PRINCIPLES OF MACROECONOMICS PART II Concepts and Problems in Macroeconomics TENTH EDITION CASE FAIR OSTER © 2012 Pearson Education, Inc Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly ofTefft 26 PART II Concepts and Problems in Macroeconomics © 2012 Pearson Education, Inc Publishing as Prentice Hall of 26 PART I CONCEPTS AND PROBLEMS IN MACROECONOMICS Introduction to Macroeconomics CHAPTER OUTLINE Macroeconomic Concerns Output Growth Unemployment Inflation and Deflation PART II Concepts and Problems in Macroeconomics The Components of the Macroeconomy © 2012 Pearson Education, Inc Publishing as Prentice Hall The Circular Flow Diagram The Three Market Arenas The Role of the Government in the Macroeconomy A Brief History of Macroeconomics The U.S Economy Since 1970 of 26 microeconomics Examines the functioning of individual industries and the behavior of individual decision-making units—firms and households PART II Concepts and Problems in Macroeconomics macroeconomics Deals with the economy as a whole Macroeconomics focuses on the determinants of total national income, deals with aggregates such as aggregate consumption and investment, and looks at the overall level of prices instead of individual prices aggregate behavior The behavior of all households and firms together sticky prices Prices that not always adjust rapidly to maintain equality between quantity supplied and quantity demanded © 2012 Pearson Education, Inc Publishing as Prentice Hall of 26 Macroeconomic Concerns Three of the major concerns of macroeconomics are Output growth Unemployment PART II Concepts and Problems in Macroeconomics Inflation and deflation © 2012 Pearson Education, Inc Publishing as Prentice Hall of 26 Macroeconomic Concerns Output Growth business cycle The cycle of short-term ups and downs in the economy PART II Concepts and Problems in Macroeconomics aggregate output The total quantity of goods and services produced in an economy in a given period recession A period during which aggregate output declines Conventionally, a period in which aggregate output declines for two consecutive quarters depression A prolonged and deep recession © 2012 Pearson Education, Inc Publishing as Prentice Hall of 26 Macroeconomic Concerns Output Growth expansion or boom The period in the business cycle from a trough up to a peak during which output and employment grow PART II Concepts and Problems in Macroeconomics contraction, recession, or slump The period in the business cycle from a peak down to a trough during which output and employment fall © 2012 Pearson Education, Inc Publishing as Prentice Hall of 26 Macroeconomic Concerns Output Growth PART II Concepts and Problems in Macroeconomics FIGURE A Typical Business Cycle In this business cycle, the economy is expanding as it moves through point A from the trough to the peak When the economy moves from a peak down to a trough, through point B, the economy is in recession © 2012 Pearson Education, Inc Publishing as Prentice Hall of 26 Macroeconomic Concerns PART II Concepts and Problems in Macroeconomics Output Growth FIGURE U.S Aggregate Output (Real GDP), 1900–2009 The periods of the Great Depression and World Wars I and II show the largest fluctuations in aggregate output © 2012 Pearson Education, Inc Publishing as Prentice Hall of 26 Macroeconomic Concerns Unemployment PART II Concepts and Problems in Macroeconomics unemployment rate The percentage of the labor force that is unemployed © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 26 Explaining the Existence of Unemployment Imperfect Information Firms may not have enough information at their disposal to know what the market-clearing wage is In this case, firms are said to have imperfect information PART III The Core of Macroeconomic Theory If firms have imperfect or incomplete information, they may simply set wages wrong—wages that not clear the labor market © 2012 Pearson Education, Inc Publishing as Prentice Hall 15 of 29 Explaining the Existence of Unemployment Minimum Wage Laws minimum wage laws Laws that set a floor for wage rates— that is, a minimum hourly rate for any kind of labor PART III The Core of Macroeconomic Theory An Open Question The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment Which argument or arguments will win out in the end is an open question © 2012 Pearson Education, Inc Publishing as Prentice Hall 16 of 29 The Short-Run Relationship between the Unemployment Rate and Inflation The unemployment rate (U) and aggregate output (income) (Y) are negatively related: when Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises FIGURE 14.3 The Aggregate Supply Curve PART III The Core of Macroeconomic Theory The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y) © 2012 Pearson Education, Inc Publishing as Prentice Hall 17 of 29 The Short-Run Relationship between the Unemployment Rate and Inflation FIGURE 14.4 The Relationship between the Price Level and the Unemployment Rate PART III The Core of Macroeconomic Theory This curve shows a negative relationship between the price level (P) and the unemployment rate (U) As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the price level rises more and more © 2012 Pearson Education, Inc Publishing as Prentice Hall 18 of 29 The Short-Run Relationship between the Unemployment Rate and Inflation inflation rate The percentage change in the price level FIGURE 14.5 The Phillips Curve PART III The Core of Macroeconomic Theory The Phillips Curve shows the relationship between the inflation rate and the unemployment rate Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate © 2012 Pearson Education, Inc Publishing as Prentice Hall 19 of 29 The Short-Run Relationship between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective FIGURE 14.6 Unemployment and Inflation, 1960–1969 PART III The Core of Macroeconomic Theory During the 1960s, there seemed to be an obvious trade-off between inflation and unemployment Policy debates during the period revolved around this apparent trade-off © 2012 Pearson Education, Inc Publishing as Prentice Hall 20 of 29 The Short-Run Relationship between the Unemployment Rate and Inflation The Phillips Curve: A Historical Perspective FIGURE 14.7 Unemployment and Inflation, 1970–2009 PART III The Core of Macroeconomic Theory From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple © 2012 Pearson Education, Inc Publishing as Prentice Hall 21 of 29 The Short-Run Relationship between the Unemployment Rate and Inflation PART III The Core of Macroeconomic Theory Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve FIGURE 14.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply © 2012 Pearson Education, Inc Publishing as Prentice Hall 22 of 29 The Short-Run Relationship between the Unemployment Rate and Inflation Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve PART III The Core of Macroeconomic Theory The Role of Import Prices FIGURE 14.9 The Price of Imports, 1960 I–2010 I The price of imports changed very little in the 1960s and early 1970s It increased substantially in 1974 and again in 1979-1980 Between 1981 and 2002, the price of imports changed very little It generally rose between 2003 and 2008, with some falloff in 2009 © 2012 Pearson Education, Inc Publishing as Prentice Hall 23 of 29 The Short-Run Relationship between the Unemployment Rate and Inflation Expectations and the Phillips Curve If inflationary expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate may not have changed In this case, the Phillips Curve will shift to the right PART III The Core of Macroeconomic Theory If inflationary expectations decrease, the Phillips Curve will shift to the left— there will be less inflation at any given level of the unemployment rate Inflation and Aggregate Demand Inflation is affected by more than just aggregate demand Where inflation depends on both the unemployment rate and cost variables, there will be no stable Phillips Curve unless the cost variables are not changing Therefore, the unemployment rate can have an important effect on inflation even though this will not be evident from a plot of inflation against the unemployment rate—that is, from the Phillips Curve © 2012 Pearson Education, Inc Publishing as Prentice Hall 24 of 29 PART III The Core of Macroeconomic Theory The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment FIGURE 14.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment If the AS curve is vertical in the long run, so is the Phillips Curve In the long run, the Phillips Curve corresponds to the natural rate of unemployment—that is, the unemployment rate that is consistent with the notion of a fixed long-run output at potential output U* is the natural rate of unemployment © 2012 Pearson Education, Inc Publishing as Prentice Hall 25 of 29 The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment natural rate of unemployment The unemployment that occurs as a normal part of the functioning of the economy Sometimes taken as the sum of frictional unemployment and structural unemployment PART III The Core of Macroeconomic Theory The Nonaccelerating Inflation Rate of Unemployment (NAIRU) NAIRU The nonaccelerating inflation rate of unemployment © 2012 Pearson Education, Inc Publishing as Prentice Hall 26 of 29 The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment The Nonaccelerating Inflation Rate of Unemployment (NAIRU) PART III The Core of Macroeconomic Theory FIGURE 14.11 The NAIRU Diagram To the left of the NAIRU, the price level is accelerating (positive changes in the inflation rate); To the right of the NAIRU, the price level is decelerating (negative changes in the inflation rate) Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate) © 2012 Pearson Education, Inc Publishing as Prentice Hall 27 of 29 Looking Ahead This chapter concludes our basic analysis of how the macroeconomy works PART III The Core of Macroeconomic Theory In the preceding seven chapters, we have examined how households and firms behave in the three market arenas—the goods market, the money market, and the labor market We have seen how aggregate output (income), the interest rate, and the price level are determined in the economy, and we have examined the relationship between two of the most important macroeconomic variables, the inflation rate and the unemployment rate In the next chapter, we use everything we have learned up to this point to examine a number of important policy issues © 2012 Pearson Education, Inc Publishing as Prentice Hall 28 of 29 PART III The Core of Macroeconomic Theory REVIEW TERMS AND CONCEPTS cost-of-living adjustments (COLAs) NAIRU cyclical unemployment natural rate of unemployment efficiency wage theory Phillips Curve explicit contracts relative-wage explanation of unemployment frictional unemployment social, or implicit, contracts inflation rate sticky wages labor demand curve structural unemployment labor supply curve unemployment rate minimum wage laws © 2012 Pearson Education, Inc Publishing as Prentice Hall 29 of 29 ... Concepts and Problems in Macroeconomics © 2012 Pearson Education, Inc Publishing as Prentice Hall of 26 PART I CONCEPTS AND PROBLEMS IN MACROECONOMICS Introduction to Macroeconomics CHAPTER OUTLINE... decision-making units—firms and households PART II Concepts and Problems in Macroeconomics macroeconomics Deals with the economy as a whole Macroeconomics focuses on the determinants of total national income,... 26 Macroeconomic Concerns Three of the major concerns of macroeconomics are Output growth Unemployment PART II Concepts and Problems in Macroeconomics Inflation and deflation © 2012 Pearson Education,