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C h a p t e r


Key Concepts The most recent recession began in the first quarter of
2001 and ended in the fourth quarter of 2001. This
recession was milder than previous recessions. A depres-
„ Origins and Issues of Macroeconomics∗ sion is a severe recession.
Modern macroeconomics began during the Great De- ♦ Between 1976 and 2006, the growth rate of real
pression, 1929–1939. The Great Depression was a GDP in the United States was about equal to that
decade of high unemployment and stagnant produc- of the rest of the world but was more variable.
tion throughout the world. Macroeconomics initially ♦ Between 1996 and 2006, of the advanced econo-
focused on short-term problems, such as high unem- mies Japan grew the slowest and the newly indus-
ployment. Recently long-term problems, such as eco- trialized nations of Asia grew the fastest.
nomic growth, have come to be considered vital. The Lucas wedge is the accumulated loss of output
that results from a slowdown in the growth rate of real
„ Economic Growth and Fluctuations GDP per person. The productivity growth slowdown
Economic growth is the expansion of the economy’s of the 1970s has created a Lucas wedge of $72 trillion.
production possibilities. It is measured by the increase The Okun gap (the output gap) is the gap between real
in real gross domestic product, also called real GDP. GDP and potential GDP. The recessions since 1973
Real GDP is the value of the total production of all the have created an accumulated Okun gap of $3.3 trillion.
nation’s farms, factories, shops, and offices measured in Economic growth expands future consumption possi-
the prices of a single year. bilities. However, economic growth allows less current
Potential GDP is the quantity of real GDP that is consumption as resources must be devoted to capital
produced when all the economy’s labor, capital, land, accumulation and might lead to more rapid depletion
and entrepreneurial ability are fully employed. of resources and more pollution.
♦ The productivity growth slowdown was the
slowing of the growth rate of output per person that „ Jobs and Unemployment
occurred during the 1970s.
In 2006, 143 million people had jobs. More new jobs
The periodic but irregular up-and-down movement in
are created during expansions and jobs are lost during
production is the business cycle. It occurs as real
GDP fluctuates irregularly around potential GDP. A
business cycle has four parts: A person is unemployed if he or she does not have a job
but is looking for work. The unemployment rate is
♦ Trough — the lower turning point, when a reces-
the number of unemployed workers as a percentage of
sion ends and an expansion begins. all the people who have jobs or are looking for one.
♦ Expansion — a period of time during which real ♦ Unemployment increases during a recession and
GDP increases. decreases during an expansion.
♦ Peak — the upper turning point, when an expan- ♦ The average unemployment rate in the United
sion ends and a recession begins. States is higher than in Japan, but lower than in
♦ Recession — a period during which real GDP Canada and Western Europe.
decreases for at least two successive quarters.

This chapter is Chapter 20 in Economics.
66 CHAPTER 4 (20)

Unemployment is a serious problem because unem- The U.S. international debt is the amount U.S. resi-
ployed workers lose income and can find their future dents owe to foreigners. Current account deficits in-
job prospects limited. crease the U.S. international debt.

„ Inflation and the Dollar „ Macroeconomic Policy Challenges

The price level is the average of the prices people pay and Tools
for all the goods and services they buy. Inflation occurs Five widely agreed upon challenges for macroeconomic
when prices rise. The inflation rate is the annual per- policy are:
centage change in the price level. Deflation occurs ♦ Boost economic growth
when the inflation rate is negative so that the price level
♦ Keep inflation low
falls. In recent years, deflation has been rare in the
United States. ♦ Stabilize the business cycle
Inflation was high in the 1970s and early 1980s, but ♦ Reduce unemployment
has been lower since then, though it has been on an up- ♦ Reduce the government and international deficits
tick since 2002. The U.S. experience with inflation has Achieving these challenges will help the economy.
been similar to that of other industrialized nations. The two general macroeconomic policy tools the gov-
Inflation in developing countries is generally higher ernment has at hand to help attain the policy goals are:
than that in developed countries.
♦ Fiscal policy — setting and changing tax rates and
Inflation reduces the value of money, so unpredictable
the amount of government spending. The federal
inflation makes transactions spread over time more
government can use fiscal policy in efforts to ac-
difficult to carry out. In times of high inflation, people
complish some of the policy challenges.
use resources to predict inflation rather than to produce
goods and services. A hyperinflation is a period when ♦ Monetary policy — changes in the interest rate
the inflation rate exceeds 50 percent per month. At and the amount of money in the economy. Mone-
such rates, inflation causes economic chaos. tary policy is under the control of the Federal Re-
serve, or Fed. The Federal Reserve can use monetary
The exchange rate is the value of the U.S. dollar in
policy to try to meet some of the policy challenges.
terms of other currencies. The exchange rate fluctuates,
sometimes rising in value—appreciating—and some-
times falling in value—depreciating.
Helpful Hints
„ Surpluses, Deficits, and Debts 1. THE MACROECONOMIC CHALLENGES : The
A government budget surplus occurs when the gov- chapter discusses five widely agreed upon macro-
ernment collects more in taxes than it spends; a gov- economic challenges. As you study the forthcoming
ernment budget deficit occurs when the government chapters, keep these challenges in mind because ul-
spends more than it collects in taxes. The U.S. federal timately we return to see what policies, if any, the
government had a surplus between 1998 to 2000 and a government might adopt to help meet these goals.
deficit after 2001. While these challenges are widely agreed upon,
The current account balance equals exports minus there is dispute among economists about ranking
imports plus interest income received from the rest of their importance as well as dispute about the
the world minus interest expense paid to the rest of the proper polices necessary to attain some of them.
world. Payments (for, say, imports) greater than re- The first disagreement matters because at times the
ceipts (from, say, exports) create a current account defi- goals collide, so that achieving one causes setbacks
cit. The United States has had a current account deficit in others. The second area of contention arises even
since 1980. with agreement on the ranking of the goals because
The government debt is the national debt. The na- there is disagreement amongst macroeconomists
tional debt is the total amount the government owes. A about how to meet the macroeconomic challenges
government budget deficit increases the national debt. and that this can lead to different policy advice.

Questions „ Multiple Choice Questions

Origins and Issues of Macroeconomics
„ True/False and Explain 11. During the Great Depression,
a. the major focus of macroeconomics switched to
Origins and Issues of Macroeconomics preventing inflation.
11. Modern macroeconomics was developed during the b. the productivity growth slowdown occurred.
decade of the Great Depression. c. economists switched their focus so that macro-
12. All macroeconomic goals are long-term goals. economics began to emphasize business cycles.
d. long-term economic growth was the major prob-
Economic Growth and Fluctuations lem facing capitalist nations.
13. Real GDP is the amount of goods and services that
are produced in a year when resources are fully em- Economic Growth and Fluctuations
ployed. 12. Real GDP
a. measures only the output of real goods, such as
14. Real GDP per person grew slowly in the 1960s and
machines and food, not “unreal” things such as
quite rapidly in the 1970s.
15. The trough is the lower turning point of the busi- b. includes all the goods and services produced in
ness cycle. the economy, including those produced in the
16. Since 1996, the growth rate of real GDP has been
c. is measured in the prices of a single year in order
lower in Japan than in the United States.
to eliminate the effects of inflation.
Jobs and Unemployment d. is the amount of goods and services that the na-
17. Unemployment rates in recent years have been tion is able to produce when its resources are
lower than those during the Great Depression. fully employed.

18. In the recession phase of a business cycle, the un- 13. Which is the proper order for the business cycle?
employment rate rises. a. Peak, recession, trough, expansion
Inflation and the Dollar b. Peak, trough, expansion, recession
c. Peak, expansion, trough, recession
19. The inflation rate can never be negative.
d. Peak, recession, expansion, trough
10. Inflation in the United States has been similar to
that in other industrialized nations. 14. Real GDP rose in all four quarters of 2003; thus
2003 was definitely a year
Surpluses, Deficits, and Debts
a. of expansion.
11. Ignoring interest income and expense, if U.S. ex- b. with a business cycle peak.
ports exceed U.S. imports, the United States has a c. of recession.
current account deficit. d. with a business cycle trough.
12. A current account deficit definitely harms the na-
15. Which of the following statements about the pro-
ductivity growth slowdown is correct?
Macroeconomic Policy Challenges and Tools a. The productivity growth slowdown was confined
13. The government can use fiscal policy and monetary to the United States.
policy to pursue its macroeconomic goals. b. The productivity growth slowdown occurred in
the 1960s.
14. Fiscal policy includes government engineered c. The growth of potential GDP slowed during the
changes in the interest rate. productivity growth slowdown.
d. Extremely low oil prices were a major cause of
the productivity growth slowdown.
68 CHAPTER 4 (20)

16. Since 1976, compared to the rest of the world, real Inflation and the Dollar
GDP growth in the United States was ____ variable 12. In the United States, the average inflation rate was
than in the rest of the world and was ____ the world highest over the decade of the
growth rate. a. 1960s.
a. more; greater than b. 1970s.
b. less; equal to c. 1990s.
c. more; slightly less than d. 2000s.
d. less; equal to
13. Which of the following is a cost of unpredictable
17. The accumulated loss of output that results from a inflation?
slowdown in the growth rate of real GDP per person a. People use resources to predict inflation rather
is called the ____ than to produce output.
a. Lucas wedge. b. It becomes too easy to obtain loans.
b. Okun gap. c. Deflation becomes an increasing problem.
c. output gap. d. All of the above are costs of unpredictable
d. growth gap. inflation.
18. Which of the following is NOT a cost of more rapid Surpluses, Deficits, and Debts
economic growth?
14. Which of the following statements about the gov-
a. Current consumption must be foregone in order ernment budget is correct?
to develop new technology or new capital.
a. Whenever tax revenues exceed government
b. Environmental damage may increase because of
spending, the government has a budget deficit,
economic growth.
b. As a fraction of GDP, the budget deficit has in-
c. Consumption possibilities expand in the future
creased steadily since 1980.
because of economic growth.
c. The government has had a budget deficit every
d. The Lucas wedge increases in size.
year since 1970.
Jobs and Unemployment d. None of the above are correct.
19. In 2006, ____ people had jobs in the United States. 15. Since 1980, the U.S. current account has had
a. 1,000,000 a. a deficit that has been large at times and small at
b. 143,000,000 other times.
c. 85,000,000 b. a surplus that has been consistently large.
d. 180,000,000 c. a deficit that has gotten consistently larger.
d. alternating small surpluses and deficits.
10. The unemployment rate generally rises during ____
in the business cycle. Macroeconomic Policy Challenges and Tools
a. a peak 16. Which of the following is NOT a policy challenge?
b. a recession
a. Boosting long-term growth.
c. a trough
b. Lowering unemployment.
d. an expansion
c. Stabilizing the business cycle.
11. Comparing the United States, Western Europe, and d. Raising the government budget deficit.
Japan, in recent years the unemployment rate has
17. Which of the following is an example of monetary
been highest in
a. the United States.
a. Changing the interest rate.
b. Western Europe.
b. Changing government spending.
c. Japan.
c. Changing tax rates.
d. the United States and Japan.
d. Changing the government’s deficit.

„ Short Answer Problems 4. What happens to real GDP and the unemployment
rate during each of the four phases of the business
1. What was the productivity growth slowdown? Why cycle?
is it important?
5. What are the costs of unemployment?
2. Suppose that real GDP per person in the United
6. How has inflation in the United States compared
States in 2007 is $30,000.
to inflation in other countries?
a. If the U.S. real GDP per person grows at 2 per-
cent per year, what is real GDP per person in
2008? In 2009? In 2012? In 2017? „ You’re the Teacher
b. If the U.S. real GDP per person grows at 3 per- 1. After class, your friend asks you: “You know, I
cent per year, what is real GDP per person in wonder what’s more important: stabilizing the
2008? In 2009? In 2012? In 2017? business cycle or boosting long-term economic
c. In 2017 what is the difference in real GDP per growth. Both seem important, and it would be cool
person if the growth rate is 3 percent per year if we could achieve both of these goals, but do you
versus 2 percent? What does this result illus- think one is more important than the other? You
trate? know, what I mean is that if we can actually
3. Between 1996 and 2006, how has the growth rate achieve only one of these goals, which one do you
of real GDP in the United States compared to that think it ought to be?” Your friend has posed a very
in Japan? To that of the European Union? To that thoughtful question; what is your equally thought-
of the newly industrialized nations of Asia? ful response?