a Roller Coaster

• Inflation– Sustained increase

– General price level

• Deflation – Sustained decrease

– General price level

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The inflation rate in the United States since 1870

Figure 6

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The Economy on a Roller Coaster

• The Great Depression, 1929-1933– Decline in economic activity

– Rapid deflation

– Production – declined 30%

– Unemployment rate• Increased from 3% to 25%

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The Economy on a Roller Coaster

• The Great Depression, 1929-1933– Revolution in economic thought

• Before: economy corrects itself• After: decrease in aggregate demand cannot

recover by themselves (J. M. Keynes) – Monetary & fiscal policy needed

– Ended: early 1940s (due to WWII)– What caused it?

• Stock bubbles• Contractionary monetary policy• Unregulated markets 22

The Economy on a Roller Coaster

• From WWII to 1973– WWII: increased government spending

• Increased aggregate demand• Accidental fiscal policy• Price controls• Shortage: consumer goods

– 1960s – strong growth

– Vietnam war – increased spending• Inflation (5-6%) & high unemployment

– Wage & price controls by Nixon23

The Economy on a Roller Coaster

• The Great StagflationGreat Stagflation, 1973-1980– OPEC – 1973 oil prices quadrupled (1st

Oil Shock)

– Poor harvests in 1973 rose food prices

– Stagflation• Inflation rate: 12%• High unemployment (9% in 1st quarter 1975)

– Inward shift of aggregate supply

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The Economy on a Roller Coaster

• The Great StagflationGreat Stagflation, 1973-1980– Economy recovered

• Government actions• Natural economic forces

– 1979 – OPEC soaring oil prices (2nd Oil Shock)• Stagflation again• Inflation: 16%

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The effects of an adverse supply shift

Figure 7

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Real GDP

Pric

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vel

D

D

S0

S0

E

S1

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The Economy on a Roller Coaster

• Reaganomics and its aftermath– High inflation

– Federal Reserve• Monetary policy (Paul Volcker)

– High interest rate to fight inflation– Result: high unemployment rate (11% in 1982)

• Fiscal policy– large tax cut

– Laffer Curve

– Help recovery beginning in the winter of 1982-1983 27

The Economy on a Roller Coaster

• Reaganomics and its aftermath– Large budget deficits

– Recovery started 1982-1983

– President Bush continues Regan’s policies• Inflation• Deficit-reduction package• Spike in oil prices triggers 1990-1991

recession

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The Economy on a Roller Coaster

• Clintonomics: deficit reduction– Deficit-reduction package, 1993 & 1997

• Tax increase & spending cuts

– Large fiscal surplus

– Economy boomed (might due to globalization and computerization)

– Lower inflation

– Aggregate supply curves• Pushed outward – rapid pace, 1996 – 1998

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The effects of a favorable supply shift

Figure 8

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Real GDP

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D0

D0

S0

S0

D1

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S1

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S2

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B

The Economy on a Roller Coaster

• Tax cuts and the Bush economy– 2001 recession

• First in 10 years

– Tax cut 2001

– Budget deficit

– Burst of government spending• War on terror

– Aggregate demand – shift outward

– Federal Reserve• Lowered interest rate 31

The Economy on a Roller Coaster

• The Great RecessionGreat Recession (Dec. 2007 – now)– Output falls hard

– 10% unemployment rate

– Inflation is modest

– Triggered by subprime crisis

Problem of Macroeconomic Stabilization

• Historical record shows– US economy has not generally produced

steady growth w/o inflation

– Short-run trade-off b/w unemployment and inflation, sometimes both increase (1970s)

– Gov policy might contribute to this performance

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Problem of Macroeconomic Stabilization

• Stabilization policy – Government programs

– Prevent or shorten recessions

– Counteract inflation, stabilize prices

Problem of Macroeconomic Stabilization

• Fight unemployment– Increase aggregate demand

• Government - Fiscal policy– Increase spending– Cut taxes

• Federal Reserve - Monetary policy– Lower interest rates

– Increase output

– Reduce unemployment

– Raise prices35

Stabilization policy to fight unemployment

Figure 9

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0

Real GDP

Pric

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D0

D0

S0

S0

D1

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Increase in output

Problem of Macroeconomic Stabilization

• Fight inflation– Decrease aggregate demand

• Government - Fiscal policy– Cut spending– Increase taxes

• Federal Reserve - Monetary policy– Increase interest rates

– Decrease inflation (decrease prices)

– Decrease output

– Increase unemployment37

Stabilization policy to fight inflation

Figure 10

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0Real GDP

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D0

D0S

SD2

D2

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B

Decrease

in prices

Stabilization policy • Prewar data

– Fluctuations – unmanaged economy• Booms & recessions

– “Natural” economic reasons

• Little government intervention

• Postwar data– Economy - managed by government policy

• Successfully (60s and 90s) or unsuccessfully (70s)

– Recessions - less severe– More inflation-prone

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Summary

• Macro vs. Micro• Macro is all about Aggregation• AD-AS curve• GDP• Business Cycles vs. Economic Growth• Brief Macroeconomic History of US• Stabilization Policy