Learning objectives. The Science of Macroeconomics slide 1. Important issues in macroeconomics

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1 Learning objectives This chapter introduces you to the issues macroeconomists study the tools macroeconomists use some important concepts in macroeconomic analysis The Science of Macroeconomics slide 1 Important issues in macroeconomics Why does the cost of living keep rising? Why are millions of people unemployed, even when the economy is booming? Why are there recessions? Can the government do anything to combat recessions? Should it?? The Science of Macroeconomics slide 2 1

2 Important issues in macroeconomics What is the government budget deficit? How does it affect the economy? Why does the U.S. have such a huge trade deficit? Why are so many countries poor? What policies might help them grow out of poverty? The Science of Macroeconomics slide 3 U.S. Gross Domestic Product in billions of chained 1996 dollars 10,000 9,000 8,000 7,000 6,000 5,000 4,000 long-run upward trend 3, The Science of Macroeconomics slide 4 2

3 U.S. Gross Domestic Product in billions of chained 1996 dollars 10,000 9,000 longest economic expansion on record 8,000 7,000 6,000 Recessions 5,000 4,000 3, The Science of Macroeconomics slide 5 Why learn macroeconomics? 1. The macroeconomy affects society s well-being. example: Unemployment and social problems The Science of Macroeconomics slide 6 3

4 Unemployment and social problems Each one-point increase in the unemployment rate is associated with: 920 more suicides 650 more homicides 4000 more people admitted to state mental institutions 3300 more people sent to state prisons 37,000 more deaths increases in domestic violence and homelessness The Science of Macroeconomics slide 7 Why learn macroeconomics? 1. The macroeconomy affects society s well-being. example: Unemployment and social problems 2. The macroeconomy affects your well-being. example 1: Unemployment and earnings growth example 2: Interest rates and mortgage payments The Science of Macroeconomics slide 8 4

5 % Unemployment and earnings growth growth growth rate rate of of inflation-adjusted inflation-adjusted hourly hourly earnings earnings change change in in Unemployment Unemployment rate rate The Science of Macroeconomics slide 9 Interest rates and mortgage payments For a $150, year mortgage: date actual rate on 30-year mortgage monthly payment annual payment Dec % $1064 $12,771 Dec % $981 $11,782 The Science of Macroeconomics slide 10 5

6 Why learn macroeconomics? 1. The macroeconomy affects society s well-being. example: Unemployment and social problems 2. The macroeconomy affects your well-being. example 1: Unemployment and earnings growth example 2: Interest rates and mortgage payments 3. The macroeconomy affects politics & current events. example: Inflation and unemployment in election years The Science of Macroeconomics slide 11 Inflation and Unemployment in Election Years year U rate inflation rate elec. outcome % 5.8% Carter (D) % 13.5% Reagan (R) % 4.3% Reagan (R) % 4.1% Bush I (R) % 3.0% Clinton (D) % 3.3% Clinton (D) % 3.4% Bush II (R) The Science of Macroeconomics slide 12 6

7 Economic models are simplied versions of a more complex reality irrelevant details are stripped away Used to show the relationships between economic variables explain the economy s behavior devise policies to improve economic performance The Science of Macroeconomics slide 13 Example of a model: The supply & demand for new cars explains the factors that determine the price of cars and the quantity sold. assumes the market is competitive: each buyer and seller is too small to affect the market price Variables: Q d = quantity of cars that buyers demand Q s = quantity that producers supply P = price of new cars Y = aggregate income P s = price of steel (an input) The Science of Macroeconomics slide 14 7

8 The demand for cars d demand equation: Q = DPY (, ) shows that the quantity of cars consumers demand is related to the price of cars and aggregate income. The Science of Macroeconomics slide 15 Digression: Functional notation General functional notation shows only that the variables are related: d Q = DPY (, ) A list of the variables that affect Q d The Science of Macroeconomics slide 16 8

9 Digression: Functional notation General functional notation shows only that the variables are related: d Q = DPY (, ) A specific functional form shows the precise quantitative relationship: Examples: d 1) Q = DPY (, ) = 60 10P + 2Y 2) = (, ) = 0.3 d Y Q D P Y P The Science of Macroeconomics slide 17 The market for cars: demand demand equation: d Q = D( P, Y ) P Price of cars The demand curve shows the relationship between quantity demanded and price, other things equal. D Q Quantity of cars The Science of Macroeconomics slide 18 9

10 The market for cars: supply supply equation: P Price s Q = S( P, P ) of cars S s The supply curve shows the relationship between quantity supplied and price, other things equal. D Q Quantity of cars The Science of Macroeconomics slide 19 The market for cars: equilibrium P Price of cars S equilibrium price equilibrium quantity D Q Quantity of cars The Science of Macroeconomics slide 20 10

11 The effects of an increase in income: demand equation: d Q = D( P, Y ) P Price of cars S An increase in income increases the quantity of cars consumers demand at each price which increases the equilibrium price and quantity. P 2 P 1 Q 1 Q 2 D 1 D 2 Q Quantity of cars The Science of Macroeconomics slide 21 The effects of a steel price increase: supply equation: s Q = S( P, P s ) P S Price 2 of cars S 1 An increase in P s reduces the quantity of cars producers supply at each price which increases the market price and reduces the quantity. P 2 P 1 Q 2 Q 1 D Q Quantity of cars The Science of Macroeconomics slide 22 11

12 Endogenous vs. exogenous variables: The values of endogenous variables are determined in the model. The values of exogenous variables are determined outside the model: the model takes their values & behavior as given. In the model of supply & demand for cars, d s endogenous: P, Q, Q exogenous: Y, Ps The Science of Macroeconomics slide 23 Now you try: 1. Write down demand and supply equations for wireless phones; include two exogenous variables in each equation. 2. Draw a supply-demand graph for wireless phones. 3. Use your graph to show how a change in one of your exogenous variables affects the model s endogenous variables. The Science of Macroeconomics slide 24 12

13 A Multitude of Models No one model can address all the issues we care about. For example, If we want to know how a fall in aggregate income affects new car prices, we can use the S/D model for new cars. But if we want to know why aggregate income falls, we need a different model. The Science of Macroeconomics slide 25 A Multitude of Models So we will learn different models for studying different issues (e.g. unemployment, inflation, long-run growth). For each new model, you should keep track of its assumptions, which of its variables are endogenous and which are exogenous, the questions it can help us understand, and those it cannot. The Science of Macroeconomics slide 26 13

14 Prices: Flexible Versus Sticky Market clearing: an assumption that prices are flexible and adjust to equate supply and demand. In the short run, many prices are sticky--- they adjust only sluggishly in response to supply/demand imbalances. For example, labor contracts that fix the nominal wage for a year or longer magazine prices that publishers change only once every 3-4 years The Science of Macroeconomics slide 27 Prices: Flexible Versus Sticky The economy s behavior depends partly on whether prices are sticky or flexible: If prices are sticky, then demand won t always equal supply. This helps explain unemployment (excess supply of labor) the occasional inability of firms to sell what they produce Long run: prices flexible, markets clear, economy behaves very differently. The Science of Macroeconomics slide 28 14

15 Outline of this book: Introductory material (chaps. 1 & 2) Classical Theory (chaps. 3-6) How the economy works in the long run, when prices are flexible Growth Theory (chaps. 7-8) The standard of living and its growth rate over the very long run Business Cycle Theory (chaps 9-13) How the economy works in the short run, when prices are sticky. The Science of Macroeconomics slide 29 Outline of this book: Policy debates (Chaps ) Should the government try to smooth business cycle fluctuations? Is the government s debt a problem? Microeconomic foundations (Chaps ) Insights from looking at the behavior of consumers, firms, and other issues from a microeconomic perspective. The Science of Macroeconomics slide 30 15

16 Chapter summary 1. Macroeconomics is the study of the economy as a whole, including growth in incomes changes in the overall level of prices the unemployment rate 2. Macroeconomists attempt to explain the economy and to devise policies to improve its performance. The Science of Macroeconomics slide 31 Chapter summary 3. Economists use different models to examine different issues. 4. Models with flexible prices describe the economy in the long run; models with sticky prices describe economy in the short run. 5. Macroeconomic events and performance arise from many microeconomic transactions, so macroeconomics uses many of the tools of microeconomics. The Science of Macroeconomics slide 32 16

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