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Chapter 06 – An Introduction to Macroeconomics

CHAPTER SIX

AN INTRODUCTION TO MACROECONOMICS

CHAPTER OVERVIEW

As you know from Chapter 1, macroeconomics studies the behavior of the economy

as a whole. It is primarily concerned with two topics: long-run economic growth and

the short-run uctuations in output and employment that are often referred to as

the business cycle. These phenomena are closely related because they happen

simultaneously. Economies show a distinct growth trend that leads to higher output

and higher standards of living in the long run, but in the short run there is a great

deal of variability. Sometimes growth proceeds more rapidly and sometimes it

proceeds more slowly. It may even turn negative for a while so that output and

living standards actually decline, a situation referred to as a recession. This

chapter provides an overview of the data that macroeconomists use to measure the

status and growth of an entire economy as well as a preview of the models that

they use to help explain both long-run growth and short-run uctuations.

WHAT’S NEW

The only major change is a new ‘Last Word’, titled “Debating the Great Recession”.

The learning objectives have been modified to match the chapter headings.

Data and the tables have been updated.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Understand the basic statistical tools and measures that economists use to analyze the economy.

2. Differentiate between Nominal GDP and Real GDP (Gross Domestic Product).

3. Understand the basic concept of unemployment.

4. Understand the basic measure of inflation.

5. Explain the miracle of modern economic growth.

6. Understand, and define, the basic concepts of savings and investment.

7. Differentiate between financial investment and economic investment.

8. Understand the role of expectations and uncertainty in economic activity.

9. Explain how unanticipated shocks to supply and demand affect the economy under fixed and

flexible prices.

10. Explain the role of inventories in the economy.

11. Explain the difference between ‘sticky prices’ and ‘flexible prices’ and understand the basic

evidence supporting the two concepts.

12. Define and identify terms and concepts listed at the end of the chapter.

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COMMENTS AND TEACHING SUGGESTIONS

1. Use this chapter to motivate growth as a broader paradigm and the business cycle as fluctuations

around the long-run rate of economic growth. This will help the student understand the

relationship between the two topics, which at times may appear disjoint.

2. Have the student consider what sort of institutions and polices promote high and sustained rates

of economic growth before turning to the question of what causes short-run (business cycle)

fluctuations in the rate of growth. Also have the students discuss what sort of polices might be

useful to mitigate business cycle fluctuations. Finally, have them discuss whether the policies

that mitigate business cycle fluctuations also promote high rates of economic (long-run) growth.

3. Help the student conceptualize business cycle movements as the result of unfulfilled

expectations and sticky prices. Use the example in the text (Figure 6.1) to clarify why and how

these assumptions can play a role in economic activity.

4. Be sure to discuss the concepts of short-run, intermediate-run, and long-run in the context of

price stickiness (or fixed prices). This will help the student conceptualize the Aggregate Supply

analysis later in the text.

5. Finally, be very precise in language when discussing the definitions of nominal GDP and Real

GDP, Financial Investment and Economic Investment, and Savings.

STUDENT STUMBLING BLOCKS

1. Students often struggle with the difference between nominal and real variables, and why the latter

concept is most important. A few examples of why real variables are important and how this

difference between ‘nominal’ and ‘real’ impacts their lives may be helpful at this point. For

example, discuss nominal and real wages in the context of inflation (another concept introduced

in this chapter). This should help them focus on the real variables later in the text.

2. Investment is a word that all of the students in the class think they understand. The meaning of

the term in ordinary conversation interferes with their ability to acquire a new definition and use

that new definition consistently.

3. Ensure that the student can differentiate between ‘financial investment’ and ‘economic

investment’. This difference is critical for understanding the relationship between ‘investment’

and the interest rate later in the text.

4. Changes in inventory, which represents the difference between what has been produced and what

is sold is also an important concept the students should have a firm grasp of before moving on to

the next chapter. It has an important role in the income determination models presented later in

the text.

5. Students may have a difficult time thinking about short-run, intermediate-run, and long-run in

economic terms. Be sure to use the ‘price stickiness’ language to help them make this adjustment.

These concepts will most likely need reinforcement in later chapters.

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LECTURE NOTES

I. Learning objectives – After reading this chapter, students should be able to:

A. Explain why economists focus on GDP, inflation, and unemployment when assessing the

health of an entire economy.

B. Discuss why increases in living standards are a historically recent phenomenon.

C. Identify why saving and investment are key factors in promoting rising living standards.

D. Describe why economists believe that “shocks” and “sticky prices” are responsible for short-

run fluctuations in output and employment.

E. Characterize the degree to which various prices in the economy are sticky.

F. Explain why the greater flexibility of prices as time passes causes economists to utilize

different macroeconomic models for different time horizons.

II. Performance and Policy

A. Real GDP, or real gross domestic product, measures the value of final goods and services

produced within the borders of a given country during a given period of time, typically a year.

It is the GDP measure in constant dollars, or GDP less the effect of inflation.

B. Nominal GDP, or nominal gross domestic product, measures the dollar value of all goods and

services produced within the borders of a given country using their current during the year

that they were produced. It differs from Real GDP in that Nominal GDP is in current dollars.

1. Real GDP is the appropriate measure one should use to determine changes in economic

activity across time. This is because nominal GDP captures BOTH changes in output and

changes in prices over time. Thus, Nominal GDP may increase without any change (or

even a decrease) in real economic activity.

C. Unemployment is the state a person is in if he or she cannot get a job despite willing to work

and actively seeking work.

1. High rates of unemployment are undesirable because they indicate that the nation is not

using a large fraction of its most important resource, the talents and skills of its people.

D. Inflation is an increase in the overall level of prices.

E. Macroeconomic models also clarify many important questions about the powers and limits of

government and economic policy. These include:

1. Can governments promote long-run economic growth?

2. Can governments reduce the severity of recessions by smoothing out short-run

fluctuations?

3. Are certain government policy tools more effective at mitigating short-run fluctuations

than other government policy tools?

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III. The Miracle of Modern Economic Growth

A. Rapid and sustained economic growth is a modern phenomenon. Before the Industrial

Revolution began in the late 1700’s in England, standards of living showed virtually no

growth over hundreds or even thousands of years.

B. The Industrial Revolution ushered in factory production and automation, along with massive

increases in research and development so that new and better technologies were constantly

being invented.

1. This resulted in Modern Economic Growth, or sustained increases in output per person

(Higher living standards).

C. The vast differences in living standards seen today between rich and poor countries are

almost entirely the result of the fact that only some countries have experienced modern

economic growth.

D. To make international comparisons of living standards three adjustments must be made. (See

Global Perspectives 6.1)

1. Convert each country’s GDP from its own currency into U.S. dollars.

2. Divide each country’s GDP measured in dollars by the size of its population.

3. Adjust per capita GDP using the Purchasing Power Parity Method (there will be more on

this later in the text).

a. This last step is necessary because some goods (non-traded goods) are typically

cheaper in poor countries.

IV. Savings, Investment, and Choosing Present and Future Consumption

A. At the heart of economic growth is the principle that in order to raise living standards over

time, an economy must devote at least some fraction of its current output to increasing future

output. This process requires both savings and investment.

1. Savings are generated when current consumption is less than current output.

2. Investment happens when resources are devoted to increasing future output.

a. Financial Investment captures what ordinary people mean when they say investment,

namely the purchase of assets like stocks, bonds, or real estate in the hope of reaping

a financial gain.

b. Economic Investment only includes money spent purchasing newly created capital

goods such as machinery, tools, factories, and warehouses. This what economists

mean when they refer to “Investment”.

B. Households are the principal source of savings and businesses are the main economic

investors.

1. Financial institutions collect savings from households and lend these funds to businesses.

Thus, savings and investment are fundamentally linked together.

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V. Uncertainty, Expectations, and Shocks

A. Decisions about savings and investment are complicated by the fact that the future is

uncertain. Investment projects sometimes produce disappointing results or even fail totally.

This implies that macroeconomics has to take into account expectations about the future.

B. Expectations are important for two reasons.

1. The more obvious reason involves the effect that changing expectations can have on

current behavior. For example, if businesses become pessimistic about the future of the

economy they may reduce investment today.

2. The less obvious reason is that firms are often forced to cope with “shocks” to the

economy.

a. A “shock” is a situation in which firms, or businesses, were expecting one thing to

happen but something else happened.

C. The economy is exposed to both demand shocks and supply shocks. Economists believe

that most short-run fluctuations are the result of demand shocks.

1. How these demand shocks affect the economy will depend on the how prices adjust.

a. Do prices adjust quickly? Or, are prices flexible? If this is the case, then a demand

shock implies that only prices will rise (see Figure 6.1a).

b. Do prices adjust slowly? Or. Are prices “sticky”? If this is the case, then a demand

shock will change output (see Figure 6.1b where prices are fixed).

c. The key point here is that the assumption about price “stickiness” is critical to the

models implications about demand shocks. What is the evidence on price

“stickiness”?

d. Consider This … The Great Recession. Demand for goods and services decreased,

loans became harder to obtain, and decreased consumer confidence all led to a

reduction in GDP and employment. Prices were quite sticky (similar to figure 6.1b)

so GDP took the brunt of these changes.

VI. How Sticky Are Prices?

A. Inflexible prices, or “sticky prices” as economists like to say, help explain how unexpected

changes in demand lead to fluctuations in GDP and employment, which is referred to as the

business cycle.

1. Table 6.1 provides the average number of months between prices changes for a selected

number of goods. As we can see, some goods have very “sticky” prices.

B. The LAST WORD “Debating the Great Recession” discusses some of the theories

attempting to explain the Great Recession and the best ways to speed recovery.

1. The Great Recession of 2007-2009 was the worst economic downturn since the Great

Depression of the 1930’s.

2. Explanations about what caused the Great Recession differ sharply among economists.

a. The Minksy Explanation: Euphoric Bubbles argument

b. The Austrian Explanation: Excessively Low Interest Rates

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VII. Categorizing Macroeconomic Models Using Price Stickiness

A. It has been argued that price stickiness can play a large role in the short-run economic

fluctuations we observe in modern economies.

B. It should be noted that price stickiness moderates over time. This is true because firms that

choose to use a fixed-price policy in the short run do not have to stick with that policy

permanently. This realization is very useful in categorizing and understanding the differences

between various macroeconomic models.

C. For example, in Chapter 11 we will look at the aggregate expenditures model where prices

are inflexible. In Chapter 12 we will allow for flexible price but restrict wage adjustments,

which will provide us with the intermediate-run Aggregate Supply schedule. Finally we will

allow all prices to adjust, which will give us the long-run Aggregate Supply schedule.

QUIZ

1. Real gross domestic product

A. is a measure of inflation

B. will increase if there is an increase in the price level

C. will increase if there is an increase in the level of output

D. can change from one year to the next even if there is no change in output

2. Suppose that real GDP increases by 5% while the population of a country increases by 7%. Then

A. output per person necessarily increases

B. output per person necessarily decreases

C. output per person necessarily remains unchanged

D. there is not enough information to determine what happens to output per person

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3. Which of the following is the best example of financial investment?

A. Ford Motor Co. builds a new manufacturing plant

B. A student pursues an MBA degree

C. A retiree purchases Google stock

D. A young couple purchases a new home

4. In economics, the word “shocks” refers to

A. situations where firms’ expectations are unmet

B. any changes in the demand for goods and services

C. any changes in the supply of goods and services

D. a decrease in real GDP

5. Higher oil prices are most likely to lead to

A. a negative demand shock

B. a positive demand shock

C. a negative supply shock

D. a positive supply shock

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6. The business cycle depicts:

A. fluctuations in the general price level.

B. the phases a business goes through from when it first opens to when it finally closes.

C. the evolution of technology over time.

D. short-run fluctuations in output and employment.

7. Which of the following statements is most accurate about advanced economies?

A. Economies experience a positive growth trend over the short run, but experience significant

variability in the long run.

B. Economies experience a positive growth trend over the long run, but experience significant

variability in the short run.

C. Economies experience positive and stable growth over both the long run and short run.

D. Economies experience little long-run growth in output, but can experience significant growth

in the short run.

8. Before the period of modern economic growth:

A. only civilizations such as the Roman Empire experienced economic growth.

B. rates of population growth virtually matched rates of output growth.

C. most economies realized high rates of growth in output per person.

D. output and population growth were stagnant.

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9. What is the difference between financial investment and economic investment?

A. There is no difference between the two.

B. Financial investment refers to the purchase of financial assets only; economic investment

refers to the purchase of any new or used capital goods.

C. Economic investment is adjusted for inflation; financial investment is not.

D. Financial investment refers to the purchase of assets for financial gain; economic investment

refers to the purchase of newly created capital goods.

10. If an economy wants to increase its current level of investment, it must:

A. sacrifice future consumption.

B. print more money.

C. offer more stocks and bonds to financial investors.

D. sacrifice current consumption.

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