Chapter 1

The Policy and

Practice of
Macroeconomics
 The Practice of Macroeconomics

• Macroeconomics is the study of economic

activity and prices in the overall economy of
a nation or a region
• Macroeconomic research draws heavily on
microeconomics, which looks at the
behavior of individual firms, households, or
markets

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 The Process: Developing
Macroeconomic Models

• Macroeconomists explain how the overall

economy works by using an economic
theory—a logical framework to explain a
particular economic phenomenon
• Economic theory involves developing an
economic model—a simplified
representation of the economic
phenomenon that takes a mathematical or
graphical form

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 The Process: Developing
Macroeconomic Models (cont’d)

• The development of an economic theory or

model typically involves five steps:
1. Identify an interesting economic question
2. Specify the variables to be explained by the
model (endogenous variables) and the
variables that explain them (exogenous
variables)
3. Posit a set of equations or graphical analysis to
connect movements in the exogenous variables
to the endogenous variables
4. Compare the conclusions of the model with what
actually happens
5. Use the model to make further predictions

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 FIGURE 1.1 Variables in
Macroeconomic Models

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 The Purpose: Interpreting
Macroeconomic Data

• Macroeconomists focus in particular on

three economic data series:
– real GDP
– unemployment rate
– inflation rate

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 The Purpose: Interpreting
Macroeconomic Data (cont’d)

• Real Gross Domestic Product (GDP)

– measures the output of actual goods and
services produced in an economy over a fixed
period, usually a year

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 FIGURE 1.2 U.S. Real GDP Per Capita,
1900-2013

Sources: Federal Reserve Bank of St. Louis, FRED Database. http://research.stlouisfed.org/fred2/; and for data before
1960, Maddison, Angus. Historical statistics. http://www.ggdc.net/maddison/

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 GDP per Capita
12000

10000

8000

6000

4000

2000

0
1985 1990 1995 2000 2005 2010 2015

China Vietnam Thailand

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 FIGURE 1.3 Cross-Country Comparison of
Real GDP Per Capita in 2012

Source: World Bank. World development indicators. http://data.worldbank.org/indicator/

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 Business Cycle

• Business cycles are recurrent up and

down movements in economic activity that
differ in how regular they are
• A recession occurs when economic activity
declines and real GDP per person falls
• A depression occurs when the decline in
real GDP is severe

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 Unemployment Rate

• The unemployment rate measures the

percentage of workers looking for work, but
who do not have jobs, at a particular point
in time

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 FIGURE 1.4 U.S. Unemployment Rate,
1929-2013

Sources: Federal Reserve Bank of St. Louis, FRED Database. http://research.stlouisfed.org/fred2/; and
data prior to 1948, National Bureau of Economic Research. Macro history database, income and
employment. www.nber.org/databases/macrohistory/contents/chapter08.html

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 FIGURE 1.5 Cross-Country Comparison of
Average Unemployment Rates, 2003-2013

Source: International Monetary Fund. http://www.imf.org/external/data.htm

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 Inflation

• The inflation rate tells us how rapidly the

overall level of prices is rising
• Deflation occurs when the inflation rate is
negative
• Hyperinflation refers to the situation of
super high inflation

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 FIGURE 1.6 U.S. Inflation Rate,
1910-2013

Source: Federal Reserve Bank of St. Louis, FRED Database. http://research.stlouisfed.org/fred2/

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 FIGURE 1.7 Cross-Country Comparison of
Average Inflation Rates, 2003-2013

Source: International Monetary Fund. http://www.imf.org/external/ data.htm

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 Macroeconomic Policy

• The goal of developing models is to the underlying

goal is to determine what policies can produce
better macroeconomic outcomes:
– How Can Poor Countries Get Rich?
– Is Saving Too Low?
– Do Government Budget Deficits Matter?
– How Costly Is It to Reduce Inflation?
– How Can We Make Financial Crises Less Likely?
– How Active Should Stabilization Policy Be?
– Should Macroeconomic Policy Follow Rules?
– Are Global Trade Imbalances a Danger?

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 FIGURE 1.8 U.S. Personal Saving
Rate, 1960-2013

Source: Federal Reserve Bank of St. Louis, FRED Database. http://research.stlouisfed.org/fred2/

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 FIGURE 1.9 Average Saving Rate for
a Number of Countries

Source: National Saving Rate, % of GDP, 2011. World Bank, World development indicators,
http://data.worldbank.org/indicator/

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 FIGURE 1.10 U.S. Government
Budget Deficits, 1930-2013

Source: Federal Reserve Bank of St. Louis, FRED Database. http://research.stlouisfed.org/fred2/

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 Fiscal and Monetary Policy

• Fiscal policy deals with government

spending and taxation
– Government budget deficit is the excess of
government spending over tax revenues for a
particular year
• Monetary policy is the management of the
money supply and interest rates
– Conducted by central banks, e.g., the Federal
Reserve of the U.S.

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 How Can We Make Financial Crises
Less Likely?

• A financial crisis is a large-scale

disruption in financial markets characterized
by sharp declines in the prices of assets
(property that includes bonds, stocks, art,
land) and business failures
• The United States and many other countries
throughout the world experienced a major
financial crisis starting in 2007

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 How Active Should Stabilization Policy
Be?

• Stabilization policy is macroeconomic

policy that aims at minimizing business
cycle fluctuations and stabilizing economic
activity
• Activists advocate the use of policies to
eliminate excessive unemployment
whenever it develops
• Nonactivists argue against the use of
stabilization policies because the economy
has a self-correcting mechanism

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 How We Will Study
Macroeconomics

• This book will emphasize the policy and

practice of macroeconomics, both by using
the models developed here and with the
policy and practice cases
• This exposure to real-world examples will
help you appreciate that economics is far
more than abstract theories

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 Chapter 2

Measuring
Macroeconomic
Data
 Preview

• To examine the different approaches to

measuring gross domestic product
• To understand real versus nominal GDP
• To understand how to measure inflation
• To understand how to measure
unemployment
• To understand different interest rates

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 Measuring Economic Activity:
National Income Accounting

• Gross domestic product (GDP) is the

total value of goods and services produced
in an economy
– the broadest measure of economic activity

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 Measuring Economic Activity:
National Income Accounting (cont’d)

• National income accounting is an

accounting system that measures economic
activity and its components
• Fundamental identity of national
income accounting:

Total Production = Total Expenditure = Total Income

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 Measuring GDP: The Production
Approach

• GDP is the current market value of all final

goods and services newly produced in the
economy during a fixed period of time
• In the case of apples and oranges, we
multiply the their prices and quantities, and
then add them up:

GDP = (price of apples ✕ quantity of apples)

+ (price of oranges ✕ quantity of oranges)

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 Market Value

• Not all goods and services are counted in

GDP because they are:
– Nonmarket goods and services, which do not
have a market price (e.g., household services
produced within a family), or
– Produced in the underground economy
• Many nonmarket goods and services are
counted in GDP by their imputed values

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 Newly Produced Goods and Services

• GDP includes only goods and services that

are newly produced in the current period
• If you buy a 3-year-old car from a car
dealership
– The cost of the used car is not included in GDP
– The value of the services provided by the car
dealership is included in GDP

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 Valued-Added Technique

• Value added is the value of a firm’s

output minus the cost of the intermediate
goods purchased by the firm
• By adding up the value added from each
firm, we get the final value of the goods
and services produced

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 Capital Goods

• A capital good (e.g., a robot) is used in

the production of other goods that is not
used up in the stages of production
• New capital goods are classified as final
goods because they are not included in
spending on other final goods and yet their
production is part of economic activity

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 Inventory Investment

• Inventory investment is the change in

inventories (firms’ holdings of raw
materials, unfinished goods and unsold
finished goods) over a given period of time
• Inventory investment is included in GDP
for the same reason that we include
capital goods

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 Fixed Period of Time

• We calculate GDP over a fixed period of

time, such as a quarter or a year
• GDP is a flow, which is an amount per a
given unit of time
• By contrast, a stock is a quantity at a
given point in time

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 Policy and Practice: Can GDP Buy
Happiness?

• Is GDP the best measurement of national well-

being?
• In 1972, the king of Bhutan proposed the
replacement of GDP by “gross national happiness”
that incorporates factors such as spirituality and
culture
• In 1990, the United Nations began to rank countries
on a so-called human development index, which is a
combination of life expectancy, education, literacy,
educational participation, and GDP
• In 2008, a French economic commission led by
Nobel Prize winner Joseph Stiglitz called for
modifications to GDP with factors such as political
freedom, physical safety, and work-life balance

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 Box: Stocks Versus Flows

• A stock is often an accumulation of flows

over time
• Examples:
– Inventory investment is a flow, which
accumulates into the stock of inventories
– Saving is a flow, which accumulates into a
person’s wealth

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 FIGURE 2.1 Stocks Versus Flows

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