macro econ theory

INTRODUCTION (Ch 1)

• Macroeconomics studies the economy as a whole, including:

o growth in incomes

o changes in the overall level of prices

o unemployment

• Macroeconomics addresses issues such as:

o What causes recessions? Can the government do something to alleviate their effects?

o Why does the cost of living keep rising?

o How can problems in the housing market spread to the rest of the economy?

o Why are some countries rich and other countries poor? What policies might help a country grow out of poverty?

o What is a government budget deficit? How does it affect workers, consumers, businesses, and taxpayers?

U.S. Real GDP per Capita (2009 Dollars)

Source: U.S. Department of Commerce and Economic History Sciences

2016 GDP (PPP) per Capita.

Source: IMF World Economic Outlook (October 2016)

U.S. Inflation Rate (% per Year)

Source: U.S. Department of Commerce and Economic History Services; based on GDP deflator.

U.S. Unemployment Rate (% of Labor Force)

Source: U.S. Department of Labor and U.S. Bureau of the Census (Historical Statistics of the United States: Colonial Times to 1970)

Economic Models

• Economic models are simplified versions of a more complex reality

o irrelevant details are stripped away

• Economic models are used to:

o show relationships between variables;

o explain the economy’s behavior;

o design policies to improve economic performance

Example of an Economic Model: Supply and Demand for New Cars

• This model shows how various factors affect the price and quantity of cars

• The market is assumed competitive: each buyer and seller is too small to affect the market price

• Variables o Qd = quantity of cars that consumers demand o Qs = quantity of cars that producers supply o P = price of new cars o Y = aggregate income o Ps = price of steel (an input)

Demand

• Demand equation: Qd = D (P,Y)

o shows that the quantity of cars consumers demand is related to the price of cars and aggregate income

The demand curve shows the relationship between quantity demanded and price, other things equal.

Supply

• Supply equation: Qs = S (P,Ps)

o shows that the quantity of cars producers supply is related to the price of cars and the price of steel

The supply curve shows the relationship between the quantity of cars supplied and the price of a car, other things equal.

Equilibrium

Qd = Qs, i.e.:

D (P,Y) = S (P,Ps)

The Effects of an Increase in Income

Qd = D (P,Y)

An increase in income increases the quantity of cars consumers demand at each price, which increases the equilibrium price and quantity.

The Effects of an Increase in the Price of Steel

Qs = S (P,Ps)

An increase in the price of steel decreases the quantity of cars producers supply at each price, which increases the equilibrium price and decreases the equilibrium quantity.

Endogenous vs. Exogenous Variables

• The values of endogenous variables are determined inside the model

• The values of exogenous variables are determined outside of the model: the model takes their values and behavior as given.

• In the model of supply and demand for cars:

o endogenous: P, Qd, Qs

o exogenous: Y, Ps

The Use of Multiple Models

• No single model can address all the issues we care about.

• For example, the supply-demand model of the car market

o can tell us how a fall in aggregate income affects the price and quantity of cars

o cannot tell us why aggregate income falls

The Use of Multiple Models (continued)

• We will use different models for studying different issues (e.g., unemployment, inflation, long-run growth).

• For each new model, you should keep track of

o its assumptions

o which variables are endogenous and which are exogenous

o the questions it can help us understand and those it cannot

Flexible vs. Sticky Prices

• Market clearing: an assumption that prices are flexible and adjust to equate supply and demand.

• In the short run, many prices are sticky – adjust sluggishly in response to changes in supply or demand. o Examples:

 many labor contracts fix the nominal wage for a year or longer

 many magazine publishers change prices only once every 3 to 4 years

Flexible vs. Sticky Prices (continued)

• The economy’s behavior depends partly on whether prices are sticky or flexible:

o If prices are 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

o If prices are flexible (long run), markets clear and the economy behaves very differently.