Macro Chapter 4

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Published on April 10, 2008

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Chapter 4:  Chapter 4 Macro vs. Micro Aggregate Demand and Supply Measuring Economic Success Output Employment Inflation Equilibrium Changes in Macroeconomics The Problem of Macroeconomic Stabilization U.S. Macroeconomic History Macro vs. Micro:  Macro vs. Micro In macroeconomics, we don’t care about what is produced and who gets to consume what. We do care about how much is produced. Its all about the big picture and not the small detail. In microeconomics, we focus on individual decision making. In macroeconomics, we focus on the behavior of the economy as a whole. Macro vs. Micro:  Macro vs. Micro Macro vs. Micro:  Macro vs. Micro Aggregation and Macroeconomics ‘Aggregation’ means combining many individual markets into one overall market. Macroeconomic models use abstract concepts like ‘the price level’ and ‘gross domestic product’ that are derived by combining many different markets into one. This process is known as ‘aggregation’. Aggregation:  Aggregation Aggregate supply curve - shows the quantity of domestic product that is supplied at each possible value of the price level. Aggregate Supply describes how much output businesses would willingly produce and sell given prices, costs, and market conditions Aggregation:  Aggregation Aggregate demand curve – shows the quantity of domestic product that is supplied at each possible value of the price level. Aggregate Demand consists of the total spending in an economy by households, businesses, governments, and foreigners. Warning on AS and AD curves:  Warning on AS and AD curves Domestic product – combine all goods and services into one product. AS and AD curves have no individual products. There is only one product, and it represents all products. Aggregate demand – demand for domestic product. Aggregate supply – supply of domestic product. Aggregation:  Aggregation But doesn’t it matter what stuff is being bought and what stuff is being sold? Isn’t it important if we are selling cars or selling cheese? Yes and no Aggregation:  Aggregation Clearly we care about the makeup of the economy, but: 1. Exactly what the national output is comprised of doesn’t really affect issues of growth, inflation, and unemployment 2. During economic fluctuations, markets tend to move together. When demand in an economy rises, demand for almost all goods rises Some Central Questions of Macroeconomics:  Some Central Questions of Macroeconomics Why do output and employment sometimes fall, and how can unemployment be reduced? What are the sources of price inflation, and how can it be kept under control? How can a nation increase its rate of economic growth? How can an economy balance all three of the above problems? The General Theory of Employment, Interest, and Money - Keynes:  The General Theory of Employment, Interest, and Money - Keynes 1. It is possible for high unemployment and underutilized capacity to persist in market economies 2. Government fiscal and monetary policies can affect output and thereby reduce unemployment and shorten economic downturn Measuring Economic Success:  Measuring Economic Success Economists evaluate the success of an economy’s performance by how well it attains these objectives: High levels and rapid growth of output (usually measured by GDP) Low levels of unemployment Price level stability (or low inflation) Measuring Economic Success: Output:  Measuring Economic Success: Output Gross Domestic Product GDP is the sum of the money values of all final goods and services produced in the domestic economy and sold on organized markets in a specified period of time, usually a year. Nominal GDP is calculated by valuing all outputs at current prices. Real GDP is calculated by valuing outputs of different years at common prices. Therefore, real GDP is a far better measure than nominal GDP of changes in total production. Measuring Economic Success: Output:  Disadvantage of Nominal GDP: It changes when prices change even if there is no change in actual production. Example: Assume a hamburger cost $1.50 in 2006. In 2007 it cost $2. In 2006 there were 100 hamburgers, which added $150 to nominal GDP. In 2007 there were 100 hamburgers, added $200 to nominal GDP. Nominal GDP makes it look like there were more hamburgers in 2007, even though there were only 100. So nominal GDP makes it look like there is economic growth, even when there is not. Solution: calculate real GDP or GDP in constant dollars. Measuring Economic Success: Output Measuring Economic Success: Output:  Measuring Economic Success: Output Shortcomings of GDP as a measure of economic well-being: -Only Market Activity is Included in GDP -GDP places no value on leisure - “Bads” counted as well as “Goods” For example, when there is a natural disaster, increased spending to solve the problems of the disaster are counted as increased GDP. -No account for ecological costs Measuring Economic Success:  Measuring Economic Success Employment: -Macroeconomic indicator most felt by individuals -Unemployment rate tends to reflect the state of the business cycle: -Falling output = falling demand for labor -Rising output = rising demand for labor Measuring Economic Success:  Measuring Economic Success Inflation: When price levels go up, we experience inflation. When price levels go down, we experience deflation. Measuring Economic Success:  Measuring Economic Success Inflation: An economy strives to keep inflation steady Rapid price increases cause problems for companies and individuals China’s Inflation:  China’s Inflation August 2004 inflation rate held steady at 5.3% Producer Prices rose 6.8% Food prices rose 14% Consumer goods rose 6.3% Housing prices rose 6% Service costs rose 2% Equilibrium Changes in Macroeconomics :  Equilibrium Changes in Macroeconomics Price A S D D S E Price S D D S E Equilibrium Changes in Macroeconomics :  Inflation Major concerns of macroeconomics Inflation Unemployment Growth  AD   price level Equilibrium Changes in Macroeconomics FIGURE 2: An Economy Slipping into a Recession:  FIGURE 2: An Economy Slipping into a Recession B Price Level S D0 D0 S E Equilibrium Changes in Macroeconomics :  Recession and Unemployment  AD  unemployment Recession = a period of time during which total output falls and therefore jobs are lost Equilibrium Changes in Macroeconomics FIGURE 3: Economic Growth:  FIGURE 3: Economic Growth Copyright © 2006 South-Western/Thomson Learning. All rights reserved. C Price Level S0 D0 D0 S0 E Equilibrium Changes in Macroeconomics :  Economic Growth Economic growth =  GDP  AD and/or AS  growth Equilibrium Changes in Macroeconomics FIGURE 7: The Effects of an Adverse Supply Shift (stagflation):  FIGURE 7: The Effects of an Adverse Supply Shift (stagflation) Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Price Level Real GDP FIGURE 8: The Effects of a Favorable Supply Shift:  FIGURE 8: The Effects of a Favorable Supply Shift Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Real GDP Price Level The Problem of Macroeconomic Stabilization:  The government wants to have a stabilization policy that can shorten recessions and fight inflation. Combating Unemployment When recessions are caused by too low aggregate demand, governments can try to increase demand. The Problem of Macroeconomic Stabilization FIGURE 9 Stabilization Policy to Fight Unemployment:  FIGURE 9 Stabilization Policy to Fight Unemployment Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Price Level Real GDP The Problem of Macroeconomic Stabilization:  Combating Inflation When inflation is caused by too high aggregate demand, governments can try to limit aggregate demand. The Problem of Macroeconomic Stabilization FIGURE 10: Stabilization Policy to Fight Inflation:  FIGURE 10: Stabilization Policy to Fight Inflation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Price Level Real GDP U.S. Macroeconomic History :  U.S. Macroeconomic History Real GDP Q P Price Level E AD AS P Q Here we see equilibrium in the market. U.S. Macroeconomic History :  U.S. Macroeconomic History Real GDP Q P Price Level E E1 AD AD1 AS P P1 Q Q1 As America entered the Viet Nam War, defense spending increased by 55 percent between 1965 and 1968. This increased Aggregate Demand, shifting the AD Curve to the right Which resulted in the high inflation that the nation experienced Between 1966-1981 U.S. Macroeconomic History :  U.S. Macroeconomic History P During the 1970s the industrial world was struck by a supply shock. Crop failures, shifting ocean currents, massive speculation on world commodity markets, turmoil in foreign exchange markets, and a MidEast war that led to a quadrupling (X4) of oil prices marked what was known as the “year of seven plagues” in 1973 The result was a rapid increase of the costs of materials and fuels, which shifted the Aggregate supply curve inward. Real GDP Q P E E1 AD AS1 AS P P1 Q Q1 U.S. Macroeconomic History :  U.S. Macroeconomic History Real GDP Q P Price Level E E1 AD AS1 AS P P1 Q Q1 The United States then experienced a period of stagflation, which was indicated by a sharp increase in inflation and a fall in real output. This effect can be illustrated by an inwards shift of the Aggregate Supply Curve, which increases prices and decreases output U.S. Macroeconomic History :  U.S. Macroeconomic History Real GDP Q P Price Level E E1 AD AD1 AS P P1 Q Q1 When President Regan took office in 1981, the economy was experiencing severe inflation, near 10 percent, an unacceptable number. The Chairman of the Federal Reserve, Paul Volcker, influenced interest rates in the so that spending would decrease, and in effect decrease demand in the economy. The result was a decrease in output, and an increase in unemployment. The reward was a decrease in inflation. U.S. Macroeconomic History :  U.S. Macroeconomic History Q During President Clinton’s first term, the national economy improved remarkably. Business improved, unemployment fell rapidly, and inflation was steady and low. Economic growth then accelerated even more during his second term. Unemployment dropped to 3.9% and inflation dropped below 2% for a brief period How did this happen? Real GDP Q P Price Level E AD AS P Q Q1 P1 AD1 AS1 Q2 P2 U.S. Macroeconomic History :  U.S. Macroeconomic History Real GDP Q P Price Level E AD AS P Q A combined increase of Aggregate Demand as well as an unexpected huge increase in Aggregate supply provides An good explanation. A shift out in AD will increase output as well as prices But if at the same time AS shifts out, output can continue to increase while prices do not rise a lot. Q1 P1 AD1 AS1 Q2 P2 U.S. Macroeconomic History :  U.S. Macroeconomic History The economic history of the United States (or any country) in the twentieth century can be more easily understood using the AS/AD model. Growth over the past century has been due to both increases in aggregate supply as well as aggregate demand. U.S. Macroeconomic History :  U.S. Macroeconomic History Historically, economies do not generally produce steady growth without inflation. Instead, economies are hit with periodic bouts of unemployment or inflation, and sometimes both. U.S. Macroeconomic History :  U.S. Macroeconomic History Thus it has become a goal of economies to minimize the damage done by inflation and unemployment. These stabilization policies are designed to shorten recessions, reduce unemployment, and stabilize inflation.

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