Ch 4: What Macroeconomics Tries to Explain

1. Ch 4:What Macroeconomics Tries to Explain • Microeconomic deals with behavior of individual decision makers and individual markets • Macroeconomic deals with broad outlines of the economy • Which view is better? • Depends on what we’re trying to do

2. Macroeconomic Goals • Economists—and society at large—agree on three important macroeconomic goals • Economic growth • Full employment • Stable prices • Why is there such universal agreement on these three goals? • Because achieving them gives us opportunity to make all of our citizens better off • There are some disagreement among economists about how to make the macro-economy perform well

3. Economic Growth • - the increase in our production of goods and services that occurs over long period of time. - in most developed economies, the annual output of goods and services has risen over time and risen faster than population (therefore…?????) • Economists monitor economic growth • By keeping track of real gross domestic product (real GDP) - The total quantity of goods and services produced in a country over a year • Real GDP has actually increased faster than the population • During this period (1929 to 2004), while U.S. population did not quite triple • Quantity of goods and services produced each year has increased more than tenfold

4. Economic Growth • Part of the reason for the rise in real GDP is an increase in population(why?)… therefore.. • Although output has grown, rate of growth has varied over the decades • Over long periods of time small differences in growth rates can cause huge differences in living standards • Economists and government officials are very concerned when economic growth slows down- growth increases the size of the economic pie (for every citizen to have a larger slice?) - growth doesn’t benefit everyone. example?) - some people believe that in the long run everyone will benefit from growth - others see role for the government (in ?) • Macroeconomics helps us understand a number of issues surrounding economic growth.

5. Real GDP (Billions of1998 dollars) 9000 8000 7000 6000 5000 4000 3000 2000 1000 1930 1940 1950 1960 1970 1990 2000 2002 Figure 1: U.S. Real Gross Domestic Product, 1929-2002

6. High Employment (or Low Unemployment) • Unemployment affects distribution of economic well being among our citizens • People who cannot find jobs suffer a loss of income • Joblessness affects all of us—even those who have jobs - A high unemployment rate means economy is not achieving its full economic potential • Average standard of living falls

7. High Employment (or Low Unemployment) • Unemployment rate • Percentage of the workforce that would like to work, but cannot find jobs (unemployment rate is never zero, even though the economy is doing well) • Used to keep track of employment • The nation’s commitment to high employment has twice been written into law • With memory of Great Depression still fresh, Congress passed Employment Act of 1946 • Required federal government to “promote maximum employment, production, and purchasing power” • A numerical target was added in 1978, when Congress passed Full Employment and Balanced Growth Act • Called for an unemployment rate of 4%

8. In the 1990s, we came closer and closer and finally—in December 1999—we reached the target again for the first time since the 1960s • In 2001 unemployment rate began to creep up again, and fluctuated between 5.2 and 6.3 percent though the first half of 2005 • All these facts are critically examined under the subject Macroeconomics.

9. 25 Unemployment Rate (Percent) 20 15 10 5 0 3 1920 1930 1940 1950 1960 1970 1980 1990 2000 200 Figure 2: U.S. Unemployment Rate, 1920-2003

10. Employment and the Business Cycle • When firms produce more output, they hire more workers—when they produce less output, they tend to lay off workers • We would thus expect real GDP and employment to be closely related, and indeed they are • Business cycles • Periodic fluctuations in GDP around its long-term growth trend- the bumps in the figure • Expansion • A period of increasing real GDP • Contraction • A period of declining real GDP

11. Employment and the Business Cycle • Recession • A contraction of significant depth, breadth and duration • Depression • An unusually severe recession • In the twentieth century, United States experienced one decline in output serious enough to be considered a depression—the worldwide Great Depression of the 1930s • From 1929 to 1933, the first four years of Great Depression, U.S. output dropped by more than 25%

12. Real Long-run upward trend of real GDP GDP The business cycle fluctuation of actual output around its long-run trend. Expansion Recession Expansion Time Figure 3: The Business Cycle

13. Stable Prices • With very few exceptions, inflation rate has been positive • During 1990s, inflation rate averaged less than 3% per year • During the 2000s (through June 2005) inflation rate averaged about 2.5% • Other countries have not been so lucky • An extreme case was the new nation of Serbia—prices rose by 1,880% in August 1993 • Why are stable prices—a low inflation rate—an important macroeconomic goal? • Because inflation is costly to society • With annual inflation rates in the thousands of percent, the costs are easy to see • Purchasing power of currency declines so rapidly that people are no longer willing to hold it

14. Economists regard some inflation as good • Price stabilization requires not only preventing inflation rate from rising too high • But also preventing it from falling too low, where it would be dangerously close to turning negative

15. 15 10 5 Inflation Rate (Percent) 0 1930 1940 1950 1960 1970 1980 1990 2000 2003 -5 -10 Figure 4: U.S. Annual Inflation Rate, 1922-2003

16. The Macroeconomic Approach • In macroeconomics, we want to understand how the entire economy behaves • Thus, we apply the steps to all markets simultaneously • How can we possibly hope to deal with all these markets at the same time? • The answer is aggregation—process of combining different things into a single category and treating them as a whole

17. Aggregation in Macroeconomics • Aggregation plays a key role in both micro- and macro-economics • In macroeconomics, we take aggregation to the extreme • Because we want to consider the entire economy at once, and yet keep our model as simple as possible • Must aggregate all markets into broadest possible categories • By aggregating in this way, can create workable and reasonably accurate models that teach us a great deal about how overall economy operates

18. Macroeconomic Controversies • Macroeconomics is full of disputes and disagreements • Modern macroeconomics began with publication of The General Theory of Employment, Interest, and Money by British economist John Maynard Keynes in 1936 • Keynes was taking on conventional wisdom of his time • Which held that the macroeconomy worked very well on its own, and the best policy for the government to follow was laissez faire – ‘leave it alone’. • This new school of thought held that the economy does not do well on its own and needed guidance from an activists and well-intentioned government.

19. Macroeconomic Controversies • While some of the early disagreements have been resolved, others have arisen to take their place • For example—the controversy over the Bush administration’s $330-billion ten-year tax cut • Because of such political battles, people who follow the news often think that there is little agreement among economists about how the macroeconomy works • In fact, the profession has come to a consensus on many basic principles, and we will stress these as we go