Chapter 20 – Overview of

Macroeconomics
 Macroeconomics is the study of the
behavior of the economy as a whole.
 It examines the forces that affect many firms,
consumers, and workers at the same time.
 Two central themes will run through our
study of macroeconomics:
1. The short-term fluctuations in output,
employment, and prices that we call the business
cycle;
2. The longer-term trends in output and living
standards known as economic growth.
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A. Key Concepts
1. Unemployment
 Why do output and employment sometimes fall,
and how can unemployment be reduced?
 From time to time, countries experience high
unemployment, which sometimes persist for
years.
 Macroeconomics examines the causes, and
suggests possible remedies such as increasing
aggregate demand or reforming labor market
institutions.

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2. Inflation
 What are the sources of price inflation, and how
can it be kept under control?
 Price is used as a yardstick to measure economic
values and conduct business.
 Inflation occurs when prices are rising rapidly,
and the price yardstick loses its value
 During this time, people get confused about
relative prices and make mistakes in their
spending and investment decisions.
 Most governments today make controlling price
inflation one of its main economic goals

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3. Economic Growth
 How can a nation increase its rate of economic
growth?
 This refers to the growth in the productive
potential of an economy.
 An economy’s productive potential is the central
factor in determining the growth in its real
wages and living standards.
 Success stories: Japan, Korea, Taiwan
 Unsuccessful: many African nations
 Common key factors of the successful countries:
predominance of free markets, low trade
barriers, honest government, strong property
rights.

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Objectives and Instruments
Measuring Economic Success
The major macroeconomic goals are a high
level and rapid growth of output, low
unemployment, and stable prices.
 Output
 The ultimate objective of economic activity is to
provide the goods and services that the
population desires.
 The most comprehensive measure of the total
output in an economy is the gross domestic
product (GDP).

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 GDP is the measure of the market value of all
final goods and services – beer, cars, rock
concerts, ferris wheel rides, and so on –
produced in a country during a year.
 There are two ways to measure GDP:
a) Nominal GDP is measured in actual market prices;
b) Real GDP is calculated in constant or invariant
prices.
 Despite the short-term fluctuations seen in
business cycles, advanced economies generally
exhibit a steady growth in real GDP and an
improvement in living standards; this process is
known as economic growth.

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 Potential GDP – represents the maximum
sustainable level of output that the economy can
produce.
 When an economy is operating at its potential,
there are high levels of utilization of the labor
force and the capital stock.
 When output rises above potential output, price
inflation tends to rise, while a below-potential
level of output leads to high unemployment.
 Potential output is determined by the economy’s
productive capacity, which depends upon the
available inputs (land, labor, capital) and the
economy’s technological efficiency.

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 High Employment, Low Unemployment
 This is the one macroeconomic indicator that is
most directly felt by individuals – employment
and unemployment.
 High employment is a situation where people are
able to get high-paying jobs without waiting too
long, getting job security and good benefits in the
process.
 The opposite would aptly describe a situation of
high unemployment.
 The unemployment rate tends to reflect the state
of the business cycle: when output is falling, the
demand for labor falls, and the unemployment
rate rises.
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 Price Stability
 This is the third macroeconomic objective, and
means that the overall price level is either
unchanged or rising very slowly.
 To track prices, government statisticians
construct price indexes, or measures of the
overall price level.
 An important example is the consumer price
index (CPI), which measures the average price of
the goods and services bought by consumers,
which we label as P (a.k.a. the inflation rate).
 For example, the CPI was 177.1 in 2001 and 179.9
in 2002 (where 1983=100).

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 We thus calculate the inflation rate for 2002 as

Inflation 2002 = [P(2002) – P(2001)] x 100%

P(2001)
= [(179.9 – 177.1)] x 100%
177.1
= 1.6%

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 A deflation occurs when prices decline (which
means that the rate of inflation is negative).
 At the other extreme is hyperinflation, a rise in
the price level of a thousand or a million percent a
year.
 This was the case in Germany in the 1920’s, Brazil
in the 1980’s, and Russia in the 1990’s.
 Prices during those times became meaningless,
and the price system broke down.

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  Price stability is important because a smoothly
functioning market system requires that prices
accurately and easily convey information about
relative scarcities.
 To summarize
 The goals of macroeconomic policy are:
1. A high and growing level of national output
2. High employment with low unemployment
3. A stable or gently rising price level

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 The Tools of Macroeconomic
Policy
Put yourself in the shoes of the chief economist
advising the government:
 Unemployment is rising and GDP is falling;
 Or perhaps productivity growth has declined, and
you wish to increase potential output growth;
 Or your country has a balance-of payments crisis,
with a large trade deficit and an attack on the
currency.
 What policies will help reduce inflation or
unemployment, speed economic growth, or correct
a trade imbalance?

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 Fiscal Policy
 Denotes the use of taxes and government
expenditures.
 Government expenditures comes in two distinct
forms:
1. First, there are the government purchases, which
comprise spending on goods and services –
purchases of tanks, construction of roads and
schools, salaries for judges, and so forth.
 Government spending determines the relative size of
the public and private sectors, and also affects the
overall level of spending in the economy, thereby
influencing the level of GDP.

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2. Second, there is taxation, which affects the
economy in two ways:
a) It affects people’s incomes. Since it increases or
decreases the disposable income of households,
taxes tend to affect the amount that people spend on
goods and services, as well as the amount of private
savings.
b) It affects the prices of goods and factors of
production and thereby affect incentives and
behavior. Many provisions of the tax code have an
impact on incentives to work and to save.

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 Monetary Policy
 The second major instrument of macroeconomic
policy is monetary policy, which the government
conducts through managing the nation’s money,
credit, and banking system.
 Money consists of the means of exchange or
method of payment.
 Today, people use currency and checking
accounts to pay their bills.
 Our own BSP (Bangko Sentral ng Pilipinas), being
our central bank, regulates the amount of money
available to the economy.

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B. Aggregate Supply and Demand

 In general, businesses would like to sell everything

they can produce at high prices.
 When prices and spending levels are depressed, they
will find that they have excess capacity.
 During other times (such as in times of war), they
cannot work hard enough to meet all the excess
demand.
 Thus, we see that aggregate supply depends on the
price level that businesses can charge, as well as the
economy’s capacity or potential output.

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 Potential output is determined by the available
inputs (labor, etc.) and the managerial and technical
efficiency with which those inputs are combined.
 National output and the overall price level are
determined by both aggregate supply and
aggregate demand.
 Aggregate demand (AD) refers to the total amount
that different sectors in the economy willingly spend
in a given period.
 It (AD) is the sum of spending by consumers,
businesses and governments, then it depends on the
level of prices, as well as on monetary policy, fiscal
policy, and other factors.

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Figure 20-5

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Figure 20-6

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Warning on AS and AD Curves

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Macroeconomic Equilibrium
 It is a combination of overall price and quantity at
which all buyers and sellers are satisfied with their
purchases, sales and prices.
 If the price level were higher than equilibrium (as
shown in Fig. 20-6), businesses would want to sell
more than purchasers would want to buy.
 Eventually, pressures would exert themselves until
once more, the price level will go back to the
equilibrium point.
 Once this point is reached, neither buyers nor
sellers would want to change their quantities
demanded or supplied, and there would be no
more pressure for the price to change.

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Macroeconomic History
 Wartime Boom
 The American economy entered the 1960’s having
experienced numerous recessions.
 Acts to stimulate the moribund economy included
sharp cuts in personal and corporate taxes (in ’63
and ’64).
 By 1965, the economy was at its potential output.
 But the government underestimated the buildup
to the Vietnam War, which increased defense
spending by fifty-five percent.
 Since the president at that time postponed the
necessary, painful fiscal steps to slow the
economy until 1968, inflationary pressures began
to overheat the economy.
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 Under the pressure of low unemployment and
high factory utilization, inflation began to rise,
inaugurating the “age of inflation” that lasted
from 1966 to 1981.
 The tax cuts and defense expenditures increased
aggregate demand, shifting the AD curve to the
right.
 Output and employment rose sharply, and prices
began to accelerate as output exceeded capacity
limits.

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 Tight Money, 1979 – 1982
 High oil prices; accelerated wages; price inflation.
 In response to double-digit inflation, the central
bank in the US (called the Federal Reserve) began
tightening money in 1979: interest rates rose
sharply; the stock market fell; credit was hard to
find.
 This action led to slowed spending by consumers
and businesses: housing construction, automobile
purchases, business investment, and net exports
declined sharply.
 The reward for these austere measures was a
dramatic decline in inflation, from an average of
12 per cent per year in the 1978-1980 period to 4
per cent during the period 1983-1988.

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 The tough monetary policies of the 1980’s set the
stage for the long economic expansion from 1982
through 2000.
 This period, marked by a single period of recession
in 1990-1991, proved to be the period of the
greatest macroeconomic stability in American
history.
 By the late 1990’s, many of those in the workforce
had never experienced a severe business cycle or
inflationary episode, and some were naively
assuming that the business cycle as taught in
schools no longer existed.

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 The Growth Century
 A final look in our macroeconomic drama
concerns the growth of output and prices over the
entire period since 1900.
 Output has grown by a factor of almost 20 since
the beginning of the twentieth century.
 How can we explain this phenomenal increase?
 Part of this growth was due to the tremendous
increase in the scale of production as inputs of
capital, labor and even land grew sharply over this
period.

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 Just as important were improvements in efficiency
due new products (i.e. automobiles) and new
processes (i.e. electronic processing).
 Less visible factors include: improved
management techniques and services (like
assembly lines and overnight delivery).
 “Invisible” factors: for example, the invention of
the indoor toilet!

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 The Role of Economic Policy
 What was the role of macroeconomic policy in the
“growth” century?
 The application of “enlightened” macroeconomic
policies (both fiscal and monetary) over the
second half of the twentieth century saw rapid
growth and much-attenuated business cycles as
compared to the first five decades of the century.
 Monetary policy, especially, helped lower
unemployment and largely stabilized prices over
the last twenty years of the century.

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 Recession, unfortunately, has not been banished,
and sound macroeconomic policies has spread
throughout the world.
 But the fundamental knowledge is available to
reduce the risk of galloping inflation and deep
depressions.

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