CH-1 The Science of Macroeconomics – Macroeconomics : Book Guide

Answers to Textbook Questions and Problems CHAPTER 1 The Science of Macroeconomics Questions for Review 1. Microeconomics is the study of how individual firms and households make decisions, and how they interact with one another. Microeconomic models of firms and households are based on principles of optimization—firms and households do the best they can given the constraints they face. For example, households choose which goods to purchase in order to maximize their utility, whereas firms decide how much to produce in order to maximize profits. In contrast, macroeconomics is the study of the economy as a whole; it focuses on issues such as how total output, total employment, and the overall price level are determined. These economy-wide variables are based on the interaction of many households and many firms; therefore, microeconomics forms the basis for macroeconomics. 2. Economists build models as a means of summarizing the relationships among economic variables. Models are useful because they abstract from the many details in the economy and allow one to focus on the most important economic connections. 3. A market-clearing model is one in which prices adjust to equilibrate supply and demand. Marketclearing models are useful in situations where prices are flexible. Yet in many situations, flexible prices may not be a realistic assumption. For example, labor contracts often set wages for up to three years. Or, firms such as magazine publishers change their prices only every three to four years. Most macroeconomists believe that price flexibility is a reasonable assumption for studying long-run issues. Over the long run, prices respond to changes in demand or supply, even though in the short run they may be slow to adjust. Problems and Applications 1. Monetary policy in the United States and the European Union has been a big topic of conversation in early 2015. The EU embarked upon a quantitative easing policy in March 2015 in an attempt to stimulate growth and prevent deflation. There has been some concern that the inflation rate in Europe will turn negative. In the United States, there is continued discussion and speculation concerning when the Federal Reserve might choose to increase the target federal funds rate. Also in the United States, the unemployment rate has declined to about 5.5 percent and this suggests that wages may begin to increase. The Federal Reserve will be watching for wage and price increases as they decide when to increase interest rates. 2. Many philosophers of science believe that the defining characteristic of a science is the use of the scientific method of inquiry to establish stable relationships. Scientists examine data, often provided by controlled experiments, to support or disprove a hypothesis. Economists are more limited in their use of experiments. They cannot conduct controlled experiments on the economy; they must rely on the natural course of developments in the economy to collect data. To the extent that economists use the scientific method of inquiry, that is, developing hypotheses and testing them, economics has the characteristics of a science. 3. We can use a simple variant of the supply-and-demand model for pizza to answer this question. Assume that the quantity of ice cream demanded depends not only on the price of ice cream and income, but also on the price of frozen yogurt: Qd = D(PIC, PFY, Y). We expect that demand for ice cream rises when the price of frozen yogurt rises, because ice cream and frozen yogurt are substitutes. That is, when the price of frozen yogurt goes up, I consume less of it and, instead, fulfill more of my frozen dessert urges through the consumption of ice cream. Chapter 1—The Science of Macroeconomics 1 The next part of the model is the supply function for ice cream, Qs = S(PIC). Finally, in equilibrium, supply must equal demand, so that Qs = Qd. Y and PFY are the exogenous variables, and Q and PIC are the endogenous variables. Figure 1-1 uses this model to show that a fall in the price of frozen yogurt results in an inward shift of the demand curve for ice cream. The new equilibrium has a lower price and quantity of ice cream. 4. The price of haircuts changes rather infrequently. From casual observation, hairstylists tend to charge the same price over a one- or two-year period irrespective of the demand for haircuts or the supply of cutters. A market-clearing model for analyzing the market for haircuts has the unrealistic assumption of flexible prices. Such an assumption is unrealistic in the short run when we observe that prices are inflexible. Over the long run, however, the price of haircuts does tend to adjust; a market-clearing model is therefore appropriate. Chapter 1—The Science of Macroeconomics 2 IN THIS CHAPTER, YOU WILL LEARN: ▪ About the issues macroeconomists study ▪ About the tools macroeconomists use ▪ Some important concepts in macroeconomic analysis Important issues in macroeconomics Macroeconomics—the study of the economy as a whole—addresses many topical issues, e.g.: ▪ What causes recessions? What is “government stimulus” and why might it help? ▪ How can problems in the housing market spread to the rest of the economy? ▪ What is the government budget deficit? How does it affect workers, consumers, businesses, and taxpayers? CHAPTER 1 The Science of Macroeconomics Important issues in macroeconomics Macroeconomics—the study of the economy as a whole—addresses many topical issues, e.g.: ▪ Why does the cost of living keep rising? ▪ Why are so many countries poor? What policies might help them grow out of poverty? ▪ What is the trade deficit? How does it affect a country’s well-being? CHAPTER 1 The Science of Macroeconomics Economic models …are simplified versions of a more complex reality. ▪ irrelevant details are stripped away …are used to: ▪ show relationships between variables ▪ explain the economy’s behavior ▪ devise policies to improve economic performance Example of a model: Supply & demand for new cars ▪ Shows how various events affect price and quantity of cars ▪ Assumes the market is competitive: each buyer and seller is too small to affect the market price Variables Qd = quantity of cars that buyers demand Qs = quantity that producers supply P = price of new cars Y = aggregate income Ps = price of steel (an input) The demand for cars Demand equation: Q d = D (P,Y ) ▪Shows that the quantity of cars consumers demand is related to the price of cars and aggregate income Digression: functional notation ▪ General functional notation shows only that the variables are related. Q d = D (P,Y ) ▪ A specific functional form shows the precise quantitative relationship.A list of the ▪ Example: variables D (P,Ythat affect ) = 60 Q– d10P + 2Y Demand Demand equation: P Quantity of cars Supply equation: Q s = S (P,PS ) The supply curve shows the relationship between quantity supplied and price, other things equal. Supply P Quantity of cars Equilibrium P The effects of an increase in income Demand equation: P The effects of a steel price increase Supply equation: …which increases the market price and reduces the quantity. Q2 Q1 Quantity of cars Endogenous vs. exogenous variables ▪ The values of endogenous variables are determined in the model. ▪ The values of exogenous variables are determined outside the model: The model takes their values and behavior as given. ▪ In the model of supply & demand for cars, endogenous: P, Q d, Q s exogenous: Y, Ps NOW YOU TRY Supply and Demand 1. Write down demand and supply equations for smartphones, include two exogenous variables in each equation. 2. Draw a supply–demand graph for smartphones. 3. Use your graph to show how a change in one of your exogenous variables affects the model’s endogenous variables. The use of multiple models ▪ No one model can address all the issues we care about. ▪ E.g., our supply–demand model of the car market… ▪can tell us how a fall in aggregate income affects price & quantity of cars. ▪ cannot tell us why aggregate income falls. The use of multiple models ▪ So we will learn different models for studying different issues (e.g., unemployment, inflation, long-run growth). ▪ For each new model, you should keep track of: ▪ its assumptions ▪ which variables are endogenous, which are exogenous ▪ the questions it can help us understand, those it cannot Prices: flexible vs. sticky ▪ Market clearing: An assumption that prices are flexible, adjust to equate supply and demand. ▪ In the short run, many prices are sticky— adjust sluggishly in response to changes in supply or demand. For example: ▪ many labor contracts fix the nominal wage for a year or longer ▪ many magazine publishers change prices only once every 3 to 4 years Prices: flexible vs. sticky ▪ The economy’s behavior depends partly on whether prices are sticky or flexible: ▪ If prices are sticky (short run), demand may not equal supply, which explains: ▪ unemployment (excess supply of labor) ▪ why firms cannot always sell all the goods they produce ▪ If prices are flexible (long run), markets clear and economy behaves very differently. Outline of this book: ▪ Introductory material (Chaps. 1, 2) ▪ Classical Theory (Chaps. 3–7) How the economy works in the long run, when prices are flexible ▪ Growth Theory (Chaps. 8, 9) The standard of living and its growth rate over the very long run ▪ Business Cycle Theory (Chaps. 10–14) How the economy works in the short run, when prices are sticky Outline of this book: ▪ Macroeconomic theory (Chaps. 15–17) Macroeconomic dynamics, models of consumer behavior, theories of firms’ investment decisions ▪ Macroeconomic policy (Chaps. 18–20) Stabilization policy, government debt and deficits, financial crises C H A P T E R S U M M A R Y ▪ Macroeconomics is the study of the economy as a whole, including ▪growth in incomes ▪ changes in the overall level of prices ▪ the unemployment rate ▪ Macroeconomists attempt to explain the economy and to devise policies to improve its performance. C H A P T E R S U M M A R Y ▪ Economists use different models to examine different issues. ▪ Models with flexible prices describe the economy in the long run; models with sticky prices describe the economy in the short run. ▪ Macroeconomic events and performance arise from many microeconomic transactions, so macroeconomics uses many of the tools of microeconomics. Solution Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058