A FIRST LOOK AT* MACROECONOMICS*

C h a p t e r 4 A FIRST LOOK AT* MACROECONOMICS* Chapter Key Ideas Outline What Will Your World Be Like? A. What will happen to economic growth, unemployment, inflation, the government budget deficit, and the U.S. international deficit? B. Macroeconomics addresses these questions and examines the policy challenges they bring. I. Origins and Issues of Macroeconomics A. Modern macroeconomics emerged during the Great Depression (1929-1939) a decade of high unemployment and stagnant production throughout the world economy. B. Short-Term Versus Long-Term Goals 1. With high unemployment during the Great Depression, the initial focus of macroeconomics was on the short term. 2. During the 1970s, inflation increased and economic growth slowed, shifting the focus of macroeconomics to the long term. C. The Road Ahead 1. During the 1990s, as information technologies further shrank the globe, the international dimension of macroeconomics became more prominent. 2. Modern macroeconomics is a broad subject that studies long-term economic growth, unemployment, inflation, the government budget deficit, and the U.S. international deficit. II. Economic Growth and Fluctuations A. Economic growth is the expansion of the economy s production possibilities. 1. We measure economic growth by the increase in real gross domestic product. 2. Real gross domestic product (also called real GDP) is the value of the total production of all the nation s farms, factories, shops, and offices measured in the prices of a single year, currently 2000. * * This is Chapter 20 in Economics. 77

78 CHAPTER 4 B. Economic Growth in the United States 1. Figure 4.1 shows real GDP in the United States since 1962. 2. Potential GDP is the real GDP that the nation produces when all the economy s labor, capital, land, and entrepreneurial ability are fully employed. a) Figure 4.1 shows that there is persistent growth in potential GDP. The longterm rate of economic growth is measured by growth in potential GDP. b) Potential GDP grew more rapidly in the 1960s than in the 1970s and early 1980s. The slow growth during the 1970s and early 1980s reflected the productivity growth slowdown. The growth rate of potential GDP increased during the 1980s and 1990s. 3. Real GDP fluctuates around potential GDP in a business cycle. a) A business cycle is the periodic but irregular up-and-down movement in production. b) A business cycle has two turning points, a peak and a trough, and two phases, recession and expansion. i) A peak is the upper turning point, the end of an expansion and the beginning of a recession. ii) A trough is the lower turning point, the end of a recession and the start of an expansion. iii) A recession is commonly defined as a period during which real GDP decreases for at least two successive quarters. iv) An expansion is the period during which real GDP increases.

A FIRST LOOK AT MACROECONOMICS 79 4. Figure 4.2 shows the most recent U.S. business cycle, including the most recent recession in 2001. 5. Recessions in recent years have been much less severe than the Great Depression. C. Economic Growth around the World 1. U.S. real GDP growth fluctuates much more than the growth rate of real GDP in the rest of the world as a whole. 2. Among advanced economies, since 1992 Japan has grown the slowest and the newly industrialized economies have grown the fastest. Among the developing economies, the most rapid growth has occurred in Asia and the slowest growth has occurred in Africa and the Western Hemisphere. 3. The U.S. share of world real GDP is almost constant and is about 21 percent, but some fast growing nations such as China have gone from 4 percent in 1982 to 13 percent in 2002. D. The Lucas Wedge and the Okun Gap 1. The Lucas wedge is the accumulated loss of output that results from a slowdown in the growth rate of real GDP per person. Since 1970, the Lucas wedge has amounted to a staggering $50 trillion. 2. The Okun gap is the gap between real GDP and potential GDP. Since 1970, it has amounted to an estimated $2.7 trillion.

80 CHAPTER 4 3. Figure 4.5 shows the Lucas wedge and the Okun Gap. E. Benefits and Costs of Economic Growth 1. The main cost of fast growth is foregone current consumption. 2. Two other possible costs are more rapid depletion of exhaustible natural resources and/or more pollution, although technological advances that bring economic growth help economize on natural resources and clean up the environment. III. Jobs and Unemployment A. Jobs 1. In 2003, 137 million people in the United States had jobs 17 million more than in 1993 and 37 million more than in 1983. 2. The pace of job creation fluctuates with the business cycle. During the 2001 recession, 2 million jobs disappeared. During the expansion of the 1990s, 2 million jobs were created each year. 3. Most new jobs are in the services industries and are, on the average, higher paying than the ones lost. B. Unemployment 1. On any one day in a normal or average year, in the United States 7 million people are unemployed. 2. The unemployment rate is the number of unemployed people expressed as a percentage of all the people who have jobs or are looking for one. The unemployment rate is not a perfect measure of the underutilization o f labor for two main reasons: a) It excludes people who are so discouraged that they ve given up the effort to find work. b) Part-time workers, who desire full-time work but cannot find it, are not counted as unemployed. C. Unemployment in the United States 1. The unemployment rate reached a peak during the Great Depression in the early 1930s. It has been high, but not nearly as high, during recessions in recent years. 2. Figure 4.6 shows the unemployment rate in the United States from 1929 through 2003.

A FIRST LOOK AT MACROECONOMICS 81 D. Unemployment Around the World 1. Since 1983, the unemployment rate has been generally higher in the United States than in Japan, but higher still in Canada and Western Europe. Business cycle fluctuations in unemployment occurred at similar times in the United States and Canada, but were out of phase when compared to Western Europe. 2. Figure 4.7 shows the unemployment rate in the United States, Canada, Western Europe, and Japan. E. Why Unemployment Is a Problem 1. Unemployment represents lost production and income. 2. Prolonged unemployment can cause lost human capital, which seriously hurts the person s future job prospects.

82 CHAPTER 4 IV. Inflation A. Inflation is a process of rising prices. The average level of prices is called the price level, and the inflation rate is measured as the percentage change in the price level. A common measure of the price level is the Consumer Price Index (CPI). B. Inflation in the United States 1. Figure 4.8 shows the U.S. inflation rate from 1963 through 2003. 2. In the early 1960s the U.S. inflation rate was low; it reached its highest levels in 1974 and 1980. Inflation then decreased during the 1980s and has stayed relatively low in the 1990s. 3. Deflation occurs when the inflation rate is negative so that the price level is falling.

A FIRST LOOK AT MACROECONOMICS 83 C. Inflation Around the World 1. Figure 4.9 shows inflation around the world since 1983. 2. Other industrial countries shared the same pattern of inflation as the United States. Developing countries have displayed much higher rates of inflation, although inflation has dropped closer to the levels of industrial countries in recent years. D. Is Inflation a Problem? 1. Unanticipated changes in the value of money mean that the amounts actually paid and received vary unpredictably. 2. People use resources to predict the inflation rate rather than to produce additional goods and services. 3. At high inflation rates money loses value very quickly; therefore people try to spend their money more rapidly. In the extreme case of a hyperinflation defined as an inflation rate that exceeds 50 percent per month inflation brings economic chaos and social disruption. 4. Getting rid of inflation is costly in terms of higher unemployment, although most economists believe this cost is temporary. V. Surpluses and Deficits A. Government and Budget Surplus and Deficit 1. The federal government has a government budget surplus if it collects more in taxes than it spends. 2. The federal government has a government budget deficit if it spends more than it collects in taxes. 3. Figure 4.10(a) shows the federal government and total government budget surplus and deficit measured as a percentage of GDP since 1962.

84 CHAPTER 4 4. Since 1970, the government has had a budget surplus from 1998 to 2000 and a budget deficit in the other years. As a fraction of GDP, the budget deficit was highest in the 1980s. B. International Deficit 1. The value of the goods and services sold to other countries (exports) plus net interest receipts minus the value of the goods and services purchased from other countries (imports) is the current account balance. 2. Figure 4.10(b) shows the history of the U.S. current account balance from 1962 to 2002. 3. Until 1982, the United States generally had a current account surplus; that is, it sold more to the rest of the world than it purchased. From 1982 to 1987, the current account deficit became large. It then decreased significantly between 1988 and 1991, after which it has increased once more and is currently near 5 percent of GDP. C. Do Deficits Matter? 1. Deficits can be harmful if the borrowing is used to buy consumption goods rather than more investment. VI. Macroeconomic Policy Challenges and Tools A. Until the development of modern macroeconomics, it was widely believed that the only economic role for government was to enforce property rights. B. Policy Challenges and Tools 1. There are now five widely agreed challenges for macroeconomic policy: a) Boost economic growth b) Keep inflation low c) Stabilize the business cycle d) Reduce unemployment e) Reduce government and international deficits

A FIRST LOOK AT MACROECONOMICS 85 2. Making changes in tax rates and government spending programs is called fiscal policy. 3. Changing interest rates and the amount of money in the economy is called monetary policy. The Federal Reserve (Fed) is in charge of monetary policy. Reading Between the Lines A news article discusses the extremely fast estimated growth of 8.2 percent at an annual rate in the third quarter of 2003. The fast growth was impacted by investment in inventories and increasing exports. Business spending and profits were also high. The fast growth helped bring real GDP back towards potential GDP. New in the Seventh Edition This chapter is a much-revised version of Chapter 22 from the fifth edition. (The chapter was not in the sixth edition.) The data have been updated from the fifth edition. Amid the revised material, completely new is the discussion of the Lucas wedge and the Okun gap. The Reading Between the Lines is new and provides an illustration of the usefulness of quantitative analysis of economic growth and business cycle fluctuations. Teaching Suggestions 1. So far, all the chapters the students have studied have been about microeconomics. Regardless of whether your students have just finished Chapter 19 and hence an entire course in microeconomics or Chapter 3 and hence just an overview of the microeconomic supply and demand model this chapter is the first that is mainly about macroeconomics. Therefore, take a little time to review the distinction between microeconomics and macroeconomics. In particular, emphasize the different perspectives of these two subjects. This approach helps smooth the transition from the microeconomic chapters and the remainder of the book. Also point out to the students that ultimately we develop an aggregate demand and supply model that is similar to the microeconomicbased demand and supply model they have already encountered. Reassuring them that they have not been wasting their time studying the previous chapters helps keep the students motivated. 2. Students generally are interested in the topic of business cycles, particularly if the economy happens to be in a recession when this chapter is covered. One point to make is the fact that economists cannot forecast with certainty the path of the business cycle. For instance, in the first quarter of 2003 many economists worried that the economy s recovery was much slower than anticipated. Though few expected another recession in the near term, nonetheless this unspoken concern was present. It turned out to be unfounded and the economy continued to expand throughout 2003, with extremely rapid GDP growth in the second half of the year.. Stress to the students that it is not stupidity on the part of economists that prevents us from knowing where the economy is heading. Rather it is the fact that forecasting is very difficult for at least two reasons. First, different sectors of the economy always send different signals. For instance, retail sales may be down, signaling a start to a recession, but housing starts may be up, indicating that an expansion will continue for a while. Second, the data that must be used always are at least a bit out-ofdate. For example, the preliminary estimate of GDP is not made until approximately six weeks after the end of the quarter, and the final revision of GDP doesn t appear until years later. Although economists forecasts are much better than those of others, forecasting GDP with complete accuracy is

86 CHAPTER 4 unlikely. Conclude by mentioning that this fact is important in later chapters when we discuss implementation of counter-cyclical policies. 3. As the second teaching suggestion points out, it is usually straightforward to interest students in the business cycle. But it is perhaps a bit more difficult to motivate interest in economic growth and the Lucas wedge. Yet economic growth and the Lucas wedge should be of immense importance to young students because they help determine the long-run standard of their lives. One way to make this point clear is to ask the students whether the difference between, say, 3 percent annual growth in income versus 4 percent annual growth is important. This difference probably does not sound important. But, suppose that the initial income was $35,000. After 10 years with 3 percent growth, the incomes would be $47,037 and with 4 percent growth the income would be $51,809. This difference of about $4,500 might not seem like much. But point out to the students that this difference is for only one year and that the annual difference will continue to enlarge: After 30 years with 3 percent growth, the incomes would be $84,954 and with 4 percent growth the income would be $113,519, a one year difference of about $40,000. And, over a 30-year working career, the total differences in income, which is the analog to the Lucas wedge, is approximately $420,000. Over a 40-year working career, the Lucas wedge difference is over $1,000,000! Viewed from this perspective, the seemingly slight 1 percentage point difference in growth rates makes for an incredibly major difference in incomes, which should easily capture your students attention. The Big Picture Where we have been: Chapter 4 does not directly use the material developed in the previous chapters. Where we are going: Chapter 4 is the first of the strictly macroeconomic chapters. It provides basic definitions (economic growth, real GDP, unemployment, inflation, and business cycles) that are used in virtually all the remaining chapters. It develops little in the way of tools, but give students something perhaps more important: a basic understanding of the issues that macroeconomists endeavor to understand and explain and a strong motivation for the students to learn about how macroeconomists explore these issues. Chapter 5 begins to develop more technical tools by looking at national income. Chapter 6 focuses on monitoring the business cycle, the labor market and the price level. Chapter 7 introduces the AS-AD model. Tool building and analysis of macroeconomics then continues through Chapter 16. Overhead Transparencies Transparency Text figure Transparency title 20 Figure 4.1 Economic Growth in the United States 21 Figure 4.2 The Most Recent U.S. Business Cycle 22 Figure 4.3 Long-Term Economic Growth in the United States 23 Figure 4.5 The Lucas Wedge and the Okun Gap 24 Figure 4.6 Unemployment in the United States 25 Figure 4.8 Inflation in the United States 26 Figure 4.10 Government Budget and International Surpluses and Deficits

A FIRST LOOK AT MACROECONOMICS 87 Electronic Supplements MyEconLab MyEconLab provides pre- and post-tests for each chapter so that students can assess their own progress. Results on these tests feed an individualized study plan that helps students focus their attention in the areas where they most need help. Instructors can create and assign tests, quizzes, or graded homework assignments that incorporate graphing questions. Questions are automatically graded and results are tracked using an online grade book. PowerPoint Lecture Notes PowerPoint Electronic Lecture Notes with speaking notes are available and offer a full summary of the chapter. PowerPoint Electronic Lecture Notes for students are available in MyEconLab. Instructor CD-ROM with Computerized Test Banks This CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor s Manual files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software. Additional Discussion Questions 11. What is the difference between macroeconomics and microeconomics? 12. Is economic growth good or bad? 13. Suppose that the government could undertake a policy that raises economic growth by 1 percentage point. Should it do so? 14. Is the business cycle good or bad for the economy? That is, if the government could eliminate the business cycle, should it do so? What if doing so also eliminated all economic growth? 15. Is the business cycle like a regular cycle, with regularly recurring expansions and contractions? 16. What phase of the business cycle is the economy currently in? 17. Unemployment is bad for the unemployed individual and bad for the nation. Hence the government ought to eliminate all unemployment. Comment on this suggestion. Is the elimination of all unemployment realistic? 18. Unemployment reached a peak in the middle of the Great Depression. Why has the unemployment rate never again attained that level? 19. What is the difference between the price level and the inflation rate? 10. Why might a government budget deficit matter for the nation? Why might a current account matter?

88 CHAPTER 4 Answers to the Review Quizzes Page 94 Page 96 (page 466 in Economics) 1. Economic growth is the increase in the nation s ability to produce goods and services. Long-term economic growth is measured by the increase in potential GDP. 2. Real GDP is the total value of goods and services produced, measured by the prices of a single year. Potential GDP is the amount of real GDP that is produced at full employment of all the nation s resources. So real GDP is the actual amount produced with the actual level of employment of the nation s resources. 3. The business cycle is the irregular up and down fluctuations in economic activity, usually measured by the up and down movements in real GDP. A business cycle has two phases: recession and expansion. 4. A recession is the phase in the business cycle that is marked by a slowdown in economic activity; it is conventionally defined as a decrease in real GDP for two or more consecutive quarters. 5. The U.S. economy was in a expansion phase during 2003. However, the economy was likely below potential GDP. 6. There was a general slowing of economic growth, which created an extremely large Lucas wedge. 7. Benefits of long-term economic growth are the possibility of increased consumption of goods and services. It allows more resources to be devoted to areas such as health care, research, and environmental protection. One cost of economic growth is the forgone consumption necessary to increase the nation s capital stock and/or its technological base. Other possible costs are more rapid depletion of natural resources and/or more environmental problems. Finally, economic growth can force rapid changes in people s jobs and consumption patterns. (page 468 in Economics) 1. A general definition of unemployment is a person who wants to work but does not have a job. A more precise definition is a worker is unemployed if he or she does not have a job but is available and willing to work and has made some effort to find work within the past four weeks. 2. The unemployment rate skyrocketed in the 1930s, hitting a peak of near 25 percent in 1932. Unemployment then fell during World War II, after which it hovered around 4 or 5 percent, rising during recessions and falling during expansions, until about 1970. After 1982, the unemployment rate generally trended down, though it increased in recessions and falling below in expansions. In 2003 the unemployment rate was a bit above 5 percent. 3. Since 1980, unemployment in Canada has generally been higher than that in the United States. The business cycle fluctuations in the two nations (e.g., the rise in unemployment during a recession) have occurred at approximately the same times. In 1983, unemployment in the United States was higher than in Western Europe. However, since 1984 unemployment in the United States has been below that in Western Europe, typically by 2 percentage points or more. Unemployment in Japan is typically lower than in the United States. However, U.S. unemployment has shown a downward trend and Japanese unemployment has shown as upward trend so that from about 1997 to 2001 unemployment was less in the United States. After 2001, the Japanese unemployment rate has been less than that in the United States, but the difference has been small. 4. Unemployment is a serious problem because of two main costs: first, unemployment means that society loses the production that the worker could have produced by working and that workers

A FIRST LOOK AT MACROECONOMICS 89 lose the income they would have been paid for working. Second, prolonged unemployment can decrease a worker s human capital, which can adversely affect their job prospects in the future. Thus unemployment inflicts cost on both society and the individual worker, with the longer lasting the spell of unemployment, the greater the costs. Page 99 (page 471 in Economics) 1. Inflation is a general, persistently upward movement in prices. Inflation will reduce the purchasing power of a given amount of money. 2. Inflation is measured as the inflation rate. The inflation rate is the percentage change in the price level. 3. Inflation in the early 1960s was between 1 and 2 percent. It began to increase in the late 1960s and rapidly increased in the 1970s. This trend was reversed in the early 1980s. Inflation decreased further during the 1990s and though it rose a bit in 2001, it has remained relatively low by historical standards. 4. Since 1983, inflation in the United States and in other industrial nations have been closely correlated. For both, inflation jumped higher in 1990 and 1999 while generally falling in other years. 5. Inflation can be a problem for several reasons. First, inflation affects the value of money. As a result, changes in inflation affect the real value of payments made and received on the basis of long-term contracts. For instance, higher inflation can reduce the real value of wage payments made to workers. In addition, inflation leads people to shift resources away from productive activities and toward forecasting inflation. For example, rather than working at his or her dental practice, a dentist may spend time forecasting the inflation rate in order to protect his or her assets. Moreover, reducing inflation often imposes a cost in terms of higher unemployment. Page 101 (a) (page 473 (a) in Economics) 1. The government s budget deficit equals the amount the government spends minus the amount it collects as taxes. 2. In the 1960s, the United States tended to have a budget surplus more often than a budget deficit. From 1970 to 1998, the federal government has had a budget deficit. As a fraction of GDP, the deficit was large in 1975 (at about 4 percent of GDP); in 1983 (at about 6 percent of GDP); and in 1992 (at about 5 percent of GDP). Overall, the deficit was large during the early 1980s but has decreased in size since 1992 and then became a surplus in 1998. This surplus lasted until 2001, after which the United States has once again had a budget deficit. 3. A nation s international deficit current account deficit equals the value of its exports minus the value of its imports plus net interest payments. 4. As a fraction of GDP, the U.S. international deficit was small during the 1970s and was sometimes positive (a surplus) and sometimes negative (a deficit). After 1982, however, the international deficit increased in size, reaching about 4 percent of GDP in 1987. Since then the deficit has fluctuated, though it increased after 2000 and reached its maximum of about 5 percent of GDP in 2002. Page 101 (b) (page 473 (b) in Economics) 1. The five macroeconomic policy challenges are: boost economic growth; keep inflation low; stabilize the business cycle; reduce unemployment; and, reduce the government budget deficit and the international deficit.

90 CHAPTER 4 2. To achieve macroeconomic goals are two policy tools: fiscal policy (changing government spending and tax rates) and monetary policy (changing interest rates and the quantity of money). 3. Fiscal policy refers to changes in the government s budget, that is, changes in federal government spending or changes in taxes. Monetary policy is conducted by the Federal Reserve and refers to changes in the quantity of money and interest rates.

A FIRST LOOK AT MACROECONOMICS 91 Answers to the Problems Data Graphing in MyEconLab allows students to plot the time-series graph or scatter diagram based on the data. To answer problems that involve more than one country, use the International Comparisons dataset and not the individual country datasets. After plotting the graph, students can print it, and then use the printed graph to answer the questions 1. a. The growth rate was highest in Canada in 2002. b. The unemployment rate in 2002 was highest in Canada. c. The inflation rate in 2002 was lowest in the United Kingdom. d. The government budget deficit in 2002 was largest in the United States. 2. a. The growth rate was highest in the United States in 1996. b. The unemployment rate was the lowest in Japan in 1996. c. The inflation rate was the lowest in Japan in 1996. d. The government budget deficit was lowest in the United States in 1996. e. No, it is not possible to say in which country consumption possibilities are growing faster. The United States seems to be doing well with a relatively high growth rate, but did not have as low of unemployment and inflation in 1996 as other countries. There is no clear winner here. What is possible to say is that Canada clearly seems to be doing relatively poorly with respect to increasing consumption possibilities. Canadian growth has relatively low growth, high unemployment, with moderate inflation and a relatively higher budget deficit. 3. a. India s economic growth rate was positive in every year from 1989 to 1996. Its economic growth rate was fastest in 1989. b. Pakistan s economic growth rate was not negative during this period. Its economic growth rate was slowest in 1993. c. From 1989 to 1993, when India s economic growth rate increased, Pakistan s decreased. But from 1993 to 1995, both economic growth rates increased. In 1996, they were the same. 4. a. Economic growth in Australia increased in 1989 and from 1993 through 1996. Economic growth was fastest in 1990. b. Economic growth in Japan decreased from 1989 to 1991 and again from 1994 to 1995. Economic growth was slowest in 1991. c. From 1989 to 1990, Australia s growth rate increased and Japan s decreased. Both countries growth rates decreased from 1990 to 1991. Australia s growth rate continued to decrease until 1993, but Japan s increased from 1991 to 1994. In 1994, Japan s growth rate decreased, while Australia s continued to increase. By 1995, both countries growth rates were increasing and the becoming close to the same. 5. a. Germany had one recession in the third and fourth quarters of 1992. A recession is a period during which real GDP decreases for at least two successive quarters. Real GDP decreased in the third and fourth quarters of 1992. b. Germany experienced a business cycle peak in the fourth quarter of 1991. A business cycle peak is the upper turning point. A peak occurs when real GDP stops growing and starts to decrease. c. Germany experienced a business cycle trough in the fourth quarter of 1992. A business cycle trough is the lower turning point of a business cycle where a recession ends and an expansion begins. d. Germany experienced an expansion during the third and fourth quarters of 1991 and from the first quarter of 1993 through the second quarter of 1994. An expansion is a period during which real GDP increases. 6. a. Students answers will vary depending on what data is available at the time. At this time the most recent data is from the first quarter of 2003 and at the present the U.S. economy is in an expansion.

92 CHAPTER 4 b. Presently, the expansion has lasted since the third quarter of 2001. c. In 2003, the growth rate sped up. 7. a. The United States had the largest budget deficit in 2002. b. In 2002, Canada, Japan, and Germany had current account surpluses, while the United States had a current account deficit. Japan had the largest current account surplus. 8. a. In 2002, Canada had the largest budget surplus. b. In 2002, the United States the largest current account deficit. 9. a. There is no clear relationship, either positive or negative, between inflation and unemployment. b. No, there is no evidence from the data that low unemployment brings an increase in the inflation rate. Low levels of both seem to be consistent with the data. 10. a. Though the precise diagram will depend on when the problem is assigned, the diagram will show that there is a positive or direct relationship: low unemployment occurs with a small budget deficit and high unemployment occurs with a large budget deficit. b. According to the graph there is evidence that low unemployment is consistent with decreases in the budget deficit. But there is not necessarily causality in this relationship because both are probably responding to a third factor, the business cycle.