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OVERVIEW OF MACROECONOMICS
I. CHAPTER OVERVIEW
The study of macroeconomics is the study of the “big picture.” It is the study of how entire economies make
decisions about using resources. It ponders the sources of growth, inflation, unemployment, and business
cycles. It ponders the ability of governments to help (or hinder) their economies by manipulating a wide
variety of policy instruments. It asks why some policies work and why some fail.
Applied macroeconomists who study the impact of economic policy on the economy as a whole have
found that certain policy objectives, and the instruments used to achieve them, may at times be incompatible.
While a particular policy objective may be admirable when considered at face value, strenuous pursuit of that
policy may be damaging to other objectives of arguably equal importance. For example, policies that produce
low unemployment rates may also generate increased inflation.
Once you complete your work on this overview, you will not have many answers. You will, instead, have
collected a multitude of questions whose answers will be addressed over the course of the next 16 chapters.
Your work on this list of questions will not, however, be an exercise in futility. In noting the significance and
the context of each question, you will build a strong foundation that can support your acquisition of greater
macroeconomic knowledge.
After you have read Chapter 20 in your text and completed the exercises in this Study Guide chapter, you
should be able to:
1. Explain the difference between microeconomics and macroeconomics.
2. Identify the major goals of macroeconomic policy.
3. Identify the major macroeconomic policy instruments used to achieve these goals.
4. Understand some of the major economic events and the related governmental policies that influenced
the United States during this century.
5. Appreciate the contribution of John Maynard Keynes to the development of governmental
macroeconomic policy.
6. Recognize the potential for tradeoffs between two or more policy objectives (e.g., price stability versus
high employment, rapid growth versus high current consumption, etc.).
7. Understand how policy instruments and exogenous variables affect induced (or endogenous)
variables.
8. Appreciate the importance of the international economy and a nation’s connection to it.
9. Develop the fundamentals of aggregate supply, aggregate demand, and macroeconomic equilibrium.
10. Use aggregate supply and aggregate demand analysis to illustrate how policy instruments and external
variables can influence either the demand or the supply side of the macroeconomy.
Note to Students: As you begin the macro section of the text there are many new terms and concepts to learn.
A little extra time and effort on your part to learn them now will pay off later!
Match the following terms from column A with their definitions in column B.
A B
__ Employment 1. A sudden change in conditions of cost or productivity that shifts aggregate
Act of 1946 supply sharply.
__ Business cycle 2. Total quantity of goods and services that the nation’s businesses are willing to
produce and sell in a given period.
__ Fiscal policy 3. Short term decline in an economy’s real output.
__ Monetary policy 4. Monitors the cost of a fixed basket of goods and services bought by the typical
urban consumer.
__ Incomes policies 5. Numerical value of the difference between the value of exports and imports.
__ Gross domestic 6. Percent of the labor force that is unemployed.
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product (GDP)
__ Nominal 7. Pattern of expansion and contraction of economic activity.
__ Real 8. The central bank’s management of the nation’s money, credit, and banking
system to affect macroeconomic activity.
__ Potential GDP 9. Rate of growth or decline of the price level from one year to the next.
__ GDP gap 10. Governmental policies used to control wages and prices.
__ Unemployment 11. Total amount that different sectors of the economy willingly spend on goods
rate and services in a given period.
__ Consumer Price 12. Maximum level of output that is also compatible with stable prices.
Index
__ Net exports 13. Measurements at current market prices.
__ Trade policies 14. Manner in which a country establishes the price of its own currency in terms of
the currency of other nations.
__ Aggregate supply 15. With this, the federal government declared its responsibility to promote
maximum employment, production, and purchasing power.
__ Aggregate demand 16. Use of government expenditure and taxes to affect macroeconomic variables.
__ International 17. The difference between potential and actual GDP.
financial
management
__ Supply shock 18. Measurements at constant market prices.
__ Recession 19. Tariffs, quotas, and other regulations that restrict or encourage imports and
exports.
__ Inflation 20. Market value of all final goods and services produced in a country during a year.
7. Our economy is tied very closely with the rest of the world through trade and finance. Political leaders and
central bankers around the globe increasingly attempt to coordinate their macroeconomic policies, for a nation’s
fiscal and monetary policies can spill over to affect its neighbors.
V. HELPFUL HINTS
1. When calculating the unemployment rate make sure that you include only those individuals who are
actively looking for work. Remember, the labor force includes the unemployed and those who are working in
the marketplace.
2. Economic growth is always measured in real or inflation-adjusted terms. If nominal GDP increases from
one year to the next by 8 percent, and if inflation during that year also increases by 8 percent, then there has
been no growth in the economy. Prices have simply increased by 8 percent, and that is why (nominal) GDP is
8 percent higher than it was the year before. There is no such thing as nominal economic growth!
3. In order to make comparisons in GDP over time, or across countries, real numbers should be used.
(Economists love to measure data in real terms.)
4. Economic growth is often measured in percentage terms. Percentage changes are fairly easy to calculate.
Any percentage change is simply the change in some variable, divided by some base or initial value, multiplied
by 100. For example, if you have two apples and you give one to a friend, we could say that your holding of
apples has been reduced by 50 percent. The change is 1, and the base value is 2; we multiplied by 100 to get
50 (percent). It is that simple. In footnote number 2 in this chapter of your text, Samuelson and Nordhaus use
the following expression to calculate the rate of inflation in the CPI:
the vertical axis, changes in it can be explained by movements along the curves—this was how the two
schedules were constructed in the first place. If any other relevant variable changes (e.g., fiscal policy,
monetary policy, or even the weather), then (at least) one of the curves will shift. Review the appendix to
Chapter 1 if you need to work on this concept.
7. Like the production-possibility frontier, the aggregate supply and aggregate demand diagram is a model of
the economy. We make some simplifying assumptions and hold other variables constant in order to better
understand and explain some economic issue.
8. As you continue your study of macroeconomics, relate these new concepts back to issues of scarcity and
the production-possibility frontier presented in Chapter 1. Note, too, the relationship to such microeconomic
issues as businesses, markets, and individuals.
These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.
induced variable?
a. Supply shocks.
b. Foreign exports.
c. Population growth.
d. World War II.
e. National output.
Figure 20-1
17. The short-run effect of increased defense spending that is not accommodated by increased taxation could be:
a. higher prices and higher GDP.
b. higher prices and lower GDP.
c. lower prices and lower GDP.
d. lower prices and higher GDP.
e. lower prices and the same GDP.
18. If the AD schedule had shifted to the right in order to accommodate the OPEC oil shock, then:
a. both prices and GDP would have remained stable.
b. output would have remained the same, albeit with higher prices.
c. output would have increased and prices decreased.
d. domestic oil prices would have fallen.
e. none of the above.
19. The effect of the orchestrated increase in interest rates in the United States in the early 1980s can be best
illustrated in an AS-AD graph by:
a. a shift left in the AS curve.
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The following problems are designed to help you apply the concepts that you learned in the chapter.
h. When the GDP gap as a percent of GDP is negative, what can you say about the relationship between
actual and potential GDP?
Figure 20-2
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2. Price stability, as a goal of macroeconomic policy, does not mean absolute stability of all prices. Absolute
stability would eliminate the natural role of changes in relative prices in allocating goods and services. Figure
20-4 from the text is reproduced here as Figure 20-2. Use it to answer parts c, d, e, and f of this question.
a. Price stability is, instead, an objective stated in terms of a price index like the CPI that (ignores price
movements across goods and services / averages price movements across goods and services /
includes only price increases across goods and services) .
b. Inflation, then, is measured as (the rate of change in the index / the absolute value of the price
index / the absolute price levels of a representative number of goods).
c. In what year was inflation the highest? ___.
d. In the last 25 years, inflation peaked in the (mid-1970s and early 1980s / mid-1980s and early
1990s / mid-1970s and mid-1980s).
e. How would you explain the dramatic fall in prices during the first years depicted in Figure 20-2?
f. Between 1929 and 1988, the average rate of inflation measured by the CPI was about (8.7 / 1.2 / 3.4)
percent.
3. The policy tools available to the policymaker are varied. They fall under three general rubrics: fiscal
policy (FP), monetary policy (MP), and incomes policy (IP). Match each of the following more specific
policies with its general classification by recording the appropriate abbreviation in the space provided:
a. A change in federal income tax rates. ___
b. An increase in the money supply. ___
c. A tax penalty on high wage settlements. ___
d. An increase in defense spending. ___
e. The elimination of the interest rate deduction against taxable income. ___
f. A change in the rate of interest that banks pay when they borrow money. ___
g. A presidential order limiting the price increase that manufacturers can charge for newly produced
goods. ___
4. Which of the following are policy instruments (PI), and which are external variables (EV) that may shock
the economy from beyond its boundaries? Identify each by recording the appropriate abbreviation in the space
provided:
a. Money supply ___
b. Wars ___
c. Expanding grain sales to the Soviet Union ___
d. Government spending ___
e. Sunspots ___
f. Population growth ___
g. Import tariffs ___
h. Tax deductions ___
i. Changes in the weather ___
j. Public employment programs ___
k. OPEC oil embargo ___
5. Suppose the population of the country is 200 million people. Suppose further that there are 96 million
people working at jobs in the marketplace and there are 4 million people looking for work.
a. How large is the labor force? ___
b. What is the unemployment rate? ___
c. For each of the statements below determine what will happen to the labor force and the unemployment
rate.
1. A student graduates from college and starts to search for a job.
The labor force will (increase / decrease / remain the same), and the unemployment rate will (go up
/ go down / remain unchanged).
2. A student graduates from college and is immediately hired by her mother’s business.
The labor force will (increase / decrease / remain the same), and the unemployment rate will (go up
/ go down / remain unchanged).
3. Jane Jones quits her job and starts looking for a better one.
The labor force will (increase / decrease / remain the same), and the unemployment rate will (go up
/ go down / remain unchanged).
4. John Jones quits his job to spend more time with his kids.
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The labor force will (increase / decrease / remain the same), and the unemployment rate will (go up
/ go down / remain unchanged).
5. Sam Smith is unhappy at his current job. He starts looking for a new job but does not quit his
current job.
The labor force will (increase / decrease / remain the same), and the unemployment rate will (go up
/ go down / remain unchanged).
6. Question 8 at the end of the chapter (“Discussion Questions”) mentions a price index known as the GDP
deflator. This price index is similar to the CPI in that it is an overall measure of inflation or price increases in
the country. One of the key differences between the two indexes is that the CPI includes a sample of typical
consumer goods and services while the GDP deflator includes all goods and services produced in the economy.
(There are some other differences, too, but we can postpone a discussion of those until we have a more detailed
discussion about inflation in Chapter 30.)
One year is chosen as the base year for the price index. In the base year the price index has a value of 100.
Since prices generally rise over time, the price index will usually be less than 100 in years prior to the base year
and greater than 100 in years after the base year.
To calculate real GDP from nominal GDP we would divide by the price index, or GDP deflator, and then
multiply by 100. Or we can write:
Similarly, nominal GDP could be calculated from real GDP with the following formula:
Table 20-1 includes hypothetical numbers for GDP in five different years.
TABLE 20-1
Nominal Real GDP Percent Change
Year GDP GDP Deflator In Real GDP
1 ____ 3690 84 ____
2 3800 ____ 91 ____
3 4000 ____ 100 ____
4 4240 ____ 106 ____
5 ____ 4800 110 ____
Figure 20-3
8. Suppose that Figure 20-4 illustrates the effect of a sudden negative energy shock.
Figure 20-4
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a. AD would represent the preshock aggregate demand curve, (AS1 / AS2) would represent the preshock
aggregate supply curve, and (AS1 / AS2) would represent the postshock aggregate supply curve.
b. (An increase / A decrease / No change) in aggregate demand would be required in the short run to
accommodate the shock and keep output at its preshock level.
c. As a result of the change in b, (prices / output) would be even (smaller / greater) than after the
initial energy shock.
Answer the following questions, making sure that you can explain the work you did to arrive at the answers.
7.
8. a. AS1, AS2
b. An increase
c. prices, greater