1

Chapter 1:
What this
Book is
About

1. Introduction
A Unified Approach to Macroeconomics
This book is about macroeconomics and the debates between economists who study
macroeconomics. The idea of distinguishing between macroeconomics and microeconomics did
not take shape until the 1930s, when John Maynard Keynes wrote The General Theory of
Employment Interest and Money. Keynes tried to explain the working of the economy as a
whole. He asked how employment related to prices, how prices and employment were influenced
by government policies, and, above all, what the government could do to maintain full
employment. Keynes used methods that were very different from those used by the
microeconomists of his day, and the novelty of his approach led to the development of two
separate subjects, macroeconomics and microeconomics, that remained disconnected for 30
years. More recently economists have recognized that the methods used to study the behavior of
individual producers and consumers in markets microeconomics can also be used to study the
working of the economy as a whole macroeconomics. This book explains the modern approach,
which treats macroeconomics and microeconomics as different parts of one subject using a single
method of analysis.

The Three Major Questions

The most important macroeconomic event in the twentieth century was the Great Depression.
The Depression affected the entire world economy, although its magnitude and timing differed
from country to country. In America the Depression began in 1930; in the course of three years
unemployment reached 25% of the labor force and the output produced by U.S. workers fell 20%
below trend. The economy did not recover from the Depression until 1941, when the United
States entered World War II. The Depression was an event of such importance in people's lives
that it shaped the way macroeconomists thought about their subject for the next 50 years. The
generation of economists who lived through this era became concerned with a single overriding
question: What causes economic booms and recessions? The study of this question is called the
economics of business cycles.
Understanding business cycles is still one of the most important goals of
macroeconomics. But although business cycles are important, they are not the most important
determinant of living standards. The quantity of goods and services produced by the residents of
a country is measured by its real Gross Domestic Product (real GDP). Although fluctuations in
real GDP are important, a more significant factor affecting economic welfare is the fact that
capitalist economies have been experiencing sustained growth in real GDP for the past two
hundred years. Recently economists have begun to see the Great Depression as a large fluctuation
in the growth rate and to search for a common explanation for business cycles and growth. The
theory of growth focuses on why economies produce more each year on average, whereas the
theory of business cycles is about why real GDP and employment fluctuate from year to year.
Figure 1.1
Real GDP per person 18902000
35
30
25

Question #1
What causes business
cycles?

20

Question #2
What causes economic
growth?

Thousands of 1996 dollars

The first two questions

adressed in this book
are these:

15
10

1900

1920

1940

1960

1980

Time
Real GDP per person
Trend in real GDP per person

2000

3
Figure 1.1 graphs real GDP per person in the United States from 1890 through 2000. 1
There are two features of this graph that you should notice. First, real GDP per person has
followed an upward trend since 1890, the first date for which we have reliable estimates. Second,
real GDP per person is subject to very big fluctuations around its long-run trend. These two
features define the first two questions that we are concerned with in this book.
The cause of inflation is the third question we will study. Inflation is the average rate of
increase of prices and sometimes, in some countries, inflation has reached astronomical
proportions. For example, at the end of World War I several European countries experienced
inflations of very high magnitudes called hyperinflations. Prices in Germany in 1923 increased
at a rate of 230% per month, which means that every day commodities cost 4% more than they
had the day before; 2 workers were forced to spend their pay the day they received it, before the
money became worthless. Episodes of hyperinflation are occasional features of economic life
today in a number of countries. Examples of countries that have experienced recent
hyperinflationary episodes include Israel, where prices increased 400% in 1985; Argentina,
where they went up by 700%, and Bolivia, where the annual price increase in 1984 was a
staggering 12,500%.

This graph shows the

average price of
commodities each year
since 1890. The blue
line represents the preWorld War II trend; the
red line represents the
post-World War II
trend. Notice how the
trend rate of inflation
has increased since
World War II.
Question #3
What causes inflation?

Price level as a percentage of

average price level in 1996

Figure 1.2
Prices in the United States since 1890
120
100
80

Korean
War

WWI

60

WWII

40

20

1900

1920

1940
Time

Pre WWII Trend

Post WWII Trend

Vietnam
War

1960

1980

2000

GDP Price Index

The scale of the vertical axis on Figure 1.1 measures GDP using logarithmic units and the horizontal axis measures
time. We call a graph of this form a logarithmic graph. Logarithmic graphs are a useful visual aid for understanding
the behavior of rapidly growing variables because they can be used to plot the variable of interest as a straight line.
The growth rate of a variable is the slope of this line.
2
Mathematical Note: To compute a daily rate from the monthly rate I used the formula (1+2.3)1/30 1 = 0.04.

4
Although we have not experienced hyperinflation in the United States, there have been
episodes of sustained inflation of a more moderate magnitude. For example, in the 1970s
inflation reached 12% and from 1973 through 1975 it stayed above 7% for three years in a row.
On average, inflation has been equal to 4.0% per year since 1946, a little higher than the prewar
rate of 1.7% per year.
Figure 1.2 shows the average price of goods and services in the United States for each
year since 1890 as a percentage of the average price level in 1996. The blue line on this figure
measures the prewar trend in the price level and the red line measures the postwar trend. The pre
and post war average inflation rates are equal to the slopes of these two lines. Notice that
inflation is higher, on average, after World War II. This is reflected in the fact that the red line is
steeper than the blue line. Because of inflation, a cup of coffee in a restaurant that cost 12 cents
in 1946 would cost $1.00 today. The third question that we will study in this book is: What
causes inflation? We will also ask how inflation is related to business cycles and growth.

2. Economic Growth
Economic growth is a sustained increase in a nations standard of living. It is measured by the
average rate of change of the real gross domestic product per person.

Sustained Economic Growth Is a Recent Phenomenon

The United States has been experiencing economic growth of about 1.9% per person for the last
hundred years, but this kind of sustained increase in living standards is a relatively recent
phenomenon in the span of human civilization. The collapse of the Roman Empire in the third
century A.D. was followed by a period of stagnation and decline in living standards that did not
Figure 1.3:
World leaders in output per worker since 1540
25
20
15

Output per Worker in 1985 Dollars

During the period from

1540 through 1810,
european countries
began to develop
capitalist institutions.
The Netherlands was
the most productive
country in the world.
From 1810 through
1880 the United
Kingdom was the
worlds most productive
economy. Since 1880
the United States has
been the world leader.

10
Netherlands Leads

UK Leads

US Leads

1600 1650 1700 1750 1800 1850 1900 1950

Netherlands

United Kingdom

United States

5
substantially improve again in the Western world until the beginnings of modern capitalism in
the eighteenth century. Since that time, real GDP per person in most capitalist countries has
grown at a rate of 1 to 2%.
The economic historian Angus Maddison has identified three periods in capitalist
development. 3 Maddison argues that the seeds of capitalism were sown in the fifteenth century
with the invention of moveable type and the advent of printing. The early sixteenth century
represents the beginning of a pre-capitalist period during which European countries began to
develop the modern institutions that are essential to the functioning of a market economy. It was
during this period that the standard of living in Europe first began to overtake that of China.
During the period from 1540 through 1810 the region that today consists of Belgium and the
Netherlands was the most technologically advanced country in the world. Around 1810, Great
Britain took over as the world's most productive economy and, in 1880, Britain itself was
overtaken by the United States. Today the United States enjoys the world's highest standard of
living. The relative productivity of these three economies is illustrated in Figure 1.3 which
graphs output per worker for the Netherlands, the United Kingdom and the United States.

Measuring Economic Growth

Economists measure the output available to an entire community with an index of the goods and
services produced called the real Gross Domestic Product (GDP). To measure the standard of
living in a country we divide real GDP by the number of people, to arrive at GDP per person.
Table 1.1: Standard of Living Indicators for Selected Countries

Per capita GNP,

1994

Per capita annual

consumption (Kg.),
1994

Per capita daily

intake

Population per
physician

Energy (Oil equivalent)

Calories

1988-91

243

2395

2439

India

Dollars of
equivalent
purchasing
power
1280

Japan

21140

3825

2921

610

USA

25880

7905

3642

420

Singapore

21900

6556

3121

725

South Korea

10330

3000

3298

1205

Mexico

7040

1577

3181

621

Russia

4610

4038

3380

210

China

2510

647

2729

730

Pakistan

2130

255

2316

2000

Source: The India Times. http://www.india-times.com/business/list52.html

Angus Maddison, Dynamic Forces in Capitalist Development, Oxford University Press, 1991.

6
Although GDP per person is an imperfect index of the standard of living of a community, it is
highly correlated with a number of other indices that have been proposed as measures of
economic well-being. Table 1.1 shows that countries with a high real GDP per person also
consume more energy and more food and have better access to physicians.
Although the use of per capita GDP as a measure of economic well-being is widespread it
has been criticized as imperfect since the changes in our living patterns that are associated with
growth are multidimensional. For example, increased production is often accompanied by
increased pollution or increased crime. Countries like Sweden and Denmark have a lower level
of real GDP per capita than the United States but they also have lower crime rates. 4 These
countries have a relatively equal distribution of income, paid for with high tax rates. In Denmark,
income tax rates are equal to 50% even for low earners and as high as 64% for those in top
brackets. This compares with 30% and 42% in the United States. 5
A single number that represents the quantities of commodities produced in two different
countries will miss differences in the quality of life that cannot be measured by market activity.
Some people would prefer to earn less money but live in an area, or a country, with other
attractions, for example, lower crime or more equality of incomes. For this reason, you should be
careful not to assume that because one country has a higher standard of living that its citizens are
better off in other dimensions.

Real and Nominal Gross Domestic Product

There are two measures of GDP, real and nominal. Nominal GDP measures the average dollar
value of the goods produced in any year, but it is not a good way to measure differences in the
average quantities of goods and services produced over time. Nominal GDP can go up from
year to year for either of two reasons. First, it may increase because a country produces more
goods and services; we call this increase growth. Second, it may increase because goods and
services cost more money on average; we call this increase inflation. To separate the increase in
GDP that comes from growth from the increase that comes from inflation, we measure the value
of GDP in two consecutive years using a common set of prices. These prices are the ones that
prevailed in one year, called the base year. GDP measured using current prices is called nominal
GDP and GDP measured using base year prices is called real GDP. Increases in living standards
are measured by changes in real GDP per person.

Comparing Economic Growth and Standards of Living across

Countries and Across Time
Just as real GDP per person can be used to make comparisons across time, it can also be used to
compare living standards across countries. The standard of living in most countries grows at a
rate of 1 to 2% per year, although the range of growth rates across countries varies from 1% in
some of the countries in sub-Saharan Africa to 7 or 8% in Japan, South Korea, and mainland
China. Cross-country differences in growth rates may seem like small numbers, but they can have
a very big impact on the standard of living because the increase each year is compounded.
4

According to official Danish statistics (available at http://www.dst.dk ) violent crimes in Denmark averaged 187 per
100,000 people in the 1990's whereas the FBI (data available at http://www.fbi.gov) reported violent crimes in the
United States at 611 per hundred thousand in 1998.
5
Source: Taxpayers association of Europe: http://www.taxpayers-europe.com

Figure
. 1.4:
GDP per Person as a Percentage of US GDP per Person in Four Selected Countries1
100
Percentage of U.S. GDP per person

Many countries grow at

about the same rate as the
United States, but the level
of GDP per person in these
countries is often much
lower. The United Kingdom
and India are examples of
countries in this group.
Other countries have
expereienced rapid growth
relative to the United
States, and their level of
GDP per person, relative to
the United States, has
increased substantially in
the past 30 years. Japan
and South Korea are
examples of countries in
this group.

80

60

40

20

0
50

55

60

65

70

75

80

85

90

Time
India
Japan

South Korea
United Kingdom

The data in Figure 1.4 are taken from the Penn World Table by Alan Heston and Robert Summers. The Heston-Summers
data is explicitly designed to make international comparisons of this kind by taking into account the cost of living in different
countries using a price index in each country for a comparable basket of commodities. At the time of writing, the most
recent revision of the Penn World Table included data through 1992 although by the time you read this book more recent
data should be available. The data is available at http://pwt.econ.upenn.edu

You are familiar with compound growth already if you have a bank account that earns
compound interest. To get a feel for the importance of compounding, consider the rule of
seventy, which can be used to gauge how fast a quantity will double in size. To use the rule of
seventy, take the growth rate of a variable that is experiencing compound growth and divide it
into 70. The result is (approximately) equal to the number of years it will take for that variable to
double. For example, suppose that you put $100 into a bank account that pays 5% annual interest.
In (70/5) = 14 years, you will have $200 in your account.
The effects of compound growth on the living standards of different countries is
illustrated in Figure 1.4, which compares the growth performance of the United Kingdom, India,
Japan, and South Korea to that of the United States over the period from 1960 to 1992. The
vertical axis of this graph measures GDP per person relative to GDP per person in the United
States; the horizontal axis measures time. Notice the tremendous differences in living standards
across the countries. The average American citizen earns 10 times as much as the average citizen
of India and a third as much again as a resident of the United Kingdom. This difference in living
standards has persisted over long periods of time for countries such as the United Kingdom and
India. Their position relative to the United States has not changed much in 30 years, and the
growth rate of per capita GDP has been (roughly) 2% per year in all three countries since 1960.

8
Using the rule of seventy, we can establish that the time needed for the standard of living to
double in any of these countries is 6
70
= 35 years.
2
Although many countries have grown at about 2% per capita, another group of countries
has grown at much faster rates since World War II. A leading example of this second group is
Japan, which increased its standard of living at an average rate of 5.5% per year between 1960
and 1992. When we apply the rule of seventy to Japan, it follows that the time it took for the
GDP per person to double in Japan was just
70
= 12.7 years.
55
.

The difference in the growth rate between the Japanese and the U.S. standard of living
may not seem very big, but small differences in growth rates have very big effects when
compounded over 30 years. In 1960 the average Japanese citizen earned just 20% of the income
of an average American; by 1990 this gap had narrowed to 80%. More recently, South Korea,
Taiwan, Hong Kong, and Singapore have all grown rapidly, and the quality of life of their
citizens has increased accordingly. The fastest growing country in the world during the 1990's
was China, where the GDP grew by more than 10% per year during the first half of the decade
and in some years it grew by as much as 14%. Although growth in China has since slowed to a
more leisurely 7%, China is still growing more than twice as fast as the United States.
In the 1990s the United States was the richest and most powerful country in the world but
this has not always been the case and it was only in the fifteenth century that Europe overtook
China as the world's most advanced civilization. The recent growth of China can be attributed to
Deng Xiaoping's program of reform, which opened up the Chinese economy to the outside world.
Since 1978, China's economic performance has brought about one of the biggest improvements
in human welfare anywhere at any time. If China meets its self-imposed targets, by 2002 its GDP
will have increased eightfold and, if China were to continue to grow at this rate, it would soon
overtake the United States as the world's richest economy.
The startling growth of Asian economies has not yet challenged the United States's
position because rapidly growing economies like China's and Japan's began from a much lower
base. But there is no reason to assume that the United States will always be the richest country in
the world. If a country can maintain even a small difference in its growth rate over a long period
of time, its standard of living will inevitably outstrip those of other nations. Economists are
interested in the reasons why economies grow at different rates and they are actively studying the
role of government policies in promoting the economic miracles of Japan, South Korea,
Singapore, Hong Kong, and China.

Mathematical Note: If 1 dollar is compounded at rate g it will be worth 1(1+g)n dollars n years later. To find out
when it has doubled set (1+g)n=2 and take natural logarithms: nln(1+g)=ln(2). Since ln(1+g) is approximately equal
to g for small g (i.e. g < 0.05) and since ln(2) = 0.693 is approximately equal to 0.7 we get that ng 0.7 where
means is approximately equal to. Hence n 100 (0.7)/g = 70/g, where the factor of 100 is necessary if we
express the growth rate g as a percentage.

3. The Business Cycle

The business cycle is an irregular, persistent fluctuation of real GDP around its trend growth rate
that is accompanied by highly coherent comovements in many other economic variables. Lets
look more closely at this definition by defining more precisely the terms economic variable,
persistent, coherent and comovement.

Measuring The Business Cycle

Macroeconomists measure the business cycle by first measuring the values of macroeconomic
variables. These are measurable quantities that record the values of economic concepts, such as
real GDP or unemployment, at different points in time. A collection of values of an economic
variable, recorded at regular intervals over a period of time, is called a time series. Business
cycles are irregular persistent movements in many different economic time series.
Some time series measure economic activity; others measure prices or trade statistics. The
most important measure of economic activity is real GDP since it is movements in GDP and its
relationships to other variables that defines the business cycle. When GDP is below trend for a
number of time periods in a row, we say the economy is in a contraction, or a recession. When
it is above trend for a number of time periods in a row, we say that the economy is in a boom or
an expansion.

35
30
25
20
15
10

40
20
0
-20
-40
1900

1920

1940

1960

1980

Time
Percentage deviation of real GDP
per person from trend (right scale)
Real GDP per person (right scale)

2000

Percentage deviation from trend

GDP per person

displays
apparently
randon
fluctuations
around a
constant trend.
Deviations of
GDP from trend
are highly
persistent; if GDP
is below trend
one year it is
likely to be below
trend in the
following year.
The tendency of
many series to
display similar
persistent
fluctuations is
called the
business cycle.

Thousands of 1996 Dollars

Figure 1.5
Random Fluctuations Around a Constant Trend

10

Trends and Cycles

Many of the time series that economists are interested in display upward trends. GDP, prices, and
consumption are examples of variables in this class. Other variables, such as interest rates and
unemployment, show no tendency to grow. In order to separate the relationship between the longrun trends in two or more time series from the relationship between their business-cycle
fluctuations, we need to define what we mean by trends and cycles. The process of separating the
observations on a single time series into two components, a trend and a cycle, is called
detrending a series.
Figure 1.5 illustrates the decomposition of GDP into trend and cycles that results from
detrending per capita GDP by drawing the best straight line through the points. This technique is
called linear detrending and is one of three popular methods of breaking a time series into trend
and cycles. (We examine two other methods in Chapter 3). Figure 1.5 shows GDP per capita (the
blue line) and the deviation of per capita GDP from its linear trend (the red line). Notice that the
red line is above zero when per capita GDP rises above its trend and below zero when GDP falls
below its trend.

Recessions, Expansions and the NBER

The National Bureau of Economic Research, an organization founded in 1920, dates recessions
and expansions. 7 The NBER is a private, nonprofit, nonpartisan research organization dedicated
to promoting a greater understanding of how the economy works. Many of the most influential
economists in North America are members of the NBER including 10 of the past 29 American
Nobel Laureates in economics and three of the past Chairmen of the President's Council of
Economic Advisors.

Percentage

Figure 1.6:
NBER Dating of Businss Cycles Since 1948
15
Figure 1.6 shows time
Shaded areas are NBER recessions
series for unemployment
10
and the deviation of GDP
from trend from 1948
through 2000. The shaded
5
areas are NBER
recessions; there have
been nine of these in the
0
post war period. The last
recession ended in March
of 1991 and since that date
-5
we have entered the
longest expansion ever
recorded since the NBER
-10
began dating cycles in
50 55 60 65 70 75 80 85
1854.
Time
GDP (deviation from trend)
Unemployment rate

You can find out more about the NBER at http://www.nber.org

90

95

11
Figure 1.6 plots unemployment and deviations of GDP from trend since the end of WWII.
The shaded areas on this graph represent recessions. These are determined by a group of
economists called the NBER Business Cycle Dating Committee. The NBER Business Cycle
Dating Committee defines a recession as a recurring period of decline in total output, income,
employment, and trade, usually lasting from six months to a year, and marked by widespread
contractions in many sectors of the economy. Sometimes growth may slow down, but GDP will
not decline. Periods like this are called growth recessions. Slowdowns also may occur without
recession, in which case the economy continues to grow, but at a pace significantly below its
long-run growth. A depression is a recession that is major in both scale and duration. 8

Coherence and the Business Cycle

When economists talk about business cycles, they are not referring to regular periodic motion of
the kind that occurs in physical systems. The business cycle is not a cycle in the same sense; it
has an important random component. But although economic variables move in an irregular way
through time, many of them move very closely together. This co-movement is called coherence.
Coherence is the relationship between variables that accounts for many of the important
characteristics of booms and recessions; when, for example, GDP is below trend, coherence
implies that unemployment is likely to be high and consumption is likely to be low.
Figure 1.7 illustrates the coherence between consumption and GDP per capita in panel A
and between unemployment and GDP per capita in panel B. In each case, the cycle in
Figure 1.7:
Procyclical and Countercyclical Variables
Panel B
40

30

30

20

20

Percent deviation from trend

Percent deviation from trend

Panel A
40

10
0
-10
-20
-30
-40
1900

1920

1940

1960

Time
Consumption

1980

2000

10
0
-10
-20
-30
-40
1900

1920

1940

1960

1980

2000

Time
GDP

Unemployment

GDP

Coherence is the tendency of two variables to move together over the business cycle. The cycle in
consumption moves with the cycle in GDP and is therefore procyclical. The cylcle in unemployment moves
against the cycle in GDP and is therefore countercyclical.

Further discussion of these concepts can be found in the NBER book, Business Cycles, Inflation and Forecasting,
2nd edition, by Geoffrey H. Moore, 1983, Ballinger Publishing Co., Cambridge, MA.

12
consumption, unemployment, and GDP has been constructed by removing a linear trend. The
cyclical component of consumption is plotted against the cyclical component of GDP per capita
in panel A, and the cyclical component of unemployment is plotted against the cyclical
component of GDP per capita in panel B. Variables like consumption that move in the same
direction as GDP over the cycle are said to be procyclical because they move with (pro) the
cycle. Unemployment, in panel B, is an example of a variable that tends to be high when GDP is
low. Variables like unemployment that move in the opposite direction to GDP over the cycle are
said to be countercyclical because they move against (counter to) the cycle.

Persistence and the Business Cycle

A second distinguishing feature of economic variables is their high degree of inertia through
time; a recession in one year is very likely to be followed by a recession in the following year.
The tendency of economic variables to display inertia is called persistence. Persistence provides
a degree of predictability to economic forecasting. Persistence and coherence together make up
the distinguishing characteristics of economic fluctuations that we refer to as business cycles. By
identifying the reasons for the coherence of a set of economic time series at a point in time and
for the persistence of each of these variables at different points in time, economists hope to be
able to explain why recessions occur and how they can be controlled.

The Social Dimension of Business Cycles

Although the economic dimension of the business cycle is important, there are many other social
indicators that have a business cycle dimension. Figure 1.8 illustrates the effect of the economy
on
Figure 1.8:
Why Business Cycles Matter
2

Normalized Units

This figure graphs violent

crime, poverty, the
unemployment rate and the
duration of unemployment
over the business cycle. In
1992, at the end of the last
recession, homicides were at
24 per 100,000, 14.8% of
Americans were below the
poverty line, 7.4% of the labor
force was unemployed and it
took 8.5 weeks to find a job.
By 1998 unemployment had
fallen to 4.5%, homicides
were down to 19 per 100,000,
the percentage of Americans
below the poverty line had
fallen to 12.7% and it took
only 6.5 weeks to find a job.

NBER
Recession

-1

-2
88

89

90

91

92

93

94

95

96

97

98

Homicides of 18 to 24 year olds

Percentage of Americans Below the Poverty Line
Unemployment rate
Duration of Unemployment

13
violent crime, poverty, the unemployment rate and unemployment duration. Crime is measured
by the number of homicides per 100,000 people among 18 to 24 year olds. This is the blue line
on the figure. The red line measures the percentage of Americans below the poverty line. The
green and black lines measure the unemployment rate and the number of weeks on average that
an unemployed person must spend looking for a job. The shaded area defines the last NBER
recession. Notice how all of these time series move with the business cycle. During expansions
there are fewer homicides, fewer Americans live in poverty, there is less unemployment and it
takes less time to find a job. For all these reasons, the study of business cycles is important since
by studying the causes of recessions economists hope to prevent them, or reduce their magnitude
and thereby to alleviate poverty and increase the welfare of the average citizen.

4. Inflation
Inflation is a sustained increase in the average price level, measured by the percentage rate of
change of one of several commonly used price indices.

Measuring Inflation
To measure inflation, we first must choose an index of the average price level. Several indices
are in common use. They differ according to the bundle of goods and services that they include:
1. The consumer price index (CPI) measures the average cost of a standard bundle of
consumer goods in a given year. The price of each good in the bundle is multiplied by a
fraction called its weight, and the weighted prices are added up to generate a single number,
called the consumer price index. For the CPI the weight of each good in the bundle is its
share in the budget of an average consumer.
2. The producer price index is also a weighted average, but the bundle of goods is selected
from an earlier stage in the manufacturing process. For example, the producer price index
includes the producer price of wheat and pork, as opposed to the consumer price of bread and
bacon.
3. The GDP deflator is the most comprehensive price index. It includes all of the goods and
services produced in the United States weighted by their relative values as a fraction of GDP.
4. The GDP price index is similar to the GDP deflator in that it includes all of the goods and
services produced in the United States. It differs from the GDP deflator in the way it weights
different commodities.
5. The PCE price index is like the GDP price index but it contains only consumer goods and
not producer goods. PCE stands for personal consumer expenditure.
In this book we typically refer to the rate of change of the GDP price index when we talk about
inflation. 9 The history of the GDP price index is graphed in Figure 1.9 as the red line and is
measured on the right axis. Figure 1.9 also illustrates the history of inflation. Inflation is related
to the GDP price index in the following way. When the GDP price index is higher in one year
9

Recently the Commerce Department has moved to the GDP price index as its price index of choice. There is now
updated data available on the GDP price index going back to 1929.

14
than in the previous year, inflation is positive; when the GDP price index is lower than in the
previous year, inflation is negative. Although inflation has been positive in every year since the
end of World War II, there have been significant episodes in U.S. history when the price level
fell. The Great Depression is the most striking example although there have been other
deflationary episodes, such as at the end of the nineteenth century and in 1920, when prices fell
by 20% in a single year. A negative inflation rate (a fall in prices like the one that occurred in
1920) is called deflation.

120
100
80
60
40

Percent per year

This figure illustrates

how inflation is
related to the GDP
price index. The
price index is
graphed in red and
measured, on the
right scale, as a
percentage of the
average price level in
1996. Inflation,
graphed in blue, is
the annual
percentage rate of
change of the price
index and is
measured in units of
percent per year on
the left scale.

30

20

20

10

Percentage of 1996 price

Figure 1.9:
Inflation and the Price Index

0
-10
-20
-30
1900

1920

1940

1960

1980

2000

Time
Inflation (left scale)

GDP price index (right scale)

Inflation and the Central Bank

It is widely accepted that inflation is caused when a country increases its money supply faster
than the rate of increase of money demand. Since the quantity of money in a country is
controlled by its central bank, the control of inflation is generally accepted to be a problem for
the central bank. In the United States the central bank is the Federal Reserve system, in the
European Union it is the European Central Bank and in most other countries there is an
equivalent national central bank that has more or less power depending on the particular political
system. Some central banks like the Federal Reserve System try to influence not only inflation
but also unemployment. Other central banks, such as those of Sweden, the United Kingdom,
New Zealand and Canada try to target the inflation rate over the medium term and they do not
attempt to influence employment or growth over the business cycle.

The Benefits of Low Inflation

15
Inflation goes hand in hand with price volatility. When inflation is low most prices do not
change very often and households and firms can easily estimate future relative prices. But in
times of moderate or high inflation not all prices change at the same rate. When the general level
of prices is comparatively stable, decision makers can interpret changes in dollar prices as
accurate signals on which to base decisions. In free economies, clear, reliable signals from prices
help people make the choices that are best for them. And, the best way to keep price signals clear
is to keep inflation low and, in principle, eliminate it. 10
The problems of high and volatile prices is worse for high rates of inflation than for low
rates. As inflation increases, prices also begin to fluctuate more and the price system begins to
function less accurately. Prices convey less information. For very high inflation rates the
problem is so bad that some markets break down completely. In hyperinflations there is typically
very high unemployment and very little output is produced as firms and households spend all
their time trying to buy and sell goods and services by barter (the process of trading one good for
another without using money).
In order to lower the inflation rate (a policy of lowering the inflation rate is called a
disinflationary), the central bank must raise the interest rate. A higher interest rate causes
inflation to decrease by reducing aggregate demand for goods and services. But it has the
unpleasant side effect of increasing unemployment and slowing the growth rate of real GDP. If
the central bank does not raise the interest rate when signs of inflation appear, the problem may
become worse and a low to moderate inflation may develop into a medium to high inflation or
even into a hyperinflation. The process of removing inflation from the economy causes a loss in
output and the output loss is higher, the higher is inflation. For this reason, central banks
throughout the world are committed to sustaining a low and stable rate of inflation by preventing
inflation from occurring at an early stage.

5. Economic Theory and Economic Facts

Economic theory does not develop in a vacuum, instead, new economic theories are driven by the
inadequacy of existing theories to understand contemporary problems. This book will trace the
development of modern macroeconomic theory by placing it in historical context.

Classical Economics and the Quantity Theory of Money

Our study begins with the classical economists from Adam Smith in the eighteenth century
through Jevons and Walras in the late nineteenth. These economists were concerned with the
functioning of the price system and their theories are embodied in the familiar ideas of supply
and demand. To the extent that macroeconomics existed as a separate subject it was concerned
mainly with understanding inflation and its relationship to the monetary system of the day.
Microeconomics provided an understanding of the determination of the level of GDP, through
the theory of the laws of supply and demand, and monetary theory in the form of the Quantity
Theory of Money, provided an explanation of inflation and the general level of prices. The
classical explanation of output and inflation is explained in chapters 4, 5 and 6.

10

For an excellent discussion of the benefits of low inflation, see the speech by Thomas C. Melzer, President, of the
Federal Reserve Bank of St. Louis. http://www.stls.frb.org/general/speeches/971028.html

16

Involuntary Unemployment and the Great Depression

Macroeconomics as a separate subject grew up after the Great Depression that began in the
United States in 1929 and lasted until 1941 when the U.S. entered the Second World War.
Because contemporary theory could not provide an adequate explanation for the Great
Depression, Keynes developed the concept of involuntary unemployment and it was his book, the
General Theory of Employment Interest and Money, that marks the beginning of a separate
discipline of macroeconomics.
Keynes was mainly concerned with trying to explain sustained high levels of
unemployment and, as a consequence, the method he developed was static. He thought of the
economy as a sequence of snapshots each of which represented an equilibrium, or rest point, of
the economy. Because he was primarily concerned with unemployment, the methods developed
by Keynes were not well suited to understanding growth or inflation.
In the 1960's economists began to struggle with the problem of understanding
unemployment and inflation with a single theory and it was realized that the Keynesian model
was incomplete. The Nobel Prize winner Milton Friedman posed the problem starkly by pointing
out that the Keynesian model could either explain the price level for a given level of output, or it
could determine output for a given price level. The model could not explain both the price level
and GDP. Friedman called this the problem of the missing equation. A search for Friedman's
missing equation caused economists to synthesize the classical ideas of Smith through Jevons
with the theories of Keynes. According to this synthesis, explained in chapters 7 though 11, the
classical theory applies in the long run but the Keynesian theory applies over shorter periods.

Postwar Macroeconomics and the Phillips Curve

Soon after Friedman raised the issue of the missing equation, New Zealand economist, A. W.
Phillips, noticed that in more than a century of data from the U.K. there had existed a remarkably
stable relationship between inflation and unemployment. When unemployment was high, money
wages tended to fall and when unemployment was low, they rose. The relationship between
inflation and unemployment is called the Phillips curve and soon after its discovery the Phillips
curve became accepted as a fact to be explained by economic theory. The Phillips curve was
adopted by contemporary macroeconomists as the missing equation that could complete the
Keynesian system and allow it to explain both output and employment.
Although there appeared to have been a stable Phillips curve since 1880, not all
economists were happy with the theoretical explanations that were offered for its existence. In
two separate articles, Milton Friedman and Edmund Phelps pointed out that even if one observed
that historically high inflation had accompanied low unemployment, one should not expect that a
relationship of this kind should be sustainable over long periods of time.
The Phelps-Friedman theory was called the natural rate hypothesis because they argued
that the unemployment rate should be determined by the factors that determine the supply and
demand for labor. They called the unemployment rate natural because they did not believe that
it should be something that could be influenced by monetary policy. The central bank could not
choose to lower the unemployment rate by increasing inflation as some economists has
previously argued might be possible.

17

Rational Expectations and Modern Dynamic Theory

The Phelps-Friedman theory was put to the test in the late 1970's and early 80's as the U.S.
economy experienced a period of high unemployment and high inflation at the same time. The
Phillips curve, that had been stable for over a hundred years, no longer seemed to apply. Phelps
and Friedman argued that inflation would be associated with lower unemployment only if the
inflation was unanticipated and their argument brought the idea of expectations into the forefront
of modern business cycle theory.
Initially, economists modeled inflation by assuming that households and firms used
mechanical rules to forecast the future, but this explanation was soon found lacking. It was
replaced by the theory of rational expectations, championed by Robert E. Lucas Jr., according to
which households and firms use all available information to form the best possible predictions of
future prices. In 1995 Lucas was awarded the Nobel Prize for his work on rational expectations
and his ideas now form a central part of the modern theory of inflation and unemployment that
we explain in chapters 15 and 16.

The Resurgence of Growth Theory

As economists began to concentrate on the relationship of unemployment to inflation, they also
became concerned with understanding economic growth. Once again, economic events were
responsible for a shift in emphasis in economic theory since in the post war period the high
unemployment that had concerned an earlier generation of economists receded into the past.
Since
the Second World War, unemployment has never exceeded ten percent and the business cycle
has been less of a problem than in previous decades.
Some economists have argued that business cycles are less of a problem than previously
because governments have learned to control them although it is possible that we have just been
lucky and that a major depression could reoccur. But for whatever reason, modern experience has
caused us to turn attention to the question of why some countries such as Japan, Singapore,
Taiwan and, more recently, China have grown so much faster than others. We study these
questions in chapters 12 through 14 in which we introduce the methods necessary to understand
not only growth but also the modern approach to business cycles and inflation.

6. Conclusion
Three main issues are addressed in this book: What determines economic growth? What are the
causes of business cycles? and What determines inflation? Economic growth is a sustained
increase in a nations standard of living. Business cycles are irregular, persistent fluctuations of
real GDP around its trend growth rate, accompanied by highly correlated comovements in many
other economic variables. Inflation is the rate of change of the average level of prices.
Economic growth is important because small difference in the growth rate can have very
big differences in the standard of living when growth is compounded over several years.
Business cycles are important because, during recessions, unemployment increases and there are
associated increases in a variety of social problems such as homicides and poverty. It is
important to avoid inflation because high inflation is associated with loss of output and

18
associated social problems. In practice, central banks usually act to remove inflation before it
reaches this stage but the policies required to do this may generate a recession.
Although the economics of growth, business cycles, and inflation are separate topics, the
factors that cause one are related to the factors that cause the others. Economic theory has
evolved in response to historical events and this book introduces ideas in historical context and
explains how they evolved and why they are important.

7. KEY TERMS
Base Year
Boom (Expansion)
Business Cycles.
Coherence
Consumer Price Index (CPI)
Contraction (Recession)
Countercyclical
Deflation
Detrending a Series
Difference Equation
Disinflation
Economic Model
Gross Domestic Product (GDP)
GDP Deflator
GDP Price Index
Growth
Hyperinflation
Inflation
Linear detrending
Macroeconomics
Microeconomics
Nominal GDP
Persistence
Personal Consumer Expenditure Price Index (PCE)
Procyclical Producer price index
Real GDP
Rule of seventy
Standard of living
Time series
Variable
Weighted average