Unit 1: Introduction to Macroeconomics
1.1: What is economics about?
Economics is a very old discipline. As the economist Robert Heilbroner put it, ever since man came down from the trees we have struggled with the problem of survival in the face of finite resources. Ultimately, economics is about the problem of scarcity. We don’t have the resources as a society to produce everything that people might want to consume, so society has to figure out some way to sort this problem out – what to produce, how to gather the resources to produce things, and how to distribute the output we do produce.
A more targeted definition is that economics is the analysis of the production, consumption and distribution of goods and services.
Command Economies and Market Economies
Historically, societies have sorted out this problem in two different ways. For most of human history, people lived in a command economy of some kind, meaning that a central authority allocated resources. Whether it was a tribal chief or a feudal lord, some central authority made a decision about what work needed to be done, who should do it, and what should happen to the product.
By contrast, nowadays most economic decisions are made through free, individual choice. In a
market economy, economic choices are made through individual decision-making. Nobody forces the farmer to grow apples. Nobody tells the store what prices to charge. And nobody tells you how many apples to eat. Yet, somehow all the work manages to get done and you manage to get apples in your refrigerator. It’s pretty amazing, if you think about it. Even though we’re all making our own uncoordinated choices and there’s no lord of the castle to tell us what to do, things come together. Without any central coordination, apples manage to get from farmers to your refrigerator. Modern capitalist economies work pretty well. This is what economics is about.
This is an oversimplification, of course. Even in market economies like the United States, some
And the problem of scarcity still isn’t completely sorted out yet – a large segment of the world’s population has a very low standard of living. Nevertheless, it is an undeniable fact that two centuries of capitalism have generated more of an increase in living standards than the tens of thousands of years of human history that preceded capitalism.
Microeconomics and Macroeconomics
There are basically two branches of economics.
Microeconomics is about individual decisions and individual markets. How should a business set prices in order to maximize its profit? How does competition in the market for cable TV impact consumer prices? How much money should you save for your retirement? These are all microeconomic questions because they are about individual choices and markets for specific goods and services.
Macroeconomics is about the performance of the economy as a whole. What makes the unemployment rate high? What determines the exchange rate between the US dollar and the Euro? What can the government do to keep prices stable? Why does China grow faster than the US does? These are all macroeconomic questions because they are about the performance of the overall economy, not about specific markets or individual choices.
This is a course in macroeconomics. Macroeconomic variables are characteristics of the economy as a whole. Examples are GDP, the unemployment rate, interest rates, inflation, exchange rates, growth rates, etc… Macroeconomics is basically about explaining what determines macroeconomic variables, how they are related to each other, and what we can do about them.
One difference between microeconomics and macroeconomics is that the study of microeconomics is very old. The ancient Greeks wrote about things that we would recognize today as microeconomics, although the study of microeconomics as an analysis of markets and free choice is usually attributed to Adam Smith in the late 1700s.
By contrast, macroeconomics as independent discipline is quite new. The idea of studying the performance of the economy overall, in the way that we think about it now, is usually credited to John Maynard Keynes in the 1930s. Historically, it was the Great Depression that precipitated this study. Almost all of the economies across the world were collapsing at the same time, so people started to think more carefully about macroeconomic relationships and what we could do about it.
analysis of individual rationality and choices, macroeconomics has always placed a heavy emphasis on public policy and management of the economy.
A third important difference is that it is still characterized by significant disagreement about fundamental concepts, in a way that is not true for microeconomics. The core ideas of microeconomic theory are pretty much settled among mainstream economists. By contrast, there is still a lot of disagreement and uncertainty about the basic pillars of macroeconomic theory and policy. A key goal of this class is to understand and evaluate the nature of these disagreements.
Macroeconomic Outcomes
In the United States, the Federal Reserve Board (Fed) is one of the most important institutions responsible for determining macroeconomic policy. Although it was founded by statute in 1913, its focus was originally very narrow and it was not until the 1950s that the United States began to broadly coordinate what we refer to today as “macroeconomic policy”. Other countries followed rapidly, and now all countries actively manage macroeconomic policy. But, again, take note of how new the discipline is. By law, the Fed operates with three policy goals.
Robust growth in the economy’s output
Full employment
Stable prices
These are generally considered to be “good” macroeconomic outcomes, so this is a good place to start thinking about macroeconomic ideas. There are two problems immediately. First, the goals might be in conflict with each other. For example, rapid growth is often accompanied by rising prices. Second, economists don’t agree about the appropriate set of policies to promote these goals.
Classical and Keynesian Macroeconomics
CLASSICAL KEYNESIAN
Markets work well on their own without any government intervention.
Macroeconomic markets can consistently underperform.
Government interference either does nothing or harms the economy.
Government can potentially improve macroeconomic outcomes
Long-run orientation: Poor short-run performance will work itself out automatically.
Short-run orientation: Fluctuations can be severe and government can manage them
Supply orientation: Growth is generated by business production of goods and services
Demand orientation: Growth is generated by spending and consumer demand for goods and services
Flexibility: Prices and wages can adjust. Things will work themselves out
Rigidity: Prices and wages are slow to move, so adjustment is difficult.
Basically, classical economists see a very limited role for government in the economy because they believe that markets work well on their own. Keynesian economists believe that the government should actively manage the economy.
1.2: Supply and demand analysis
How does the economy work, organizing buyers and sellers, even with no central coordination? The basic answer is markets and prices. Markets are the basis of a capitalist economy. A market
is a collection of buyers and sellers who have a potential to trade with each other. We will begin by looking at buyers and sellers separately, and then look at what happens when they interact.
The basic supply and demand model that we will study here remains the basic building block for understanding how markets operate.
Demand
The quantity demanded of a good is the number of units that buyers want to buy at a given price. Importantly, this reflects only buyer preferences, not whether there are actually any sellers willing to sell at the given price. If the price of a Mercedes Benz were $1, then the quantity demanded would probably be very high! Quantity demanded is just the number of units that buyers would
buy if the price were at a particular level.
A demand curve describes quantity demanded at various prices. You might present this information as a list, a graph or an equation, but the key feature is that it describes the number of units that buyers want to buy at different prices.
The law of demand states that, as the price rises, the quantity demanded falls. This makes good sense – at higher prices, buyers don’t want to buy as many units.
When we draw a demand curve, conventionally the price appears on the vertical axis and the quantity appears on the horizontal axis. According to the law of demand, the demand curve is
For example, if the price of barley is $4, then consumers want to buy 20 tons of barley. But if the price rises to $5, then consumers want to buy only 15 tons of barley. This is the law of demand.
There is a point about terminology here that seems minor, but turns out to be important. Suppose that the price of barley falls from $4 to $2. The correct statement is that the quantity demanded of barley rises from 20 tons to 30 tons. This is shown on the diagram by moving along the demand curve from $4 down to $2.
demand curve to the right. In other words, there is now a new, higher demand curve for barley. The new curve is labeled D’. When the demand curve shifts, the correct statement is that there is an increase in demand for barley.
At each price, consumers now want to buy more barley than what they wanted before. For example, at a price of $5, consumers want to buy 30 tons of barley instead of 15 tons.
A rightward shift of the demand curve, meaning that consumers want to buy more units at each price, is called an increase in demand. A leftward shift, meaning that consumers want to buy fewer units at each price, is called a decrease in demand.
To summarize this point, when the price of barley changes, this is depicted as a movement along
the given demand curve. This is referred to as a change in quantity demanded. When something else, other than the price of barley, changes the amount of barley that consumers want to buy, this is depicted as a shift of the demand curve. This is referred to as a change in demand.
Changes in quantity demanded are caused by changes in price. But what kinds of things shift the demand curve? In other words, other than price, what kinds of things might change how much of something that consumers want to buy?
Change in population: As the population of buyers increases, the demand for the product will increase. As the population of buyers falls, the demand for the product will fall.
Change in income: If a product is a normal good, then higher consumer incomes will make the demand for the product rise. For example, as consumer income rises, there is more demand for luxury automobiles. On the other hand, if a product is an inferior good, then higher consumer incomes will make the demand for the product fall. For example, the demand for cheap ground beef would fall as consumer incomes rise, because consumers would substitute a better product in place of it.
Change in expected future price: If consumers expect prices to rise in the future, then they will want to buy more of the product today. For example, if you anticipated that the price of gas was going up tomorrow, you would probably fill your tank today. A higher expected future price increases demand for a product today.
Change in the price of substitute goods: Two goods are substitutes when an increase in the price of one good causes demand for another good to rise. For example, an increase in the price of coffee would cause the demand for tea to rise since consumers would substitute tea in place of coffee. Substitutes are things that are consumed in place of each other.
Change in the price of complementary goods: Two goods are complements when an increase in the price of one good causes the demand for the other good to fall. For example, an increase in the price of French fries would cause the demand for catsup to fall since French fries and catsup are consumed together.
Let’s do a few examples of demand curve shifts. All of the examples below relate to the market for beef. We will show how various changes affect the demand for beef. In each case, the original demand curve is labeled D and the new demand curve as a result of the change is labeled D’.
Millions of immigrants increase US population
This is an increase in population, which would make the demand for beef rise.
Chicken prices fall significantly
Chicken and beef are substitutes, so a decline in the price of chicken would make the demand for beef fall.
Surgeon general warns that eating beef increases risk of heart attack
This is a change in consumer tastes and preferences. Demand for beef falls.
Consumer incomes drop for the third month in a row
Beef is a normal good, so lower consumer incomes reduce the demand for beef.
Beef prices fall – Consumers buy more
A lower price causes an increase in quantity demanded, not a shift of the demand curve. The effect is a movement along the curve.
Charcoal prices drop
Supply
The quantity supplied of a good is the number of units that sellers want to sell at a given price. Importantly, this reflects only the seller side of the market, not whether there are actually buyers willing to buy the product. For example, if apples sold for $100 a pound, the quantity supplied of apples would be very high since farmers would want to grow and sell lots of apples at this price.
A supply curve describes quantity supplied at various prices. You might present this information as a list, a graph or an equation, but the key feature is that it describes the number of units that sellers would want to sell at different prices.
The law of supply states that, as the price rises, the quantity supplied rises. This makes good sense. At higher prices, more sellers will be willing to sell a particular product and existing sellers will want to sell more units. Because of the law of supply, the supply curve slopes upwards. The graph below shows an example of the supply curve for barley. At higher prices, more barley will be grown by farmers.
Exactly the same warning about terminology applies to the supply curve as to the demand curve. When the price of barley increase from $3 to $4, the quantity supplied of barley rises from 10 tons to 20 tons. It is incorrect to say that the supply of barley increases in this case.
As before, a rightward shift of the supply curve is an increase in supply since there are more units produced at each price. A leftward shift of the supply curve is a decrease in supply since there are fewer units produced at each price.
Like with the demand curve, changes in price change quantity supplied and cause a movement along a given supply curve. Anything other than price that changes the number of units that sellers want to sell causes a change in supply and a shift of the supply curve.
Other than price, what things might change the amount that sellers want to sell? That is, what kinds of things shift the supply curve?
Change in input costs: Anything that makes a product cheaper to produce will increase the supply of the product. For example, a reduction in the cost of labor will increase the supply of barley. Anything that makes the product more expensive to produce will lower the supply of the product. For example, an increase in the price of seed will reduce the supply of barley.
Change in technology: New technologies that make it easier to produce something will increase the supply of the product. For example, new tractors that make harvesting easier will increase the supply of barley.
Change in the number of producers: An increase in the number of farmers who grow barley raises the supply of barley. A reduction in the number of farmers who grow barley will lower the supply of barley.
Taxes and subsidies: Government policy can change the supply of a product. A tax on barley production charged to farmers would lower the supply of barley. A subsidy for the production of barley would raise the supply of barley.
Let’s do some examples of shifts in the supply curve. This example deals with the supply of cars.
Auto workers agree to wage cuts
This is a decrease in input costs, which raises the supply of cars.
New robot technology enhances efficiency
This is new technology making it easier to produce cars, so the supply of cars rises.
Government imposes new tax on cars
If sellers have to pay a tax for cars produced, the supply of cars falls.
Cost of steel rises
Steel is an input used in producing cars, so the supply of cars falls
Major auto producer goes bankrupt
A reduction in the number of producers lowers the supply of cars.
Consumers reject new models
Market Equilibrium
A market involves interaction of buyers and sellers together. For a long time, economists were confused about what fundamentally determines the price of a product. Is it the value of the product to the people who buy and use it? Or is it the cost of producing it? Alfred Marshall, the father of modern microeconomics, finally resolved this problem in the late 1890s, by showing that it is actually the demand and supply together that interact to determine the price / value of a product.
The equilibrium price is the price at which quantity demanded equals quantity supplied. Let’s combine the demand curve and the supply curve for barley that we have been working with. Recall that the demand curve shows the number of units buyers want to buy at different prices and the supply curve shows the number of units that sellers want to sell at different prices.
The equilibrium price in this case is $4 – this is the price at which the quantity supplied and the quantity demanded of barley are equal to each other. The amount of barley that buyers want to buy exactly equals the amount of barley that sellers want to sell. But what does this mean and why is it important? The idea of “equilibrium” in economics is not much different than the idea of equilibrium in physical or chemical systems. Basically, equilibrium is a kind of stability or a prediction of the outcome of a process. As we will explain below, if the price is anything other than $4, it will have a tendency to change and get closer to $4.
barley than what buyers want to buy. Logically, if farmers have more barley for sale than buyers want to buy from them, they will lower their prices to clear out the excess. In other words, $6 cannot be an equilibrium price since the price has a tendency to fall.
What if the price in the market were $3? Here we have the opposite problem. While the quantity demanded of barley is 25 tons, the quantity supplied of barley is only 10 tons. This is called excess demand – buyers want to buy more barley than what sellers are willing to sell. Some buyers who are not able to buy barley will be willing to pay higher prices to get it, and so $3 cannot be an equilibrium price. The price will have a tendency to rise.
This is a general principle: Any time the price of a product is above equilibrium, there will be an excess supply of the product – lots of unhappy sellers who can’t find buyers. Sellers will lower their prices to clear out the excess supply, and so price will tend to fall. Any time the price of a product is below equilibrium, there will be an excess demand for the product – lots of unhappy buyers who can’t find the product available from sellers. The price will tend to rise in this case since buyers will be willing to pay more and sellers will raise prices to allocate scarce units.
But when barley reaches a price of $4, the market is at equilibrium. Quantity demanded and quantity supplied are equal. Every buyer who wants to buy barley for $4 is able to find barley to purchase. At the same time, every producer who is willing to sell barley for $4 is able to find someone to sell it to. Nobody has any incentive to do anything differently. All buyers who want to buy barley can do it. All sellers who want to sell barley can do it. Demand and supply are equal.
If the price is anything other than $4, there are either sellers who can’t find buyers or there are buyers who can’t find anyone willing to sell to them. But $4 is a magical price, because at this price quantity demanded and quantity supplied are exactly equal. That’s what makes $4 stable and that’s what makes it the equilibrium price.
Changes to Equilibrium
The equilibrium price and quantity are where the demand and supply curves cross. In the example above, the equilibrium is for 20 tons of barley to be traded at an equilibrium price of $4. But if some event caused the demand curve or the supply curve to shift, then a new equilibrium would be established. By examining the graph, we can see what happens to the equilibrium price and the equilibrium quantity in these cases.
The price of fast-food hamburgers rises suddenly
Hamburgers are a substitute for pizzas, so an increase in the price of hamburgers will increase the demand for pizzas.
As shown on the diagram, the equilibrium price of a pizza rises, and the equilibrium quantity of pizzas rises.
Food service workers fight hard and get a pay increase
The cost of producing a pizza rises, and so the supply of pizzas falls.
As shown on the diagram, the equilibrium price of a pizza rises, and the equilibrium quantity of pizzas falls.
Consumer incomes fall for the third month in a row
Because pizzas are a normal good, a decline in consumer income causes the demand for pizzas to fall.
As shown on the diagram, the equilibrium price of a pizza falls and the equilibrium quantity of pizzas falls.
Manufacturers develop new automated technology to slice pizzas
New technologies that make it easier to produce pizza increase the supply of pizza.
Simultaneous Shifts
In the examples above, only one curve shifted. In all cases, we could determine what happened to both the equilibrium price and to the equilibrium quantity. But sometimes events may occur which shift both the supply and the demand curve simultaneously.
For example, consider the Mad Cow Disease scare. In this case, there were many infected cattle, so the supply of beef fell. At the same time, consumers were scared about the potential risk of eating beef, so the demand for beef fell also. A reduction in the supply of beef and a reduction in the demand for beef occurred simultaneously. Let’s illustrate this on a diagram.
You can see on the diagram that the equilibrium quantity falls for sure. But what about the price? If the supply curve shifted left by a greater amount, then the new price would be higher than the original equilibrium price. But if the demand curve shifted left by a greater amount, then the new price would be lower than the original equilibrium price. Overall, the price could rise, fall or stay the same. It depends on which curve shifts by a larger amount. In this case, we say that the change in price is ambiguous or indeterminate.
Indeed, in some parts of the US the price of beef fell as a result of the Mad Cow scare, and in some parts of the US the price of beef rose as a result of the Mad Cow scare.
This is a general principle. When only one curve shifts, you can determine what happens to both price and quantity. But when both the supply and the demand curves shift simultaneously, you can determine what happens to one of the two variables, but not to both.
In this case, we can see that the equilibrium price of the product rises for sure. The change in quantity is indeterminate. If demand had increased by a larger amount, the equilibrium quantity would be higher than it was originally. If the supply had decreased by a larger amount, the equilibrium quantity would be lower than what it was originally.
Again, the general principle is that when both the supply and the demand curve shift simultaneously, you can determine what happens to one of price or quantity, but the change in the other variable will be indeterminate.
Elasticity
How sensitive is the quantity demanded of a product to changes in price? Let’s look at two different demand curves.
We say that the first demand curve is relatively inelastic because quantity demanded changes relatively little as a result of price changes. We say that the second demand curve is relatively
elastic because quantity demanded changes by a relatively large amount as a result of price changes. We will not go into the details of how to calculate and work with elasticities, but you should know generally what it means for demand to be more or less elastic.
1.3: Non-equilibrium prices
In microeconomics, most analysis of individual markets assumes that the market is in equilibrium, or at least is adjusting to equilibrium. By contrast, in macroeconomics, it is common to encounter models with prices that are persistently higher or lower than the equilibrium price. The basic reason is that prices and wages in the macroeconomy may be slow to adjust; for example, buyers might have long-term contracts with sellers that specify prices. Another reason for out-of-equilibrium price is government policy. For example, the government sets a minimum wage; workers cannot be paid less than this wage. In these models, non-equilibrium prices are not something unusual that will fix itself. Rather, non-equilibrium prices may actually be the normal condition.
While it is important in macroeconomics to understand the process of adjustment to equilibrium, it is also important to understand what happens when markets are not in equilibrium.
Recall the market for barley that we worked with in the previous section.
The equilibrium price for barley is $4. This is where the quantity supplied of barley and the quantity demanded for barley are equal.
When the price is $3, the quantity demanded for barley is 25 tons but the quantity supplied of barley is only 10 tons. This is called excess demand or a shortage. Specifically, in this case we say that there is a shortage of 15 tons, since this is the difference between what buyers want to buy and what sellers want to sell. There will be some buyers who want to buy barley but who can’t find anyone to sell it to them. This makes sense since the price is too low.
The quantity exchanged is the amount of barley actually traded by buyers and sellers. In this case, although buyers want to buy 25 tons of barley, farmers only grow and sell 10 tons of barley. Therefore, the quantity exchanged of barley is only 10 tons. It doesn’t matter if buyers want to buy 25 tons, because at a price of $3, producers are only willing to sell 10 tons.
Prices set below equilibrium generally cause shortages and long waits. While this may intuitively seem like an attractive way to help buyers, in the end it actually ends up hurting buyers who suffer from the shortages and have difficulty purchasing the product.
Here, the quantity supplied of barley is 40 tons but the quantity demanded for barley is only 10 tons. Although producers want to sell 40 tons of barley when the price is set at this high level, buyers only want to buy 10 tons of barley. This is called excess supply or a surplus. Specifically, the surplus of barley is 30 tons in this case. There will be sellers who want to sell barley, but can’t find anyone to sell it to. This makes sense because the price is too high.
Again, the quantity exchanged is the quantity of barley actually traded at this price. Although sellers have 40 tons of barley for sale, buyers only are interested in buying 10 tons. Thus, the quantity exchanged is only 10 tons. It doesn’t matter that farmers want to grow and sell 40 tons if buyers are only interested in buying 10 tons.
Put these two examples together, and you see an important point. Whenever the price in a market is such that that quantity demanded and quantity supplied are not equal, the quantity exchanged is equal to whichever is the lower of the two. This is called the short-side rule.
