1 introduction to macroeconomics chapter 5 © 2003 south-western/thomson learning
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1
Introduction to Macroeconomics
CHAPTER
5
© 2003 South-Western/Thomson Learning
2
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
3
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
4
Economic Fluctuations
Economic fluctuations
The rise and fall of economic activity relative to the long-term growth trend of the economy
5
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
6
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
7
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
8
Exhibit 2: Annual Percentage Change in U.S. Real GDP from 1929 to 2003
9
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
10
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
11
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
12
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
13
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
14
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
15
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
16
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
17
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.
18
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
19
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
20
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
21
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
22
Great Depression and Before
Prior to the Great Depression, macroeconomic policy was based primarily on the laissez-faire policy
23
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
24
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
25
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
26
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
27
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.
28
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
29
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
30
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
31
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.
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