Download Chapter 6: An Introduction to Macroeconomics Learning objectives

Chapter 6: An Introduction to Macroeconomics
Learning objectives:
 Explain why economists focus on GDP, unemployment, and inflation when assessing the
health of an entire economy.
 Discuss why sustained increases in living standards are historically recent phenomena.
 Identify why saving and investment are key factors in promoting rising living standards.
 Describe why expectations, shocks, and sticky prices are responsible for short-run
fluctuations in output and employment.
 Characterize the degree to which various prices in the economy are sticky.
 Explain why the greater flexibility of prices as time passes causes economists to use
different macroeconomic models for different time horizons.
Assessing the health of the economy: performance and policy
Macroeconomics allows us to ask questions like:
 Why does Norway have an average income of $99,000 while Burundi has an average
income of $240?
 Why do some countries grow quickly and others not grow at all?
 Why do all countries experience recessions and expansions? A recession is a period of
decline in total output, income, and employment.
 What government policies can help to achieve growth or to smooth out the business
cycle? The business cycle refers to recurring increases and decreases in the level of
economic activity over periods of years.
To assess the health and development of an economy, macroeconomists focus on three variables.
1. Real GDP
Real GDP (real gross domestic product) is a measure of the value of final goods and services
produced within the borders of a given country during a given time period, typically a year.
To calculate real GDP, statisticians typically start by calculating nominal GDP, the dollar value
of all goods and services produced within the borders of a given country using the country’s
current prices during the year the goods and services were produced.
Since nominal GDP uses current prices, a rise in nominal GDP can come from either a rise in
actual output or simply a rise in prices. Real GDP takes out the effect of price changes so that we
can see how actual output has changed.
A simple example:
Suppose that there is only one good in the economy: Dal sweatshirts. Suppose that a Dal
sweatshirt cost $40 in 2014 and $50 in 2015, and that 10 sweatshirts were produced and sold in
2014 and 10 sweatshirts were produced and sold in 2015.
What is 2014 nominal GDP? $___  ___ = $____.
What is 2015 nominal GDP? $___  ___ = $____.
Nominal GDP has increased, even though production is the same in both years.
Nominal GDP can give us a misleading picture of the state of the economy. Nominal GDP could
be rising because of higher production, or it could be rising because of higher prices.
Instead we calculate real GDP, which removes the effects of price changes and shows actual
changes in output from year to year. Real GDP evaluates a current year’s production based not
on current prices but on past prices. E.g., if we evaluate 2015 production (10 sweatshirts) at 2014
prices ($40), we see that production hasn’t actually changed from 2014 to 2015, because real
GDP is the same in 2015 as it was in 2014.
In 2014, Canada’s nominal GDP was $1.973 trillion, and real GDP (using 2007 prices) was
$1.747 trillion.
2. Unemployment
Unemployment is a failure of the economy to employ its labour force fully, and occurs when a
person cannot get a job despite being willing to work and actively seeking work.
Unemployment represents lost potential output due to unused resources, and incurs many social
costs such as depression and higher crime rates.
Canada’s unemployment rate in November 2015 was 7.1%. The Nova Scotia unemployment rate
was 8.6%.
3. Inflation
Inflation is an increase in the overall price level.
If wages don’t also go up, rising prices will cause decreases in standard of living. As well, an
unanticipated (surprise) jump in inflation reduces the purchasing power of people’s savings.
In the 1970s, inflation reached over 15%; in the 1980s, the high point was around 12%; in the
1990s and 2000s, inflation tended to stay below 3%.
Canada’s inflation rate from November 2014 to November 2015 was 1.4%.
Studying macroeconomics helps us to determine the appropriate use of government policy.
 How can governments promote long-run economic growth?
 How can governments reduce the severity of recessions?
 Are certain government policy tools more effective than others, e.g. monetary policy
versus fiscal policy?
 Is there a trade-off between lower rates of unemployment and higher rates of inflation?

Does government policy work best when it is announced in advance or when it is a
surprise?
The miracle of modern economic growth
Modern economic growth refers to the historically recent phenomenon in which nations for the
first time have experienced sustained increases in output per person. Before the modern period,
countries experienced increases in output but not output per person (the standard of living).
Even a growth rate of output per person of 2% per year implies that output per person will
double in around 35 years. A growth rate of output per person of 10% per year, such as was seen
in China until recently, implies a doubling of output per person in 7 years!
The vast differences in living standards seen today between rich and poor countries are almost
entirely the result of the fact that only some countries have experienced modern economic
growth.
In the late 1700s, living standards around the world were very similar, but that is no longer true.
Saving, investment, and choosing between present and future consumption
To raise living standards over time, an economy must devote at least some fraction of its current
output to increasing future output, through saving.
Saving is the accumulation of funds that results when people in an economy spend (consume)
less than their incomes during a given time period.
Saving is important because it provides the funds for investment. Investment refers to spending
for the production and accumulation of capital and additions to inventories.
Investment is done by firms, not individuals. Do not confuse investment with financial
investment, the purchase of financial assets (stocks, bonds, mutual funds) or real assets (houses,
land, factories), or constructing such assets, in the expectation of financial gain.
Households are the source of saving, but businesses are the ones who use those saved funds to do
investments. How do the funds get from households to businesses? Through banks and other
financial intermediaries.
These institutions collect the savings of households, rewarding savers with interest, dividends,
and sometimes capital gains (increases in asset values). They then lend the funds to businesses,
which invest in equipment, factories, and other capital goods
Uncertainty, expectations, shocks, and short-run fluctuations
Both saving and investment depend on expectations about the future. Expectations are the
anticipations of consumers, firms, and others about future economic conditions.
Expectations are important because they affect current behaviour; for example, a firm will not
invest in building a new factory if it thinks it won’t be able to sell the output that the factor
produces.
Expectations are also important because they may be wrong. Shocks are situations in which one
thing is expected to occur, but in reality, something different occurs. A firm may invest in
building a new factory and then a sudden recession will reduce demand for output, and the firm
did not expect that when it built the factory.
Shocks can occur to demand or to supply. Demand shocks are sudden, unexpected changes in
aggregate demand, and supply shocks are sudden, unexpected changes in aggregate supply.
Economists believe that most short-run fluctuations are the result of demand shocks. Supply
shocks are less frequent but can have a large effect on the economy when they occur.
The economy reaches its potential (full employment) if there are no shocks. But suppose there is
a shock to demand, either a rise in demand or a fall in demand.
First let’s consider a rise in demand when prices are flexible. Flexible prices are product prices
that react within seconds to changes in supply and demand. With flexible prices, if demand falls,
the price will also fall; if demand rises, the price will also rise.
If the prices of goods and services always adjust quickly to unexpected changes in demand, then
the economy could always produce at its optimal capacity, since prices would adjust to ensure
that the quantity demanded of each good and service would always equal the quantity supplied.
In reality, many prices in the economy are inflexible. Inflexible prices (or sticky prices) are
product prices that remain in place (at least for a while) even though supply or demand has
changed. Output then has to adjust.
Manufacturing firms typically attempt to deal with unexpected changes in demand by
maintaining inventory of goods that have been produced but remain unsold.
If demand falls for many goods and services across the entire economy for an extended period of
time, then many firms will find inventories piling up and will be forced to cut production. This
results in recession, with GDP falling and unemployment rising. On the other hand, if demand is
unexpectedly high for a prolonged period of time, the economy will boom and unemployment
will fall.
How sticky are prices?
The extent to which prices are inflexible affects the size of recessions and expansions. So how
sticky are prices? It depends on the good.
Item
Coin-operated laundry machines
Newspapers
Haircuts
Taxi fare
Veterinary services
Magazines
Computer software
Beer
Microwave ovens
Milk
Electricity
Airline tickets
Gasoline
Average number of
months between price
changes
46.4
29.9
25.5
19.7
14.9
11.2
5.5
4.3
3.0
2.4
1.8
1.0
0.6
Why are some prices so inflexible?
One reason is that firms selling final goods and services know that consumers prefer stable,
predictable prices that do not fluctuate rapidly with changes in demand. Consumers are trying to
maximize their well-being given their income and the prices of the goods and services they buy,
and fluctuating prices make this more difficult. Firms maintain goodwill by keeping prices
constant.
Another reason is that firms may be afraid that if they cut their prices, their rivals may simply
match the price cut, leading to a price war. So markets in which there are only a few firms
(oligopoly) may have stickier prices.
Categorizing macroeconomic models using price stickiness
Price stickiness plays a large role in short-run fluctuations in output. However, price stickiness
moderates over time. If unexpected changes in demand begin to look permanent, many firms will
allow their prices to change so that both price changes and quantity changes serve to equalize
quantities supplied with quantities demanded. Prices therefore go from being completely
inflexible (stuck) in the extreme short run to fully flexible in the long run.
The model we use in Chapters 10 and 11 assumes that prices are completely inflexible. But then
we move to a model in Chapter 12 that allows prices to be more flexible over time.