Dorn Busch 11

1-1
Copyright 2013 McGraw-Hill Education (Australia) Pty Ltd

Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e
CHAPTER 1

An introduction to
macroeconomics
1-2
Objectives
Introduce three linked macroeconomic models that explain
the behaviour of the economy.
Explain the long-run growth in productive capacity.
Use the concepts of aggregate supply and aggregate
demand to explain what determines the rate of inflation.
Introduce the concept of the business cycle to explain
variations from the long-run growth path.
Outline the two main schools of thought that have influenced
the economic policy debate in the past 50 years.
1-3
Chapter organisation
1.1 Macroeconomics encapsulated in three models
1.2 To reiterate...
1.3 Schools of thought
1.4 Outline and preview of the text
1.5 Prerequisites and recipes
1-4
1.1 Three models
Macroeconomics is organised around three models.
Each model is concerned with different time frames:
The long run
The medium run
The short run.
Lets consider each in more detail.

1-5
Very long-run economic growth
The long run is a period of decades or more over
which potential output is expected to grow.
The time period is usually measured in multiples
of decades (e.g. 20 years or more).
Growth theory explains the long-run behaviour
of the economy.
Short-run fluctuations in important variables like
employment, investment and output are ignored,
on the assumption that changes in these variables
average out over time.

continued
1-6
The long-run level of output is determined solely by
supply-side considerations.
Output is determined by the productive capacity of
the economy.
All factors of production (land, labour, capital and
technology) are assumed to be fully employed.
The economy is operating at its potential output.
continued
1-7
Economic growth is a function of increases in
productive capacity.
Major causes of economic growth are:
development of new technology
accumulation of physical and human capital
appropriate provision of infrastructure
higher rates of domestic saving.

continued
1-8
Economic growth determines the changes in the
standard of living.
A country growing at an average of 4% per year
instead of 2% will have a 50% higher standard of
living over a generation of 20 years.
This higher 4% average annual growth rate will lead
to a seven-fold increase in the standard of living over
100 years!
1-9
Fixed productive capacity
In the long run, the productive capacity of the
economy is assumed to be constant or fixed.
The productive capacity of the economy determines
output.

continued
1-10
This is represented by a vertical aggregate supply
schedule at real output level Y0 (potential output).
P
Y
0
Y
AS
P
r
i
c
e

l
e
v
e
l

continued
1-11
This level of output is associated with a certain rate
of growth in prices.
What determines the change in the overall price level
(the inflation rate)?
The aggregate supply (AS)aggregate demand (AD)
model explains short- to medium-run determination
of inflation and real output.
continued
1-12
For each price level, the AD schedule represents the
level of output where both the goods and money
markets are in equilibrium.
The intersection of the AS and AD schedules
determines the price (P0) and real output (Y0).

continued
1-13
AD and AS in the long run.
P
Y
0
Y
AD
P
r
i
c
e

l
e
v
e
l

AS
P
0
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The short run
The short run is a period of time short enough that
markets are unable to clear.
In the short run, actual output can deviate from
potential output.
Short-run fluctuations in real output are important.
AD is the major determinant of these variations.
In the short run, the price level is pegged, making the
short-run AS schedule horizontal.

continued
1-15
The short run
AD and AS in the short run.

P
Y
0
Y
AD
P
r
i
c
e

l
e
v
e
l

P
0
1-16
The medium run
How do we describe the transition between the short
run and the long run?
High AD pushes real output above Y0 (according to
the long-run model).
Over time, firms will increase prices and the AS
curve will move upwards.
The medium run will give an upward-sloping AS
curve.
continued
1-17
The medium run
The relative steepness of the AS curve is a major
controversy in macroeconomics.
P
Y
0
Y
AD
P
r
i
c
e

L
e
v
e
l

AS
P
0
1-18
1.2 To reiterate
Growth theory and the ASAD framework can be
used to analyse many macroeconomic issues.
These two models provide a basis for the further
analysis of:
growth and GDP
the business cycle.
Lets consider each in turn.
1-19
Growth and GDP
Table 1.1 Per capita real income growth rates for various countries,
19132010 and 19812010 (average annual growth rate, per cent)
continued
1-20
Growth and GDP
Table 1.1 compares the per capita real income
growth rates in various countries.
There are very large differences over the period
19132010; ranging from 0.6% for Ghana to 3.6%
for China.
Japan (2.9%), Brazil (2.3%) and Ireland (2.2%) are
the next highest band.
Note the lower but similar growth rates for Australia
(1.6%) and New Zealand (1.5%).
1-21
The business cycle and the output
gap
The business cycle describes the variation of
economic activity around the path of trend growth.
Inflation, growth and unemployment all demonstrate
cyclical patterns that contribute to this variation.
The output gap measures cyclical variations in
output from the trend growth path.
It measures the difference between actual and
potential output.
continued
1-22
The business cycle and the output gap
Output gap actual output potential output.
During a recession, actual output falls below
potential output. A negative gap is associated with
unemployment.
During a boom, actual output rises above potential
output. A positive gap is associated with over
employment.
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The business cycle and inflation
The cost of the cycle above trend is inflation and the
cost below trend is unemployment.
The costs of inflation are less obvious than those of
unemployment.
Unemployment is associated with a loss in potential
output.
Inflation upsets price relationships and reduces the
efficiency of the price system.
1-24
Business cycle features
Business cycles have common characteristics.
Business cycles are associated with a pattern of
expansion (recovery) and contraction (recession).
Economic variables can indicate something of the
nature of the business cycle.
Procyclical variables rise with expansionary business
activity (e.g. output, employment, interest rates and
money supply).
continued
1-25
Countercyclical variables (like inventories and
bankruptcies) move in the opposite direction to
business activity.
Some variables exhibit more variability (volatility)
than others.
For example, inventories are volatile while
consumption is smooth, especially relative to output.
Business cycles do not occur as regular fluctuations
in the level of economic activity.
continued
1-26
The impulse-propagation model can be used to
explain what causes actual output to deviate from
the trend.
The impulse-propagation model explains:
how shocks (impulses) disturb the economy from its long-
run trend
how this leads to effects that last (propagate) over time.
Economists disagree over possible propagation
mechanisms.
continued
1-27
There are three broad types of shocks:
policy shocks, which affect fiscal expenditure and interest
rates (e.g. fiscal and monetary policies)
supply shocks, which affect production and price-setting
(e.g. technology advances)
private sector shocks, which affect aggregate demand (e.g.
changes in private investment).
continued
1-28
There is debate about the several aspects of
Australian business cycles.
What is a business cycle?
How are variations in economic activity separated
from the trend?
Which indicators should be used to measure the
business cycle?
continued
1-29
Various economic indicators can be used to measure
the course of the business cycle:
Leading indicators, like firms profitability and building
approvals precede changes in GDP.
Lagging indicators, like unemployment lag changes
in real GDP.
Variables can be aggregated into a composite index
that will give a coincident index to measure turning
points in the business cycle.
continued
1-30
Two types of business cycle can be identified:
The classical business cycle considers actual levels so that
a fall in GDP describes negative growth.
Two consecutive quarters of negative growth in real GDP is
called a (classical) recession.
The growth cycle considers fluctuations in growth rates of
the economy around the trend growth rate.
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1.3 Schools of thought
During the 1960s there were two main views:
The monetarists believed the economy is best left
to itself.
The Keynesians argued that government intervention could
improve economic performance.
Two schools have developed since then:
The New Classical school in the 1970s
The New Keynesian school in the 198090s.
1-32
New Classical school
Three central assumptions of the New Classical
school are:
economic agents optimise
decisions are made rationally using all available information
(rational expectations)
markets are assumed to clear.
These assumptions ensure there is no involuntary
unemployment.
They also lead to a further assumption that markets
are continuously in equilibrium.
1-33
New Keynesian school
Extends the earlier Keynesian view that markets will
not always clear even if agents are maximising.
Reasons are varied and include:
There is incomplete information.
Institutions affect the workings of markets.
Costs of changing wages and prices lead to price rigidities.
These reasons explain fluctuations in output and
employment.
1-34
Economic controversies
The two main competing views of modern
macroeconomics are highlighted in real-world
political and media discussions.
These differences are frequently exaggerated in
debate.
There are significant areas of agreement.
Debate and research continually evolve new areas of
consensus, e.g. there is increasing agreement on
information problems with wage-price setting.
1-35
1.4 Text outline and preview
The key overall concepts of this book are growth,
aggregate supply and demand.
Chapter 2 examines national income accounting.
Chapters 35 explore the ADAS model, wage/price
adjustment and the basics of policy.
Chapters 67 consider long-run economic growth.
Chapters 810 explore the underpinnings of AD the
ISLM model.
Chapters 11 extends AD model to an open economy.
Chapters 1216 examine individual sectors that make up an
economy.
Chapters 1718 consider the issues of inflation and
unemployment.

continued
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1.4 Text outline and preview
Chapter 19 examines the theory of policy in an uncertain
world.
Chapter 20 considers big macro-economic events.
Chapter 21 extends the analysis to international
adjustments and interdependence.
Chapter 22 presents an introduction to some of the frontiers
of economic research.
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1.5 Prerequisites and recipes
The text requires no mathematical prerequisite
beyond high school algebra.
There are a number of helpful websites, including:
www.mhhe.com/au/dornbusch (for chapter summaries and
problems)
www.rba.gov.au
www.treasury.gov.au
www.abs.gov.au
www.asx.com.au
www.ecosoc.org.au
www.economist.com
www.voxeu.org
www.aeaweb.org/rfe.

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Copyright 2013 McGraw-Hill Education (Australia) Pty Ltd

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