Macro Chapter 4

8/3/2019 Macro Chapter 4

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Chapter 4: The Realmof Macroeconomics

Macroeconomics



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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



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Learning Objectives

A new understanding of the difference between microand macro

Explain aggregate demand and aggregate supply

Explain the measurements of economic success Describe the effects of a change in aggregatedemand or aggregate supply

Understand the problem of macroeconomic

stabilization



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Macro vs. Micro

In macroeconomics, we don’t care about what is produced andwho gets to consume what. We do care about how much isproduced.

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 asa whole.



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Macro vs. Micro

Macroeconomics analyzes the size of theeconomy (pie), not caring what's inside or howits divided.

Microeconomics looks at the ingredients andwho gets to eat it, not caring about the size andshape.



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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’ thatare derived by combining many different marketsinto one. This process is known as ‘aggregation’.



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Aggregation Aggregate supply curve - shows the quantity of

domestic product that is supplied at each possiblevalue of the price level.

Aggregate Supply describes how much outputbusinesses would willingly produce and sell givenprices, costs, and market conditions



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Aggregation

Aggregate demand curve – shows the quantityof domestic product that is supplied at eachpossible value of the price level.

Aggregate Demand consists of the totalspending in an economy by households,businesses, governments, and foreigners.



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Warning on AS and AD curves

Domestic product – combine all goods and services intoone product. AS and AD curves have no individualproducts. There is only one product, and it

represents all products.

Aggregate demand – demand for domestic product.

Aggregate supply – supply of domestic product.



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Aggregation

But doesn’t it matter what stuff is beingbought and what stuff is being sold?

Isn’t it important if we are selling cars or selling cheese?

Yes and no



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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, andunemployment

2. During economic fluctuations, markets tend to movetogether. When demand in an economy rises,

demand for almost all goods rises



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Some Central Questions of

MacroeconomicsWhy do output and employment sometimes fall, andhow can unemployment be reduced?

What are the sources of price inflation, and how canit be kept under control?

How can a nation increase its rate of economicgrowth?

How can an economy balance all three of the aboveproblems?



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The General Theory of Employment,Interest, and Money - Keynes

1. It is possible for high unemployment andunderutilized capacity to persist in marketeconomies

2. Government fiscal and monetary policiescan affect output and thereby reduceunemployment and shorten economic

downturn (slow or negative economic growth)



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Measuring EconomicSuccessEconomists evaluate the success of aneconomy’s performance by how well itattains these objectives:

High levels and rapid growth of output(usually measured by GDP)

Low levels of unemployment

Price level stability (or low inflation)



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Measuring Economic Success:OutputGross Domestic Product GDP is the sum of the money values of all final goods and

services produced in the domestic economy and sold onorganized markets in a specified period of time, usually a year.

Nominal GDP is calculated by valuing all outputs at currentprices.

Real GDP is calculated by valuing outputs of different years atcommon prices. Therefore, real GDP is a far better measurethan nominal GDP of changes in total production.



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Disadvantage of Nominal GDP: It changes when prices changeeven if there is no change in actual production.

Example: Assume a hamburger cost $1.50 in 2006. In 2007 itcost $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 therewere more hamburgers in 2007, even though there were only100. So nominal GDP makes it look like there is economicgrowth, even when there is not.

Solution: calculate real GDP or GDP in constant dollars.

Measuring Economic Success:Output



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Measuring Economic

Success: OutputShortcomings 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



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Measuring EconomicSuccessEmployment:

-Macroeconomic indicator most felt by

individuals-Unemployment rate tends to reflect thestate of the business cycle:

-Falling output = falling demand for labor

-Rising output = rising demand for labor



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Measuring EconomicSuccessInflation:

When price levels go up, we experience

inflation.

When price levels go down, we experiencedeflation.



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Measuring EconomicSuccessInflation:

An economy strives to keep inflation

steady

Rapid price increases cause problems for companies and individuals



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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%



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Q 0

P r i c e

P 0

D1

A

S

D

D

S

E

Quantity(a)

P r i c e

P 0

S

D

D

S

E

Quantity(a)

D1

Inflation.





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FIGURE 2: An Economy Slippinginto a Recession

D2

B P r i c e

L e v e l

S

D0

D0

S

E

Domestic Product

D2



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Recession and Unemployment ↓AD⇒unemployment Recession = a period of time during which total

output falls and therefore jobs are lost




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FIGURE 3: Economic Growth

Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

D1

C

P r i c e

L e v e l

S 0

D0

D0

S 0

E

Domestic Product

D1

S1

S1

Q 0 Q 1



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Economic Growth Economic growth = ↑GDP ↑AD and/or ↑ AS ⇒ growth




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FIGURE 8: The Effects of aFavorable Supply Shift


Real GDP

P r i c e

L e v e l

D0

D0

S 0

S 0

S 1

S 1

D1

D1

S 2

S 2

C

BE



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FIGURE 7: The Effects of anAdverse Supply Shift(stagflation)


S 1

S 1 D

D

S 0

S 0

P r i c e

L e v e l

Real GDP

A

E



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The government wants to have a stabilizationpolicy that can shorten recessions and fightinflation.

Combating Unemployment When recessions are caused by too low aggregate

demand, governments can try to increase demand.




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FIGURE 9 Stabilization Policy toFight Unemployment


Increase inoutput

P r i c e

L e v e l

Real GDP

S

S D0

D0

E

D1

D1

A



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Combating Inflation When inflation is caused by too high aggregate

demand, governments can try to limit aggregate

demand.




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FIGURE 10: Stabilization Policyto Fight Inflation


Decreasein prices

P r i c e

L e v e l

Real GDP

S

S

D0

D0

E

D2

D2

B



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Real GDP

Q

P

P r i c e

L e v e

l

E

AD

AS

P

Q

Here we see equilibrium inthe market.



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Real GDP

Q

P

P r i c e

L e v e

l

E

E1

AD AD1

AS

P

P1

Q Q1

As America entered the Viet Nam War, defensespending increased

by 55 percent between1965 and 1968.

This increased AggregateDemand, shifting the AD

Curve to the rightWhich resulted in thehigh inflation that thenation experienced

Between 1966-1981



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PDuring the 1970s the industrial worldwas struck by a supply shock.

Crop failures, shifting ocean currents,

massive speculation on worldcommodity markets, turmoil in foreignexchange markets, and a MidEast warthat led to a quadrupling (X4) of oilprices marked what was known asthe “year of seven plagues” in 1973

The result was a rapid increase of thecosts of materials and fuels,which shifted the Aggregate supplycurve inward.

Real GDP

Q

P

E

E1

AD

AS1

AS

P

P1

QQ1





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Real GDP

Q

P

P r i c e

L e v e

l

E

E1 AD

AD1

AS

PP1

QQ1

When President Regan took office in 1981, the economy wasexperiencing severe inflation,near 10 percent, an unacceptablnumber.

The Chairman of the FederalReserve, Paul Volcker,influenced interest rates in theso that spendingwould decrease, and in effect

decrease demand in theeconomy.The result was a decrease inoutput, and an increase inunemployment. The reward

was a decrease in inflation.



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Q

During President Clinton’s firstterm, the national economyimproved remarkably. Businessimproved, unemployment fell

rapidly, and inflation was steadyand low.Economic growth thenaccelerated even more duringhis second term.

Unemployment dropped to 3.9%and inflation dropped below 2%for a brief period

How did this happen?Real GDP

Q

P

P r i c e

L e v e

l

E AD

AS

P

Q Q1

P1

AD1

AS1

Q2

P2



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Real GDP

Q

P

P r i c e

L e v e

l

E AD

AS

P

Q

A combined increase of Aggregate Demand as well asan unexpected huge increasein Aggregate supply provides

An good explanation.

A shift out in AD will increaseoutput as well as prices

But if at the same time AS

shifts out, output can continueto increase while prices do notrise a lot.

Q1

P1

AD1

AS1

Q2

P2



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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 dueto both increases in aggregate supply aswell as aggregate demand.



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Historically, economies do not generallyproduce steady growth without inflation.

Instead, economies are hit with periodic

occurences of unemployment or inflation, andsometimes both.




Thus it has become a goal of economies tominimize the damage done by inflation andunemployment.

These stabilization policies are designed toshorten recessions, reduce unemployment,and stabilize inflation.

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Macro Chapter 4