A First Look at Macroeconomics Chapter 4
Origins and Issues in Macroeconomics • Economists began to study economic growth, inflation and international finance as long ago as 1750’s • However, modern macroeconomics did not emerge until great depression • Pessimism about classical economics • It was in this climate macroeconomics emerged with the publication in 1936 of John Maynard Keynes famous book
Short term vs Long term goals • Keynes’ theory was that depression and high unemployment result from insufficient spending. • By the late 1960’s and 1970’s inflation increased, economic growth slowed and unemployment became persistent. • So macroeconomic problem is complex • The long term problem and short term problems are intertwined most usefully studied together.
Road Ahead • Pay most attention to short term problems but never completely lose sight of long term issues. • Modern macroeconomics is a broad subject that studies all the issues that we have just identified: economic growth, unemployment and inflation.
Economic Growth and Flactuations • Economic growth is the expansion of country’s production possibilities. • We measure growth by increase in Real GDP. • Potential GDP: when all the economy’s land, labor capital and entrepreneurial ability are fully employed the value of production is called potential GDP. • Real GDP fluctuates around potential GDP and long term economic growth rate is measured by the growth rate of potential GDP.
Economic Fluctuations: Business Cycle • Business Cycle is periodic but irregular up and down movement in production. • When real GDP is less than potential GDP, some resources are underused. • When real GDP is greater than potential GDP, resources are over utilized. • Recession: real GDP decreases, growth rate is negative • Expansion: real GDP increases, growth rate is positive. • Two Turning points: peak and trough
Lucas Wedge and Okun’s Gap • Costs of productivity slow down . Two Measures – (a) Lucas Wedge & (b) Okun Gap • Lucas wedge is the accumulated loss of output that results from a slow down in the growth rate of real GDP per person • Okun’s Gap: Real GDP – Potential GDP = output gap • When output gap is negative, it is okun gap • This is not a accumulated measure, its been calculated for each year.
Benefits and Cost of Higher growth • Higher growth means higher income, thus high standard of living. • Costs are – (a) forgone current consumption (b) rapid depletion of natural resources.
Jobs and Unemployment • Results from business cycle fluctuations. • Unemployment is a phenomenon described as people searching for jobs but not getting one. • Unemployment Rate: Unemployed / work force • Why unemployment is a problem ? • Lost of production and incomes • Lost Human capital
Inflation • Price level is the average of all prices people pay for all the goods and services that they buy. • Common measure is Consumer Price Index (CPI). • Inflation rate is the annual percentage change in the price level. • If inflation rate is negative its called deflation
Surplus, Deficits and Debts • If government collects more taxes than it spends it is said to have budget surplus. • And if it spends more than its tax revenue its budget deficit. • Economists measure budget deficit or surplus as a % of GDP • Deficit brings debts • Deficit and Debts matter. • If government borrows to increase country’s infrastructure or investment, its not likely to cause problems in the future.
Classical and Keynesian View • Classical View: Economy behaves best if government leaves people free to pursue their own self interest. • Whereas Keynesian view is that economy behaves badly if left alone and that government action is needed to achieve and maintain full employment
Five challenges of macroeconomic policy • Boost economic growth • Keep inflation low • Stabilize business cycle • Reduce unemployment • Reduce government and international deficits
Policy Tools • Fiscal Policy – • Making changes in tax rates and in government spending programs is called fiscal policy • Fiscal policy can be used to boost long term growth by creating incentives that encourages saving, investment and technological change • Fiscal policy can also be used to smooth business cycle
Monetary Policy: Changing interest rate and changing the amount of money in the economy is called monetary policy • Principal aim to keep inflation in check • When economy is in recession, central bank might reduce interest rate to inject money in the economy.