Table Of ContentNovember 7, 2004
Chapter 1
Thinking about Macroeconomics
In macroeconomics, we study the overall or aggregate performance of an
economy. A lot of our focus will be on an economy’s total output of goods and services,
as measured by the real gross domestic product (GDP). We will study the breakdown
of GDP into its major components: consumption, gross private domestic investment
(purchases of new capital goods—equipment and structures—by the private sector),
government consumption and investment, and net exports of goods and services. We
also examine the aggregates of employment (persons with jobs) and unemployment
(persons without jobs who are seeking work).
These terms refer to quantities of goods or labor. We are also interested in the
prices that correspond to these quantities. For example, we consider the dollar prices of
the goods and services produced in an economy. When we look at the price of the typical
or average item, we refer to the general price level. We also study the wage rate, which
is the dollar price of labor; the rental price, which is the dollar price paid to use capital
goods; and the interest rate, which determines the cost of borrowing and the return to
lending. When we consider more than one economy, we can study the exchange rate,
which is the rate at which one form of money (say the euro) exchanges for another form
of money (say the U.S. dollar).
We will set up an economic model, which allows us to study how the various
quantities and prices are determined. We can use the model to see how the quantities and
prices change in response to disturbances, such as a technological advance. We can also
investigate the effects of the government’s policies. For example, we consider monetary
policy, which involves the determination of the quantity of money and the setting of
interest rates. We also study fiscal policy, which pertains to the government’s choices of
expenditures, taxes, and fiscal deficits.
The performance of the overall economy matters for everyone because it
influences incomes, job prospects, and prices. Thus, it is important for us—and even
more important for government policymakers—to understand how the macroeconomy
operates. Unfortunately, as is obvious from reading the newspapers, macroeconomics is
not a settled scientific field. Although there is consensus on many issues—such as some
of the determinants of long-run economic growth—there is also controversy about many
topics—such as the sources of economic fluctuations and the short-run effects of
monetary policy. The main objective of this book is to convey the macroeconomic
knowledge that has been attained, as well as to point out areas in which a full
understanding has yet to be achieved.
I. Output, Unemployment, and Prices in U.S. History
To get an overview of the subject, consider the historical record for some of the
major macroeconomic variables in the United States. Figure 1.1 shows the total output of
goods and services from 1869 to 2003. (The starting date is determined by the available
2
data.) Our measure of aggregate output is the real gross domestic product (GDP).1 This
concept expresses quantities in terms of a base year, which happens to be 2000.
Chapter 2 considers national-income accounting and thereby provides the conceptual
details for measuring real GDP.
The general upward trend of real GDP in Figure 1.1 reflects the long-term growth
of the U.S. economy. The average growth rate of real GDP from 1869 to 2003 was 3.5%
per year. This growth rate meant that, over 134 years, the economy’s total output of
goods and services expanded 113-fold. If we divide through by population to determine
real per capita GDP, we find that the average per capita growth rate was 2.0% per year.
This rate equals the 3.5% per year growth rate of real GDP less the 1.5% per year growth
rate of population. The growth rate of real per capita GDP of 2.0% per year meant that,
over 134 years, the real GDP per capita expanded 15-fold.
Figure 1.2 shows the growth rate of real GDP for each year from 1870 to 2003.
The year-to-year growth rates vary substantially around their mean of 3.5%. These
variations are called economic fluctuations or, sometimes, the business cycle.2 When
real GDP falls toward a low point or trough, the economy is in a recession or an
economic contraction. When real GDP expands toward a high point or peak, the
economy is in a boom or an economic expansion.
The dates marked in Figure 1.2 correspond to the major U.S. recessions
since 1869. There are many ways to classify periods of recession. In this graph we mark
as years of recession the years of low economic growth. In chapter 6, we use a somewhat
1 The graph uses a proportionate (logarithmic) scale, so that each unit on the vertical axis corresponds to the
same percentage change in real GDP. Because of data availability, the numbers before 1929 refer to real
gross national product (GNP). We discuss the relation between GDP and GNP in chapter 2.
2 The term business cycle can be misleading because it suggests a more regular pattern of ups and downs in
economic activity than actually appears in the data.
3
more sophisticated method to classify recessions. However, most of the classifications
are the same as those shown in Figure 1.2.
Note in Figure 1.2 the Great Depression from 1930 to 1933, during which real
GDP declined at 8% per year for four years. Other major recessions before World War II
occurred in 1893-94, 1907-08, 1914, 1920-21, and 1937-38. In the post-World War II
period, the main recessions were in 1958, 1974-75, and 1980-82.
For economic booms, note first in Figure 1.2 the high rates of economic growth
during World Wars I and II and the Korean War. Peacetime periods of sustained high
economic growth before World War II were 1875 to 1880, 1896 to 1906, much of the
1920s, and the recovery from the Great Depression from 1933 to 1940 (except for the
1937-38 recession). After World War II, the periods of sustained high economic growth
were 1961 to 1973 (except for the brief recession in 1970), 1983 to 1989, and 1992
to 2000.
Another way to gauge recessions and booms is to consider the unemployment
rate—the fraction of persons seeking work who have no job. Figure 1.3 shows the
unemployment rate for each year from 1890 to 2003. Over this period, the median
unemployment rate was 5.6%. (The mean was 6.3%.) During recessions, the
unemployment rate typically rises above its median. The extreme is the Great
Depression, during which the unemployment rate reached 22% in 1932. Also noteworthy
in the pre-World War II period are the average unemployment rates of 18% for 1931-35,
12% for 1938-39, 11% for 1894-98, and 8% for 1921-22. In the post-World War II
period, the highest unemployment rate was 10% in 1982-83. Other periods of high
unemployment rates were 8% in 1975-76 and 7% in 1958, 1961, and 1991-93.
4
Figures 1.2 and 1.3 show the turbulence of the U.S. economy during the two
world wars and the 1930s. But suppose that we abstract from these extreme episodes and
compare the post-World War II period with the one before World War I. Then the major
message from the data is the similarity between the post-World War II and pre-World
War I periods.
The average growth rate of real GDP was 3.4% per year from 1948 to 2003,
compared with 3.8% from 1870 to 1914 and 3.4% from 1890 to 1914. The median
unemployment rates were 5.6% from 1948 to 2003 and 5.2% from 1890 to 1914. (The
means were 5.6% and 6.4%, respectively.) The extent of economic fluctuations—in the
sense of the variability of growth rates of real GDP or of unemployment rates—was only
moderately larger in the pre-World War I period than in the post-World War II period.3
The economy has, of course, changed greatly over the 134 years from 1869 to 2003—
including a larger role for government, a diminished share of agriculture in the GDP, and
dramatic changes in the monetary system. Nevertheless, the U.S. data do not reveal
major changes in the intensity of economic fluctuations or in the average rate of
economic growth.
Figure 1.4 shows the evolution of the U.S. price level from 1869 to 2003. This
graph measures the price level as the deflator for the GDP—we discuss the details of this
price index in chapter 2. One striking observation is the persistent rise in the price level
since World War II, contrasted with the movements up and down before World War II.
There are long periods in the earlier history—1869 to 1892 and 1920 to 1933—during
which the price level fell persistently.
3 For a detailed comparison of real GDP and unemployment rates for the two periods, see Christina Romer
(1986, 1987, 1988).
5
Figure 1.5 shows the annual inflation rate from 1870 to 2003. Each year’s
inflation rate is calculated as the growth rate of the price level shown in Figure 1.4.
Notice that the inflation rates since World War II were all greater than zero, except
for 1949. In contrast, many of the inflation rates before World War II were less than
zero. Note also in the post-World War II period that the inflation rate fell sharply from a
peak of 8.8% in 1980-81 to an average of 2.5% from 1983 to 2003 and only 1.9% from
1992 to 2003.
In subsequent chapters, we shall relate the changing behavior of the inflation rate
to the changing character of monetary institutions and monetary policy. In the pre-World
War II period, a key element is the gold standard—which the United States adhered to
from 1879 until World War I and, to some extent, from World War I until 1933. In the
post-World War II period, a key element is the changing monetary policy of the U.S.
Federal Reserve. Notably, since the mid 1980s, the Federal Reserve and other major
central banks have successfully pursued a policy of low and stable inflation.
II. Economic Models
As mentioned, we want to understand the determinants of major macroeconomic
variables, such as real GDP and the general price level. To carry out this mission, we
will construct a macroeconomic model. A model can be a group of equations or graphs
or a set of conceptual ideas. We will use all of these tools in this book—some equations
but, more often, graphs and ideas.
An economic model deals with two kinds of variables: endogenous variables and
exogenous variables. The endogenous variables are the ones that we want the model to
6
explain. For example, the endogenous variables in our macroeconomic model include
real GDP, investment, employment, the general price level, the wage rate, and the interest
rate.
The exogenous variables are the ones that a model takes as given and does not
attempt to explain. A simple example of an exogenous variable is the weather (at least in
models that do not allow for feedback from the economy to climate change). In many
cases, the available technologies will be exogenous. For a single economy, the
exogenous variables include the world prices of commodities such as oil and wheat, as
well as levels of income in the rest of the world. In many cases, we will treat government
policies as exogenous variables—for example, choices about monetary policy and about
the government’s spending and taxes. In particular, we will treat conditions of war and
peace—which have important macroeconomic consequences—as exogenous variables.
The central idea of a model is that it tells us how to go from the exogenous
variables to the endogenous variables. Figure 1.6 illustrates this process. We take as
given the group of exogenous variables shown in the left box in the diagram. The model
tells us how to go from these exogenous variables to the group of endogenous variables,
shown in the right box in the diagram. Therefore, we can use the model to predict how
changes in the exogenous variables affect the endogenous variables.
In macroeconomics, we are interested in the determination of macroeconomic—
that is, economy-wide aggregate—variables, such as real GDP. However, to construct a
macroeconomic model, we shall find it useful to build on a microeconomic approach to
the actions of individual households and businesses. This microeconomics investigates
individual decisions about how much to consume, how much to work, and so on. Then
7
we can add up or aggregate the choices of individuals to construct a macroeconomic
model. The underlying microeconomic analysis is called microeconomic foundations.
These foundations will help us build a useful macroeconomic model.
A. A simple example—the coffee market
To illustrate general ideas about models and markets, we can start with the market
for a single product, coffee. Our analysis will focus on three key tools used by
economists: demand curves, supply curves, and market-clearing conditions (demand
equals supply).
Individuals decide how much coffee to buy, that is, the quantity of coffee to
demand. Influences on this demand include the individual’s income, the price of coffee,
P , and the price of a substitute good, say P , the price of tea. Since each individual is a
c T
negligible part of the coffee and tea markets, it makes sense that each individual would
neglect the effect of his or her coffee and tea consumption on P and P . That is, each
c T
individual is a price-taker; he or she just decides how much coffee and tea to buy at
given prices, P and P . This assumption about price-taking behavior is called perfect
c T
competition.
Reasonable behavior for an individual suggests that the individual’s quantity of
coffee demanded would rise with income, fall with the coffee price, P , and rise with the
c
price of the substitute good, P . These results for individuals are examples of
T
microeconomic analysis. If we add up across all individuals, we can determine the
aggregate quantity of coffee demanded as a function of aggregate income, denoted by Y,
and the prices P and P . We can isolate the effect of the coffee price, P , on the total
c T c
8
quantity of coffee demanded by drawing a market demand curve. This curve shows the
total quantity of coffee demanded, Qd , as a function of P .
c c
Figure 1.7 shows the market demand curve for coffee. As already noted, a
decrease in P increases Qd . Recall, however, that the demand curve applies for given
c c
values of aggregate income, Y, and the price of tea, P . If Y rises, the quantity of coffee
T
demanded, Qd , increases for a given price, P . Therefore, the demand curve shown in
c c
Figure 1.7 would shift to the right. If P falls, the quantity of coffee demanded, Qd ,
T c
decreases for a given price, P . Therefore, the demand curve would shift to the left.
c
We also have to consider how individual producers of coffee decide how much to
offer for sale on the market, that is, how much coffee to supply. Influences on this supply
include the price of coffee, P , and the cost of producing additional coffee. We assume,
c
as in our analysis of demand, that the suppliers of coffee are price-takers with respect
to P . This assumption could be questioned because some producers of coffee are large
c
and might consider the effects of their actions on P . However, an extension to allow for
c
this effect would not change our basic analysis of the market for coffee.
Reasonable behavior by an individual producer suggests that the quantity of
coffee supplied would rise with the price of coffee, P , and fall with an increase in the
c
cost of producing additional coffee. For example, bad weather that destroys part of the
coffee crop in Brazil would raise the cost of producing coffee and, thereby, reduce the
coffee supplied by Brazilians. These results for individual producers are examples of
microeconomic analysis.
If we add up across all producers, we can determine the aggregate quantity of
coffee supplied. One result is that a rise in P increases the aggregate quantity of coffee
c
9
supplied, Qs. The total quantity supplied also depends on weather conditions in coffee-
c
producing areas, such as Brazil and Colombia.
As in our analysis of demand, we can isolate the effect of the coffee price, P , on
c
the total quantity of coffee supplied by drawing a market supply curve. This curve,
shown in Figure 1.8, gives the total quantity of coffee supplied, Qs, as a function of P .
c c
As already noted, an increase in P raises Qs. This supply curve applies for given cost
c c
conditions for producing coffee, in particular, for given weather in coffee-producing
areas. If bad weather destroys part of Brazil’s coffee crop, the market quantity of coffee
supplied, Qs, decreases for a given price, P . Therefore, the supply curve shown in
c c
Figure 1.8 would shift to the left.
Demand and supply curves are functions
The market demand for coffee can be written as a function,
Qd = D(P, Y, P ).
c c T
The function D(·) determines the quantity of coffee demanded, Qd , for any
c
specified values of the three demand determinants, P, Y, and P . We assume
c T
that the function D(·) has the properties that Qd decreases with the price of
c
coffee, P, rises with income, Y, and rises with the price of tea, P . Figure 1.7
c T
graphs Qd against P for given values of the other demand determinants, Y
c c
and P . It is important to distinguish the demand curve, D(·), shown in
T
Figure 1.7, from the quantity demanded, Qd , at a given price, P (and for given Y
c c
10
