Topic Five

A First Look at the Macro Economy

Required Readings:

  • The Wall Street Journal

Additional Readings:

  • Charles L. Schultze, Memos to the President, Memorandum 1


  • You should be able to explain what macroeconomics is about.
  • You should be able to explain what determines the level of economic activity (i.e. production, sales, employment, etc.) in general terms and identify what would cause changes in economic activity.
  • You should be able to differentiate between the beliefs of the “Laissez-Faire” schools of thought with the “Policy Activist” schools of thought.

Notes:  A First Look At Macro Economics

What is Macro?

DEF: Macroeconomics – the study of aggregate economic activity.

What is included in “Aggregate Economic Activity?

– Any person working on the job

– Any firm doing anything to produce or sell a product

– Any consumer doing anything to make a purchase

Aggregate Economic Activity is the sum of everything

that goes on in every market,

  • all production
  • all consumption
  • all exchange.

How do we summarize all this activity?

We focus on three types of markets:  1. Product Markets
2. Labor Markets
3. Money (& Financial) Markets

Macro is about 3 questions:

1. What determines GDP (or aggregate economic activity in general)?
2. What causes changes in GDP?
3. What can government do to affect GDP (i.e. “Stabilization Policy”)?

Throughout history, there have been two competing views about these 3 questions.

NOTE: These are two views about the workings of

and the role of govt in a market economy
(i.e. the best way to organize or run a market economy).
These views have gone by different names at different times, but we can think of them as:

I. Laissez-Faire              and         II. Policy Activism
– or Classical                              – or Keynesian
Monetarist                                    New Keynesian
New Classical
Supply Side

Supporters of Laissez-Faire believe that:

i. The Economy Is Inherently Stable.
– Business cycles are self-correcting
(i.e. both recessions and booms eventually end);
– Unemployment is a temporary condition; most unemployed people
will eventually find a new job if they look long enough;

ii. Government Policies Cannot Improve the Workings of the Economy
and They May Make it Worse.
– Many recessions and inflationary periods are caused by Govt
mismanagement of the economy;

iii. Competition is the Driving Force in Economic Progress
– competition is the reason why the U.S. standard of living
has increased over time.
– { compare with iii below }

Supporters of Policy Activism believe that:

i. The Economy is Inherently UNStable
– The economy has a tendency to fall into recessions on its own;
– Business cycles are NOT self-correcting;
ii. Government Has a Responsibility to “Fix” the Instability of the Economy
– If the govt doesn’t do something, recessions will last if not indefinitely,

then at least a long time;
– Unemployment will last if not indefinitely, then at least a long time;

iii. Competition Imposes Painful Costs on Society
– Competition may not be an unambiguous blessing;
– People lose jobs; businesses go bankrupt;
– A humanistic society should not make these folks bear all the costs of society reaping the benefits of competition.

As we investigate specific theories of Macroeconomics, you should keep in mind these two competing views, and you should determine the extent to which each theory fits one view or the other.

Question: Are these two views mutually exclusive?
Answer: Not necessarily or not completely (e.g. see iii)
They may each be focusing on different aspects of the real world.
Two Sets of Factors Determine GDP (and Economic Activity in General):

1. Aggregate Supply Factors; and

2. Aggregate Demand Factors.

I. Aggregate Supply Factors (What determines potential output?)

The amount of GDP produced in a country depends on the availability of:

Factors Of Production – the basic inputs used in producing goods and services,

i.e. Natural Resources – land and raw materials;

Labor – human effort (physical and mental);

Capital – NOT financial capital, but rather PHYSICAL capital,
goods produced for the purpose of producing other goods,
e.g. machines, buildings, equipment, etc.
Anything which is not consumed for personal use is considered a capital good;

Entrepreneurship – The person who has the idea for the business and combines the                                                   other factors of production is an entrepreneur.
The entrepreneur is a RISK TAKER.

If any factor of production increases, the result will be more output!

In particular, for fixed K, NR, and E, there is a one-to-one relationship between employment (i.e. labor, L) and (real) output (i.e. Q)

à In other words,

A higher level of employment (or a lower level of unemployment}
requires a higher level of output or GDP!

At any time, the factors of production are fixed.
à As a consequence, GDP has a limit,

which we can represent as the production possibilities curve.

Btr |



|___________________ Guns

Usually, aggregate supply changes only slowly, so at any point in time it can be taken as fixed.

In short, the aggregate supply factors determine Potential GDP at any time!

II. Aggregate Demand Factors

Given Potential GDP, what determines Actual GDP?

– A firm (for example) can supply between 0 and its maximum output level,

so what determines how much it will in fact produce?

ANS: Spending by      (1) Consumers
(2) (other) Businesses
(3) Government, and

(4) Foreigners

Importance Of Spending To GNP:

Shark Analogy: Spending = Swimming
GDP = Shark’s level above the ocean floor

– If a shark stops swimming, it will sink.
If an economy stops spending, its GDP will fall

Producers only produce to sell
– If people buy less, they will produce less (e.g. paradox of thrift)
– If people buy more, they will produce more

In sum, the Aggregate Demand factors determine the actual GDP at any time

In the S.R., Aggregate Demand is more important
In the L.R., Aggregate Supply is more important

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