The Science of Macroeconomics

Chapter 1 of Macroeconomics,

Kaism_tar2006@yahoo.fr
 Classroom

• Macroeconomics: 05-2024-2025

mot6sby
 As you may recall from course microeconomics last year,
economics is divided into two branches: microeconomics and
macroeconomics.
- Microeconomics is the study of how individual households and
firms make decisions and how they interact with one another
in markets.
- Macroeconomics is the study of the economy as a whole. The
goal of macroeconomics is to explain the economic changes
that affect many households, firms, and markets
simultaneously
• The term « macroeconomis » was coined by Regnar
Frish, Norwegian economist , in 1933 to apply to the
study of relationships between broad economic
aggregates such as national income, inflation, aggregate
unemplyement and so on.
• In 1936, John Maynard Keynes published his
revolutionary book, « The General Theory of
Employement, Interest and Money. This book laid the
foundation of Macroecnomics.
Because the economy as a whole is a collection of
many households and many firms interacting in
many markets, microeconomics and
macroeconomics are closely linked. The basic
tools of supply and demand, for instance, are as
central to macroeconomic analysis as they are to
microeconomic analysis
 Learning objectives
This chapter introduces you to :

1. The issues macroeconomists study.

2. The tools macroeconomists use.

3. Some important concepts in macroeconomic analysis.

 What Macroeconomists Study
• Because the state of the economy affects everyone,
macroeconomic issues play a central role in national political
debates.

• Macroeconomic issues are also central to world politics, and

the international news is filled with macroeconomic questions
 What Macroeconomists Study
Macroeconomists address a broad variety of questions:
• Why are some countries rich and others poor?
• Why have some countries’ incomes grown rapidly over the
past decade while others have stagnated?
• Why do some countries have high rates of inflation while
others maintain stable prices?
• Why do all countries experience periods of economic
stagnation or even crisis?
 What Macroeconomists Study
• What can government policy do to help an economy recover from a
slump?
• How do we know whether the amount of money that has been printed
is too much, too little, or just enough?
• Should China keep the value of the yuan fixed with respect to the US
dollar?
• Why has the US been running huge trade deficits? Does it matter?
• What, if anything, can the government do to promote rapid growth in
incomes, low inflation, and stable employment?
 Macroeconomics
• These questions are all macroeconomic in nature because they concern
the workings of the entire economy
• Macroeconomics attempts to answer these and many related
questions.

• Macroeconomics is the study of the economy as a whole

The job of explaining the workings of the economy as a whole

falls to macroeconomists
 Macroeconomics
• To this end,
• Macroeconomists collect data on incomes, price levels, interest
rates, unemployment, and many other macroeconomic variables
from different time periods and different countries

• They then try to build general theories to explain the data that
history gives them (They then attempt to formulate general theories to explain these
data. Like astronomers studying the evolution of stars or biologists studying the evolution of
species, macroeconomists usually cannot conduct controlled experiments in a laboratory.
Instead, they must make use of the data that history gives them)
 Aspects of Macroeconomics

• There are two aspects of macroeconomics that make it unique :

– The interconnections among the different parts of the economy are

important,

– The dynamics that propel an economy forward over time are

important
 Macroeconomics: interconnections

• First, macroeconomics is where we learn how to think about

the economy as a collection of multiple markets that affect,
and are affected by, each other.
• It is not enough to analyze the goods market, and then the
asset market, and then the labor market, and so on; all
markets must be analyzed together, as interacting arenas of
economic activity.
 Macroeconomics: dynamics

• Second, macroeconomics is where students learn to think

dynamically about the economy.
• It is important to understand how today leads to tomorrow,
how tomorrow leads to the day after, and so on.
• This emphasis on the dynamic laws of motion of an economy
also makes macroeconomics different.
What sort of economic variables does macroeconomics try to explain?

MACROECONOMIC DATA
 Macroeconomics
• Macroeconomics is a young and imperfect science
– Macroeconomists were not generally successful in predicting the
global economic crisis of 2008
– Even after the crisis, they were unable to agree on what should be
done to deal with the crisis
• Nevertheless, the importance of the subject is clearer than
ever
 Macroeconomic data
• Economists use many types of data to measure the performance of an economy.
Three macroeconomic variables are especially important:
– Real gross domestic product (GDP) measures the total income of everyone in
the economy (adjusted for the level of prices);
– The inflation rate measures how fast prices are rising;

– The unemployment rate measures the fraction of the labor force that is out of
work.
Macroeconomists study how these variables are determined, why they
change over time, and how they interact with one another
 Gross Domestic Product
(GDP of the U.S. in billions of chained 1996 dollars)

longest economic expansion

on record

Expansion

Recessions
The Historical Performance of the U.S.
Economy: Figure 1.1

Source: https://fred.stlouisfed.org/series/A939RX0Q048SBEA
 The Historical Performance of the U.S. Economy: Figure 1.1
Two aspects of this figure are noteworthy.

- First, real GDP grows over time. Real GDP per person today is more than
eight times higher than it was in 1900
- Second, although real GDP rises in most years, this growth is not steady.
There are repeated periods during which real GDP falls, the most dramatic
instance being the early 1930s.
GDP per capita for Tunisia
The Historical Performance of the U.S.
Economy: Figure 1.2

Source: https://fred.stlouisfed.org/series/A191RI1A225NBEA
 The Historical Performance of the U.S. Economy: Figure 1.2
You can see that inflation varies substantially over time.

- In the first half of the twentieth century, the inflation rate averaged only slightly
above zero.
- Periods of falling prices, called deflation, were almost as common as periods of
rising prices.

- By contrast, inflation has been the norm during the past half century
- Inflation became most severe during the late 1970s, when prices rose at a rate of
almost 10 percent per year.
- In recent years, the inflation rate has been about 2 percent per year, indicating that
prices have been fairly stable.
The Historical Performance of the U.S.
Economy: Figure 1.3

Source: https://fred.stlouisfed.org/series/UNRATE
The Historical Performance of the U.S. Economy: Figure 3
- Notice that there is always some unemployment in the
economy.
- In addition, although the unemployment rate has no
long-term trend, it varies substantially from year to year.
- Recessions and depressions are associated with unusually
high unemployment.
Unemployment rate for Tunisia
 How Economists Think
- Economists often study politically charged issues, but they
try to address these issues with a scientist’s objectivity.
- Like any science, economics has its own set of tools —
terminology, data, and a way of thinking — that can seem
foreign and arcane to the layperson.
 How Economists Think
- Economists use models to understand the world, but an economist’s
model is more likely to be made of symbols and equations than
plastic and glue.
- Economists build their “toy economies” to explain economic
variables, such as GDP, inflation, and unemployment.

- Economic models illustrate, often in mathematical terms, the

relationships among the variables
 HOW ECONOMISTS THINK: GRAPHS

Models have two kinds of variables: endogenous

variables and exogenous variables
 How Economists Think: graphs
• Every economic theory consists of
– Endogenous variables
– Graphs that show how the endogenous variables are linked to each
other (model)
– Exogenous variables (shift variables)
• The theory predicts how changes in the exogenous variables
affect the endogenous variables
 Endogenous and exogenous variables
• Endogenous variables are those variables that a
model explains
• The endogenous variables of a theory are those
variables whose fluctuations the theory is trying
to explain
 Endogenous and exogenous variables
• Exogenous variables are those variables that a model takes as
given
• The exogenous variables of a theory are those variables that
the theory assumes are crucial to understanding the
endogenous variables, but are themselves not a concern of the
theory
 Graphs
• Graphs are used to represent the various ways in which the
endogenous variables are linked to each other
• The graphs together determine the predicted values of the
endogenous variables
• Changes in exogenous variables cause the graphs to shift
• The shifts of the graphs then tell us how the endogenous
variables are likely to be affected
 Example of a model:
The supply & demand for the pizza
• To make these ideas more concrete, let’s review the most
celebrated of all economic models — the model of supply and
demand.
• Imagine that an economist wants to figure out what factors
influence the price of pizza and the quantity of pizza sold.
• She would develop a model to describe the behavior of pizza
buyers, the behavior of pizza sellers, and their interaction in
the market for pizza.
 Example of a model:
The demand function for the pizza
• For example, the economist supposes that the quantity of pizza
demanded by consumers Q d depends on the price of pizza P and on
aggregate income Y . This relationship is expressed in the equation below
:

Where :
Q d = quantity of pizza demanded by consumers
P = price of pizza
Y = aggregate income
 Example of a model:
The supply function for the pizza
• Similarly, the economist supposes that the quantity of pizza supplied by
pizzerias Q s depends on the price of pizza P and on the price of materials Pm
, such as cheese, tomatoes, flour, and anchovies. This relationship is the
supply function.

Where :
Q s= quantity of pizza supplied by pizzerias
P = price of pizza
Pm = price of materials (an input)
 Example of a model:
The pizza market : equilibrium

• Finally, the economist assumes that the price of

pizza adjusts to bring the quantity supplied and
quantity demanded into balance:
d s
Q =Q
 Example of a model:
The pizza market

• These three equations compose a model of the market for pizza:

Equilibrium
Qd = Q s
 Example: the pizza market
- Endogenous variables: price and quantity
• The theory also needs :
– Graphs that show how the endogenous variables are linked to each
other (model)
– Exogenous variables (shift variables)
 Example: the pizza market
The Model of Supply and Demand
• The economist illustrates the model with a supply-and-demand
diagram,

• The most famous economic model is that of supply and demand for a
good or service — in this case, pizza.

• The demand curve is a downward-sloping curve relating the price of

pizza to the quantity of pizza that consumers demand.

• The supply curve is an upward-sloping curve relating the price of

pizza to the quantity of pizza that pizzerias supply.
 Graphs: Supply
•The supply curve shows the
relationship between the
quantity of pizza supplied
and the price of pizza,
holding the price of materials
constant.
•The supply curve slopes
upward because a higher
price of pizza makes selling
pizza more profitable, which
encourages pizzerias to
produce more of it.
Economists believe that shifts of the supply curve for a good or
service are mainly the result of four factors
1. Changes in input prices
2. Changes in technology
3. Changes in the number of producers
4. Changes in expectations
 Graphs: Demand

•The demand curve shows the

relationship between the quantity of
pizza demanded and the price of pizza,
holding aggregate income constant.

•The demand curve slopes downward

because a higher price of pizza
encourages consumers to buy less pizza
and switch to, say, hamburgers and tacos.
Demand Curve Shifters
• Economists believe that there are five principal factors that
shift the demand curve for a good or service:
1. Changes in the number of consumer
2. Changes in income
3. Changes in the prices of related goods or services
4. Changes in tastes

5. Changes in expectations

49
 Graphs: Supply and Demand

•The equilibrium for the market is the

price and quantity at which the supply
and demand curves intersect.

•At the equilibrium price, consumers

choose to buy the amount of pizza that
pizzerias choose to produce.
 Graphs: equilibrium

•The point where the two

curves cross is the market
equilibrium, which shows
the equilibrium price of
pizza and the equilibrium
quantity of pizza.
 Example: the pizza market
• This model of the pizza market has two exogenous variables and two
endogenous variables.
• The exogenous variables : are aggregate income and the price of
materials. The model does not explain them but instead takes them
as given.
• The endogenous variables : are the price of pizza and the quantity of
pizza exchanged.

These are the variables that the model explains.

 Shift variables for demand

• The model can be used to show how a change in

any exogenous variable (the aggregate income or
the price of materials), affects both endogenous
variables (the price of pizza and the quantity of
pizza exchanged).
 Shift variables for demand

Income ↑
prices of competing goods ↑
prices of complementary goods ↓
population ↑
Preference for pizza ↑
 Shift variables for demand

Income
prices of competing goods
prices of complementary goods
population
Preference for pizza
 Shift variables for demand

• Example (a): an increase in the aggregate

income
If aggregate income increases , the demand
for pizza increases , as in panel (a) of the next
Figure.
 Shift variables for demand

• And when the demand for pizza increases,

both the equilibrium price and the
equilibrium quantity of pizza rise, as shown in
the next graph.
 Shift variables for demand

Income ↑
Demand of pizza↑ (from D1 to D2)
Equilibrium price ↑ (from P1 to P2)
Equilibrium quantity↑(from Q1 to Q2)

• The market moves to the new intersection of supply

and demand.
 Shift variables for supply
▪ Example (b): An increases in the price of
materials,

Similarly of example (a), if the price of materials

increases , the supply of pizza decreases , as
shown in panel (b) of next Figure
 Shift variables for supply

Technology
prices of raw materials
Wages
 Shift variables for supply

Technology ↓
prices of raw materials ↑
Wages ↑
 Shift variables for Supply
• And when the price of materials increases,
The model shows that in this case, the
equilibrium price of pizza rises, while the
equilibrium quantity of pizza falls as in the next
figure.
 Shift variables for Supply

Price of materials ↑
Supply of pizza ↓ (from D1 to D2)
Equilibrium price ↑ (from P1 to P2)
Equilibrium quantity ↓ from Q1 to Q2)

• The market moves to the new intersection of

supply and demand.
 Predictions
• Now all our ducks are in a row!
• We can use our theory to predict how changes in the
exogenous (shift) variables will affect the endogenous
variables
 Predictions: demand shifters

Income ↑
prices of competing goods ↑
prices of complementary goods ↓
population ↑

Predictions Grid P Q
Income + +
prices of competing goods
prices of complementary
goods
population
ad spending by pizzerias
At this point, you should do problem 3
Sales tax rate ↓
on page 15 of the textbook.
 Predictions: demand shifters

Income ↑
prices of competing goods ↑
prices of complementary goods ↓
population ↑

Predictions Grid P Q
Income + +
prices of competing goods + +
prices of complementary - -
goods
population + +
ad spending by pizzerias + +
At this point, you should do problem 3
Sales tax rate ↓ - -
on page 15 of the textbook.
 Predictions: supply shifters

Technology ↓
prices of raw materials ↑
Wages ↑

Predictions Grid P Q
Technology
Prices of raw materials
Wages
 Predictions: supply shifters

Technology ↓
prices of raw materials ↑
Wages ↑

Predictions Grid P Q
Technology - +
Prices of raw materials + -
Wages + -
HOW ECONOMISTS THINK:
ALGEBRA
 How Economists Think: algebra
• Every economic theory consists of
– Endogenous variables
– Exogenous variables and parameters (shift variables)
– Equations that show how the variables and parameters are linked to
each other (model)
• The theory predicts how changes in the exogenous variables
and parameters affect the endogenous variables
 Equations
• Each equation algebraically represents one
idea/assumption about how the (endogenous and
exogenous) variables and parameters are linked to
each other
 Solving the equations
• If we have a set of equations such that the number of
equations is equal to the number of endogenous variables in
the equations, then we can usually solve the equations and
express each endogenous variable in the equations in terms of
the exogenous variables and parameters
• These solutions predict the likely effects of the exogenous
variables and parameters on the endogenous variables
 Example of a model:
The supply & demand for new cars
• Explains the factors that determine the price of cars and the quantity
sold
• Assumes the market is competitive: each buyer and seller is too small
to affect the market price
• Variables:
Q d = quantity of cars that buyers demand
Q s = quantity that producers supply
P = price of new cars
Y = aggregate income
Ps = price of steel (an input)
The demand for cars

This equation shows that the quantity

of cars consumers demand (Q d)
is related to the price of cars (P)
and aggregate income (Y).
 Digression: Functional notation
• General functional notation
shows only that the variables are related:

A list of the
variables
that affect Q d
 Digression: Functional notation
• General functional notation
shows only that the variables are related:

▪ A specific functional form shows

the precise quantitative relationship:
 The market for cars: demand
P
Price
of cars

The demand curve shows the

relationship between quantity demanded
and price, other things equal.
D

Q Quantity
of cars
 The market for cars: supply
P
Price
of cars S

The supply curve shows the relationship

between quantity supplied and price,
other things equal.
D
Q Quantity
of cars
The market for cars: equilibrium
P
Price
of cars S

equilibrium
price
D
Q Quantity
of cars

equilibrium
quantity
 The effects of an increase in income:
P
Price
of cars S

An increase in income increases

the quantity P2
of cars consumers demand at P1
each price... D2
D1
Q Quantity
…which increases the Q1 Q2 of cars
equilibrium price and
quantity.
 The effects of a steel price increase:
P
S2
Price
of cars S1

An increase in Ps reduces the

quantity of cars producers P2
supply at each price… P1

D
Q Quantity
…which increases the market Q2 Q1 of cars
price and reduces the
quantity.
 Endogenous vs. exogenous variables:
• The values of endogenous variables
are determined in the model.
• The values of exogenous variables
are determined outside the model:
the model takes their values & behavior
as given.
• In the model of supply & demand for cars,
 A Multitude of Models
No one model can address all the issues we care about. For
example,
▪ If we want to know how a fall in aggregate income affects new
car prices, we can use the S/D model for new cars.
▪ But if we want to know why aggregate income falls, we need a
different model.
 A Multitude of Models
• So we will learn different models for studying different issues (e.g.,
unemployment, inflation, long-run growth).
• For each new model, you should keep track of
– its assumptions,
– which of its variables are endogenous and which are exogenous,
– the questions it can help us understand, and those it cannot.
 Prices: flexible versus sticky
• Economists normally presume that the price of a good or a service
moves quickly to bring quantity supplied and quantity demanded
into balance.
• In other words, they assume that markets are normally in
equilibrium, so the price of any good or service is found where the
supply and demand curves intersect.
• This assumption, called market clearing (is central to the model of
the pizza market discussed earlier).
• For answering most questions, economists use market-clearing
models.
 Prices: flexible versus sticky
• Market clearing: an assumption that prices are flexible and adjust
to equate supply and demand.
• Although market-clearing models assume that all wages
and prices are flexible, in the real world some wages and
prices are sticky.
 Prices: flexible versus sticky
• In fact, many wages and prices adjust slowly.
– Labor contracts often set wages for up to three years.
– Many firms leave their product prices the same for long periods
of time; for example, magazine publishers change their
newsstand prices only every three or four years.
• Although market-clearing models assume that all wages
and prices are flexible, in the real world some wages and
prices are sticky.
 Prices: flexible versus sticky
• Short run : in the short run, many prices are sticky-
they adjust only sluggishly in response to supply/demand
imbalances.
For example :
– labor contracts that fix the nominal wage
for a year or longer
– magazine prices that publishers change
only once every 3-4 years
 Prices: flexible versus sticky
• Market-clearing models might not describe the economy at every instant, but they
do describe the equilibrium toward which the economy gravitates.

• Therefore, most macroeconomists believe that price flexibility is a good

assumption for studying long-run issues, such as the growth in real GDP that we
observe from decade to decade.
• For studying short-run issues, such as year-to-year fluctuations in real GDP and
unemployment, the assumption of price flexibility is less plausible.

Over short periods, many prices in the economy are fixed at predetermined
levels. Therefore, most macroeconomists believe that price stickiness is a better
assumption for studying the short-run behavior of the economy.
 Prices: flexible versus sticky
• The economy’s behavior depends partly on whether prices are
sticky or flexible:
• If prices are sticky, then demand won’t always equal supply. This
helps explain
– unemployment (excess supply of labor)
– the occasional inability of firms to sell what they produce.
• Long run: prices are flexible, markets are clear, economy behaves
very differently
 Conclusion:
• Market-clearing models might not describe the economy at
every instant, but they do describe the equilibrium toward
which the economy gravitates.
• Therefore, most macroeconomists believe that price
flexibility is a good assumption for studying long-run issues,
such as the growth in real GDP that we observe from decade
to decade.
 Conclusion:
• For studying short-run issues, such as year-to-year fluctuations in real
GDP and unemployment, the assumption of price flexibility is less
plausible.
• Over short periods, many prices in the economy are fixed at
predetermined levels.
• Therefore, most macroeconomists believe that price stickiness is a
better assumption for studying the short-run behavior of the
economy.