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The Science of Macroeconomics

MACROECONOMICS
N. Gregory Mankiw
® Fall 2014
PowerPoint Slides by Ron Cronovich
update
© 2015 Worth Publishers, all rights reserved
 IN THIS CHAPTER, YOU WILL LEARN:

1. The issues macroeconomists

study.
2. The tools macroeconomists use.

3. Some important concepts in

macroeconomic analysis.

CHAPTER 1 The Science of Macroeconomics 1

 Macroeconomics : definition

Macroeconomics : is the study of the economy

as a whole, addresses many topical issues
Examples :
 What causes recessions?
 What is the government budget deficit?
How does it affect workers, consumers, businesses, and taxpayers?
 What is the trade deficit? How does it affect the country’s well-
being?
 Why are so many countries poor? What policies might help them
grow out of poverty? Etc…

CHAPTER 1 The Science of Macroeconomics 2

 Macroeconomics : aspects

 There are two aspects of macroeconomics that

make it unique :
 The interconnections : a collection of multiple markets
(goods market, money market, labor market), that affect,
and are affected by, each other.

So all markets must be analyzed together

 The dynamics : Macroeconomics is where we learn to

think dynamically about the economy.

It is important to understand how today leads to tomorrow,

how tomorrow leads to the day after, and so on

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 The issues macroeconomists study
 Macroeconomists Use Macroeconomics :
 To understand why economies grow : macroeconomics
explains why resources increase over time and the
consequences for our standard of living
 To understand economic fluctuations : all economies are
subject to economic fluctuations
 To make informed business decisions : to understand the
complexities of interest rates and inflation and how they
affect the firm
 To use macroeconomics variables data to build general
theories
CHAPTER 1 The Science of Macroeconomics 4
 How Economists Think: Graphs

 Three macroeconomic variables are especially

important :
- Real Gross Domestic Product (GDP)
- Inflation Rate
- Unemployment Rate
 Macroeconomists study how these variables are
determined, why they change over time, and how they
interact with one another.

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U.S. Real GDP per capita
(2009 dollars)

$50,000 9/11/2001

First
$40,000
oil price
Great shock
Financial
$30,000 Depression crisis

$20,000 World
War I Second oil
price shock
$10,000

World War II
$0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010
 Two main features of GDP data :
Two main points Macroeconomists should get from this
graph:
1. Over the long run : real GDP grows over time.
(clear upward trend in living standards, e.g. Real GDP per person today is more
than eight times higher than it was in 2010).

2. In the short run : There are repeated periods

during which real GDP falls (fluctuations)

(Although real GDP rises in most years, this growth is not steady, e.g. the most
dramatic instance being the early 1930s)

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 Some important concepts in
macroeconomic analysis
 Periods of declining GDP, are called
Recessions if they are mild,

 Periods of declining GDP, are called

Depressions if they are more severe (is a
recession that lasts three or more years)

 Periods of rising GDP, are called

Expansions

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 U.S. Real GDP per capita
(2009 dollars)

$50,000 longest economic

expansion on record
$40,000

$30,000
Expansion
$20,000
Recessions
$10,000

Depressions
$0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010
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 Macroeconomics variables data
(Inflation Rate)

 Inflation Rate : measures the percentage

change in the average level of prices from the year
before.
Example :
 The next Figure shows the U.S. inflation rate.
 You can see that inflation varies substantially over time.
 Periods of falling prices, called deflation, were almost
as common as periods of rising prices.

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U.S. Inflation Rate
(% per year)
25
World Second
20
War I First oil price
15 oil price shock
shock
10

-5
Financial
Great
-10 crisis
Depression
-15
1940
1900

1910

1920

1930

1950

1960

1970

1980

1990

2000

2010
 Three main features of
inflation rate data :

1. Over When the inflation rate is above zero,

prices are rising.

2. When it is below zero, prices are falling.

3. If the inflation rate declines but remains

positive, prices are rising but at a slower
rate.
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 Macroeconomics variables data
(Unemployment Rate)

 The unemployment rate : measures

the percentage of people in the labor
force who do not have jobs.
 Next graph shows the Unemployment Rate in
the U.S. Economy .
 The figure shows that the economy always has
some unemployment and that the amount
fluctuates from year to year.

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U.S. Unemployment Rate
(% of labor force)
30

Great
25 Depression

20

15 World Oil price

War I shocks Financial
World crisis
10 War II

0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010
 How Economists Think: Algebra
 Like any science, economics has its own set of
tools (variables, data, models and a way of
thinking).
 Economists use models to :
 show relationships between variables
 explain the economy’s behavior
 devise policies to improve economic
performance
 The most celebrated of all economic models is :
“The model of Supply and Demand”

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 Example (1)of a model:
Supply & demand for new cars
 Our example shows how various events affect price and
quantity of cars
 We 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)

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 The demand function for cars
demand equation: Q d = D (P,Y )
 shows that the quantity of cars consumers
demand (Q d ) is related to the price of cars (P)
and aggregate income (Y ).

 Where :
Qd = quantity of cars that buyers demand
P = price of new cars
Y = aggregate income

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 The demand for cars

demand equation: Q  D (P ,Y )
d

This equation shows that the

quantity
of cars consumers demand (Q d)
is related to the price of cars (P)
and aggregate income (Y).

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 Digression: functional notation
 General functional notation
shows only that the variables are related.
Q d = D (P,Y ) A list of the
 A specific functional form variables
that affect Q d
shows the precise quantitative relationship

D (P,Y ) = e – f P + gY
Example:
D (P,Y ) = 60 – 10P + 2Y
 Here, e, f, and g are any trio of non-negative numbers
 They are called parameters

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 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

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 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

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 The market for cars: Equilibrium
The point where the two
curves cross is the market P
equilibrium, which shows Price
the equilibrium price of of cars S
cars and the equilibrium
quantity of cars.
Market
equilibrium equilibrium
price
D
Q
Quantity
of cars
equilibrium
quantity

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 The effects of : an increase in income
demand equation: (a) A Shift in Demand

Q d = D (P,Y ) P
Price
An increase in income increases of cars S
the quantity of cars consumers
demand at each price…
P2
…which increases the equilibrium
price and quantity. P1
D2
Income ↑ D1
Demand of cars↑ (from D1 to D2) Q
Equilibrium price ↑ (from P1 to P2) Q1 Q2
Quantity
Equilibrium quantity↑(from Q1 to Q2)
of cars
The market moves to the new
intersection of supply and demand.

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 The effects of : a steel price increase

supply equation: (b) A Shift in Supply

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.

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 How Economic Models Work
 An economist’s model is made of symbols and
equations

 Models have two kinds of variables:

Endogenous Variables

and

Exogenous Variables

CHAPTER 1 The Science of Macroeconomics 25

 Endogenous vs. exogenous variables
 The values of endogenous variables
are determined in the model (that a model explains).
 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 variables are :P, Q d, Q s
Exogenous variables are :Y, Ps

CHAPTER 1 The Science of Macroeconomics 26

 Example (2)of a model:
Supply & demand for Pizza
 To make these ideas more concrete, let’s review a
second example.
 Imagine that an economist wants to figure out what
factors influence the price of pizza and the quantity of
pizza sold.
 He would develop a model to describe :
1. the behavior of pizza buyers,
2. the behavior of pizza sellers, and
3. their interaction in the market for pizza.
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 The demand function for the pizza
 For example, the economist supposes that the
quantity of pizza demanded by consumers Q d
depends on the price of pizza P and on aggregate
income Y . This relationship is expressed in the
equation below :
demand equation: Q  D (P ,Y )
d

Where :
Q d = quantity of pizza demanded by consumers
P = price of pizza
Y = aggregate income
CHAPTER 1 The Science of Macroeconomics 28
 The supply function for the pizza
 Similarly, the economist supposes that the quantity of
pizza supplied by pizzerias Q s depends on the price
of pizza P and on the price of materials Pm , such as
cheese, tomatoes, flour, and anchovies. This
relationship is the supply function.

Where :
Q s= quantity of pizza supplied by pizzerias
P = price of pizza
Pm = price of materials (an input)

CHAPTER 1 The Science of Macroeconomics 29

 The pizza market : equilibrium

 Finally, the economist assumes

that the price of pizza adjusts to
bring the quantity supplied and
quantity demanded into balance:
Qd = Q s

CHAPTER 1 The Science of Macroeconomics 30

 The model of pizza market
 These three equations compose a model of the
market for pizza:
demand equation:
Q d  D (P ,Y )
supply equation:
Q s  S (P , Ps )

Equilibrium
Qd = Q s
CHAPTER 1 The Science of Macroeconomics 31
 Example: the pizza market
- Endogenous variables: price and quantity
 The theory also needs :
 Graphs that show how the endogenous variables
are linked to each other (model)
 Exogenous variables (shift variables)

CHAPTER 1 The Science of Macroeconomics 32

 The Model of Supply and Demand

 The economist illustrates the model with a supply-

and-demand diagram,
 The most famous economic model is that of supply and
demand for a good or service — in this case, pizza.
 The demand curve is a downward-sloping curve
relating the price of pizza to the quantity of pizza that
consumers demand.
 The supply curve is an upward-sloping curve relating
the price of pizza to the quantity of pizza that pizzerias
supply.

CHAPTER 1 The Science of Macroeconomics 33

 Graphs: Supply

•The supply curve shows

the relationship between
the quantity of pizza
supplied and the price of
pizza, holding the price of
materials constant.
•The supply curve slopes
upward because a higher
price of pizza makes
selling pizza more
profitable, which
encourages pizzerias to
produce more of it.

CHAPTER 1 The Science of Macroeconomics 34

 Graphs: Demand

•The demand curve shows

the relationship between the
quantity of pizza demanded
and the price of pizza,
holding aggregate income
constant.
•The demand curve slopes
downward because a higher
price of pizza encourages
consumers to buy less pizza
and switch to, say,
hamburgers and tacos.

CHAPTER 1 The Science of Macroeconomics 35

 Graphs: Supply and Demand

•The equilibrium for the

market is the price and
quantity at which the supply
and demand curves
intersect.

•At the equilibrium price,

consumers choose to buy
the amount of pizza that
pizzerias choose to produce.

CHAPTER 1 The Science of Macroeconomics 36

 Graphs: equilibrium

•The point where

the two curves
cross is the
market
equilibrium, which
shows the
equilibrium price
of pizza and the
equilibrium
quantity of pizza.

CHAPTER 1 The Science of Macroeconomics 37

 Example: the pizza market
 This model of the pizza market has two exogenous
variables and two endogenous variables.
 The exogenous variables : are aggregate income
and the price of materials. The model does not
explain them but instead takes them as given.
 The endogenous variables : are the price of
pizza and the quantity of pizza exchanged.

These are the variables that the model explains.

CHAPTER 1 The Science of Macroeconomics 38

 Shift variables for demand

 The model can be used to show how

a change in any exogenous
variable (the aggregate income or
the price of materials), affects both
the price of pizza and the quantity of
pizza exchanged (endogenous
variables).

CHAPTER 1 The Science of Macroeconomics 39

 Shift variables for demand

 Example (a): an increase in the

aggregate income
 If aggregate income increases ,
the demand for pizza increases ,
as in panel (a) of the next Figure.

CHAPTER 1 The Science of Macroeconomics 40

 Shift variables for demand

Income ↑
prices of competing goods ↑
prices of complementary goods ↓
population ↑
Preference for pizza ↑

CHAPTER 1 The Science of Macroeconomics 41

 Shift variables for demand

 And when the demand for pizza

increases,
both the equilibrium price and the
equilibrium quantity of pizza rise,
as shown in the next graph.

CHAPTER 1 The Science of Macroeconomics 42

 Shift variables for demand

Income ↑
Demand of pizza↑ (from D1 to D2)
Equilibrium price ↑ (from P1 to P2)
Equilibrium quantity↑(from Q1 to Q2)

The market moves to the new

intersection of supply and demand.

CHAPTER 1 The Science of Macroeconomics 43

 Shift variables for supply

 Example (b): An increases in the

price of materials,

Similarly of example (a), if the

price of materials increases ,
the supply of pizza decreases , as
shown in panel (b) of next Figure

CHAPTER 1 The Science of Macroeconomics 44

 Shift variables for supply

prices of raw materials ↑

Technology ↓
Wages ↑

CHAPTER 1 The Science of Macroeconomics 45

 Shift variables for Supply

 And when the price of materials

increases,
The model shows that in this case,
the equilibrium price of pizza rises,
while the equilibrium quantity of
pizza falls as in the next figure.

CHAPTER 1 The Science of Macroeconomics 46

 Shift variables for Supply

Price of materials ↑
Supply of pizza ↓ (from D1 to D2)
Equilibrium price ↑ (from P1 to P2)
Equilibrium quantity ↓ from Q1 to Q2)

The market moves to the new

intersection of supply and demand.

CHAPTER 1 The Science of Macroeconomics 47

 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.
 But, if we want to know why aggregate income
falls, we need a different model.

CHAPTER 1 The Science of Macroeconomics 48

 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,
 And those it cannot.

CHAPTER 1 The Science of Macroeconomics 49

 Prices: flexible vs. sticky
 Market clearing: an assumption that prices are
flexible and adjust to equate supply and demand
 market-clearing models assume that all wages
and prices are flexible
 But 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

CHAPTER 1 The Science of Macroeconomics 50

 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

CHAPTER 1 The Science of Macroeconomics 51

 Conclusion:
 Market-clearing models might not describe the
economy at every instant, but they do describe
the equilibrium toward which the economy
gravitates.
 Therefore, most macroeconomists believe that
price flexibility is a good assumption for
studying long-run issues, such as the growth in
real GDP that we observe from decade to
decade.

CHAPTER 1 The Science of Macroeconomics 52

 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.

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 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.

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