CHAPTER 5 Introduction to Macroeconomics 101

S U M M A R Y1. Microeconomics examines the functioning of individual

industries and the behavior of individual decision-makingunits. Macroeconomics is concerned with the sum, or aggre-gate, of these individual decisions—the consumption of allhouseholds in the economy, the amount of labor suppliedand demanded by all individuals and firms, and the totalamount of all goods and services produced.

MACROECONOMIC CONCERNS p. 90

2. The three topics of primary concern to macroeconomists arethe growth rate of aggregate output; the level of unemploy-ment; and increases in the overall price level, or inflation.

THE COMPONENTS OF THE MACROECONOMY p. 92

3. The circular flow diagram shows the flow of income receivedand payments made by the four groups in the economy—households, firms, the government, and the rest of theworld. Everybody’s expenditure is someone else’s receipt—every transaction must have two sides.

4. Another way of looking at how households, firms, the gov-ernment, and the rest of the world relate is to consider themarkets in which they interact: the goods-and-services mar-ket, labor market, and money (financial) market.

5. Among the tools that the government has available for influ-encing the macroeconomy are fiscal policy (decisions on

E C O N O M I C S I N P R A C T I C E

The Economy and the Election in 2008On November 4, 2008, Democrat Barak Obamawas victorous over Republican John McCain in theU.S. presidential election, winning over 53 percentof the popular vote.

At the time of the 2008 election, the economywas not doing well. Output was falling and unem-ployment was rising. Indeed, in the fall of 2008, theUnited States was in the midst of a worldwidefinancial crisis in which large financial institutionsaround the globe were faltering. In the UnitedStates, fiscal policy and monetary policy wereexpansive in 2008 as policy makers tried to help the economy. These policies are discussed in futureEconomics in Practice boxes. The policies were not enough, however, to prevent a contraction.

The economy and election outcomes are closely linked. The state of the economy is almostalways an important issue in U.S. presidential elections. Voters appear to hold the party that isin power in the White House accountable for the economy. Voters tend to favor the incumbent-party candidate if the economy is good (high output and low inflation) and vote against theincumbent-party candidate if the economy is bad (low output and high inflation). In fact, it ispossible to quantify the relationship between the economy and election outcomes using thetools of econometrics, one of the fields listed in Table 1.2 on p. 9. One of the authors of this text(Fair, Predicting Presidential Elections and Other Things, Stanford University Press, 2002) has anequation that explains the incumbent-party vote share for president based on output and infla-tion (and some non-economic incumbency information). Economic performances and elec-tion outcomes back to the 1916 election are used for the analysis. Given predictions of outputand inflation before an election, this equation can be used to predict each party’s vote share.

Two years ahead of the 2008 election, on November 1, 2006, the equation was predicting, giveneconomic forecasts that were available at the time, that the Democratic challenger, whoever he orshe might be, would get 53.5 percent of the vote. During the next two years the economic fore-casts changed as new economic information became available, which allowed a new vote predic-tion to be made. The final vote prediction before the election, on October 30, 2008, was51.9 percent for the Democratic challenger (Obama). In fact, Obama got 53.3 percent of the vote,so the predictions from the vote equation were quite close to what actually occurred. Two yearsahead the equation was predicting that the Democrats would win and by roughly the amount bywhich they did! Not all economic and political predictions are this accurate, but it is important torealize that the economy is generally very important in influencing elections. The economy wasstruggling at the time of the 2008 election, and the incumbent-party candidate lost.

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102 PART II Concepts and Problems in Macroeconomics

taxes and government spending) and monetary policy (con-trol of the money supply, which affects interest rates).

A BRIEF HISTORY OF MACROECONOMICS p. 95

6. Macroeconomics was born out of the effort to explain theGreat Depression of the 1930s. Since that time, the disciplinehas evolved, concerning itself with new issues as the prob-lems facing the economy have changed. Through the late

1960s, it was believed that the government could “fine-tune”the economy to keep it running on an even keel at all times.The poor economic performance of the 1970s, however,showed that fine-tuning does not always work.

THE U.S. ECONOMY SINCE 1970 p. 99

7. Since 1970, the U.S. economy has seen four recessions andtwo periods of high inflation.

R E V I E W T E R M S A N D C O N C E P T S

aggregate behavior, p. 89

aggregate output, p. 90

business cycle, p. 90

circular flow, p. 93

contraction, recession, or slump, p. 90

corporate bonds, p. 95

deflation, p. 92

depression, p. 90

dividends, p. 95

expansion or boom, p. 90

fine-tuning, p. 96

fiscal policy, p. 95

Great Depression, p. 95

hyperinflation, p. 92

inflation, p. 92

macroeconomics, p. 89

microeconomics, p. 89

monetary policy, p. 95

recession, p. 90

shares of stock, p. 95

stagflation, p. 96

sticky prices, p. 89

transfer payments, p. 93

Treasury bonds, notes, and bills, p. 95

unemployment rate, p. 91

P R O B L E M SVisit www.myeconlab.com to complete the problems marked in orange online. You will receiveinstant feedback on your answers, tutorial help, and access to additional practice problems.

1. Define inflation. Assume that you live in a simple economy inwhich only three goods are produced and traded: fish, fruit, andmeat. Suppose that on January 1, 2007, fish sold for $2.50 perpound, meat was $3.00 per pound, and fruit was $1.50 perpound. At the end of the year, you discover that the catch waslow and that fish prices had increased to $5.00 per pound, butfruit prices stayed at $1.50 and meat prices had actually fallen to$2.00. Can you say what happened to the overall “price level”?How might you construct a measure of the “change in the pricelevel”? What additional information might you need to con-struct your measure?

2. Define unemployment. Should everyone who does not hold ajob be considered “unemployed”? To help with your answer,draw a supply and demand diagram depicting the labor market.What is measured along the demand curve? What factors deter-mine the quantity of labor demanded during a given period?What is measured along the labor supply curve? What factorsdetermine the quantity of labor supplied by households duringa given period? What is the opportunity cost of holding a job?

3. [Related to the Economics in Practice on p. 97] The Economicsin Practice describes prosperity and recession as they aredepicted in literature. At the beginning of 2008, there was adebate about whether the U.S. economy was in recession. Lookat the data on real GDP growth and unemployment anddescribe the pattern since 2007. You can find raw data onemployment and unemployment at www.bls.gov, and you canfind raw data on real GDP growth at www.bea.gov. (In both

cases, use the data described in “Current Releases.”) Summarizewhat happened during 2008. Did we have a recession? Explain.

4. A recession occurred in the U.S. economy during the first threequarters of 2001. National output of goods and services fell dur-ing this period. But during the fourth quarter of 2001, outputbegan to increase and it increased at a slow rate through the firstquarter of 2003. At the same time, between March 2001 andApril 2003, employment declined almost continuously with aloss of over 2 million jobs. How is it possible that output riseswhile at the same time employment is falling?

5. Describe the economy of your state. What is the most recentlyreported unemployment rate? How has the number of payrolljobs changed over the last 3 months and over the last year? Howdoes your state’s performance compare to the U.S. economy’sperformance over the last year? What explanations have beenoffered in the press? How accurate are they?

6. Explain briefly how macroeconomics is different from microeco-nomics. How can macroeconomists use microeconomic theoryto guide them in their work, and why might they want to do so?

7. During 1993 when the economy was growing very slowly,President Clinton recommended a series of spending cuts andtax increases designed to reduce the deficit. These were passedby Congress in the Omnibus Budget Reconciliation Act of 1993.Some who opposed the bill argue that the United States waspursuing a “contractionary fiscal policy” at precisely the wrongtime. Explain their logic.

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CHAPTER 5 Introduction to Macroeconomics 103

8. Many of the expansionary periods during the twentieth centuryoccurred during wars. Why do you think this is true?

9. In the 1940s, you could buy a soda for 5 cents, eat dinner at arestaurant for less than $1, and purchase a house for $10,000.From this statement, it follows that consumers today are worseoff than consumers in the 1940s. Comment.

10. [Related to Economics in Practice on p. 99] John MaynardKeynes was the first to show that government policy could beused to change aggregate output and prevent recessions by sta-bilizing the economy. Describe the economy of the world at thetime Keynes was writing. Describe the economy of the UnitedStates today. What measures were being proposed by thePresidential candidates in the election of 2008 to prevent or enda recession in 2008-2009? Where the actions taken appropriate

from the standpoint of John Maynard Keynes? Did they havethe desired effect?

11. [Related to Economics in Practice on p. 101] Presidential elec-tions are often influenced by the current state of the economy.The state of the U.S economy was a major campaign issue in the2008 presidential election. Go to www.bls.gov to find the quar-terly data on the unemployment rate in 2008, and www.bea.govto find the quarterly GDP data for 2008. Based on this data, wasthe economy in a recession prior to the 2008 presidential elec-tion? Does there appear to be any link between the electionresults and the state of the economy? Briefly explain how theelection results may or may not have been influenced by thestate of the economy in 2008. For more information, seefairmodel.econ.yale.edu/vote2008/index2.htm.

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