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An Introduction to Macroeconomics

While most of what is in this chapter will be covered again elsewhere, it is a good warm-up chapter and you can begin to learn the

vocabulary of macro.

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MacroThe authors have a statement on page 6 that macroeconomics is about examining the economy as a whole. While the emphasis will not be on individual firms or households, aggregates will be studied.An aggregate is a collection of specific economic units treated as if they were one unit. So, we will consider households as an aggregate, as well as the business sector and government.

Some macroeconomic ideas we will explore are total output, total employment, total income, aggregate expenditures, and the general level of prices.

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General IdeasWhen you consider the US economy of the last 100 years there has been a great deal of progress. Over these last 100 years we have seen in a macro sense1) Long run economic growth – to use a pizza analogy – each year a bigger pie seems to be made and often each person gets a bigger slice, and2) Short run fluctuations called the business cycle occur. So, while the economy in general has been doing better, around that trend there are ups and downs. The down periods may be called a recession.

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Major conceptsWhen the macro economy is studied the ideas of GDP (output or production), unemployment and inflation will usually be mentioned.

GDP stands for the Gross Domestic Product. The nominal GDP totals the dollar value of all final goods and services produced within the borders of the country using the prices of the year. As an example, in the US orange juice is produced each year. If we are looking at year 2010, then the output of orange juice is evaluated at the price of orange juice in 2010.

If 10 gallons of OJ were produced in 2010 and each gallon had a market value of $5, then in GDP OJ would account for $50 worth of the total.

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Real GDP, or RGDPSay in 2009 it was also the case that 10 gallons of OJ was produced, but the price was $4. Then in 2009 the 10 gallons contributed to GDP by the amount $40. Since the amount produced is the same both years you would think it would be measured the same each year. But, from year 2009 to 2010 in my example the price went from $4 to $5. The GDP went up only because of a price change.

The real GDP, RGDP, corrects for price level changes and therefore has a focus on production level changes. We will see more later how this is accomplished.

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UnemployedIn macro to be counted as unemployed a person has to not have a job, be willing to work, and actively seeking work. Later we will calculate an unemployment rate.

A major problem with unemployment is the production of the goods and services that would have occurred are lost forever.

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InflationInflation is an increase in the overall level of prices. It has been the case in the US that inflation occurs most every year, but sometimes it is bigger or smaller than what folks expect.

If it is bigger that folks expect, for example, people who have saved will see that the amount they have saved will not buy as much as they had anticipated.

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Monetary and Fiscal PolicyThere has been considerable study about how the economy at the national level performs. With this in mind, there has also been study about the Federal Reserve System use of Monetary Policy and Federal Government use of Fiscal Policy and how these policies might impact the performance of the economy.

Part of our task later will be to consider a model of the economy and what role the Federal Reserve and the Federal Government play in that model.

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Economic GrowthEconomic growth has to do with the growth in production stated as an average, or on a per person (per capita) basis.

The handy rule of 70 tells us something will double in n years if it is growing at x percent each year. The formula here is n = 70/x. So, if something is growing at 2% per year, in 70/2 = 35 years the amount will be doubled.If the growth rate is 3% the amount will double in 70/3 = 23..33 years. The higher the growth rate the sooner our amount is doubled.When you remember the basic idea of scarcity, higher growth rates alleviate the scarcity situation.

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Economic GrowthRemember that the basic resources in an economy are land, labor, capital and entrepreneurial ability. If the economic system can obtain more resources then more goods and services can be made than previously.The resource capital includes the man made items such as machinery, tools, factories and warehouses that are used in the production of other items. Much of the growth in the US in the last 100 years is due to the greater use of capital goods.

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Saving and Economic InvestmentHouseholds are the principal source of saving in the economy, where saving is the income that has not been consumed in the current period for things such as hamburgers, fries, jeans, and tires, for example.Financial institutions such as banks, insurance companies and “money management firms” reward the household for saving by interest and dividends and maybe even capital gains.

Why do financial institutions do this? They do it because they have the idea that businesses have ideas about buying capital goods and expanding and making their business better. Then financial institutions will lend to business and charge a fee. The businesses undertake economic investment here.

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InvestmentBusiness who take the loans undertake investment in capital goods. The is what we mean by investment in economics.

When you and I are outside an economics class we might talk about how our saving is an investment. It is, but we are undertaking financial investment to make our future better, perhaps.

Perhaps my next slide will help you see what “investment” is all about in a macro class. Investment is not what household do with their saving – this is financial investment! Investment is what businesses do with funding from financial institutions – they buy capital goods!Remember using capital goods makes our economy so much more productive! We have better growth!

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Financial Institutions like banks

Households may have saving that includes various types of financial investments that they get through financial institutions.

Businesses go to financial institutions to borrow and then buy capital goods – businesses undertake investment!

(Isn’t this special!)

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Uncertainty, Expectations, and ShocksHow big of a factory should a company build and what types of tools should it put in the factory?The question is not easy to answer because no one knows the future with certainty (well, the sun will rise tomorrow!). So, folks study as much as they can and from this study formulate a view of the world. The view is their expectation.

Now, with the expectation, people act!

Do you think people are shocked when their expectation is not met? SURE!In economics, a shock is when something unexpected happens. Shocks can be good and shocks can be bad.

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ShocksBusinesses want to make profit (they are profit maximizers).

Expectations about business prospects are formed.

Positive demand shocks happen when demand is higher than expected and negative demand shocks are when demand is lower than expected. Most of the attention in our text will be about demand shocks and how they affect the economy.

Part of actually turning a profit involves developing accurate expectations about future market conditions.

The graph on the next slide will be used in a story that will be developed on many slides.

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An Analogy - a single firm’s experience

Price

Units per week

Dhigh

DmediumDlow

40,00037,00035,000

700 900 1150

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The analogyAfter much research and thought (and expectations formed) a company builds a facility that has an optimal rate of output of 900 units per week – we see this at the vertical line in the graph.(By the way, your car gets optimal gas mileage, in terms of miles per gallon, at about 55 miles per hour. Your car can go slower or faster, but miles per gallon will drop and thus it is more costly to drive those miles.)

To make 900 units a week, behind the scenes of the graph the firm will hire a certain amount of labor and other inputs.

The firm expects the demand to be D medium one (slangy, huh?) and will produce the product for a price of $37,000 and collect a profit.

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Expectations MetIn the graph the firm expected demand to be D medium. If D medium occurs, with 900 units made, all can be sold at $37,000 with profit earned and labor and other inputs used as expected.

So, if expectations are always correct, the output and employment at the firm will be steady. This means there would be no fluctuations.

(This would be at odds with reality, because we see fluctuations!)

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Expectations Not MetIf demand is not the expected amount D medium what happens?

The authors of our text have 2 options to consider (and they explain that over the course of time both will play out).

1) If the price can freely fluctuate-then when demand is lower than expected (shockingly) the

price will fall, -then when demand is higher than expected (shockingly)

the price will rise.

Under this option demand shocks have no impact on output and employment, only on the price.

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Expectations Not Met, Part Two2) If the price is not freely flexible (the case of sticky prices! – focus on the horizontal line in the graph)

-when demand is lower than expected-inventories build up-output will be cut below 900-employment will be cut some

-when demand is higher than expected-inventories become too low-output will be cranked up above 900-employment will be added to.

Demand shocks have no impact on price, the shocks just have an impact on output and employment.

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Are Prices Sticky?(If you spill your Coke on them! )

In the short term-consumers like you and me want stable prices (sure we

tolerate gas price gyrations, but don’t mess with the price of our toothpaste and garbage bags!)

-firms like stable prices and don’t want price wars to break out. So, in the short term prices seem sticky!

In the longer term prices tend to adjust to the new reality and expectations are adjusted to see this new reality.

So, in the chapters to come these ideas are more fully explored!Let’s doooooo iiiiiiiiiitttttttttttttttttttttt!