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Introduction to Macroeconomics

CHAPTER

5

© 2003 South-Western/Thomson Learning

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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

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Flow and Stock Variables

Flow VariableAn amount per period of timeAverage spending per week, hours worked per month, etc.

Stock VariableAn amount measured at a particular point in timeAmount of cash on hand you have nowNumber of housing units in existence today

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Economic Fluctuations

Economic fluctuations

The rise and fall of economic activity relative to the long-term growth trend of the economy

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Components of Business CyclesTwo phases

Periods of expansionPeriods of contraction

DepressionSevere contractionLasting longer than one year and accompanied by high unemployment

RecessionMilder contractionDecline in total output lasting at least two consecutive quarters

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Exhibit 1: Hypothetical Business Fluctuations

A recession begins after theprevious expansion hasreached its peak, or high point and continues until theeconomy reaches a trough,or low point.

Peak

Trough

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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

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Exhibit 2: Annual Percentage Change in U.S. Real GDP from 1929 to 2003

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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

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Leading Economic Indicators

Declines in leading economic indicators 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

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Aggregate Output

Aggregate outputTotal amount of goods and services produced in the economy during a given period

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

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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

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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 indexShows how the economy’s general price level changes over timeCan be used to convert production in different years into dollars of constant purchasing power

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Aggregate Demand Curve

Aggregate demand curve shows the relationship between the price level in the economy and the real GDP demanded, other things constant

Among the factors held constant along a given aggregate demand curve are

The price levels in other countriesThe exchange rates between the U.S. dollar and foreign currencies

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Exhibit 4: Aggregate Demand CurveExhibit 4: Aggregate Demand Curve

The inverse relationship depicted by the aggregate demand curve reflects the fact that as the price level increases, other things constant, the purchases of the four major decision makers decline

0

50

100

150

2 4 6 8 10 12 14 16

Real GDP trillions of 1996 dollars

Price

leve

l tril

lions

of 19

96 do

llars

AD

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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 constant

Assumed constant along an aggregate supply curve are

Resource prices, including wage ratesThe state of technologyThe rules of the game that provide production incentives

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Exhibit 5:Aggregate Demand & SupplyExhibit 5:Aggregate Demand & Supply

150

109100

50

0 9.3 Real GDP

(trillions of 1996 dollars)

AD

AS

Pri

ce

le

ve

l (1

996

= 1

00

)

Equilibrium in the national economy occurs where the

AD and AS curves intersect.

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Equilibrium

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 economyMore people are employed

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Short History of U.S. EconomyHistory 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• Moderate increases in the price level

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Exhibit 6: Decrease in AggregateExhibit 6: Decrease in Aggregate

AS

AD1929

12.6

822 Real GDP (billions of 1996 dollars)

Pri

ce le

vel (

1996

= 1

00)

AD1933

9.3

6030

The Great Depression can be viewed as a shift to the left of the aggregate demand curve.

This resulted in a drop of both the price level and real GDP.

Demand between 1929 and 1933Demand between 1929 and 1933

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Great Depression and Before

Why did aggregate demand decline so much during this period?

Stock market crash of 1929Grim business expectationsDrop in consumer spendingWidespread bank failuresSharp decline in the nation’s money supplySevere restrictions on world trade

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Great Depression and Before

Prior to the Great Depression, macroeconomic policy was based primarily on the laissez-faire policy

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Age of KeynesKeynes 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

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Age of KeynesKeynes proposed that the government jolt the economy out of its depression by increasing aggregate demand

Direct stimulus by increasing its own spendingIndirect stimulus by cutting taxes to stimulate the primary components of private-sector demand, consumption and investment

Federal budget deficitFlow variable that measures, for a particular period, the amount by which total federal outlays exceed total federal revenues

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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

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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

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Exhibit 7: Stagflation Between 1973-1975 Exhibit 7: Stagflation Between 1973-1975

AD

AS1973

33.6

4.12

Real GDP

(trillions of 1996 dollars)

Pri

ce le

vel (

1996

= 1

00)

0

AS1975

40.0

4.08

The stagflation of the mid-1970s can be represented as a reduction in aggregate supply.

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Experience Since 1980The stagflation of the 70s shifted policy maker’s attention from aggregate demand to aggregate supply

Supply-side economicsThe 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

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Experience Since 1980In 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

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Experience Since 1980

However, during this period, the growth in federal spending exceeded the growth in tax revenues federal budget deficits swelled resulting in a huge federal debtGovernment debt

Stock variableMeasures the net accumulation of prior deficitsNearly doubled in the period of 1980 to 1992 relative to GDP

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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 before slipping into a recession.