Macroeconomics

Chapters 12- 16

Domain Focus

SSEMA1

The student will illustrate the means by which economic activity is measured.

Domain Focus

SSEMA2

The student will explain the role and functions of the Federal Reserve System.

Domain Focus

SSEMA2

The student will explain the role and functions of the Federal Reserve System.

SSEMA1 The student will illustrate the means by which economic activity is measured.

a. Explain that overall levels of income, employment, and prices are determined by the spending and production decisions of households, businesses, government, and net exports. b. Define Gross Domestic Product (GDP), economic growth, unemployment, Consumer Price Index (CPI), inflation, stagflation, and aggregate supply and aggregate demand. c. Explain how economic growth, inflation, and unemployment are calculated. d. Identify structural, cyclical, and frictional unemployment. e. Define the stages of the business cycle, as well as recession and depression. f. Describe the difference between the national debt and government deficits.

Macroeconomics

• Reminder- Macroeconomics= the study of the behavior and the decision making of entire economies

Circular Flow Model

Gross Domestic Product

• Gross= total

• Domestic= produced anywhere in the 50 states, by anyone

• Product= final goods and services

What does GDP measure?

Total amount of final goods and services produced in a country

in one year.

(Measure of Output)

Gross Domestic Product

• Gross Domestic Product (GDP)- the dollar value of all final goods and services produced within a country’s borders in a given year– Dollar Value- the total of the selling prices of all

goods and services produced in a country in one calendar year

– Final Goods and Services- products in the form sold to consumers

• Intermediate goods- used in the production of final goods– Produced within a country’s borders- includes cars

produced in the U.S. by a Japanese automaker

Are there any cool formulas you can give us relating to this

interesting concept?

GDP=C+I+G+(X-M)

Expenditure Approach• C= consumption spending (think consumers)

72%• I= investment spending

(think businesses investing in themselves)

15%• G= government spending

17%

• (X-M)= difference between exports and imports -4%

Expenditure Approach• Expenditure Approach (output-expenditure

approach)– Estimate the annual expenditures or amounts spent on

four categories of final goods and services• Consumer goods and services

– Durable goods- goods that last for a relatively long time (refrigerators, cars, etc.)

– Nondurable goods- goods that last a short period of time (food, light bulbs, etc.)

• Business Goods and services• Gov’t goods and services• Net exports or imports of goods and services

– Add together the amounts spent on all four categories to arrive at the total expenditures on goods and services produced during the year

Expenditure Approach

GDP=C+I+G+(X-M)

Income Approach

• Income Approach– Calculates GDP by adding up all the incomes in the

economy

• Results from the two approaches are compared to judge accuracy

What is counted in GDP?

• FINAL goods and services

• Goods/Services produced here, even if by a foreign co.

What is NOT counted?

• Things produced outside the country.

• Illegal stuff

• Purely financial transactions

…and INTERMEDIATE GOODS

Limitations of GDP

• GDP does not take into account certain economic activities– NonMarket Activities- goods and services that

people make or do themselves– The underground economy- black market and

illegal goods, legal informal transactions– Negative Externalities- unintended economic side

effects– Quality of life

Problems associated with GDP

• Slow to calculate

• Does not count everything (it’s an estimate)

• Inflation can distort the figure

Real vs. Nominal

Nominal Versus Real GDP

• Nominal GDP- GDP measured in current prices

• Real GDP- GDP expressed in constant, or unchanging prices

Nominal and Real GDP

Year 1 Nominal GDP

Suppose an economy‘s entire output is cars and trucks.

This year the economy produces:

10 cars at $15,000 each = $150,000

+ 10 trucks at $20,000 each = $200,000

Total = $350,000

Since we have used the current year’s prices to express the current year’s output, the result is a nominal GDP of $350,000.

In the second year, the economy’s output does not increase, but the prices of the cars and trucks do:

This new GDP figure of $370,000 is misleading. GDP rises because of an increase in prices. Economists prefer to have a measure of GDP that is not affected by changes in prices. So they calculate real GDP.

10 cars at $16,000 each = $160,000

+ 10 trucks at $21,000 each = $210,000

Total = $370,000

Year 2 Nominal GDP

10 cars at $15,000 each = $150,000

+ 10 trucks at $20,000 each = $200,000

Total = $350,000

To correct for an increase in prices, economists establish a set of constant prices by choosing one year as a base year. When they calculate real GDP for other years, they use the pricesfrom the base year. So we calculate the real GDP for Year 2 using the prices from Year 1:

Year 3 Real GDP

Real GDP for Year 2, therefore, is $350,000

Real and Nominal GDP

Economic Growth

• Economic growth is measured by finding real GDP per capita (real GDP divided by the total population)

• Real GDP per capita is considered the best measure of a nation’s standard of living.

• The basic measure of a nation’s economic growth rate is the percentage change of real GDP over a given period of time

Per Capita GDP

GDP divided by a country’s population

Other Income and Output Measures

• GDP is the primary measure of output• Gross National Product (GNP)- the annual

income earned by U.S. owned firms and U.S. citizens– Depreciation (the loss of the value of capital

equipment that results from normal wear and tear) is not taken into account

Aggregate SupplyAggregate Supply- the total amount of goods and

services in the economy available at all possible price levelsEconomists add up the total supply of goods and services

produced for sale in the economy (GDP)Calculate the price level (the average of all prices in the

economy)As the prices of most goods and services change, the

price level changes.Firms respond by changing their output (real GDP)

Prices rise- production increasesPrices fall- production decreases

Aggregate Supply

Aggregate Demand

• Aggregate Demand- the amount of goods and services in the economy that will be purchased at all possible price levels– Lower price levels means greater purchasing

power for households; falling prices increase wealth and demand

– Higher price levels causes purchasing power to decline; reduction in the quantity of goods and services demanded

Aggregate Demand

AS/AD Equilibrium

• Aggregate Supply/Aggregate Demand Equilibrium= AS/AD Equilibrium

• Any shift in aggregate supply or aggregate demand will have an impact on real GDP and on the price level

Aggregate Demand and Aggregate Supply Lesson

Factors that shift an AD Curve

• Changes in– Consumer Spending– Investment Spending– Government Spending– Net Export Spending

• Increases in Aggregate Demand increase real GDP and the price level

• Decreases in Aggregate Demand decrease real GDP and price level

Aggregate Demand and Aggregate Supply Lesson

Factors that shift an AS Curve• Changes in

– The prices of inputs (land, labor, capital, and entrepreneurship)

– Productivity– Technology– Government Regulations

• Increases in Aggregate Supply increase real GDP and lower the price level

• Decreases in Aggregate Supply decrease real GDP and raise the price level

AD/AS

Business Cycles

• Business Cycles- a period of macroeconomic expansion followed by a period of contraction

• Business cycles are not minor ups and downs- they are major changes in real GDP above or below normal levels

Business Cycle

GDP

Phases of a Business Cycle

1. Expansion- a period of economic growth as measured by a rise in real GDP– Economic Growth- a steady, long-term increase in

real GDP– Plentiful jobs, a falling unemployment rate, and

business prosperity

2. Peak- the height of an economic expansion, when real GDP stops rising

Phases of a Business Cycle

3. Contraction- a period of economic decline marked by falling real GDP

Unemployment rate risesRecession- a prolonged economic contraction-

generally lasts from 6 to 18 monthsDepression- a recession that is especially long and

severe; high unemployment and low factory outputStagflation- a decline in real GDP combined with a rise

in the price level4. Trough- the lowest point in an economic

contraction, when real GDP stops falling

What affects Business Cycles?

• Business cycles are affected by 4 main variables1. Business Investment

• When the economy is expanding businesses invest heavily in new plants and equipment

• When firms decide they have expanded enough or demand falls they cut back on investment spending

2. Interest Rates and Credit• When interest rates are low households and firms borrow

more money• When interest rates climb, investments and job growth dries

up

What affects Business Cycles?

3. Consumer Expectations– Fears of a weakening economy can cause

consumer confidence to fall- people begin saving their money; the opposite is also true

4. External Shocks• Negative External Shocks- Disruptions in the oil supply,

wars that interrupt normal trade relations, droughts that severely reduce crop harvests

• Positive External Shocks- discovery of a large deposit of oil or minerals, a perfect growing season

Business Cycle Forecasting

• Leading Indicators- key economic variables that economists use to predict a new phase of a business cycle– Stock Market– Interest Rates– Manufacturers new orders of capital goods

Business Cycles in American History

• The Great Depression- the most severe economic downturn in the history of industrial capitalism

• John Maynard Keynes- The General Theory of Employment, Interest, and Money– Economies could fall into long-lasting contractions– Government intervention might be needed to pull

an economy out of a depression

Am I Unemployed?

Unemployment1. Structural2. Cyclical3. Frictional

Types of UnemploymentFrictional Unemployment• Occurs when people change jobs, get laid off from their current jobs, take

some time to find the right job after they finish their schooling, or take time off from working for a variety of other reasons

Structural Unemployment • Occurs when workers' skills do not match the jobs that are available.

Technological advances are one cause of structural unemploymentSeasonal Unemployment (DO NOT NEED TO KNOW for EOCT)• Occurs when industries slow or shut down for a season or make seasonal

shifts in their production schedulesCyclical Unemployment• Unemployment that rises during economic downturns and falls when the

economy improves

Structural Unemployment

Cyclical Unemployment

Frictional Unemployment

What is “unemployed”?

• People available for work who made a specific effort to find work in the past month and who during the most recent survey week, worked less than one hour for pay or profit.

• Also people who worked in a family business without pay for less than 15 hours a week.

How is unemployment measured?

• It’s an important indicator of the health of the economy.

• Bureau of Labor statistics polls sample of population to determine how many are employed and unemployed.

• Unemployment rate is the percentage of nation’s labor force that is unemployed.

• It is only a national average – it’s doesn’t reflect regional trends.

Full Employment

• The level of employment reached when there is no cyclical unemployment (no one out of work because of downturn in the economy – everyone who wants a job has one)

• 4-6% unemployment is “normal”.

Limitations

• Figures don’t count those who have become frustrated and stopped looking for work (have to have looked for work in the past 4 weeks)

• If you have a part time job you are considered employed even if you would rather have a full time job – took this one because it’s all you could find.

The Effects of Rising Prices

• Inflation- a general increase in prices• Purchasing power- the ability to purchase

goods and services, is decreased by rising prices

• Price level - the relative cost of goods and services in the entire economy at a given point in time

Degrees of Inflation

• Creeping inflation– Range of 1-3%

• Galloping inflation– Can go as high as 100-300%

• Hyperinflation– Out of control– In range of 500%– Doesn’t happen often – last stage before monetary

collapse. (WW II – Hungary and Germany)

Causes of Inflation

• The Quantity Theory- too much money in the economy leads to inflation; inflation can be tamed by increasing the money supply at the same rate that the economy is growing.

• The Cost-Push Theory- inflation occurs when producers raise prices in order to meet increased costs– Leads to wage-price spiral- the process by which

rising wages cause higher prices and higher prices cause higher wages

Causes of Inflation

• The Demand-Pull Theory- inflation occurs when demand for goods and services exceeds existing supplies

• Wage-price spiral – self-perpetuating spiral – higher prices force workers to ask for higher wages. Producers try to recover this by raising prices, which forces workers to ask for higher wages….

Effects of Inflation• Purchasing Power

– The dollar will not buy the same amount of goods that it did in years past.

• Interest Rates– When a bank's interest rate matches the inflation

rate, savers break even. When a bank's interest rate is lower than the inflation rate, savers lose money.

• Income– If wage increases match the inflation rate, a worker's

real income stays the same. If income is fixed income, or income that does not increase even when prices go up, the economic effects of inflation can be harmful.

Price Indexes• Price Index- a measurement that shows how the

average price of a standard group of goods change over time

• Consumer Price Index (CPI)- a price index determined by measuring the price of a standard group of goods meant to represent the “market basket” of a typical urban consumer– Market Basket- a representative collection of goods

and services– Inflation Rate- the percentage of change in price level

over time

Calculating the CPI• Price index = cost today X 100 cost in base yearPrice index is current value of a “basket” of goods and service divided

by cost of same basket in base year and then multiplied by 100.- Mixed basket of goods used because prices can go up or down for

reasons that have nothing to do with inflation.- Having a large group of representative items helps eliminate the

effect of some product’s price dropping while others tend to be on the rise.

- Base year can be any year.- Price index for the base year will always be 100.- Index values over 100 indicate inflation.- Index values under 100 indicate deflation.

Calculating Inflation• To determine the inflation rate

from one year to the next:– Take the CPI for year A and

subtract the CPI for year B– Multiply by 100

Inflation Calculator

www.bls.gov

Debt v. Deficit

• What is the national debt?• What caused the national debt?• Where does the government get the

money when it wants to spend more than it takes in?

• What is a budget deficit?• What is a budget surplus?

Questions for You

Budget Deficits and the National Debt

Balanced Budget- a budget in which revenues are equal to spending

The federal budget is almost never balanced Budget Surplus- a situation in which the

government takes in more than it spends Budget Deficit- a situation in which the

government spends more than it takes in

The National Debt

• National Debt- the total amount of money the federal government owes to bondholders–The U.S. government is viewed as

stable and trustworthy and can borrow money at a low interest rate

The difference between DEFICITS and DEBT

• Deficit- the amount of money the government borrows for one budget year

• Debt- the sum of all government borrow up to that time that has not been repaid

www.usdebtclock.org

SSEMA3 The student will explain how the government uses fiscal policy to promote price stability, full employment, and

economic growth.

a. Define fiscal policy. b. Explain the government’s taxing and

spending decisions.

Fiscal Policy

Fiscal Policy

Actions taken by the Federal Government to influence the economy (business cycles).

How do they do it?

Taxation (revenue)

Spending (expenditures)

-transfer payments-

How/When/Why

If the economy needs a “boost” the Federal Government might:

_______________ taxes.

_______________ spending.

How/When/Why

If the economy needs to be “cooled off” the Federal Government might:

_______________ taxes.

_______________ spending.

Understanding Fiscal Policy

Fiscal policies are used to achieve economic growth, full employment, and price stability.

Federal Budget- a plan for the federal government’s revenues and spending for the coming year› Lists expected income› Shows how much money will be spent

Understanding Fiscal Policy

• Fiscal Year- a twelve-month period that can begin on any date (October 1-September 30 for the Federal Government)

Fiscal Policy and the Economy

• Expansionary Policies- fiscal policies, like higher spending and tax cuts, that encourage economic growth– Used to raise the level of output in the economy– Encourage growth– Government spending increases aggregate

demand

Fiscal Policy and the Economy

• Contractionary Policies- fiscal policies, like lower spending and higher taxes, that reduce economic growth– Used when demand exceeds supply to slow the

growth of the economy (GDP)– Used to slow or prevent inflation– Leads to a decrease in aggregate demand which

leads to lower prices

Limits of Fiscal Policy

• The government cannot change spending for entitlements

• Difficult to know the current state of the economy (GDP)

• Even more difficult to predict future economic performance

Keynesian Economics

John Maynard Keynes- The General Theory of Employment, Interest, and Money› Comprehensive explanation of economic forces› Told economists and politicians how to get out of

economic crises and how to avoid them› Focused on the economy as a whole› Productive Capacity- the maximum output that an

economy can produce without big increases in inflation

› Demand-Side Economics- the idea that government spending and tax cuts help an economy by raising demand

Keynesian Economics

› Keynesian Economics- a form of demand-side economics that encourages government action to increase or decrease demand and output

› Fiscal policy should be used to fight periods of recession/depression and periods of inflation

› Advocated the use of expansionary and contractionary fiscal policies

› Multiplier Effect- the idea that every one dollar of government spending creates more than one dollar in economic activity

SSEMA2 The student will explain the role and functions of the Federal Reserve System.

a. Describe the organization of the Federal Reserve System.

b. Define monetary policy. c. Describe how the Federal Reserve uses the

tools of monetary policy to promote price stability, full employment, and economic growth.

Federal Reserve Act of 1913

• Created the Federal Reserve System• Composed of 12 independent regional banks• Could lend money to other banks in times of

need

Structure of Federal Reserve System

• Board of Governors- the seven-member board that oversees the Federal Reserve System– Appointed for staggered 14 year terms (keeps

members from being pressured politically)– President picks a chair for a 4 year term from the

board of governors

Structure of the Federal Reserve System

• Federal Reserve Districts- the twelve banking districts created by the Federal Reserve Act (one Federal Reserve Bank is located in each district)

• All nationally charted banks are required to join the Fed

• Member banks own shares in the Fed and therefore gives the system of high degree of political independence

Monetary Policy

Monetary Policy DVD

Monetary Policy

The actions the Federal Reserve (Central Bank) takes to influence the

level of GDP and the rate of inflation in the economy.

How Do They Do It?

• Tools of the FED1. Open Market Operations2. Discount Rate (Fed to Banks)3. Federal Funds Rate (bank to bank4. Reserve Requirements

Tools of the Federal Reserve

• Open Market Operations- the buying and selling of government securities to alter the money supply– Bond Purchases - In order to increase the money

supply, the Federal Reserve Bank of New York buys government securities on the open market.

– Bond Sales- When the Fed sells bonds, it takes money out of the money supply.

• Discount Rate (Federal Reserve to Bank)- the interest rate that banks pay to borrow money from the Federal Reserve

Tools of the Federal Reserve

• Federal Funds Rate (bank to bank)- the interest rate that banks pay to borrow money from each other

• Reserve Requirement- the amount of money that a bank must keep on hand; set by the Federal Reserve

Fiscal and Monetary Policy Tools

Fiscal policy tools Monetary policy tools

1. increasing government spending

2. cutting taxes

Expansionary tools

1.open market operations: bond purchases

2. decreasing the discount rate

3.decreasing reserve requirements

Contractionary tools

1.decreasing government spending

2. raising taxes

1.open market operations: bond sales

2. increasing the discount rate

3. increasing reserve requirements

Fiscal and Monetary Policy Tools

How/When/Why

If the economy needs a “boost” the Federal Reserve might:

_______________ bonds._______________ interest rates._______________ reserve requirements.

How/When/Why

If the economy needs to be “cooled off” the Federal Reserve might:

_______________ bonds._______________ interest rates._______________ reserve requirements.