Summary of Chapter 1 - DFS Macroeconomics

CHAPTER 1: INTRODUCTION

Chapter Outline

 Introduction to macroeconomics
 The long run and short run
 Economic models and the real world
 A first look at the AD-AS framework
 Unemployment and inflation
 Actual and potential GDP
 Economic cycles
 Recessions and economic slumps

Learning Objectives

Upon completion of the chapter students would have learned

 The use of the AD-AS diagram as an important tool in macroeconomic analysis.
 Differentiate between the effects of policy changes in the long run, the short run, and the
medium run.
 The difference between fiscal and monetary policy.
 Certain key concepts in macroeconomics including real, nominal, actual, and potential GDP.
 Interpret economic indicators and understand their importance in assessing current economic
trends.
 The different schools of macroeconomic thought and how they developed from the problems
of the time in which they were formed.

Summary of the Chapter

It provides an overview of the key concepts covered in the textbook. It also outlines the different
time frames that are used to describe the economy in the aggregate. The very long-run model
focuses on the growth of productive capacity and ignores fluctuations in employment and output.
This is important when trying to explain why some countries have higher average growth rates
(and thus higher living standards) than others. In the long run, fluctuations in demand relative to
the level of productive capacity determine the level of prices. But in the very short run, the level
of output is determined by aggregate demand alone, while prices are not affected by changes in
aggregate demand. The medium run describes the transition between the short run and the long
run. In this case, economic policies or disturbances affect the rates of inflation and unemployment
simultaneously, and the speed at which prices adjust is critical for analyzing the effects of the
disturbances or policy changes.

The behavior of the economy can be analyzed using the AD-AS model. Three different AS-curves
are presented, each describing a different time frame: the vertical AS-curve describes the very long
run, the horizontal AS-curve describes the very short run, and the upward-sloping AS-curve
describes the medium run. The AD-AS framework is a very simplified representation of the real
world that cannot describe the behavior of all people and enterprises in an economy. However, it
serves very well to explain how economic disturbances affect output, employment, and prices, and
how policies can be used to mitigate economic disturbances. In summary, the following points
may be noted.
 The very long-run AS-curve is vertical, that is, output is determined by aggregate supply alone.
 The very short-run AS-curve is horizontal, that is, output is determined by aggregate demand
alone.
 The medium-run AS-curve is upward sloping, that is, fluctuations in aggregate supply or
aggregate demand can determine actual output and the price level under the assumption that
productive capacity is given.
 There is a significant difference between the demand and supply analysis which was used in
microeconomics classes and the aggregate demand and aggregate supply framework in a
macroeconomics class.

To understand the behavior of the economy as a whole, students must learn some basic concepts.
For example, GDP, that is, the market value of all final goods and services currently produced in
a country over a certain time period. A nation's GDP changes as the amount of available resources
and the efficiency with which these resources are used changes. Since the level of nominal GDP
can change simply due to inflation or a change in population, real GDP per capita is often used as
a measure for the standard of living in a country. But even real GDP per capita is not a perfect
measure for people's welfare since it does not take into consideration such things as changes in the
distribution of income, environmental quality, or leisure activities.

The performance of an economy is generally judged by three broad measures: the growth rate of
output, the unemployment rate, and the inflation rate. The trend path of output is the path that real
GDP would take if all factors of production were fully employed (also known as potential GDP).
Actual GDP generally tends to be below this trend path, since in most years the factors of
production are not fully employed. The output gap measures the size of these cyclical deviations
and is defined as the gap between potential GDP and actual GDP. This gap grows during recessions
when unemployment increases. In periods of exceptional growth, like in the late 1990s, actual
GDP can become larger than potential GDP, so the GDP gap can actually become negative.

Knowing the speed with which prices adjust is critical in understanding the workings of the
economy, and much economic research is devoted to this subject. The Phillips curve shows an
empirical relationship between changes in inflation and the unemployment rate in the medium run.
The question of whether there is a useful trade-off between unemployment and inflation is of
considerable importance for the implementation of macroeconomic stabilization policies, and there
is much controversy among economists about the usefulness of the Phillips-curve.

It is beyond the scope of this chapter to go into details about the different schools of
macroeconomic thought, but it is worthwhile to broadly understand the major advances in
macroeconomic thinking. For example, out of the Great Depression in the 1930s came John
Maynard Keynes' General Theory. Keynes questioned Adam Smith's and the classicals’ contention
that the free market, if left alone, would lead to an optimal allocation of resources and that
unsatisfactory outcomes are only temporary. He also advocated government intervention, mainly
fiscal stimulation of aggregate demand, as a way out of a deep recession.
Much earlier Karl Marx also questioned the free market approach, believing that capitalism would
lead inevitable to a class struggle. His views remain controversial and are often neglected in
textbooks. In the 1960s, monetarists, led by Milton Friedman, challenged Keynes' views, stating
that unstable monetary growth is the primary cause of economic fluctuations. Monetarists tend to
favor minimal government intervention and advocate the control of money supply as a way to keep
inflation low. The new classical school, which includes Robert Lucas, Thomas Sargent, Robert
Barro and others, emerged in the 1970s. The neo-classicals believed that government intervention
has little value for stabilization policy. Consumers and firms make rational decisions using all
available information and, as a result, wages and prices adjust and markets clear rapidly. In their
view, most unemployment is voluntary and attempts to affect the unemployment rate are likely to
be counterproductive. In the 1980s, economists including Larry Summers, Gregory Mankiw,
George Akerlof, Ben Bernanke and others moved beyond the Keynesian tradition. These new
Keynesians believe that markets do not clear easily because of the information and adjustment
costs involved. They try to provide a theoretical explanation for the slow adjustment of wages and
prices and suggest that a better understanding of the wage and price adjustment may lead to more
successful activist policies designed to stabilize the economy.

The late 1970s and early 1980s also saw the emergence of supply-side economists such as Arthur
Laffer, Paul Craig Roberts and others, who advocated tax cuts. They suggest that tax cuts would
stimulate incentives to work, save, and invest, which would increase productivity and therefore
reduce inflation and unemployment simultaneously. The successes or failures of the tax cuts
during the Rajiv Gandhi administration in mid-1980s and now during the Modi government (refer
to the corporate tax cuts announced by our current FM on 20 September, 2019) call for an
assessment of the claims made by supply-side economists. Similar supply-side measures
introduced by the Reagan administration in the US during the 1980s have led to an enormous
increase in the U.S. national debt caused by massive federal deficits.

To summarize, the Chapter provides an outlook of some of the issues that will be discussed in later
chapters. During the delivery of the course more importance would be given to students to develop
an ability to apply certain ideas, concepts, or models to the economic issues of today. The ultimate
goal of any student of macroeconomics should be to be able to use economic reasoning in a
meaningful way when discussing current economic problems.