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Introduction to
Macroeconomics
CHAPTER
20
© 2003 South-Western/Thomson Learning
1
The National Economy
Recall that macroeconomics concerns
the overall performance of the economy
The term economy describes the structure
of economic life, or economic activity, in a
community, a region, a country, a group of
countries or the world
Gross product
Most commonly used measure of an
economy’s size
Measures the market value of final goods
and services produced in a particular
geographical region during a given period
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Gross Domestic Product
GDP = Gross Domestic Product
Focuses on the U.S. economy
Measures the market value of all final
goods and services produced in the
United States during a given period
Helps us keep track of the economy’s
incredible variety of goods and services
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The National Economy
Macroeconomic policy typically focuses
on the performance of the national
economy, including how the national
economy interacts with other economic
countries around the world
Economy continually renewing itself
Money circulates throughout the
economy, facilitating the exchange of
resources and products among
individual economic units
Money is called a medium of exchange
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Flow and Stock Variables
Flow Variable
An amount per period of time
Average spending per week, hours worked
per month, etc.
Stock Variable
An amount measured at a particular point in
time
Amount of cash on hand you have now
Number of housing units in existence today
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Knowledge and Performance
As long as the economy functions
smoothly, policy makers need not
understand how it works
However, when problems occur – high
inflation, severe unemployment – we
must understand how a healthy
economy works before we can consider
how the problem can be corrected
In order to do this, we must understand
the essential relationships among key
economic variables
6
Mercantilism
National policy makers have sometimes
implemented the wrong economic
prescription because of a flawed theory
about how the economy works
Mercantilism
Belief that a nation’s economic vitality was
thought to spring from the stock of precious
metals accumulated in the public treasury
One way of accumulating gold and silver is
for a nation to sell more output to
foreigners than it bought from them 
tariffs and quotas were popular
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Economic Fluctuations
Economic fluctuations
The rise and fall of economic activity
relative to the long-term growth trend of
the economy
Business cycles
Vary in length and intensity but have some
features in common
Easiest way to understand economic
fluctuations is to examine their
components
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Components of Business Cycles
Two phases
Periods of expansion
Periods of contraction
Depression
Severe contraction
Lasting longer than one year and
accompanied by high unemployment
Recession
Milder contraction
Decline in total output lasting at least two
consecutive quarters
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Exhibit 1: Hypothetical Business Fluctuations
The long-term growth trend
is shown by the upward
sloping straight line.
Economic fluctuations
reflect movements along this
growth trend.
A recession begins after the
previous expansion has
reached its peak, or high
point and continues until the
economy reaches a trough,
or low point.
Period between a peak and a
trough is a recession and the
period between a trough and
subsequent peak is an
expansion.
Peak
Trough
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U.S. Growth
U.S. economy in 2001 was more than
eleven times larger than in 1929 as
measured by real gross domestic
product – real GDP
Real GDP means the effects of changes
in the economy’s price level have been
stripped away  the remaining changes
reflect real changes in the value of
goods and services produced
11
Exhibit 2: Annual Percentage Change in
U.S. Real GDP from 1929 -2001
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Increases in Production
Production tends to increase over the
long run because of
Increases in the amount and quality of
resources, especially labor and capital
Better technology
Improvements in the rules of the game that
facilitate production and exchange
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Business Cycle
Turning points – peaks and troughs –
are defined as officially occurring by the
NBER only after the fact
Since a recession means that output
declines for at least two consecutive
quarters, a recession is not so
designated until six months after it
begins and a recovery is officially
underway after two consecutive
quarters of growth
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Leading Economic Indicators
Months before a recession is fully
underway, changes in these leading
economic indicators point to the coming
storm
All these activities are called leading
economic indicators because they
usually predict, or lead to, a downturn
and upturns point to an economic
recovery
For example, in the early stages of a
recession firms reduce overtime and new
hiring, machinery orders slip, and the stock
market turns down
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Aggregate Output
Aggregate output
Total amount of goods and services produced in the
economy during a given period
Unit of aggregate output is a composite
measure of all output in the same sense that
a unit of food is a composite measure of all
food
Best measure of aggregate output is real
gross domestic product, or real GDP
Aggregate demand is the relationship
between the average price of aggregate
output and the quantity of aggregate
output demanded
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Price Level
Average price of aggregate output is
called the price level
The price level in any year is an index
number, or reference number,
comparing average prices that year to
average prices in some base, or
reference, year
When we say that the price level is higher,
we mean compared to where it was
Average price of all goods and services
produced in the economy relative to the
price level in some base year
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Price Level
The price level in the base year has a
benchmark value of 100
Price levels in other years are expressed
relative to the base-year price level
Price level or price index used to make
Comparisons in prices across time
Accurate comparisons of real aggregate
output over time
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GDP Price Index
After adjusting GDP for price changes,
we end up with what is called the real
gross domestic product, or real GDP
The GDP price index
Shows how the economy’s general price
level changes over time
Can be used to convert production in
different years into dollars of constant
purchasing power
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Aggregate Demand Curve
Aggregate demand curve shows the
relationship between the price level in
the economy and the real GDP
demanded, other things constant
Sums demands of the four economic
decision makers: households, firms,
governments, and the rest of the world
Among the factors held constant along a
given aggregate demand curve are
The price levels in other countries
The exchange rates between the U.S. dollar
and foreign currencies
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The vertical axis measures an
index of the economy’s price
level relative to a 1996 base
year price level of 100.
The horizontal axis shows real
GDP, which measures output in
dollars of constant purchasing
power, using 1996 prices
The inverse relationship
depicted by the aggregate
demand curve reflects the fact
that as the price level increases,
other things constant, the
purchases of the four major
decision makers decline
Price level trillions of 1996 dollars
Exhibit 4: Aggregate Demand Curve
150
100
50
AD
0
2
4
6
8
10
12
14
16
Real GDP trillions of 1996 dollars
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Aggregate Supply Curve
Aggregate supply curve shows how
much output U.S. producers are willing
and able to supply at each price level,
other things quantity
Assumed constant along an aggregate
supply curve are
Resource prices, including wage rates
The state of technology
The rules of the game that provide
production incentives
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Exhibit 5:Aggregate Demand & Supply
Equilibrium in the national
economy occurs where the
AD and AS curves intersect.
AS
Price level (1996 = 100)
Wage rates are typically
assumed to be constant
along the aggregate supply
curve  firms find a
higher price level more
profitable so they increase
real GDP supplied.
Equilibrium real GDP in 2001
was about $9.3 trillion at a
price level of 109. At any other
price level, quantity demanded
would not match quantity
supplied.
150
109
100
50
AD
0
9.3
Real GDP
(trillions of 1996 dollars)
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Equilibrium
Although employment is not measured
directly along the horizontal axis in
Exhibit 5
Firms usually must hire more workers to
produce more output  higher levels of
real GDP can be beneficial because
More goods and services are available in the
economy
More people are employed
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Short History of U.S. Economy
History of the U.S. economy can be
crudely divided into four economic eras
Prior to and including the Great Depression
• These contractions were often accompanied by a
falling price level
After the Great Depression to the early
1970s
• Was an era of generally strong economic growth
• Moderate increases in the price level
From the early 1970s to the early 1980s
• High unemployment and high inflation
Since the early 1980s
• Good economic growth
• Moderate increases in the price level
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Price level (1996 = 100)
Exhibit 6: Decrease in Aggregate
Demand between 1929 and 1933
AS
The Great Depression can be
viewed as a shift to the left of
the aggregate demand curve.
This resulted in a drop of
both the price level and real
GDP.
12.6
9.3
AD1929
AD1933
0
603
822
Real GDP
(billions of 1996 dollars)
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Great Depression and Before
Why did aggregate demand decline so
much during this period?
Stock market crash of 1929
Grim business expectations
Drop in consumer spending
Widespread bank failures
Sharp decline in the nation’s money supply
Severe restrictions on world trade
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Great Depression and Before
Prior to the Great Depression,
macroeconomic policy was based
primarily on the laissez-faire policy
If people were allowed to pursue their
self-interest in free markets, resources
would e guided as if by an “invisible
hand” to produce the greatest, most
efficient level of aggregate output 
contractions were essentially selfcorrecting
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Age of Keynes
Keynes argued that aggregate demand
was inherently unstable
In part, this instability occurs because
business investment decisions were
often guided by unpredictable “animal
spirits” of business expectations
Keynes saw no natural forces operating
to ensure that the economy, even if
allowed a reasonable time to adjust,
would return to a high level of
employment and output
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Age of Keynes
Keynes proposed that the government
jolt the economy out of its depression
by increasing aggregate demand
Direct stimulus by increasing its own
spending
Indirect stimulus by cutting taxes to
stimulate the primary components of
private-sector demand, consumption and
investment
Federal budget deficit
Flow variable that measures, for a particular
period, the amount by which total federal
outlays exceed total federal revenues
30
Age of Keynes
To visualize what Keynes had in mind,
federal policies would be designed to
shift the aggregate demand back to its
original position in Exhibit 6 with the
result that equilibrium real GDP and
employment would increase
The Keynesian approach can be though
of as demand-side economics because it
focused on how changes in aggregate
demand could promote full employment
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Age of Keynes
Trying to avoid another depression,
Congress approved the Employment Act
of 1946
Which imposed a clear responsibility on the
federal government to foster
• Maximum employment
• Maximum production
• Maximum purchasing power
Created the Council of Economic Advisers
Required the president to report annually on
the state of the economy
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The Great Stagflation: 1973 - 1980
The combined stimulus of federal
spending on both the war in Vietnam
and social programs in the late 1960s
increased aggregate demand enough
that the inflation rate began to increase
The high inflation rates induced
President Richard Nixon to introduce
ceilings on prices and wages in 1971
To compound these problems, OPEC
reduced the supply of oil with the
resulting increase in world prices
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The Great Stagflation
The combination reduced aggregate
supply as shown in Exhibit 7 with the
result that we had the stagflation of the
1970s
Stagflation
Stagnation, or a contraction in the
economy’s aggregate output combined with
Inflation, a rise in the economy’s price level
Primarily a supply side problem  the
demand-management policies of Keynes
were relatively ineffective
34
Exhibit 7: Stagflation Between 1973-1975
Price level (1996 = 100)
The stagflation of the mid-1970s can be
represented as a reduction in aggregate supply.
AS1975
AS1973
40.0
33.6
AD
0
4.08 4.12
Real GDP
(trillions of 1996 dollars)
35
Experience Since 1980
The stagflation of the 70s shifted policy
maker’s attention from aggregate
demand to aggregate supply
Supply-side economics
The federal government, by lowering tax
rates, would increase after-tax earnings,
which would provide incentives to increase
the supply of labor and other resources
The resulting increase in aggregate
supply would achieve the goals of
expanding real GDP and reducing the
price level
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Experience Since 1980
In 1981 President Reagan and Congress
cut personal income tax rates by an
average of 23% to be phased in over 3
years
Before the tax cut was fully
implemented, recession hit in 1982 and
the unemployment rate shot up to 10%
After the recession, the economy began
what was at the time the longest
peacetime expansion on record
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Experience Since 1980
However, during this period, the growth
in federal spending exceeded the
growth in tax revenues  federal
budget deficits swelled
The huge deficits that occurred during
this period accumulated as a huge
federal debt
Government debt
Stock variable
Measures the net accumulation of prior
deficits
Nearly doubled in the period of 1980 to
1992 relative to GDP
38
Experience Since 1980
The huge federal deficits led both
Presidents George H.W. Bush and
William Clinton to increase taxes
When combined with the Republican
Congress reductions in federal
spending, the deficit problem turned to
surpluses
By early 2001 the U.S. economic
expansion became the longest on record
and has only recently began to slow
39