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 individual units
• No matter how large
• Example: GE’s pricing policy
• Macroeconomics
– Behavior of entire 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
3
Macroeconomics & Microeconomics
• Macroeconomics
– Assume most details
• Resource allocation & income distribution
• Relatively unimportant
• Microeconomics
– Ignore macroeconomics issues
– Focus – individual markets
• Allocate resources
• Distribute income

4
Supply & Demand in Macroeconomics
• Aggregate demand (AD)
AD curve
– Quantity of domestic product – demanded
– Each possible value of price level
• Aggregate supply (AS)
AS curve
– Quantity of domestic product – supplied
– Each possible value of price level

5
Figure 1
Two interpretations of a shift in the demand curve

D1
S S
Price

Price
D D0
A
P1
E E
P0 P0

S S
D1
D D0
0 Q0 0

Quantity Quantity

(a) (b) 6
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

7
Figure 2
An economy slipping into a recession
D0 S

D2
E
Price Level

P0
B
P2

S D0
D2
0 Q2 Q0

Domestic Product
8
Supply & Demand in Macroeconomics
• Macroeconomists study
– Inflation
– Recession & unemployment (Business
Cycles)
– Economic growth

9
Figure 3
Economic growth
D1
S0
D0 S1

C
Price Level

D1

S0 D0
S1

0 Q0 Q1

Domestic Product
10
 Gross Domestic Product
• Gross domestic product (GDP)
– Sum: money values
– All final 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
11
 Gross Domestic Product
• Nominal GDP
– GDP in current dollars
– Value outputs – current prices
• Real GDP
– Value outputs of different years at
common prices
– GDP in constant dollars

12
 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

13
 Gross Domestic Product
• Final goods and services
– Purchased by their ultimate users
• Intermediate good - purchased
– For resale
– For use in producing another good

14
 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: “Green GDP”
15
 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

16
Figure 4
Nominal GDP, real GDP, real GDP per capita since 1959

17
Figure 5
The growth rate of U.S. real GDP since 1870

18
 The Economy on a Roller Coaster
• Inflation
– Sustained increase
– General price level
• Deflation
– Sustained decrease
– General price level

19
Figure 6
The inflation rate in the United States since 1870

20
 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%

21
 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 Nixon
23
 The Economy on a Roller Coaster
• The Great Stagflation,
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

24
 The Economy on a Roller Coaster
• The Great Stagflation,
Stagflation 1973-1980
– Economy recovered
• Government actions
• Natural economic forces
– 1979 – OPEC soaring oil prices (2nd Oil
Shock)
• Stagflation again
• Inflation: 16%

25
Figure 7
The effects of an adverse supply shift
D
S1
S0

A
Price Level

S1
S0 D

0
Real GDP

26
 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

28
 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

29
Figure 8
The effects of a favorable supply shift
D1
S0
D0 S1 S2

C
Price Level

B
E

D1

S0 D0
S1 S2
0

Real GDP 30
 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 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

33
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 prices
35
Figure 9
Stabilization policy to fight unemployment
D1
S0
D0

A
Price Level

D1

S0 D0
Increase in output
0
Real GDP

36
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 unemployment
37
Figure 10
Stabilization policy to fight inflation
D0 S

D2
E
Price Level

B
Decrease
in prices

S D0
D2
0
Real GDP

38
 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
39
 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