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Chapter 1
The Importance of
Macroeconomics
Principal Uses of Macroeconomics
for Business Managers
• Understanding the economy
• Realizing how changes in economic variables
will affect your business
• Understanding how changes in fiscal and
monetary policy may affect sales and profits.
• To a limited extent, forecasting the future,
although that probably is impossible. But when
a major unexpected change does occur, you
should be able to react quickly and accurately.
Principal Macroeconomic Goals of
any Society
• Full Employment. Provide a job for
everyone who wants to work.
• Low, Stable Inflation. Economic decisions
should be based on maximizing producer
value or consumer utility, not as a hedge
against rising prices.
• Rapid growth in productivity and the
standard of living
Different Types of Policies Used to
Control the Economy
• Monetary Policy: moves affecting the cost and
availability of credit.
• Fiscal Policy: spending programs and tax rates
• Trade Policy: regulations affecting free trade
and quotas and tariffs; sometimes try and affect
the value of the currency.
• Regulatory Policy: programs affecting
government intervention and regulation, but with
a minimal budget impact.
Current Core of Macroeconomic
Theory
• 1. All major components of aggregate
demand – consumption, investment, and
net exports – are negatively related to the
real rate of interest, which is the nominal
rate minus the expected rate of inflation.
Core Point #2
• In the short run, movements in economic
activity are dominated by changes in
aggregate demand, while in the long run,
the economy tends to return to a steadystate growth path
Core Point #3
• The long-run growth rate is determined by
(a) the ratio of investment to GDP, and (b)
the degree to which fiscal, trade, and
regulatory policies encourage the spread
of free markets and technical innovation
and invention.
Core Point #4
• The central bank controls the nominal
short-term interest rate, but the real longterm interest rate affects aggregate
demand. Long-term interest rates are
determined in large part on the expected
future rate of inflation.
Core Point #5
• Economic agents have forward-looking
expectations, which means they base their
decisions on what they expect to happen
in the future, as contrasted to simpler
extrapolations of the past. Of course, their
predictions are not always accurate, but
people learn from past mistakes and
adjust their expectations accordingly.
Core Point #6
• Changes in monetary policy affect both
output and prices in the short run, but only
prices in the long run. There is no longrun tradeoff between unemployment and
inflation.
Core Point #7
• Changes in monetary policy affect real
output with a shorter lag than inflation.
Because monetary policy is transmitted
through a variety of methods, and because
the lags are variable, the short-term
impact of monetary policy often cannot be
predicted accurately
Core Point #8
• In the short run, wages are based on
predetermined variables, which means
they react to changes in the economy only
with a substantial lag. In the long run, the
real wage is equal to the marginal
productivity of labor, while the nominal
wage is determined by monetary factors.
Core Point #9
• Federal government budget deficits can be
financed either by selling Treasury
securities to the central bank, which is akin
to printing money and is inflationary, or by
selling them to the private sector, which
will raise real interest rates and hence
reduce real growth.
Core Point #10
• Markets clear and economic agents
attempt to maximize their utility, subject to
short-term rigidities and adjustments,
liquidity constraints, and incorrect
expectations. Nonetheless, labor markets
may not clear for many years, leading to
extended periods of high unemployment
even though the rest of the economy
appears to be in equilibrium.
An empirical discipline
• Discussions about macroeconomics are
often influenced by personal opinions,
since they affect the amount of money that
each individual has. As a result, what
passes for “facts” is often weighted by
personal bias.
• As a result, whenever possible, we try and
test theories to see if they agree with the
existing facts.
Different Reactions to Similar
Policies
• Similar changes in policies, such as tax cuts,
Federal reserve easing or tightening, or public
works spending programs may have far different
effects on the economy.
• In part, the results depend on the phase of the
business cycle when these changes are
implemented.
• Expectations are also important. The impact will
generally be greater if the policy change was
unexpected, and smaller if a similar change has
been made in the recent past.
Why Economists Disagree
• Difference between positive economics –
what is – and normative economics – what
should be.
• Ceteris paribus conditions often change,
so what works one time may not work the
next time.
• “Junk science” and spurious econometric
correlations often dominate the discussion.
• Political biases often confused with facts.