Chapter 1: The Science of Macroeconomics

1. Chapter 1:The Science of Macroeconomics

2. Main Macroeconomic Variables • Economic growth rate measures the percentage change of the Real GDP • Inflation rate measures the percentage change of the general price level (e.g., the CPI) • Unemployment rate measures the percentage of the labor force who are out of work

3. Historical Record of the U.S. Economy • Real GDP per capita (or income per person) has increased (in 1992 prices) from about $5,000 in 1900 to over $30,000 in 2000. • This rapid growth, however, has been interrupted by periods of declining income, called recession or depression (e.g., 1929-33, 1990-91)

4. Figure 1-1: Growth Trends

5. Historical Record of the U.S. Economy • High inflation during periods of expansion and boom (e.g., WW I and II) • Low inflation or deflation during periods of recession (e.g., 1920-21 and 1929-33) • During the energy crises of the 1970s, the economy recorded high inflation in periods of recession (stagflation)

6. Figure 1-2: Inflation Trends

7. Historical Record of the U.S. Economy • Unemployment is high during periods of recession and depression (e.g., 1929-33) • Unemployment is low during periods of expansion and boom (WW I and II, the 1990s)

8. Figure 1-3: Unemployment Trends

9. Economic Models • A model is a simplified theory that shows the relationships among variables. • Exogenous variables are those that come from outside of the model. • Endogenous variables are those that the model explains • The model shows how changes in the exogenous variables affect the endogenous variables.

10. Figure 1-4: Economic Model Exogenous Variables Model Endogenous Variables

11. Demand-Supply Model • Demand model: Q = D(P, Y); Supply model: Q = S(P, Pm) • Endogenous variables are quantity (Q) and price (P) of the good • Exogenous variables are consumer income (Y) and price of materials (Pm) • Market equilibrium D(P, Y) = S(P, Pm) determines P and Q. The model explain how changes in Y and/or Pm affect equilibrium values.

12. Market System • Network of buyers & sellers who transact in the market • Buyers “demand” goods & services • Sellers “supply” goods & services

13. Advantage of Market Economy • Free interactions between buyers & sellers • Full information to make decisions • Freedom of choice between alternatives

14. Demand • Definition: quantities of a good or service consumers are able to buy at various prices • Law of Demand: P and Q are negatively related • Movement along demand is caused by a change in P

15. Demand Line Price D A 2.00 B 1.50 D Quantity 1000 1500

16. Increase in Demand D’ Price An increase in Y causes the demand to increase D A C 2.00 B D’ D Quantity 1500 2000

17. Supply • Definition: quantities of a good or service producers are able to sell at various prices • Law of Supply: P and Q are positively related • Movement along supply is caused by a change in P

18. Supply Line Price S 2.00 B 1.50 A S 500 1000 Quantity

19. Increase in Supply Price An decrease Pm causes the supply to increase S B S’ A 1.50 C S S’ 500 1000 Quantity

20. Equilibrium • A condition at which the independent plans of buyers and sellers exactly coincide in the marketplace. • At equilibrium: D(P, Y) = S(P, Pm) determine equilibrium P & Q

21. Demand-Supply Interaction D Price Surplus S 2.50 Equilibrium 2.00 B 1.50 Shortage S D Quantity 500 1000 1500

22. Stability • Shortage: at a price below equilibrium quantity demanded > quantity supplied • Surplus: at a price above equilibrium quantity supplied > quantity demanded • Price adjustments eliminate shortages & surpluses

23. Increase in Demand: Price D’ D S Higher Price Larger Quantity B P’ A P D’ D S Quantity Q Q’

24. Increase in Supply: Price D S S’ A P Lower Price Larger Quantity B P’ S D S’ Q’ Quantity Q

25. Increase in Demand & Supply: Price D’ D S S’ P’ B Here: Higher Price Larger Quantity A P D’ S D S’ Quantity Q Q’