Williamson 3e IM 01

Chapter 1 Introduction

Teaching Goals

Macroeconomics primarily studies economic growth and business cycles. Over time, there is a prevailing upward trend in the standard of living. However, such growth can be rather erratic. There are some periods of very rapid growth, some periods of rather anemic growth, and also some periods of temporary economic decline. Explanations for the overall upward trend in standards of living are the subject of economic growth analysis. Explanations of variations in growth over shorter time horizons are the subject of business cycle analysis. Students should be able to distinguish between microeconomic topics and macroeconomic topics. Students should understand the distinction between growth analysis and business cycle analysis.

Although microeconomics and macroeconomics are separate branches of study, both branches are guided by the same set of economic principles. Standard economic theory is guided by the assumption of maximizing behavior. As a first approximation, we therefore view the macroeconomy as a collection of markets with maximizing participants. These participants are price-taking agents and the economy is closely approximated by a competitive equilibrium.

Because the economy as a whole is extremely complex, macroeconomists must rely on somewhat abstract models. Although the structure of such models does not correspond to all of the details of life in a complex society, these models offer the best hope of providing simple, yet accurate descriptions of how the macroeconomy works, and how government policies may affect macroeconomic outcomes.

Economists are in broad consensus about the mechanisms of economic growth. There is less agreement about the causes and consequences of business cycles. Careful study concludes that most business cycles are very similar in many ways. Therefore, macroeconomists are in search of a logically consistent paradigm for the typical business cycle. Currently popular explanations of the “typical” business cycle include Keynesian sticky-price models, money supply surprise models, real business cycle models, and Keynesian coordination failure models.

Classroom Discussion Topics

One good way to get the ball rolling is to list some macroeconomic concerns like stagnant economic growth, unemployment, inflation, government budget deficits, tax burdens, balance of trade deficits, financing of Social Security, and the like. Draw on current news or look at various policy proposals discussed in Washington. Ask or poll students as to whether they are personally concerned about such problems and what original prejudices they might have about causes and effects. Sometimes students express concerns about topics that are perhaps more microeconomic in nature, like inequality in the distribution of income and environmental concerns. Emphasize that economic growth may provide enough extra resources to help deal with these issues.

2 Williamson • Macroeconomics, Third Edition

Students often have conflicting ideas about the current state of the economy. Sometimes their perspectives may be governed by their individual circumstances, what they read in the paper, what they see on TV and the like. Ask them whether they believe that times are currently good or bad. Ask them why they think the way that they do. Ask them how they can more objectively back up or check out their casual impressions about the current state of the economy.

Outline

I. What Is Macroeconomics?

II. Gross National Product, Economic Growth, and Business Cycles

A. Adjustments for Inflation and Population Growth

B. Historical Growth Perspectives

C. The Great Depression and World War II: Business Cycles

D. Growth Measurement

E. Trend and Cyclical Components

III. Macroeconomic Models

A. Modeling in General

B. Rational Behavior

C. Competitive Equilibrium

D. Hypotheses and Hypothesis Testing

IV. Microeconomic Principles

A. When Do Microeconomic Reactions Affect Macroeconomic Outcomes?

B. Rational Expectations and the Lucas Critique

V. Disagreement in Macroeconomics

A. Exogenous and Endogenous Growth Models

B. Keynesian Sticky-Price Models

C. Money Surprise Theory

D. Real Business Cycle Models

E. Keynesian Coordination Failure Models

VI. What Do We Learn from Macroeconomic Analysis?

A. Fundamentals: Preferences and Productive Capacity

B. The Efficiency of Market Outcomes

C. The Cost of Government Activities

D. Expectations in Macroeconomics

E. Technological Progress

F. Inflation and Money Growth

G. Business Cycles Are Remarkably Similar

Chapter 1 Introduction 3

H. Foreign Events May Have Domestic Consequences

I. Money Is a Socially Useful Contrivance

J. Unemployment Can Be a Valuable Use of Time

K. Is There an Inflation–Output Tradeoff?

VII. Understanding Current and Recent Macroeconomic Events

A. The Productivity Slowdown 1. Average Labor Productivity 2. The Slowdown: Late 1960s-early 1980s 3. Measurement Error? 4. Adjustment to New Technology?

B. Taxes, Government Spending, and the Government Deficit 1. The Upward Trend in the Size of Government 2. Crowding Out the Private Sector 3. The Deficit and Government Savings 4. Ricardian Equivalence

C. Inflation 1. The Historical Record 2. Inflation and Money Growth

D. Interest Rates 1. The Nominal Interest Rate and the Real Interest Rate 2. Inflation and Nominal Interest Rates

E. Macroeconomic Activity 1. The Historical Record 2. Possible Causes of Recent Recessions

F. Trade and the Twin Deficits of the 1980s 1. The Current Account and International Financial Transactions 2. Current Account Deficits and Government Budget Deficits

G. Unemployment 1. Unemployment and Aggregate Economic Activity 2. The Structure of the Population 3. Government Intervention 4. Sectoral Shifts

Textbook Question Solutions

Questions for Review 1. Macroeconomics focuses on questions that affect large numbers of individuals, including those in

other nations.

2. Microeconomists study the behavior of individual households and firms. Because the economy as a whole is comprised of a large number of households and firms, interactions at the aggregate level are the results of decisions of individual households and firms.

3. The average American was eight times as rich.


4. The Great Depression of the 1930s and World War II.

5. What causes sustained economic growth? Could economic growth continue indefinitely, or is there some limit to growth? Is there anything that governments can or should do to alter the rate of economic growth? What causes business cycles? Could the dramatic decreases and increases in economic growth that occurred during the Great Depression and World War II be repeated? Should government act to smooth business cycles?

6. The slope represents the exponential growth rate.

7. The trend in a series is a smooth curve fit to the data. The business cycle component is equal to the actual series values minus the trend values.

8. Experimentation may cause irreparable harm to a large number of people.

9. A model must be simple to capture the essential features of the world that are relevant to problems at hand.

10. No. Exact descriptions of reality are too complicated to provide useful results.

11. The consumers and firms that interact in the economy. The set of goods that consumers wish to consume. Consumers’ preferences over goods. The technology available to firms for producing goods. The resources available.

12. Macroeconomic models help us answer questions about how the economy behaves. Models are useful if they reasonably and accurately explain the phenomenon of interest.

13. Macroeconomic behavior is the result of many microeconomic decisions. To answer policy questions, we need to know whether a proposed policy change is likely to affect the behavior of the individual decision makers.

14. Money surprise theory Real business cycle theory Keynesian coordination failure theory Keynesian sticky wage model

15. True productivity continued to rise, but was imprecisely measured. Time was required for the economy to adjust to new technology.

16. An increase in government spending consumes resources that might otherwise be used by the private sector.

17. Holding government spending fixed, a cut in taxes today must be offset by a tax increase in the future. Such a policy change should not affect private decisions to purchase goods and services.


18. The cause of inflation is excessive growth in the money supply.

19. The nominal interest rate expresses dollar interest payments as a percentage of the amount borrowed. The real interest rate measures that amount of purchasing power that will be required to repay a loan. The (expected) real interest rate is approximately equal to the nominal interest rate minus the (expected) rate of inflation.

20. 1974–75, 1981–82, 1990–91, 2001.

21. For given amounts of domestic production and spending, government deficits must be financed by borrowing from abroad. Total borrowing from abroad is equal to the current account deficit. Therefore, if the government budget deficit increases, the current account budget deficit automatically increases by the same amount, unless there is some offset due to changes in domestic production or spending.

22. The level of aggregate economic activity The structure of the population Government intervention Sectoral shifts

Problems 1. Calculating Growth Rates Data:

Year Real Per Capita GNP

1950 $11,745 1960 $13,951 1970 $18,561 1980 $22,784 1990 $28,598 1995 $30,525 1996 $31,396 1997 $32,520 1998 $33,544 1999 $34,367 2000 $35,265 2001 $35,165 2002 $35,368 2003 $35,895 2004 $36,939 2005 $37,773


(a) Actual Percentage Growth Rates, 1996–2005.

Year Real Per Capita GNP %Growth

1995 $30,525 1996 $31,396 2.85 1997 $32,520 3.58 1998 $33,544 3.15 1999 $34,367 2.45 2000 $35,265 2.61 2001 $35,165 −0.28 2002 $35,368 0.58 2003 $35,895 1.49 2004 $36,939 2.91 2005 $37,773 2.26

(b) Approximate Percentage Growth Rates, 1996–2005.


1995 $30,525 1996 $31,396 2.81 1997 $32,520 3.52 1998 $33,544 3.10 1999 $34,367 2.42 2000 $35,265 2.58 2001 $35,165 −0.28 2002 $35,368 0.58 2003 $35,895 1.48 2004 $36,939 2.87 2005 $37,773 2.23

The approximation is extremely close. The approximation works well for small percentage changes.

(c) Actual Percentage Growth Rates for Decades, 1950–2000.


1950 $11,745 1960 $13,951 18.78 1970 $18,561 33.04 1980 $22,784 22.75 1990 $28,598 25.52 2000 $35,265 23.31


Approximate Percentage Growth Rates.


1950 $11,745 1960 $13,951 17.21 1970 $18,561 28.55 1980 $22,784 20.50 1990 $28,598 22.73 2000 $35,265 20.96

The approximation is still relatively close, but the approximation errors are larger because the growth rates are larger. Note that the approximation formula actually calculates the continuously compounded growth rate.

(d) Growth is fastest in the 1960s. Growth is slowest in the 1950s.

2. Some obvious possibilities include Federal Reserve open market purchases to keep the money supply from shrinking, instituting bank reforms before the Depression started, avoiding high tariff rates, etc.

3. Newton’s model of falling bodies. Ignores air resistance. Works well for most dense objects, doesn’t work well for feathers.

Diagrams of plays in football and basketball. Ignores the characteristics of individual players, and opponent reactions. Works well for evenly matched teams.

Scale models of new aircraft designs. Ignores working engines and interior contents. Wind tunnel testing approximates aerodynamics of actual aircraft.

4. Income taxes are collected as a percentage of income. Sales taxes are collected as a percentage of sales. Collections therefore fall if there is a reduction in the level of economic activity.

5. Taxes as a percentage of GDP rose, and at the same time, spending as a percentage of GDP fell.

6. In the early 1980s, inflation and money growth were moving in the opposite directions. Also, since the mid-1980s, fluctuations in the money growth rate occur in the absence of fluctuations in the rate of inflation. However, the relationship between money growth and inflation is consistently confirmed over longer time spans. The period of time from the late 1960s through the early 1980s was characterized by higher inflation and higher money growth relative to the periods before and after.

7. As one possibility, fundamental changes in the supply and demand for lending may explain changes in the real rate of interest. Alternatively, the mid-1970s was a period of rising inflation. Borrowers’ willingness to pay interest depends on their expectations of future inflation. If higher inflation was expected to be temporary, the low observed real interest rates of the period would be consistent with somewhat higher expected real interest rates.


8. Throughout the 1990s, imports rose dramatically. Although exports also increased, exports grew less rapidly than imports.

9. At the end of the 1960s the work force was relatively old, and older workers are generally unemployed less than younger workers. This period predates the entrance of the baby boom generation. When a large number of young workers enter the labor force, the average age of the workforce declines, and unemployment may be expected to rise. The end of the 1960s also coincided with the peak years of the Vietnam War. Many young men who might otherwise have been unemployed were drafted into the armed forces.

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Williamson 3e IM 01