Chapter 1:The Science of MacroeconomicsChapter 1:The Science of Macroeconomics

Main Macroeconomic Variables

Economic growth rate measures the percentage change of the Real GDP

Inflation rate measures the percentage change of the general price level (e.g., the CPI)

Unemployment rate measures the percentage of the labor force who are out of work

Historical Record of the U.S. Economy

Real GDP per capita (or income per person) has increased (in 1992 prices) from about $5,000 in 1900 to over $30,000 in 2000.

This rapid growth, however, has been interrupted by periods of declining income, called recession or depression (e.g., 1929-33, 1990-91)

Figure 1-1: Growth Trends

Historical Record of the U.S. Economy

High inflation during periods of expansion and boom (e.g., WW I and II)

Low inflation or deflation during periods of recession (e.g., 1920-21 and 1929-33)

During the energy crises of the 1970s, the economy recorded high inflation in periods of recession (stagflation)

Figure 1-2: Inflation Trends

Historical Record of the U.S. Economy

Unemployment is high during periods of recession and depression (e.g., 1929-33)

Unemployment is low during periods of expansion and boom (WW I and II, the 1990s)

Figure 1-3: Unemployment Trends

Economic Models

A model is a simplified theory that shows the relationships among variables.

Exogenous variables are those that come from outside of the model.

Endogenous variables are those that the model explains

The model shows how changes in the exogenous variables affect the endogenous variables.

Figure 1-4: Economic Model

Model Endogenous VariablesExogenous Variables

Demand-Supply ModelDemand model: Q = D(P, Y); Supply model: Q = S(P, Pm)

Endogenous variables are quantity (Q) and price (P) of the good

Exogenous variables are consumer income (Y) and price of materials (Pm)

Market equilibrium D(P, Y) = S(P, Pm) determines P and Q. The model explain how changes in Y and/or Pm affect equilibrium values.

Market System

Network of buyers & sellers who transact in the market

Buyers “demand” goods & services

Sellers “supply” goods & services

Advantage of Market Economy

Free interactions between buyers & sellers

Full information to make decisions

Freedom of choice between alternatives

DemandDemand

Definition: quantities of a good or service consumers are able to buy at various prices

Law of Demand: P and Q are negatively related

Movement along demand is caused by a change in P

Demand LineDemand Line

Price

Quantity

D

D

1.50

2.00

1000 1500

A

B

Increase in Demand

Price

Quantity

D

D

2.00

1500 2000

A

B

D’

D’

C

An increase in Y causesthe demand to increase

Supply

Definition: quantities of a good or service producers are able to sell at various prices

Law of Supply: P and Q are positively related

Movement along supply is caused by a change in P

Supply Line

Price

Quantity

S

S

1.50

2.00

500 1000

A

B

Increase in Supply

Price

Quantity

S

S

1.50

500 1000

S’

S’

A

B

C

An decrease Pm causesthe supply to increase

EquilibriumEquilibrium

A condition at which the independent plans of buyers and sellers exactly coincide in the marketplace.

At equilibrium: D(P, Y) = S(P, Pm) determine equilibrium P & Q

Demand-Supply Interaction

Price

Quantity

D

D

1.50

2.00

1000 1500

Equilibrium

B

500

2.50S

SShortage

Surplus

Stability

Shortage: at a price below equilibrium quantity demanded > quantity supplied

Surplus: at a price above equilibrium quantity supplied > quantity demanded

Price adjustments eliminate shortages & surpluses

Increase in Demand:

Price

Quantity

D

D

P

P’

Q Q’

A

D’

D’

B

S

S

Higher PriceLarger Quantity

Increase in Supply:

Price

Quantity

S

S

P’

P

Q Q’

S’

S’

A

B

D

D

Lower PriceLarger Quantity

Increase in Demand & Supply:

Price

Quantity

D

D

D’

D’

S

S

A

S’

S’

B

P

P’

Q Q’

Here:Higher PriceLarger Quantity