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CHAPTER 1
INTRODUCTION
Chapter Outline
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Introduction to macroeconomics
How Economists Think: Markets, Models and Time Frames
Flexible and Sticky Prices
Market Clearing, Non -Market Clearing and Time
The Data that Our Models are Trying to Explain
Gross Domestic Product
The Price Level and the Inflation Rate
Money and Interest Rates
The Unemployment Rate
The International Economy
What’s Next
Working With Data
Changes from the Previous Edition
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We have expanded the concepts of short run and long run in an important direction. We have now
divided the generic short run into the very short run, which corresponds to fixed price models, and the short run
which corresponds to sticky price models. The generic long run is divided into the long, which is basically the
Classical market clearing model, and the very long run, which is growth theory.
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The data coverage in Section 1-2 has been expanded and now contains on the money supply and
interest rates in Figures 1-10 and 1-11.
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Finally, we have introduced a new feature in each chapter call Policy in Action. This will help student
relate the models and data that are discussed in each chapter of some of the major policy events in Canada.
Learning Objectives
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Students should be able to understand how economists use models, and how price in a market plays an
important role of ensuring market equilibrium.
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Students should understand how price movement in some markets may be assumed to be slow or even
fixed, and how macroeconomics uses these fixed and flexible price assumptions to identify different time
frames for analysis: the very long run, the long run, the short run and the very short run, and understand how
these time frames are tied to the fixed and flexible price assumptions, and assumptions concerning factors of
production.
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Students should understand that in the very long run and the long run, the AS curve is vertical, in the
short run the AS curve is upward sloping, and in the very short run the AS curve is horizontal.
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Students should understand how actual macroeconomic data is consistent with the assumptions that
underlie these time frames.
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Accomplishing the Objectives
This chapter is designed to set the theme for the rest of the book. Broadly speaking, this theme is that
macroeconomics (at least at this level) involves an interaction of theory with the data. From the perspective of
the theory, the model chosen to analyze a particular situation will depend upon whether the time frame under
consideration is the short run or the long run. From the perspective of the data, each chapter presents graphs of
Canadian data that support the theory under consideration. Therefore, this chapter affords an excellent
opportunity to get students involved and interested.
Theory
Students should get used to the idea that theory involves the use of models. At this level, modeling is
accomplished through (mostly) diagrams. It may be a safe bet to assume that students have retained very little
of the knowledge that may have been learned in principles. This is why Figure 1-1, and the surrounding
discussion is a valuable tool. Students should learn two valuable lessons here:
1.
Models are composed of endogenous and exogenous variables. A change is an exogenous variable
brings about a change in the endogenous variables.
2.
Disequilibrium, which is brought about by a change in an exogenous variable, is eradicated by a
change in price.
In macroeconomics speed of adjustment of price is crucial for the distinction between long run and
short run. The time frames and assumed adjustment speeds are then tied to the shape of the aggregate supply
curve. In the long run and the very long run, the price adjustment is assumed to be infinitely quick, and the AS
curve is assumed to be vertical. The difference between the long run and the very long run is that, in the very
long run, the capital stock is assumed to be changing, and, therefore, the long run AS curve is assumed to be
vertical, but shifting outwards (see Figure 1-2). This is the domain of growth theory. In the long run we assume
that the capital stock is fixed, and the AS curve is vertical, but stationary. In the very short run, we assume that
the price level is fixed, and the AS curve is horizontal. In the short run, we assume that the AS curve is
upward sloping. Prices are assumed to be sticky, and the AS curve is derived from the Phillips curve.
Data
This chapter can also be used to introduce students to the data that will be used throughout the book.
If you wish to teach a very data intensive course, this book will allow you to do this. Many classrooms are now
equipped for the net, and it would be good idea to introduce data retrieval through CANSIM II at the outset.
This will allow students to take full advantage of the working with data sections, many of which will guide the
students through data retrieval and manipulation. The benefit to this is that you will hold the attention of a lot
of the students.
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Suggestions and Pitfalls
One of the best ways to start a course in macroeconomics is to relate macroeconomics to real world
events. We find it helpful to use the example from Chapter 1: get students involved in a discussion of how can
two macroeconomists on the news give opposite answers to the same question? This leads to a discussion of
the use of models and how economists proceed. As well, this should lead to a discussion of how policy can
interact with the economy and what the data actually looks like. Throughout the text, students will be
encouraged to examine real world data through the Working With Data sections, which are before the chapter
summary sections in each chapter. In addition, the Policy in Action feature in each chapter will be of interest
for class discussions. In this chapter we examine the monetary policy reaction immediately following the
events of September, 2001.
While Chapter 1 provides some tables and figures that show recent trends in output growth, inflation
and unemployment, students should be encouraged to look at other sources of economic data. CANSIM II
provides an enormous amount of current and historical data, and students using this book will be directed to
this data source often. Another good source is the Bank of Canada webpage at http://www.bankofcanada.ca/.
In addition, there are numerous sources on the Internet. A useful starting place is a site called Resources for
Economists on the Internet at http://rfe.wustl.edu/EconFAQ.html.
Since Chapter 2 will start out by discussing GDP measurements and price indexes, some instructors
may also want to discuss some of the economic indicators that are most often used in assessing the current
position in the economic cycle and assign Chapter 2 simultaneously with Chapter 1. Students will be more
interested and motivated if they know how to interpret new economic developments and how to make
predictions of where the economy may be headed based on the news they read in the newspaper.
The effects of changes in aggregate demand on output and prices depend largely on the slope of the
AS-curve. It is important to know whether prices remain fixed or have had time to adjust. Clearly,
macroeconomic stabilization policies have different effects on economies with high unemployment than on
economies that are close to full employment.
Although the AD-AS framework is a very simplified representation of the real world, it is a useful
framework for explaining real world events. For many students, this analysis is probably still the most intuitive
way to show how prices and output are affected by economic disturbances or policy measures designed to
mitigate them. Most will remember the AD-AS diagram from their introductory macroeconomics course, but it
may be useful to stress again that there is a significant difference between market demand and market supply
and aggregate demand and aggregate supply.
It is always helpful for students to learn early on that there are no clear-cut answers to many of the
questions that this course will address, and that economists’ interpretations of events and proposals for
solutions often vary widely. Students should be aware of the historical and economic situations that lead to the
development of different macroeconomic theories and should understand that new theories continue to be
formulated.
Solutions to Problems in the Textbook:
Discussion Questions:
1. Figure 1-10 shows that the Canadian unemployment rate was steadily increasing through the 60s and 70s.
Figure 1-5 shows that real GDP per capita was, on average, increasing during this period. One explanation,
using the labour model from Section 1-1, is that the real wage was slow to adjust and that the labour market
may take a long period of time to reach a new equilibrium after a shock such as an increase in female labour
force participation.
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2. Inflation occurs when the price level is rising and deflation occurs when the price level is decreasing.
Therefore, when the inflation rate is negative, there is deflation. There were bursts of inflation in 1914-1920,
due to World War I and 1939-1950, due to World War II. There was a sustained inflation from approximately
1960 to the early 1990’s, mostly due to excessive aggregate demand policies. There was deflation immediately
after World War I, and again in the early 1930s, due to the effects of the great depression.
3. The answer to this question is contained in Box 1-3. If we were to study the Canadian economy from the
perspective the decisions of one individual, or from the perspective of just one market, this would be the study
of microeconomics. Alternatively, if we view the economy from the perspective of aggregate outcomes – total
production or the inflation rate for the whole economy – this would be the study of macroeconomics. It is
important to remember that microeconomics and macroeconomics are both sub-disciplines of economics, and
each applies economic theory to the problems that are studied. The only real difference between
microeconomics and macroeconomics is the perspective. While microeconomics views the economy from the
perspective of individual decisions and individual markets, macroeconomics views the economy in aggregate.
There is a tendency to think of the AD/AS model in macroeconomics as being the same as the
demand/supply model from microeconomics. This can be somewhat misleading in two important ways. First,
consider the price on the vertical axis in each model. In macroeconomics, this is the price level, which is an
index of all prices in the economy. That is, it is a measure of overall purchasing power. Therefore, if the price
level increases, there has been an increase in the price of all goods. In microeconomics, the price on the
vertical axis is the price of one individual good, with all other individual prices being held constant.
Therefore, if the price were to increase, there would be a relative price change for this one good. Second,
consider the quantity on the horizontal axis. In macroeconomics, this is the amount of goods produced, or
GDP. Of course, GDP is composed of a variety of goods, but in macroeconomics we treat these various goods
as one composite good. Therefore, an increase in this quantity is an increase in production for the economy as
a whole. In microeconomics, the quantity on the horizontal axis is the quantity of one good in the particular
market that is being studied. An increase in this quantity is simply an increase production of that one good.
4. If the long run AS curve is shifting out by 2% per year, and aggregate demand is increasing by 5% per year,
then the inflation rate would be 3% (assuming that the income elasticity of money demand equals 1.0). If AD
were increasing by 1% per year, there would be deflation of 1% per year.
Application Questions:
Please Note:
Generally speaking, we will not be providing answers for the application questions that are CANSIM II related.
These are an opportunity for the student to learn how to use CANSIM II, and how to manipulate data. Most of
the time, the end results will be to replicate a figure from the text.
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Additional Problems:
1.
Comment on the following statement:
"A country’s rate of economic growth is determined solely by the amount of resources available
to the country."
Increases in the availability of resources, that is, labour and capital used in the production of goods and
services, account for only part of a nation's economic growth. The efficiency with which these factors of
production are used also affects economic growth. Increases in the efficiency of production result from
increases in the education and skill levels of the labour force and from newer and more efficient technology. In
addition, the factors of production are not fully employed all the time. During an expansion or recovery, the use
of the factors of production increases, which leads to an increase in production and output.
2.
Comment on the following statement:
“Since the long-run AS-curve is vertical, we can conclude that the total real output of a nation
cannot grow in the long run.”
The AD-AS framework is a static framework that assumes that potential GDP is fixed. However, the potential
GDP of a nation grows over time as the amount of available resources or the efficiency with which these
resources are used increases. Figure 1-4 in the text clearly indicates that the long-run (vertical) AS-curve moves
to the right by a small percentage each year.
3.
Comment on the following statement:
“Long-run growth can best be studied by focussing on the reasons for business cycles.”
Growth theory tries to explain the average growth rate of an economy over many years and therefore ignores
the short-run fluctuations (recessions and booms) that occur over the course of business cycles. Growth theory
focuses primarily on the accumulation of inputs and improvements in technology that allow for an increased
standard of living over time.
4.
Comment on the following statement:
“In the very short run real output is fixed, and therefore any increase in aggregate demand will
simply increase the price level but not affect how many goods and services are produced in an
economy.”
The short run aggregate supply curve is completely horizontal, based on the assumption that prices are
constant. Therefore an increase in aggregate demand will increase the level of output but will not affect the
price level in the short run. It follows therefore that in the short run the level of output is solely determined by
aggregate demand.
5.
In the 1960s, increases in the rate of unemployment were generally associated with decreases in
the inflation rate and vice versa. But in the 1970s and 1980s unemployment and inflation often
moved in the same direction. How can you explain this?
A shift in aggregate demand causes the unemployment rate and the inflation rate to move in opposite
directions, whereas a shift in aggregate supply causes unemployment and inflation to move in the same
direction. Most disturbances in the 1960s came from the aggregate demand side, while many of the
disturbances in the 1970s and 1980s came from the supply side.
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6.
True or false? Why?
"There is always a clear tradeoff between unemployment and inflation."
False. The Phillips curve describes an empirical relationship between wage and price inflation and the rate of
unemployment. This curve shows that the higher the rate of unemployment, the lower the rate of inflation and
vice versa (at least in the short run). However, in the long run there is no clear- cut tradeoff between inflation
and unemployment since the short-run Phillips curve shifts as inflationary expectations change. The economic
events of the 1970s and 1980s showed us that unemployment and inflation can increase or decrease
simultaneously.
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