Lecture 2 – Chapter 5

Review of Supply and Demand in Microeconomics

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Supply and Demand in Macroeconomics

• Moving to Macroeconomic Aggregates• Aggregate demand curve

• Quantity of domestic product that is demanded at each possible value of the price level

• Aggregate supply curve• Quantity of domestic product that is supplied at each

possible value of the price level

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• Recall the Three macroeconomic concerns1. Inflation

• Sustained increase in the general price level

2. Recession - unemployment• A period of time during which the total output of the

economy declines. Production falls, people lose jobs and are unemployed.

• Leftward shift of aggregate demand curve

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Supply and Demand in Macroeconomics

An Economy Slipping into a Recession: Total Demand for Goods and Services Falls

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• Three macroeconomic concerns3. Economic growth

• Over time, both aggregate demand and aggregate supply shift right

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Supply and Demand in Macroeconomics

Figure 3 Economic Growth

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Definition of Gross Domestic Product

• Gross Domestic Product (GDP)• Sum of the money values of all final goods and services• produced in the domestic economy and sold on

organized markets • during a specified period of time, usually a year

• Another way to says this – • Total value of all final goods and services• produced in the domestic economy and sold on

organized markets at current prices• during a specified period of time, usually a year

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Gross Domestic Product

• Money as a measuring rod• How to add apples and oranges

• Nominal GDP: GDP in current dollars• Calculated by valuing all outputs at current prices• We will call this NGDP

• Real GDP: GDP in constant dollars• Calculated by valuing outputs of different years at

common prices• We will call this RGDP

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Gross Domestic Product

• Real GDP and recessions• A recession is a period of time in which real GDP

falls• Some say after two consecutive quarters• Great Recession - 2007:4 – 2009:2

• RGDP fell from $14,992 to $14,356 billion • RGDP fell 4.24%

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Gross Domestic Product

• What gets counted in GDP?• For a particular year includes only goods and

services produced that year

• Only includes final goods and services• Goods purchased by their ultimate users• Intermediate good is a good used in the production of

another good• Why don’t we include the value of intermediate goods?

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Intermediate and Final Good

Tires taken from that pile and mounted on the wheels of the new car before it is sold are considered intermediate goods.Tires taken from that pile to replace tires on your old car are considered final goods.

If we included the value of the tires (an intermediate good) on new cars and the value of new cars (including the tires), we would be double counting.

Gross Domestic Product

• What gets counted in GDP?• Domestic denotes production within the

geographic boundaries of the U.S. regardless of who owns the resources• Japanese Honda plant in U.S. is part of

U.S GDP• Includes only goods and services that pass

through organized markets

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What’s Not Included in GDP

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• Non-market goods and services such as chores performed at home by family members (non-market)

• Underground activities, both legal and illegal such as legal unrecorded activities paid for in cash or illegal gambling (non- market)

• Sales of used goods (no production)• Financial transactions such as trading of stocks and

bonds (no production)• Government transfer payments: a payment to a

person that is not for goods and services currently supplied such as social security (no production)

LIMITATIONS OF THE GDP CONCEPTGDP AND SOCIAL WELFARE

If crime levels went down, society would be better off, but a decrease in crime is not an increase in output and is not reflected in GDP.

An increase in leisure is also an increase in social welfare, but sometimes associated with a decrease in GDP.

Most nonmarket and domestic activities, such as housework and child care, are not counted in GDP even though they amount to real production.

LIMITATIONS OF THE GDP CONCEPT

underground economy - the part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP.

distribution of income - GDP also has nothing to say about the distribution of output among individuals in a society.

pollution – environmental deterioration is not subtracted out.

The Economy on a Roller Coaster

• Some history of the U.S. economy• Growth with booms and recessions

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The Business Cycle

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Long-run upward trend is 3%. In the expansion phase of the cycle, growth is > the trend. When output falls, we are in a recession.

Figure 4 Nominal GDP, Real GDP, and Real GDP per Capita since 1959

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The Economy on a Roller Coaster

• What about the growth rate of real GDP?• Macroeconomic fluctuations - the business

cycle

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Figure 5 The Growth Rate of U.S. Real Gross Domestic Product since 1870

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Annualized data for GDP, real GDP, and growth rate, by quarters

Self test - How do we calculate the 3.8% real GDP growth rate for 2010-II?

The Economy on a Roller Coaster

• What about the price level over time?• Inflation

• Sustained increase in the general price level

• Deflation • Sustained decrease in the general price level

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Figure 6 The Inflation Rate in the United States since 1870

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The Economy on a Roller Coaster

• The Great Depression, 1929-1933• Significant decline in economic activity and

rapid deflation• Production declined 26%, and business

investment ceased • Unemployment rate increased from 3% to

25%• World-wide event

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The Economy on a Roller Coaster

• The Great Depression, 1929-1933• Led to a revolution in economic thought• Before: Classical Economists - Economy

corrects itself• After: John Maynard Keynes

• Economy does not correct itself quickly• Household and business firms can reduce demand • Decrease in aggregate demand reducing output and

employment• Role of monetary and fiscal policy

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The Economy on a Roller Coaster

• From WWII to 1973• Great Depression ended when U.S. mobilized for war• Fiscal policy – government spending boosted

aggregate demand• Price controls and shortages• 1960’s: period of unprecedented noninflationary

growth• Keynesian success?

• Inflation returned starting late 1960s and early 1970s

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The Economy on a Roller Coaster

• The Great Stagflation, 1973-1980• OPEC – 1973 oil prices quadrupled, poor

harvests, and removal of price controls led to more inflation

• U.S. economy also went into a recession• Stagflation

• Inflation that occurs while the economy is growing slowly or in a recession

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The Effects of an Adverse Supply Shift - Stagflation

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The Economy on a Roller Coaster

• Reaganomics and its aftermath• Recovery underway in 1981 but still high

inflation• Federal Reserve used monetary policy

• Actions by the Federal Reserve to influence aggregate demand by changing interest rates

• Recovery that started in 1982-1983 long lasting

• Unemployment fell from 11% to 5.5%• Inflation fell from 10% to less than 3%

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The Economy on a Roller Coaster

• Reaganomics and its aftermath• President Bush

• Inflation started to rise• Congress passed a deficit-reduction

package• Spike in oil prices• 1990-1991 recession

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The Economy on a Roller Coaster

• Clintonomics: deficit reduction and the “New Economy”• Deficit-reduction package, 1993 & 1997:

both tax increases and spending cuts• Budget deficit became a budget surplus• At same time economy boomed, and

inflation lower• The “New Economy”

• Globalization and computerization

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Figure 8 The Effects of a Favorable Supply Shift

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The Economy on a Roller Coaster

• Tax cuts and the Bush economy• 2001 recession, the first in 10 years• Tax cut 2001 brought back budget deficit• War on terrorism led to an increase in

government spending• Federal Reserve lowered interest rate• The housing bubble and it’s bursting

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The Economy on a Roller Coaster

• Obamanomics and the Great Recession• January 2009, economy was sinking• Jobs - disappearing at a rapid pace• More tax cuts• A burst of federal spending• Large-scale aid to state and local

governments

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The Economy on a Roller Coaster

• Obamanomics and the Great Recession• Bush, Obama administrations, the Fed

• Variety of unprecedented emergency measures - to rescue the collapsing financial system

• Summer 2009, the Great Recession was over

• Economy started growing again but unemployment remained high

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Problem of Macroeconomic Stabilization

• Stabilization policy • Government programs designed to

prevent or shorten recessions and to counteract inflation (stabilize prices)

• Combating unemployment• Suppose output is too low: high

unemployment

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Figure 9 Stabilization Policy to Fight Unemployment

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Problem of Macroeconomic Stabilization

• Combating unemployment• Government pushes out aggregate

demand using• Fiscal policy: increase spending and/or

cut taxes• Monetary policy: lower interest rates

• Output increases, unemployment falls, and prices rise

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Figure 9 Stabilization Policy to Fight Unemployment

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Problem of Macroeconomic Stabilization

• Combating inflation• Government would want to decrease

aggregate demand • Fiscal policy: cut spending and/or

increase taxes• Monetary policy: increase interest rates

• Inflation and output decreases, unemployment increases

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Figure 10 Stabilization Policy to Fight Inflation

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Does Stabilization Policy Really Work?

• Compare economic fluctuations before and after WWII

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Figure 5 The Growth Rate of U.S. Real Gross Domestic Product since 1870

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Does Stabilization Policy Really Work?

• Compare economic fluctuations before and after WWII• Before the war, frequent and sometimes large

fluctuations• After the war, less recessions and less severe fluctuations

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Does Stabilization Policy Really Work?

• Compare inflation before and after WWII

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Figure 6 The Inflation Rate in the United States since 1870

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Does Stabilization Policy Really Work?

• Compare inflation before and after WWII• Before the war, periods of price stability and deflation• After the war, only positive inflation so prices increase

each year

• Overall• Since WWII, success of government managing economy

has been mixed• Although recession less severe, economy appears to be

more prone to inflation

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