Macroeconomics • Macroeconomic theories try to explain the business cycle, economic policies try to control it. Business cycles are alternating periods of economic growth and contraction. The Business Cycle 20 Great 15 Depression 10 20 World War II 15 Korean War Vietnam War Long-term average growth (3%) 5 3 0 –5 –10 15 10 5 3 0 Growth recession Recession –5 –10 –15 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 REAL GDP (units per time period) The Business Cycle Peak Growth trend Peak Peak Trough Trough TIME The Unemployment Record Rate of Unemployment (Percent) 25 20 15 10 5 0 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 The Historical Record 20 Inflation 16 A 12 8 4 B 0 4 8 Deflation 12 1920 1930 1940 1950 1960 1970 1980 1990 2000 Evolution of Macro Theory • Classical economics Based on the concept of laissez faire, the doctrine of “leave it alone,” of nonintervention by government in the market mechanism • The Great Depression was a stunning blow to classical economists. • Keynes developed an alternate view of the macro economy. • market forces and changing prices did not solve high unemployment, required government intervention Evolution of Macro Theory cont. • Keynesian policy suggests government stimulate economy when high unemployment • Contract economy when inflationary • Monetarist Policy, expansionary policies lead to inflation • Supply-Side Policy, stimulate economy’s ability to produce • Current policy combination of Keynesian and supply-side Macroeconomic Model Aggregate Demand and Supply Examines forces that effect macroeconomy Provides avenues for government policy fiscal policy monetary policy Aggregate Demand • Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. • It is used to refer to the collective behavior of all buyers in the marketplace. Aggregate Demand • Three separate reasons explain the downward slope of the aggregate demand curve: – The real-balances effect. – The foreign-trade effect. – The interest-rate effect. Aggregate Supply • Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus. Aggregate Supply • Two reasons explain the upward slope of the aggregate supply curve: – The profit effect. – The cost effect. Macro Equilibrium • Aggregate supply and demand curves summarize the market activity of the whole (macro) economy. • Equilibrium occurs at intersection of aggregate demand and supply • It is the only price-output combination that is mutually compatible with aggregate supply and demand. PRICE LEVEL (average price) Macro Equilibrium Aggregate supply P1 E PE Aggregate demand D1 QE S1 REAL OUTPUT (quantity per year) Demand-Side Theories Inadequate demand Excessive demand AS0 AS0 E0 E2 P2 E1 AD0 AD1 Q1 QF REAL OUTPUT P0 E0 AD2 AD0 QF Q 2 REAL OUTPUT PRICE LEVEL (average price) Supply-Side Theories AS1 AS0 E3 P3 E0 P0 AD0 Q3 QF REAL OUTPUT (quantity per year) Long-Run Self Adjustment • Some economists argue that short-run theories are pointless. • In their view, short-run fluctuations in real output or prices are just statistical noise. • This argument is based on Classical and monetarist views of long-run stability. PRICE LEVEL (average price) The “Natural” Rate of Output AS P2 P1 AD2 AD1 QN REAL OUTPUT(quantity per year) Three Basic Policy Strategies • Shift aggregate demand curve - find and use policy tools that stimulate or restrain total spending. • Shift the aggregate supply curve - find and implement policy levers that reduce the costs of production or otherwise stimulate more output at every price level. • Laissez-faire - if we can’t identify or control the determinants of aggregate supply and demand, then we shouldn’t interfere with the market. Specific Policy Options • All the following policy strategies have been tried at one time or another: Classical approaches. Fiscal policy. Monetary policy. Supply-side policy. Trade policy. Eclecticism.