CHAPTER

1
The Science of Macroeconomics

The whole of science is nothing more than the refinement of everyday thinking.
—Albert Einstein

1-1 What Macroeconomists Study

W
hy have some countries experienced rapid growth in incomes over
the past century while others stay mired in poverty? Why do some
countries have high rates of inflation while others maintain stable
prices? Why do all countries experience recessions and depressions—recurrent
periods of falling incomes and rising unemployment—and how can government
policy reduce the frequency and severity of these episodes? Macroeconomics,
the study of the economy as a whole, attempts to answer these and many relat-
ed questions.
To appreciate the importance of macroeconomics, you need only read the
newspaper or listen to the news. Every day you can see headlines such as
INCOME GROWTH REBOUNDS, FED MOVES TO COMBAT INFLA-
TION, or STOCKS FALL AMID RECESSION FEARS. These macroeconomic
events may seem abstract, but they touch all of our lives. Business executives fore-
casting the demand for their products must guess how fast consumers’ incomes
will grow. Senior citizens living on fixed incomes wonder how fast prices will
rise. Recent college graduates looking for jobs hope that the economy will boom
and that firms will be hiring.
Because the state of the economy affects everyone, macroeconomic issues play
a central role in national political debates.Voters are aware of how the economy
is doing, and they know that government policy can affect the economy in pow-
erful ways. As a result, the popularity of the incumbent president often rises
when the economy is doing well and falls when it is doing poorly.
Macroeconomic issues are also central to world politics, and if you read the
international news, you will quickly start thinking about macroeconomic ques-
tions. Was it a good move for much of Europe to adopt a common currency?
Should China maintain a fixed exchange rate against the U.S. dollar? Why is the
United States running large trade deficits? How can poor nations raise their
standard of living? When world leaders meet, these topics are often high on
their agenda.

3
4| PART I Introduction

Although the job of making economic policy belongs to world leaders, the
job of explaining the workings of the economy as a whole falls to macroecono-
mists. Toward this end, macroeconomists collect data on incomes, prices, unem-
ployment, and many other variables from different time periods and different
countries. They then attempt to formulate general theories to explain these data.
Like astronomers studying the evolution of stars or biologists studying the evo-
lution of species, macroeconomists cannot conduct controlled experiments in a
laboratory. Instead, they must make use of the data that history gives them.
Macroeconomists observe that economies differ across countries and that they
change over time. These observations provide both the motivation for develop-
ing macroeconomic theories and the data for testing them.
To be sure, macroeconomics is a young and imperfect science. The macroecon-
omist’s ability to predict the future course of economic events is no better than the
meteorologist’s ability to predict next month’s weather. But, as you will see, macro-
economists know quite a lot about how economies work. This knowledge is use-
ful both for explaining economic events and for formulating economic policy.
Every era has its own economic problems. In the 1970s, Presidents Richard
Nixon, Gerald Ford, and Jimmy Carter all wrestled in vain with a rising rate of
inflation. In the 1980s, inflation subsided, but Presidents Ronald Reagan and
George Bush presided over large federal budget deficits. In the 1990s, with Pres-
ident Bill Clinton in the Oval Office, the economy and stock market enjoyed a
remarkable boom, and the federal budget turned from deficit to surplus. But as
Clinton left office, the stock market was in retreat, and the economy was heading
into recession. In 2001 President George W. Bush reduced taxes to help end the
recession, but the tax cuts also contributed to a reemergence of budget deficits.
President Barack Obama moved into the White House in 2009 in a period of
heightened economic turbulence. The economy was reeling from a financial crisis,
driven by a large drop in housing prices and a steep rise in mortgage defaults. The
crisis was spreading to other sectors and pushing the overall economy into anoth-
er recession.The magnitude of the downturn was uncertain as this book was going
to press, but some observers feared the recession might be deep. In some minds, the
financial crisis raised the specter of the Great Depression of the 1930s, when in its
worst year one out of four Americans who wanted to work could not find a job.
In 2008 and 2009, officials in the Treasury, Federal Reserve, and other parts of gov-
ernment were acting vigorously to prevent a recurrence of that outcome.
Macroeconomic history is not a simple story, but it provides a rich motivation
for macroeconomic theory.While the basic principles of macroeconomics do not
change from decade to decade, the macroeconomist must apply these principles
with flexibility and creativity to meet changing circumstances.

CASE STUDY
The Historical Performance of the U.S. Economy
Economists use many types of data to measure the performance of an econo-
my. Three macroeconomic variables are especially important: real gross domes-
tic product (GDP), the inflation rate, and the unemployment rate. Real GDP
 CHAPTER 1 The Science of Macroeconomics | 5

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 unem-
ployment 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.
Figure 1-1 shows real GDP per person in the United States. Two aspects of
this figure are noteworthy. First, real GDP grows over time. Real GDP per per-
son today is about eight times higher than it was in 1900. This growth in aver-
age income allows us to enjoy a much higher standard of living than our
great-grandparents did. 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. Such periods are called
recessions if they are mild and depressions if they are more severe. Not sur-
prisingly, periods of declining income are associated with substantial econom-
ic hardship.

FIGURE 1-1
Real GDP per person First oil price shock
(2000 dollars) World Great World Korean Vietnam
40,000 Second oil price shock
War I Depression War II War War
32,000

9/11
16,000 terrorist
attack

8,000

4,000
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Year

Real GDP per Person in the U.S. Economy Real GDP measures the total
income of everyone in the economy, and real GDP per person measures the
income of the average person in the economy. This figure shows that real
GDP per person tends to grow over time and that this normal growth is
sometimes interrupted by periods of declining income, called recessions
or depressions.
Note: Real GDP is plotted here on a logarithmic scale. On such a scale, equal distances on
the vertical axis represent equal percentage changes. Thus, the distance between $4,000 and
$8,000 (a 100 percent change) is the same as the distance between $8,000 and $16,000
(a 100 percent change).
Source: U.S. Department of Commerce and Economic History Services.
6| PART I Introduction

FIGURE 1-2

Percent

30 World Great World Korean Vietnam First oil price shock

War I Depression War II War War Second oil price shock
25

20

Inflation 15
9/11
10 terrorist
attack
5

−5

Deflation −10

−15

−20
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Year

The Inflation Rate in the U.S. Economy The inflation rate measures the percent-
age change in the average level of prices from the year before. When the inflation
rate is above zero, prices are rising. When it is below zero, prices are falling. If the
inflation rate declines but remains positive, prices are rising but at a slower rate.
Note: The inflation rate is measured here using the GDP deflator.
Source: U.S. Department of Commerce and Economic History Services.

Figure 1-2 shows the U.S. inflation rate.You can see that inflation varies substan-
tially 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 dur-
ing 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 or 3 percent per year, indicating that prices have been fairly stable.
Figure 1-3 shows the U.S. unemployment rate. 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. The highest
rates of unemployment were reached during the Great Depression of the 1930s.
These three figures offer a glimpse at the history of the U.S. economy. In the
chapters that follow, we first discuss how these variables are measured and then
develop theories to explain how they behave. ■
 CHAPTER 1 The Science of Macroeconomics | 7

FIGURE 1-3

Percent unemployed
World Great World Korean Vietnam First oil price shock
War I Depression War II War War Second oil price shock
25

20
9/11
terrorist
attack
15

10

0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Year

The Unemployment Rate in the U.S. Economy The unemployment rate measures
the percentage of people in the labor force who do not have jobs. This figure shows
that the economy always has some unemployment and that the amount fluctuates
from year to year.
Source: U.S. Department of Labor and U.S. Bureau of the Census (Historical Statistics of the United States:
Colonial Times to 1970).

1-2 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 layman.The best way to become familiar with these tools is to prac-
tice using them, and this book affords you ample opportunity to do so. To make
these tools less forbidding, however, let’s discuss a few of them here.

Theory as Model Building

Young children learn much about the world around them by playing with toy
versions of real objects. For instance, they often put together models of cars,
trains, or planes. These models are far from realistic, but the model-builder
8| PART I Introduction

learns a lot from them nonetheless. The model illustrates the essence of the real
object it is designed to resemble. (In addition, for many children, building
models is fun.)
Economists also 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 help explain economic vari-
ables, such as GDP, inflation, and unemployment. Economic models illustrate,
often in mathematical terms, the relationships among the variables. Models
are useful because they help us to dispense with irrelevant details and to focus
on underlying connections. (In addition, for many economists, building mod-
els is fun.)
Models have two kinds of variables: endogenous variables and exogenous vari-
ables. Endogenous variables are those variables that a model tries to explain.
Exogenous variables are those variables that a model takes as given. The pur-
pose of a model is to show how the exogenous variables affect the endogenous
variables. In other words, as Figure 1-4 illustrates, exogenous variables come from
outside the model and serve as the model’s input, whereas endogenous variables
are determined within the model and are the model’s output.

FIGURE 1-4

Exogenous Variables Model Endogenous Variables

How Models Work Models are simplified theories that show the key
relationships among economic variables. The exogenous variables are
those that come from outside the model. The endogenous variables are
those that the model explains. The model shows how changes in the
exogenous variables affect the endogenous variables.

To make these ideas more concrete, let’s review the most celebrated of all eco-
nomic models—the model of supply and demand. Imagine that an economist
wanted to figure out what factors influence the price of pizza and the quantity
of pizza sold. He or she would develop a model that described the behavior of
pizza buyers, the behavior of pizza sellers, and their interaction in the market for
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
Qd = D(P, Y ),
where D( ) represents the demand function. Similarly, the economist supposes
that the quantity of pizza supplied by pizzerias Q s depends on the price of pizza P
 CHAPTER 1 The Science of Macroeconomics | 9

and on the price of materials Pm, such as cheese, tomatoes, flour, and anchovies.
This relationship is expressed as
Q s = S(P, Pm ),
where S( ) represents the supply function. Finally, the economist assumes that the
price of pizza adjusts to bring the quantity supplied and quantity demanded into
balance:
Q s = Q d.
These three equations compose a model of the market for pizza.
The economist illustrates the model with a supply-and-demand diagram, as in
Figure 1-5. 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 con-
sumers to switch to other foods and buy less pizza. 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. The equilibrium for the market is the price and quantity at
which the supply and demand curves intersect. At the equilibrium price, con-
sumers choose to buy the amount of pizza that pizzerias choose to produce.
This model of the pizza market has two exogenous variables and two endoge-
nous variables. The exogenous variables are aggregate income and the price of

FIGURE 1-5

Price of pizza, P The Model of Supply and

Supply
Demand 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
Market the quantity of pizza that con-
equilibrium sumers demand. The supply
curve is an upward-sloping
Equilibrium curve relating the price of
price pizza to the quantity of pizza
Demand that pizzerias supply. The
price of pizza adjusts until the
Equilibrium
quantity quantity supplied equals the
quantity demanded. The
Quantity of pizza, Q
point where the two curves
cross is the market equilibri-
um, which shows the equilib-
rium price of pizza and the
equilibrium quantity of pizza.
10 | PART I Introduction

materials. The model does not attempt to explain them but instead takes them as
given (perhaps to be explained by another model). The endogenous variables are
the price of pizza and the quantity of pizza exchanged. These are the variables
that the model attempts to explain.
The model can be used to show how a change in one of the exogenous vari-
ables affects both endogenous variables. For example, if aggregate income
increases, then the demand for pizza increases, as in panel (a) of Figure 1-6. The
model shows that both the equilibrium price and the equilibrium quantity of
pizza rise. Similarly, if the price of materials increases, then the supply of pizza
decreases, as in panel (b) of Figure 1-6. The model shows that in this case the

FIGURE 1-6

(a) A Shift in Demand Changes in Equilibrium In

panel (a), a rise in aggregate
Price of pizza, P
income causes the demand
S for pizza to increase: at any
given price, consumers now
want to buy more pizza. This
is represented by a rightward
shift in the demand curve
from D1 to D2. The market
P2 moves to the new intersec-
tion of supply and demand.
The equilibrium price rises
from P1 to P2, and the equi-
P1 librium quantity of pizza rises
D2
from Q1 to Q2. In panel (b),
a rise in the price of materi-
D1 als decreases the supply of
Q1 Q2 Quantity of pizza, Q pizza: at any given price,
pizzerias find that the sale of
pizza is less profitable and
(b) A Shift in Supply therefore choose to produce
Price of pizza, P less pizza. This is represented
S2 by a leftward shift in the sup-
ply curve from S1 to S2. The
market moves to the new
S1
intersection of supply and
demand. The equilibrium
price rises from P1 to P2, and
the equilibrium quantity falls
P2 from Q1 to Q2.

P1

Q2 Q1 Quantity of pizza, Q
 CHAPTER 1 The Science of Macroeconomics | 11

equilibrium price of pizza rises and the equilibrium quantity of pizza falls. Thus,
the model shows how changes either in aggregate income or in the price of
materials affect price and quantity in the market for pizza.
Like all models, this model of the pizza market makes simplifying assumptions.
The model does not take into account, for example, that every pizzeria is in a
different location. For each customer, one pizzeria is more convenient than the
others, and thus pizzerias have some ability to set their own prices. The model
assumes that there is a single price for pizza, but in fact there could be a differ-
ent price at every pizzeria.
How should we react to the model’s lack of realism? Should we discard the
simple model of pizza supply and demand? Should we attempt to build a more
complex model that allows for diverse pizza prices? The answers to these ques-
tions depend on our purpose. If our goal is to explain how the price of cheese
affects the average price of pizza and the amount of pizza sold, then the diversi-
ty of pizza prices is probably not important. The simple model of the pizza mar-
ket does a good job of addressing that issue. Yet if our goal is to explain why
towns with ten pizzerias have lower pizza prices than towns with two, the sim-
ple model is less useful.

Using Functions to Express Relationships

Among Variables
All economic models express relationships among In this case, the demand function is
economic variables. Often, these relationships are D(P, Y) = 60 − 10P + 2Y.
expressed as functions. A function is a mathemati-
cal concept that shows how one variable depends For any price of pizza and aggregate income, this
on a set of other variables. For example, in the function gives the corresponding quantity of
model of the pizza market, we said that the quan- pizza demanded. For example, if aggregate
tity of pizza demanded depends on the price of income is $10 and the price of pizza is $2, then
pizza and on aggregate income. To express this, the quantity of pizza demanded is 60 pies; if the
we use functional notation to write price of pizza rises to $3, the quantity of pizza
FYI

demanded falls to 50 pies.

Qd = D(P, Y).
Functional notation allows us to express the
This equation says that the quantity of pizza general idea that variables are related, even when
demanded Qd is a function of the price of pizza P we do not have enough information to indicate
and aggregate income Y. In functional notation, the precise numerical relationship. For example,
the variable preceding the parentheses denotes we might know that the quantity of pizza
the function. In this case, D( ) is the function demanded falls when the price rises from $2 to
expressing how the variables in parentheses $3, but we might not know by how much it falls.
determine the quantity of pizza demanded. In this case, functional notation is useful: as long
If we knew more about the pizza market, we as we know that a relationship among the vari-
could give a numerical formula for the quantity ables exists, we can express that relationship
of pizza demanded. For example, we might be using functional notation.
able to write
Qd = 60 − 10P + 2Y.
12 | PART I Introduction

The art in economics is in judging when a simplifying assumption (such as

assuming a single price of pizza) clarifies our thinking and when it misleads us.
Simplification is a necessary part of building a useful model: any model con-
structed to be completely realistic would be too complicated for anyone to
understand.Yet models lead to incorrect conclusions if they assume away features
of the economy that are crucial to the issue at hand. Economic modeling there-
fore requires care and common sense.

The Use Of Multiple Models

Macroeconomists study many facets of the economy. For example, they examine
the role of saving in economic growth, the impact of minimum-wage laws on
unemployment, the effect of inflation on interest rates, and the influence of trade
policy on the trade balance and exchange rate.
Economists use models to address all of these issues, but no single model can
answer every question. Just as carpenters use different tools for different tasks,
economists use different models to explain different economic phenomena. Stu-
dents of macroeconomics, therefore, must keep in mind that there is no single
“correct’’ model that is always applicable. Instead, there are many models, each of
which is useful for shedding light on a different facet of the economy. The field
of macroeconomics is like a Swiss army knife—a set of complementary but dis-
tinct tools that can be applied in different ways in different circumstances.
This book presents many different models that address different questions and
make different assumptions. Remember that a model is only as good as its
assumptions and that an assumption that is useful for some purposes may be mis-
leading for others.When using a model to address a question, the economist must
keep in mind the underlying assumptions and judge whether they are reasonable
for studying the matter at hand.

Prices: Flexible Versus Sticky

Throughout this book, one group of assumptions will prove especially important—
those concerning the speed at which wages and prices adjust to changing eco-
nomic conditions. Economists normally presume that the price of a good or a
service moves quickly to bring quantity supplied and quantity demanded into bal-
ance. 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 inter-
sect. This assumption is called market clearing and is central to the model of the
pizza market discussed earlier. For answering most questions, economists use
market-clearing models.
Yet the assumption of continuous market clearing is not entirely realistic. For
markets to clear continuously, prices must adjust instantly to changes in supply
and demand. 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 typically change
 CHAPTER 1 The Science of Macroeconomics | 13

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.
The apparent stickiness of prices does not make market-clearing models use-
less. After all, prices are not stuck forever; eventually, they adjust to changes in
supply and demand. 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 assump-
tion for studying the short-run behavior of the economy.

Microeconomic Thinking and Macroeconomic Models

Microeconomics is the study of how households and firms make decisions and
how these decisionmakers interact in the marketplace. A central principle of
microeconomics is that households and firms optimize—they do the best they can
for themselves given their objectives and the constraints they face. In microeco-
nomic models, households choose their purchases to maximize their level of sat-
isfaction, which economists call utility, and firms make production decisions to
maximize their profits.
Because economy-wide events arise from the interaction of many households
and firms, macroeconomics and microeconomics are inextricably linked. When
we study the economy as a whole, we must consider the decisions of individual
economic actors. For example, to understand what determines total consumer
spending, we must think about a family deciding how much to spend today and
how much to save for the future.To understand what determines total investment
spending, we must think about a firm deciding whether to build a new factory.
Because aggregate variables are the sum of the variables describing many indi-
vidual decisions, macroeconomic theory rests on a microeconomic foundation.
Although microeconomic decisions underlie all economic models, in many
models the optimizing behavior of households and firms is implicit rather than
explicit. The model of the pizza market we discussed earlier is an example.
Households’ decisions about how much pizza to buy underlie the demand for
pizza, and pizzerias’ decisions about how much pizza to produce underlie the
supply of pizza. Presumably, households make their decisions to maximize utili-
ty, and pizzerias make their decisions to maximize profit.Yet the model does not
focus on how these microeconomic decisions are made; instead, it leaves these
decisions in the background. Similarly, although microeconomic decisions
underlie macroeconomic phenomena, macroeconomic models do not necessar-
ily focus on the optimizing behavior of households and firms, but instead some-
times leave that behavior in the background.
 14 | PART I Introduction

Nobel Macroeconomists
The winner of the Nobel Prize in economics is ing an infinite discounted sum of one-period util-
announced every October. Many winners have ities, but you couldn’t prove it by me. To me it
been macroeconomists whose work we study in felt as if I were saying to myself: ‘What the hell.’”
this book. Here are a few of them, along with Robert Lucas (Nobel 1995): “In public school sci-
some of their own words about how they chose ence was an unending and not very well organized
their field of study: list of things other people had discovered long ago.
Milton Friedman (Nobel 1976): “I graduated from In college, I learned something about the process
college in 1932, when the United States was at the of scientific discovery, but what I learned did not
bottom of the deepest depression in its history attract me as a career possibility. . . . What I liked
before or since. The dominant problem of the time thinking about were politics and social issues.”
was economics. How to get out of the depression? George Akerlof (Nobel 2001): “When I went to
How to reduce unemployment? What explained the Yale, I was convinced that I wanted to be either an
paradox of great need on the one hand and unused economist or an historian. Really, for me it was a
resources on the other? Under the circumstances, distinction without a difference. If I was going to
becoming an economist seemed more relevant to be an historian, then I would be an economic his-
the burning issues of the day than becoming an torian. And if I was to be an economist I would
applied mathematician or an actuary.” consider history as the basis for my economics.”
James Tobin (Nobel 1981): “I was attracted to Edward Prescott (Nobel 2004): “Through discus-
the field for two reasons. One was that economic sion with [my father], I learned a lot about the way
FYI

theory is a fascinating intellectual challenge, on the businesses operated. This was one reason why I
order of mathematics or chess. I liked analytics and liked my microeconomics course so much in my
logical argument. . . . The other reason was the first year at Swarthmore College. The price theory
obvious relevance of economics to understanding that I learned in that course rationalized what I
and perhaps overcoming the Great Depression.” had learned from him about the way businesses
Franco Modigliani (Nobel 1985): “For awhile it was operate. The other reason was the textbook used
thought that I should study medicine because my in that course, Paul A. Samuelson’s Principles of Eco-
father was a physician. . . . I went to the registration nomics. I loved the way Samuelson laid out the the-
window to sign up for medicine, but then I closed ory in his textbook, so simply and clearly.”
my eyes and thought of blood! I got pale just think- Edmund Phelps (Nobel 2006): “Like most Ameri-
ing about blood and decided under those condi- cans entering college, I started at Amherst College
tions I had better keep away from medicine. . . . without a predetermined course of study or without
Casting about for something to do, I happened to even a career goal. My tacit assumption was that I
get into some economics activities. I knew some would drift into the world of business—of money,
German and was asked to translate from German doing something terribly smart. In the first year,
into Italian some articles for one of the trade associ- though, I was awestruck by Plato, Hume and James.
ations. Thus I began to be exposed to the economic I would probably have gone into philosophy were it
problems that were in the German literature.” not that my father cajoled and pleaded with me to
Robert Solow (Nobel 1987): “I came back [to try a course in economics, which I did the second
college after being in the army] and, almost with- year. . . . I was hugely impressed to see that it was
out thinking about it, signed up to finish my possible to subject the events in those newspapers I
undergraduate degree as an economics major. had read about to a formal sort of analysis.”
The time was such that I had to make a decision If you want to learn more about the Nobel
in a hurry. No doubt I acted as if I were maximiz- Prize and its winners, go to www.nobelprize.org.1

1 The first five quotations are from William Breit and Barry T. Hirsch, eds., Lives of the Laureates,
4th ed. (Cambridge, Mass.: MIT Press, 2004). The next two are from the Nobel Web site. The last
one is from Arnold Heertje, ed., The Makers of Modern Economics, Vol. II (Aldershot, U.K.: Edward
Elgar Publishing, 1995).
 CHAPTER 1 The Science of Macroeconomics | 15

1-3 How This Book Proceeds

This book has six parts. This chapter and the next make up Part One, the Intro-
duction. Chapter 2 discusses how economists measure economic variables, such
as aggregate income, the inflation rate, and the unemployment rate.
Part Two, “Classical Theory: The Economy in the Long Run,” presents the
classical model of how the economy works. The key assumption of the classical
model is that prices are flexible. That is, with rare exceptions, the classical model
assumes that markets clear. Because the assumption of price flexibility describes
the economy only in the long run, classical theory is best suited for analyzing a
time horizon of at least several years.
Part Three, “Growth Theory: The Economy in the Very Long Run,” builds on
the classical model. It maintains the assumptions of price flexibility and market
clearing but adds a new emphasis on growth in the capital stock, the labor force,
and technological knowledge. Growth theory is designed to explain how the
economy evolves over a period of several decades.
Part Four, “Business Cycle Theory: The Economy in the Short Run,” exam-
ines the behavior of the economy when prices are sticky. The
non-market-clearing model developed here is designed to analyze short-run
issues, such as the reasons for economic fluctuations and the influence of gov-
ernment policy on those fluctuations. It is best suited for analyzing the changes
in the economy we observe from month to month or from year to year.
Part Five, “Macroeconomic Policy Debates,” builds on the previous analysis to
consider what role the government should have in the economy. It considers
how, if at all, the government should respond to short-run fluctuations in real
GDP and unemployment. It also examines the various views of how government
debt affects the economy.
Part Six, “More on the Microeconomics Behind Macroeconomics,” presents
some of the microeconomic models that are useful for analyzing macroeconom-
ic issues. For example, it examines the household’s decisions regarding how much
to consume and how much money to hold and the firm’s decision regarding how
much to invest. These individual decisions together form the larger macroeco-
nomic picture. The goal of studying these microeconomic decisions in detail is
to refine our understanding of the aggregate economy.

Summary
1. Macroeconomics is the study of the economy as a whole, including growth
in incomes, changes in prices, and the rate of unemployment. Macroecono-
mists attempt both to explain economic events and to devise policies to
improve economic performance.
2. To understand the economy, economists use models—theories that simplify
reality in order to reveal how exogenous variables influence endogenous
variables. The art in the science of economics is in judging whether a
16 | PART I Introduction

model captures the important economic relationships for the matter at

hand. Because no single model can answer all questions, macroeconomists
use different models to look at different issues.
3. A key feature of a macroeconomic model is whether it assumes that prices
are flexible or sticky. According to most macroeconomists, models with
flexible prices describe the economy in the long run, whereas models with
sticky prices offer a better description of the economy in the short run.
4. Microeconomics is the study of how firms and individuals make decisions
and how these decisionmakers interact. Because macroeconomic events
arise from many microeconomic interactions, all macroeconomic models
must be consistent with microeconomic foundations, even if those founda-
tions are only implicit.

K E Y C O N C E P T S

Macroeconomics Recession Exogenous variables

Real GDP Depression Market clearing
Inflation and deflation Models Flexible and sticky prices
Unemployment Endogenous variables Microeconomics

Q U E S T I O N S F O R R E V I E W

1. Explain the difference between macroeconomics 3. What is a market-clearing model? When is it

and microeconomics. How are these two fields appropriate to assume that markets clear?
related?
2. Why do economists build models?

P R O B L E M S A N D A P P L I C AT I O N S

1. What macroeconomic issues have been in the affect the price of ice cream and the quantity of
news lately? ice cream sold. In your explanation, identify the
2. What do you think are the defining characteris- exogenous and endogenous variables.
tics of a science? Does the study of the economy 4. How often does the price you pay for a haircut
have these characteristics? Do you think macro- change? What does your answer imply about the
economics should be called a science? Why or usefulness of market-clearing models for analyz-
why not? ing the market for haircuts?
3. Use the model of supply and demand to explain
how a fall in the price of frozen yogurt would