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Real GDP




Figure 8 takes the graphical analysis of economic growth from Figure 3 and adds a
new aggregate supply curve, S2S2, which lies to the right of S1S1. With supply curve S2S2
instead of S1S1, the economy moves from point E not just to point C, as in the earlier fig-
ure, but all the way to point B. Comparing B to C, we see that the economy winds up
both farther to the right (that is, it grows faster) and lower (that is, it experiences less in-
flation). That, in a nutshell, is how our simple aggregate demand“aggregate supply
framework explains this episode of recent U.S. economic history.


Tax Cuts and the Bush Economy
The Clinton boom ended around the middle of 2000”just before the election of Presi-
dent George W. Bush. Real GDP grew very slowly in the second half of 2000 and then
actually declined in two quarters of 2001, marking the first recession in the United States
in 10 years.
The tax cut of 2001 turned out to be remarkably well timed, however, and the war on
terrorism led to a burst of government spending. Both of these components of fiscal pol-
icy helped shift the aggregate demand curve outward, thereby mitigating the recession.
(Refer back to Figure 1(b) on page 86.) The Federal Reserve also lowered interest rates to
encourage more spending. The recession ended late in 2001. But the recovery was ex-
tremely weak until the spring of 2003, when growth finally picked up”remaining strong
through 2006 before slowing a bit late in 2007 and into 2008. The tax cuts of 2001“2003,
while giving the economy a boost, also brought back large budget deficits.




ISSUE REVISITED: WHY DID THE ECONOMY SLOW DOWN?
At the start of this chapter, we asked why U.S. economic growth weakened
after early 2006. The analysis in the chapter suggests that we should look for
a slowdown in aggregate demand to find the answer. And, indeed, there
was one”some (but not all) of it made in Washington. Why did policy mak-
ers do this? Worried about inflation, the Federal Reserve started raising in-




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Licensed to:

Chapter 5 99
An Introduction to Macroeconomics



terest rates in the middle of 2005. Tax cutting, which had helped propel the economy in
the years 2002“2004 also petered out, partly because policy makers became worried
about large budget deficits. In addition, the nation™s spending on housing began to sag
as the so-called housing bubble burst. Each of these factors restrained the growth of ag-
gregate demand, as compared to 2003“2005, and therefore the growth of real GDP.




THE PROBLEM OF MACROECONOMIC STABILIZATION:
A SNEAK PREVIEW
This brief look at the historical record shows that our economy has not generally pro-
duced steady growth without inflation. Rather, it has been buffeted by periodic bouts of
unemployment or inflation, and sometimes it has been plagued by both. We have also
hinted that government policies may have had something to do with this performance.
Let us now expand upon and systematize this hint.
To provide a preliminary analysis of stabilization policy, the name given to govern- Stabilization policy is the
name given to government
ment programs designed to shorten recessions and to counteract inflation, we can once
programs designed to pre-
again use the basic tools of aggregate supply and demand analysis. To facilitate this
vent or shorten recessions
discussion, we have reproduced as Figures 9 and 10 two diagrams found earlier in this
and to counteract inflation
chapter, but we now give them slightly different interpretations. (that is, to stabilize prices).


Combating Unemployment
Figure 9 offers a simplified view of government policy to fight unemployment. Suppose
that in the absence of government intervention, the economy would reach an equilib-
rium at point E, where the aggregate demand curve D0D0 crosses the aggregate supply
curve SS. Now if the output corresponding to point E is too low, leaving many workers
unemployed, the government can reduce unemployment by increasing aggregate demand. Sub-
sequent chapters will consider in detail how this is done. But our brief historical review
has already mentioned three methods: Congress can spend more or reduce taxes (“fiscal



FIGURE 9
D1
Stabilization Policy to
S Fight Unemployment
D0

A
Price Level




E




D1


D0
S
Increase in
output


Real GDP




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Licensed to:
Part 2
100 The Macroeconomy: Aggregate Supply and Demand



policy”), as it recently did with the 2008 “stimulus” bill; or the Federal Reserve can
lower interest rates (“monetary policy”), as it also did in late 2007 and early 2008. In the
diagram, any of these actions would shift the demand curve outward to D1D1, causing
equilibrium to move to point A. In general:
Recessions and unemployment are often caused by insufficient aggregate demand.
When such situations occur, fiscal or monetary policies that successfully augment de-
mand can be effective ways to increase output and reduce unemployment. But they also
normally raise prices.

Combating Inflation
The opposite type of demand management is called for when inflation is the main
macroeconomic problem. Figure 10 illustrates this case. Here again, point E, the inter-
section of aggregate demand curve D0D0 and aggregate supply curve SS, is the equilib-
rium the economy would reach in the absence of government policy. But now suppose
the price level corresponding to point E is considered “too high,” meaning that the price
level would be rising too rapidly if the economy were to move to point E. Government
policies that reduce demand from D0D0 to D2D2 can keep prices down and thereby
FIGURE 10
reduce inflation. Some examples are reducing government spending or raising taxes, as
Stabilization Policy to
done by the Clinton administration in the 1990s, or raising
Fight Inflation
interest rates, which the Federal Reserve did in 2005“2006.
Thus:
S
Inflation is frequently caused by aggregate demand racing
D0
ahead too fast. When this is the case, fiscal or monetary
policies that reduce aggregate demand can be effective
D2
anti-inflationary devices. But such policies also decrease
real GDP and raise unemployment.
E
Price Level




This, in brief, summarizes the intent of stabilization pol-
Decrease icy. When aggregate demand fluctuations are the source of
B
in prices
economic instability, the government can limit both reces-
sions and inflations by pushing aggregate demand ahead
when it would otherwise lag and restraining it when it
would otherwise grow too quickly.
D0

S
Does It Really Work?
D2

Can the government actually stabilize the economy, as these
simple diagrams suggest? That is a matter of some debate”
Real GDP
a debate that is important enough to constitute one of our
Ideas for Beyond the Final Exam.
We will deal with the pros and cons in Part 3. But a look back at Figures 5 and 6
(page 93) may be instructive right now. First, cover the portions of the two figures that
deal with the period after 1940, the portions from the shaded area rightward in each
figure. The picture that emerges for the 1870“1940 period is that of an economy with
frequent and sometimes quite pronounced fluctuations.
Now do the reverse. Cover the data before 1950 and look only at the postwar period.
There is indeed a difference. Instances of negative real GDP growth are less common and
business fluctuations look less severe. Although government policies have not achieved
perfection, things do look much better.
When we turn to inflation, however, matters look rather worse. Gone are the periods of
deflation and price stability that occurred before World War II. Prices now seem only to
rise. This quick tour through the data suggests that something has changed. The U.S. econ-
omy behaved differently from 1950 to 2007 than it did from 1870 to 1940.




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Licensed to:

Chapter 5 101
An Introduction to Macroeconomics



Although controversy over this point continues, many economists attribute this shift
in the economy™s behavior to lessons the government has learned about managing
the economy”lessons you will be learning in the next Part of this book. When you
IDEAS FOR
look at the prewar data, you see the fluctuations of an unmanaged economy that BEYOND THE
went through booms and recessions for “natural” economic reasons. The government FINAL EXAM
did little about either. When you examine the postwar data, on the other hand, you
see an economy that has been increasingly managed by government policy”
sometimes successfully and sometimes unsuccessfully. Although the recessions are
less severe, this improvement has come at a cost: The economy appears to be more
inflation-prone than it was in the more distant past. These two changes in our econ-
omy may be connected. But to understand why, we will have to provide some
relevant economic theory.
We have, in a sense, spent much of this chapter running before we have learned to
walk”that is, we have been using aggregate demand and aggregate supply curves exten-
sively before developing the theory that underlies them. That is the task before us in the
rest of Part 2.




| SUMMARY |
some periods of falling prices (deflation), more recent
1. Microeconomics studies the decisions of individuals and
firms, the ways in which these decisions interact, and history shows only rising prices (inflation).
their influence on the allocation of a nation™s resources 7. The Great Depression of the 1930s was the worst in U.S.
and the distribution of income. Macroeconomics looks at history. It profoundly affected both our nation and coun-
how entire economies behave and studies the pressing tries throughout the world. It also led to a revolution in
social problems of economic growth, inflation, and un- economic thinking, thanks largely to the work of John
employment. Maynard Keynes.
2. Although they focus on different subjects, microeco- 8. From World War II to the early 1970s, the American
nomics and macroeconomics rely on virtually identical economy exhibited steadier growth than in the past.
tools. Both use the supply-and-demand analysis intro- Many observers attributed this more stable perform-
duced in Chapter 4. ance to the implementation of the monetary and fiscal
policies (collectively called stabilization policy) that
3. Macroeconomic models use abstract concepts like “the
Keynes had suggested. At the same time, however,
price level” and “gross domestic product” that are derived
the price level seems only to rise”never to fall”in the
by combining many different markets into one. This
modern economy. The economy seems to have become
process is known as aggregation; it should not be taken lit-
more “inflation-prone.”
erally but rather viewed as a useful approximation.
9. Between 1973 and 1991, the U.S. economy suffered
4. The best specific measure of the nation™s economic out-
through several serious recessions. In the first part of that
put is gross domestic product (GDP), which is ob-
period, inflation was also unusually virulent. This un-
tained by adding up the money values of all final
happy combination of economic stagnation with rapid
goods and services produced in a given year. These
inflation was nicknamed “stagflation.” Since 1982, how-
outputs can be evaluated at current market prices (to
ever, inflation has been low.
get nominal GDP) or at some fixed set of prices (to get
real GDP). Neither intermediate goods nor transac- 10. The United States enjoyed a boom in the 1990s, and
tions that take place outside organized markets are unemployment fell to its lowest level in 30 years. Yet in-
included in GDP. flation also fell. One explanation for this happy
combination of rapid growth and low inflation is that
5. GDP measures an economy™s production, not the in-

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