Economics 3rd ch04

Economics
THIRD EDITION

By John B. Taylor
Stanford University

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Chapter 17 (Macro 4)
Macroeconomics: The
Big Picture
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Overview
• This chapter introduces the major themes and
components of modern macroeconomics. It defines
macroeconomics in terms of economic growth and
economic fluctuations. It summarizes the recent
historical record of a few key macroeconomic
variables and emphasizes a set of key facts about
economic growth and economic fluctuations. An
overview of the major sources of macroeconomic
theory is provided to explain these facts. Finally, the
role of economic policy is introduced with a brief
discussion of fiscal and monetary policy.

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Teaching Objectives
1. Explain how economic growth and economic
fluctuations occur together, but make clear the
difference between the two.
2. Provide an account of the important facts about
economic growth and economic fluctuations.
3. Introduce major theoretical perspectives on both
economic growth (Solow model) and economic
fluctuations (Keynes, monetarism, and rational
expectations).
4. Introduce the role that economic policy can play
in promoting economic growth and reducing
economic fluctuations.
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1. Economic Output Over Time
• 1a. Real GDP is the starting point for studying
macroeconomics. Figure 17.1 distinguishes
economic growth trends from business cycles, or
fluctuations.
1b. Economic growth can be measured in terms of

individual benefit by using real GDP per capita
values, providing an indicator of average wellbeing in an economy.

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Figure 17.1 (Macro 4)
Economic Growth and Fluctuations

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1. Economic Output Over Time
• 1c. The growth record of the United States over
the past 40 years is based on real GDP growth of 3
percent and per capita growth of 1.7 percent.
However, these growth rates cover two distinct
periods. The first period (1955-1975) growth rate
was about 3.25 percent, compared to the second
period (1975-1994) rate of 2.5 percent. Explaining
this growth slowdown has been a major challenge
for economists.

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Figure 17.2
(Macro 4)
Visualizing Economic Growth

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Economic fluctuations
• 1d. Economic fluctuations define the parts of a
business cycle (see Figures 17.2 and 17.2).
• Note the irregular duration and variable depth and
peak of cycles. This may be related to particular
administrations or events. It is important to point out
that economic fluctuations differ from cycles in
physical sciences.
• The aftermath of a recession, a recovery, is gradual,
and the effect of an improvement in the economy is
usually delayed.
• A comparison between the 1990-1991 recession and
the Great Depression of the 1930s is made in Figure
17.4.
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Economic Fluctuations:
Recession / Expansion

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Figure 17.3 (Macro 4)
The Phases of Business Cycles

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Figure 17.4
(Macro 4)
Growth and
Fluctuations
Throughout
the Twentieth
Century

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2. Jobs, Inflation, and Interest Rates

• 2a. Job creation, or the net increase in employment,
along with measures of labor productivity, are two of
several variables used to describe an economy's
performance.
• Figure 17.5 illustrates employment growth over the last
40 years. Labor productivity has increased at about 1.3
percent per year when measured in real GDP per hour.
But again there are two periods of productivity growth,
reflecting the productivity slowdown of the last 20 years:
2 percent for the period from the mid-1950s to the mid1970s, compared to 0.7 percent since. Small differences
make for large differences over long periods of time.

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Figure 17.5
(Macro 4)
The Unemployment Rate

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Unemployment
• 2b. The unemployment rate rises in a recession and
falls in a recovery but with a delay, as shown in
Figure 17.6. The contrast in the magnitude between

recent rates and the Great Depression is provided by
Figure 17.7. The labor force participation rate,
although rising gradually over the last 40 years, also
varies over the business cycle as workers are
discouraged from further job search or decide to
retire early, causing the rate to fall in a recession.

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Figure 17.6
(Macro 4)
Unemployment During the Great Depression

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Inflation
• Inflation is closely linked to the business cycle, as
seen from the shaded areas in Figure 17.8.
• There is a long-term positive trend to inflation
over the last 40 years, even though disinflation has
been a feature of the last decade.
• Inflation has never been zero during the period
and is expected to remain positive on average in
the future.

• The cost of inflation is the uncertainty about how
to determine prices and anticipate future changes
in prices. Inflation has not been low or stable, both
desirable goals.
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Figure 17.7
(Macro 4)
The Ups and Downs in Inflation

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Interest rates
• Interest rates are also linked to business cycles.
• Interest rates, such as mortgage and savings
deposit rates, along with the federal funds rate, are
affected by the performance of the economy, as
shown in Figure 17.8.
• Real interest rates, the difference between nominal
interest rates and expected inflation, provide a way
of explaining the close relationship between
inflation and interest rates.
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Figure 17.8
(Macro 4)
The Ups and Downs in Interest Rates

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3. Macroeconomic Theory and Policy
• 3a. Economic growth theory and economic
fluctuations theory are the long- and short-term
parts of macroeconomic theory, respectively. The
trend line of Figure 19.1 is potential GDP, or the
long-run tendency of GDP, and is an average-level
GDP that reflects the long-term growth rate, the
slope of the trend line.

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Aggregate Supply
• 3b. The term aggregate supply is used to describe
potential GDP in the short-run setting of economic
fluctuations. Aggregate supply is determined by the

available labor, capital, and technology.
• 3b.1 The concept of the aggregate production
function is used to relate real GDP to the inputs:
labor, capital, and technology. Because of this longterm relationship between inputs and output, any
slowdown in economic growth must be due to a
slowdown in the growth of one or more of the
inputs.

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Economic policies
• 3c. Policy for long-term economic growth
(sometimes called supply side policy) attempts to
increase potential GDP, or aggregate supply.
• Fiscal and monetary policy are other tools to
improve economy.

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Fiscal policy
• 3c.1 Fiscal policy can affect aggregate supply
through the use of tax changes or changes in
spending or borrowing. These incentives alter
labor, capital, and technology inputs to the

production function.

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Monetary policy

• 3c.2 Monetary policy is concerned primarily with
the control of the money supply in order to control
inflation. A low and stable rate of inflation is
desirable because it reduces the uncertainty
associated with determining prices and future
inflation when inflation is high or variable.

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