Chapter
5 Introduction to Macroeconomics
I. What is Macroeconomics?
Macroeconomics
studies the performance of the economy as a whole.
Economy- the structure of economic
life or economic activity in a community, a region, a country, a group of countries,
or the world.
The
focus of macroeconomics is the National Economy and how the national economy
interacts with other national economies around the world.
Why
do we focus on the national level?
-
There
is freer movement of people and goods within a country
-
Each
country has its own culture, language, communication, transportation,
government and currency
-
Each
country has its own "rules of the game"- regulations, customs for
conducting economic activity
GROSS
PRODUCT-
market value of all final goods and services produced in a region during a
particular time period.
Use
Gross Product to track same economy over time or compare different ones.
III.
Why do we study macroeconomics?
1. Does the economy work well on its own?
2. When and how can we use policy to control
negative aspects of the economy?
3. We want to make sure that our remedies don't do
more harm than good.
The
national economy is extremely complex- we can't hope to gather information
about all variables involved in it - and this is not necessary.
What
we want/need to know are essential relationships among key economic variables-
allow us to produce theories/models to explain and predict what happens to the
economy.
Economic
Fluctuation-
Rise and fall of economic activity relative to a long-term growth trend (also
called business cycles.)
The
economy has two phases:
1.
Expansion- A phase of economic activity during which there is an increase in the
economy's total production.
2.
Contraction- A phase of economic activity during which there is a decrease in the
economy's total production.
Depression- A severe reduction in an economy's total
production accompanied by high unemployment that lasts more than a year.
Recession- A period of decline in total output usually
lasting at least six months and marked by contractions in many sectors of the
economy. (6 months-1 year.)
Despite
ups and downs, the US economy has grown over the long run.
Why
does production tend to increase over time?
1. Increased in amount and quality of resources
2. Better technology
3. Improvements in "rules" that facilitate
production/exchange
Since
1940 economy has doubled in size every 21 years on average.
**Because
of seasonal fluctuations, economy doesn't move smoothly through phases.
**Can
only identify turning points after the fact.
Economists
use LEADING ECONOMIC INDICATORS to predict downturn or upturn.
In early stages of recession:
-Business slows down
-Orders for machinery and
equipment slip
-Stock market turns down
-Households reduce spending
on big-ticket items
*
These indicators can't tell us when the turning point will occur.
To
understand the reasons for these fluctuations - Need to develop a theory. To do
so, we need to simplify millions of relationships to isolate important
elements.
Aggregate- Formed by the collection
of units or particles into a body, mass, or amount.
Aggregate
Output- The
total quantity of goods and services produced in an economy during a given time
period.
Price
Level- A
composite measure reflecting the prices of food, housing, clothing,
entertainment, medical care, and all other output.
Familiar
Measures:
Aggregate
Output: GDP
(Gross Domestic Product)
-Market
value of all final goods and services produced in US during a given time period
(unit $$)
Price
Level:
1.
Consumer
Price Index (CPI)- tracks the changes in the price of the "basket" of
goods/services consumed by a typical family.
2.
GDP
Price Index - tracks average price of all items in the gross domestic product.
AGGREGATE
DEMAND-
A curve representing the relationship between the economy's price level and the
amount of aggregate output demanded per period of time, other things held constant.
As
price level falls, households demand more.
Why? Some wealth is generally held in checking accounts, savings, and
as cash. When the price level decreases, this wealth is worth more (has more
buying power). So people will be more willing and more able to demand more
goods and services.
AGGREGATE
SUPPLY-A
curve representing the relationship between the economy's price level and the
amount of aggregate output supplied per period of time, other things held
constant.
As
price level increased- more than the cost of production - firms find it
profitable to expand output.
In
general, higher GDP (aggregate output) is good for 2 reasons:
1.
To produce output, firms employ more people (generally)- more employment.
2.
More goods and services are available.
VI.
Short History of US Economy (Using AD/AS analysis)
1.
Great Depression and Before
Great
Depression-
Deepest economic contraction in our nation's history
Graph:
Unemployment
jumped from 3%(1929) to 25% (1933).
Possible
reasons for decrease in AD:
1.
Grim
business expectations
2.
Drop
in consumer spending
3.
Sharp
decline in the money supply
Prior
to Depression, government policy was laissez-faire (Adam Smith-Wealth of
Nations). If people are left to pursue their own interests in free markets,
resources would be used most efficiently and the economy would reach the most
efficient level of aggregate output.
2.
Great Depression à Early 1970s
Great
Depression stimulated new thinking.
John
Maynard Keynes
(1883-1946) The General Theory of Employment, Interest, and Money
a.
AD
inherently unstable because private spending (particularly investment) often
guided by "animal spirits" of business expectations.
(Role of expectations in economics. Example: All firms expect greater
demand. To expand output, firms buy more capital and hire more workers.
Households, as suppliers, earn more income and so increase demand for goods and
resources. Producers help bring about the increase in demand they expected.)
b.
No
natural forces operating to ensure that economy would self-adjust.
c.
Expansionary
fiscal policy to deal with contractions.
-Increase government
spending
-Cutting taxes
Expansionary
Policy à Government Budget Deficit
DEMAND-SIDE
ECONOMICS-focuses
on how changes in AD affect employment prices and using AD.
When WWII broke out - huge federal deficit financed the war. War related demand stimulated ADà Seeming to confirm KEYNES.
EMPLOYMENT
ACT OF 1946àmade it the responsibility
of the federal Government to foster employment, production, and purchasing
power. Required president to report annually to a counsel of economic advisers.
1960s
- Golden Age of Keynesian Economics
The
government attempted to fine-tune the economy to avoid recession.
3.
The Great Stagflation
Through
the 1960s, some economists felt that economic fluctuations were a thing of the
past.
But
in the early 1970s, fluctuations returned. Began to see periods of
inflation/recession.
INFLATION- A sustained increase in
economy's price level.
STAGFLATION- A contraction of a
nation's output accompanied by inflation.
Reasons
for stagflation:
1.
Crop
failures decrease AS.
2.
OPEC
price increases decrease AS.
Stagflation
Graph:
Problem
of STAGFLATION on the supply side, economics has not been the same
since.
4.
Since 1980
SUPPLY-SIDE
ECONOMICS
- Macroeconomic policy that focuses on increasing AS through tax cuts or other
changes to increase incentives to produce
1.
Lower taxes--> Increase after tax earnings--->resource owners increase labor
supply
--->Greater
resource supply---> increase AS---> increase GDP, lower price level.
Graph:
1981
Reagan cut personal income taxes by 23%.
Before
tax went into effect-recession hit, unemployment rate up to 10%
After
recession-longest peacetime expansion in US history
But
the Federal Deficit Swelled (By 1992 topped $290 billion)
Debt- Stock variable that
measures net accumulation of prior deficits
Deficit-flow variable
1993
Clinton pushed tax increases, budget cuts.
Budget
surplus projections depend on the state of the economy.
Projected 2002 surplus of $313 billion
changed to projected deficit of $1 billion for fiscal year beginning October 1.
2/3 reduction due to recession
lower tax rate explains 14%
higher spending explains remaining 19%
10-year
projected surplus of $5.6 trillion through 2011 revised to $1.9 trillion after
tax cut and revised economy. Projected
lower revenue results in $350 billion increase in cost of government debt.