MACROECONOMICS

N. Gregory Mankiw

CHAPTER
1
The Science of Macroeconomics
 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 the
country’s well-being?

CHAPTER 1 The Science of Macroeconomics

3
REAL GDP PER PERSON IN THE U.S. ECONOMY

4
THE INFLATION RATE IN THE U.S. ECONOMY

5
THE UNEMPLOYMENT RATE IN THE U.S.
ECONOMY

6
 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

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7
The Market Forces of Supply and Demand
 Supply and demand are the two words that
economists use most often.
 Supply and demand are the forces that make
market economies work.
 Modern microeconomics is about supply,
demand, and market equilibrium.
MARKETS AND COMPETITION

 A market is a group of buyers and sellers of a

particular good or service.

 The terms supply and demand refer to the

behavior of people . . . as they interact with one
another in markets.
MARKETS AND COMPETITION

 Buyers determine demand.

 Sellers determine supply

COMPETITIVE MARKETS

 A competitive market is a market in which there

are many buyers and sellers so that each has a
negligible impact on the market price.
COMPETITION: PERFECT AND OTHERWISE

 Perfect Competition
 Products are the same
 Numerous buyers and sellers so that each has no
influence over price
 Buyers and Sellers are price takers

 Monopoly
 One seller, and seller controls price
COMPETITION: PERFECT AND OTHERWISE

 Oligopoly
 Few sellers
 Not always aggressive competition

 Monopolistic Competition
 Many sellers
 Slightly differentiated products

 Each seller may set price for its own product

DEMAND

 Quantity demanded is the amount of a good

that buyers are willing and able to purchase.
 Law of Demand
 Thelaw of demand states that, other things equal,
the quantity demanded of a good falls when the
price of the good rises.
THE DEMAND CURVE: THE RELATIONSHIP BETWEEN
PRICE AND QUANTITY DEMANDED

 Demand Schedule
 The demand schedule is a table that shows the
relationship between the price of the good and the
quantity demanded.
CATHERINE’S DEMAND SCHEDULE
THE DEMAND CURVE: THE RELATIONSHIP BETWEEN
PRICE AND QUANTITY DEMANDED

 Demand Curve
 Thedemand curve is a graph of the relationship
between the price of a good and the quantity
demanded.
FIGURE 1 CATHERINE’S DEMAND SCHEDULE AND DEMAND
CURVE

Price of
Ice-Cream Cone
$3.00

2.50

1. A decrease
2.00
in price ...

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
Copyright © 2004 South-Western
MARKET DEMAND VERSUS INDIVIDUAL DEMAND

 Market demand refers to the sum of all

individual demands for a particular good or
service.
 Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
SHIFTS IN THE DEMAND CURVE

 Change in Quantity Demanded

 Movement along the demand curve.
 Caused by a change in the price of the product.
CHANGES IN QUANTITY DEMANDED
Price of Ice-
Cream A tax that raises the
Cones
price of ice-cream
B cones results in a
$2.00
movement along the
demand curve.

1.00 A

D
0 4 8 Quantity of Ice-Cream Cones
SHIFTS IN THE DEMAND CURVE

 Consumer income
 Prices of related goods

 Tastes

 Expectations

 Number of buyers
SHIFTS IN THE DEMAND CURVE

 Change in Demand
A shift in the demand curve, either to the left or
right.
 Caused by any change that alters the quantity
demanded at every price.
 FIGURE 3 SHIFTS IN THE DEMAND CURVE

Price of
Ice-Cream
Cone

Increase
in demand

Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0 Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
SHIFTS IN THE DEMAND CURVE

 Consumer Income
 As income increases the demand for a normal good
will increase.
 As income increases the demand for an inferior
good will decrease.
CONSUMER INCOME
NORMAL GOOD
Price of Ice-
Cream Cone
$3.00 An increase
2.50 in income...
Increase
2.00 in demand

1.50

1.00

0.50
D2
D1 Quantity of
Ice-Cream
0 1 2 3 4 5 6 7 8 9 10 11 12 Cones
CONSUMER INCOME
INFERIOR GOOD
Price of Ice-
Cream Cone
$3.00

2.50 An increase
2.00
in income...
Decrease
1.50 in demand

1.00

0.50

D2 D1 Quantity of
Ice-Cream
0 1 2 3 4 5 6 7 8 9 10 11 12 Cones
SHIFTS IN THE DEMAND CURVE

 Prices of Related Goods

 When a fall in the price of one good reduces the
demand for another good, the two goods are called
substitutes.
 When a fall in the price of one good increases the
demand for another good, the two goods are called
complements.
TABLE 1 VARIABLES THAT INFLUENCE
BUYERS

Copyright©2004 South-Western
SUPPLY

 Quantity supplied is the amount of a good that

sellers are willing and able to sell.
 Law of Supply
 The law of supply states that, other things equal,
the quantity supplied of a good rises when the price
of the good rises.
THE SUPPLY CURVE: THE RELATIONSHIP BETWEEN
PRICE AND QUANTITY SUPPLIED

 Supply Schedule
 The supply schedule is a table that shows the
relationship between the price of the good and the
quantity supplied.
BEN’S SUPPLY SCHEDULE
THE SUPPLY CURVE: THE RELATIONSHIP BETWEEN
PRICE AND QUANTITY SUPPLIED

 Supply Curve
 The supply curve is the graph of the relationship
between the price of a good and the quantity
supplied.
 FIGURE 5 BEN’S SUPPLY SCHEDULE AND SUPPLY CURVE

Price of
Ice-Cream
Cone
$3.00

2.50
1. An
increase
in price ... 2.00

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity of cones supplied.
Copyright©2003 Southwestern/Thomson Learning
MARKET SUPPLY VERSUS INDIVIDUAL SUPPLY

 Market supply refers to the sum of all individual

supplies for all sellers of a particular good or
service.
 Graphically, individual supply curves are
summed horizontally to obtain the market
supply curve.
SHIFTS IN THE SUPPLY CURVE

 Input prices
 Technology

 Expectations

 Number of sellers
SHIFTS IN THE SUPPLY CURVE

 Change in Quantity Supplied

 Movement along the supply curve.
 Caused by a change in anything that alters the
quantity supplied at each price.
CHANGE IN QUANTITY SUPPLIED
Price of Ice-
Cream S
Cone
C
$3.00
A rise in the price
of ice cream
cones results in a
movement along
A the supply curve.
1.00

Quantity of
Ice-Cream
0 1 5 Cones
SHIFTS IN THE SUPPLY CURVE

 Change in Supply
A shift in the supply curve, either to the left or right.
 Caused by a change in a determinant other than
price.
 FIGURE 7 SHIFTS IN THE SUPPLY CURVE

Price of
Ice-Cream Supply curve, S3
Supply
Cone
curve, S1
Supply
Decrease curve, S2
in supply

Increase
in supply

0 Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
TABLE 2 VARIABLES THAT INFLUENCE SELLERS

Copyright©2004 South-Western
SUPPLY AND DEMAND TOGETHER

 Equilibrium refers to a situation in which the

price has reached the level where quantity
supplied equals quantity demanded.
SUPPLY AND DEMAND TOGETHER
 Equilibrium Price
 The price that balances quantity supplied and
quantity demanded.
 On a graph, it is the price at which the supply and
demand curves intersect.
 Equilibrium Quantity
 The quantity supplied and the quantity demanded
at the equilibrium price.
 On a graph it is the quantity at which the supply
and demand curves intersect.
SUPPLY AND DEMAND TOGETHER
Demand Schedule Supply Schedule

At $2.00, the quantity demanded

is equal to the quantity supplied!
 FIGURE 8 THE EQUILIBRIUM OF SUPPLY AND DEMAND

Price of
Ice-Cream
Cone Supply

Equilibrium price Equilibrium

$2.00

Equilibrium Demand
quantity

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
FIGURE 9 MARKETS NOT IN EQUILIBRIUM

(a) Excess Supply

Price of
Ice-Cream Supply
Cone Surplus
$2.50

2.00

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones

Copyright©2003 Southwestern/Thomson Learning

EQUILIBRIUM

 Surplus
 When price > equilibrium price, then quantity
supplied > quantity demanded.
 There is excess supply or a surplus.
 Suppliers will lower the price to increase sales, thereby
moving toward equilibrium.
EQUILIBRIUM

 Shortage
 When price < equilibrium price, then quantity
demanded > the quantity supplied.
 There is excess demand or a shortage.
 Suppliers will raise the price due to too many buyers
chasing too few goods, thereby moving toward
equilibrium.
FIGURE 9 MARKETS NOT IN EQUILIBRIUM

(b) Excess Demand

Price of
Ice-Cream Supply
Cone

$2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones

Copyright©2003 Southwestern/Thomson Learning

EQUILIBRIUM

 Law of supply and demand

 The claim that the price of any good adjusts to bring
the quantity supplied and the quantity demanded
for that good into balance.
THREE STEPS TO ANALYZING CHANGES IN
EQUILIBRIUM

 Decide whether the event shifts the supply or

demand curve (or both).
 Decide whether the curve(s) shift(s) to the left
or to the right.
 Use the supply-and-demand diagram to see
how the shift affects equilibrium price and
quantity.
 FIGURE 10 HOW AN INCREASE IN DEMAND AFFECTS THE
EQUILIBRIUM
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream . . .

Supply

$2.50 New equilibrium

2.00
2. . . . resulting Initial
in a higher
equilibrium
price . . .
D

0 7 10 Quantity of
3. . . . and a higher Ice-Cream Cones
quantity sold.
Copyright©2003 Southwestern/Thomson Learning
THREE STEPS TO ANALYZING CHANGES IN
EQUILIBRIUM
 Shifts in Curves versus Movements along
Curves
A shift in the supply curve is called a change in
supply.
 A movement along a fixed supply curve is called a
change in quantity supplied.
 A shift in the demand curve is called a change in
demand.
 A movement along a fixed demand curve is called a
change in quantity demanded.
 FIGURE 11 HOW A DECREASE IN SUPPLY AFFECTS THE
EQUILIBRIUM

Price of
Ice-Cream 1. An increase in the
Cone price of sugar reduces
the supply of ice cream. . .
S2
S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. . . . resulting
in a higher
price of ice
cream . . . Demand

0 4 7 Quantity of
3. . . . and a lower Ice-Cream Cones
quantity sold.
Copyright©2003 Southwestern/Thomson Learning
TABLE 4 WHAT HAPPENS TO PRICE AND QUANTITY WHEN
SUPPLY OR DEMAND SHIFTS?

Copyright©2004 South-Western
 Economists use the model of supply and
demand to analyze competitive markets.
 In a competitive market, there are many buyers
and sellers, each of whom has little or no
influence on the market price.
 The demand curve shows how the quantity of a
good depends upon the price.
 According to the law of demand, as the price of a good
falls, the quantity demanded rises. Therefore, the
demand curve slopes downward.
 In addition to price, other determinants of how much
consumers want to buy include income, the prices of
complements and substitutes, tastes, expectations,
and the number of buyers.
 If one of these factors changes, the demand curve
shifts.
 The supply curve shows how the quantity of a good
supplied depends upon the price.
 According to the law of supply, as the price of a good
rises, the quantity supplied rises. Therefore, the supply
curve slopes upward.
 In addition to price, other determinants of how much
producers want to sell include input prices, technology,
expectations, and the number of sellers.
 If one of these factors changes, the supply curve shifts.
 Market equilibrium is determined by the
intersection of the supply and demand curves.
 At the equilibrium price, the quantity demanded
equals the quantity supplied.
 The behavior of buyers and sellers naturally
drives markets toward their equilibrium.
 To analyze how any event influences a market,
we use the supply-and-demand diagram to
examine how the even affects the equilibrium
price and quantity.
 In market economies, prices are the signals
that guide economic decisions and thereby
allocate resources.
 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
CHAPTERP
1s = price
The of steel
Science (an input)
of Macroeconomics
62
 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

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 DIGRESSION: FUNCTIONAL NOTATION

 General functional notation

shows only that the variables are related.
A list of the
Q d = D (P,Y ) variables
that affect Q d
 A specific functional form shows
the precise quantitative relationship.
 Example:
D (P,Y ) = 60 – 10P + 2Y

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 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

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65
 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

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 THE MARKET FOR CARS: EQUILIBRIUM
P
Price
of cars S

equilibrium
price
D
Q
Quantity
of cars
equilibrium
quantity

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 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 the Q1 Q2 Quantity
equilibrium price and of cars
quantity.

CHAPTER 1 The Science of Macroeconomics

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 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 at P1
each price…
D

…which increases the Q

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

CHAPTER 1 The Science of Macroeconomics

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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: Y, Ps
CHAPTER 1 The Science of Macroeconomics
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 THE USE OF MULTIPLE MODELS

 No one model can address all the issues we

care about.
 E.g., a supply-demand model of the U.S. car
market…
 can tell us how a fall in aggregate U.S. income
affects price & quantity of cars.
 cannot tell us why aggregate income falls.

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 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
 itsassumptions
 which variables are endogenous,
which are exogenous
 the questions it can help us understand,
those it cannot

CHAPTER 1 The Science of Macroeconomics

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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 3-4 years
CHAPTER 1 The Science of Macroeconomics
73
 PRICES: FLEXIBLE VS. STICKY

 The economy’s behavior depends partly on

whether prices are sticky or flexible:
 Ifprices sticky (short run),
demand may not equal supply, which explains:
 unemployment (excess supply of labor)
 whyfirms cannot always sell all the goods
they produce
 Ifprices flexible (long run), markets clear and
economy behaves very differently

CHAPTER 1 The Science of Macroeconomics

74
 Using Microeconomics in Macroeconomics

Microeconomics

Microeconomics is the study of how households and firms

make decisions and how these decision makers interact in the
broader marketplace. In microeconomics, an individual chooses to
maximize his or her utility subject to his or her budget constraint.

Macroeconomics
Macroeconomic events arise from the interaction of many
individuals trying to maximize their own welfare. Because
aggregate variables are the sum of the variables describing
individuals’ decisions, the study of macroeconomics
is based on microeconomic foundations.
 CHAPTER SUMMARY
 Macroeconomics is the study of the
economy as a whole, including
 growth in incomes
 changes in the overall level of prices
 the unemployment rate

 Macroeconomists attempt to explain the

economy and to devise policies to improve
its performance.
 CHAPTER SUMMARY
 Economists use different models to
examine different issues.
 Models with flexible prices describe the
economy in the long run; models with sticky
prices describe the economy in the short
run.
 Macroeconomic events and performance
arise from many microeconomic
transactions, so macroeconomics uses
many of the tools of microeconomics.