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CHAPTER 1
The Science of Macroeconomics
Notes to the Instructor
Chapter Summary
Chapter 1 presents a brief introduction to macroeconomics. The chapter explains the type of questions macroeconomists address, introduces the concept of an economic model, and discusses the roles of price flexibility and price stickiness in macroeconomic models.
Comments
The amount of introduction required naturally depends upon the students’ previous exposure to macroeconomics in principles or in other courses. I try to stress the relevance of macroeconomics; a good way to do this is to bring in copies of that day’s newspapers and show how they contain stories related to the course. I also stress the importance of basic macroeconomic literacy and emphasize that macroeconomics teaches a way of thinking about and understanding the economy rather than a set of facts. I highlight how models help us focus on essentials and avoid unnecessary distractions that can lead us astray. One way to do this is to show how common sense can sometimes give incorrect answers; an example from the textbook is that protectionist policies don’t improve the trade balance. The supply and demand model presented in Chapter 1 provides a vehicle to explain the role of microeconomics in macroeconomics and to show how macroeconomics uses many tools and ideas from microeconomics. The lecture notes emphasize this and also explain how macroeconomics differs from microeconomics in its level of aggregation and in that it has more of a general-equilibrium focus. The textbook works, as do economists, by using different models to answer different questions, but I reassure students that we also emphasize how different models fit together. The companion website for students and instructors has been updated for use with the 10th edition of Macroeconomics (www.worthpublishers.com/mankiw). The site offers a superb set of software-based features and a PowerPoint®^ tutorial for students. In addition, the PowerPoint slides for instructors have been updated and include animated graphics and other innovative pedagogical features. Students will find the website both helpful and fun to use. The website includes Self-Tests and Flashcards that provide immediate feedback to students, a Data Plotter that students can use to graph and compare macroeconomic data, a feature titled A Game for Macroeconomists that allows students to make policy choices as president of the United States, and a Macro Models component that provides students with the hands-on opportunity to manipulate the models of the textbook. These software features can be used simply as a source of additional exercises for students to do on their own, or they can be incorporated directly into classroom discussions. For example, to integrate the software into a class, students might be given an assignment to develop a policy memo for the president that requires the use of both the Macro Models feature and the Data Plotter. The instructor might then run a mock cabinet meeting and have students present their findings and policy recommendations. The software also can be used to design advanced essay questions for students. Some possibilities and suggestions for using the software are provided in the Notes to Instructors section of subsequent chapters. The student resource titled Student PowerPoint Tutorials provides students with an animated set of slides that will help reinforce the material from the text and lectures. This tutorial uses superb graphics and a dose of humor to enliven macroeconomics. A good way of
incorporating this feature is to suggest that students view the slides after reading each chapter to help deepen their understanding. For enhancing your classroom lectures, I strongly recommend the use of the PowerPoint slides for instructors that are available on the website. This resource is now fully animated and includes explanations of the text’s models and case studies, along with notes to instructors. The presentations are organized by chapter, and you can easily augment them by inserting your own slides.
Use of the Economy.com Website
The Economy.com website provides a rich source of data for supplementing lectures and designing class projects. A good use of this resource for Chapter 1 is to create graphs of real GDP growth, CPI inflation, and the unemployment rate over the past few years to provide an up- to-date picture of the economy’s main economic indicators. Locate the data on the website’s data page and choose the appropriate settings to create a graph.
Chapter Supplements
This chapter includes the following supplements: 1-1 The Recent Behavior of the U.S. Economy: A Guide to the Case Studies 1-2 Presidential Elections and the Economy 1-3 When Is the Economy in a Recession? 1-4 Economic Rhetoric 1-5 Additional Readings Lecture Notes
1-1 What Macroeconomists Study
Economics is the study of how people, businesses, and governments behave and interact in the production and allocation of goods and services. Traditionally, economics is divided into microeconomics, which studies the behavior of individuals and organizations (consumers, firms, and the like) at a disaggregated level, and macroeconomics, which studies the overall or aggregate behavior of the economy. Since this book studies macroeconomics, we seek to explain phenomena such as inflation, unemployment, and economic growth, and we are not concerned with, say, the demand for or supply of peanuts. In macroeconomics, we do two things. First, we seek to understand the economic functioning of the world we live in; and second, we look at whether we can do anything to improve the performance of the economy. That is, we are concerned with both explanation and policy prescriptions. Explanation involves an attempt to understand the behavior of economic variables, both at a moment in time and as time passes. Modern macroeconomics recognizes that it is important to focus on more than just short periods of time, and so it has an explicitly dynamic focus. We thus try to explain the behavior of economic variables over time. This means that we wish to explain the behavior of the economy both in the long run and in the short run. Supplement 1-1, “The Recent Behavior of the U.S. Economy” Figure 1-
To try to understand the economy and focus on what is important, we do a couple of things. First, we aggregate. Instead of worrying about individual goods—pizza, bread, automobiles, peanuts, and the like—we think about some aggregate of them all. We call this good real GDP and denote it by the symbol Y. GDP stands for gross domestic product. It is a measure of the total production in the economy; indeed, explaining the behavior of the economy is largely a matter of explaining the behavior of real GDP over time. We consider the definition of GDP more carefully later. The second thing we do is to build models_. Models_ are abstractions from reality that serve as frameworks of analysis. Just as aerospace engineers build model planes to put in a wind tunnel and judge that these models need not be equipped with “fasten seat belt” signs but should be equipped with wings, so economists construct representations of the economy that include important variables and exclude unimportant variables. Many different sciences, such as meteorology, physics, and biology, use models. In economics, as in many other sciences, the models with which we work are usually mathematical. We develop mathematical explanations of the economy and use algebra and graphs to help understand how the economy works. The aim of macroeconomics and this textbook is not so much to provide facts about macroeconomics as to give a framework of analysis for coherent thinking about macroeconomic issues. The previous analysis of the pizza market is an example of a model. This model represents the determination of the equilibrium price and quantity traded in a simple setting. In constructing that model, we judged that the price of pizza, the price of cheese, and aggregate income are all important in understanding the demand for and supply of pizza; we implicitly decided that all other variables were less important and could be left out. Knowing what to include and what not to include in a model is the art of the economist; it requires judgment and skill. We can use the model of the pizza market to answer certain questions. For example, we might wonder what effect an increase in consumers’ incomes might have on the price of pizza. An increase in income would imply that at any given P , consumers would demand more pizza. The demand curve would shift to the right. Thus, we see that price and quantity both rise. Similarly, an increase in the price of materials would cause the supply curve to shift in, raising the equilibrium price of pizza and lowering the quantity traded. This experiment is typical of the way economists use a model. They change one variable, taken as given, and look at the effect on other variables that the model explains. Variables taken as given from outside the model are known as exogenous variables; variables explained within the model are known as endogenous variables. A typical experiment with an economic model thus involves changing an exogenous variable and looking at the effect on endogenous variables. This is known as a comparative static experiment.
FYI: Using Functions to Express Relationships Among Variables
Economists use mathematics—particularly graphs and algebra—to help understand the economy. For example, we have thus far said two things:
- The supply of pizza depends on the price of pizza and the price of materials.
- The demand for pizza depends on the price of pizza and aggregate income. A mathematician uses symbols to express concepts such as these more compactly:
- Qs^ = S ( P , Pm );
- Qd^ = D ( P , Y ). Here S ( ) and D ( ) are functions: they indicate relationships among variables. Qs , Qd , P , Pm , and Y are variables, denoting the quantity of pizza supplied, the quantity of pizza demanded, the Figure 1- Figure 1-
price of pizza, the price of materials, and aggregate income, respectively. An example of a supply function is Qs^ = 15 P – 2 Pm. Another example is Qs^ = 13( P / Pm ). Very often in economics, we do not know very much about the exact nature of the relationships among variables, and so we prefer the general functional notation used earlier. We can illustrate these relationships on a diagram. This diagram shows that the supply of pizza increases with the price of pizza, and the demand for pizza decreases with the price of pizza. To remind us that the quantity of pizza supplied also depends on the price of materials, Pm is sometimes put in parentheses when we label the supply curve. Similarly, we sometimes put Y in parentheses when we label the demand curve to remind us that demand also depends on income. Supplement 1-4, “Economic Rhetoric”
The Use of Multiple Models
Macroeconomists use a multitude of models because different models are appropriate for different questions. If we wanted to understand the effects of government deficits on interest rates, for example, we would not want to use a model that included the price of cheese. An important aim of the textbook is to demonstrate economists’ methods of analysis and use of models, and so the textbook works as economists do, by using different models to answer different questions. Part of the skill of being an economist is learning how to integrate these different models into a coherent view of the economy.
Prices: Flexible Versus Sticky
We noted earlier that macroeconomics is concerned with both explanation and policy recommendations. Not surprisingly, much of the debate among macroeconomists has to do with their different views on policy. Essentially, these debates often come down to whether or not the economy, left on its own, does a good job of allocating resources, or whether government intervention can improve upon the performance of the economy. This theme recurs throughout our analysis. In trying to understand the role of policy in macroeconomics, our conclusions depend crucially on what we believe about the behavior of prices. In our example of the pizza market, we supposed that the price of pizza adjusted to equate supply and demand—we supposed that the market cleared. In this case, the market does a good job of matching up suppliers and demanders, and all mutually beneficial trades are carried out. In some markets, prices are indeed very flexible, but in other markets, we have much less confidence that market clearing occurs at all times. Instead, we think that some prices are sticky —slow to adjust. For example, labor contracts often set wages for a number of years in advance, and mail-order catalogs post prices that are set for a number of months. Economists thus usually think that, for macroeconomics, it is reasonable to suppose that prices are completely flexible in the long run only. In the short run, we often make an assumption of price stickiness to help us explain the behavior of the economy. One other difference between microeconomics and macroeconomics is worth mentioning. In microeconomics, we usually focus on a single market. In macroeconomics, we pay attention to how outcomes in one market affect what goes on in another market. For example, we often Figure 1-
CASE STUDY EXTENSION
1-1 The Recent Behavior of the U.S. Economy: A Guide to the Case
Studies
Many of the case studies in the textbook address the recent history of the U.S. economy. Taken together, the case studies provide a picture of the U.S. economic experience during this century, particularly over the past several decades. The following is an overview: For a basic picture of U.S. economic performance, the Chapter 1 case study “The Historical Performance of the U.S. Economy” shows the behavior of real GDP, inflation, and unemployment since
- The long-run picture shows that GDP grows through time, although this growth is often interrupted by recessions, most recently in 2007 to 2009. The Chapter 9 case study “The Slowdown in Productivity Growth” notes the slowdown in the long-run growth rate experienced by the United States and other countries that began in the early 1970s. Another Chapter 9 case study highlights the importance of differences in management practices as a reason why countries have experienced differences in productivity performance. The Chapter 14 case study “Inflation and Unemployment in the United States” shows unemployment and inflation over the past four decades and illustrates the stagflation (high unemployment and high inflation) of the 1970s; this contrasts with the relatively stable growth of the 1950s and 1960s. The Chapter 10 case study “How OPEC Helped Cause Stagflation in the 1970s and Euphoria in the 1980s” explains how the experience of the 1970s was in large measure the result of supply shocks associated with increases in the price of oil. The United States thus entered the 1980s with very high inflation rates by historical standards. Eliminating this inflation was a top priority for Federal Reserve Chair Paul Volcker, who pursued a tight monetary policy. Nominal interest rates rose in the short run but fell in the longer run as the inflation rate fell, as discussed in the Chapter 11 case study “Does a Monetary Tightening Raise or Lower Interest Rates?” As a result of these policies, the U.S. economy also entered what was at the time the most severe contraction since the 1930s. Although monetary policy was contractionary, fiscal policy in the 1980s was expansionary. Taxes were cut, and spending rose. The fall in government saving (rise in the government deficit) caused the debt to reach a level unprecedented in peacetime (see the Chapter 17 case study “The Troubling Long-Term Outlook for Fiscal Policy” for a long-run perspective on the debt). Ultimately, the tight monetary policies did succeed in decreasing inflation and inflation expectations, and the economy gradually returned to full employment. This recovery was aided by a fall in oil prices in the mid-1980s (the Chapter 10 case study cited above). By the end of the decade, output was close to the natural rate, and inflation was low. The question of whether macroeconomic policy is responsible for reduced volatility of economic activity in the decades following World War II is considered in the Chapter 16 case study “Is the Stabilization of the Economy a Figment of the Data?” While the 1990s witnessed the longest period of expansion during the postwar era, the business cycle had not been vanquished as two recessions occurred during the first decade of the 2000s. The onset of recession in 2001 is analyzed in the Chapter 12 case study “The U.S. Recession of 2001.” Following several years of expansion, the economy then experienced a deep and prolonged recession beginning at the end of 2007, as discussed in the Chapter 12 case study “The Financial Crisis and the Great Recession of 2008 and 2009.” The sluggish recovery from that recession may have been exacerbated by uncertainty concerning the course of economic policy, a topic discussed in the Chapter 16 case study “How Does Policy Uncertainty Affect the Economy?” 7
ADDITIONAL CASE STUDY
1-2 Presidential Elections and the Economy
The influence of economic events on politics is apparent during presidential elections. Economic policy provides a primary topic of debate for the candidates, and the state of the economy has a powerful influence on the outcome of the election. In fact, according to economist Ray Fair, one can forecast the outcome of a presidential election with remarkable accuracy by looking at how well the economy is doing. History shows that the incumbent party is helped by growing incomes and is hurt by rising prices. Fair has used the historical evidence to produce an equation that forecasts the winner of the popular vote (but not that of the electoral college!) using the following information:
- which party is currently in power,
- whether an incumbent is running for reelection,
- the number of terms the incumbent party has been in power,
- the growth in income per person in the first three quarters of the election year,
- the rate at which prices have been rising in the two years prior to the election, and
- the number of quarters during the current administration (prior to the election) in which the growth rate of real income per person was greater than 3.2 percent. Fair’s equation would have correctly predicted the winner of the popular vote in 21 of the 26 presidential elections from 1916 to 2016.^0 The elections it would have missed were Kennedy–Nixon in 1960, Humphrey–Nixon in 1968, Bush–Clinton in 1992, Bush–Gore in 2000, and Clinton–Trump in 2016. Predicting the Bush–Clinton election was complicated by the strong showing of a third-party candidate, Ross Perot. Fair’s model assumes that Perot drew votes away equally from Bush and Clinton. Interestingly, the equation predicted that Al Gore would lose the popular vote in the 2000 election, when in fact he won a majority but lost in the electoral-college tally. Similarly, the model predicted Clinton would fall short in the popular vote in 2016, but she actually bested her opponent by 3 million votes, while losing the presidency in the electoral college. Fair’s analysis indicates that voters apparently have a short time horizon with regard to economic events. This provides support for the view that administrations can manipulate the economy in an attempt to improve their reelection chances.^0 Even though the state of the economy is apparently very important in determining presidential election outcomes, this need not mean that voters look only to their own economic well-being. Research by social psychologists and political scientists on the motivations of individual voters suggests that they in fact take a broader view. Donald Kinder and David Sears summarize this research as follows: With respect to economic performance, voters may simply examine their own circumstances, supporting candidates and parties that best advance their own economic interests. Yet such “pocketbook” voters are hard to find. Although the economic predicaments of personal life do occasionally influence political choice, the effects are never very strong and usually they are utterly trivial. Declining financial condition, job loss, preoccupation with personal problems—none of these seems generally to motivate presidential voting. (^0) R. Fair, “Presidential and Congressional Vote-Share Equations,” American Journal of Political Science , January 2009, 55–72. The 2014 update to Fair’s equations, available at fairmodel.econ.yale.edu/, now correctly predicts vote shares for the Wilson–Hughes election of 1916. (^0) See the discussion of the political business cycle in Chapter 16 and also Supplements 16-9, “Distrust of Policymakers,” and 16-10, “The Political Business Cycle.” 8
ADDITIONAL CASE STUDY
1-3 When Is the Economy in a Recession?
On November 26, 2001, the Business Cycle Dating Committee of the National Bureau of Economic Research reported that the U.S. economy had entered a recession during March 2001. The committee, which is composed of leading macroeconomists, made its decision even though data on real GDP showed a small increase in the April through June quarter of the year and began to decline only during the July to September quarter. A popular rule of thumb used by the media (and economists) is that a recession occurs when a decline in real GDP lasts for at least two consecutive quarters. At the time that the Business Cycle Dating Committee issued its report, real GDP had declined for only one quarter. Why then did the committee make the call that a recession had begun? The committee defines a recession as “a significant decline in activity spread across the economy, lasting more than a few months, [and] visible in industrial production, employment, real income, and wholesale-retail trade.”^0 Unlike the popular rule of thumb, “the committee gives relatively little weight to real GDP because it is only measured quarterly and it is subject to continuing, large revisions.”^0 The data the committee emphasizes are available monthly, with at most only a couple of weeks’ lag between the end of the month and the time when the data are released. This feature of the data allows the committee to date recessions monthly. Although the monthly data are subject to revisions, these revisions tend to occur sooner and are often smaller than those for GDP. In their report, the committee noted that real manufacturing and trade sales had peaked in August 2000, industrial production (the output of factories, mines, and utilities) had peaked in September 2000, and employment had peaked in March 2001. In addition, all three of these indicators had shown persistent declines into the fall of 2001. Real personal income (net of transfer payments), however, had not reached a peak and was still growing. The committee concluded that the decline in industrial output and employment was substantial enough and sufficiently spread across sectors of the economy to warrant the dating of a recession. In choosing the peak-employment month of March as the turning point, the committee emphasized total employment as the broadest measure of economic activity on a monthly basis. Nearly 20 months after reporting on the start of the recession, the committee met again on July 17, 2003, and determined that the recession had ended in November 2001. The relatively long delay in dating the trough of the recession was the result of mixed signals from the data. Even though real GDP, sales, and income all grew strongly during 2002, employment had not yet begun to recover and industrial production remained well below its previous peak. As a result, “the committee waited to make the determination of the trough date until it was confident that any future downturn in the economy would be considered a new recession and not a continuation of the recession that began in March 2001.”^0 Again in late 2008, as signs intensified that economic performance had deteriorated, the committee met on November 28 and determined that the economic expansion had ended nearly a year earlier, in December 2007. In arriving at its decision, the committee emphasized payroll employment, which it described as the “most reliable comprehensive estimate of employment.”^0 The committee noted that employment peaked in December 2007 and had declined every month since then. Almost two years later, on September 20, 2010, the committee determined that economic conditions had bottomed out in June 2009, making the recession, at 18 months, the longest since the Great (^0) Business Cycle Dating Committee, “The Business-Cycle Peak of March 2001,” National Bureau of Economic Research, November 26, 2001, p. 1. For further details on business cycle dating, see the committee’s web page, at www.nber.org/cycles. (^0) Ibid., p. 1. The recent move to a chain-weight measure of real GDP, however, eliminated one reason for revisions that occurred in the past when base-year weights were updated. Even so, GDP continues to be subject to major revisions as new source data become available, sometimes with a lag of several years. (^0) Business Cycle Dating Committee, “July 17, 2003 Announcement,” National Bureau of Economic Research, July 17, 2003, p. 1. (^0) Business Cycle Dating Committee, “Determination of the December 2007 Peak in Economic Activity,” National Bureau of Economic Research, December 11, 2008, p. 1. 10
Depression. Once again, the committee had waited to make its decision to ensure that “any future downturn would be a new recession and not a continuation of the recession that began in December 2007.”^0 In arriving at its decision, the committee emphasized accelerating growth in GDP during the last half of 2009, even as employment continued to decline, noting that in “previous business cycles, aggregate hours and employment have frequently reached their troughs later than the NBER’s trough date.”^0 (^0) Business Cycle Dating Committee, “Announcement of June 2009 Business Cycle Trough/End of Last Recession,” National Bureau of Economic Research, September 20, 2010, p. 1. (^0) Ibid, p. 2. 11
misinformation is a pity, really, and worth trying to offset. Yet these outside observers of economics cannot be blamed for misunderstanding it. Economics does not very well understand itself. If it understood its own way of conversing—its rhetoric—maybe some of its neurotic behavior would stop.^0 The extent of real disagreement among economists, as we have argued several times, is in fact exaggerated. The extent of their agreement, however, makes the more puzzling the venom they bring to minor disputes. The assaults on Milton Friedman or on J.K. Galbraith have a bitterness beyond reason. The unreason, though, has its reason. If one cannot reason about values, and if what matters most is placed in the value half of the fact-value split, then it follows that one will embrace unreason when talking about things that matter. The claims of an overblown methodology of science serve merely to spoil the conversation. Economists, without thinking much, have metaphors about the economy; and they have also, without thinking much, metaphors for their scholarly conversation. It would be good for them to become aware of their metaphors and improve them in shared discourse.^0 Mastery of the models and ideas explained in the textbook will not provide answers to all of the questions or disputes that concern macroeconomists. But it will help the reader to be an informed participant in the macroeconomic conversation. (^0) Ibid., xix. (^0) Ibid., 184. 13
LECTURE SUPPLEMENT
1-5 Additional Readings
Supplements to various chapters suggest additional readings that may be useful for students who are writing papers, doing projects, or simply wishing to know more about the topics covered in the textbook. The sources listed are relatively accessible to students. Some of the readings cited in the supplements are from these sources. The Journal of Economic Perspectives includes symposia and review articles designed to explain economic ideas to nonspecialists. Although the mathematical sophistication of these articles varies, students should usually be able at least to grasp the basic ideas discussed. The American Economic Review Papers and Proceedings , published in May of each year, includes papers from the American Economic Association’s annual conference. Each issue includes about three or four short papers on each of about two dozen topics of current interest to researchers. These papers are usually nontechnical discussions of recent research by the author(s). The Journal of Economic Literature is an important source of references. It includes listings of academic journal publications, indexed by author, and thus is the place to look for references to work by a particular individual as well as to check the contents of recent academic journals. It also includes many book reviews, grouped by subject area, and occasional detailed survey articles. The New Palgrave is a four-volume encyclopedia of economics.^0 The articles published in it vary greatly in terms of length, technical sophistication, and breadth and idiosyncrasy of coverage. Nevertheless, with a bit of persistence, students researching a topic are more likely than not to find helpful information in these volumes. The Brookings Papers on Economic Activity contain articles on current macroeconomic topics and a summary of discussions of those articles by leading macroeconomists. The National Bureau of Economic Research Macroeconomics Annuals (Cambridge, Mass.: MIT Press) adopts a similar format. The publications of the various Federal Reserve Banks often include articles that are both useful and accessible. These are available on the Internet. The Economist newsmagazine generally has good coverage of world economic and political events informed by sensible economic reasoning. The Economic Report of the President is an excellent source for basic macroeconomic data. Whereas economics journals generally contain articles that are technically sophisticated in terms of the mathematics and the statistics they employ, it is often possible for the discerning student to grasp the main point of many articles without getting too embroiled in the mathematics and econometrics. Good general journals to consult are American Economic Review , Economic Journal , Journal of Political Economy, and Quarterly Journal of Economics. Some of these journals occasionally include survey articles or review articles. Finally, daily newspapers such as the New York Times or the Wall Street Journal are always worth reading to keep up to date on current economic news. (^0) P. Newman, J. Eatwell, and M. Milgate, eds., The New Palgrave: A Dictionary of Economics: 2nd ed_._ (London: Palgrave Macmillan, 2008).
