Macro Economics contd.

PROF. RUSHEN CHAHAL

Prof. Rushen Chahal

02/12/12

Macro Economics contd.

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

Prof. Rushen Chahal

02/12/12

Macro vs. Micro

In macroeconomics, we dont care about what is produced

and who gets to consume what. We do care about how much is produced.

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 as a whole.

Prof. Rushen Chahal

02/12/12

Macro vs. Micro

Macroeconomics analyzes the size of the economy (pie), not caring what's inside or how its divided. Microeconomics looks at the ingredients and who gets to eat it, not caring about the size and shape.

Prof. Rushen Chahal

02/12/12

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 that are derived by combining many different markets into one. This process is known as aggregation.

Prof. Rushen Chahal

02/12/12

Aggregation
Aggregate supply curve - shows the quantity of domestic product that is supplied at each possible value of the price level. Aggregate Supply describes how much output businesses would willingly produce and sell given prices, costs, and market conditions

Prof. Rushen Chahal

02/12/12

Aggregation
Aggregate demand curve shows the quantity of domestic product that is supplied at each possible value of the price level. Aggregate Demand consists of the total spending in an economy by households, businesses, governments, and foreigners.

Prof. Rushen Chahal

02/12/12

Warning on AS and AD curves

Domestic product combine all goods and services into one product. AS and AD curves have no individual products. There is only one product, and it represents all products.

Aggregate demand demand for domestic product. Aggregate supply supply of domestic product.

Prof. Rushen Chahal

02/12/12

Aggregation
But doesnt it matter what stuff is being bought and what stuff is being sold? Isnt it important if we are selling cars or selling cheese? Yes and no

Prof. Rushen Chahal

02/12/12

Aggregation
Clearly we care about the makeup of the economy, but: 1. Exactly what the national output is comprised of doesnt really affect issues of growth, inflation, and unemployment 2. During economic fluctuations, markets tend to move together. When demand in an economy rises, demand for almost all goods rises

Prof. Rushen Chahal

02/12/12

Some Central Questions of Macroeconomics

Why do output and employment sometimes fall, and how can unemployment be reduced? What are the sources of price inflation, and how can it be kept under control? How can a nation increase its rate of economic growth? How can an economy balance all three of the above problems?

Prof. Rushen Chahal

02/12/12

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

1. It is possible for high unemployment and underutilized capacity to persist in market economies 2. Government fiscal and monetary policies can affect output and thereby reduce unemployment and shorten economic downturn

Prof. Rushen Chahal

02/12/12

Measuring Economic Success

Economists evaluate the success of an economys performance by how well it attains these objectives: High levels and rapid growth of output (usually measured by GDP) Low levels of unemployment Price level stability (or low inflation)

Prof. Rushen Chahal

02/12/12

Measuring Economic Success: Output

Gross Domestic Product GDP is the sum of the money values of all final goods and services produced in the domestic economy and sold on organized markets in a specified period of time, usually a year.
Nominal GDP is calculated by valuing all outputs at current

prices.

Real GDP is calculated by valuing outputs of different years

at common prices. Therefore, real GDP is a far better measure than nominal GDP of changes in total production.

Prof. Rushen Chahal

02/12/12

Measuring Economic Success: Output

Disadvantage of Nominal GDP: It changes when prices change even if there is no change in actual production. Example: Assume a hamburger cost $1.50 in 2006. In 2007 it cost $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 there were more hamburgers in 2007, even though there were only 100. So nominal GDP makes it look like there is economic growth, even when there is not. Solution: calculate real GDP or GDP in constant dollars.

Prof. Rushen Chahal

02/12/12

Prof. Rushen Chahal

02/12/12

Measuring Economic Success: Output

Shortcomings 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

Prof. Rushen Chahal

02/12/12

Measuring Economic Success

Employment: -Macroeconomic indicator most felt by individuals -Unemployment rate tends to reflect the state of the business cycle:
-Falling output = falling demand for labor -Rising output = rising demand for labor

Prof. Rushen Chahal

02/12/12

Measuring Economic Success

Inflation: When price levels go up, we experience inflation. When price levels go down, we experience deflation.

Prof. Rushen Chahal

02/12/12

Measuring Economic Success

Inflation: An economy strives to keep inflation steady Rapid price increases cause problems for companies and individuals

Prof. Rushen Chahal

02/12/12

Chinas 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%

Prof. Rushen Chahal

02/12/12

Equilibrium Changes in Macroeconomics

D1 D S D A E P0 S

Price

P0

Price

D1 S D S D

Q0 Quantity (a)
Prof. Rushen Chahal

Inflation. 02/12/12

Quantity (a)

Equilibrium Changes in Macroeconomics

Inflation

Major concerns of macroeconomics

Inflation Unemployment Growth

AD price level

Prof. Rushen Chahal

02/12/12

FIGURE 2: An Economy Slipping into a Recession

D0 D2 S

Price Level

E B

D0 S D2 Domestic Product
Prof. Rushen Chahal

02/12/12

Equilibrium Changes in Macroeconomics

Recession and Unemployment

AD unemployment Recession = a period of time during which total output falls and therefore jobs are lost

Prof. Rushen Chahal

02/12/12

FIGURE 3: Economic Growth

D1 S0 S1

D0 C

Price Level

S0 S1 D0 Q0 Q1 Domestic Product
Prof. Rushen Chahal

D1

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

02/12/12

Equilibrium Changes in Macroeconomics

Economic Growth

Economic growth = GDP AD and/or AS growth

Prof. Rushen Chahal

02/12/12

FIGURE 7: The Effects of an Adverse Supply Shift (stagflation)

D S1 S0

Price Level

A E

S1 S0 Real GDP
Prof. Rushen Chahal

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

02/12/12

FIGURE 8: The Effects of a Favorable Supply Shift

D1 S0 S1 D0 C S2

Price Level

D1 S0 S1 S2 Real GDP
Prof. Rushen Chahal
Copyright 2006 South-Western/Thomson Learning. All rights reserved.

D0

02/12/12

The Problem of Macroeconomic Stabilization

The government wants to have a stabilization policy

that can shorten recessions and fight inflation. Combating Unemployment

When recessions are caused by too low aggregate demand, governments can try to increase demand.

Prof. Rushen Chahal

02/12/12

FIGURE 9 Stabilization Policy to Fight Unemployment

D1 S D0 A

Price Level

D1 S D0 Increase in output Real GDP

Prof. Rushen Chahal
Copyright 2006 South-Western/Thomson Learning. All rights reserved.

02/12/12

The Problem of Macroeconomic Stabilization

Combating Inflation

When inflation is caused by too high aggregate demand, governments can try to limit aggregate demand.

Prof. Rushen Chahal

02/12/12

FIGURE 10: Stabilization Policy to Fight Inflation

D0 D2 S

Price Level

E Decrease in prices B

D0 S D2 Real GDP
Prof. Rushen Chahal
Copyright 2006 South-Western/Thomson Learning. All rights reserved.

02/12/12

U.S. Macroeconomic History

P AS

Here we see equilibrium in the market.

Price Level

E AD Q Real GDP Q
02/12/12

Prof. Rushen Chahal

U.S. Macroeconomic History

P1 P

Prof. Rushen Chahal

As America entered the Viet Nam War, defense AS spending increased by 55 percent between 1965 and 1968. This increased Aggregate E1 Demand, shifting the AD E ADCurve to the right 1 AD Which resulted in the high inflation that the Q Q1 Q nation experienced Real GDP Between 1966-1981 02/12/12

Price Level

U.S. Macroeconomic History

AS1 AS

During the 1970s the industrial world was struck by a supply shock.

P1 P

E1 E AD Q1 Q Real GDP

Crop failures, shifting ocean currents massive speculation on world commodity markets, turmoil in foreig exchange markets, and a MidEast wa that led to a quadrupling (X4) of oil prices marked what was known as the year of seven plagues in 1973

The result was a rapid increase of th costs of materials and fuels, which shifted the Aggregate supply Q curve inward.
02/12/12

Prof. Rushen Chahal

U.S. Macroeconomic History

AS1 AS

Price Level

The United States then experienced a period of stagflation, which was indicated by a sharp increase in inflation and a fall in real output.

P1 P

E1 E AD Q1 Q Real GDP

This effect can be illustrated by an inwards shift of the Aggregate Suppl Curve, which increases prices and decreases output

Q
02/12/12

Prof. Rushen Chahal

U.S. Macroeconomic History

P AS

P P1

E E1 AD1 AD

Q1 Q Real GDP
Prof. Rushen Chahal

When President Regan took office in 1981, the economy wa experiencing severe inflation, near 10 percent, an unacceptab number. The Chairman of the Federal Reserve, Paul Volcker, influenced interest rates in the so that spending would decrease, and in effect decrease demand in the economy. The result was a decrease in output, and an increase in Q unemployment. The reward was a decrease in inflation.
02/12/12

Price Level

U.S. Macroeconomic History

Price Level

P1 P2 P

During President Clintons first term, the national economy improved remarkably. Busines AS improved, unemployment fell AS1 rapidly, and inflation was stead and low. Economic growth then accelerated even more during his second term.

E AD Q Q1 Q2 Real GDP

AD1

Unemployment dropped to 3.9% and inflation dropped below 2% for Q a brief period How did this happen?
02/12/12

Prof. Rushen Chahal

U.S. Macroeconomic History

Price Level

A combined increase of Aggregate Demand as well as an unexpected huge increase AS in Aggregate supply provides AS1 An good explanation. A shift out in AD will increase output as well as prices

P1 P2 P

E AD Q Q1 Q2 Real GDP

AD1 But if at the same time AS Q

shifts out, output can continue to increase while prices do no rise a lot.

Prof. Rushen Chahal

02/12/12

U.S. Macroeconomic History

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 due to both increases in aggregate supply as well as aggregate demand.

Prof. Rushen Chahal

02/12/12

U.S. Macroeconomic History

Historically, economies do not generally produce steady growth without inflation. Instead, economies are hit with periodic bouts of unemployment or inflation, and sometimes both.

Prof. Rushen Chahal

02/12/12

U.S. Macroeconomic History

Thus it has become a goal of economies to minimize the damage done by inflation and unemployment. These stabilization policies are designed to shorten recessions, reduce unemployment, and stabilize inflation.

Prof. Rushen Chahal

02/12/12