CHAPTER

The Science of Macroeconomics

Modified for ECON 2204

by Bob Murphy

© 2016 Worth Publishers, all rights reserved

 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 2

 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 a
country’s well-being?

CHAPTER 1 The Science of Macroeconomics 3

 U.S. Real GDP per capita
(2009 dollars)

$50,000 9/11/2001

First
$40,000
oil price
Great shock
Financial
$30,000 Depression crisis

$20,000 World
War I Second oil
price shock
$10,000

World War II
$0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010
U.S. Inflation Rate
(% per year)
25
World Second
20
War I First oil price
15 oil price shock
shock
10

-5
Financial
Great
-10 crisis
Depression
-15
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010
U.S. Unemployment Rate
(% of labor force)
30
Great
25 Depression

20

15 World Oil price

War I shocks Financial
World crisis
10 War II

0
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010
 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 10

 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 11
 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 12

 The market for cars: Demand

Demand equation: P
Price
Qd = D (P,Y ) of cars

The demand curve

shows the relationship
between quantity D
demanded and price, Q
other things equal. Quantity
of cars

CHAPTER 1 The Science of Macroeconomics 14

 The market for cars: Supply

Supply equation: P
Price
Qs = S (P,PS ) of cars S

The supply curve

shows the relationship
between quantity D
supplied and price, Q
other things equal. Quantity
of cars

CHAPTER 1 The Science of Macroeconomics 15

 The market for cars: Equilibrium

P
Price
of cars S

equilibrium
price
D
Q
Quantity
of cars
equilibrium
quantity

CHAPTER 1 The Science of Macroeconomics 16

 The effects of an increase in income
Demand equation:
P
Q d = D (P,Y ) Price
of cars S

An increase in income
increases the quantity P2
of cars consumers P1
demand at each price… D2
D1
Q
…which increases Q1 Q2
Quantity
the equilibrium price of cars
and quantity.

CHAPTER 1 The Science of Macroeconomics 17

 The effects of a steel price increase
Supply equation:
P S2
Q s = S (P,PS ) Price
of cars S1

An increase in Ps
reduces the quantity of P2
cars producers supply P1
at each price…
D

…which increases the Q

Q2 Q1
market price and Quantity
of cars
reduces the quantity.

CHAPTER 1 The Science of Macroeconomics 18

 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: Y , Ps
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 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

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 Prices: flexible vs. sticky

§ The economy’s behavior depends partly on

whether prices are sticky or flexible:
§ If prices are 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 are flexible (long run), markets clear
and economy behaves very differently.

CHAPTER 1 The Science of Macroeconomics 23