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Chapter 1

Introduction
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McGraw-Hill/Irwin
Macroeconomics, 10e 1-2
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 What Is Macroeconomics?
• Macroeconomics is the study of the behavior of the
economy as a whole and the policy measures that the
government uses to influence it
• Utilizes measures including total output, rates of unemployment
and inflation, and exchange rates
• Examines the economy in the short and long run
• Short run: movements in the business cycle
• Long run: economic growth
• Macroeconomics aggregates the individual markets vs.
microeconomics examines the behavior of individual
economic units and the determination of prices in
individual markets
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 Macroeconomics In Three Models
• Study of macroeconomics is grounded in three models,
each appropriate for a particular time period
1. Very Long Run Model: domain of growth theory  focuses
on growth of the production capacity of the economy
2. Long Run Model: a snapshot of the very long run model, in
which capital and technology are largely fixed
• The given level of capital and technology determine the level of
potential output
• Output is fixed, but prices determined by changes in AD
3. Short Run Model: business cycle theories
• Changes in AD determine how much of the productive capacity
is used and the level of output and unemployment
• Prices are fixed in this period, but output is variable

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 Very Long Run Growth
• Figure 1-1a illustrates growth of income per person in the U.S.
over last century  growth of 2-3% per year
• Growth theory examines how the accumulation of inputs and
improvements in technology lead to increased standards of living
• Rate of saving is a significant determinant of future well being and
economic growth.

[Insert Fig.1-1 here]

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 The Long Run Model
• In the long run, the AS curve is [Insert Figure 1-2 here]
vertical and pegged at the
potential level of output
• Output is determined by the
supply side of the economy and
its productive capacity
• The price level is determined by
the level of demand relative to the
productive capacity of the
economy
• Conclusion: high rates of
inflation are always due to
changes in AD in the long run

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 The Short Run Model
• Short run fluctuations in output [Insert Figure 1-4 here]
are largely due to changes in
AD
• The AS curve is flat in the short
run due to fixed/rigid prices, so
changes in output are due to
changes in AD
• Changes in AD in the short run
constitute phases of the
business cycle
• In the short run, AD determines
output, and thus unemployment

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 The Medium Run
• How do we get from the [Insert Figure 1-5 here]
horizontal short run AS curve
to the vertical long run AS
curve?
• The medium run AS curve is
tilting upwards towards the
long run AS curve position
• When AD pushes output above
the sustainable level, firms
increase prices
• As prices increase, the AS curve
is no longer pegged at a particular
price level

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 The Phillips Curve
• The speed of price adjustment [Insert Figure 1-6 here]
is illustrated by the Phillips
curve, which plots the inflation
rate against the unemployment
rate
• In the short run, AS curve is
relatively flat, and movements
in AD drive changes in prices,
output, and unemployment

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 Growth and GDP
• The growth rate of the economy is the rate at which
GDP is increasing
• Most developed economies grow at a rate of a few percentage
points per year
• For example, the US real GDP grew at an average rate of 3.4
percent per year from 1960 to 2005
• Growth rate is far from smooth
• Growth in GDP is caused by:
1. Increases in available resources (labor and capital)
2. Increases in the productivity of those resources

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The Business Cycle and the Output Gap
• Business cycle is the pattern of [Insert Figure 1-7 here]
expansion and contraction in
economic activity about the
path of trend growth
• Trend path of GDP is the path
GDP would take if factors of
production were fully utilized
• Deviation of output from the
trend is referred to as the
output gap
• Output gap = actual output –
potential output
• Output gap measures the
magnitude of cyclical deviations
of output from the potential level

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[Insert Figure 1-8 here]

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 Inflation and the Business Cycle
• The inflation rate can be [Insert Figure 1-9 here]
estimated by the percentage
change in the consumer price
index (CPI)
• CPI is a price index that measures
the cost of a given basket of
goods bought by the average
household
• If AD is driving the economy,
periods of growth are
accompanied by increases in
prices and inflation, while
periods of contraction
associated with reduced prices
and negative inflation rates
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