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CHAPTER 1
Introduction to Macroeconomics

Textbook: Mankiw, N. Gregory -

Macroeconomics

Greg Mankiw

Learning objectives

This chapter introduces you to

• The issues Macroeconomists study
• The tools Macroeconomists use
• Some important concepts in
Macroeconomic analysis

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Macroeconomics vs Microeconomics

What is macroeconomics?
Microeconomics
’That branch of economics that deals with small-scale
economic factors; the economics of the individual firm,
product, consumer, etc., rather than the aggregate of such
individuals’
Macroeconomics
‘The branch of economics that deals with large-scale
economic factors; the economics of a national economy as
a whole.’
(both from Oxford English
Dictionary)

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Macroeconomics vs. Microeconomics

Microeconomics
Decisions of individual units
• No matter how large
• Example: GE’s pricing policy
Macroeconomics
Behavior of entire economies
• No matter how small
• Example: inflation in Monaco
Economic aggregates: aggregate output, inflation,
unemployment, …

Macroeconomics & Microeconomics

Macroeconomics
Assume most details
• Resource allocation & income distribution
Microeconomics
Ignore macroeconomics issues
Focus – individual markets
• Allocate resources
• Distribute income

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What Macroeconomics is About

Macroeconomics is the study of the structure and

performance of national economies and of the policies
that governments use to try to affect economic
performance.

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Macroeconomics & Aggregation

Aggregation
Combine many individual markets into one overall market
Why can we aggregate?
Composition of demand & supply
• In various markets
• Important for microeconomics issues
• Not important for macroeconomics issues
During economic fluctuations, markets move up or down
together

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Aggregation
Macroeconomists ignore distinctions between individual
product markets and focus on national totals.
The process of summing individual economic variables to
obtain economywide totals is called aggregation.

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Supply & Demand in Macroeconomics

Aggregate demand (AD) curve
Quantity of domestic product – demanded
Each possible value of price level
Aggregate supply (AS) curve
Quantity of domestic product – supplied
Each possible value of price level

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Figure 1
Two interpretations of a shift in the demand curve

AD1
AS AS
AD AD0
Price
Price

A
P1
E E
P0 P0

AS AS
AD1
AD AD0
0 Q0 0

Quantity Quantity

(a) (b) 14

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Supply & Demand in Macroeconomics

Inflation
Sustained increase in price level
Outward shift of aggregate demand curve
Recession – period of time
Total output – declines
• Production falls
• People lose jobs
Inward shift of aggregate demand curve

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Figure 2
An economy slipping into a recession
AD0 AS

AD2
E
P0
Price Level

B
P2

AS AD0
AD2
0 Q2 Q0

Domestic Product
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Supply & Demand in Macroeconomics

Macroeconomists study
Inflation
Recession & unemployment (Business Cycles)
Economic growth

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Figure 3
Economic growth
AD1
AS0 AS1
AD0

C
Price Level

AD1

AS0 AS1 AD0

0 Q0 Q1

Domestic Product
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Important Issues in Macroeconomics

Macroeconomics, the study of the economy as

a whole, addresses many topical issues:
- Why does the cost of living keep rising?
- Why are millions of people unemployed,
even when the economy is booming?
- What causes recessions?

- Can the government do anything to combat

recessions? Should it?

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Important Issues in Macroeconomics

Macroeconomics, the study of the economy as

a whole, addresses many topical issues:
- What is the government budget deficit?
- How does it affect the economy?
- Why does the U.S. have such a huge trade deficit?
- Why are so many countries poor? What policies might
help them grow out of poverty?

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What Macroeconomists Study

• Real GDP – The total income of everyone in the

economy (adjusted for price level).

• Inflation Rate – How fast prices are rising.

• Unemployment Rate – The fraction of labor force that

is out of work.

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Business Cycles

Business cycles are short-run contractions and

expansions of economic activity.

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Economic Growth and Fluctuations

Figure shows the long-term growth trend and cycles.

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Recessions
• Recession is the downward phase of a
business cycle when national output is
falling or growing slowly.
– Hard times for many people
– A major political concern

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Unemployment
• Recessions are usually accompanied
by high unemployment: the number of
people who are available for work and
are actively seeking it but cannot find
jobs.

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Inflation

• When prices of most goods and

services are rising over time it is
inflation. When they are falling it is
deflation.
• The inflation rate is the percentage
increase in the average level of prices.

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Effects of Inflation
• When the inflation rate reaches an
extremely high level the economy tends to
function poorly.
• The purchasing power of money erodes
quickly, which forces people to spend their
money as soon as they receive it.

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Budget Deficits
• The economy is affected when there are
large budget deficits: the excess of
government spending over tax collection.

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The International Economy

• An economy which has extensive trading
and financial relationships with other
national economies is an open economy.
An economy with no relationships is a
closed economy.

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The International Economy

(continued)
• International trade and borrowing
relationships can transmit business cycles
from country to country.

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Exports and Imports

• Exports are goods and services produced
in the country and consumed abroad.
• Imports are goods and services produced
abroad and consumed in the country .

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Trade Imbalances

• Trade imbalances (trade surplus and

deficit) affect output and employment.
– Trade surplus: exports exceed imports.
– Trade deficit: imports exceed exports.

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The Exchange Rate

• The trade balance is affected by the
exchange rate: the amount of Canadian
dollars that can be purchased with a unit
of foreign currency.

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Why learn macroeconomics?

1. The macroeconomy affects society’s well-
being.
§ example: Unemployment and social problems
Each one-point increase in the u-rate is associated
with:
§ 920 more suicides
§ 650 more homicides
§ 4000 more people admitted to state mental
institutions
§ 3300 more people sent to state prisons
§ 37,000 more deaths
§ increases in domestic violence and homelessness

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Why learn macroeconomics?

2. The Macroeconomy affects your well-
being.
Macroeconomics looks at fiscal and monetary
policies and their aggregate effects, while wellbeing
looks at outcomes such as income, life expectancy
and sustainability.

Income allows people to satisfy their needs and

pursue many other goals that they deem important
to their lives.

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How Economists Think

Economic Models
…are simplified versions of a more complex reality
• irrelevant details are stripped away
…are used to
• show relationships between variables
• explain the economy’s behavior
• devise policies to improve economic performance

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Building a macro model

Microeconomics is concerned with individual agents and

markets
Macroeconomics is concerned with the aggregate
implications of microeconomics
i.e. macroeconomic outcomes (GDP, unemployment
inflation) are the result of microeconomic actions.

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Theory as Model Building:

Supply & demand for new cars
ž shows how various events affect price and quantity
of cars
ž assumes the market is competitive: each buyer and
seller is too small to affect the market price
ž Variables:
Q d = quantity of cars that buyers demand
Q s = quantity that producers supply
P = price of new cars
Y = aggregate income
P s = price of steel (an input)

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The demand for cars

demand equation: Q d = D (P, Y)

shows that the quantity of cars consumers demand is
related
to the price of cars (P) and
aggregate income (Y)

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Digression: functional notation

General functional notation

shows only that the variables are related.
Q d = D (P, Y)
A specific functional form shows
the precise quantitative relationship.
AExample:
list of the
variables
that affect Q d

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The market for cars: Demand

P
Price
of cars

The demand curve

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

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The market for cars: Supply

P
Price
of cars S

The supply curve

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

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The market for cars: Equilibrium

P
Price
of cars S

equilibrium
price
D
Q
Quantity
of cars
equilibrium
quantity
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The effects of an increase in income

P
Price
of cars S

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

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The effects of a steel price increase

P
S2
Price
of cars S1

An increase in Ps
reduces the quantity of P2
cars producers supply P1
at each price…
D
…which increases the Q
Q2 Q1 Quantity
market price and
reduces the quantity. of cars

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Endogenous vs. Exogenous Variables

The values of endogenous variables are determined in

the model.
The values of exogenous variables are determined
outside the model: the model takes their values &
behavior as given.
In the model of supply & demand for cars,

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A Multitude of Models

No one model can address all the issues we care

about.
e.g., our supply-demand model of the car market…
can tell us how a fall in aggregate income affects price
and quantity of cars.
cannot tell us why aggregate income falls.

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A Multitude of Models

So we will learn different models for studying different

issues (e.g., unemployment, inflation, long-run
growth).
For each new model, you should keep track of:
- assumptions
- which variables are endogenous, and which are
exogenous
- the questions it can help us understand, and those it
cannot

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Macroeconomic Policy

A nation’s economic performance depends on:

- natural and human resources;
- capital stock;
- technology
- economic choices made by citizens;
- macroeconomic policies of the government.

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Macroeconomic Policy (continued)

Macroeconomic policies:
Fiscal policy: government spending and taxation at
different government levels.
Monetary policy: the central bank’s control of short-term
interest rates and the money supply.

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Macroeconomic research: The Classical

Approach

The invisible hand of Economics: General welfare

will be maximized (not the distribution of
wealth) if:
there are free markets;
individuals act in their own best interest.

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The Classical Approach (continued)

To maintain markets’ equilibrium – the quantities

demanded and supplied are equal:
Markets must function without impediments.
Wages and prices should be flexible.

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The Classical Approach (continued)

Thus, according to the classical approach, the

government should have a limited role in the
economy.

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The Keynesian Approach

Keynes (1936) assumed that wages and prices

adjust slowly.
Thus, markets could be out of equilibrium for long
periods of time and unemployment can persist.

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The Keynesian Approach (continued)

Therefore, according to the Keynesian approach,

governments can take actions to alleviate
unemployment.

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The Keynesian Approach (continued)

The government can purchase goods and services,

thus increasing the demand for output and reducing
unemployment.
Newly generated incomes would be spent and would
raise employment even further.

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Chapter summary

1. Macroeconomics is the study of the economy

as a whole, including
• growth in incomes

• changes in the overall level of prices

• the unemployment rate

2. Macroeconomists attempt to explain the

economy and to devise policies to improve
its performance.

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Chapter summary

3. Economists use different models to examine

different issues.
4. Macroeconomic events and performance
arise from many microeconomic transactions,
so macroeconomics uses many of the tools
of microeconomics.
5. Models built on microeconomics, so don’t
forget everything you learned last semester
6. Next time: introduction to aggregate statistics
(GDP etc) before we start on the theory.

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