Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
Chapter 4: A First Look at Macroeconomics
I. Economics as a Social Science
A. Economics is the social science that studies the choices that individuals,
businesses, governments, and societies make as they cope with scarcity. It
can be divided into two areas of study:
1. Microeconomics is the study of the choices individuals and businesses
make, the way those choices interact in the markets, and the influence of
governments.
2. Macroeconomics is the study of the performance of the national
economy and the global economy.
B. Economic questions arise because we face scarcity—we all want more than
we can get.
1. Because we are unable to satisfy all of our wants, we must make choices.
2. Incentives are the rewards that encourage us, or the penalties that
discourage us, from taking an action. The incentives that we face will
influence the choices that we make when dealing with scarcity.
C. How are goods and services produced?
1. Factors of production (or, economic resources) are the productive
resources used to produce goods and services. These include land
(natural resources), labor (the work time and work effort of people),
capital (tools, instruments, and machines that are used to produce goods
and services), and entrepreneurship (the human resource that organizes
land, labor, and capital).
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
2. The quality of labor depends on human capital, which is the knowledge
and skill that people obtain from education, work experience, and on-thejob training.
II. Origins and Issues of Macroeconomics
A. Modern macroeconomics emerged during the Great Depression (19291939) 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.
III. 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.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
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.
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 long-term 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.
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.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
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.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.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
IV. 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 of
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.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
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.
V. 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.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
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.
VI. 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.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
3. Figure 4.10(a) shows the federal government and total government
budget surplus and deficit measured as a percentage of GDP since 1962.
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.
VII. 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.
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Principles of Macroeconomics
Dr. S. Ghosh
Spring 2007
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
2. Making changes in tax rates and government spending programs is called
fiscal policy.
The government (the Congress in the U.S.) is in charge of fiscal policy.
3. Changing interest rates and the amount of money in the economy is
called monetary policy.
The central bank (The Federal Reserve in the U.S.) is in charge of
monetary policy.
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