PART

:
:.

i
:

TW^

macroeconomrcs:
Econorrric Growth
and Business
Cycles

Overview of Macroeconomics

'l'hc

uhole purpose o.f tlte u onont\ i.s ltntrluctnn of {txtrl: or

strt,ires.lbt con.suntptiort nlnu or in lltc.fitlurr. I Iltith llp l urdut
rtf ltrool'shoul.rl ahuals

ln

on. l.lusc

uln uoulrl produre lc.s.s rather

lltutt norc, tt llu.s'ulut zt,tnli leaue idle leopk or ntaclti.nes or

nd thlt roukl lc uscd. ll i.s rtnazi.n hol me.n\ t't-tot.s t ut be
Iounrl to.jtrslifl surlt ua,;lc: ./i'ur ttl inJlr iort, lnlane-of-lxqnenls
drli.tit..t, n.lnla tt:,i bulgt,ts, txt:e.ssiue nttional deltt, lo.ss of
con.fidenrc in the fullrn:
lu

.llrrn t s

Iirbirt.

lIlul

.\'tlion ttl l.t tntntit

-{rt' jolrs rlcrttifrrl or lrirrrl tr lirlrli ..\lt' rel tr:rgt's

lrrrtl lirirrg stanrlirrrls Qlrrving larirllr, ()r illc (()r)surn(r\ strrrggling lr ur:rkc crtrls nrt'<'t :rs -llirt'
irrfllrlion rcrlrrttt lr';rl u;rgcs? Is tllt't' ir terio<l of
f inrurt irrl trrbt'l:lnr t' rlitlr slot k
rrict's r-isirre llrrirtlvi () is tlrt tt'ntr;rl lr:rnk rrsnlg n)()r)etar\ l)()li(\
t() f ielll (,ll tlrt'r'l1t' ts rl flllinq lrorrsirrg pli<r's:rrr<l
rr Iin:urr i;rl r risisr \\'lriLl arc thc irnncts ol glolrrrli:rtion lurrl Iirlt'lgn tr':rrlc oll clollltsli< t'rrrrlot'rrrt rrt
:trtrl oulrrrl: Tltt'st' rlttestions ;tlt ttnUltl lo nrir(ro(r'ononrirs. rrlticlr is the strbjt'ct tl tlrt' Iillrrrrinu
( lr:r t ( r \
l)
Macrocconomics is tlre strrrlr r rl t lrt lrt'llirr i, ,r r l
Ilrt ccorrorrry:rs a ulrolt'. ll cranlint's tllt' firrlts tlr:rl
allcct lir-nrs, c()llsul)tcls, alltl lrrkt'r's irr tlrt' lrgtrr'gal(' Il ( ()lltrasts rr'itlt microeconomics. \'llit lr stLrrlics
ilrrlivirlrral prices, ruarttitit s, anrl lnlu kt'ts

.l\ro

rtrrtr;rl tlrt urts rrill rrrrr lllrorrqlt ()lu

of llItt rot

sur'\'('\

t or rorr rir s:

o l'ltt'

sllor L-(t r l l]rrr uirti()lrs in r)llll)lt, t'nttlornlcnt. Iinlrnr r:rl t , t I i t ir rr s . ;rrrrl rliccs tltal rrt
t ltll tlr< /,1rllri,' 111,'
a '[ ]rt lrng<'r.t< rnr lr(n(l\ irr(,utl)ul ;rrrrl lirinustlrr
,r

rflttls kttrrrrlt lt,, rrtnotttit lttnt'llt

I It, rIr'r, |,rrrrr| |r| ,,1 nl;r( r{,(' 'n'tt)ir s \\lr\ ,rl|l
ttl lltt trlrjor t k t l r , g t s ()f t\\ ('ll ti( tll ( ('lr lln \
('(
lo
it .'. ll arlinq t';r n rch lrt'tlt'r rrrlrl<'r'st:rnrl
ittg ol lrou lo t orulr:rt r< r'iorlic t't rrnrllir clist's ltntl
Irolv to stiurrrlrtt lont-tcr-rr ct-orrnrit grrrltlr Irr
lr

lrr

lr

r('sl)olrs( tr thc ( ir t':rt l)t'rlt'ssiorr. .folttt \l:tr rr:tr rl

Ktrrrt s rltvclol-lerl llis rtrtlrttion;ur tltt otr'. trlrit lt
lrclrt'rl cxll;tin tllt' lrr cs tt-<,rlttcittr.l ('( ()1lonr(
II t c t
I r l t s .utd sttgqt'st t rl Il()\\ go\'( tlnn('llts ( iut
r

r rir

66

CHAPTER

control thc worst excesses of the business cycle.

A[ thc salne time, economists have endeirvrred to
rrndcrstarrd the mechanics of long-term econonric
glowtll.
Macrteconomic issues dominated the [].S.
political and economic agenda for much of tl.rc
last centrrrv. In the 1930s, rvhen production,
errrplovrnent, and prices collapsed in the Llnitcd
States ancl across much of the industrial rvolkl,
cconornists and political leaders \4restled with
thc calanrity of the Gre:rt Depression. f)urirrg tlrc
Vietnanr \.t'ar in the 1960s and rhe energv criscs
of the 1970s, the burning isstre was "stagflation,"
a c<mbination of sl<w gror4'th and rising pr ices.
The I990s witnessed a period of rapid growth,
falling unemployment, and stable priccs-years
rvhen everything went right, labelecl by sornc as
"the fabulous decade." Then asse t-market bubbles
burst twice in the first decade of thc 2000s. The
first shock was a sharp declinc in thc prices of
technology stocks in 2000, anrl this was lbllowed
b,v a sharp decline in housing prices after 2007.
'I'ltc 2007-2009 housing-price decline producccl a
plofirtrnd financial crisis and led ro a dcep arrcl
lorrg reccssion.
Sonetimes, macroeconomic failurcs laisc lifiand<leatlr questions for countries and even tor idcologics. T'he communist leaders of the fonner Sovict
Llrrion proclainred that they rvould overtake tlre \{'cst

ecollornicallv. History proved at to be a hollow

prornisc, as Rtrssia, a country teeming with natural
lcs{rurccs and nriliulry rnight, was unable to producc
aclc<rratc lutter fbr its citizens along u.ith tlre grrns

for its irnpcrial armies. Eventuall macroecononric

failures brought dourr the communist regimcs of thc
Sovict Union and Eastern Errrope and convinccd
pcoplc of the economic superiority of privatc rrrar
kcts as the best approach to encouragir.rg rapid cc<r
nornic growth.
'l'his chapter will sene as an introduction
to tnacroeconorrrics. It presenS the major concepts ancl
shows horv they appl,v to ke1, historical and policy
qrestons of r-ecent years. But this introclrrction is
only a [irst coul.sc to whet the appetite. Not ulttil vor
have nrastcl'cd all the chapters in Parls Five through
Seven can you fully enjoy the rich macroeconontic
banquel that has been a source of both inspiration
lbl ccorrcnric policy and continued corltrovcrsy
arnollg tllacloeconomrs$.

OVERVIIJ,W

OI' MACROECONOMICS

A. KEY CONGEPTS OF
1{ACROEGONOMICS
THE BIRTH OF I'IACROECONOMICS
'l'he 1930s marked the first srirrings of the scicnce
of rnacroeconomics, founded by John Maynard
Kcyncs as he tried to understancl the econornic
rnecharism that produced the Great f)eprcssion,
Alier World \4ar II, reflecring both the increaslng
influence ofKeynesian views and the Fear of atother
depression, the U.S. Congress formally proclaimed
f-ederal responsibility for macroeconolnic perfbrmance.

[t enacted rhe landrark Ernployrnent Act

of I946, which stated:

The Congress hereby declares at it s thc conrinuing
policy and responsibility of tlrc federal government
to use all pracricable means consistent with ia needs
and oblig'ations . . . to promorc maximum emplolment,
pro(lucl i()r, ancl purchasing power.

Ftr the first time, Congress affirmed rhc govenrrnent's role in promoting output growth, fcrstering
emplovrnent, and maintaining price srability. The
Enrplclyrnent Act usefully frames the thrcc central
q ucstions of macroeconomics:
|

Why

luztt

oupul and emplolment sometimts fall, and

unemployrnent be reduced? All market

un

of expansion and
cotrtraction known as business 4c1r.s. The latcst
business-cycle recession in the United Statcs
occurred after a severe financial-market crisis
that began in 2007. Housing and stock prices
Icll sharply, and banks tighrened credit ard
lending. As a result, outpur and employment
lcll sharpll'. Political leaders around the world
used the tools of monetary and fiscal policy to
rcduce unemployment and stimulate economic
ccorrorrries show patterns

actlvlty.
From time to time countries experience high
rrncnrployrnent that persiss for long periods,
sornctirnes as long as a decade. Such a periocl
occtrr-red in the United States during the Great

Dcpression, which began in I 929. In thc follorving years, unemplol'rnent rosc to almost
onc-quarter of the ''orkforce, while industrial
prodnction fell by one-half. One of thc dcepcst

THF, BIRTH OF

Nf

li 8lEl.l0It[A lJ[Aitl

A(]RO[,(:ONOI\I I(:S

an(l nlost prolonged econottlic dr'wlrtttrtrs of the

nr<tlcrn cra cau)c in.faparr, rvhich experienced

declinirrg pr-iccs arrd rvas rurable to shake off

high trncrn plol'lrlc tl t atrd slou ecotrotrlic groutl.t
aftel I 990.
Nlrcr<cctnotttics strdics thc sottt-ces of pet'sistent ttnerrt plovrtrctl t alrd high irrflation. Hal'
itrg consitlcretl tltc s IItrtorrrs, ltlacl x'colt lttists
srrggest possible rcltctlics, sttch as ttsitrg InoIrctarl policv to alter intet est ratcs rr(l clctlit conditions <lr rtsitrg fiscal ittstrltttrcttLs sttclt as taxcs
:rnd spending. The lives and fi)rtrtncs of nrillions
of people depend ttporr rvhethe r ecottolttists Iirtcl
colrt-ct cli:rgnoses frlr nrajor Inncroeconotnic ril-

nlcrrts-and rrporr niether g()vernntenls aPPlv

2,

thc riglrt rnedicinc at the rif{ht time.

l{lut.l urc lh.c stntn u o[ pnce infkion. and lunu an
it ln kfltt. untltt t otlnl? A urarket econonly ttses
-lriccs as a lardstick to meastlr? econotnic valttes
antl conrhrct brtsitress. \tlrt'n prices at'c t-isinga plrcrronrenon rve c:rll in.flnlion-the price
yarrlstick loscs its valrre. l)rrring periods of high
inflatior, pcorlc rnay ger <rrtrfitsed ilbotlt relative prices an<l rnakc nistakes in their spelldittg
arrd int'esLtncrtt tlccisiotts.'lirx btrr-dens tl.:tv ristl.
Il<>rrseholcls olr lircrl irtctrncs fiIrd that irflrtion
is eating awav at thcil rt'al incorlres.
Ilf acroe

corrorrric rolicv lr:rs

irrcre:rsingl,v

emphasirc(l lorv artd staltlc irrflatiolr as a key goirl.

Nlanv cotultries sct "inflatiolt targcts" frrr their
econonlic policv, witlt targcts ofictl bcirrg irl the
range fl'()rn I to 3 pcl cc t l)cr vcar. Except fbr
brief spikes, tlre Unitctl Statcs has srtccecded in

conuinittf inflatiolr ovcr tltc last tw-r decades,

th an average inflation latc ol 3 Pcrccrlt Per
l'ear for the cons(tl cr pricc ilrtlcx. ^\{all,v corttr-

rvi

tries have not bccn so sttcccsslitl. l'orInt-r-lv socialist corurtries like Rttssia antl ttatrt l-atirr .'\nrcrican
and developirrg cotttrtrics cxrt:t ictrced il.rflation
rates of 50, 100, ol 1000 pcrcctrt pcr vear in the
last two decatles. 'l'he illlationarl rccord itr the
last ferv ]e rs wirs itt Lrotrblctl Z,irlrbabrve, whet'e

inflation was arorttrtl 20,(X)0,000 P('rcent Per

ye ar in 200t]. A chicke lr lhat cost l0 tl.rorrsarrd
Zirnbabn'e:ul tlollars at thc bcginning of the year
rvould cost l0 trillitn Zirulalvcatr dollars at the
end! \lh1- l'u the Unitctl Statcs ablc to colrtaitr
the inflatiorrarl' tiger, n'hilc Zirnbabwc Ihiled to
do so? \{acroeconotllics catr stlggcst tllc proPet'

67

role ol nronetary and liscal policics, of cxchangerate systems, irtrd rl at ilttle pcrrclcnt cclllral ballk
in containing inf latiorr.
3. I lou run a nalion intreas its rale oJ cronomit grouth?

The single most important goal ol lllacl occ(F

n<lnlics concerns a nation's lolrg-tcrnr cc<ltlottlic
growth. This refers to the growth in thc pe r capita
()utput of a country. Strch grorvth is tlte ccllral

f:rctor ir.r determining the grorvth in real rvages

arrd livirrg standards. IVfost countries of N<rth

r\nrerica and \4'estern Europe have enjo)'ed

rapid economic grorvth for tu'o centuries, and
rcsidents in these countries have high average
incorrrt-s. Ovcr thc last five decades, ,lLsian countrics srrch as Japan, Sotrth Korea, and Tairvan
plodrrct'rl clramatic girins in living sundarcls for
thcir qrcoplcs. China's growth has similarl;- been
outsl.an(lir'rg in rccent years. A ferv countries,
particrrlally thosc o[ stttrSaharan Africa, have
srrfll'rcrl dcclirrirrg per capit:r output and living
sta rrrlar-rls.

Nations want to know the ingredienrs in a

srrcccssfirl gr-owth lccirc. F.conotnic historians
have firrnd that tllc kc,v factors itr long-term economic growth includc cliarlcc otr rvcll-regrtlated
prir':rte mirrkets fbr ll0st ccoDot ic acti\iry, stable
nl:.rcroecortotlic policv, higlr latcs o[ sang and
investmcnt. oPcnncss to il) terllatiol.lal tracle,

nrtd accotuttable arrtl r)oncorrrrpt

governirrg

institutions.

All econornies face inevitablc tradcoffs among these

g<l:rls. Increiusing thc ratc ol growtlr o[ outptlt or,'er
the long nrn rnav reqttire grcatcl itrvcstment in edtlc:rtion and capital, but higher invcstrncnt l'equiles
lower crrrrent consttmption <f itents likc fbod, clothing, and recreation. Adclitionall,v, policYtnakers are
sornetimes forced t< rein iIt thc ccollornv throrrgh
macroeconomic policies whclt it glorvs too fast in
order to prevent rising irrflation or when financial
conditions exhibit irratitnal cxttbct atrce.
There are no Inirgic fbrtrltrlas fbr cnsrrring lou'
ard strble inflation, high crnployrnent, and rapid
growth. \{acr<.ecorttrnisls havc vigor-orts debates
about both the goals autl tllc appropriate policies for reaching tlre goals. Btrt sotlttd nlacroecorrornic policies lre essential if a cottntry rvishes to
achieve its economic objectives itr tltc mosf effective

rnn

ner.

CHAPTER

()\'ERvtE!\' OF VA(:R( ) ti(:ONOIU I (;S

Objectives

The Patron Saint of Macroeconomics

Ever), dscusson

of

macroeconomic policy

must begin withJohn Maynard Keynes. Keynes

(1883-194) was a many-sided genius who

won eminence in the fields of maemacs, philosoptry, and

litenture.In addition, he found time to run a large insurance
ompany, advise the Brish treasury help govem the Bank
of England, edit a world-hmous economics joumal, collect
modern art and rre books, sart a repenory theaten and
marry a leading Russian ballerina. He was also an investor
who knew how to make money by shrewd speculation, both
for himself and for his college, King's College, Cambridge.
His principal contrbuton, howeven was his invenrion
of a new way of looking at macroeconomcs and macroeconomc policy. Before Keynes, most economists and policymakers accepted the highs and lows of business cycles as
being as inevitable as the tides.These long-held views left

them helpless in the fuce of rhe Great Depression of the

1930s. But Keynes took an enormous intellectual leap in

his f936 book, The GenerolTheory of Employment lnterest

ond Money. He made a twofold argumenc First, he argued

at it

s possible for high unemployment and underutilized capacity to persst in market economies. In addton.
he argued that toyernment fiscal and monetary polices
can affect output and thereby reduce unemployment and
shorten economic downturns.
These proposions had an explosive impact when
Keynes first introduced them, engendering much controveny and dispute. In the years after World War ll, Keynesan economcs came to dominate macroeconomics and
government policy. Since then, new developments incorporatn8 suppll hctors, expecbtions, and alternative views
of wage and price dynamics have undermined the earlier
Keynesian consensus. Whle few economists now believe
that government action can eliminate business cycles. as
Keynesian economcs once seemed to promise, neither
economics nor economc policy has been the same since

Keynes! great discovery.

oBJECTTYES AND TNSTRUMENTS

OF MACROECONOMICS
Having sun,eved the principal issrres of nlacr()ccLF
nonlics, wc now turn to a discrnsiolr of thc nrajor.
goals anrl instruments of macroeconornic policr'.
Horv do ccolornists cvaluate the success of an ec()nomy's ovelall rcrfbrrnance? lttrat are the tools tlrat

Output:
High level and rapid gro*'th of output
Ernployment

tligh level of employment with low involuntary

unemployment
Srable prices

lntruments
Monetary pogn
Bulng and sellilrg bonds, regulating financial
instituti<ns
Frscal

poliq+

Government expenditures
Taxadon

TAALE 4- | , Goals and Instruments of Macroeconomic

Policy
I lre top ralt <l thc talrk' rlisrlavs thc maior goirls of mactoecororrir' rolit v. Tlrt. los'cr half shows the majo[ instrunlcnl-\ ()r xlli< r' rneasttres uvailable tc modern ecrltonies,
Polir r rrrakt.rs change thc itstrumenLs of' policv to allect
tltt'race lnd dirt'ction ()l ec(,trurnic rctivil\,

govcrlrnrcnts

crn use to

pursue their economic goals?

'Iablc 4-l lisrs thc major objectives and ir.lsrnrncnts

of rnacroeccrronric poliq.

Meosuring Economic Succes

'l'hc rnajor rnacroeconomic goals are a high level ancl
lapid gnlrvtlr <-rf outptrt, low trnemployment, alrd stablc
pliccs. \1t, will trse this section both fo defir.e the rnajor'

rnacroeconomic tenns and

to

discrrss

thcir

intoor'-

tance. A rrrore detailed treatmerrt of rhe data ,-rf lnacro

ccononrics is p<-rstponed to the text chapfer. Sornc kcy
data ale provided in the appendix ro this chaptcr.

Output The ultimate objecrive of econonic activi[,

prolide the goods and sen'iccs rhar rhc population desires. What corld be morc rnportant fbr an
econornv than to prodrce ample sheltcr, lbod, cducation, and recreation for it.s people?
'fhc lrrost comprehensive measrlre of thc total
output in an economy is the gross domestic product
((;t)P). GDP is tle rneasure of the marketvalue of all
is to

69

oBJECTVES AND INSTRUMENTS OF MACROECONOMIGS

c(g
o

8to
.

o
e
o
o-_

;5

o
o

9s
.

E-5

Ef
c

1930 1940 1950

1980 1900

1960

2000

Yar

FIGURE

{.l.

Growrh Rte of US. Real Gros Domestic Product, f 929-200E

Real GDP is the most comprehensive measure of an economy's output. This gure shows
the rate of gr',owth from one year to the nexL Note the suing of negative growth rates in the
Great fl'epression of e 1930s. AIrc, we see the Great Moderaon of the last few years, in

which output was less rolatile than in earlier periods.

So!ae: U,S. Brsu of

E o$omic Anallss

at eltu'goe- Shedcd fgionr are major economic

final goods and services--beer, cars, rock concerts,

donkey rides, and so onToduced in a country
during a year, There are two ways to measure GDP.
Nonial GDP is measured in actual marhet Prices.
Rcal GDP is calculated in constant or inrariant prices
(where we meuure e number of cas times the
prices of cars in a given year such as 2000).
Real GDP is the most closely watched measure
of outpuq it serves as e carefully monitored pulse
of a nation's economy. Figure 4-l showt the growth
rate of real GDP in the United States since 1929. The
growth rate is defined as
% growth rate of real GDP in year f
_ GDP, - GDP-r

=rooxff

For example, real GDP in 2)6 was $11,294.8 billion and in 2007 was Sl l,523.9 billion (both in

domtums.

2000 prices). A calculator will ehow that the growth

of real GDP in 2ffi7 was 2.0 percent over the year.
It is worthwhile making sure you can replicate this
calculation. Note e sharp economic decline during
the Great Depression of the 1950s, the boom during
World War II, and e recessions in 1974, f 982, l99l,
and 2008.
Despite the short-term fluctuations seen in brsi.
ness cycles, advnced economies generally exhibit a
steady long-te rm growth in real GDP and an improvement in living standards; this process is known as
eamonic grwth. The American economy has proved
itself a powerful engine of progress over a period
of more than a century as shown by e growth in

potential output.

Potential GDP represene the maximum srs.

tainable level of output that the economy can
produce. When an economy is operating at its

70

CHAPTER

Actual

GDP

OVERVIEW OF MACROECONOMICS

Potentiat GDP

5,000

4,000

1l

3,000

(!

2,000
-o

,500

,000

(E

1930

1940

1950

1960

1970

1980

1990 2oOO

2o1o

Year

FIGURE 4-2. Actual and Potential GDP in rhe Unired Srates

Business cycles occrrr when actual out[)ut rlt'rarts frorn its potential. The smooth blue line
potential or ten(l ()rrrpur ()tct rhe pcriod 1929-2008. Potential outpur has lfnr$n
about 3.4 rcrlcnt anrruallv. Note the large gap bem'een actral and lxrl<:nrial oLrrpur during
shows

thc (lrt'at Dcprcssion

ofthe

1930s.

S,rrt(e: U S lJtll(atl (tl l:cotx)tn( i\tr )sis, (irrgftrsion.rl llrrrlget Oflicc,lrrr-l auth(rs'csnrarcs. Norc rltat achtal
( iDP is drrtrtlr srit'rt( (l Ii tn'r rtxk rlling drla thilc
x)telrial {)urprt is an analvr.:rl (un(cpr rlcr ivc(l f)nr ircrual
(;DP n(l rncDrol{^rrcl|t rl.rr.

porential, thcrc arc high levels of utilization of the

labor force arrd thc capital stock. \4/hen output rises
above potcntial otrtpr-rt, price infladon tends ro rise,
rr4rilc a bclow-potential level of output leads to high
urlemployrnent.
Potcntial output is detemined by e econonry's
prodrrctivc capacitl', which depends upon rhe inpuls
alailable (capital, labo land, etc.) and the economy's
techrrological clticiency. Potenrial GDP tends ro grow
steadily bccarse inpua like labor and capiral and thc
level o[ tcchntlogv change quite slowly ovel. rime. By
contra-st, actual GDP is subject to large busirress-cyclc
swings iI spclcling patterns change sharpl,v.

During busirrcss downturns, actual GDP

belorv its potentia.l, and unemplolment rises.

falls

In 1982,
for examplc, thc U.S. economv produced about

$400 billion less than its potential ourpur. This rep

rescntccl $5000 lost per family during a single vear. A
reession is a period of significant decline in rotal output, income, and emplolmenr, usually lasting nrore
than a f'ew months and marked by widespread contmctions in many sectors of the economy. A sevcrc
and pr'<rtracted downturn is called a d4rcssinn. Output can be ternporarily above its porenrial during
boor'rs and wartime as capacity limirs are strainecl,
but the high utilizaon rares may bring rising inflation and are usuallv brought to an end by mone tarl
or liscal policy.
Figure 4-2 shor,rs the esrimared potential and
actual output lbr the period 1929-2008. Note how
largc thc gap between actual and potenrial ortput
was during thc Great Depression ofrhe l930s.

oBJE(:TIVI:S,\NI) |\S',l RL

\.1

l':N l s

7a

)lj \l {(lR()!.(.()\( )\l I(.s

(D

:o
q

-()

t5

(o

ln

()

E.

1930

1940

19s0

1960

1980

1970

1990 2000

2010

Year

FIGURE 4-3. Unemployment Rises in Recessions, Falls during Expansions

[-hc ttttcnrplorrrrt.nl r:rt( tn( itstr(s tlrt'lr:tctiou <ll tlrt'Ilt,t lirtcc tltat is lrxrlirtt lil rrotk [rrtl
c1lt()t li(l rvotl. L'ncrnrlorr)r( nt Iis(s irt ltrtsirrcss< r't lc <lor*nttttlts alrrl flrlls tltttittg t rt;ttt'
sitirs. Shaclc<l rcgi<ns:rrc NIJUIi rct t ssiolls
Snrrr: t S lhr,rrol l,tbr'r Sl.tlrslr(.l ntnt'l)tx tllt|

High Employment, Low Unemployment ()l all thtr

l ll acr{)cconorn ic irr(lic;rtors. el nPl()\'lI)('l l t itlt(l Lltt'tltplovrnt-nt are nr()sl directlv fL'lt lx irrdivirltals l't'oplc lant to be able ro get hif{ll-l)it\ i rg .iolls lvithottt
scarching ()l waiting too lonfl, all(l tll('\ $:tlrt t() ha\'('
joll scr rrritr :trtrl grxrd bctrefits. Itl lIl:t( t()((otlt'tl)i
tcf'rns, tlr('sc l-t' the obiectivcs <>l high tupltnuntt'
rvlrich is tlrc c()flnterpnrt of' lrrit' ttnrnpktnu'nl. l'ig'
rrr-c 4-ll shorvs trettds iu t tttt'ttt plovltrctl t (t\'('r tlt('
last eight decades. The unemployment ratc ()ll tlr('
Yertical axis is tlre PerccllLag( ol tllt'lab(|l firx c lll:rl is
unerrpl()led. The IrlroI lol ct' incltlclt's all enrploved
pers()ns atrd thosc ttttclttlloyt'tl irtrlivicltrals rvlto :tle
seekitrg.iobs. It cxclutlcs tllost'u'itl.totlt rr'<l-k rtllo aLe
n()t l(x)king fbr jol;s.
r

The ttnemplor

tt

rcrr

t Iatc

1t-lrds

to rt'flcct

the

skrre of the bltsincss cvclt': $ht'lt olttl)lll is filling, the

denland lor lalxI Ialls arrd tlre l ttr('ttt Pl()\ nlell t rrte
rises. Unelnplovrncrlt rcachcd epiderlric Pl()l)orti()lls
in tlre (]reat Depressiolt of'thr- l{)31)s, tr'lrt'tt as Inttch
as oDeluarter <l thc rvorklbrc(' \{:ts icllcd. Sitcc
\\rorld \4ar II. rttrcnr pl<l'mel tt it) tll(' Llrtitt'd St:rtes

has flllctltzrt('(l ltrt lrns lrt'oitlctl tllt' ltiulr r?tl('s :lss()ciilt('d \\'il h dt'lrt cssit>ns.

Price Stobility.'Ilrc thir-rl tnlt ro('rtt)orrric obiet tirc

is rtrr .slabilil. T'his is defillt'tl ;ts :t lt'tv :rlrd st:tblt'
irr

laliorr r:rtt'.

tr.l{ |* lrit,.'s, {0rt't ttttl('llt 'il:tlisti( iall\ (()ll\tnrcl pricc indexes, or rr)cirsr ('s ol tltc ovt't all rrit t'
level.,\n itrtrortatrt cxirtrtrlt' is tltt' consumer price
index ((,ltl), r.'lticlt Ittastrt's th<' tlt'lrd in tltt':rvt'tae pli<c of'goo<ls antl st'trict's bottqlrt llr c()llstllll-

l)

els. \\'c u'ill gtttctallr (lctt()l(' llle ovcrall lritt' l<'re I

bv thc lctte t ,f'.
llcrnorttists rlr(';t\trr(' prict' stabilitv bv krokittg at
inflation, ()r thc rate of inflation' Tlic iltflltiort ratc
is thc rctcctttagc cltartgc irr tlt'orclall lcvcl ol rtitcs
fi'oltr ottc ),car t() tlr(' rr('\1. F()r t:ratnplt'. tllt' (ll)l rvrrs
2l)1.(i in 200(iarrrl 207.i] itl 2(X)7. Thc in fl:tti<l r-I rrtc c:tlcrrlatiorr is irrst likc tlr(' gr()wlll-l'atc cal< ttllttiol alort':
Ratc ol inflatiorr irt te:tr I

l(X) X

t,,

I',

1,,
,

72

CHAPTER

OVERVIEW OF MACROECONOMICS

12

c)

5ro
e
o
o

l-n

c'r

,p

!
c

.9

E6

5
!

o
!

o
1960

1965 1970

1980 1985

1975

1990

1995

2000

2005

2010

Year

FIGURE l-1. U.S. Consumer Price Inflation, 1960-2008

Thr: rtc of inflation measures the rate ol clranr: of prices from one vear to e next; here
wc scc the rate of inflation as measured Jrl,tltc consumer price index (CPI). Mosr inflationan episodes have been associatc(l with shocks to oil or food prices. Note that inflation has
moved in a narro\! corridor since the mid-1980s.
Sottrce: tl-S. Rrrearr ol

\,!'e thus calculate the

tbor

Stirtisric$. Dara show r.rre

inflation rare for 2007

Ratc of inflation in 2007

:
:

207.3

(f inflrion fom l2 m,,r(hs crlier.

as

201.6
201.6
2-BVo per vear
100

Figure 4-4 shows the irflarion rare for the CPI from
1960 to 2008. Sincc e end of rhe infladonary period
in the early 1980s, inflation has averaged 3 percenr
per )ar through 2008.
A deJlatiort occurs when prices decline (which
means that lhc rate of inflation is negative). At the
other cxtrclne is a lryperinflatioz, a rise ir the price
level of a thousand or a million Dercent a vear. In
such sitratiors, as in l'4'eimar Geranv in tlc lg20s.
Brazil in thc I980s, Russia in the 1990s, or Zirnbabwe

in recent years, prices are rtually rneaningless and

the price system breaks down.

Price stabiliry is important because a smoothly

fiurctioning market sysrem requires at prices
accurately convey information about relative scarcities. History has shown that high inflaon imposes
many costs-some visible and some hidden-on an
economy. With high inflation, taxes become highly
variable, the real values of people's pensions are
eroded, and people spend real resources to avoid
depreciating rubles or pesos. But declining prices
(deflation) are also costly. Hence, most nations seek
the golden mean of slowly rising prices as the best
way of encouraging the price system to function
ef6cientl,v.

7l

oBJECTTVL,S AND INSTRUMENTS OF MACROECONOMICS

To summarize:
l lt< gr,.tlr,rl ltrltt IottrtttotI||r lrt lltt r :ttt

l. \ lriglr:tltrl rll,,rtilt! ltrt lol ttllllrtt;tl ()llll)tl(

2. Iliglr t rtlIrI,,rrrrt rlt rrillt lorr ttttcltlpltrlltt tlt
3. \ stlrlllt ()t g( lttl\ ri.irr{ rr ir c lctt l
The Tools of Mocroeconomic PolicY
Put y'oursclf in the shoes of the chief economist
adsing thc government. Unemployment is rising
and GDP is falling. Or perhaps the burst of a sPeculative bubble in housing prices has led to massive
defaults, banking losses, and a credit crunch. Or
your country has a balarcc-o[-payments crisis, wi a
large trade deficit and a foreign<xchange rate that
is in free fall. What policies will help reduce inflation
or unemplolment, speed cconomic gro\^th, or correct a trade imbalance?

CovernmenE have certain instruments that they

can rrse to affect macroccoromic activiw. A ltoliq
instntmmt is an economic variable ttnder the control
of government at can affect one or more of the
macroeconomic goals. By changing monetary fiscal,
and other policies, governmenls can avoid the worst
excesses of the business cycle or increa.sc the growth
rate of potential output. The major instrtlmenls of
nacroeconomic policv are listed irl e bottom half
of Table 4-l

Fiscol Policy. Fiscal policy denotes the use of taxes

arrd gorernment expenditures. Ootentmml expmdilures come in tn'o distinct forms. First there are government purchases. These comprise spending on
goods and services-purcheues of tanks, construcdon
of roads, salaries for judges, and so forth. In addition, there are government transf'er payments, which
increase the incomes of targeted groups such as the
elderly or the unemployed. (iovernment sPending
determines e relative size of the public ancl private
sectors. that is, how much of our GDP is consumed
collecrively rather than prilately. From a macroecc
nomic perspective, government expenditures also
affect the overll level of spending in the economy
and thereby influence the lerel of GDP'
The other part of fiscal policy, taxation' aflects
the overall economy in two ways' To begin with,
taxes affect people's incomes. By leang households
with more or less disposable or spendable income,
taxes affect the amount people spend on goods and

services as wcll as the amotlnt of private sang' Prilate consumption ancl saving have important effects
on investrnent and outprtt in the short and long run.
In addition, taxcs affect the prices of goods
and factors of production and thereby affect incentives and behavior. Thc Unitecl States has often
employed special tax provisiotrs (such as an investment tax credit or accelerated depreciation) as wals
of increasing investment and boosting economic
growth. Many proyisions of thc tax codc have an
important impact on economic acvity through
their effect on the incentives to work atd [o save.

Monetory Policy. The second major instrument <.f

macneconomic policy is monetary policy, which
e goverrrment condrcls through managing the
natior's nrone credit, ancl banking slstem. You nlay
have read how our central bank, the Federal Reserve
System, affccs thc economy by determining shortterm interest rtes. How cloes the Federal Resene
or any othcr ccntral bank actually accomplish this?
It does s< prirnarilv by setting short-nrn interest-rte
targcts and tlrrough buling and selling government
securities to attain those urgets. Through its operations, the Federal Resen'e inflrtences manv financial
and economic variables, sttch as interest rtes, stock
prices, housing priccs, and loreign exchange rates.
These frnancial variablcs affect spending on investment, parcularly in horrsing, business investment,
consumer durables, aud exports and imports.

Historicalll', the Fed has raised interest rtes

when inflation threatencd to rise too high. This led
to reduced investmcnt and consumption, causing
a decline in GDP and lower inflation. In the most
recent slowdtwn, which started in 2007, the Fed
acted quickl)' to lower interest rates, prode credit,
and extend its lending facilities outside trditional
banking institutions.
The cetral bank is a key macroeconomic institrtion for evcrv country.Japan, Britain, Russia, and the
countries of the Errropean Union all have powerful
central banks. In an "open econom,v"-that is, one
whose borders are open to goods, sen'iccs, and financial flows-the exchange-rate systern is also a central
part of monetary policy.

Monetary policy is the tool thal cotlntries most

ofien rely on to stabilize the business cycle, although
it bec<mes less potent in deep recessi<ns. The cxact
way that central banks can affect econ<.rnic actilitv

74

ll

CHAPTER

be thoroughly analyzed in the chapters on mon-

etary policy'.
Summar-v:

,\ nlttirlr lr:rs lro rrr:rjot kirrrls of lolir'ics tlll t ( irl

bc rrscrl l() llur'\u( its nl:rr'rrrt'( l)ontir. r-lo:rls llsr.;rl
>olicr;trt<l nr()n{ t;rr\ l)r,li( \.

l.

Frscal

rrlitr

cotrsists rrl govcnrrrrr'trl <'rx.rtrlitrrrc

arrcl t:natio; r. (,()\ ct'trrlt('t)l ('\l)t'n<lil urr' irrllr rcrrr.t.s

lhc lclative sizc rf collt,r'livt' srt'rrrlitru ;rrrrl rr irrrtt.

corrsLrnr.rtiorr. lhrittiott strlttt't< 1s llllr illr.ont.s,

2.

rt'drccs pr ir:rte stcnrlirrr. n(l irfli'ctri rIir':rtc. s:rr..

irrg. llr rrltlitiorr. ir aflccts irtvr.strlt'lrt ;rrrrl rort ntirl ()utllut. Fiscal Prllicr is >r irrrat.ilv rrst'<l lo alli.ct
Jong-tcr-nr ccolrornic gl ()\\'tl) tltr()uuh ils irrrrart orr
n;rtionll s:lirrg alrcl itrrcstlrt<'ltl: it is :rlso rst.rl to
stirnulrrlc srerrrlirrg in rlet'Jt rrl slr:rr r rcr.t'ssiorrs.
\{onctarr rolicr, trrrtrlrrctcrl lr, t I I t . ' I t | | | l) n k.
(

rlett'rntincs slrrr'l-rrnl iltt(,r'('st t-:ll(,s. lt lllt'r.ll

;rfli,cts crcilit toll<litions. inclrrrlilrg .rss<.t rr it.r.s
srrclr rs slot k lulrl ltontl ;r it t's,ulrl crr lr:llLlr. l:rtr.s.
(ihanqt's irr iutclrst )it(('s.:tl(,trq rrilll otlrcr lllr,utt i;rl r orrrlitirns. :rllt.t t stt'trrling ill st'r trl.s srrr ll ,rs
ltrrsillt,ss irrrcstnlt'rrt. lrorrsirrg. :ut<l lr1.<'itIll l.;rrll
\lonctur tolicr ltlrs rul inll)()nitnt t'llt,r't ort lrolll
ircu.ritl (;[)[) :rnrl tott.rrrirrl ( ll)P

INTERNATIONAL

LI

NKAG ES

No nation is an island unto itsclf. Nations increas-

ingly participare in the rvorld economy and are

linked togeer through rrade and finance-this is
the phenornenon called glnbalization. As the costs of
transportation and comurunication have declinecl,
international linkages have become tighter than
they *'ere a generadon ago. International trade has
replaced empire-building and rnilitary conquest as
the surest road to national wcalth and influence.

The trade linkages of impors and exporls of

goods and services are seen whcn the United States
irnports cars from Japan or cxports computers to
Mexico. Financial linkages corne in activities such
as foreigners' buying U.S. bonds for their sovereign
debt funds or Americans' diversif ing rheir pensin
funds with emerging-rnarket stocks.
Nations keep a closc rvatch on their internrtior.ral

transactions. One particularlv important measrlre

is the balance on (ur-rent arcount. Ths reDresenls .he
nurrrerical difference ben+ecn the ,alui of exoorLs

4 . OvERvIE\.F

iUA(IROECOT\-OI\, CS

and thc raltre cf irnpors, along with somc odler adjustnrcnts. ( I'he curret)t account is closelv related to rul
xl.orts, rvhich is the difference ltetrvccn the value of
cxports and the valrre of imporls of goods and ser-

viccs.) lVhen exporls exceecl inrports, rhe difference is

a srrr'rlus, while a negative balance is a deficir. In 2007,
cxports totalecl $2463 billion, wl.rile toral inrports and
lrct transfers were $3194 billior-r; thc cliff'erence was
the U.S. c urrenr-accour.r t deficit of $731 billion.

For mrst of the twenticth century. the United

Srtes hd a surphrs in its folcign trade, exporting
rnore than ir imported. But trading patrerns changed
dlanratically in the lasr quartct-cerrtury As sat'ing

in the United Snres declinecl and tbreign sang

incre ased, a substanrial part of lbreign sang flowed

to the United Sares. The counrerpart of foreignels saving in the United Statcs was that the current
account trrned sharply to deficit. As foreign investrrcnt in the narion increased, the United States by
2008 orved on balance around $2/l trillion to foreigners. S<.me economist-s rl'orr-l thal the large foreign
clcbt poses maior risks for the Ulited Srres-risks
that we will analyze in later chapters.
.As ecoromies become more closclr, linked, interlrational c(onomic polict treconres molc itnporLant,
particulal h' in srnall open economies. But rctDember
that irrtcrrrational trade and nance are not cnds in
themsclvcs. Rether, international exchangc sen/es
rhe ultirnatc goal of improling liling srandards.
Thc rnajor areas ofconcern are trade policies and

itrtcrrratiorral financial mallagement.'liadz poli{ies

consist of tariffs, quotas, and otlrer regulations that
IcsLr ict or encourage impons and exports. Most
tradc policies have litrle effect on short-run macro.
cconorDic performance, but frorn tinc to time, as tt?s
thc casc in the 1930s, restricdons on international
tradc arc so severe that rhev carrse rnajor cconomic
dislocatiorrs, inllations, or recessio rrs.
A sccorrd set of policies is intnn.ationol finu,ncial
,n.nnagtmuL A country's intentational trade is influer.rccd by its fbrcign exchange rare, whicb rcpresents
thc plice <-rf its owr.r currency in terms of the currencics of other nations, Foreign cxchange svstems are
an integral part of monetary policy. In small open
cconornies, rnanaging the exchange rate is the single
rlrost inrportant macroeconomic policy:
'I

lrt intt'l rlttirnrl ecor)olnr is atr ilrtl.icate lveb <f

lrirrlinr :rn<l fill;rlrt ittl c()llll('('ti()r'ts arnon{ corntries.

7S

I\Sll)1. Ill!: \1.\(:R()1.(:()\()\l\' \(;(,Rt.(;.\tl'- si l'l'1.\"\Nl) t)l'ltl.\\l)

lVlren the internatiolral ccottolt'lic svstclll rtll)s

snroothly, it contribtttcs to laPirl cconollli( grorr'th:
whcn trading systents brcak <lorvtr, plodttctitln atrcl
incornes suffer thrt>ttghotlt lllc lrrrld. (irtttrtrics
thcrt-[ore consider tlre itnpact.s of tl irclt' lolicies and
intclnationa'l financial polit ics oll thcil- rlotlrestic
olrjectives of high otttPttt, higll ctrl l)l()\'nl('ll l. rld
oricc statilin'.

B. AGGREGATE SUPPLY

AND DEMAND

Tht't'torrorrrit llislt-r ol tl:rtitltts c:ttt l)c sccll ill tlrt'itt)ll( rot't ononlit rt't fttrttt:rtrt c. l-c<ltrottlists ltart'
rlt'r't:krrcd af{gt cgut(' str rrh'a tt cl-dtttnirtrcl altitlvsis ttr
lr<'lr t'xrl:rirr tltt tt[tirrI trcllds irl otttlttt atr<l rtitt's.
\\t' b<'gin lrr trrlainirru this itrt'rot'uttlt to<l ol lltrtt-

rtrt't:ollollrits alttl tllctr tst' il ttl ttllrlcstaIt<l soltt'

r)p()r't:ur( llistot it irl crt'trts.

INSIDE THE MACROECONOI.IY:

AGGREGATE SU PPLY AN D DEi'IAND
Definitions of Aggregote SUPPIY
dnd Demond
I Iorv do rlifli'It'rrt lirlt t's irrlt'r';t< t to (lct('l lllill(' ()\('l'
all ecrnonrit uttivitri' ligrrrr' 1- slrorus lllt' lclationslrirs urU()t)g tlt(' rlillt'rt'tlt r:rriallt's insitlc tlrc
lllilcfo('(ononr\. lt st tatalt's lal-iitblt's itltl trlt tat-

t i rr g :tufl ('gill(' sttlllv lttttl tltt'rst'

iifli'ctirrg af4jr('e:tt( tlt'lrrtllrl. \\'llilt' thc clivisioll is
sirrrplilit'rl, <liritlirtg r'tr irtlrlt's ittft lllt'st' two c:ll('fa(F
r-ics ht'llrs rs ttn<[t' st:ttltl \lllirt (l('t('r]litl('s tlrc lcvcls
of orrt>ttt. l ict's. atttl ttttt'ttttlot tttt'ttl.
l'll<' lotrt l r:rlt of Figttr.t' l-5 shrlr"'s lltc lirltts
alli'cting irggr cgitt( strrrlr'. Aegregate suPPly I ( li'l s
to th(' t()trl (luanlit\ f {I<xds alrrl scl-r'itt's tllitt tll('
r)irti()u's ltsirttsst's *illirlql\' rt-orlttct' alrtl stll itl :t
givcn rcliorl. .\ggrcgatc srrttlr (olictt rvr-ittt tt -'l\)
rlt'rcrrtls ttpolt tltc pr-ict' lelt'1. tht' rto<lrtt tirt' t aratitv of thc e((,It()nl\', atrrl tltc lert'l of t'<sts.
In gcnetal. llttsitrt'sst's rvorrltt likt' to st'll cvttr'
thing tlrcy cntt .ttotltttt'lt hiqh lliccs. L'll<l<'I solllt'
cir<'rullstatlces, rtict's attrl stt'tl<littu lcr'<'ls lllar bc
depresscd, so llrtsint'ss< s rrriglrt lirrrl ll)('\'llit\c ('x'(css
capacit\'. Urttlt l otltt'r colldiliorts. sttt ll as dtrr itrg a

t'gtrics: tlrost alli't

1r;rIli t(' lr<,llt. fit ttll ics ttlar ltt' ort't:llittg :tt c:tr:tr'ilr
:ts brrsint'sses scralrtlle ttl pto<lttcc t.ttottgh l(t l.ll('('l
all tlrr:ir ol'ders.
\{rt: st:r:, then, tlrat n{gt ('girt(' sttl-rlv rlt'lt'lrds olt
thr' rrict: level tlrat bttsiltcsst's talt clralgt' as rvt'll
as ol lhe ccotl<lt\"s catlrtitr' ()r I)()t('lltial ()tltPtll
l)rtelrli:rl olllput ir) ttrr) is ( l c (' l l l i l t t l l;v tlrc availbilirv of prodrrctivc itrpttts (lrrlror atr<[ tallital bcirtg
Illc nr()sl inlp()rl:rrrl) aDd thc tttitttaget ial al<l tccllnicrl cllicicncv with s'hich tll()s(' itrl)tts arc colltbittctl.
\utiortal otttrttt attrl tlrt'tr'crall pricc Iel'cl arc
rlctcr.nlirrtrl lrr llrt' trvitl blarlt's ol the scissors ol
;lf{glcg:rtc srrrilr' arrtl rlt'nralrcl. The second blade
is aggregate demand, wlli< h rt'fi'rs to tlte t()tal
illn()ll t tllirt tlillilcrrt st'r'tol's itl lhe ectluolnl' rvillingll srt'ntl irt t trivt'rl rcriorl. '\ggregirte dclnirll(l
(<ficn rr,r-ittt'rr ,1,f)) ctrrals t()tal spelding otr g<>o<ls
artl srrviccs. It tlc-lcrr<ls ott tht' levt'l rlf'prices, as
w<:ll as rn nr()Il('tl{rv rolicr. fiscal policl'. x,r,t"t'
t

frrt trl s.

Tlrc cornporrctrtri ()l irtur('q2rt(' dt'tttirtd illclttclc

!t, t.\uttl,litn (the t irls. loutl. ltrl<l olltt't < ottrtttttpliott
grrrrrls b<rttght bt' ct.rttstttttel s ; i rrittsl nten | (( ()llslrtlction ol-hottscs irtrcl fac[<rics as rrt'll :ts llrrsincss eqtripnr('11t); {:'nlr', r,ttttl lturrlmscs (srrtlt as stt'ttditrg <ttr
t<'achers arrrl ltrissilcs); .rtxl nel rrlnnts (thc diflt'rt'rrcc
bcl$et'n exp()rts :ttrd ilrtrOt ts). Auurcgatc d<'lnrtld is
aflt'cterl lx the pt'iccs irt rlllit lt tltt'goorls al't'oflerccl,
ltr'<.xoqcttotts filrccs likc rv:ts itll<l rvcatht'l-,:rlrrl bv
r

g()\1'nrnr('nI policics.

lising lrrth bl:t<lcs ol tlrt' stissots ()l agf{reg?rte

srrrrlr arrrl rlt'rn:ut<1. rtc lttltitvc tltt' rcsrrltillu eqtrilibr-irut, as is sltorvn irr tlrt' right-lralrcl circle of Figrr't'-l-5. \:rtional ottttttt ltlr<l tltc pricc lcvcl settle at
tlrat lt'rcl rvltr' t' dt'tllrtttclcrs rvillilrglv brr' what bttsiTht' t'csttltitr outptrt atrd price
It'rr'l rlct r'rtittt' <'t tt ;lovtnctr t. ttlttttt)lttytnt'lrt, altd
intcrnational tt:t<le.
rrcsscs rvillirrglr sr'll.

Aggregote Supply ond Demond Curves

,\ggrcgate sLttph arrtl tlctltalrd ctlrtt's llrt' oftctt
uscrl lo ltclt attallze ttlrtct ot cr l lt ttt ir- r otlrliti<ltrs.
Rccall that irr Ohaptcr l-l rrt ttscrl lnarket sllPpl\ and
dt'rnarrrl cunes to artalvzc tltt' tticcs atrrl qrlal)tities

of-individrral pt-odttcts. Att altalogotts gla.lhical appllriltlrs c:U'r help rts tttrclet-stlrlltl lt('rv ll)()ll('tala'lolicy or
tt'c lr rrologir:;rl t hatrgc at ts tltt ortglt aegrtg:rte srrpplv
anrl denr;rnd to dctcrlrtillt'ttrttiollal ()tltPllt :rlrd tl)c
u-icc lcvel.

76

CHAPTER .l

OVERVIEW OF MACROECONOMICS

FIGURE {-5. Agregate Supply and Demand Derermine the Major Macroeconomic
Varibles
This key diagram shows the mqior factors afiecting overall economic activity. on e left
are the major
pply and demand; these include policy
variables, like
th stocks of capiral and labor. In the
center' aggregate supply and demand interct. The chef outcomes are shown on the right
in hexagons: output, employment, the price level, and inrcrnational trde.

Figure 44 shows the aggregate srrpply and

demand schedules for the output of an entire economy. On the horizortal a<is is the tohl output (real
GDP) of the economy. On the vertical axis is the overall price 'level (as me.uured by the "price of GDp").
We use the symbol Q for real ouput and P for the
price level.

The downward-sloping crrve is the aggregate

demand schedule, or D curve. It represents what

everyone in the economy-<onsumers, businesses,

foreignen, and governments-would buy at different aggregate price levels (with oer factors affecring
aggreSate demand held constant). From the curyer we
see at at an overIl price level of 150, otal spending

would be $3000 billion (per year). If the price level

rises to 200, total spending would fall ro 92300 billion.
The upward-sloping curve is the agreg-ate sup,ply
schedrle, orl{S curve. This curve represents the

lNslDU

IllL

MA(IROE(:ONONY: AGCRE(;.\TE SUPPLY AND DEMA\l)

rl

uumffm ucfl

77

determination of total output and the overall price level,

with such things as the money suppl fiscal policy, and the
caDital stock held constant.

.9

-t

E.w
o
(d

150

;o

rnn

Aggregate supply and demand explain how totdl toxes

afrect aggregate demand, naonal outpuq and the overll
price level. Mcroeconomic supply and demand might consider the way increases in gosoline toxes affect Purchases of
gasoline, holding income constanLThe two sets of curves
have a superlcal resemblance, but they explain very differ-

250

ent phenomena.

'--

Note as well at we have drawn the AS curve as

upward-sloping and the AD curve as downward-sloping.
We explain the reasons for these slopes in later chaPters.

9so
0

1,000 2,000 3,000 4,000

5.000

Real GDP (bllrons)

FIGURE 4-. Aggregate Price and Output Are

Determined by e lnieraction of Aggregatc Suppl,v
and Dcnrand

The .{/) crne rcPr('s('nl-\ llrc quantity of total spending at

different price levels, with otlrt'r'fa<-ltrs held constatrt. The
A.\crrnve shors what firms will prodtrtt' antl scll at dillerert
rrirr'k'rr'ls, otlrer t hings equal.
Nati<nal orrtrrrt attd the overall price level are detcrmined at ttrc inl('rr('( li(,rl of the aggregate denrrnd and
supply cun,es, at point /:. Tltis t'qrrilibriurn occuni t n
over;rll price lcvel wherc firrrts willirtgly prorluce and sell
what consttmers irnd othe r dem:rlrtlcr s willingly brry"

qlHntity ol goods and senices that businesses are

willing to produce and sell at each price level (with
otllcr dctcrminant"s of aggregate supply held constant). Accol'ding to the curve, businesses will wallt t<.r
'level
of 150; the,v r.r'ill rvant
scll ti3000 billion at a pdce
to sell a highcr qrrantitr $3300 billion, if prices rise
to 200. As thc lcvel of total orrtput demanded rises,
busirresscs rvill rvant to sell more goods and seniccs
at a higher price level.

Mocroeconomic Equitibdum. rvf'e now see how aggregate output and rhe pricc lcvcl adjust or equilibrate
ro bring aggregatc supplv and aggregate demand
into balancc. That is, wc rrse the A.S and AD concepts
to see lrow rqui.libri.um utlues of lrncc nnd quanlity are
determined or t< lind thc Parrd Qth:rt satisff the buvers :rnd sellers all takcn togcthcr. For the A.S and AD
cunes shown in Figrrle 4{i, thc ovcrall economy is in
equilibrium at point l Only at thal Point, where the
P : I l-r0, are spenders
level of otrtptrt is Q : 3gg
",,0
and sellers satisficd. Orrly at point Ii are demanders
willing to buv exactl'l'lhc amortnt that brtsinesses are
willing t<.r producc and scll.
I Iow docs the ecotromy reach its equilit>
rirm? Indeed, what clo wc rrcan bv equilibrium? A
macoeconomic eqrrilibrium is a combinarion of o1rall price and quantit'at which all buyers and sellers are
satisfied with thcir orcmll purchases, sales, and Prices'
Figure 4-6 illustratcs thc concePt. If the price
lerel were higher than equilibriurn, sa)', at P = 200,
businesses wottld want

to scll more than purchas-

ers would want 1<r buy; btrsinesses would desire to

scll quantity' (i while huyers r,rould want to purchzrse

only anrount R. Goorls would pile up on the sltelvcs

as lilrns proclttced more than consll[let s bought.
Warning on AS and AD Curves
Before proceeding, here is one mPortant
word of caution: Do not confuse the macroeconomic AD and AS curves with the

microeconomc DD and SS curves. The microeconomic

supply and demand curves show the quenties and prices
of individual commodities, with such things as national
ncome and other goods' prices held as given. By conrsL the aggre8ate supply and demand curves show e

Bccause of the excess aggregate srrppl,v of'gootls,

flnns rvould cut production artcl sltavc thcir prices'

The overall price level would begin to dccline or

risc less rapidlv. As the price level dcclincd fror.r
its origir.ral too high level, the gap betwccn dcsirecl
total spending and desired total salcs rvottld narrorv.
llventualh', prices rvould decline t<,t tllc Poitrt lr'here
orerall demand and productiolr wcrc in balance.
At the rnacroeconomic equilibriun), thcrc would be

78

CHAPTER

OVER\I},W OI' MACROECONOMIcS

neither excess supply nor cxcess demand-and no

pressure to change thc ovcrall price level.

MACROECONOMIC HISTORY:
| 900-2008
can rse thc aggrcgate supplv-and-demand appa-

ratus to aralvzc rcccnt A-ruerican macroeconomic

history. rr{e focus on thc ccrrrrnic expansion during the Vietnanr War, thc dccp recession crused bv
the monetarv contraction ol the early 1980s, and
the phenomenal record ol cc<-rronic gro\{th during the twentieth ccntlu'y. This chapter's appendix also provides data r-rr lrrajor macroeconomic

\4e

0)r

variables.

Wortime Boom. The ncrican economy entered

the 1960s har,ing expcrienced rnultiple recessions
(see Figure 4-3). Plcsidenr.fohn Kennedy brought
Keynesian ecor.ronrics to llbslrington. I lis ec<nomic
advisers reconmcndccl cxralrsionary policies, and
Congress enacted mesurcs to stirnulate the econom particularly crrls in pt rsonal ancl corporate
taxcs in 1963 and 196.1. ()DP gre* rapidl,,- rltrr-ing this
pcriod, unemploymenr declined, and inflatiorl rvas
containcci. By I965, the economv rlzls at ifs potcntial
output.
Unfbrtunately, the government rrndercstilDated
tlrc nragnitude of the buildup for rhe Victrrarn War.;
dclcnse spending grew by 55 percent from lgti5 tr.r
1968. [,vcn when it became clear rhar a rnajor irrf lationary booln was under war,, Presiden t.f ohnson postponed painlul fiscal steps to slow rhe econorrry.'fax
incrcases and cililian expenditure cuts camc onlv in
1968, which nas too lare ro pre\,nr inflationarv prcssures li'orn overheadng the economy. Thc t-cclcral
Rescrvc accornmodated the expansion with rapid
nloncy growth and low inrerest rates. As a rcsult, the
cconorny grew very rapidly over thc pcriod 19661970. Under the pressure of low rrncrnploynent and
high factory utilizarion, inflation bcgan to rise, inaugrlrating the "Grear Inflation" rhat lastcd fiom 1966
through 1981.
Figure 4-7 illusrrares rlte cvcnts of this period.
'I'hc tax culs and defense expenditur.cs shilted the
aggreg'te demand curve ro the right li.tnl AD to A1)',
with the equilibritrm shifting frorn l.' rt E'. Output
aud ernployment rose sharply, and inf latitn rose as
out put exceeded capaciry limits. Econ<rnists lcrrned

oo'
Reat

cDP

FIGURE 4-7. Wartime Boom Is Propelled by Increasing

Aggregatc Demand

During wartirrrc, increased militan spendir.rg increascs

aggrl:gar(. sx.nding, mo\ing aggregate demand fi.onr ,4I)
to ,{/)', wit}r cquilibrium output increasing lionr r- to f.i'.

14h(:n ()rtput rises far above potenal output, rhc [)ric(:

l<:vt'l rnrr'cs up sharply from P t< /', arrd wartirrrr: inflatirn
cnst|cs.

that it was easier to stimulatc thc cconorny than to

persuade policy'rnakers ro raise taxcs to slow the
cconom)' when inflation rhreatencd. I'his lesson led
rnany to question the rvisdom of usir.rg hscal policies
to stabilize the economy.

Tight Money, 1979-1982, Thc 1970s were a rime

of troubles, with rising oil priccs, grain shortages,
a sharp increase in imporr priccs, union militancy,
and accelerating wagcs. Price inflation became
embeclrled in thc U.S. and many other economies.
As Figure 4-4 on page 72 shors, inflation rose to
doubledigit levcls in thc 1978-1980 period.
Douhledigit inllati<,n wrs unaccepbble. In
response, the Fcclcral Rcscrve, rnder the leadership of economisr Paul lblcker, prescribed the
strong nredicinc ol tight money to slow rhe inflation. hrterest rat"cs rose sharply in 1979 ancl 1g80,
the stock markct li'll, ard credit was hard to fincl.
The Fed's tight-moncv policy slowed spending by

79

MACROECONOMI(i HIS'l'ORY: l900-2008

consutncrs and businesses. Panicularly hard-hit were

intcrest-se rsitive componenLs of aggregate demand.
After 1979, housing constmction, automobile Purchases, business investment, and net exporrs declined

AS*e

sharply.
Vl'e can picture how tight money reduced aggregate demand in Figure 4-7 sirnply by rcversing the
arrow. That is, tight monetary policy redtrccd spending and produced a leftward and downward shift of
the aggrelate demand curve----exactly the oPPosite
of the effect of the tax cuts and defense buildup dur-

ing thc

_9

O.

1960s.

Thc effecs of the tight money were twofbld.

Firut, trutput moved below irs potential and unemployment rosc sharply (see Figure 4-3 on page 7l).
Sec<nd, tight money and high unemployment prt>
duccd a drarnatic decline in inflation, from an average of l2 percent per year in the 1978-1980 period
to an average of around 4 percent per year in the
subsequcnt period (see Figure 4-4). Tight monetary
policies succecdcd in bringing an end to the Great
Inflation, but thc nation paid through higher unem-

ployment ard lowcr output during the period of

ght money.
The Growth Century. Thc firal act in our macrG
economic drama conccrns the growth of orrtput and
prices over the entirc pcriod since 1900. Output has
grown by a l'actor of 34 since the beginning of the
r"'*entieth century. How can we explain this phenomenal increase?
A careful lo<.k at Amcrican economic growth
reveals that the growth rate during the twentieth
century averaged 3% perccnt per year. Part of is
grol^th wai due to growth in the scale of production
as inputs of capital, labrr, and cven land grew sharply
over this period. Just as ilnporunt were improvements in efliciency' duc to new products (such as
automobiles) and ncw processes (such as electronic
computing). Other, less visible factors also contrit>
uted to cconomic growth, such as improved managerncnt techniqtes and improved services (including
such innovations as e assembly line and overnight
delivew).

Many economists believe that the lrcasured

growth rrnderctates true Srowth because our oflicial statistics tend to miss the contribution to living
standards from new products and improvemenus in
prodrrct quality. For example, with e introduction

o,,

oroou

u,

Fca output
FIGURE 4-8. Ciror. tlr in Prtcntial OtlPut Dctcrrnircs
l,orr{-Run llcrrronric I'crfirntiurce
Over the twentieth ccntttry, irr(r(:ascs in labor, capinl, ancl
efhciency led to a \ast incrcast: in llrc cconom,v's producdve potenal, shifting aggreppte suppl" far to tlr<: right. In
tlre long mn, aggregate supply is the primarr tletcnrtittattt
of outprt Hrowth.

of thc indoor toilct, millions of people no longer had

to struggle through thc winter snows to relieve themselves in outlrotrscs, yct this increased comfort never
showed up in rncasurcd gross domestic product.
How can wc picttrrc the tremendous rise in output in our ,4.9,4D apparatus? Figrrre 4-8 shows the

The incrcase in inputs and improvemens in

efliciency led to a massive rightward shift of the
AS curve liorn r1.5,,r' to ,451r,r,r. Production costs also
increa;ed sharply. l'or cxalnple, average earnings rose
fr<-m $0.15 pcr hour in 1900 to over $30 per hour
in 2008. -I'hcse cosr increases shifted the AS curvc
upward. 'fhc overall effect, then, was thc increase itr
both output and prices shown in Figure 4-8.

way.

The Role of Mocroeconomic Policy

Macroeconomic policy played a ccntral role in the
improved business<ycle conditions of thc last halfcentury. The discoverv and applicatiotr of macroeconomics, along with a good apprcciation of the
role and limitations of monetary and liscal policy,
redrrced business<ycle volatility alrd lcd to the

80

cHAPTER

Great Moderation. The application ol' fiscal policy,

and especially monetary polict, helpcd lowc rlernplolrnent and ensured largely stablc priccs ovcl the
last rwo decades. \4'hen thc Llnitcd Statcs faced a
major shock to irs financial st'stcnr in 2007-2009, ccntral bankers remembered nnd un tlastuod thc lessons
of the Great Depression. They klreu that financial
fears are contagious, thar bank collapscs can lead [o

bank runs, and that instability brccds rnore instabiliry Knowledge of macroeconontic historv and theory',

4 .

()\'ERVIHW ()F l\,tA(:R0 ti(:() NOMtcs

and the intenention of the ce ntral bank as a lender of

last resort, can cushion :r bar.rking shock and prevent
bank crises fronr turning itrto dt-cp depressions.
There is l.x miraclc ctrr-c li' macroeconomic
shocks, however. ll'hcn a stccp decline in output
and employment ht rlre LJrritcd Sratcs in 2007-2009,
nroneury and fiscal policir.s rvclc launclred to soften
the blow, but tlrey coulrl nor conrplerely ofl'set it. Up
to no!r', the kno$'lcdgc is available to prevent depressiorts, hrrt not to banisll rt.r't.ssi<tns.

SUM}IARY
A. Key Concepts of Macroeconomics
l Macroeconomics is the studv of lrt' bclrarior of the

ar'(' nrtn(.r('us instnrmerLs with which governmetrLs

(ar stccr' the econonlv: (a) Fiscal policv (govcrrrnrcrrt
spending :rrrd utxation) l.relps dctr:r'rrrirrr. tht. alloca-

entire economy: lt analvzt.s long.nrn gronth :rs well as

the cvclical nrovr:rncnts in total outptrt, unemplo).'ment
and inflalion, artl internadonal rrade and firance.
TIris contrsts 'irh microeconomics, which strrclies tht'
lxrhavior of individual markeLs, prices, and output.s.

2. Thc Llnited States proclaimed its macroeconorn ir. goalr

in the Employment .A.ct of 194{i. which dcclar.rrl lrat

3.

federal policy r,ras'to promote llaxilllrr r:rnrloyrrrclt t,

production, and purchasing pow<'r." Sincc then, rhe
nadon's priorities anrong thcsr: rlrlr.<'goals have shifted.
But all market ecoroni<'s still face ree cenral macrG
economic qrrr:srions: (a) Why do output and emplovnrcrt somemes fall, and how can unemDlolrn('rrt l('
rcdrced? () \4hat are rhe sources of rrirc inflariorr.
and how can it be kept under control? (r) How can r
nation increase its rate of ecolrornic grorrth?
In addition to these 1x'rplcxing questions is the hard

fact that therr: arc ineritable conflicts or

rradeollis

anong these goals: Rapid growth in fture livirrg starrdards ma,v mean reducing consunrlttiorr trxlat,, and
curbing inflation ma,v involre a t(:nrJX,rry prriod of

4,

high unemployment.
Economisls eraluatc tht: srccess of an economv's ove.all perf onrrance by how well it attains these ob jet-tix's:
(a) high levels and rapid growth ol orrput (rrrcasured
b,v real gross domestic pr-odrr< t) and consumption;
() a low unemployrncnr rate and high employment,
with an anrplc supply of good jobs: (r) low and suble

inllation.

5. Befort: thc science of macroeconomics rras devt.ktrl.

corrntries tended to drilt arourcl in th<' slrifting rrracrrrconomic currents without a 'udr[t:1. Tixlav, thcre

6.

ti<r.t cf resources ktwcen rr-ivalc and <rrllective goods,

alfects people's inctnlr:s all<l cousrrnption. ancl provides
ircentires fbr ilvr.strrt'lt and olhcr economic decisions.
() Nlonetar-r' lxrlicy-particrrl:rrlr' e setng <f shortter-m ir'ttcrcst ratr.s lrv thc cenr.rl b:rnk-iIects all interest tal('s, $(.t llri(('s. credit crndidons, and exchange
ratr.s. Tl<. rrrost hearilv allected sectol.S are housing, bu.sin('ss y('stlncnl, consttmer durbles, and net exp()rls.
Thc rration is brr a small palt ol irn incr.r:asirrgly inic-

grated global econonrv in which corlrtrics are linked

togethcl throtrgh trark. ()f grxxls and senices and
throrrgh f inarrt ial florvs. .{ smoothl!, nrnning internatirral <.r'oDolltic srstem contribttes to rapid econonric
growth, brrt the interrational econorny <.an tllrow
sand in the engirre of gxxvth wherr tlarlt. flows arc
inrernrpted or thc internati()ral fillant.ial rncchanism
breaks d<>ur. l)r:aling witlr irrtcrnational uade and
litalrcc is hilr orr the agenda of all countries.

B. Aggregate Supply and Demand

7. lhe central (()n(('l)ts ftr undersranding the deter.nrinatiolr of national otrtput and the p ce lr:lel ar'
aggrefte suppl,v

(.4,!

) and ;rggregarr. dt.rnarrd (AD).

Agglegate demand colsists ol tlrc total spending in an

econorny by lxrrscholds, brsinesses, governmellts, and
lirrcigncrs. [t lcpresents the rourl outpur that wodd bc
willirrglv borrght at each price level, given rhc nr()n('tarJ
anrl fiscal policies and other lhclols alli'ctirrg dt.nand.

Aggregate supply descr-ibes how rrut lr orrtpur brrsinesses would willingly Prorlrrtc arrd sell givcn prices,
costs, and nrarket crrrrlit iolls.

I t'Rt ltrR

Rl,:,\l)|N(;,\\I) |Nf

l. lt

\ l. r

\\'1.

8l

Bsll'l.s

rlrrs cirsv nroncr, lr'<l t() a rallid itlcLeasc il aggrcgrtte

rlt nr:ul<1. Thc rcsrrlt rlas a sltat r ttrlttt tr itr rtit cs atrd

rrrr',r ltarc tltt'siuttt'shapcs it:i tll('l:ttlliliiir

slrl)l)lI ;tn(l tlcnratttl t ttrt s :tttlt zt rl ill nti<-tot'tltlltirs. l}rrt lrutart' ol rott'tttial corfitsirts of lti< ltxtr

8, ,.lSrurtl .11)<

irflttion. At tltt'ctt<l of tht' 1970s. ttortotttit xrli<yrrlt'rs rt'erctcrl t() tl)c nsin{ iltflati<r br tightcrring
-['lr(' lcsult
||r()r( liu\' xrlitv atr<l riusirB irtefest rat('s.

r()nri( irn(l irHgrc{t(' :trlllr atrd rlt lll:rlt<1.

9. 'I lr<' ovcr ll t|rir( r(x ( (rttr)rlli(- cqtrililltrttllt. (l('lcrtllinillg
lx)tlt agqrcg:tt( -rritt .rttrl ()rtll)lll, ((rrll('s rlltt'rc tllc -1,\
n(l .-1/) cun('r' intt r st't t.'\l tlr< t rrriIiIrr irrrtr rr it t' lercl'
lirrrililrrirrru ()utl)tt (rl (lcpart flr)rtl lttll ctttplortlrt ttt

Iorrt.rcrl srt'rrrlinl.l ()r inl('r(sl-st'nsitir-c rlcnratr<ls

srr<lr lts h<tttsirrg. irtrcsttt<ttt, atttl ttcl t'xlotts. Sitlct:
tll(' nli(l l98Os, llr(' LI.S. tcon<rttv luts txrt'tictttttl
rr rt liocl rl lorr' irtllali<n ult(l irlfi(qrlcrrt irrtd, rrtrtil

l)ot('trtial ()ttl J)ttl.

10. Rcccrt Aru.ritlrr lrislor slrorrs lttt itttgttll cr<l<'
ol aggrcgatt' <ltrl;rtrd ltl<l sttltlr sltotks ittttl rolicr

ll. ()vcl thc lrrrg run, llr( ur()\\'llr (,1 lx)t('ntial ottPtt
irrcrc:rscrl lggr('glttc supl)l\' (n()trrr()rrlr atlrl lt'rl tt

rrr< hascrs rr'illirrglr l>trl rvhnt bttsittt sst s r''illirulv scll.

lc( ( ntl\', nriltl t cr t ssiorrs-

()r'

r( ir{

li()ns. lrl tlrt nlirl-lllti{)s, r{lII'IIIrIIrtt rI

:itcl(l\ gr()r\lll irt otttrttt

<lcfit its

irD<l

livirrg starttltrls.

CONCEPTS FOR REVIEW

Haior l.lacroeconomic ConcPts
( ) rl( )t1lcs \ s. tlll( r( )('( r )ll( )llltc\
n|lt(
gross rLrrrrcstir rlorlttct (('l)l'), actttal
arr<l Jrotc n t ial
cIl l)l()\'nr('n t, tltrctltllot trtt ttl,

| ( )( (

llllcnll)l()\ t]lcnt r;tt('

Aggregate Supply and Demand

irrllt i n. rl< flrttiotl

(

((ll'l)

onsrrI)('r >r'ict' indcx

n(

ilggr ('gar(' surplr', aggrcgatc

l ( \lx)Its

frsr:rl xrlit r' (gor crrr tttctr t

t rrt rrlitrrrt s, lit\iIl i(,n

rk ruarl

,lS t rr r't'.,{/) ctttlc

t'qu ilitrrirrnr of ,{5 xr)cl .-11)
sor rls tl lotr;-Ltut ('cotl()tt)ic
gr'()wtIl

1('rr policv

FURTHER READING AND INTERNET WEBSITES

Further Reading
I'hc glt'ltl clitssit rl Irir(

()('( ()tr()tlli(ri is .lr>ltlt illartt;tt<l

Kevrrt's. /l'' Otnotl l hu- ol linltlunnl. lnltttl unl
,Iloy (lltrcrtt-t. N<'rr \irlk. litst rttlrlisltctl irr l1)li5l
KtrDts rr;rs (lrtc ol thc tttlrst gratclitl \!lil('ls lllollll
cc()flr)fr\t\. {r rrtlirrt' trliti<t rl l ltt Otttl l hutr is
r'irilrrlrlt irt r'ir' nar ti:'l t.rtt / n'ftrrnrt/ suhrtl /u on on irt/
kn rtrt/glnrt rtI Ihurl/.
Tlrt'r't' rc rrarrr grxxl illt('t ttl('(liirtc t('\tl)(x)k\ ()tl lllltcr()c(.()n()nli(s. \'or t ltr r lltrtllt tlrtst rrltt.lt tot rv.tttt t<l <lig
nror< <lt't'rll itrto stu ilit torir r.

()tlil)c irt utr(. &?\\-g0o gr,rrt).

gottd stttttcc tltr

^nr)llr('rtirl Brrtlr't ()llite'
nllcr()ec(l)()rr( issucs is lrc Oottgt'cssiot
n llit lt issttcs rct iodic rt't<lrts t)tl tllc ccttllt)lIl\'?tt)(l lll(' slal('
rrf tlrr'frttrlgt t .rt Itr1l4r.(h,.!!)1t.
R<'scirrtll olgirrriz;ttir>trs olictr ttlttlaitt t'ltr'llt'nt onlire
rlisr-rrssiorts (rl (-tlrr('tll Init( t (tcc()tl()ltlit isstt s. St't'
cslcr ilrllr' tlrc rlt'bsitcs r>l tltt' []r-ookitrgs lltstitttiott. rrt'.
Itrxtlitngt.',r.luttl tlr' \trr'irrt l.trtct-prisc ltrstitrte, a,r,.
(t

t't ttt{.

S(,rrr' ( \(('ll('rl lrlog' t,rtttaittittg l)lit(trx(.)ltlltl(\ l('

tlrt' lirlkrrr,irrg: \ lrlo ol ltarling littropcltt) ll)d sonl('
,\rt'r'it

Websites

\flrcroccrtottri< isstt's lttc it celttritl llr( tt)(' ()l ltrnlvsis ilt

l)ouotnir llrn1 rl tht l\rti ntt. \';trittts rt'.rrs itf(' iI\irilill)l('

ln

ccorror

isls ortllt itts

rtch itrtctcstitr cconotnic

tlu lnlantlit,nql Ilrrakl

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82

CHAPTER

OVERVIEW OF MACROET]ONOMICS

QUESTTONS FOR DTSCUSSTON

l.

\4rhat are the major objecdves

ol

d. A sharp decrease itr nct cxports rhat follorved a

macroeconornics?

r,lrite a bfief clefinior ol <'ar:lr of these objectives.

L,xplain carelully wlry <.arlr rrlrjcctive is important.
Usirrg thc data frorn the appendix to rhis chaprer, calculatc tlre following:
a. The infladon rate in l98l ancl 2007
b. The growth rate of real OI)Pin l982and 1984
c. I'he a!rage inflatiorr rait.fronl lg70 to 1980 and

deep depression in East Asia

thc Reagan administration implemented
a liscal polity that reduced taxes and increased gover nrncnt spending.

6. ln 1981-1983,

a.

fi-onr 2000 to 2007

d.

Thc average growth rare of real GDP from lg2tl to

2008

llltnl: The formulas iD the text gir<' tlrc tcchnique for

calculating l-rear gr()wtlr ratcs. Growth rtes for multiple vears use the following formula:

s,'"''

100

fr Xrr ''

ll?=l
Ll^r ,,

7.

1l
I

where &(') is the avemgr: anrrrral growth rate of the variable X lbr e rl ycars l,ctween year (, n) and vear ,.
For examrlc, itsstme that the CPI in (l - 2) is 100.{)
whilc rhe CPI in 1'ear 1is 106.@. Ihen the averagc ratr:

of inflation

i'

roo x

[l

'$*f l' '

t] =

3 percent per

y<:ar.l

.t.

What rvorld be the effect of each ol the followirrg on

aggregate demand or ol aggr-cgatt: srrpply,
(always holding other thin{ri constant)?

ir,s

inclicated

a. A large cut r pcts()nal anrl business taxes (ou

AD)

b.

Art arms-rednction agreement reducing defcnst.

spending (on AD)

An increase in potential ourrrrl (on A.S)
,4, monetan' looscrrirrg tllat lo\lers interes[ rates
(on D)
l'<r'each rf thc evenLs listed in question 3, use the A,!
rtl) apparatus to sh<w the effect on orrrprl and on the

c.
d.

overall price level.

Put yourself in the sltoes o1-ar t.corromic policymaker.
The economy is in ccrrilibrirrrn with P = 100 and Q =
3000 - potential GDP lbu refuse to "accommodate"
inflaon; ral is, you want to keep prices absolutely stablc at P : 100, no mater what happens to output. \bu
( an rse moneErry and fiscal policies to irffcct aggregate
demand. but ,vou cannot alliTt af{l.ir cKate supplv in the
short ur. How would yorr rcslrnd to:
a, A surpr ise incrcirsc in investrnent spending
b. A sharp foorl-rrice increase following catastrophic
f looding of the Mississippi Riler
c. A productivity decline that reduces potential output

8.

Explain why this policy would tcnd ro increase

aggregate demarrd. Sh<rw the impact on output

and priccs assuming onlv an lD shift.
b. Thc srrpph.side school holds that tx cuts would
affect aggregate supply mainl,v by increa-sing potential orrtput. .{ssuming tlrat tht' Rcagan 6scal measures affected ,4.$ as wcll as AD, show rhe impact on
output and thc price level. Explain why the impacr
of the Reagan fiscal policies on outpur is unarnbipuous while the impact ot.l prices is unclcar.
The Clinton econonric package ar passcd by C,ongress
in 1993 had the ellct of tiglrtening fiscal policy by
raising taxes and krwr.ring spending. Show the effect
ol this policy (n) irssuming that there is no counteracting n)onctary policy and () :ssurning that monerary
xrlicv completely neutralized the impact on GDP and
that the lo$.er deficit leads to highcr invcstment and
higher grow of potential outprrr.
The United Statcs expcrienced a major economic
doryrtrrrn in the earl,v 1980s. Consider the data on real
GDP and e price level in lhble 4-2.
a. For the years l98l to ll)tll'r, calculatc the rate of
growth of real GDP ancl tht: ratt: ()f inflation. Can
,vou determine in which ycar there was a steep
business dowrrIrrrn or rercssioni,
b. In an ,,1.94,D diagram like Figure 4-6 (page 77),
draw a set of A.S and ,41) cun'es rhat rnacc ort the
price and orrtput equilibria sh<wrr in rhe table.
How would you exrlain thc recession that )'ou
have

idertifit'd?

Real GDP
($, bitlion, 2000 prices)

Price lwel+
(2000 = r00)

1980

5,161.7

l98l

5,2s1 .7

54.1
59.1

1982

5,189.3
5,423.8
5,813.6
6,053.7

62.7
65.2
67.7
69.7

Year

1983
1984
1985

*Notc that the price index shown is the price index for GDP, which
mearwes tlrc price trend for all conrxrncna ofCDP.

TABLE 4-2.

Appendix 4
MACROECONOMIC DATA FOR THE UNITED STATES

Nominal
GDP

Year ($, bion)

1929 10:1.6
5ri.4
l9:t3
92.2
1939
223.1
l)4ir
1948 269.2
1950 293.8
1960 ?6.4
1970 I,038.5
r97l I,l27.l
1972 I,231J.3
lf)73 1,382.7
t971 I,500.0
1975 I,{i3ll.3
1976 |,825.3
1977 2,030.9
197U 2.294.7
1979 2,1-63.3
1980 2.7t19.1-r
tgnl 3.128..1
1982 3.255.0
1983 3.536.7
l9t14 3.9:-t3.2
1985 .r.220.3
1986 +.-162.11
,1.739.5
| 9n7
1988 5,103.8
1989 5,411,1.4
1990 5,803.I
l99l I-r,995.1)
M92 ri,337.7
1993 ri,657..1
1994 ,072.2
1995 7,397.7
1996 7.81{i.9
'1997
ti,30+.3
99rJ 8,7.17 .0
1999 9.26ft.4
2000 9.817.0
2001 l0.l2ri.0
:002 10.469.ri
2003 0.960.8
200't I l.( ,]5.9
20(li 12.433.9
200ri 13,194.7
2O0 t'
I 3,u07.0
f

'I

2(X)r.r

11,30,1..1

Real GDR
2000 prices
($, billion)

Unemployment
rate

CPI
|

982- l9tt4

(o/ol

100

rate (cPI)
(7a per year\

Federal budget
surplus ( +)

or decit

($, billion)

Nei
exPorts
($, billion)

0.{

{J(i5.2

3.2

t7.l

0.0

t.0

t).11)-:,

2{.9

13.0

0.9

0.t

950.7
1.786.3
I,(i.13.2

I t'.2

-5.2

13.1)

1.4

t.9

18.0

2.2
7.+

-2. I
-29.0

-0.8

3.8

24.0

| ,7 t'7.2

r:t.2

24.1

2,501.u
3.771.9
3,ft98.7
.l, I 01.9
{,3.{ l {

l).1)

29.6

t.5

5.0

3lJ.ii

6.0
l.6

40.5

5.7
4. I

4l.ft

:1.2

4.9

4'1.,1

6.t

4,3t9.5

l'r.6

.19.3

10.4

'1,31 I .?

.5

4,1-r.10.9

7.7

8.7
l).o

.1.750.6

7.1

I'r,0I5.0

6.t

53.t
5(i.9
60.6
65.?

5,t73.5

ir.9

tz-1,

5. r 61.7

7.2

82.4
90.9
96.5
99.6

12.7

103.1)

4.3
3.5

4.0

5.291.7
5. I U9.3

l'r.423.f|

9.7
9.6

5,813.6
6.053.8
(i.263.6

7.2

6.475.I

6.2

t07 .6
109.7
I 13.6

6,712.7

:).:)

I18.3

6,9tr 1.4

a)-:)

7,I I 2.ir

130.7

7, 100.5

5.tt
6.9

7,336.r1
7,532. t-

7.O

ti.3

15.2

4.0

-28.4

0.6

2{..+

23.9

-ttt./
-,14.1
26.5

-22.5
-13.1

- Ito.-t

- r31.9
- 173.0
-|(i8.I
- 175.0

6.t

48.2

2.6

fi.(i

152.,1

2.8

u,32it.9

i).'l

156.9

2.ll

8,703.5
9.066.9

.1.9

I (i0.1-r

2.3

-:t:t.1

+.1t
'1.2

163.0

3tt.t3

l66.li

1.5
2.2

1.0

t72.2
'l77.tl

3.3
2.8

l0:1.6
| 89.5
46.7

5.u

179.9
184.0

1.6

-2,17 .9

.1

195.3

2.5
2.6
3.3

4.6
4.0

20t.6

3.2

207.3

2.tt

2li'.2

4.1

6.0
5.5

1-r.tJ

Ittt.9

r r

711.0

-27 .5

- 33.2

-297.4

-2t?.3

- 6l-r.0
-93.6

197.0

91.4

t,11.8

-9(i.2

-273.5

101.6
159.9

-Z(iO.l-r

379.;-r

367.0
424.4

-372.1

-220.0

-499.1
-615.4
-714.(i
-762.0

-.156.5

-727.9

- 370. (i
- 3 1u.3
-

399.4

707.tt

ic d:rl;r (liscttssecl in tlris

tlrl)('lll rrthsilt's ,rI tL4ntt. fKlsk s.g01,,

rir( r'ot'conorn

clra;rt.r'. \,1:rjrrr-cfata c;rn bc oburirccl throtrglr l(t\ct

{tnl,

-:t l .l

-IJJ.2

7,835.ir
8,031.7

9.890.7
10,o48.9
10,30t.1
10.675.7
I I ,003.5
I I.3I9.4
I l 523.9
1 I .666.0

12.5

20.0

34.5

145.0

2.1)

7.{)

-130.1

190.8

144.5

).'t 70..1

- t02.7
I t5.2
- 132.7
- t15.2
- | 10.4

6.9

I,f

-2i.4

-53.(i

-2t3.7

-23.1

.3

4.1

3.0

0.8

16.0
1.6

69.0

3(i.2
| 40.3
|

4.1

13.8

172.O

-.t.{

-11.3

1.1)

-t.5

o.7
4.2

7.2

9.9
3.1

5.:)

l).1)

7.4
10.7

ti.0

0.u

3.6

t.l

)..1

TABLE 44.I .
-lablc 4A-l crntains solnt' ol tht' nttior
tuttu,.lutt.

Inflation

<r- tuttm. bl.s.gtlt.

83