1
INTRODUCTION
FOCUS OF THE CHAPTER
• We begin our study of macroeconomics with an introduction to the three models around which
it is organized and the time horizons to which they apply. We also take a preliminary look at
economic growth, inflation, unemployment, and the business cycle, and provide an overview
of the textbook.
SECTION SUMMARIES
1.
Macroeconomics Encapsulated in Three Models
Almost everything you will learn about macroeconomics can be understood in the context of
three models: growth theory, which describes the behavior of the economy in the very long run
when capital, labor, and technology can all vary, and the aggregate supply-aggregate demand
(AS-AD) model, which describes the behavior of the economy at all shorter horizons. This is
really a combination of two different models: one of aggregate supply, another of aggregate
demand. Different assumptions about aggregate supply determine the time horizon over which
the model applies.
It is useful to have some working definitions of the time frames we’re talking about. The “very
long run,” the domain of growth theory, refers to periods of decades or more, during which all of
the inputs to productioncapital, labor, the level of technology and size of the populationcan
change. We look at the behavior of potential rather than actual output over this period; we
watch the amount of output that would be produced, if all inputs to production were fully
employed.
The terms “long”, “medium” and “short” run refer to periods of time during which the supplies
of capital, labor, etc. are fixed, or during which the level of potential output is constant. The main
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CHAPTER 1
difference between these time periods is whether we assume these inputs are fully employed: in
the long run we assume that they have to be, so that output equals potential output; at shorter
horizons, we let them be either over- or underemployed and look at the resulting output gap.
P
Aggregate Supply is horizontal in the
sh ort–run
AS
short run, when prices are fixed.
AD
Y
Figure 11
AS-AD IN THE SHORT RUN
The AS-AD model looks at the way that the demand for all of a country’s products (described by
the AD curve) interacts with the supply of those products (described by the AS curve) to
determine its price level and level of output. Potential output in this model is always fixed; only
actual output can change.
We determine the time horizon over which the AS-AD model applies by changing our
assumptions about the aggregate supply curve:
•
In the long run, when all inputs are fully employed, the AS curve is vertical at the level of
potential output, and output is determined by aggregate supply alone.
•
In the short run, a period of time so brief that the price level does not have time to
change, the AS curve is flat, and that output is determined by aggregate demand alone.
•
In the medium run, somewhere between these extremes, inputs do not have to be fully
employed, the price level is not frozen, and the AS curve slopes upward.
We will return to this topic in Chapter 5.
INTRODUCTION
2.
3
To Reiterate
The growth rate of the economy is the rate at which output is increasing. The trend path of GDP
is the rate at which output would grow, were all inputs of production fully employed.
How are these different? The first is the amount by which actual output grows. The second is the
amount by which potential output grows.
The business cycle is the cycle of expansion and contraction around the trend path of output.
The output gap measures the difference between potential and actual output. It moves with the
business cycle - increasing during recessions, and decreasing during recovery, sometimes
decreasing so far that it becomes negative (it does this when inputs are over-employed).
Inflation is inversely related to the output gapprices and output rise together when they are
caused by changes in AD, and increases in output, when potential output is fixed, cause the
output gap to fall.
When inputs are underemployed, output is below its potential. When inputs are overemployed
(think of everyone in the economy working overtime and missing dinner), output is above
potential output. We will find later that this second situation is inflationary.
And what is inflation? The rate of inflation is the percentage change in the price level. That price
level is often measured with the consumer price index (CPI)  a series that keeps track of the cost
of a “typical” urban consumer’s basket of goods. The percentage change in the CPI over one year
would be a measure of that year’s consumer inflation.
3.
Outline and Preview of the Text
Chapter 2, which covers national income accounting, introduces a number of identities that are
used throughout the text. Chapters 3 and 4 cover growth theory, the behavior of potential output
over the very long run. Chapters 5 and 6 introduce the AS-AD model, our framework for
thinking about output at business-cycle frequencies. Chapter 7 looks at inflation and
unemployment over this same horizon. Chapter 8 introduces monetary policymaking in the US.
Chapters 9–11 delve deeper into aggregate demand; chapter 12 broadens our perspective to
include international linkages. Chapters 13–18 take a closer look at the individual pieces of the
domestic economy: consumption, investment, etc. along with some policy issues. Chapter 19
highlights the issues surrounding high inflation and large government deficits, and Chapter 20
serves as an introduction to the basics of international macroeconomics. Chapter 21 introduces
several concepts from the frontiers of economic research.
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CHAPTER 1
P
l ong–run AS
Aggregate Supply is vertical in
the long run when output must
equal potential output.
AD
Y
Figure 12
4.
Prerequisites and Recipes
AS-AD IN THE LONG RUN
It is always best to read economics with a
pencil in your hand. You will periodically need to stop and scribble a graph, highlight a problem
area, or make note of an important definition. Do not be afraid to do this; textbooks aren’t
supposed to read like novels. In some of the more difficult chapters you should be stopping quite
often.
You might also want to get into the habit of following current events, if you don’t already. It will
remind you that you’re learning all of this theory only in order to understand the world more
fully.
KEY TERMS
very long run
long run
short run
medium run
growth theory
aggregate supply/demand (AS-AD) model
aggregate supply (AS) curve
aggregate demand (AD) curve
Phillips curve
growth rate
business cycle
trend path of real GDP
output gap
potential output
inflation
consumer price index (CPI)
employment
expansion
level
rate of increase
recession
recovery
peak
productivity increases
slump
trough
INTRODUCTION
GRAPH IT 1
The easiest way to check an economy’s health is to chart its real GDP. When real GDP is
increasing by more than usual, the economy is doing welland vice versa. This Graph It asks
you to plot the annual rate of change in U.S. real GDP for the years 1990 through 2012, and to
compare it to the trend rate of growth. We assume the trend rate of growth to be 3%a rough
estimate of the economy’s average growth rate since 1960. Can you identify the up-swings and
down-swings of the business cycle?
TABLE 11
Percent change from
previous year
Year
GDP
1990
8033.9
1991
8015.1
-0.2
1992
8287.1
3.4
1993
8523.4
1994
8870.7
1995
9093.7
1996
9433.9
1997
9854.3
1998
10283.5
1999
10779.8
2000
11226.0
2001
11347.2
2002
11553.0
2003
11840.7
2004
12263.8
2005
12638.4
2006
12976.2
2007
13228.9
2008
13228.8
2009
12880.6
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CHAPTER 1
2010
13063.0
2011
13299.1
2012
13588.8
In order to fill out the chart, you must first calculate the rates of change of GDP and then plot
them. For example, real GDP was $8,033.9 billion in 1990 and $8,015.1 billion in 1991. The annual
growth rate, therefore, was 100 x {(8,015.1  8,033.9)/ 8,033.9}, or roughly -0.2%. We’ve filled in the
first few years for you on the chart, and on Table 11. You do the rest!
THE LANGUAGE OF ECONOMICS 1
Models
An economic model consists of a set of assumptions and one or more equations. The equations
describe how the model’s variablesinputs or outputs whose value is not necessarily
constantrelate to one another.
Assumptions are very, very important. As we have seen in the case of the aggregate supplyaggregate demand model, an assumption (like a vertical AS curve) may be valid in some cases
(when markets fully clear, for example) but not others. We would never assume the aggregate
supply curve to be vertical. And we would never use growth theory to describe business cycle
fluctuations (it just can’t do it). The validity of a model’s assumptions is a key consideration when
we decide whether to use it to answer a question.
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INTRODUCTION
We must always exercise judgment when applying models. A good model simplifies the real
world by choosing not to worry about the aspects that aren’t relevant to whatever problem it is
meant to explain. Due to this aspect, there will be problems to which certain models should not
be appliedproblems for which some omitted relationships are relevant. Modeling requires
more than just math; it requires judgment.
REVIEW OF TECHNIQUE 1
Active Learning
There are two components of active learning: active reading and active review. Active reading is
a particularly good skill to develop, as you can use it while reading your textbooks, reading the
newspaper, or reading the reports of your many advisors once you become president. The key to
reading actively is reading with a pencil. That way, as you read, you can underline key ideas,
write down the assumptions that lie behind argumentative statements (a weather person, for
example, might say “tomorrow will be sunny” and mean “tomorrow will be sunny if there is no
change in the prevailing winds, which should blow Hurricane Rita directly to the north, right
past us”), and translate statements into graphs (the statement “this year the price of corn has
increased, and the quantity sold has decreased,” for example, could be illustrated as a shift in the
supply curve on a basic, microeconomic supply/demand graph).
To review actively, look back through everything you’ve underlined. Work through as many
problems as possible. Make flash cards for key terms, to make sure you are able to define them.
Make a list of key assumptions for each model, and think about when these assumptions are and
are not valid. This will help you to decide when and when not to apply a particular model to a
problem. Keep a “big picture” map, where you can mark the connections between the various
models that you learn. Then, when you get lost, you can simply refer to your map.
1
2
3
4
CROSSWORD
5
6
ACROSS
7
2 Measure of the price level
6 Slope of this curve determines
8
time horizon of AS-AD model
8 Type of theory used for very long run
9
10
9 What you're studying
11 Growth theory and the AS-AD model
are applicable over different lengths of
_____
11
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CHAPTER 1
DOWN
1 Output produced when all inputs are fully employed
3 Rate of change of the price level
4 Type of cycle, fluctuates around trend path of output
5 ___ run, vertical AS
7 We simplify the real world using
10 Type of gap, measures difference between potential and actual output
FILL-IN QUESTIONS
1.
The very long-run behavior of the economy is the domain of ______________.
2.
The economy’s behavior over the short, medium, and long run, however, is best described
by the ________________________ model.
3.
The ______________ curve describes the quantity of output that firms are willing to supply
at each price level.
4.
The ______________ curve describes the total demand for goods at each price level.
5.
The ______________ curve is vertical in the long run, when all inputs are fully employed.
6.
In the long run, the output gap is ______________.
7.
The ______________ measures the cost of a typical urban consumer’s purchases.
TRUE-FALSE QUESTIONS
T
F
1.
In the short run, the aggregate supply curve is horizontal.
T
F
2.
In the medium run, the aggregate supply curve is vertical.
T
F
3.
The aggregate supply curve is upward sloping when prices do not adjust.
T
F
4.
Prices rise when actual output is below potential output.
T
F
5.
Very little of what you will learn about macroeconomics can be fit into a growth
theory/aggregate supply/aggregate demand framework.