Chapter Outline

 What macroeconomics is about?

 What macroeconomists do?
 Why macroeconomists disagree?
 Three central concepts around which this course is organized:
• The short-run: What happens to the economy from year to year.
• The medium run: What happens to the economy over a decade or so.
• The long run: What happens to the economy over a half century or longer.
What Macroeconomics is about
 Macroeconomics: The study of the structure and performance of
national economies and government policies that affect economic
performance.
 Issues addressed by macroeconomists:
• Long-run economic growth
• Business cycles
• Unemployment
• Inflation
• The international economy
• Macroeconomic policy
 Aggregation: from microeconomics to macroeconomics
Quick Intro to GNP and GDP
 GNP – focused on nationality – Sum of value of finished (or final) goods and services
(as opposed to intermediate outputs) produced by a country’s economic agents (firms
and households) during one year, regardless of whether production takes place within
or outside the country.
 GDP – geographically focused – Sum of value of finished (not intermediate) goods and
services produced in a country during one year, regardless of whether foreigners or
that country’s economic agents are doing the production.
 Alternative definition of GDP (or GNP) – national income – Instead of determining the
size of the economy by counting up the value of all finished goods and services, one
can estimate GDP by summing value added, industry/sector by industry/sector. The
single industry’s value-added is distributed as income to the suppliers of labor, capital,
and other factors of production. Accordingly, the summation of all value added in an
economy equals national income.
 Figure 1.1: Output of United States since 1869. (Note decline in
output in recessions; increase in output in some wars.)
 Two main sources of growth:
• Population growth
• Increases in average labor productivity
 Average labor productivity: Output produced per unit of labor input.
• Fig. 1.2 shows average labor productivity for U.S since 1900.
• Average labor productivity growth: About 2.5% per year from 1949 to 1973;
1.1% per year from 1973 to 1995; 1.7% per year from 1995 to 2011
Business Cycle
 Business cycle: Short-run contractions and expansions in economic
activity.
 Downward phase is called a recession. During a recession, national
output may be falling or perhaps growing only very slowly.
 Macroeconomists put a lot of effort into trying to figure out what
causes business cycles and deciding what can do or should be done
about them
Unemployment
 Unemployment: the number of people who are available for work and
actively seeking work but cannot find jobs.
 The best-known measure of unemployment is the unemployment
rate. U.S. experience is shown in Fig. 1.3.
 Recessions have led to significant increases in the unemployment rate
in the postwar period.
Inflation
 Inflation: The prices of goods and services are rising over time. U.S.
experience shown in Fig.
 Deflation: when prices of most goods and services decline.
 Inflation rate: the percentage increase in the average level of prices.
 Hyperinflation: an extremely high rate of inflation. High inflation also
means that the purchasing power of money erodes quickly.
Open vs. closed economies
 Open vs. closed economies :
• Open economy is an economy that has extensive trading and financial relationships
with other national economies. Today, every major economy is an open economy.
• Closed economy: an economy that does not interact economically with the rest of
the world.
 An important topic in macro: How international trade and borrowing
relationships can help transmit business cycles from country to country.
 Trade imbalances. U.S. experience shown in Fig. Question: Are they bad for
U.S. or for the economies of this country’s trading partners?
• Trade surplus: exports exceed imports
• Trade deficit: imports exceed exports
Macroeconomic policy
 Macro policies affect the performance of the economy as a whole.
 Fiscal policy: government spending and taxation. It is determined at
the national, state, and local levels in the U.S.
 Effects of changes in federal budget.
 U.S. experience in Fig.
 Relation to trade deficit?
 Monetary policy: growth of money supply or a nominal interest rate
(the federal fund rates); determined by central bank (the Fed in U.S).
Aggregation
 Aggregation: summing individual economic variables to obtain
economywide totals.
 Micro: focuses on individual consumers, workers, and firms, each of
which is too small to have an impact on the national economy.
 Macro focuses on national totals.
 Distinguishes microeconomics (disaggregated) from macroeconomics
(aggregated).
What macroeconomists do?
 Macroeconomic forecasting: Forecasting is a minor part of what
macroeconomists do.
• Relatively few economists make forecasts.
• Forecasting is very difficult: (1) our understanding of how the economy works
could be better; (2) it is impossible to take into account all the uncertain
factors (many of them are not strictly economic) that might affect future
economic trends.
 Rather than predicting what will happen, most macroeconomists are
engaged in analyzing and interpreting events as they happen (macro
analysis) or trying to understand the economy's structure in general
(macro research).
What macroeconomists do?
 Macroeconomic analysis:
• Private sector economists try to determine how general economic trends will
affect their employees’ investments, opportunities for expansion, the demand
for their products, and so on.
• Public sector (national and regional governments and international agencies)
economists: to assist in policymaking. For example, by writing reports
assessing various macro problems and identifying and evaluating possible
policy options. The World Bank, the International Money Fund, and the
Federal Reserve Banks.
 Does having many economists ensure good macroeconomic policies?
No, since politicians, not economists, make major decisions.
Macro research
 Goal: to make general statements about how the economy works.
 Macro research proceeds primarily through the formulation and testing of
theories.
 Economic theory: a set of ideas about the economy, organized logically.
 Economic model: a simplified description of some aspect of the economy.
 Theoretical and empirical research are necessary for forecasting and
economic analysis.
 Usefulness of economic theory or models depends on the reasonableness of
assumptions, the possibility of being applied to real problems, empirically
testable implications, theoretical results consistent with real-world data
In touch with data and research:
developing and testing an
economic

theory
State the research question.
 Make provisional assumptions that describe the economic setting and the
behavior of the economic actors.
 Work out the implications of the theory.
 Conduct an empirical analysis to compare the implications of the theory with the
data.
 Evaluate the results of your comparisons: If the theory fits the data well, Use the
theory to predict what would happen if the economic setting or policies change. If
the theory fits the data poorly, Start by developing a new model and repeat steps
2-5. If the theory fits the data moderately well, Either do with a partially
successful theory or modify the model with additional assumptions and then
repeat steps 2-5.
Why Macroeconomists disagree
Positive vs. normative analysis
Positive analysis: examines the economic consequences of a policy but
does not address the question of whether those consequences are
desirable.
Normative analysis: determines whether a policy should be used.
For example, consider evaluating the effects on the economy of a 5%
increase in the income tax.
Classical vs. Keynesians. (1) The
classical approach
 The economy works well on its own.
 The “invisible hand” (Adam Smith (1776): The Wealth of Nations): the
idea that if there are free markets and individuals conduct their
economic actions in their own best interests, the overall economy will
work well.
 Wages and prices adjust rapidly to equilibrium.
 Equilibrium is a situation in which the quantities demanded and supplied are
equal.
 Changes in wages and prices are signals that coordinate people’s actions
 Result: The government should have only a limited role in the economy
(2) The Keynesian approach
 The Great Depression: Classical theory failed because high
unemployment was persistent.
 Keynes (1936): The General Theory of Employment, Interest, and
Money.
 Keynes: Persistent unemployment occurs because wages and prices
adjust slowly, so markets remain out of equilibrium for long periods.
Conclusion: The government should intervene to restore full
employment.
The evolution of the classical-Keynesian debate

 Keynesians dominated from WWII to 1970.

 Stagnation led to a classical comeback in the 1970s.
 Last 30 years: excellent research with both approaches.
A unified approach to
macroeconomics
 This course will use a single model to present both classical and Keynesian
ideas. It draws heavily from both the classical and Keynesian traditions.
 Individuals, Firms, and the government interact in three markets: goods, assets,
and labor markets.
 The model’s macro analysis: starts with micro foundations: individual optimizing
behavior (consumer’s utility maximization and firm’s profit maximization).
 Both agree that, in the long run, wages and prices are perfectly flexible.
 Short run: Classical case - flexible wages and prices; Keynesian case - wages and
prices are slow to adjust. These two assumptions can be incorporated into the
model. This aspect allows us to compare classical and Keynesian conclusions
and policy recommendations.