CHAPTER ONE

macro

The Science of Macroeconomics

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint Slides by Ron Cronovich
2002 Worth Publishers, all rights reserved

Learning objectives
This chapter introduces you to

the issues macroeconomists study

the tools macroeconomists use some important concepts in
macroeconomic analysis

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Important issues in macroeconomics

Why does the cost of living keep rising?

Why are millions of people unemployed,

even when the economy is booming?

Why are there recessions?

Can the government do anything to combat recessions? Should it??

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Important issues in macroeconomics

What is the government budget deficit?
How does it affect the economy?
deficit?

Why does the U.S. have such a huge trade Why are so many countries poor?

What policies might help them grow out of poverty?

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U.S. Gross Domestic Product

in billions of chained 1996 dollars
10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 1970

1975

1980

1985

1990

1995

2000

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U.S. Gross Domestic Product

in billions of chained 1996 dollars
10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 1970

longest economic expansion on record

Recessions

1975

1980

1985

1990

1995

2000

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Why learn macroeconomics?

1. The macroeconomy affects societys well-being. example:

Unemployment and social problems

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Unemployment and social problems

Each one-point increase in the unemployment rate is associated with: 920 more suicides 650 more homicides 4000 more people admitted to state mental institutions 3300 more people sent to state prisons 37,000 more deaths increases in domestic violence and homelessness
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Why learn macroeconomics?

1. The macroeconomy affects societys well-being. example:

Unemployment and social problems

2. The macroeconomy affects your well-being. example 1: example 2:

Unemployment and earnings growth

Interest rates and mortgage payments

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Unemployment and earnings growth

5 4 3 2 1 0 -1 -2 -3 -4 -5 1965

1970

1975

1980

1985

1990

1995

2000

growth rate of inflation-adjusted hourly earnings change in Unemployment rate

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Interest rates and mortgage payments

For a $150,000 30-year mortgage:
date
Dec 2000 Dec 2001

actual rate on 30-year mortgage

7.65% 6.84%

monthly payment
$1064 $981

annual payment
$12,771 $11,782

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Why learn macroeconomics?

1. The macroeconomy affects societys well-being. example:

Unemployment and social problems

2. The macroeconomy affects your well-being. example 1: example 2:

Unemployment and earnings growth

Interest rates and mortgage payments 3. The macroeconomy affects politics & current events.
example:

Inflation and unemployment in election years

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Inflation and Unemployment in Election Years

year
1976 1980 1984

U rate
7.7% 7.1% 7.5%

inflation rate
5.8% 13.5% 4.3%

elec. outcome
Carter (D) Reagan (R) Reagan (R)

1988
1992 1996 2000

5.5%
7.5% 5.4% 4.0%

4.1%
3.0% 3.3% 3.4%

Bush I (R)
Clinton (D) Clinton (D) Bush II (R)

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Economic models
are simplied versions of a more complex reality irrelevant details are stripped away Used to show the relationships between economic variables explain the economys behavior devise policies to improve economic performance

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Example of a model: The supply & demand for new cars

explains the factors that determine the price of
cars and the quantity sold.

assumes the market is competitive: each buyer

and seller is too small to affect the market price

Variables: Q d = quantity of cars that buyers demand Q s = quantity that producers supply P = price of new cars Y = aggregate income Ps = price of steel (an input)
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The demand for cars

demand equation:

Q D (P ,Y )

shows that the quantity of cars consumers demand is related to the price of cars and aggregate income.

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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 variables that affect Q d

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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: Examples:
1)
2) 0.3Y

Q d D (P ,Y ) 60 10P 2 Y
Q D (P ,Y )
d

P
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The market for cars: demand

demand equation:
Price of cars

D (P ,Y )

The demand curve shows the relationship between quantity demanded and price, other things equal.

D
Quantity of cars

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The market for cars: supply

supply equation:
Price of cars

P
S

Q S (P , Ps )
The supply curve shows the relationship between quantity supplied and price, other things equal.

D
Quantity of cars

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The market for cars: equilibrium

Price of cars

P
S

equilibrium price

D
Quantity of cars

equilibrium quantity
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The effects of an increase in income:

demand equation:

Q d D (P ,Y )
An increase in income increases the quantity of cars consumers demand at each price which increases the equilibrium price and quantity.

Price of cars

P
S

P2

P1
D1 Q1 Q2

D2

Quantity of cars

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The effects of a steel price increase:

supply equation:

Q S (P , Ps )
An increase in Ps reduces the quantity of cars producers supply at each price

Price of cars

S2

S1

P2 P1 D Q2 Q1
Quantity of cars

which increases the market price and reduces the quantity.

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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 & behavior as given.

In the model of supply & demand for cars, endogenous: P , Qd , Qs

exogenous:
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Y , Ps
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Now you try:

1. Write down demand and supply

equations for wireless phones; include two exogenous variables in each equation.
2. Draw a supply-demand graph

for wireless phones.

3. Use your graph to show how a

change in one of your exogenous variables affects the models endogenous variables.
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A Multitude of Models
No one model can address all the issues we care about. For example, If we want to know how a fall in aggregate income affects new car prices, we can use the S/D model for new cars. But if we want to know why aggregate income falls, we need a different model.

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A Multitude of 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 of its variables are endogenous and

which are exogenous, the questions it can help us understand, and those it cannot.
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Prices: Flexible Versus Sticky

Market clearing: an assumption that prices
are flexible and adjust to equate supply and demand.

In the short run, many prices are sticky---

they adjust only sluggishly in response to supply/demand imbalances. For example, labor contracts that fix the nominal wage for a year or longer magazine prices that publishers change only once every 3-4 years
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Prices: Flexible Versus Sticky

The economys behavior depends partly on
whether prices are sticky or flexible:

If prices are sticky, then demand wont

always equal supply. This helps explain

unemployment (excess supply of labor) the occasional inability of firms to sell what they produce

Long run: prices flexible, markets clear,

economy behaves very differently.

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Outline of this book:

Introductory material Classical Theory
(chaps. 1 & 2) (chaps. 3-6)

How the economy works in the long run, when prices are flexible
(chaps. 7-8)

Growth Theory

The standard of living and its growth rate over the very long run
(chaps 9-13)

Business Cycle Theory

How the economy works in the short run, when prices are sticky.
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Outline of this book:

Policy debates
(Chaps. 14-15)

Should the government try to smooth business cycle fluctuations? Is the governments debt a problem?
(Chaps. 16-19)

Microeconomic foundations

Insights from looking at the behavior of consumers, firms, and other issues from a microeconomic perspective.

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Chapter summary
1. Macroeconomics is the study of the

economy as a whole, including growth in incomes changes in the overall level of prices the unemployment rate economy and to devise policies to improve its performance.

2. Macroeconomists attempt to explain the

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Chapter summary
3. Economists use different models to

examine different issues.

4. Models with flexible prices describe the

economy in the long run; models with sticky prices describe economy in the short run. arise from many microeconomic transactions, so macroeconomics uses many of the tools of microeconomics.
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5. Macroeconomic events and performance

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