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15-1
Graphing the Macroeconomy
•
Supply and demand graph for tutoring services from Chapter 1 can be
transformed to represent economy as a whole
15-2
Graphing the Macroeconomy (cont.)
15-3
Graphing the Macroeconomy (cont.)
• Graph explained:
– GDP
• Stands for gross domestic product
• Nation’s total output
– AD
• Stands for aggregate demand
• Quantity of total output (GDP) demanded (purchased) at alternative
price levels
• Downward sloping
– Substitution is not possible
– Decline in average price level does not make GDP more affordable,
since purchasing power depends on both incomes and prices
– AS
• Stands for aggregate supply
• Quantity of total output (GDP) supplied (produced) at alternative
price levels
• Upward sloping
– Higher prices give producers greater incentive to produce products;
quantity of output supplied increases when prices of output increase
15-4
Gross Domestic Product
• Market value of all final goods and services produced in
economy in given time period, usually one year
– Final goods and services include all products as well as services
that are purchased as final products
• Example: Purchasing bag of flour at supermarket to bake a cake
and then eat it vs. bakery buying bag of flour to bake a cake and
then sell it
– All goods comprising GDP must be produced during particular
year
• Example: If you sell your 10-year home this year, value of home
does not constitute part of this year’s GDP; but if you employ
current services of realtor, value of realtor’s services are included in
this year’s GDP
– Necessary to define gross domestic product in value terms,
specifically dollars in United States
• Must first attach value to physical quantities of output produced;
then can add them up to tabulate total domestic product
– Use market prices to value physical quantities of output
» Market price includes retail price of product plus any sales and
excise taxes paid by consumer
15-5
Gross National Product
• Market value of all final goods and services
produced by economy over particular time
period
– Word “by” in definition distinguishes gross national
product (GNP) from gross domestic product (GDP)
• Example of GDP: If Mexican citizen comes up to United
States during summer to pick tomatoes, value of these
tomatoes would be included in U.S. GDP
– Tomatoes are produced within physical boundaries of U.S.
• Example of GNP: If U.S. citizen makes earrings in Mexico,
value of earrings is counted as part of U.S. GNP
– Doesn’t matter where earrings are produced, as long U.S.
citizen produces them
15-6
Real vs. Nominal GDP
• Real GDP
– GDP calculated at constant prices (prices that exist in a base
year)
• Example: If 1982 is base year, real GDP in 1990 calculated by
valuing 1990 production of a product at prices that existed in 1982
– 1990 Real GDP = 1982 prices × 1990 production
– Number to use when comparing information over different time
periods
– Adjusted for inflation
• Nominal GDP
– GDP calculated at current prices (actual prices of a particular
year)
• Example: 1990 nominal GDP includes production of product valued
at prices that exist in the year 1990
– 1990 Nominal GDP = 1990 prices × 1990 production
– Number to consider when trying to make sense of information for
one year only
– Not adjusted for inflation
15-7
Flaws of GDP
• Gross domestic product is typically used as
indicator of economic activity, as well as
measure of standards of living
– When GDP is high, assumption is that economy is
doing well and that standards of living are high
– When GDP is growing over time, assumption is that
economic activity and standards of living are
increasing
• Some flaws in these assumptions
– The following make GDP an imperfect measure of economic
activity and standards of living:
» Nonmarket activities
» Underground economy
» Distribution and composition of national output
15-8
Nonmarket Activities
• Exclusion of nonmarketed goods and services serves to
understate full value of productive activity in economy
• Exclusion of nonmarketed goods and services also
distorts comparisons
– During 1950s, most women stayed home as full-time
homemakers, but in 1990s, many women had entered formal
labor market, paying out money for services that they had
previously provided themselves
• Comparisons of countries’ GDPs distorted as well
– In many Third World countries, many families grow own food,
build own homes, and gather own water and fuel; GDP statistics
are very low in part because many of these nonmarketed
activities go unreported
15-9
Underground Activities
• Underground economy involves economic
activity that is never reported to government,
either because activity is illegal or participants
wish to evade taxes
– Such underground activity causes GDP to understate
actual economic activity
• Similarly, any time person engages in under-thetable exchange, usually to avoid payment of
personal income taxes, activity is not recorded
and therefore doesn’t enter GDP statistics
15-10
Composition and Distribution
• Composition of GDP
– Goods and services of which GDP consists
• Example: If small country primarily produces armaments and
other military hardware, its people may not be achieving
same quality of life as those of another country that has
similar level of GDP but primarily produces health care,
educational services, and other goods and services directly
meeting needs of people
• Distribution of income
– How national income is distributed within economy
• Makes a great deal of difference whether nation’s income
flows primarily to small, select, elite group of people or is
distributed more equally within country
15-11
Aggregate Demand
• Will increase whenever any of following
sectors increase purchases:
–
–
–
–
Consumers
Businesses
Government
Foreign purchasers
15-12
Consumers
• Individual consumers purchase U.S.
durable and nondurable goods and
services
– Durable goods
• Products with life of longer than one year
– Nondurable goods
• Products with life of less than one year
• Consumer purchases represent largest
component of aggregate demand
15-13
Consumers (cont.)
• Consumers will increase purchases of goods
and services as result of variety of factors:
– When consumer incomes rise, consumer purchases
go up
– When consumer expectations of future improve,
consumer purchases go up
– Government policies to reduce personal income taxes
will serve to increase consumer incomes because
what is left after paying taxes will be higher
– Government policies that increase government
income transfers will increase consumer incomes
– When interest rates fall, cost of borrowing money
declines; consumers more willing to purchase
expensive items that they must buy with borrowed
money
15-14
Businesses
• Private business firms in economy also purchase U.S.
GDP
– Examples: Computers, office buildings, etc.
• Businesses “purchase” changes in inventories (unsold
goods and materials)
– Business normally holds variety of inventories
• Increases or decreases in inventories included in aggregate
demand as business purchases
• Business purchases are relatively small component of
aggregate demand, but tend to fluctuate a lot
• Business purchases influenced by variety of factors:
– If economy is improving and businesses expect sales to boom,
may begin purchasing more inventory now to meet future
consumer demand
– Decline in interest rates means that new inventory is cheaper
and easier for businesses to buy
15-15
Government
• Government purchases goods, services, and
structures
• Only government purchases of U.S. GDP are
represented along aggregate demand curve
• Income transfers not included in category of
government purchases of goods and services
– Cash transfers from government for which no good or
service is provided in return
• Examples: Social Security benefits, unemployment
compensation, etc.
• Any increase in government purchases will
increase aggregate demand
15-16
Foreign Purchasers
• Foreigners purchase some of our
production, ranging from around 8 to 12
percent of U.S. GDP in recent years
– Include individual people, businesses, and
governments of other countries
• Refer to their purchases as U.S. exports
– Anything that causes our exports to increase will result in
increase in aggregate demand
15-17
Shifts in Aggregate Demand
•
Increase in aggregate demand caused by increase in purchases by
consumers, businesses, government, or foreigners is represented as
forward shift in aggregate demand
15-18
Shifts in Aggregate Supply
•
Aggregate supply increases if:
– Costs of production decrease
– Technological advance makes production of nation’s output cheaper15-19
and easier
Demand-Pull Inflation
•
Caused by increase in aggregate demand
– Aggregate demand curve shifts forwards, resulting in increase in gross
domestic product, as well as increase in average price level
15-20
Cost-Push Inflation
•
Caused by increase in costs of production
– Aggregate supply curve shifts backwards, resulting in decrease in
gross domestic product, as well as increase in average price level
15-21
Profit-Push Inflation
•
Results from market power of various industries within U.S. economy
– When business firms use market power, output is deliberately restricted to drive
up prices and profits
• If market power is extensive, conditions show up as backward shift in
aggregate supply curve
15-22
Fiscal Policy
• Use of government spending and tax
policy to shift aggregate demand curve
• Can be either expansionary or
contractionary
– Expansionary fiscal policy
• Increases aggregate demand, thereby expanding
GDP
– Contractionary fiscal policy
• Decreases aggregate demand, thereby
contracting GDP
15-23
Expansionary Fiscal Policy
15-24
Expansionary vs. Contractionary Fiscal Policy
•
Expansionary fiscal policy consists of one or
more of following tools:
1. Increase in government purchases of goods and
services
2. Reduction in taxes
3. Increase in income transfers
•
Contractionary fiscal policy consists of one or
more of following tools:
1. Decrease in government purchases of goods and
services
2. Increase in taxes
3. Decrease in income transfers
15-25
Monetary Policy
• Changes made in nation’s money supply to shift
aggregate demand curve
• Whereas fiscal policy is under control of
government, monetary policy is under control of
Federal Reserve
– Federal Reserve controls nation’s money supply
• Changes in nation’s money supply will affect interest rate
– Increase in supply of money will cause reduction in interest rate
» Reflects expansionary monetary policy
– Decrease in nation’s money supply will cause increase in
interest rate
» Reflects contractionary monetary policy
• Monetary policy affects economy through effects on interest
rates
– Rise in interest rate will cause reduction in business purchases,
as well as decrease in consumer purchases
15-26
Monetary Policy (cont.)
• Is an aggregate demand-side policy
– Designed to influence aggregate demand
• Federal Reserve may choose either
expansionary or contractionary monetary
policy, depending on state of economy
15-27
Contractionary Monetary Policy
15-28
Shortcomings of Fiscal and Monetary Policy
• Operates on aggregate demand side of
economy:
– Increase in aggregate demand, as in case of
expansionary fiscal policy, results in increase
in GDP and employment, but at cost of
creating inflation
– Decrease in aggregate demand, as in case of
contractionary monetary policy, reduces
problem of inflation, but at cost of creating
recession and unemployment
15-29
Supply-Side Policy
• Use of various tools to improve incentives
for workers and businesses to produce
more, thereby increasing aggregate supply
and GDP
– Cuts in personal income tax rates
– Cuts in government transfer programs
– Cuts in government regulations
15-30
Supply-Side Policy (cont.)
15-31
Cuts in Personal Income Tax Rates
• From supply-side perspective, tax cut must take
form of reduction in tax rates, because it is
assumed that tax rates influence decisions about
work effort
– Reduction in tax rates considered tantamount to
increase in hourly wages; assumed that people will
respond to incentive of higher after-tax wages by
increasing work effort
• If nation’s workers respond as desired, increased work effort
will result in expanded production, which will increase supply
side of economy
– Aggregate supply will shift forward, resulting in expanded GDP
and decreased price level
15-32
Cuts in Income Transfers
• In terms of supply-side policy, reducing
transfers forces people to seek
employment
– With more people working, production
expands and aggregate supply increases
15-33
Deregulation
• Reduction of government regulations
– By reducing certain regulations, it is argued
that businesses will expand production,
thereby increasing aggregate supply side of
economy
15-34
Effects of Supply-Side Policy
• Labor economists believe that overall impact of changes
in after-tax wages is close to zero
– Most people are unable to alter number of hours they work, so
increased incentives for work effort will not change number of
hours worked
– Others may decide to cut work hours because tax-rate cuts allow
them to maintain desired level of income while working fewer
hours
• Many have argued that cuts in government transfers do
not result in expanded work effort
– Transfer programs in early 1980s were meant for women with
small children and others unable to work
– Many participants in current welfare system will not be able to
work unless needs for child care, transportation, job training, and
education are met
– Given possibility of recession at any time, jobs may simply be
unavailable
15-35
The Objective of Supply-Side Policy
• Conservative objective of reducing
government role in economy is at root of
supply-side policies
– Supply-siders would reduce:
• Government domestic spending and involvement
in social programs
• Taxes to increase spending ability of private sector
• Government regulatory control over business
15-36
The Economic Left and the Economic Right
• THE ECONOMIC LEFT
(Liberal)
– Favor fiscal policy that
increases government
purchases and transfers,
especially if government
purchases are for domestic
programs
• THE ECONOMIC RIGHT
(Conservative)
– Would prefer to see fiscal
policy that reduces taxes
and places more
purchasing power in private
sector of economy
– Often supportive of high
levels of defense-related
spending
– Would prefer use of
monetary policy
– Favor use of supply-side
policy
15-37
Appendix: The Slope of the Aggregate Demand Curve
•
Aggregate demand curve slopes downward
– Downward slope indicates that quantity of gross domestic product
demanded increases when average price level falls and decreases
when average price level rises
15-38
Appendix: The Slope of the
Aggregate Demand Curve (cont.)
•
Relationship between quantity of GDP
demanded and average price level is negative
for three reasons:
1. If average price level in U.S. rises relative to price
levels in other countries, then American consumers
will tend to buy more foreign goods and fewer
American goods
2. Fixed amount of money (i.e., money in a savings
account) loses purchasing power when prices of
purchased items increase
3. When interest rates rise, people and businesses
reduce purchases of big-ticket items (i.e., cars,
homes, factories)
15-39
Appendix: The Slope of the
Aggregate Demand Curve (cont.)
• Keep in mind difference between factors that
cause movement along aggregate demand
curve and factors that cause shift in aggregate
demand curve
– Because average price level is on vertical axis of
graph of aggregate demand, any change in average
price level that causes changes in quantity of GDP
demanded is reflected as movement along demand
curve
– On the other hand, changes not precipitated by
change in average price level—such as changes in
population size, consumer incomes, or government
fiscal or monetary policy—will cause shift in entire
aggregate demand curve
15-40
Appendix: The Slope of the Aggregate Supply Curve
•
Economists have come to various conclusions about the shape of
aggregate supply curve, depending on whether they consider long run or
short run, as well as other assumptions
15-41
Appendix: The Slope of the
Aggregate Supply Curve (cont.)
• Notice that aggregate supply curve has flat range (Range A),
upward-sloping range (Range B), and vertical range (Range C)
– Range A
• Sometimes called Keynesian range, because it is typical of depression era
when John Maynard Keynes developed his theory of economy
– GDP was low and unemployment rates were extremely high
• Any increase in aggregate demand within flat Keynesian range of aggregate
supply will increase output and employment, without causing any attendant
inflation
– Range B
• Can be viewed as reflecting normal state of economy—that is, one with
moderate levels of GDP and employment
• Any shift of aggregate demand within this range will create trade-off between
unemployment and inflation
– Range C
• Corresponds to situation of high GDP and fully employed economy
• Increase in aggregate demand in context of full employment will only create
inflation, without creating any additional output or employment
15-42
Appendix: The Slope of the
Aggregate Supply Curve (cont.)
15-43