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the aggregate supply curve shifted out unusually
crease in its well-being. For example, the GDP places no
rapidly.
value on housework, other do-it-yourself activities, or
leisure time. On the other hand, even commodities that 11. One major cause of inflation is that aggregate demand
might be considered as “bads” rather than “goods” are may grow more quickly than does aggregate supply.
counted in the GDP (for example, activities that harm In such a case, a government policy that reduces aggre-
the environment). gate demand may be able to stem the inflation.
6. America™s economic history shows steady growth punc- 12. Recessions often occur because aggregate demand grows
tuated by periodic recessions”that is, periods in which too slowly. In this case, a government policy that stimulates
real GDP declined. Although the distant past included demand may be an effective way to fight the recession.



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Part 2
102 The Macroeconomy: Aggregate Supply and Demand



| KEY TERMS |
Aggregation 84 Nominal GDP 88 Fiscal policy 95
Aggregate demand curve 86 Real GDP 88 Stagflation 96
Aggregate supply curve 86 Final goods and services 89 Monetary policy 97
Inflation 87 Intermediate good 89 Stabilization policy 99
Recession 87 Real GDP per capita 92
Gross domestic product (GDP) 88 Deflation 93




| TEST YOURSELF |
1. Which of the following problems are likely to be studied c. Smith goes to the woods, cuts down a tree, and uses
by a microeconomist and which by a macroeconomist? the wood to build himself a garage that is worth
$50,000.
a. The rapid growth of Google
d. The Jones family sells its old house to the Reynolds
b. Why unemployment in the United States fell from
family for $400,000. The Joneses then buy a newly
2003 to 2006
constructed house from a builder for $500,000.
c. Why Japan™s economy grew faster than the U.S. econ-
e. You purchase a used computer from a friend for $200.
omy in the 1980s, but slower in the 2000s
f. Your university purchases a new mainframe com-
d. Why college tuition costs have risen so rapidly in
puter from IBM, paying $25,000.
recent years
g. You win $100 in an Atlantic City casino.
2. Use an aggregate supply-and-demand diagram to study
what would happen to an economy in which the aggre- h. You make $100 in the stock market.
gate supply curve never moved while the aggregate de- i. You sell a used economics textbook to your college
mand curve shifted outward year after year. bookstore for $60.
3. Which of the following transactions are included in j. You buy a new economics textbook from your college
gross domestic product, and by how much does each bookstore for $100.
raise GDP?
a. Smith pays a carpenter $50,000 to build a garage.
b. Smith purchases $10,000 worth of materials and
builds himself a garage, which is worth $50,000.




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Chapter 5 103
An Introduction to Macroeconomics



| DISCUSSION QUESTIONS |
1. You probably use “aggregates” frequently in everyday the earlier year.) Most young people think that prices
discussions. Try to think of some examples. (Here is one: have always risen. Why do you think they have this
Have you ever said, “The students at this college gener- opinion?
ally think . . .”? What, precisely, did you mean?) 3. Give some reasons why gross domestic product is not a
2. Try asking a friend who has not studied economics in suitable measure of the well-being of the nation. (Have
which year he or she thinks prices were higher: 1870 or you noticed newspaper accounts in which journalists
1900? 1920 or 1940? (In both cases, prices were higher in seem to use GDP for this purpose?)




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:




The Goals of Macroeconomic Policy
When men are employed, they are best contented.
B E N J A M IN F R A N K L I N

Inflation is repudiation.
CA LV I N CO O L ID G E



S omeone once quipped that you could turn a parrot into an economist by teaching
him just two words: supply and demand. And now that you have been through
Chapter 4 and Chapter 5, you see what he meant. Sure enough, economists think of the
process of economic growth as having two essential ingredients:
• The first ingredient is aggregate supply. Given the available supplies of inputs Inputs are the labor,
machinery, buildings, and
like labor and capital, and the technology at its disposal, an economy is able to
other resources used to
produce a certain volume of outputs, measured by GDP. This capacity to pro-
produce outputs.
duce normally increases from one year to the next as the supplies of inputs
grow and the technology improves. The theory of aggregate supply will be our Outputs are the goods and
focus in Chapters 7 and 10. services that the economy
produces.
• The second ingredient is aggregate demand. How much of the capacity to pro-
duce is actually utilized depends on how many of these goods and services
people and businesses want to buy. We begin building a theory of aggregate
demand in Chapters 8 and 9.




CONTENTS
TYPES OF UNEMPLOYMENT OTHER COSTS OF INFLATION
PART 1: THE GOAL OF ECONOMIC GROWTH
HOW MUCH EMPLOYMENT IS “FULL THE COSTS OF LOW VERSUS HIGH
PRODUCTIVITY GROWTH: FROM LITTLE
EMPLOYMENT”? INFLATION
ACORNS . . .
UNEMPLOYMENT INSURANCE: LOW INFLATION DOES NOT NECESSARILY
ISSUE: IS FASTER GROWTH ALWAYS
BETTER? THE INVALUABLE CUSHION LEAD TO HIGH INFLATION
THE CAPACITY TO PRODUCE: POTENTIAL PART 3: THE GOAL OF LOW INFLATION | APPENDIX | How Statisticians
GDP AND THE PRODUCTION FUNCTION Measure Inflation
INFLATION: THE MYTH AND THE REALITY
Index Numbers for Inflation
THE GROWTH RATE OF POTENTIAL GDP Inflation and Real Wages
The Consumer Price Index
The Importance of Relative Prices
ISSUE REVISITED: IS FASTER GROWTH ALWAYS Using a Price Index to “Deflate” Monetary Figures
BETTER? INFLATION AS A REDISTRIBUTOR Using a Price Index to Measure Inflation
OF INCOME AND WEALTH
PART 2: THE GOAL OF LOW UNEMPLOYMENT The GDP Deflator
REAL VERSUS NOMINAL INTEREST RATES
THE HUMAN COSTS OF HIGH
UNEMPLOYMENT INFLATION DISTORTS MEASUREMENTS
COUNTING THE UNEMPLOYED: Confusing Real and Nominal Interest Rates
THE OFFICIAL STATISTICS The Malfunctioning Tax System




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Part 2
106 The Macroeconomy: Aggregate Supply and Demand



Corresponding to these two ingredients, economists visualize a dual task for those who
make macroeconomic policy. First, policy should create an environment in which the economy
can expand its productive capacity rapidly, because that is the ultimate source of higher living
standards. This first task is the realm of growth policy, and it is taken up in the next
Growth policy refers to
chapter. Second, policy makers should manage aggregate demand so that it grows in line with the
government policies
intended to make the economy™s capacity to produce, avoiding as much as possible the cycles of boom and bust that
economy grow faster in we saw in the last chapter. This is the realm of stabilization policy. As we noted in the last
the long run.
chapter, inadequate growth of aggregate demand can lead to high unemployment, while ex-
cessive growth of aggregate demand can lead to high inflation. Both are to be avoided.
Thus, the goals of macroeconomic policy can be summarized succinctly as achieving
rapid but relatively smooth economic growth with low unemployment and low inflation. Unfortu-
nately, that turns out to be a tall order. In chapters to come, we will explain why these goals
cannot be attained with machine-like precision and why improvement on one front often
spells deterioration on another. Along the way, we will pay a great deal of attention to both
the causes of and cures for sluggish growth, high unemployment, and high inflation.
But before getting involved in such weighty issues of theory and policy, we pause in
this chapter to take a close look at the three goals themselves. How fast can”or should”
the economy grow? Why does a rise in unemployment cause such social distress? Why is
inflation so loudly deplored? The answers to some of these questions may seem obvious
at first. But, as you will see, there is more to them than meets the eye.
The chapter is divided into three main parts, corresponding to the three goals. An ap-
pendix explains how inflation is measured.


PART 1: THE GOAL OF ECONOMIC GROWTH
To residents of a prosperous society like ours, economic growth”the notion that stan-
dards of living rise from one year to the next”seems like part of the natural order of
things. But it is not. Historians tell us that living standards barely changed from the
Roman Empire to the dawn of the Industrial Revolution”a period of some 16 centuries!
Closer in time, per-capita incomes have tragically declined, on net, in most of the former
Soviet Union and some of the poorest countries of Africa in recent decades. Economic
growth is not automatic.
Growth is also a very slow, and therefore barely noticeable, process. The typical Ameri-
can probably will consume about 1 to 2 percent more goods and services in 2008 than he
or she did in 2007. Can you perceive a difference that small? Perhaps not, but such tiny
changes, when compounded for decades or even centuries, transform societies. During
the twentieth century, for example, living standards in the United States increased by a
factor of almost 7”which means that your ancestors in the year 1900 consumed roughly
one-seventh as much food, clothing, shelter, and other amenities as you do today. Try to
imagine how your family would fare on one-eighth of its current income.



PRODUCTIVITY GROWTH: FROM LITTLE ACORNS . . .
Small differences in growth rates make an enormous difference”eventually. To illustrate
this point, think about the relative positions of three major nations”the United States, the
United Kingdom, and Japan”at two points in history: 1870 and 1979. In 1870, the United
States was a young, upstart nation. Although already among the most prosperous coun-
tries on earth, the United States was in no sense yet a major power. The United Kingdom,
by contrast, was the preeminent economic and military power of the world. The Victorian
era was at its height, and the sun never set on the British Empire. Meanwhile, somewhere
across the Pacific was an inconsequential island nation called Japan. In 1870, Japan had
only recently opened up to the West and was economically backward.




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Chapter 6 107
The Goals of Macroeconomic Policy




The Wonders of Compound Interest
Growth rates, like interest rates, compound so You may not be impressed by the difference
that, for example, 10 years of growth at 3 per- between 30 percent and 34.4 percent. If so, fol-
cent per year leaves the economy more than 30 low the logic for longer periods. After 20 years of
percent larger. How much more? The answer is 3 percent growth, the economy will be 80.6 per-




SOURCE: © Popperfoto/Getty Images
cent bigger (because (1.03)20 5 1.806), not just
34.4 percent. To see how we get this figure, start
60 percent bigger. After 50 years, cumulative
with the fact that $100 left in a bank account for
growth will be 338 percent, not 150 percent.
one year at 3 percent interest grows to $103,
And after a century, it will be 1,822 percent, not
which is 1.03 3 $100. If left for a second year,
just 300 percent. Now we are talking about large
that $103 will grow another 3 percent”to 1.03
discrepancies! No wonder Einstein once said,
3 $103 5 $106.09, which is already more than
presumably in jest, that compounding was the
$106. Compounding has begun.
Notice that 1.03 3 $103 is (1.03)2 3 $100. most powerful force in the universe.
Similarly, after three years the original $100 will grow to (1.03)3 3 The arithmetic of growth leads to a convenient “doubling rule”
that you can do in your head. If something (the money in a bank
$100 5 $109.27. As you can see, each additional year adds an-
account, the GDP of a country, and so on) grows at an annual rate of
other 1.03 growth factor to the multiplication. Now returning to
g percent, how long will it take to double? The approximate answer is
answer our original question, after 10 years of compounding, the
depositor will have (1.03)10 3 $100 5 $134.39 in the bank. Thus 70/g, so the rule is often called “the Rule of 70.” For example, at a 2
percent growth rate, something doubles in about 70/2 5 35 years. At
the balance will have grown by 34.4 percent. By identical logic, an
a 3 percent growth rate, doubling takes roughly 70/3 5 23.33 years.
economy growing at 3 percent per year for 10 years will expand
Yes, small differences in growth rates can make a large difference.
34.4 percent in total.



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( 126 .)



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