Performance and Policy

Real GDP
Corrects for price changes

Nominal GDP
Uses current prices

Unemployment Inflation
Increase in overall level of prices
6-1

Performance and Policy

Can governments:
Promote economic growth? Reduce severity of recession?

Is monetary or fiscal policy more effective at mitigating recession? Is there a tradeoff between inflation and unemployment?
6-2

Economic Performance
Output growth
3.1% per year 1995-2005

Unemployment rate
4.6% in 2007

Inflation rate
2.7% in 2007
6-3

Economic Growth
Standard of living measured by output per person No growth in living standards prior to Industrial Revolution Modern economic growth
Output per person rises Not experienced by all countries
6-4

GDP Per Person 2007

U.S. dollars based on purchasing power parity
United States Canada United Kingdom Japan France South Korea Saudi Arabia Russia Mexico China India North Korea Tanzania Burundi
Zimbabwe $188
6-5

$45,845 $38,345 $35,134 $33,576 $33,187 $24,782 $23,243 $14,692 $12,774 $5,292 $2,659 $1,900 $1,256 $371

Savings and Investment

Saving
Tradeoff current for future consumption

Investment
Financial investment Economic investment

Banks and financial institutions

6-6

Expectations
The future is uncertain Expectations affect investment Shocks
What happens is not what you expected

Demand shocks Supply shocks

6-7

Shocks
Demand shocks and flexible prices
Price falls if demand low Sales unchanged

Demand shocks and sticky prices

Maintain inventory Sales change Business cycles
6-8

Demand Shocks
Flexible Prices $40,000

Price

$37,000

$35,000

DH DL
900 Cars per week
6-9

DM

Demand Shocks
Fixed Prices

Price

$37,000

DH DL
700 900 1150
6-10

DM

Cars per week

Sticky Prices
Explain fluctuations is GDP Average months between price changes
Coin-operated Laundry Machine Newspaper Haircut Taxi fare Veterinary service Magazine Beer 46.4 29.9 25.5 19.7 14.9 11.2 4.3 Microwave Ovens 3.0 Milk 2.4 Electricity 1.8 Airline ticket 1.0 Gasoline 0.6 Computer software 5.5

6-11

Sticky Prices
Many prices sticky in short run
Consumers prefer stable prices Firms want to avoid price wars

All prices flexible in long run

Firms adjust to unexpected, but permanent changes in demand

6-12

Inventory Management
Computerized inventory tracking Unexpected changes in demand easier to observe Firms make better output and employment decisions Less severe business cycles Only two mild recessions since adoption
Possible explanation
6-13

Key Terms
business cycle recession real GDP nominal GDP unemployment inflation modern economic growth savings investment financial investment economic investment expectations shocks demand shocks supply shocks inventory inflexible prices (sticky prices) flexible prices
6-14

Next Chapter Preview

Measuring Domestic Output and National Income

6-15