Chapter 1 The Science of Macroeconomics IN THIS CHAPTER YOU WILL LEARN about the issues macroeconomists study about the tools macroeconomists use some important concepts in macroeconomic analysis CHAPTER 1 The Science of Macroeconomics 2 Important issues in macroeconomics Macroeconomics the study of the economy as a whole addresses many topical issues e g What causes recessions What is government stimulus and why might it help How can problems in the housing market spread to the rest of the economy What is the government budget deficit How does it affect workers consumers businesses and taxpayers CHAPTER 1 The Science of Macroeconomics 3 Important issues in macroeconomics Macroeconomics the study of the economy as a whole addresses many topical issues e g Why does the cost of living keep rising Why are so many countries poor What policies might help them grow out of poverty What is the trade deficit How does it affect the country s well being CHAPTER 1 The Science of Macroeconomics 4 U S Real GDP per capita 2005 dollars 50 000 9 11 2001 40 000 Great Depression 30 000 20 000 First oil price shock World War I Financial crisis Second oil price shock 10 000 2010 2000 1990 1980 The Science of Macroeconomics 1970 1960 1950 1940 1930 CHAPTER 1 1920 1900 0 1910 World War II 5 U S Inflation Rate per year 25 World War I 20 Second oil price shock First oil price shock 15 10 5 0 5 2010 2000 1990 1980 The Science of Macroeconomics 1970 1960 1940 1930 1920 1910 1900 CHAPTER 1 1950 Great Depression 10 15 Financial crisis 6 U S Unemployment Rate of labor force 30 20 World War I Oil price shocks 5 1990 1980 The Science of Macroeconomics 1970 1960 1940 1930 1920 CHAPTER 1 Financial crisis Great Depression 1910 1900 0 Financial crisis World War II 10 1950 15 2010 25 Second oil price shock Great First Depression oil price shock 2000 World War I 7 Economic models are simplified versions of a more complex reality irrelevant details are stripped away are used to show relationships between variables explain the economy s behavior devise policies to improve economic performance CHAPTER 1 The Science of Macroeconomics 8 Example of a model Supply demand for new cars shows how various events affect price and quantity of cars 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 CHAPTER 1 The Science of Macroeconomics 9 The demand for cars demand equation Q d D P Y shows that the quantity of cars consumers demand is related to the price of cars and aggregate income CHAPTER 1 The Science of Macroeconomics 10 Digression functional notation General functional notation shows only that the variables are related Q d D P Y A specific functional form shows the precise quantitative relationship A list of the Example variables D P Y affect 60Q d10P 2Y that CHAPTER 1 The Science of Macroeconomics 11 The market for cars Demand demand equation Q D P Y d P Price of cars The demand curve shows the relationship between quantity demanded and price other things equal CHAPTER 1 The Science of Macroeconomics D Q Quantit y of cars 12 The market for cars Supply supply equation Q S P Ps s P Price of cars The supply curve shows the relationship between quantity supplied and price other things equal CHAPTER 1 The Science of Macroeconomics S D Q Quantit y of cars 13 The market for cars Equilibrium P Price of cars S equilibrium price D Q equilibrium quantity CHAPTER 1 The Science of Macroeconomics Quantit y of cars 14 The effects of an increase in income demand equation Q d D P Y P Price of cars An increase in income increases the quantity of cars consumers demand at each price S P2 P1 D1 which increases the equilibrium price and quantity CHAPTER 1 The Science of Macroeconomics Q1 Q2 D2 Q Quantit y of cars 15 The effects of a steel price increase supply equation Q s S P Ps P Price of cars An increase in Ps reduces the quantity of cars producers supply at each price S1 P2 P1 which increases the market price and reduces the quantity CHAPTER 1 S2 The Science of Macroeconomics D Q2 Q1 Q Quantit y of cars 16 Endogenous vs exogenous variables The values of endogenous variables are determined in the model 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 P Q d Q s exogenous CHAPTER 1 Y Ps The Science of Macroeconomics 17 NOW YOU TRY Supply and Demand 1 Write down demand and supply equations for smartphones include two exogenous variables in each equation 2 Draw a supply demand graph for smartphones 3 Use your graph to show how a change in one of your exogenous variables affects the model s endogenous variables CHAPTER 1 The Science of Macroeconomics 18 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 CHAPTER 1 The Science of Macroeconomics 19 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 those it cannot CHAPTER 1 The Science of Macroeconomics 20 Prices flexible vs sticky Market clearing An assumption that prices are flexible adjust to equate supply and demand 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 21 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 22 Outline of this book Introductory material Chaps 1 2 Classical Theory Chaps 3 7 How the economy works in the long run when prices are flexible Growth Theory Chaps 8 9 The standard of living and