Chapter 6Chapter 6

Macroeconomics Macroeconomics

the Big Picturethe Big Picture

12-1Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

John Maynard KeynesJohn Maynard Keynes

1936 Keynesian Economics1936 Keynesian Economics Government Can Help a Government Can Help a

Depressed Economy Depressed Economy Through Monetary and Through Monetary and Fiscal PoliciesFiscal Policies..

Monetary PolicyMonetary Policy

Monetary Policy- The Monetary Policy- The Government uses Changes Government uses Changes in the Quantity of Money to in the Quantity of Money to Alter Interest Rates and Alter Interest Rates and Affect Overall SpendingAffect Overall Spending

Fiscal PolicyFiscal PolicyThe Setting of The Level The Setting of The Level of Government Spending of Government Spending

and Taxation By and Taxation By Government Government

Policymakers.Policymakers.

The Influence of Monetary and The Influence of Monetary and Fiscal Policy on Aggregate Fiscal Policy on Aggregate

DemandDemand Many Factors Influence Aggregate Many Factors Influence Aggregate

Demand Besides Monetary and Fiscal Demand Besides Monetary and Fiscal Policy. Policy.

In Particular, Desired Spending By In Particular, Desired Spending By Households and Business Firms Households and Business Firms Determines The Overall Demand For Determines The Overall Demand For Goods and ServicesGoods and Services..

Fiscal Policy and Aggregate Fiscal Policy and Aggregate DemandDemand

Fiscal PolicyFiscal Policy Refers To The Government’s Refers To The Government’s Choices Regarding The Overall Level of Choices Regarding The Overall Level of Government Purchases or Taxes.Government Purchases or Taxes.

Fiscal Policy Influences Saving, Investment, Fiscal Policy Influences Saving, Investment, and Growth In The Long Run.and Growth In The Long Run.

In The Short Run, Fiscal Policy Primarily In The Short Run, Fiscal Policy Primarily Affects The Aggregate Demand.Affects The Aggregate Demand.

Fiscal PolicyFiscal Policy

Fiscal policy is Fiscal policy is the manipulation of the the manipulation of the federal budget to attain price stability, federal budget to attain price stability, relatively full employment, and a relatively full employment, and a satisfactory rate of economic growthsatisfactory rate of economic growth To attain these goals, the government To attain these goals, the government

must manipulate its spending and taxesmust manipulate its spending and taxes

12-3Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

There was no such thing as fiscal There was no such thing as fiscal policy until John Maynard Keynes policy until John Maynard Keynes invented it in the 1930sinvented it in the 1930s He maintained thatHe maintained that

The only way out of the Depression was to The only way out of the Depression was to boost aggregate demand by increasing boost aggregate demand by increasing government spendinggovernment spending

If we ran a big enough budget deficit, we If we ran a big enough budget deficit, we could jump-start the economy and, in effect, could jump-start the economy and, in effect, spend our way out of the depressionspend our way out of the depression

Putting Fiscal Policy into Putting Fiscal Policy into PerspectivePerspective

12-4Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

When Firms Fall on Hard Times When Firms Fall on Hard Times They Cut Back on Production They Cut Back on Production and Employees. This Lowers and Employees. This Lowers The Real GDP and Incomes. If The Real GDP and Incomes. If

The Fall in Income and The Rise The Fall in Income and The Rise in Unemployment is Moderate in Unemployment is Moderate

It Is Called a It Is Called a RecessionRecession, If , If Severe It Is Called a Severe It Is Called a

DepressionDepression..

RecessionRecession

A Period of Declining Real A Period of Declining Real Income and Rising Income and Rising Unemployment.Unemployment.

DepressionDepression

A Severe Recession.A Severe Recession.

Economic Fluctuations Economic Fluctuations Are Normal and Occur in Are Normal and Occur in

Every Country and Every Country and Economy.Economy.

Let Us Look At These Let Us Look At These Fluctuations in Terms of Real Fluctuations in Terms of Real GDP, Investment Spending GDP, Investment Spending

and The Unemployment Rate and The Unemployment Rate Since 1965.Since 1965.

Note:Note: That There is No That There is No Discernable Pattern.Discernable Pattern.

In The Following Figures In The Following Figures Recessions Are Denoted Recessions Are Denoted As The Shaded Areas.As The Shaded Areas.

Figure 1 A Look At Short-Run Figure 1 A Look At Short-Run Economic FluctuationsEconomic Fluctuations(a) Real GDP

Billions of2000 Dollars

1965 1970 1975 1980 1985 1990 1995 2000 20052,000

4,000

6,000

8,000

$10,000

3,000

5,000

7,000

9,000

Real GDP

Figure 1 A Look At Short-Run Figure 1 A Look At Short-Run Economic FluctuationsEconomic Fluctuations

(b) Investment Spending

1965 1970 1975 1980 1985 1990 1995 2000 2005

Billions of2000 Dollars

0

500

1,000

$1,500

InvestmentSpending

Figure 1 A Look At Short-Run Figure 1 A Look At Short-Run Economic FluctuationsEconomic Fluctuations

(c) Unemployment Rate

1965 1970 1975 1980 1985 1990 1995 2000 2005

Percent ofLabor Force

2

4

6

8

10

12%

UnemploymentRate

3 Key Facts About 3 Key Facts About Economic FluctuationsEconomic Fluctuations Fact 1: Economic Fluctuations Are Fact 1: Economic Fluctuations Are

Irregular and Unpredictable.Irregular and Unpredictable. Fact 2: Most Macroeconomic Fact 2: Most Macroeconomic

Quantities Fluctuate Together.Quantities Fluctuate Together. Fact 3: As Output Falls, Fact 3: As Output Falls,

Unemployment Rises.Unemployment Rises.

Fact 1: Economic Fact 1: Economic Fluctuations Are Irregular Fluctuations Are Irregular and Unpredictable.and Unpredictable.

Fluctuations in The Economy Fluctuations in The Economy Are Called Are Called Business CyclesBusiness Cycles. . When Times Are Good When Times Are Good Businesses Expand and When Businesses Expand and When They Are Bad They Contract.They Are Bad They Contract.

Business CyclesBusiness Cycles

Fluctuations In Economic Fluctuations In Economic Activity, Such As Activity, Such As Employment and Employment and

Production.Production.

Important Note:Important Note:

These These Business CycleBusiness Cycle Fluctuations Are Fluctuations Are Unpredictable and Follow Unpredictable and Follow No Regular Pattern.No Regular Pattern.

Fact 2: Most Macroeconomic Fact 2: Most Macroeconomic Quantities Fluctuate Together.Quantities Fluctuate Together.

When Real GDP Falls in a Recession So When Real GDP Falls in a Recession So Does Personal Income, Corporate Does Personal Income, Corporate

Profits, Consumer Spending, Profits, Consumer Spending, Investment Spending, Production, Investment Spending, Production, Home Sales, Auto Sales and Other Home Sales, Auto Sales and Other

Items.Items.

Fact 2: Most Macroeconomic Fact 2: Most Macroeconomic Quantities Fluctuate Together.Quantities Fluctuate Together.

When Real GDP Falls in a When Real GDP Falls in a Recession So Does Personal Recession So Does Personal Income, Corporate Profits, Income, Corporate Profits,

Consumer Spending, Investment Consumer Spending, Investment Spending, Production, Home Sales, Spending, Production, Home Sales,

Auto Sales and Other Items.Auto Sales and Other Items.

When Economic Conditions When Economic Conditions Deteriorate, Much of The Deteriorate, Much of The Decline is Attributable To Decline is Attributable To Reductions in Investment Reductions in Investment Spending Such As On New Spending Such As On New

Factories, Housing, Equipment Factories, Housing, Equipment and Inventories.and Inventories.

Fact 3: As Output Falls, Fact 3: As Output Falls, Unemployment Rises.Unemployment Rises.When Firms Choose To Produce When Firms Choose To Produce A Smaller Quantity of Goods A Smaller Quantity of Goods and Services, They Lay Off and Services, They Lay Off Workers, Increasing The Workers, Increasing The Unemployment.Unemployment.

In Each of The Recessions, The In Each of The Recessions, The Unemployment Rate Rose Unemployment Rate Rose Substantially. When The Substantially. When The

Recession Ends and The Real Recession Ends and The Real GDP Starts To Expand, The GDP Starts To Expand, The

Unemployment Rate Gradually Unemployment Rate Gradually Declines. A Normal Declines. A Normal

Unemployment Rate is 5-6 %.Unemployment Rate is 5-6 %.

Long-Run Economic Long-Run Economic GrowthGrowth

Long-run Economic Growth Long-run Economic Growth is the Sustained Upward is the Sustained Upward Trend in the Economy’s Trend in the Economy’s Output Over TimeOutput Over Time

Figure 2.4 The Inflation Rate in the United States, 1960-2005

InflationInflation

Inflation- is A Overall Inflation- is A Overall Rising of Prices.Rising of Prices.

DeflationDeflation

Deflation- is an Overall Deflation- is an Overall Falling in the Level of Falling in the Level of PricesPrices

Price StabilityPrice Stability

The Economy Has Reached The Economy Has Reached Price Stability When The Price Stability When The Overall Level of Prices Overall Level of Prices Changes Slowly or Not At Changes Slowly or Not At All.All.

StagflationStagflation

A Period of Falling Output A Period of Falling Output and Rising Prices.and Rising Prices.

Open EconomyOpen Economy

An Economy is an Open An Economy is an Open Economy When it Actively Economy When it Actively Trades Goods and Services Trades Goods and Services with Other Countries.with Other Countries.

Trade DeficitTrade Deficit

A Country Runs a Trade A Country Runs a Trade Deficit When the Value of Deficit When the Value of Goods and Services Goods and Services Bought From Foreigners is Bought From Foreigners is More Than the Goods and More Than the Goods and Services it Sells to Them.Services it Sells to Them.

Trade SurplusTrade Surplus

An Economy Runs a Trade An Economy Runs a Trade Surplus When The Value of Surplus When The Value of Goods and Services Goods and Services Bought From Foreigners is Bought From Foreigners is Less Than The Value of Less Than The Value of Goods and Services it Sells Goods and Services it Sells to Them.to Them.