CHAPTER 4

A First Look at Macroeconomics

After studying this chapter you will be able to

Describe the origins and issues of macroeconomics

Describe the trends and fluctuations in economic growth
and explain the benefits and costs of economic growth
Describe the trends and fluctuations in unemployment
and explain why unemployment is a problem
Describe the trends and fluctuations in inflation and the
value of the dollar and explain why inflation is a problem
Describe the trends and fluctuations in surpluses,
deficits, and debts and explain why they matter
Identify the macroeconomic policy challenges and list the
tools available for meeting them
What Will Your World Be Like?

Will tomorrow’s world be more prosperous than today?

Will jobs be plentiful?
Will the cost of living be stable?
Will the government’s and the nation’s deficit continue to
increase?
What macroeconomic policy tools does the government
have to steer the course of the economy?
Origins and Issues of Macroeconomics

Economists began to study economic growth, inflation, and

international payments during the 1750s.
Modern macroeconomics dates from the Great
Depression, a decade (1929-1939) of high unemployment
and stagnant production throughout the world economy.
John Maynard Keynes book, The General Theory of
Employment, Interest, and Money, began the subject.
Origins and Issues of Macroeconomics

Short-Term Versus Long-Term Goals

Keynes focused on the short-term—on unemployment and
lost production.
“In the long run,” said Keynes, “we’re all dead.”
During the 1970s and 1980s, macroeconomists became
more concerned about the long-term—inflation and
economic growth.
Economic Growth and Fluctuations

Economic growth is the expansion of the economy’s

production possibilities—an outward shifting PPF.
We measure economic growth by the increase in real
GDP.
Real GDP (real gross domestic product) is the value of the
total production of all the nation’s farms, factories, shops,
and offices, measured in the prices of a single year.
Economic Growth and Fluctuations

Economic Growth in the

United States
Figure 4.1 shows real
GDP in the United States
from 1960 to 2005.

The figure highlights:

 Growth of potential GDP
 Fluctuations of real GDP
around potential GDP
Economic Growth and Fluctuations

Growth of Potential GDP

Potential GDP is the value
of production when all the
economy’s labor, capital,
land, and entrepreneurial
ability are fully employed.
During the 1970s, the
growth of output per person
slowed—a phenomenon
called the productivity
growth slowdown.
Economic Growth and Fluctuations

Fluctuations of Real GDP

Around Trend
Real GDP fluctuates
around potential GDP in a
business cycle—a
periodic but irregular up-
and-down movement in
production.
Economic Growth and Fluctuations

Every business cycle has two phases:

1. A recession
2. An expansion
and two turning points:
1. A peak
2. A trough
Figure 4.2 on the next slide illustrates these features of
the business cycle.
Economic Growth and Fluctuations
Most recent business cycle in the United States
Economic Growth and Fluctuations

A recession is a period during which real GDP

decreases for at least two successive quarters.
An expansion is a period during which real GDP
increases.
Economic Growth and Fluctuations

Figure 4.3 shows the long-term growth trend and cycles.

Economic Growth and Fluctuations

Economic Growth
Around the World
Figure 4.4(a) compares
the growth rate of real
GDP per person in the
United States with that for
the rest of the world as a
whole.
Economic Growth and Fluctuations

Figure 4.4(b) compares

economic growth in the
United States with that in
other countries and
regions from 1996 to
2006.
Among the advanced
economies, Japan has
grown slowest and the
newly industrialized Asian
economies have grown
fastest.
Economic Growth and Fluctuations

Among the developing

economies, Central and
South America have
grown slowest and Asia
has grown fastest.
The world has grown a bit
faster than the United
States.
Economic Growth and Fluctuations

The Lucas Wedge and Okun Gap

How costly are the growth slowdown and the lost
output over the business cycle?
To answer that question we measure:
 The Lucas wedge
 The Okun gap
Economic Growth and Fluctuations

The Lucas Wedge

The Lucas wedge is the
accumulated loss of
output from the
productivity growth
slowdown of the 1970s .
Figure 4.5(a) shows that
the Lucas wedge is $72
trillion or 6.5 times the
real GDP in 2005.
Economic Growth and Fluctuations

The Okun Gap

Real GDP minus
potential GDP is the
output gap.
A negative output gap
is called an Okun gap.
Figure 4.5(b) shows the
Okun gap from
recessions since 1973
is $3.3 trillion or about
30 percent of real GDP
in 2005.
Economic Growth and Fluctuations

Benefits and Costs of Economic Growth

The Lucas wedge is a measure of the dollar value of lost
real GDP if the growth rate slows. This cost translates into
real goods and services.
It is a cost in terms of less health care for the poor and
elderly, less cancer and AIDS research, worse roads, and
less to spend on clean air, more trees, and cleaner lakes.
But fast growth is also costly. Its main costs is forgone
current consumption. To sustain growth, resources must be
allocated to advancing technology and accumulating
capital rather than to current consumption.
Jobs and Unemployment

Jobs
In 2006, 143 million people in the United States had jobs.
This number is 16 million more than in 1996 and 33 million
more than in 1986.
But the pace of job creation fluctuates.
During the recession, the number of jobs shrinks.
During the 19901991 recession, more than 1 million jobs
were lost and during the 2001 recession, 2 million jobs
disappeared.
Jobs and Unemployment

Unemployment
Not everyone who wants a job can find one.
On an average day in a normal year, 7 million people in
the United States are unemployed.
In a recession, the number is larger. For example, in 1990-
1991 recession, 9 million people were looking for jobs.
The unemployment rate is the number of unemployed
people expressed as a percentage of all the people who
have jobs or are looking for one.
Jobs and Unemployment

The unemployment rate is not a perfect measure of the

underutilization of labor. For two reasons:
The unemployment rate
1. Excludes people who are so discouraged that they
have given up looking for jobs.
2. Measures unemployed people rather than unemployed
labor hours. So it does not tells us about the number of
part-time workers who want full-time jobs.
Jobs and Unemployment
Unemployment in in United States
Figure 4.6 shows the unemployment rate from 1926 to
2006.
Jobs and Unemployment
During the 1930s, the unemployment rate hit 25 percent.
Jobs and Unemployment
The lowest rate occurred during World War II at 1.2 percent.
Jobs and Unemployment
During recent recessions, the unemployment rate increased
but was not as high as in the Great Depression.
Jobs and Unemployment
The unemployment rate is never zero. Since World War II, it
has averaged 5 percent.
Jobs and Unemployment
Unemployment Around
the World
Figure 4.7 compares the
unemployment rate in the
United States with those
in Japan, Western
Europe, and Canada.
The U.S. unemployment
rate has been lower than
that in Western Europe
and Canada but higher
than that in Japan.
Jobs and Unemployment

The cycle in unemployment

in Canada is similar to that
in the United States.
The cycle in unemployment
in Western European is out
of phase with that in the
United States.
Unemployment in Japan
has drifted upwards since
the mid-1990s.
Jobs and Unemployment

Why Unemployment Is a Problem

Unemployment is a serious economic, social, and
personal problem for two main reasons:
 Lost production and incomes
 Lost human capital
The loss of a job brings an immediate loss of income and
production—a temporary problem.
A prolonged spell of unemployment can bring permanent
damage through the loss of human capital.
Inflation and the Dollar

We measure the level of prices—the price level— as the

average of the prices that people pay for all the goods and
services that they buy.
The Consumer Price Index—the CPI—is a common
measure of the price level.
We measure the inflation rate as the percentage change
in the price level.
Inflation arises when the price level is rising persistently.
If the price level is falling, inflation is negative and we have
deflation.
Inflation and the Dollar
Inflation in the United States

Was low in
the 1960s.
Increased in
the 1970s
and early
1980s.
Fell during
the 1980s
and 1990s.
Increased
after 2002.
Inflation and the Dollar

Inflation Around the

World
Figure 4.9(a) shows the
inflation rate in the United
States compared with that
in other industrial
countries.
U.S. inflation is similar to
that in other industrial
countries.
Inflation and the Dollar

Figure 4.9(b) shows the

inflation rate in industrial
countries has been much
lower than that in
developing countries.
Inflation and the Dollar

Hyperinflation
The most serious type of inflation is hyperinflation—an
inflation rate that exceeds 50 percent a month.
Why Inflation is a Problem
Inflation is a problem for many reasons, but the main one is
that once it takes hold, it is unpredictable.
Unpredictable inflation is a problem because it
 Redistributes income and wealth
 Diverts resources from production
Inflation and the Dollar

Unpredictable changes in the inflation rate redistribute

income in arbitrary ways between employers and workers
and between borrowers and lenders.
A high inflation rate is a problem because it diverts
resources from productive activities to inflation forecasting.
From a social perspective, this waste of resources is a
cost of inflation.
Eradicating inflation is costly because it brings a period of
greater than average unemployment.
Inflation and the Dollar

The Value of the Dollar

The value of the U.S. dollar in terms of other currencies is
called the exchange rate—a measure of how much your
dollar will buy in other parts of the world.
An example is the number of pesos that 1 U.S. dollar will
buy.
Surpluses, Deficits, and Debts

Figure 4.10 shows the

U.S. dollar exchange rate.
When value of the dollar
decreases, the U.S. dollar
depreciates against other
currencies.
When value of the dollar
increases, the U.S. dollar
appreciates against other
currencies.
Inflation and the Dollar

Why the Exchange Rate Matters

When the U.S. dollar appreciates, U.S. consumers pay
less for imported goods.
But the higher dollar makes it harder for U.S. producers to
complete in foreign markets. A higher dollar hurts U.S
producers.
When the U.S. dollar depreciates, U.S. consumers pay
more for imported goods. So a lower dollar hurts
consumers.
But the lower dollar makers it easier for U.S. producers to
complete in foreign markets.
Surpluses, Deficits, and Debts

Government Budget Balance

If a government collects more in taxes than it spends, it
has a government budget surplus.
If a government spends more than it collects in taxes, it
has a government budget deficit.
Surpluses, Deficits, and Debts
Figure 4.11(a) shows the
U.S. federal government
budget balance from
1960 to 2005.
The budget deficit as a
percentage of GDP
increases in recessions
and shrinks in expansions
In 1998, a budget surplus
emerged, but the budget
deficit reappeared in
2001.
Surpluses, Deficits, and Debts

International Surplus and Deficit

If a nation imports more than it exports, it has an
international deficit.
If a nation exports more than it imports, it has an
international surplus.
The balance on the current account equals U.S. exports
minus U.S. imports but also takes into account interest
payments paid to and received from the rest of the world.
Surpluses, Deficits, and Debts

Figure 4.11(b) shows the

U.S. current account
balance from 1960 to
2005.
During the 1980s
expansion, a large deficit
appeared but it almost
disappeared during the
1990–1991 recession.
The current account
deficit in 2005 was 6.3
percent of GDP.
Surpluses, Deficits, and Debts

Deficits Bring Debts

A debt is the amount that is owed.
When a government or a nation has a deficit, its debt
grows.
A government’s or a nation’s debt equals the sum of all
past deficits minus past surpluses.
A government’s debt is called national debt.
Surpluses, Deficits, and Debts

Figure 4.12(a) shows the

U.S. government debt
from 1945 to 2005.
Budget surpluses and
rapid economic growth
shrink the debt.
Budget deficits and
slower economic growth
swelled the debt.
Surpluses, Deficits, and Debts

Figure 4.12(b) shows the

U.S. international debt
from 1975 to 2005.
Until 1986, the United
States was a net lender
to the world.
But with increased
deficits, the United
States is now a net
borrower from the world.
Macroeconomic Policy Challenges
and Tools

Classical and Keynesian Views

Economists’ views fall into two broad schools:
Classical view: The economy behaves best if the
government leaves people free to pursue their own self-
interest. Attempts by the government to improve
macroeconomic performance will not succeed.
Keynesian view: The economy behaves badly if left alone
and that government action is needed to achieve and
maintain full employment.
Macroeconomic Policy Challenges
and Tools

Five widely agreed policy challenges for macroeconomics

are to:
1. Boost economic growth
2. Keep inflation low
3. Stabilize the business cycle
4. Reduce unemployment
5. Reduce government and international deficits
Macroeconomic Policy Challenges
and Tools

Two broad groups of macroeconomic policy tools are

Fiscal policy—making changes in tax rates and
government spending
Monetary policy—changing interest rates and changing
the amount of money in the economy
The government conducts fiscal policy.
The Federal Reserve (the Fed) conducts monetary policy.
THE END