Vandan Desai

ECON 102—Principles of Macroeconomics

Chapter 5—Macroeconomics: The Big Picture

(Lecture otes)

I. Real GDP over Time

A. Real gross domestic product (real GDP)—a measure of the value of all the goods and
services newly produced in a country during some period of time, adjusted for
changes in prices over time
i. Also called output or production
ii. Most comprehensive measure of how well the economy is doing
B. Economic growth—an upward trend in real GDP, reflecting expansion in the
economy over long period of time
C. Economic fluctuations—short term swings in real GDP that lead to deviations of the
economy from its long-term growth trend (also called business cycles)
D. Economic Growth: The Relentless Uphill Climb
i. Large increase in real GDP means people in U.S. produce a much greater
amount of goods and services each year than they did 35 years ago
1. Leads to improvements in economic well-being of individuals
2. To understand how individuals benefit from increases in real GDP,
a. Average production per person (real GDP per capita) = real
GDP / # of people in economy (increased ~2% each year)
• Total production of all food, clothes, cars, houses,
CDs, concerts, education, computers, etc. per person
• Increase in real GDP per capital improves the
standard of living of individuals
b. Annual economic growth rate—percentage increase in real
GDP each year (for last 35 years, ~3% growth in real GDP)
ii. Over long spans of time, small differences in economic growth, even less than
1 percent per year, can transform societies
E. Economic Fluctuations: Temporary Setbacks and Recoveries
i. Recession—a decline in real GDP that lasts for at least six months (vary in
regularity, duration, and depth)
ii. Peak—the highest point in real GDP before a recession
iii. Trough—the lowest point of real GDP at the end of a recession
iv. Expansion—the period between the trough of a recession and the next peak,
consisting of a general rise in output and employment
v. Recovery—the early part of an economic expansion, immediately after the
trough of the recession
vi. A Recession’s Aftermath
1. Economy usually takes many years to return to normal after recession
2. Thus, a period of bad economic times always follows a recession
while the economy recovers
3. Recession is when real GDP is declining (not down); even when real
GDP starts climb again, bad effects can be present after recession
vii. Recessions versus Depressions (Depressions—recessions that last for a long
time and are deep)—The Great Depression of 1930s

II. Unemployment, Inflation, and Interest Rates

A. Unemployment During Recessions
i. Unemployment rate—the percentage of labor force that is unemployed
1
 Vandan Desai
ECON 102—Principles of Macroeconomics

ii. Labor force—consists of those who are either working or looking for work
iii. Unemployment rates rise during recessions b/c people are laid off and new
jobs are difficult to find
B. Inflation
i. Inflation rate—the percentage increase in the overall price level over a given
period of time, usually one year
ii. Inflation has increased before each recession and then decline during and
immediately after each recession
iii. There are long-term trends in inflation
1. Low point during 1970s to high point in 1980—the Great Inflation
2. Decline in inflation is called disinflation
3. Deflation—when inflation is negative and the average level falls
iv. There is no reason to expect the inflation rate to be zero, even on average
C. Interest Rates
i. Interest rate—the amount received per dollar loaned per year, usually
expressed as a percentage (e.g., 6 percent) of the loan
ii. Different Types of Interest Rates
1. Mortgage interest rate—rates on loans to buy a house
2. Saving deposit interest rate—rates people get on their savings
deposits at banks
3. Treasury bill rate—interest rate the government pays when it borrows
money from people for a year or less
4. Federal funds rate—interest rate banks charge each other on very
short-term loans
iii. When interest rates rise, it becomes more expensive to borrow funds to buy a
house or a car, so many people postpone such purchases
iv. Interest rates rise before each recession then decline during & after recession
v. There are long-term trends in inflation rate
vi. Trends and fluctuations of interest rates are intimately connected with the
trends and fluctuations in inflation and real GDP
1. When inflation rises, people who lend money will be paid back in
funds that are worth less b/c average price of goods ↑ more quickly
2. To compensate for this decline in value of funds, lenders require a
higher interest rate
vii. Real interest rate—the interest rate minus the expected rate of inflation; it
adjusts the nominal interest rate for inflation
viii. Nominal interest rate—the interest rate uncorrected for inflation
ix. To keep the real interest rate from changing by a large amounts as inflation
rises, the nominal interest rate has to increase with inflation

III. Macroeconomic Theory and Policy

A. Two goals of economic policy—raise long-term growth and reduce size of short-term
economic fluctuations
B. Before one can be confident about recommending a policy, one needs a coherent
theory to explain the facts
i. Economic growth theory—explain long-term upward ↑of real GDP over time
ii. Economic fluctuations theory—explain short-term fluctuations in real GDP
iii. Economic growth theory and economic fluctuations theory combine to form
macroeconomic theory, which explains why economy both grows/fluctuates

2
 Vandan Desai
ECON 102—Principles of Macroeconomics

C. The Theory of Long-Term Economic Growth

i. Potential GDP—the economy’s long-term growth trend for real GDP,
determined by the available supply of capital, labor, and technology; real
GDP fluctuates above and below potential GDP
1. #ot the maximum amount of real GDP
2. Sometimes, real GDP goes above potential GDP—more like the
average or normal level of real GDP
ii. Potential GDP of an economy is given by its aggregate supply determined by
labor, capital, and technology
1. Aggregate supply—the total value of all goods and services produced
in the economy by the available supply of capital, labor, and
technology (also called potential GDP)
2. Labor—number of hours people are available to work in producing
goods and services
3. Capital—factories, improvements to cultivated land, machinery and
other tools, equipment, and structures used to produce goods/services
4. Technology—anything that raises the amount of output that can be
produced with a given amount of labor and capital
iii. Real GDP = F(labor, capital, technology)
1. Real GDP is a function of labor, capital, and technology
2. Production function—the relationship that describes output as a
function of labor, capital, and technology
3. A higher long-term economic growth rate for economy requires a
higher growth rate for one or more of these determinants
D. The Role of Government Policy
i. Economic policies that aim to increase long-term economic growth are
sometimes called supply-side policies b/c they concentrate on increasing the
growth of potential GDP, which is the aggregate supply of the economy
ii. Fiscal policy—gov’t policy concerning taxing, spending, and borrowing
1. Affect the incentive to invest in new capital, to hire more people
(labor), and in new technology and thereby stimulate long-term
economic growth
iii. Monetary Policy—government policy concerning the money supply and the
control of inflation
1. Assigned institution—central bank (Federal Reserve System)
2. Low and stable inflation b/c inflation negatively correlated with long-
term economic growth:
a. Inflation raises uncertainty and thereby reduces incentives to
invest in capital or improve technology
b. Lower capital and lower technological growth reduce growth
E. The Theory of Economic Fluctuations
i. Emphasizes fluctuations in demand for good/services as reason for ups/downs
ii. Aggregate demand—the total demand for goods and services by consumers,
businesses, government, and foreigners
1. Increases and decreases in aggregate demand cause changes in real
GDP above and below potential GDP
iii. Real GDP fluctuates around potential GDP; fluctuations in the economy
are not due solely to fluctuations in potential GDP (the economy’s aggregate
supply) b/c most of determinants of potential GDP change rather smoothly

3
 Vandan Desai
ECON 102—Principles of Macroeconomics

F. The Role of Macroeconomic Policy

i. Policies used to influence economic fluctuations are sometimes called
demand-side policies b/c they aim to influence aggregate demand in economy
ii. Fiscal Policy—government purchases and taxes used to influence demand
1. Signs of entering recession—implement tax cuts/spending increases
2. Policies intended to mitigate negative impact on aggregate demand of
other factors, such as fall in consumer or investor confidence
iii. Monetary Policy—changes in interest rates to influence demand
1. Inflation on rise—raise interest rates to slow down spending
2. Federal reserve also concerned with minimizing adverse impact of
recessions—lowers interest rate when about to go in recession