Economics Chapter 1 Homework Some possibilities and suggestions for using the software are

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CHAPTER 1

The Science of Macroeconomics

Notes to the Instructor

Chapter Summary

Comments

The amount of introduction required naturally depends upon the students’ previous exposure to

macroeconomics in principles or in other courses. I try to stress the relevance of

macroeconomics (a good way to do this is to bring in copies of that day’s newspapers and show

how they contain stories related to the course) and the importance of basic macroeconomic

literacy. I emphasize that macroeconomics teaches a way of thinking about and understanding

The supply and demand model presented in Chapter 1 provides a vehicle to explain the

role of microeconomics in macroeconomics and to show how macroeconomics uses many tools

and ideas from microeconomics. The lecture notes emphasize this and also explain how

macroeconomics differs from microeconomics in its level of aggregation and in that it has more

of a general–equilibrium focus. The textbook works, as do economists, by using different models

to answer different questions, but I reassure students that we also emphasize how different

models fit together.

The companion Web site for students and instructors has been updated for use with the

ninth edition of Macroeconomics (www.worthpublishers.com/mankiw). The site offers a superb

set of software–based features and a PowerPoint® tutorial for students. In addition, the

PowerPoint slides for instructors have been updated and include animated graphics and other

innovative pedagogical features.

Students will find the Web site both helpful and fun to use. The Web site includes Self–

Tests and Flashcards that provide immediate feedback to students, a Data Plotter that students

can use to graph and compare macroeconomic data, a feature titled A Game for

Macroeconomists that allows students to make policy choices as President of the United States,

and a Macro Models component that provides students with the hands–on opportunity to

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Use of the Dismal Scientist Web Site

The Dismal Scientist Web site provides a rich source of data for supplementing lectures and

designing class projects. A good use of this resource for Chapter 1 is to create graphs of real

GDP growth, CPI inflation, and the unemployment rate over the past few years to provide the

latest picture of the economy’s main economic indicators. Locate the data on the Web site’s data

page and choose the appropriate settings to create a graph.

Chapter Supplements

This chapter includes the following supplements:

1-2 Presidential Elections and the Economy

1-3 When Is the Economy in a Recession?

1-5 Additional Readings

Lecture Notes | 3

Lecture Notes

1-1 What Macroeconomists Study

Economics is the study of the economy and the behavior of people in the economy.

Traditionally, economics is divided into microeconomics, which studies the behavior of

individuals and organizations (consumers, firms, and the like) at a disaggregated level, and

macroeconomics, which studies the overall or aggregate behavior of the economy. Since this

book studies macroeconomics, we seek to explain phenomena such as inflation, unemployment,

and economic growth, and we are not concerned with, say, the demand for or supply of peanuts.

Case Study: The Historical Performance of the U.S. Economy

Perhaps the three most important indicators of the macroeconomic performance of an economy

are real gross domestic product (GDP), the inflation rate, and the unemployment rate. Real GDP

is a measure of the quantity of goods and services produced in the economy in a given year. The

historical record shows that real GDP has risen substantially over time, although this growth is

irregular, and there are periods when output actually falls. The inflation rate is a measure of how

1-2 How Economists Think

Theory as Model Building

A key element of economic analysis—both microeconomic and macroeconomic—is the study of

markets and prices. In an economy, goods are traded and exchanged. We think about this as

taking place in markets. The economist’s idea of a market is an abstract representation of a real

equilibrium condition to our representation of the pizza market:

Qs = Qd.

In terms of the graph, this is equivalent to looking for the point where the supply and demand

curves meet. We return to this example shortly.

!

Supplement 1–1,

“The Recent

Behavior of the

U.S. Economy”

!Figure 1-1

!Figure 1-2

!Figure 1-3

4 | CHAPTER 1 The Science of Macroeconomics

automobiles, peanuts, and the like—we think about some aggregate of them all. We call this

good real GDP and denote it by the symbol Y. GDP stands for gross domestic product. It is a

measure of the total production in the economy; indeed, explaining the behavior of the economy

is largely a matter of explaining the behavior of real GDP over time. We consider the definition

of GDP more carefully later.

The previous analysis of the pizza market is an example of a model. This model represents

the determination of the equilibrium price and quantity traded in a simple setting. In constructing

that model, we judged that the price of pizza, the price of cheese, and aggregate income are all

important in understanding the demand for and supply of pizza; we implicitly decided that all

other variables were less important and could be left out. Knowing what to include and what not

taken as given, and look at the effect on other variables that the model explains. Variables taken

as given from outside the model are known as exogenous variables; variables explained within

the model are known as endogenous variables. A typical experiment with an economic model

thus involves changing an exogenous variable and looking at the effect on endogenous variables.

This is known as a comparative static experiment.

FYI: Using Functions to Express Relationships Among Variables

Economists use mathematics—particularly graphs and algebra—to help understand the

economy. For example, we have thus far said two things:

1. The supply of pizza depends on the price of pizza and the price of materials.

1. Qs = S(P, Pm);

2. Qd = D(P, Y).

Here S( ) and D( ) are functions: they indicate relationships among variables. Qs, Qd, P, Pm, and

Y are variables, denoting the quantity of pizza supplied, the quantity of pizza demanded, the

Lecture Notes | 5

price of pizza, the price of materials, and aggregate income, respectively. An example of a

supply function is

Qs = 15P – 2Pm.

Another example is

A Multitude of Models

Macroeconomists use a multitude of models because different models are appropriate for

different questions. If we want to understand the effects of government deficits on interest rates,

for example, we would not want to use a model that included the price of cheese. An important

Prices: Flexible Versus Sticky

We noted earlier that macroeconomics is concerned with both explanation and policy

recommendations. Not surprisingly, much of the debate among macroeconomists has to do with

their different views on policy. Essentially, these debates often come down to whether or not the

economy, left on its own, does a good job of allocating resources, or whether government

intervention can improve upon the performance of the economy. This theme recurs throughout

Economists thus usually think that, for macroeconomics, it is reasonable to suppose that

prices are completely flexible in the long run only. In the short run, we often make an

assumption of price stickiness to help us explain the behavior of the economy.

One other difference between microeconomics and macroeconomics is worth mentioning.

In microeconomics, we usually focus on a single market. In macroeconomics, we pay attention

focus.

Microeconomic Thinking and Macroeconomic Models

Although microeconomics and macroeconomics are separate aspects of economic inquiry, they

make use of many of the same tools. Indeed, the distinction between macroeconomics and

microeconomics, though sometimes useful, is also somewhat artificial. Modern macroeconomics

FYI: Nobel Macroeconomists

The Nobel Prize in economics is awarded annually. A number of winners have been

macroeconomists whose work we discuss in this book. These include: Milton Friedman (1976),

1-3 How This Book Proceeds

Macroeconomists face difficulties as scientists because they cannot conduct experiments. (They

have this in common with some other scientists, such as paleontologists or astronomers.) But

macroeconomists do seek to understand the behavior of the economy, which means

understanding the behavior of economic data. We make progress in macroeconomics by looking

at the data, observing certain patterns, building models that may help explain those patterns, and

then seeing if those models are consistent with other aspects of the data or new data when they

CASE STUDY EXTENSION

1-1 The Recent Behavior of the U.S. Economy: A Guide to the Case

Studies

1900. The long–run picture shows that GDP grows through time, although this growth is often interrupted

by recessions, most recently in 2007 to 2009. The Chapter 9 case study “The Slowdown in Productivity

Growth” notes the slowdown in the long–run growth rate experienced by the United States and other

countries from the early 1970s through the mid–1990s. Another Chapter 9 case study highlights the

importance of differences in management practices as a reason why countries have experienced

differences in productivity performance. The Chapter 14 case study “Inflation and Unemployment in the

United States” shows unemployment and inflation over the past four decades and illustrates the stagflation

(high unemployment and high inflation) of the 1970s; this contrasts with the relatively stable growth of the

1950s and 1960s.

The Chapter 10 case study “How OPEC Helped Cause Stagflation in the 1970s and Euphoria in the

1980s” explains how the experience of the 1970s was in large measure the result of supply shocks

associated with increases in the price of oil. The United States thus entered the 1980s with very high

Ultimately, the tight monetary policies did succeed in decreasing inflation and inflation expectations,

and the economy gradually returned to full employment. This recovery was aided by a fall in oil prices in

the mid–1980s (the Chapter 10 case study cited above). By the end of the decade, output was close to the

natural rate and inflation was low. The question of whether macroeconomic policy is responsible for

reduced volatility of economic activity in the decades following World War II is considered in the Chapter

18 case study “Is the Stabilization of the Economy a Figment of the Data?”

While the 1990s witnessed the longest period of expansion during the postwar era, the business cycle

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ADDITIONAL CASE STUDY

1-2 Presidential Elections and the Economy

The influence of economic events on politics is apparent during presidential elections. Economic policy

provides a primary topic of debate for the candidates, and the state of the economy has a powerful

influence on the outcome of the election. In fact, according to economist Ray Fair, one can forecast the

outcome of a presidential election with remarkable accuracy by looking at how well the economy is doing.

History shows that the incumbent party is helped by growing incomes and is hurt by rising prices.

Fair has used the historical evidence to produce an equation that forecasts the winner of the popular

vote (but not that of the electoral college!) using the following information:

• which party is currently in power,

• whether an incumbent is running for reelection,

• the number of terms the incumbent party has been in power,

Fair’s equation would have correctly predicted the winner of the popular vote in 21 of the 25 presidential

elections from 1916 to 2012.1 The elections it would have missed were Kennedy–Nixon in 1960,

Humphrey–Nixon in 1968, Bush–Clinton in 1992, and Bush–Gore in 2000. Predicting the Bush–Clinton

election was complicated by the strong showing of a third–party candidate, Ross Perot. Fair’s model

assumes that Perot drew votes away equally from Bush and Clinton. Interestingly, the equation predicted

that Al Gore would lose the popular vote in the 2000 election, when in fact he won a majority but lost in

the electoral–college tally.

Fair’s analysis indicates that voters apparently have a short time horizon with regard to economic

events. This provides support for the view that administrations can manipulate the economy in an attempt

to improve their reelection chances.2

With respect to economic performance, voters may simply examine their own circumstances,

supporting candidates and parties that best advance their own economic interests. Yet such

“pocketbook” voters are hard to find. Although the economic predicaments of personal life do

occasionally influence political choice, the effects are never very strong and usually they are

utterly trivial. Declining financial condition, job loss, preoccupation with personal problems—

none of these seems generally to motivate presidential voting.

Whereas pocketbook voters might ask the political system and its officials, “What have you done for

me lately?” sociotropic voters would ask, “What have you done for the country lately?” The political

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ADDITIONAL CASE STUDY

1-3 When Is the Economy in a Recession?

On November 26, 2001, the Business Cycle Dating Committee of the National Bureau of Economic

Research reported that the U.S. economy had entered a recession during March 2001. The committee,

which is composed of leading macroeconomists, made its decision even though data on real GDP showed

a small increase in the April through June quarter of the year and began to decline only during the July to

September quarter. A popular rule of thumb used by the media (and economists) is that a recession occurs

when a decline in real GDP lasts for at least two consecutive quarters. At the time that the Business Cycle

Dating Committee issued its report, real GDP had declined for only one quarter. Why then did the

committee make the call that a recession had begun?

The committee defines a recession as “a significant decline in activity spread across the economy,

lasting more than a few months, [and] visible in industrial production, employment, real income, and

wholesale–retail trade.”1 Unlike the popular rule of thumb, “the committee gives relatively little weight to

real GDP because it is only measured quarterly and it is subject to continuing, large revisions.”2 The data

the committee emphasizes are available monthly, with at most only a couple of weeks’ lag between the

end of the month and the time when the data are released. This feature of the data allows the committee to

date recessions monthly. Although the monthly data are subject to revisions, these tend to occur sooner

and are often smaller than those for GDP.

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LECTURE SUPPLEMENT

1-4 Economic Rhetoric

The textbook proceeds, as do economists, by applying different models to different questions. Judging

whether or not a given model is appropriate is difficult; any model, by definition, leaves things out, and

there is no simple way to know whether we have included or excluded the “right” features of the world.

The data inform our inquiry but are simply not good enough or abundant enough to settle many of the

important questions beyond dispute.1 The important questions, meanwhile, often turn in part on issues of

policy and politics. Throughout the history of macroeconomics, there has been disagreement between

economists who believe that the economy functions well without government intervention and those who

believe that the government can improve economic performance. This basic disagreement has survived

numerous refinements of our macroeconomic models and numerous confrontations of those models with

the data.

The economist and economic historian D. McCloskey argues that economists claim to adopt a

particular “scientific” methodology to settle such disputes, whereas in practice they—like other

scientists—proceed by persuasion, rhetoric, and metaphor.2 The modernist methodology to which

economists nominally subscribe is, according to McCloskey and many others, rigid and outdated;

McCloskey believes that economics would benefit if economists acknowledged how their research is

really carried out.3

McCloskey’s argument is not at all that economics is unscientific or useless, but simply that the

conventions of economic discourse impede fruitful communication.

In the flight of rockets the layman can see the marvel of physics, and in the applause of

audiences the marvel of music. No one understands the marvel of economics well who has not

studied it with care. This leaves its reputation in the hands of politicians and journalists, who

have other things on their minds. The result is much mistaken criticism of economics as being

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The extent of real disagreement among economists, as we have argued several times, is in fact

exaggerated. The extent of their agreement, however, makes the more puzzling the venom they

bring to minor disputes. The assaults on Milton Friedman or on J.K. Galbraith have a bitterness

beyond reason. The unreason, though, has its reason. If one cannot reason about values, and if

what matters most is placed in the value half of the fact–value split, then it follows that one will

6 Ibid., 184.

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LECTURE SUPPLEMENT

1-5 Additional Readings

Supplements to various chapters suggest additional readings that may be useful for students who are

writing papers, doing projects, or simply wishing to know more about the topics covered in the textbook.

The sources listed are relatively accessible to students. Some of the readings cited in the supplements are

from these sources.

book reviews, grouped by subject area, and occasional detailed survey articles.

The New Palgrave is a four–volume encyclopedia of economics.1 The articles published in it vary

greatly in terms of length, technical sophistication, and breadth and idiosyncrasy of coverage.

Nevertheless, with a bit of persistence, students researching a topic are more likely than not to find helpful

information in these volumes.

main point of many articles without getting too embroiled in the mathematics and econometrics. Good

general journals to consult are American Economic Review, Economic Journal, Journal of Political

Economy, and Quarterly Journal of Economics. Some of these journals occasionally include survey

articles or review articles.

Finally, daily newspapers such as the New York Times or the Wall Street Journal are always worth

reading to keep up to date on current economic news.

1 P. Newman, J. Eatwell, and M. Milgate, eds., The New Palgrave: A Dictionary of Economics: 2nd ed. (London: Palgrave Macmillan, 2008).