III. Macroeconomic Analysis

Measuring Economic Performance

• Gross Domestic Product (GDP): The primary measure of an economy’s performance, GDP is the total value of all final goods and services produced on a nation’s soil in a year. Intermediate goods are excluded to avoid double-counting.
  • GDP Exclusions: GDP does not count non-production transactions like purely financial transactions (stocks), public/private transfer payments (Social Security, gifts), and secondhand sales.
  • Approaches to GDP:
    1. Expenditures Approach: GDP = C + I + G + Xn (Consumption + Gross Investment + Government Spending + Net Exports).
    2. Income Approach: Sums wages, rents, interest, and profits.
  • Nominal vs. Real GDP: Nominal GDP is measured in current prices and is unadjusted for inflation. Real GDP is adjusted for inflation, providing a more accurate measure of output changes over time.
• The Business Cycle: The natural fluctuation of GDP, consisting of four phases: peak, contraction (recession is two consecutive quarters of declining GDP), trough, and expansion.
• Unemployment:
  • Frictional: Workers temporarily between jobs or searching for new ones.
  • Structural: Mismatch between workers’ skills and the skills demanded by employers, often due to technological change.
  • Cyclical: Caused by the contraction phase of the business cycle.
• Inflation: A general rise in the price level over a sustained period.
  • Demand-Pull Inflation: Caused by an increase in aggregate demand that outpaces the economy’s productive capacity.
  • Cost-Push Inflation: Caused by an increase in the costs of production (e.g., input prices), which shifts the aggregate supply curve left.
  • Effects of Inflation: Unanticipated inflation hurts fixed-income recipients, savers, and creditors. It benefits debtors and those with flexible incomes tied to a Cost-of-Living Adjustment (COLA).

National Income and Price Determination

• Aggregate Demand (AD): The total amount of real output that buyers (households, firms, government, foreigners) collectively desire to purchase at each price level. The AD curve is downward sloping due to:
  • Real-Balance Effect: A higher price level reduces the purchasing power of money, decreasing consumption.
  • Interest-Rate Effect: A higher price level increases demand for money, raising interest rates and reducing investment and consumption.
  • Foreign-Purchases Effect: A higher domestic price level makes domestic goods more expensive for foreigners and foreign goods cheaper for domestic consumers, reducing net exports.
• Aggregate Supply (AS): The total amount of real output that producers will collectively produce at each price level. The AS curve has three ranges:

• 1. Horizontal/Keynesian Range: High unemployment and idle resources; output can increase without raising the price level.
  2. Intermediate Range: As the economy nears full employment, output increases are accompanied by a rising price level.
  3. Vertical/Classical Range: The economy is at full capacity; further increases in demand only raise the price level (inflation) with no change in output.
• Equilibrium: The intersection of the AD and AS curves determines the economy’s equilibrium price level and real GDP.

Fiscal Policy: Government’s Role in Stabilization

• Classical vs. Keynesian Economics:
  • Classical: Believes the economy is self-correcting and will naturally return to full employment. Advocates for a hands-off approach.
  • Keynesian: Argues that the economy can be in equilibrium below full employment and that government intervention is necessary to correct recessions and inflation.
• Fiscal Policy Tools:
  • Expansionary Fiscal Policy: Used to combat a recession. Involves increasing government spending and/or decreasing taxes to shift AD to the right.
  • Contractionary Fiscal Policy: Used to combat inflation. Involves decreasing government spending and/or increasing taxes to shift AD to the left.
• Built-in Stabilizers: Automatic changes in tax revenue and government spending that occur with fluctuations in GDP, which help to moderate the business cycle (e.g., progressive income taxes, unemployment benefits).
• Problems with Fiscal Policy: Implementation can be slow due to administrative and operational lags, and it can be influenced by political pressures.

Monetary Policy: The Federal Reserve and the Money Supply

• Functions of Money: Money serves as a medium of exchange, a unit of account, and a store of value.
• The Money Supply:
  • M1: Most liquid form; includes currency, checkable deposits, and traveler’s checks.
  • M2: Includes M1 plus savings deposits, small-time deposits (CDs < $100k), and money market mutual funds.
  • M3: Includes M2 plus large-time deposits (> $100k).
• The Federal Reserve (The Fed): The central bank of the United States. It is run by a Board of Governors and includes 12 district banks. The Federal Open Market Committee (FOMC) sets monetary policy.
• Tools of Monetary Policy:

• The Phillips Curve: Illustrates the short-run trade-off between inflation and unemployment. The long-run Phillips curve is vertical at the natural rate of unemployment, suggesting no long-run trade-off.