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The Science of Macroeconomics

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  • To the professor: Much of this chapter is review to students who have taken principles of economics. I’d encourage you to consider one of the following: 1. Spend relatively little time on it (perhaps one 50-minute class session), because it’s perhaps the easiest chapter in the book, and because there often is not quite enough time in the semester to cover all the chapters we’d like to cover. 2. Couple this chapter with some type of classroom activity or discussion, to engage your students, motivate the topic, and set the tone for a great semester. Idea: find two articles from current periodicals with opposing viewpoints on the same issue; bring copies to class; randomly assign students into pairs; in each pair, one student reads one of the articles, the other student reads the other article; allow 15 minutes for students to read their assigned article; then each student gets 5 minutes to teach the content of his or her article to the other student in the pair; then 10 minutes of class discussion. Note: I’ve added a fair amount of extra material to the PowerPoint presentation of this chapter, especially material that motivates the study of macroeconomics. If you want to get through the chapter more quickly, you might consider cutting some of this additional material.

    1. 2. Learning objectives <ul><li>This chapter introduces you to </li></ul><ul><li>the issues macroeconomists study </li></ul><ul><li>the tools macroeconomists use </li></ul><ul><li>some important concepts in macroeconomic analysis </li></ul>
    2. 3. Important issues in macroeconomics <ul><li>Why does the cost of living keep rising? </li></ul><ul><li>Why are millions of people unemployed, even when the economy is booming? </li></ul><ul><li>Why are there recessions? Can the government do anything to combat recessions? Should it?? </li></ul>
    3. 4. Important issues in macroeconomics <ul><li>What is the government budget deficit? How does it affect the economy? </li></ul><ul><li>Why does the U.S. have such a huge trade deficit? </li></ul><ul><li>Why are so many countries poor? What policies might help them grow out of poverty? </li></ul>
    4. 5. U.S. Gross Domestic Product in billions of chained 1996 dollars long-run upward trend…
    5. 6. U.S. Gross Domestic Product in billions of chained 1996 dollars Recessions longest economic expansion on record
    6. 7. Why learn macroeconomics? <ul><li>The macroeconomy affects society’s well-being. </li></ul><ul><ul><li>example: Unemployment and social problems </li></ul></ul><ul><li>Each one-point increase in the u-rate is associated with: </li></ul><ul><ul><li>920 more suicides </li></ul></ul><ul><ul><li>650 more homicides </li></ul></ul><ul><ul><li>4000 more people admitted to state mental institutions </li></ul></ul><ul><ul><li>3300 more people sent to state prisons </li></ul></ul><ul><ul><li>37, 000 more deaths </li></ul></ul><ul><ul><li>increases in domestic violence and homelessness </li></ul></ul>
    7. 8. Why learn macroeconomics? <ul><li>The macroeconomy affects your well-being. </li></ul><ul><ul><li>Unemployment and earnings growth </li></ul></ul>
    8. 9. Why learn macroeconomics? <ul><li>The macroeconomy affects your well-being. </li></ul><ul><ul><li>Interest rates and mortgage payments </li></ul></ul>For a $150,000 30-year mortgage: $9,888 $824 5.21% $11,520 $960 6.63% 6/20/03 6/21/02 annual payment monthly payment actual rate on 30-year mortgage date
    9. 10. Why learn macroeconomics? <ul><li>The macroeconomy affects politics & current events. </li></ul><ul><ul><li>Inflation and unemployment in election years </li></ul></ul>year U rate inflation rate elec. outcome 1976 7.7% 5.8% Carter (D) 1980 7.1% 13.5% Reagan (R) 1984 7.5% 4.3% Reagan (R) 1988 5.5% 4.1% Bush I (R) 1992 7.5% 3.0% Clinton (D) 1996 5.4% 3.3% Clinton (D) 2000 4.0% 3.4% Bush II (R)
    10. 11. Economic models <ul><li>… are simplified versions of a more complex reality </li></ul><ul><ul><li>irrelevant details are stripped away </li></ul></ul><ul><li>Used to </li></ul><ul><ul><li>show the relationships between economic variables </li></ul></ul><ul><ul><li>explain the economy’s behavior </li></ul></ul><ul><ul><li>devise policies to improve economic performance </li></ul></ul>
    11. 12. Example of a model: The supply & demand for new cars <ul><li>explains the factors that determine the price of cars and the quantity sold </li></ul><ul><li>assumes the market is competitive : each buyer and seller is too small to affect the market price </li></ul><ul><li>Variables: </li></ul><ul><ul><li>Q d = quantity of cars that buyers demand </li></ul></ul><ul><ul><li>Q s = quantity that producers supply </li></ul></ul><ul><ul><li>P = price of new cars </li></ul></ul><ul><ul><li>Y = aggregate income </li></ul></ul><ul><ul><li>P s = price of steel (an input) </li></ul></ul>
    12. 13. The demand for cars <ul><li>shows that the quantity of cars consumers demand is related to the price of cars and aggregate income. </li></ul>
    13. 14. Digression: Functional notation <ul><li>General functional notation shows only that the variables are related: </li></ul>A list of the variables that affect Q d
    14. 15. Digression: Functional notation <ul><li>General functional notation shows only that the variables are related: </li></ul><ul><li>A specific functional form shows the precise quantitative relationship: </li></ul>
    15. 16. The market for cars: demand Q Quantity of cars P Price of cars The demand curve shows the relationship between quantity demanded and price, other things equal. D
    16. 17. The market for cars: supply Q Quantity of cars P Price of cars D S The supply curve shows the relationship between quantity supplied and price, other things equal.
    17. 18. The market for cars: equilibrium Q Quantity of cars P Price of cars S D equilibrium price equilibrium quantity
    18. 19. The effects of an increase in income: An increase in income increases the quantity of cars consumers demand at each price... … which increases the equilibrium price and quantity. D 2 Q Quantity of cars P Price of cars S D 1 Q 1 P 1 P 2 Q 2
    19. 20. The effects of a steel price increase: An increase in P s reduces the quantity of cars producers supply at each price… … which increases the market price and reduces the quantity. Q Quantity of cars P Price of cars S 1 D Q 1 P 1 P 2 Q 2 S 2
    20. 21. Endogenous vs. exogenous variables: <ul><li>The values of endogenous variables are determined in the model. </li></ul><ul><li>The values of exogenous variables are determined outside the model: the model takes their values & behavior as given. </li></ul><ul><li>In the model of supply & demand for cars, </li></ul>
    21. 22. Now you try: <ul><li>Write down demand and supply equations for wireless phones; include two exogenous variables in each equation. </li></ul><ul><li>Draw a supply-demand graph for wireless phones. </li></ul><ul><li>Use your graph to show how a change in one of your exogenous variables affects the model’s endogenous variables. </li></ul>
    22. 23. A multitude of models <ul><li>No one model can address all the issues we care about. For example, </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>But if we want to know why aggregate income falls, we need a different model. </li></ul></ul>
    23. 24. A Multitude of Models <ul><li>So we will learn different models for studying different issues (e.g., unemployment, inflation, long-run growth). </li></ul><ul><li>For each new model, you should keep track of </li></ul><ul><ul><li>its assumptions, </li></ul></ul><ul><ul><li>which of its variables are endogenous and which are exogenous, </li></ul></ul><ul><ul><li>the questions it can help us understand, </li></ul></ul><ul><ul><li>and those it cannot. </li></ul></ul>
    24. 25. Prices: flexible versus sticky <ul><li>Market clearing : an assumption that prices are flexible and adjust to equate supply and demand. </li></ul><ul><li>In the short run, many prices are sticky --- they adjust only sluggishly in response to supply/demand imbalances. For example, </li></ul><ul><ul><li>labor contracts that fix the nominal wage for a year or longer </li></ul></ul><ul><ul><li>magazine prices that publishers change only once every 3-4 years </li></ul></ul>
    25. 26. Prices: flexible versus sticky <ul><li>The economy’s behavior depends partly on whether prices are sticky or flexible: </li></ul><ul><li>If prices are sticky, then demand won’t always equal supply. This helps explain </li></ul><ul><ul><li>unemployment (excess supply of labor) </li></ul></ul><ul><ul><li>the occasional inability of firms to sell what they produce. </li></ul></ul><ul><li>Long run: prices flexible, markets clear, economy behaves very differently </li></ul>
    26. 27. Outline of this book: <ul><li>Introductory material (Chaps. 1 & 2) </li></ul><ul><li>Classical Theory (Chaps. 3 to 6) How the economy works in the long run, when prices are flexible </li></ul><ul><li>Growth Theory (Chaps. 7 to 8) The standard of living and its growth rate over the very long run </li></ul><ul><li>Business Cycle Theory (Chaps 9 to 13) How the economy works in the short run, when prices are sticky </li></ul>
    27. 28. Outline of this book: <ul><li>Policy debates (Chaps. 14 to15) Should the government try to smooth business cycle fluctuations? Is the government’s debt a problem? </li></ul><ul><li>Microeconomic foundations (Chaps. 16 to 19) Insights from looking at the behavior of consumers, firms, and other issues from a microeconomic perspective </li></ul>
    28. 29. Chapter summary <ul><li>Macroeconomics is the study of the economy as a whole, including </li></ul><ul><ul><li>growth in incomes, </li></ul></ul><ul><ul><li>changes in the overall level of prices, </li></ul></ul><ul><ul><li>the unemployment rate. </li></ul></ul><ul><li>Macroeconomists attempt to explain the economy and to devise policies to improve its performance. </li></ul>
    29. 30. Chapter summary <ul><li>Economists use different models to examine different issues. </li></ul><ul><li>Models with flexible prices describe the economy in the long run; models with sticky prices describe economy in the short run. </li></ul><ul><li>Macroeconomic events and performance arise from many microeconomic transactions; so macroeconomics uses many of the tools of microeconomics. </li></ul>