EC214 - Chapter 1 The Science of Macroeconomics

EC214 - Chapter 1
The Science of Macroeconomics
The Science of Macroeconomics

IN THIS CHAPTER, YOU WILL LEARN:
 about the issues macroeconomists study

 about the tools macroeconomists use
 some important concepts in macroeconomic
analysis
1
Important issues in macroeconomics
Macroeconomics, the study of the economy as
a whole, addresses many topical issues, e.g.:
 What causes recessions? What is
“government stimulus” and why might it help?
 How can problems in the housing market spread
to the rest of the economy?
 What is the government budget deficit?
How does it affect workers, consumers,
businesses, and taxpayers?
CHAPTER 1 The Science of Macroeconomics 2

Important issues in macroeconomics
Macroeconomics, the study of the economy as
a whole, addresses many topical issues, e.g.:
 Why does the cost of living keep rising?
 Why are so many countries poor? What policies
might help them grow out of poverty?
 What is the trade deficit? How does it affect the
country’s well-being?

U.S. Real GDP per capita
(2005 dollars)
$50.000
9/11/2001
$40.000
First
oil price
$30.000 Great shock Financial
Depression crisis
$20.000
World Second oil
War I price shock
$10.000
World War II
$0
1900
1910
1920
1930
1940
1950
1960
1980
1990
2000
2010
1970
U.S. Inflation Rate
(% per year)
25
World
20 War I Second
First oil price
15 oil price shock
shock
10
-5 Financial
Great crisis
-10
Depression
-15
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
U.S. Unemployment Rate
(% of labor force)
30
World
War I Great Second
25 First oil price
Depression
oil price shock
shock
20
15 World Oil price

War I Financial
shocks
crisis
10 World
War II
Financial
5 Great crisis
Depression
0
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
Economic models
…are simplified versions of a more complex reality
 irrelevant details are stripped away
…are used to
 show relationships between variables
 explain the economy’s behavior
 devise policies to improve economic
performance

Example of a model:
Supply & demand for new cars
 shows how various events affect price and
quantity of cars
 assumes the market is competitive: each buyer
and seller is too small to affect the market price
Variables
Qd = quantity of cars that buyers demand
Qs = quantity that producers supply
P = price of new cars
Y = aggregate income
Ps = price of steel (an input)
The demand for cars
demand equation: Q d = D (P,Y )
 shows that the quantity of cars consumers
demand is related to the price of cars and
aggregate income

Digression: functional notation
 General functional notation

shows only that the variables are related.
Q d = D (P,Y )
 A specific functional form shows

the precise quantitative
A list of the relationship.
 Example:
variables
) = 60 Q
d
D (P,Y
that affect – 10P + 2Y

The market for cars: Demand
demand equation: P
Price
Qd = D (P,Y ) of cars
The demand curve

shows the relationship
between quantity D
demanded and price, Q
other things equal. Quantity
of cars

The market for cars: Supply
supply equation: P
Price
Qs = S (P,PS ) of cars S
The supply curve

shows the relationship
between quantity D
supplied and price, Q
other things equal. Quantity
of cars

The market for cars: Equilibrium
P
Price
of cars S
equilibrium
price
D
Q
Quantity
of cars
equilibrium
quantity

The effects of an increase in income
demand equation:
P
Q d = D (P,Y ) Price
of cars S
An increase in income
increases the quantity P2
of cars consumers P1
demand at each price… D2
D1
Q
…which increases Q1 Q2
Quantity
the equilibrium price of cars
and quantity.

The effects of a steel price increase
supply equation:
P S2
Q s = S (P,PS ) Price
of cars S1
An increase in Ps
reduces the quantity of P2
cars producers supply P1
at each price…
D
…which increases the Q
Q2 Q1
market price and Quantity
of cars
reduces the quantity.

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 and behavior
as given.
 In the model of supply & demand for cars,
endogenous: P, Q d, Q s
exogenous: Y , Ps
NOW YOU TRY
Supply and Demand
1. Write down demand and supply equations for
smartphones; include two exogenous variables
in each equation.
2. Draw a supply-demand graph for smartphones.
3. Use your graph to show how a change in one

of your exogenous variables affects the
model’s endogenous variables.
17
The use of multiple models
 No one model can address all the issues we
care about.
 E.g., our supply-demand model of the car
market…
 can tell us how a fall in aggregate income
affects price & quantity of cars.
 cannot tell us why aggregate income falls.

The use of multiple 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 variables are endogenous,
which are exogenous
 the questions it can help us understand,
those it cannot

Prices: flexible vs. sticky
 Market clearing: An assumption that prices are

flexible, adjust to equate supply and demand.
 In the short run, many prices are sticky –
adjust sluggishly in response to changes in
supply or demand. For example:
 many labor contracts fix the nominal wage
for a year or longer
 many magazine publishers change prices
only once every 3 to 4 years

Prices: flexible vs. sticky
 The economy’s behavior depends partly on

whether prices are sticky or flexible:
 If prices sticky (short run),
demand may not equal supply, which explains:
 unemployment (excess supply of labor)
 why firms cannot always sell all the goods
they produce
 If prices flexible (long run), markets clear and
economy behaves very differently

Outline of this book:
 Introductory material (Chaps. 1, 2)
 Classical Theory (Chaps. 3–7)
How the economy works in the long run, when
prices are flexible
 Growth Theory (Chaps. 8, 9)
The standard of living and its growth rate over the
very long run
 Business Cycle Theory (Chaps. 10–14)
How the economy works in the short run, when
prices are sticky
Outline of this book:
 Macroeconomic theory (Chaps. 15–17)

Macroeconomic dynamics, models of consumer
behavior, theories of firms’ investment decisions
 Macroeconomic policy (Chaps. 18–20)
Stabilization policy, government debt and
deficits, financial crises

CHAPTER SUMMARY
 Macroeconomics is the study of the economy as a

whole, including
 growth in incomes
 changes in the overall level of prices
 the unemployment rate
 Macroeconomists attempt to explain the economy
and to devise policies to improve its performance.
24
CHAPTER SUMMARY
 Economists use different models to examine

different issues.
 Models with flexible prices describe the economy
in the long run; models with sticky prices describe
the economy in the short run.
 Macroeconomic events and performance arise
from many microeconomic transactions, so
macroeconomics uses many of the tools of
microeconomics.
25

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EC214 - Chapter 1

The Science of Macroeconomics

The Science of Macroeconomics

 about the issues macroeconomists study

CHAPTER 1 The Science of Macroeconomics 2

CHAPTER 1 The Science of Macroeconomics 3

15 World Oil price

CHAPTER 1 The Science of Macroeconomics 7

CHAPTER 1 The Science of Macroeconomics 9

 General functional notation

 A specific functional form shows

CHAPTER 1 The Science of Macroeconomics 10

The demand curve

CHAPTER 1 The Science of Macroeconomics 11

The supply curve

CHAPTER 1 The Science of Macroeconomics 12

CHAPTER 1 The Science of Macroeconomics 13

CHAPTER 1 The Science of Macroeconomics 14

CHAPTER 1 The Science of Macroeconomics 15

 The values of endogenous variables

3. Use your graph to show how a change in one

CHAPTER 1 The Science of Macroeconomics 18

CHAPTER 1 The Science of Macroeconomics 19

 Market clearing: An assumption that prices are

CHAPTER 1 The Science of Macroeconomics 20

 The economy’s behavior depends partly on

CHAPTER 1 The Science of Macroeconomics 21

 Macroeconomic theory (Chaps. 15–17)

CHAPTER 1 The Science of Macroeconomics 23

 Macroeconomics is the study of the economy as a

 Economists use different models to examine

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