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Introduction

P A R T I

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The Science of Macroeconomics

The whole of science is nothing more than the refinement of everyday thinking.

—Albert Einstein

1C H A P T E R

What Macroeconomists Study

Why have some countries experienced rapid growth in incomes overthe past century while others stay mired in poverty? Why do somecountries have high rates of inflation while others maintain stable

prices? Why do all countries experience recessions and depressions—recurrentperiods of falling incomes and rising unemployment—and how can governmentpolicy reduce the frequency and severity of these episodes? Macroeconomics,the study of the economy as a whole, attempts to answer these and many relat-ed questions.

To appreciate the importance of macroeconomics, you need only read thenewspaper or listen to the news. Every day you can see headlines such asINCOME GROWTH REBOUNDS, FED MOVES TO COMBAT INFLA-TION, or STOCKS FALL AMID RECESSION FEARS. These macroeconomicevents may seem abstract, but they touch all of our lives. Business executives fore-casting the demand for their products must guess how fast consumers’ incomeswill grow. Senior citizens living on fixed incomes wonder how fast prices willrise. Recent college graduates looking for jobs hope that the economy will boomand that firms will be hiring.

Because the state of the economy affects everyone, macroeconomic issues playa central role in national political debates. Voters are aware of how the economyis doing, and they know that government policy can affect the economy in pow-erful ways. As a result, the popularity of the incumbent president often riseswhen the economy is doing well and falls when it is doing poorly.

Macroeconomic issues are also central to world politics, and if you read theinternational news, you will quickly start thinking about macroeconomic ques-tions. Was it a good move for much of Europe to adopt a common currency?Should China maintain a fixed exchange rate against the U.S. dollar? Why is theUnited States running large trade deficits? How can poor nations raise theirstandard of living? When world leaders meet, these topics are often high ontheir agenda.

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Although the job of making economic policy belongs to world leaders, thejob of explaining the workings of the economy as a whole falls to macroecono-mists. Toward this end, macroeconomists collect data on incomes, prices, unem-ployment, and many other variables from different time periods and differentcountries. They then attempt to formulate general theories to explain these data.Like astronomers studying the evolution of stars or biologists studying the evo-lution of species, macroeconomists cannot conduct controlled experiments in alaboratory. Instead, they must make use of the data that history gives them.Macroeconomists observe that economies differ across countries and that theychange over time. These observations provide both the motivation for develop-ing macroeconomic theories and the data for testing them.

To be sure, macroeconomics is a young and imperfect science. The macroecon-omist’s ability to predict the future course of economic events is no better than themeteorologist’s ability to predict next month’s weather. But, as you will see, macro-economists know quite a lot about how economies work. This knowledge is use-ful both for explaining economic events and for formulating economic policy.

Every era has its own economic problems. In the 1970s, Presidents RichardNixon, Gerald Ford, and Jimmy Carter all wrestled in vain with a rising rate ofinflation. In the 1980s, inflation subsided, but Presidents Ronald Reagan andGeorge Bush presided over large federal budget deficits. In the 1990s, with Pres-ident Bill Clinton in the Oval Office, the economy and stock market enjoyed aremarkable boom, and the federal budget turned from deficit to surplus. But asClinton left office, the stock market was in retreat, and the economy was headinginto recession. In 2001 President George W. Bush reduced taxes to help end therecession, but the tax cuts also contributed to a reemergence of budget deficits.

President Barack Obama moved into the White House in 2009 in a period ofheightened economic turbulence. The economy was reeling from a financial crisis,driven by a large drop in housing prices and a steep rise in mortgage defaults. Thecrisis was spreading to other sectors and pushing the overall economy into anoth-er recession. The magnitude of the downturn was uncertain as this book was goingto press, but some observers feared the recession might be deep. In some minds, thefinancial crisis raised the specter of the Great Depression of the 1930s, when in itsworst year one out of four Americans who wanted to work could not find a job.In 2008 and 2009, officials in the Treasury, Federal Reserve, and other parts of gov-ernment were acting vigorously to prevent a recurrence of that outcome.

Macroeconomic history is not a simple story, but it provides a rich motivationfor macroeconomic theory. While the basic principles of macroeconomics do notchange from decade to decade, the macroeconomist must apply these principleswith flexibility and creativity to meet changing circumstances.

4 | P A R T I Introduction

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The Historical Performance of the U.S. Economy

Economists use many types of data to measure the performance of an econo-my. Three macroeconomic variables are especially important: real gross domes-tic product (GDP), the inflation rate, and the unemployment rate. Real GDP

CASE STUDY


C H A P T E R 1 The Science of Macroeconomics | 5

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measures the total income of everyone in the economy (adjusted for the levelof prices). The inflation rate measures how fast prices are rising. The unem-ployment rate measures the fraction of the labor force that is out of work.Macroeconomists study how these variables are determined, why they changeover time, and how they interact with one another.

Figure 1-1 shows real GDP per person in the United States. Two aspects ofthis figure are noteworthy. First, real GDP grows over time. Real GDP per per-son today is about eight times higher than it was in 1900. This growth in aver-age income allows us to enjoy a much higher standard of living than ourgreat-grandparents did. Second, although real GDP rises in most years, thisgrowth is not steady. There are repeated periods during which real GDP falls,the most dramatic instance being the early 1930s. Such periods are calledrecessions if they are mild and depressions if they are more severe. Not sur-prisingly, periods of declining income are associated with substantial econom-ic hardship.

Real GDP per Person in the U.S. Economy Real GDP measures the totalincome of everyone in the economy, and real GDP per person measures theincome of the average person in the economy. This figure shows that realGDP per person tends to grow over time and that this normal growth issometimes interrupted by periods of declining income, called recessions or depressions.

Note: Real GDP is plotted here on a logarithmic scale. On such a scale, equal distances onthe vertical axis represent equal percentage changes. Thus, the distance between $4,000 and$8,000 (a 100 percent change) is the same as the distance between $8,000 and $16,000 (a100 percent change).Source: U.S. Department of Commerce and Economic History Services.

FIGURE 1-1

WorldWar I

GreatDepression

WorldWar II

KoreanWar

VietnamWar

First oil price shockSecond oil price shock

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

40,000

32,000

16,000

8,000

4,000

Year2000

Real GDP per person (2000 dollars)

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Figure 1-2 shows the U.S. inflation rate. You can see that inflation varies substan-tially over time. In the first half of the twentieth century, the inflation rate averagedonly slightly above zero. Periods of falling prices, called deflation, were almost ascommon as periods of rising prices. By contrast, inflation has been the norm dur-ing the past half century. Inflation became most severe during the late 1970s, whenprices rose at a rate of almost 10 percent per year. In recent years, the inflation ratehas been about 2 or 3 percent per year, indicating that prices have been fairly stable.

Figure 1-3 shows the U.S. unemployment rate. Notice that there is alwayssome unemployment in the economy. In addition, although the unemploymentrate has no long-term trend, it varies substantially from year to year. Recessionsand depressions are associated with unusually high unemployment. The highestrates of unemployment were reached during the Great Depression of the 1930s.

These three figures offer a glimpse at the history of the U.S. economy. In thechapters that follow, we first discuss how these variables are measured and thendevelop theories to explain how they behave. ■


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The Inflation Rate in the U.S. Economy The inflation rate measures the percent-age change in the average level of prices from the year before. When the inflationrate is above zero, prices are rising. When it is below zero, prices are falling. If theinflation rate declines but remains positive, prices are rising but at a slower rate.

Note: The inflation rate is measured here using the GDP deflator.Source: U.S. Department of Commerce and Economic History Services.

FIGURE 1-2

1900

30

25

20

15

10

5

0

−5

−10

−15

−20

Percent

Inflation

Deflation

1910

World War I

Great Depression

World War II

Korean War

Vietnam War

First oil price shock Second oil price shock

1920 1930 1940 Year

1950 1960 1970 1980 1990 2000

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How Economists Think

Economists often study politically charged issues, but they try to address theseissues with a scientist’s objectivity. Like any science, economics has its own set oftools—terminology, data, and a way of thinking—that can seem foreign andarcane to the layman. The best way to become familiar with these tools is to prac-tice using them, and this book affords you ample opportunity to do so. To makethese tools less forbidding, however, let’s discuss a few of them here.

Theory as Model Building

Young children learn much about the world around them by playing with toyversions of real objects. For instance, they often put together models of cars,trains, or planes. These models are far from realistic, but the model-builder

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The Unemployment Rate in the U.S. Economy The unemployment rate measuresthe percentage of people in the labor force who do not have jobs. This figure showsthat the economy always has some unemployment and that the amount fluctuatesfrom year to year.

Source: U.S. Department of Labor and U.S. Bureau of the Census (Historical Statistics of the United States:Colonial Times to 1970).

FIGURE 1-3

1900

25

20

15

10

5

0

Percent unemployed

1910

WorldWar I

GreatDepression

WorldWar II

KoreanWar

VietnamWar

First oil price shockSecond oil price shock

1920 1930 1940Year

1950 1960 1970 1980 1990 2000

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learns a lot from them nonetheless. The model illustrates the essence of the realobject it is designed to resemble. (In addition, for many children, buildingmodels is fun.)

Economists also use models to understand the world, but an economist’smodel is more likely to be made of symbols and equations than plastic andglue. Economists build their “toy economies” to help explain economic vari-ables, such as GDP, inflation, and unemployment. Economic models illustrate,often in mathematical terms, the relationships among the variables. Models are useful because they help us to dispense with irrelevant details and to focuson underlying connections. (In addition, for many economists, building mod-els is fun.)

Models have two kinds of variables: endogenous variables and exogenous vari-ables. Endogenous variables are those variables that a model tries to explain.Exogenous variables are those variables that a model takes as given. The pur-pose of a model is to show how the exogenous variables affect the endogenousvariables. In other words, as Figure 1-4 illustrates, exogenous variables come fromoutside the model and serve as the model’s input, whereas endogenous variablesare determined within the model and are the model’s output.

To make these ideas more concrete, let’s review the most celebrated of all eco-nomic models—the model of supply and demand. Imagine that an economistwanted to figure out what factors influence the price of pizza and the quantityof pizza sold. He or she would develop a model that described the behavior ofpizza buyers, the behavior of pizza sellers, and their interaction in the market forpizza. For example, the economist supposes that the quantity of pizza demandedby consumers Qd depends on the price of pizza P and on aggregate income Y.This relationship is expressed in the equation

Qd = D(P, Y ),

where D( ) represents the demand function. Similarly, the economist supposesthat the quantity of pizza supplied by pizzerias Q s depends on the price of pizza


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How Models Work Models are simplified theories that show the keyrelationships among economic variables. The exogenous variables arethose that come from outside the model. The endogenous variables arethose that the model explains. The model shows how changes in theexogenous variables affect the endogenous variables.

FIGURE 1-4

Endogenous VariablesModelExogenous Variables


P and on the price of materials Pm, such as cheese, tomatoes, flour, and anchovies.This relationship is expressed as

Qs = S(P, Pm),

where S( ) represents the supply function. Finally, the economist assumes that theprice of pizza adjusts to bring the quantity supplied and quantity demanded intobalance:

Qs = Qd.

These three equations compose a model of the market for pizza.The economist illustrates the model with a supply-and-demand diagram, as in

Figure 1-5. The demand curve shows the relationship between the quantity ofpizza demanded and the price of pizza, holding aggregate income constant. Thedemand curve slopes downward because a higher price of pizza encourages con-sumers to switch to other foods and buy less pizza. The supply curve shows therelationship between the quantity of pizza supplied and the price of pizza, holdingthe price of materials constant. The supply curve slopes upward because a higherprice of pizza makes selling pizza more profitable, which encourages pizzerias toproduce more of it. The equilibrium for the market is the price and quantity atwhich the supply and demand curves intersect. At the equilibrium price, con-sumers choose to buy the amount of pizza that pizzerias choose to produce.

This model of the pizza market has two exogenous variables and two endoge-nous variables. The exogenous variables are aggregate income and the price of


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FIGURE 1-5

Supply

Demand

Price of pizza, P

Quantity of pizza, Q

Equilibrium price

Equilibrium quantity

Marketequilibrium

The Model of Supply andDemand The most famouseconomic model is that ofsupply and demand for agood or service—in this case,pizza. The demand curve is adownward-sloping curverelating the price of pizza tothe quantity of pizza that con-sumers demand. The supplycurve is an upward-slopingcurve relating the price ofpizza to the quantity of pizzathat pizzerias supply. Theprice of pizza adjusts until thequantity supplied equals thequantity demanded. Thepoint where the two curvescross is the market equilibri-um, which shows the equilib-rium price of pizza and theequilibrium quantity of pizza.


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materials. The model does not attempt to explain them but instead takes them asgiven (perhaps to be explained by another model). The endogenous variables arethe price of pizza and the quantity of pizza exchanged. These are the variablesthat the model attempts to explain.

The model can be used to show how a change in one of the exogenous vari-ables affects both endogenous variables. For example, if aggregate incomeincreases, then the demand for pizza increases, as in panel (a) of Figure 1-6. Themodel shows that both the equilibrium price and the equilibrium quantity ofpizza rise. Similarly, if the price of materials increases, then the supply of pizzadecreases, as in panel (b) of Figure 1-6. The model shows that in this case the


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FIGURE 1-6

Price of pizza, P

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D1

Q1 Q2

P1

P2

S


S2

S1

Q1 Q2

P2

P1

D

Price of pizza, P


(a) A Shift in Demand

(b) A Shift in Supply

Changes in Equilibrium Inpanel (a), a rise in aggregateincome causes the demandfor pizza to increase: at anygiven price, consumers nowwant to buy more pizza. Thisis represented by a rightwardshift in the demand curvefrom D1 to D2. The marketmoves to the new intersec-tion of supply and demand.The equilibrium price risesfrom P1 to P2, and the equi-librium quantity of pizza risesfrom Q1 to Q2. In panel (b),a rise in the price of materi-als decreases the supply ofpizza: at any given price,pizzerias find that the sale ofpizza is less profitable andtherefore choose to produceless pizza. This is representedby a leftward shift in the sup-ply curve from S1 to S2. Themarket moves to the newintersection of supply anddemand. The equilibriumprice rises from P1 to P2, andthe equilibrium quantity fallsfrom Q1 to Q2.


equilibrium price of pizza rises and the equilibrium quantity of pizza falls. Thus,the model shows how changes either in aggregate income or in the price ofmaterials affect price and quantity in the market for pizza.

Like all models, this model of the pizza market makes simplifying assumptions.The model does not take into account, for example, that every pizzeria is in adifferent location. For each customer, one pizzeria is more convenient than theothers, and thus pizzerias have some ability to set their own prices. The modelassumes that there is a single price for pizza, but in fact there could be a differ-ent price at every pizzeria.

How should we react to the model’s lack of realism? Should we discard thesimple model of pizza supply and demand? Should we attempt to build a morecomplex model that allows for diverse pizza prices? The answers to these ques-tions depend on our purpose. If our goal is to explain how the price of cheeseaffects the average price of pizza and the amount of pizza sold, then the diversi-ty of pizza prices is probably not important. The simple model of the pizza mar-ket does a good job of addressing that issue. Yet if our goal is to explain whytowns with three pizzerias have lower pizza prices than towns with one pizzeria,the simple model is less useful.


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All economic models express relationships amongeconomic variables. Often, these relationships areexpressed as functions. A function is a mathemati-cal concept that shows how one variable dependson a set of other variables. For example, in themodel of the pizza market, we said that the quan-tity of pizza demanded depends on the price ofpizza and on aggregate income. To express this,we use functional notation to write

Qd = D(P, Y).

This equation says that the quantity of pizzademanded Qd is a function of the price of pizza Pand aggregate income Y. In functional notation,the variable preceding the parentheses denotesthe function. In this case, D( ) is the functionexpressing how the variables in parenthesesdetermine the quantity of pizza demanded.

If we knew more about the pizza market, wecould give a numerical formula for the quantityof pizza demanded. For example, we might beable to write

Qd = 60 − 10P + 2Y.

Using Functions to Express Relationships Among Variables

In this case, the demand function is

D(P, Y) = 60 − 10P + 2Y.

For any price of pizza and aggregate income, thisfunction gives the corresponding quantity ofpizza demanded. For example, if aggregateincome is $10 and the price of pizza is $2, thenthe quantity of pizza demanded is 60 pies; if theprice of pizza rises to $3, the quantity of pizzademanded falls to 50 pies.

Functional notation allows us to express thegeneral idea that variables are related, even whenwe do not have enough information to indicatethe precise numerical relationship. For example,we might know that the quantity of pizzademanded falls when the price rises from $2 to$3, but we might not know by how much it falls.In this case, functional notation is useful: as longas we know that a relationship among the vari-ables exists, we can express that relationshipusing functional notation.


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The art in economics is in judging when a simplifying assumption (such asassuming a single price of pizza) clarifies our thinking and when it misleads us.Simplification is a necessary part of building a useful model: any model con-structed to be completely realistic would be too complicated for anyone tounderstand. Yet models lead to incorrect conclusions if they assume away featuresof the economy that are crucial to the issue at hand. Economic modeling there-fore requires care and common sense.

The Use Of Multiple Models

Macroeconomists study many facets of the economy. For example, they examinethe role of saving in economic growth, the impact of minimum-wage laws onunemployment, the effect of inflation on interest rates, and the influence of tradepolicy on the trade balance and exchange rate.

Economists use models to address all of these issues, but no single model cananswer every question. Just as carpenters use different tools for different tasks,economists use different models to explain different economic phenomena. Stu-dents of macroeconomics, therefore, must keep in mind that there is no single“correct’’ model that is always applicable. Instead, there are many models, each ofwhich is useful for shedding light on a different facet of the economy. The fieldof macroeconomics is like a Swiss army knife—a set of complementary but dis-tinct tools that can be applied in different ways in different circumstances.

This book presents many different models that address different questions andmake different assumptions. Remember that a model is only as good as itsassumptions and that an assumption that is useful for some purposes may be mis-leading for others. When using a model to address a question, the economist mustkeep in mind the underlying assumptions and judge whether they are reasonablefor studying the matter at hand.

Prices: Flexible Versus Sticky

Throughout this book, one group of assumptions will prove especially important—those concerning the speed at which wages and prices adjust to changing eco-nomic conditions. Economists normally presume that the price of a good or aservice moves quickly to bring quantity supplied and quantity demanded into bal-ance. In other words, they assume that markets are normally in equilibrium, so theprice of any good or service is found where the supply and demand curves inter-sect. This assumption is called market clearing and is central to the model of thepizza market discussed earlier. For answering most questions, economists usemarket-clearing models.

Yet the assumption of continuous market clearing is not entirely realistic. Formarkets to clear continuously, prices must adjust instantly to changes in supplyand demand. In fact, many wages and prices adjust slowly. Labor contracts oftenset wages for up to three years. Many firms leave their product prices the samefor long periods of time—for example, magazine publishers typically change


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their newsstand prices only every three or four years. Although market-clearingmodels assume that all wages and prices are flexible, in the real world somewages and prices are sticky.

The apparent stickiness of prices does not make market-clearing models use-less. After all, prices are not stuck forever; eventually, they adjust to changes insupply and demand. Market-clearing models might not describe the economy atevery instant, but they do describe the equilibrium toward which the economygravitates. Therefore, most macroeconomists believe that price flexibility is agood assumption for studying long-run issues, such as the growth in real GDPthat we observe from decade to decade.

For studying short-run issues, such as year-to-year fluctuations in real GDPand unemployment, the assumption of price flexibility is less plausible. Overshort periods, many prices in the economy are fixed at predetermined levels.Therefore, most macroeconomists believe that price stickiness is a better assump-tion for studying the short-run behavior of the economy.

Microeconomic Thinking and Macroeconomic Models

Microeconomics is the study of how households and firms make decisions andhow these decisionmakers interact in the marketplace. A central principle ofmicroeconomics is that households and firms optimize—they do the best they canfor themselves given their objectives and the constraints they face. In microeco-nomic models, households choose their purchases to maximize their level of sat-isfaction, which economists call utility, and firms make production decisions tomaximize their profits.

Because economy-wide events arise from the interaction of many householdsand firms, macroeconomics and microeconomics are inextricably linked. Whenwe study the economy as a whole, we must consider the decisions of individualeconomic actors. For example, to understand what determines total consumerspending, we must think about a family deciding how much to spend today andhow much to save for the future. To understand what determines total investmentspending, we must think about a firm deciding whether to build a new factory.Because aggregate variables are the sum of the variables describing many indi-vidual decisions, macroeconomic theory rests on a microeconomic foundation.

Although microeconomic decisions underlie all economic models, in manymodels the optimizing behavior of households and firms is implicit rather thanexplicit. The model of the pizza market we discussed earlier is an example.Households’ decisions about how much pizza to buy underlie the demand forpizza, and pizzerias’ decisions about how much pizza to produce underlie thesupply of pizza. Presumably, households make their decisions to maximize utili-ty, and pizzerias make their decisions to maximize profit. Yet the model does notfocus on how these microeconomic decisions are made; instead, it leaves thesedecisions in the background. Similarly, although microeconomic decisionsunderlie macroeconomic phenomena, macroeconomic models do not necessar-ily focus on the optimizing behavior of households and firms, but instead some-times leave that behavior in the background.


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The winner of the Nobel Prize in economics isannounced every October. Many winners havebeen macroeconomists whose work we study inthis book. Here are a few of them, along withsome of their own words about how they chosetheir field of study:

Milton Friedman (Nobel 1976): “I graduated fromcollege in 1932, when the United States was at thebottom of the deepest depression in its historybefore or since. The dominant problem of the timewas economics. How to get out of the depression?How to reduce unemployment? What explained theparadox of great need on the one hand and unusedresources on the other? Under the circumstances,becoming an economist seemed more relevant tothe burning issues of the day than becoming anapplied mathematician or an actuary.”

James Tobin (Nobel 1981): “I was attracted tothe field for two reasons. One was that economictheory is a fascinating intellectual challenge, on theorder of mathematics or chess. I liked analytics andlogical argument. . . . The other reason was theobvious relevance of economics to understandingand perhaps overcoming the Great Depression.”

Franco Modigliani (Nobel 1985): “For awhile it wasthought that I should study medicine because myfather was a physician. . . . I went to the registrationwindow to sign up for medicine, but then I closedmy eyes and thought of blood! I got pale just think-ing about blood and decided under those condi-tions I had better keep away from medicine. . . .Casting about for something to do, I happened toget into some economics activities. I knew someGerman and was asked to translate from Germaninto Italian some articles for one of the trade associ-ations. Thus I began to be exposed to the economicproblems that were in the German literature.”

Robert Solow (Nobel 1987): “I came back [tocollege after being in the army] and, almost with-out thinking about it, signed up to finish myundergraduate degree as an economics major.The time was such that I had to make a decisionin a hurry. No doubt I acted as if I were maximiz-

Nobel Macroeconomistsing an infinite discounted sum of one-period util-ities, but you couldn’t prove it by me. To me itfelt as if I were saying to myself: ‘What the hell.’”

Robert Lucas (Nobel 1995): “In public school sci-ence was an unending and not very well organizedlist of things other people had discovered long ago.In college, I learned something about the processof scientific discovery, but what I learned did notattract me as a career possibility. . . . What I likedthinking about were politics and social issues.”

George Akerlof (Nobel 2001): “When I went toYale, I was convinced that I wanted to be either aneconomist or an historian. Really, for me it was adistinction without a difference. If I was going tobe an historian, then I would be an economic his-torian. And if I was to be an economist I wouldconsider history as the basis for my economics.”

Edward Prescott (Nobel 2004): “Through discus-sion with [my father], I learned a lot about the waybusinesses operated. This was one reason why Iliked my microeconomics course so much in myfirst year at Swarthmore College. The price theorythat I learned in that course rationalized what Ihad learned from him about the way businessesoperate. The other reason was the textbook usedin that course, Paul A. Samuelson’s Principles of Eco-nomics. I loved the way Samuelson laid out the the-ory in his textbook, so simply and clearly.”

Edmund Phelps (Nobel 2006): “Like most Ameri-cans entering college, I started at Amherst Collegewithout a predetermined course of study or withouteven a career goal. My tacit assumption was that Iwould drift into the world of business—of money,doing something terribly smart. In the first year,though, I was awestruck by Plato, Hume and James.I would probably have gone into philosophy were itnot that my father cajoled and pleaded with me totry a course in economics, which I did the secondyear. . . . I was hugely impressed to see that it waspossible to subject the events in those newspapers Ihad read about to a formal sort of analysis.”

If you want to learn more about the NobelPrize and its winners, go to www.nobelprize.org.1

1 The first five quotations are from William Breit and Barry T. Hirsch, eds., Lives of the Laureates,4th ed. (Cambridge, Mass.: MIT Press, 2004). The next two are from the Nobel Web site. The lastone is from Arnold Heertje, ed., The Makers of Modern Economics, Vol. II (Aldershot, U.K.: EdwardElgar Publishing, 1995).


How This Book Proceeds

This book has six parts. This chapter and the next make up Part One, the Intro-duction. Chapter 2 discusses how economists measure economic variables, suchas aggregate income, the inflation rate, and the unemployment rate.

Part Two, “Classical Theory: The Economy in the Long Run,” presents theclassical model of how the economy works. The key assumption of the classicalmodel is that prices are flexible. That is, with rare exceptions, the classical modelassumes that markets clear. Because the assumption of price flexibility describesthe economy only in the long run, classical theory is best suited for analyzing atime horizon of at least several years.

Part Three, “Growth Theory: The Economy in the Very Long Run,” builds onthe classical model. It maintains the assumptions of price flexibility and marketclearing but adds a new emphasis on growth in the capital stock, the labor force,and technological knowledge. Growth theory is designed to explain how theeconomy evolves over a period of several decades.

Part Four, “Business Cycle Theory: The Economy in the Short Run,” exam-ines the behavior of the economy when prices are sticky. Thenon-market-clearing model developed here is designed to analyze short-runissues, such as the reasons for economic fluctuations and the influence of gov-ernment policy on those fluctuations. It is best suited for analyzing the changesin the economy we observe from month to month or from year to year.

Part Five, “Macroeconomic Policy Debates,” builds on the previous analysis toconsider what role the government should have in the economy. It considershow, if at all, the government should respond to short-run fluctuations in realGDP and unemployment. It also examines the various views of how governmentdebt affects the economy.

Part Six, “More on the Microeconomics Behind Macroeconomics,” presentssome of the microeconomic models that are useful for analyzing macroeconom-ic issues. For example, it examines the household’s decisions regarding how muchto consume and how much money to hold and the firm’s decision regarding howmuch to invest. These individual decisions together form the larger macroeco-nomic picture. The goal of studying these microeconomic decisions in detail isto refine our understanding of the aggregate economy.

Summary

1. Macroeconomics is the study of the economy as a whole, including growthin incomes, changes in prices, and the rate of unemployment. Macroecono-mists attempt both to explain economic events and to devise policies toimprove economic performance.

2. To understand the economy, economists use models—theories that simplifyreality in order to reveal how exogenous variables influence endogenousvariables. The art in the science of economics is in judging whether a

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1. Explain the difference between macroeconomicsand microeconomics. How are these two fieldsrelated?

2. Why do economists build models?

K E Y C O N C E P T S

Macroeconomics

Real GDP

Inflation and deflation

Unemployment

Q U E S T I O N S F O R R E V I E W

Recession

Depression

Models

Endogenous variables

Exogenous variables

Market clearing

Flexible and sticky prices

Microeconomics

3. What is a market-clearing model? When is itappropriate to assume that markets clear?

model captures the important economic relationships for the matter athand. Because no single model can answer all questions, macroeconomistsuse different models to look at different issues.

3. A key feature of a macroeconomic model is whether it assumes that pricesare flexible or sticky. According to most macroeconomists, models withflexible prices describe the economy in the long run, whereas models withsticky prices offer a better description of the economy in the short run.

4. Microeconomics is the study of how firms and individuals make decisionsand how these decisionmakers interact. Because macroeconomic eventsarise from many microeconomic interactions, all macroeconomic modelsmust be consistent with microeconomic foundations, even if those founda-tions are only implicit.


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P R O B L E M S A N D A P P L I C A T I O N S

1. What macroeconomic issues have been in thenews lately?

2. What do you think are the defining characteris-tics of a science? Does the study of the economyhave these characteristics? Do you think macro-economics should be called a science? Why orwhy not?

3. Use the model of supply and demand to explainhow a fall in the price of frozen yogurt would

affect the price of ice cream and the quantity ofice cream sold. In your explanation, identify theexogenous and endogenous variables.

4. How often does the price you pay for a haircutchange? What does your answer imply about theusefulness of market-clearing models for analyz-ing the market for haircuts?


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