Macroeconomics

Ch 1 review questions
1. What is a business cycle? How does the unemployment rate behave over
the course of a business cycle? Does the unemployment rate ever reach
zero?
Ans. The business cycle refers to economic activity's short-run movements (expansions
and recessions). The unemployment rate rises in recessions and declines in expansions.
The unemployment rate never reaches zero, even at the peak of an expansion.

2. Why is macroeconomic forecasting so difficult? Does this difficulty mean

economics is a worthless field of study?
Ans. Forecasting is difficult not only because our understanding of how the economy
works is imperfect, but also because it is impossible to take into account all the factors
many of them not strictly economic that might affect future economic trends. Therefore,
Macroeconomic forecasters rarely offer a single prediction. Instead, they usually combine
a "most likely" forecast with "optimistic" and "pessimistic" alternative scenarios.
Like meteorologists and doctors, economists deal with a system whose complexity makes
gaining a thorough understanding difficult and forecasting the system's behaviour even
more difficult. Rather than predicting what will happen, most macroeconomists analyse
and interpret events as they happen (macroeconomic analysis) or try to understand the
structure of the economy in general (macroeconomic research).

3. What is meant by aggregation? Why is aggregation important for

macroeconomic analysis?
Ans. The process of summing individual economic variables to obtain economy-wide
totals is called aggregation. The use of aggregation and the emphasis on aggregate
quantities such as aggregate consumption, aggregate investment, and aggregate output
are the primary factors that distinguish macroeconomics from microeconomics.

4. Why is wage and price flexibility crucial to the idea of the invisible hand?
Ans. Wage and price flexibility is crucial to the invisible-hand idea because, in a free-
market system, changes in wages and prices are the signals that coordinate the actions of
people in the economy. To illustrate, suppose that war abroad disrupts oil imports. This
drop in supply will drive up the price of oil. A higher oil price will make it profitable for
domestic oil suppliers to pump more oil and drill more wells. The higher price will also
induce domestic consumers to conserve oil and switch to alternative sources of energy.
Increased demand for alternative energy sources will raise their prices and stimulate
their production, and so on. Thus, in the absence of impediments such as government
price controls, the adjustment of prices helps the free-market economy respond.
5. List the principal professional activities of macroeconomists. What role
does macroeconomic research play in each of these activities?
Ans. Macroeconomists engage in forecasting, macroeconomic analysis, macroeconomic
research, and data development. Macroeconomic research can be useful in investigating
forecasting models to improve forecasts, in providing more info on how the economy
works to help macroeconomic analysts, and in telling data developers what types of data
should be collected. Research provides the basis (results and ideas) for forecasting,
analysis, and data development.

6. What steps are involved in developing and testing an economic theory or

model? What are the criteria for a useful theory or model?
Ans. The steps in developing and testing an economic model or theory are: (1) state the
research Q, (2) make provisional assumptions that describe the economic setting and the
behaviour of the economic actors; (3) work out the implications of the theory; (4)
conduct an empirical analysis to compare the implications of the theory with data; and
(5) eval the results of your comparisons. The criteria for a useful theory or model are that
(1) it has reasonable and realistic assumptions; (2) it is understandable and manageable
enough for studying real problems; (3) its implications can be tested empirically using
real-world data; and (4) its implications are consistent with the data.

7. Might two economists agree about the effects of a particular economic

policy but disagree about the desirability of implementing the policy?
Explain your answer.
Ans. Yes, it is possible for economists to agree about the effects of a policy (that is, to
agree on the positive analysis of the policy), but to disagree about the policy's desirability
(normative analysis). For example, suppose economists agree that reducing inflation to
zero within the next year would cause a recession (positive analysis). Some economists
might argue that inflation should be reduced, because they prefer low inflation even at
the cost of higher unemployment. Others would argue that inflation isn't as harmful to
people as unemployment is, and would oppose such a policy. This is normative analysis,
as it involves a value judgement about what policy should be.

8. Compare the classical and Keynesian views on the speed of wage and
price adjustment. What are the important consequences of the
differences in their views?
Ans. Classicals see wage and price adjustment occurring rapidly, white Keynesians think
that wages and prices adjust only slowly when the economy is out of equilibrium. The
classical theory implies that unemployment will not persist because wages and prices
adjust to bring the economy rapidly back to equilibrium. But if Keynesian theory is
correct, then the slow response of wages and prices means that unemployment may
persist for long periods of time unless the gov't intervenes.
 9. What was stagflation, and when did it occur? How did it change
economists' views about macroeconomics?
Ans. Stagflation was a combination of stagnation (high unemployment) and inflation in
the 1970s. It changed economists' views because the Keynesian approach couldn't explain
stagflation satisfactorily.

Ch 2 Measurement of the national economy

 The national income accounts are an accounting framework used in measuring current
economic activity. Almost all countries have some form of official national income
accounts.
 The product approach measures economic activity by adding the market values of
goods and services produced, excluding any goods and services used up in intermediate
stages of production. This approach makes use of the value-added concept. The value
added of any producer is the value of its output minus the value of the inputs it purchases
from other producers. The product approach computes economic activity by summing
the value added by all producers.
 The income approach measures economic activity by adding all income received by
producers of output, including wages received by workers and profits received by owners
of firms.
 The expenditure approach measures activity by adding the amount spent by all
ultimate users of output. In this example, households are the ultimate users of oranges.
 total production = total income = total expenditure
 Product approach: The product approach defines a nation's gross domestic product
(GDP) as the market value of final goods and services newly produced within a nation
during a fixed period of time.
 Market Value. Goods and services are counted in GDP at their market values- that is,
at the prices at which they are sold.
 Homemaking and child-rearing services performed within the family without pay, for
example, are not included in GDP, although homemaking and child care that are
provided for pay (for example, by professional housecleaners or by private day-care
centers) are included.
 Newly Produced Goods and Services. As a measure of current economic activity, GDP
includes only goods or services that are newly produced within the current period.
GDP excludes purchases or sales of goods that were produced in previous periods.
 Final Good and services . Goods and services produced during a period of time may
be classified as either intermediate goods and services or final goods and services.
 Intermediate goods and services are those used up in the production of other
goods and services in the same period that they themselves were produced.
 Final goods and services are those goods and services that are not intermediate.
Final goods and services are the end products of a process.
 Final goods are of 2 types capital and consumer
 GDP ==GNP - NFP. GNP: Gross National Product. NFP: Net Factor Payments from
abroad
 Expenditure Approach:
Y =GDP= total production (or output) = total income = total expenditure

C = consumption;
I = investment;
G = government purchases of goods and services;
 NX = net exports of goods and services.
Y = C + I + G + NX.
 Consumption(C): Consumption is spending by domestic households on final goods
and services, including those produced abroad. Consumption expenditures are
grouped into three categories:
 consumer durables, which are long-lived consumer items, such as cars,
televisions, furniture, and major appliances (but not houses, which are classified
under investment);
 nondurable goods, which are shorter-lived items, such as food, clothing, and fuel;
and
 services, such as education, health care, financial services, and transportation.
 Investment(I): Investment includes both spending for new capital goods, called
fixed investment, and increases in firms' inventory holdings, called inventory
investment. Fixed investment in turn has two major components:
 business fixed investment, which is spending by businesses on structures
(factories, warehouses, and office buildings, for example) and equipment (such as
machines, vehicles, computers, and furniture) and software;
 residential investment, which is spending on the construction of new houses and
apartment buildings. Houses and apartment buildings are treated as capital
goods because they provide a service (shelter) over a long period of time.
 Government purchases(G) of goods and services, which include any expenditure
by the government for a currently produced good or service, foreign or domestic.
Transfers, a category that includes government payments for Social Security and
Medicare benefits, unemployment insurance, welfare payments, and so on, are
payments (primarily to individuals) by the government that are not made in
exchange for current goods or services. As a result, they are excluded from the
government purchases category and are not counted in GDP as calculated by the
expenditure approach.
 Net exports(NX) are exports minus imports.
 Income Approach: National income is the sum of eight types of income
 Compensation of employees. Compensation of employees is the income of workers
(excluding the self-employed) and includes wages, salaries, employee benefits
(including contributions by employers to pension plans), and employer contributions
to Social Security.
 Proprietors' income. Proprietors' income is the income of the nonincorporated self-
employed. Because many self-employed people own some capital (examples are a
farmer's tractor or a dentist's X-ray machine), proprietors' income includes both
labor income and capital income.
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