1

INTRODUCTION

FOCUS OF THE CHAPTER

We begin our study of macroeconomics with an introduction to the three models around which
it is organized and the time horizons to which they apply. We also take a preliminary look at
economic growth, inflation, unemployment, and the business cycle, and provide an overview of
the textbook.

SECTION SUMMARIES
1.

Macroeconomics Encapsulated in Three Models

Almost everything you will learn about macroeconomics can be understood in the context of
three models: growth theory, which describes the behavior of the economy in the very long run
when capital, labor, and technology can all vary, and the aggregate supply-aggregate demand
(AS-AD) model, which describes the behavior of the economy at all shorter horizons. This is
really a combination of two different models: one of aggregate supply, another of aggregate
demand. Different assumptions about aggregate supply determine the time horizon over which
the model applies.
It is useful to have some working definitions of the time frames were talking about. The very
long run, the domain of growth theory, refers to periods of decades or more, during which all of
the inputs to production capital, labor, the level of technology and size of the population can
change. We look at the behavior of potential rather than actual output over this period; we watch
the amount of output that would be produced, if all inputs to production were fully employed.
The terms long, medium and short run refer to periods of time during which the supplies
of capital, labor, etc. are fixed, or during which the level of potential output is constant. The main
difference between these time periods is whether we assume these inputs are fully employed: in
the long run we assume that they have to be, so that output equals potential output; at shorter
horizons, we let them be either over- or underemployed and look at the resulting output gap.

1
1

CHAPTER 1

Aggregate Supply is horizontal in the

sh ortrun
AS

short run, when prices are fixed.

AD
Y

Figure 11
AS-AD IN THE SHORT RUN

The AS-AD model looks at the way that the demand for all of a countrys products (described by the AD
curve) interacts with the supply of those products (described by the AS curve) to determine its price level
and level of output. Potential output in this model is always fixed; only actual output can change.
We determine the time horizon over which the AS-AD model applies by changing our assumptions about the
aggregate supply curve:

In the long run, when all inputs are fully employed, the AS curve is vertical at the level of potential
output, and output is determined by aggregate supply alone.

In the short run, a period of time so brief that the price level does not have time to change, the AS
curve is flat, and that output is determined by aggregate demand alone.

In the medium run, somewhere between these extremes, inputs do not have to be fully employed, the
price level is not frozen, and the AS curve slopes upward.

We will return to this topic in Chapter 5.

2.

To Reiterate

The growth rate of the economy is the rate at which output is increasing. The trend path of GDP is the rate at
which output would grow, were all inputs of production fully employed.
How are these different? The first is the amount by which actual output grows. The second is the amount by
which potential output grows.
The business cycle is the cycle of expansion and contraction around the trend path of output.

INTRODUCTION
3
The output gap measures the difference between potential and actual output. It moves with the business
cycle - increasing during recessions, and decreasing during recovery, sometimes decreasing so far that it
becomes negative (it does this when inputs are
over-employed).
P

l ongrun AS

Inflation is inversely related to the output

gap prices and output rise together when they
are caused by changes in AD, and increases in
output, when potential output is fixed, cause the
output gap to fall.
When inputs are underemployed, output is
below its potential. When inputs are
overemployed (think of everyone in the economy
working overtime and missing dinner), output is
above potential output. We will find later that
this second situation is inflationary.

AD
Y

Figure 12

AS-AD IN THE LONG RUN

And what is inflation? The rate of inflation is the
percentage change in the price level. That price
level is often measured with the consumer price index (CPI) a series that keeps track of the cost of a
typical urban consumers basket of goods. The percentage change in the CPI over one year would be a
measure of that years consumer inflation.

3.

Outline and Preview of the Text

Chapter 2, which covers national income accounting, introduces a number of identities that are used
throughout the text. Chapters 3 and 4 cover growth theory, the behavior of potential output over the very
long run. Chapters 5 and 6 introduce the AS-AD model, our framework for thinking about output at
business-cycle frequencies. Chapter 7 looks at inflation and unemployment over this same horizon. Chapter 8
introduces monetary policymaking in the US. Chapters 911 delve deeper into aggregate demand; chapter 12
broadens our perspective to include international linkages. Chapters 1318 take a closer look at the
individual pieces of the domestic economy: consumption, investment, etc. along with some policy issues.
Chapter 19 highlights the issues surrounding high inflation and large government deficits, and Chapter 20
serves as an introduction to the basics of international macroeconomics. Chapter 21 introduces several
concepts from the frontiers of economic research.

Aggregate Supply is vertical in

the long run when output must
equal potential output.

CHAPTER 1

4.

Prerequisites and Recipes

It is always best to read economics with a pencil in your hand. You will periodically need to stop and scribble
a graph, highlight a problem area, or make note of an important definition. Do not be afraid to do this;
textbooks arent supposed to read like novels. In some of the more difficult chapters you should be stopping
quite often.
You might also want to get into the habit of following current events, if you dont already. It will remind you
that youre learning all of this theory only in order to understand the world more fully.

KEY TERMS
very long run
long run
short run
medium run
growth theory
aggregate supply/demand (AS-AD) model
aggregate supply (AS) curve
aggregate demand (AD) curve
Phillips curve
growth rate
business cycle
trend path of real GDP
output gap

potential output
inflation
consumer price index (CPI)
employment
expansion
level
rate of increase
recession
recovery
peak
productivity increases
slump
trough

GRAPH IT 1
The easiest way to check an economys health is to chart its real GDP. When real GDP is
increasing by more than usual, the economy is doing well and vice versa. This Graph It asks you
to plot the annual rate of change in U.S. real GDP for the years 1990 through 2012, and to compare
it to the trend rate of growth. We assume the trend rate of growth to be 3% a rough estimate of
the economys average growth rate since 1960. Can you identify the up-swings and down-swings
of the business cycle?

TABLE 11
Year

GDP

1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

8033.9
8015.1
8287.1
8523.4
8870.7
9093.7
9433.9
9854.3
10283.5
10779.8
11226.0
11347.2
11553.0
11840.7
12263.8
12638.4
12976.2
13228.9
13228.8
12880.6
13063.0
13299.1
13588.8

Percent change from

previous year

-0.2
3.4

In order to fill out the chart, you must first calculate the rates of change of GDP and then plot
them. For example, real GDP was $8,033.9 billion in 1990 and $8,015.1 billion in 1991. The annual
growth rate, therefore, was 100 x {(8,015.1 8,033.9)/ 8,033.9}, or roughly -0.2%. Weve filled in
the first few years for you on the chart, and on Table 11. You do the rest!

THE LANGUAGE OF ECONOMICS 1

Models
An economic model consists of a set of assumptions and one or more equations. The equations
describe how the models variables inputs or outputs whose value is not necessarily
constant relate to one another.
Assumptions are very, very important. As we have seen in the case of the aggregate supplyaggregate demand model, an assumption (like a vertical AS curve) may be valid in some cases
(when markets fully clear, for example) but not others. We would never assume the aggregate
supply curve to be vertical. And we would never use growth theory to describe business cycle
fluctuations (it just cant do it). The validity of a models assumptions is a key consideration when
we decide whether to use it to answer a question.
We must always exercise judgment when applying models. A good model simplifies the real
world by choosing not to worry about the aspects that arent relevant to whatever problem it is
meant to explain. Due to this aspect, there will be problems to which certain models should not
be applied problems for which some omitted relationships are relevant. Modeling requires
more than just math; it requires judgment.

REVIEW OF TECHNIQUE 1
Active Learning
There are two components of active learning: active reading and active review. Active reading is
a particularly good skill to develop, as you can use it while reading your textbooks, reading the
newspaper, or reading the reports of your many advisors once you become president. The key to
reading actively is reading with a pencil. That way, as you read, you can underline key ideas,
write down the assumptions that lie behind argumentative statements (a weather person, for
example, might say tomorrow will be sunny and mean tomorrow will be sunny if there is no
change in the prevailing winds, which should blow Hurricane Rita directly to the north, right
past us), and translate statements into graphs (the statement this year the price of corn has
increased, and the quantity sold has decreased, for example, could be illustrated as a shift in the
supply curve on a basic, microeconomic supply/demand graph).
To review actively, look back through everything youve underlined. Work through as many
problems as possible. Make flash cards for key terms, to make sure you are able to define them.
Make a list of key assumptions for each model, and think about when these assumptions are and
are not valid. This will help you to decide when and when not to apply a particular model to a
problem. Keep a big picture map, where you can mark the connections between the various
models that you learn. Then, when you get lost, you can simply refer to your map.
1

7
8

10

11

CROSSWORD
ACROSS

2 Measure of the price level

6 Slope of this curve determines
time horizon of AS-AD model
8 Type of theory used for very long run
9 What you're studying
11 Growth theory and the AS-AD model are applicable over different lengths of _____
DOWN

1 Output produced when all inputs are fully employed

3 Rate of change of the price level
4 Type of cycle, fluctuates around trend path of output
5 ___ run, vertical AS
7 We simplify the real world using

10 Type of gap, measures difference between potential and actual output

FILL-IN QUESTIONS
1.

The very long-run behavior of the economy is the domain of ______________.

2.

The economys behavior over the short, medium, and long run, however, is best described by
the ________________________ model.

3.

The ______________ curve describes the quantity of output that firms are willing to supply
at each price level.

4.

The ______________ curve describes the total demand for goods at each price level.

5.

The ______________ curve is vertical in the long run, when all inputs are fully employed.

6.

In the long run, the output gap is ______________.

7.

The ______________ measures the cost of a typical urban consumers purchases.

TRUE-FALSE QUESTIONS
T

1.

In the short run, the aggregate supply curve is horizontal.

2.

In the medium run, the aggregate supply curve is vertical.

3.

The aggregate supply curve is upward sloping when prices do not adjust.

4.

Prices rise when actual output is below potential output.

5.

Very little of what you will learn about macroeconomics can be fit into a growth
theory/aggregate supply/aggregate demand framework.