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Introduction to Macroeconomics

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Mike Fair

on 10 October 2014

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Transcript of Introduction to Macroeconomics

Chapter 23
Introduction to Macroeconomics
D. Macroeconomic models also clarify many important questions about the powers and limits of
government and economic policy. These include:

C. Inflation
is an
increase in the overall level of prices.
This is troublesome because it reduces the standard of living and reduces the purchasing power of incomes and savings.

Demand Pull Inflation
. Performance and Policy
Learning Objectives
How macroeconomics studies both long-run economic growth and short-run fluctuations in
output and unemployment.

Why economists focus on GDP, inflation, and unemployment when assessing the health of
an entire economy

That sustained increases in living standards are a historically recent phenomenon.
. Why saving and investment are key factors in promoting rising living standards.
Why economists believe that “shocks” and “sticky prices” are responsible for short-run
fluctuations in output and employment.

. Gross Domestic Product
1. Real GDP measures the value of final goods and services produced within the borders of
a country during a specific period of time, typically a year.

2. Nominal GDP measures the dollar value of all goods and services produced within the borders of a country, using their current prices during the year that they were produced.

3. Nominal GDP captures both changes in output and changes in prices over time. Thus, nominal GDP may increase without any change (or even with a decrease) in real economic activity.

4. Real GDP is the appropriate measure to determine changes in economic activity across time, because it statistically removes the effects of price changes; changes in real GDP only reflect actual changes in output.

is the state a person is in if he or she cannot get a job despite being
willing to
work and actively seeking work.
High rates of unemployment are undesirable because they
indicate that the nation is not using a large fraction of its most important resource—the
talents and skills of its people.

1. Can governments promote long-run economic growth?
2. Can governments reduce the severity of recessions by
smoothing out short-run fluctuations?

3. Are certain government policy tools more effective than others at mitigating short-run fluctuations?

4. Is there a trade-off between lower rates of unemployment and higher rates of inflation?
5. Does government policy work best when it is announced in advance or when it is a surprise?

III. The Miracle of Modern Economic Growth
A. Rapid and sustained economic growth is a modern phenomenon. Before the industrial
revolution began in the late 1700s in England,
standards of living showed virtually no growth over hundreds or even thousands of years.
While output did increase, the population increased at virtually the same rate, leaving the output per person and standard of living stagnant.

B. The
industrial revolution
ushered in factory production and automation, along with massive increases in research and development, so that new and better technologies were constantly being invented. This
resulted in modern economic growth, or sustained increases in output
per person
higher living standards

C. The vast
differences in living standards
seen today between rich and poor countries are almost entirely the
result of the fact that only some countries have experienced modern economic growth.

To make international comparisons of living standards, three adjustments must be made
1. Convert each country’s GDP from its own currency into United States dollars.
2. Divide each country’s GDP by the size
of its population.
3. Adjust per capita GDP for purchasing power parity, because some goods are typically cheaper in poor countries.

IV. Saving, Investment, and Choosing Present and Future Consumption
. At the heart of economic growth is the principle that in order to raise living standards over time, an economy
must devote at least some fraction of its current output to increasing future output.
This process
requires both saving and investment.

Saving occurs when current consumption is less than current output
(or when current spending is less than current income). Households must make a trade-off between consumption and saving; therefore, increased saving can only come at the expense of current consumption.

2. Investment happens when resources are devoted to increasing future output.
Financial investment
captures what ordinary people mean when they say investment, namely the
purchase of assets like stocks, bonds, or real estate
in the hope of reaping a financial gain.

Economic investment
only includes money spent purchasing
newly-created capital goods
, such as machinery, tools, factories, and warehouses. This is what economists mean when they refer to investment.

are the principal source of
, while
are the main

Financial institutions
collect savings from households and lend these funds to businesses.
are fundamentally
linked together

for future production
can only increase if saving increases
; therefore, investment is ultimately
limited by the amount of saving.

V. Uncertainty, Expectations, and Shocks
.Decisions about saving and investment are complicatedby the fact that the
future is uncertain
. Macroeconomics has to take into account expectations about the future.

Changing expectations can affect current behavior
. If businesses become
about the future of the economy, they may
reduce investment
today. Less current investment means less future consumption.

Firms are also forced to cope with shocks
—situations in which they were expecting one
thing to happen, but something else happened. If a firm expected to make a handsome
profit on a new investment, but consumers had no demand for the product, the firm must
decide how to cope with the unexpected result.

The economy is exposed to both demand shocks and supply shocks.

Demand shocks
are unexpected changes in the demand for goods and services, while
supply shocks
are unexpected changes in the supply of goods and services.
Shocks can be positive or negative

Economists believe that
most short-run fluctuations in GDP are the result of demand
How these demand shocks affect the economy depends on how prices adjust.


If prices are flexible and adjust quickly
, a
demand shock implies that only prices will change

. If prices are “
” and
adjust slowly
, a
demand shock will change output and employment

Consider This … The Great Recession
. In 2008, a serious financial crisis led to the worst recession since the Great Depression.

As product demand significantly decreased, prices only slightly decreased; therefore,
the recession primarily affected output and employment. Output fell by 2.7 percent
in 2009, and the unemployment rate rose to more than 10 percent.

Firms attempt to deal with unexpected shocks by maintaining an inventory,
output that has been produced but has not yet been sold. As a result, the firm can
respond to sharp increases in demand by selling its inventory, and then rebuild its
inventory when demand decreases
. But if the firm experiences a
sustained decrease in demand, it will eventually have to reduce production;
unsold inventory incurs costs but no revenues.

VI. How Sticky Are Prices?
A. I
nflexible or “sticky” prices
help explain how unexpected changes in demand lead to the fluctuations in GDP and employment that occur over the business cycle.

While some products like stocks and commodities can change prices within minutes, the average good or service goes 4.3 months between price changes

Prices tend to be “sticky” because consumers prefer stable, predictable price
s and because
firms fear their rivals will match price cuts, reducing their profits.

VII. Categorizing Macroeconomic Models Using Price Stickiness
Price “stickiness” can play a large role in short-run economic fluctuations.
Price “stickiness” moderates over time;
firms that use a fixed-price policy in the short run do
not have to stick with that policy permanently. If demand changes begin to look permanent,
firms may lower their prices in order to reduce the amount by which they must reduce output
and employment.

This realization is very useful in categorizing and understanding the
differences between various macroeconomic models.

1. The
aggregate expenditures model
assumes prices and wages are permanently inflexible
The aggregate supply
– aggregate demand model assumes flexible prices, but restricts wage adjustments, which will provide us with the intermediate-run aggregate supply

3. The
long-run aggregate supply schedule
illustrates what happens when all wages and prices are able to adjust.

All three
models are important to understand what happens in the economy in different periods of time after an unexpected supply or demand shock.

Inventory Management and the Business Cycle
Before computers
, firms only counted inventory a few times a year.

-Unexpected shifts indemand could cause large changes in inventory before the firms realized what happened.

- Firms would then sharply increase or reduce output and employment in response to the change in demand, causing
large fluctuations in the economy.

Computerized inventory tracking systems
allow firms to
follow inventories in real time
, so they can make subtle, immediate changes in output and employment.

- Before the Great Recession of 2007-2009, many economists believed this change in inventory tracking had
moderated business cycles.

C. S
ome argue
that the i
nventory tracking systems may have actually contributed to the steep decline in the economy during the Great Recession.

-Because firms were immediately aware of the severity of the demand shock, they quickly reduced output and employment, further deepening the recession.

-Result: the Great Recession was longer and deeper than it
might otherwise have been without such immediate access to data.

The End....

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