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Test Bank for Macroeconomics, 5th Edition by N. Gregory Mankiw
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Introduction
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, 1
C H A P T E R O N E
The Science of Macroeconomics
The whole of science is nothing more than the refinement of everyday
thinking.
— Albert Einstein
1-1 What Macroeconomists Study
Why have some countries experienced rapid growth in incomes over the past
century while others stay mired in poverty? Why do some countries have high
rates of inflation while others maintain stable prices? Why do all countries expe-
rience recessions and depressions—recurrent periods of falling incomes and ris-
ing unemployment—and how can government policy reduce the frequency and
severity of these episodes? Macroeconomics, the study of the economy as a
whole, attempts to answer these and many related questions.
To appreciate the importance of macroeconomics, you need only read the
newspaper or listen to the news. Every day you can see headlines such as IN-
COME GROWTH SLOWS, FED MOVES TO COMBAT INFLATION, or
STOCKS FALL AMID RECESSION FEARS. Although these macroeconomic
events may seem abstract, they touch all of our lives. Business executives forecast-
ing the demand for their products must guess how fast consumers’ incomes will
grow. Senior citizens living on fixed incomes wonder how fast prices will rise.
Recent college graduates looking for jobs hope that the economy will boom and
that firms will be hiring.
Because the state of the economy affects everyone, macroeconomic issues play
a central role in political debate.Voters are aware of how the economy is doing,
and they know that government policy can affect the economy in powerful
ways.As a result, the popularity of the incumbent president rises when the econ-
omy is doing well and falls when it is doing poorly.
Macroeconomic issues are also at the center of world politics. In recent years,
Europe has moved toward a common currency, many Asian countries have expe-
rienced financial turmoil and capital flight, and the United States has financed
large trade deficits by borrowing from abroad. When world leaders meet, these
topics are often high on their agendas.
2|
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, C H A P T E R 1 The Science of Macroeconomics | 3
Although the job of making economic policy falls to world leaders, the job of
explaining how the economy as a whole works falls to macroeconomists.Toward
this end, macroeconomists collect data on incomes, prices, unemployment, and
many other variables from different time periods and different countries. They
then attempt to formulate general theories that help to explain these data. Like
astronomers studying the evolution of stars or biologists studying the evolution
of species, macroeconomists cannot conduct controlled experiments. Instead,
they must make use of the data that history gives them. Macroeconomists ob-
serve that economies differ from one another and that they change over time.
These observations provide both the motivation for developing macroeconomic
theories and the data for testing them.
To be sure, macroeconomics is a young and imperfect science. The macro-
economist’s ability to predict the future course of economic events is no better
than the meteorologist’s ability to predict next month’s weather. But, as you will
see, macroeconomists do know quite a lot about how the economy works.This
knowledge is useful both for explaining economic events and for formulating
economic policy.
Every era has its own economic problems. In the 1970s, Presidents Richard
Nixon, Gerald Ford, and Jimmy Carter all wrestled in vain with a rising rate of
inflation. In the 1980s, inflation subsided, but Presidents Ronald Reagan and
George Bush presided over large federal budget deficits. In the 1990s, with Pres-
ident Bill Clinton in the Oval Office, the budget deficit shrank and even turned
into a budget surplus, but federal taxes as a share of national income reached a
historic high. So it was no surprise that when President George W. Bush moved
into the White House in 2001, he put a tax cut high on his agenda. The basic
principles of macroeconomics do not change from decade to decade, but the
macroeconomist must apply these principles with flexibility and creativity to
meet changing circumstances.
CAS E STU DY
The Historical Performance of the U.S. Economy
Economists use many types of data to measure the performance of an economy.
Three macroeconomic variables are especially important: real gross domestic
product (GDP), the inflation rate, and the unemployment rate. Real GDP mea-
sures the total income of everyone in the economy (adjusted for the level of
prices).The inflation rate measures how fast prices are rising.The unemploy-
ment rate measures the fraction of the labor force that is out of work. Macro-
economists study how these variables are determined, why they change over
time, and how they interact with one another.
Figure 1-1 shows real GDP per person in the United States. Two aspects
of this figure are noteworthy. First, real GDP grows over time. Real GDP
per person is today about five times its level in 1900.This growth in average
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, 4| P A R T I Introduction
figure 1-1
Real GDP per person First oil price shock
(1996 dollars) World Great World Korean Vietnam Second oil price shock
35,000 War I Depression War II War War
30,000
20,000
10,000
5,000
3,000
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Year
Real GDP per Person in the U.S. Economy
Real GDP measures the total income of everyone in the economy, and real GDP per
person measures the income of the average person in the economy. This figure shows
that real GDP per person tends to grow over time and that this normal growth is
sometimes interrupted by periods of declining income, called recessions or
depressions.
Note: Real GDP is plotted here on a logarithmic scale. On such a scale, equal distances on the vertical
axis represent equal percentage changes. Thus, the distance between $5,000 and $10,000 (a 100
percent change) is the same as the distance between $10,000 and $20,000 (a 100 percent change).
Source: U.S. Bureau of the Census (Historical Statistics of the United States: Colonial Times to 1970) and U.S.
Department of Commerce.
income allows us to enjoy a higher standard of living than our great-grand-
parents did. Second, although real GDP rises in most years, this growth is
not steady. There are repeated periods during which real GDP falls, the
most dramatic instance being the early 1930s. Such periods are called reces-
sions if they are mild and depressions if they are more severe. Not surpris-
ingly, periods of declining income are associated with substantial economic
hardship.
Figure 1-2 shows the U.S. inflation rate. You can see that inflation varies
substantially. In the first half of the twentieth century, the inflation rate aver-
aged only slightly above zero. Periods of falling prices, called deflation, were
almost as common as periods of rising prices. In the past half century, inflation
has been the norm.The inflation problem became most severe during the late
1970s, when prices rose at a rate of almost 10 percent per year. In recent years,
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, C H A P T E R 1 The Science of Macroeconomics | 5
figure 1-2
Percent
30 World Great World Korean Vietnam First oil price shock
War I Depression War II War War Second oil price shock
25
20
Inflation 15
10
5
0
−5
Deflation −10
−15
−20
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Year
The Inflation Rate in the U.S. Economy
The inflation rate measures the percentage change in the average level of prices from
the year before. When the inflation rate is above zero, prices are rising. When it is
below zero, prices are falling. If the inflation rate declines but remains positive, prices
are rising but at a slower rate.
Note: The inflation rate is measured here using the GDP deflator.
Source: U.S. Bureau of the Census (Historical Statistics of the United States: Colonial Times to 1970) and U.S.
Department of Commerce.
the inflation rate has been about 2 or 3 percent per year, indicating that prices
have been fairly stable.
Figure 1-3 shows the U.S. unemployment rate. Notice that there is always
some unemployment in our economy. In addition, although there is no long-
term trend, the amount of unemployment varies from year to year. Reces-
sions and depressions are associated with unusually high unemployment.The
highest rates of unemployment were reached during the Great Depression of
the 1930s.
These three figures offer a glimpse at the history of the U.S. economy. In the
chapters that follow, we first discuss how these variables are measured and then
develop theories to explain how they behave.
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, 6| P A R T I Introduction
figure 1-3
Percent
unemployed World Great World Korean Vietnam First oil price shock
War I Depression War II War War Second oil price shock
25
20
15
10
5
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Year
The Unemployment Rate in the U.S. Economy
The unemployment rate measures the percentage of people in the labor force who do
not have jobs. This figure shows that the economy always has some unemployment
and that the amount fluctuates from year to year.
Source: U.S. Bureau of the Census (Historical Statistics of the United States: Colonial Times to 1970) and U.S.
Department of Commerce.
1-2 How Economists Think
Although economists often study politically charged issues, they try to address
these issues with a scientist’s objectivity. Like any science, economics has its own
set of tools—terminology, data, and a way of thinking—that can seem foreign
and arcane to the layman.The best way to become familiar with these tools is to
practice using them, and this book will afford you ample opportunity to do so.To
make these tools less forbidding, however, let’s discuss a few of them here.
Theory as Model Building
Young children learn much about the world around them by playing with toy
versions of real objects. For instance, they often put together models of cars,
trains, or planes.These models are far from realistic, but the model-builder learns
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, C H A P T E R 1 The Science of Macroeconomics | 7
a lot from them nonetheless.The model illustrates the essence of the real object it
is designed to resemble.
Economists also use models to understand the world, but an economist’s
model is more likely to be made of symbols and equations than plastic and glue.
Economists build their “toy economies” to help explain economic variables, such
as GDP, inflation, and unemployment. Economic models illustrate, often in
mathematical terms, the relationships among the variables. They are useful be-
cause they help us to dispense with irrelevant details and to focus on important
connections.
Models have two kinds of variables: endogenous variables and exogenous
variables. Endogenous variables are those variables that a model tries to ex-
plain. Exogenous variables are those variables that a model takes as given.The
purpose of a model is to show how the exogenous variables affect the endoge-
nous variables. In other words, as Figure 1-4 illustrates, exogenous variables come
from outside the model and serve as the model’s input, whereas endogenous
variables are determined inside the model and are the model’s output.
To make these ideas more concrete, let’s review the most celebrated of all eco-
nomic models—the model of supply and demand. Imagine that an economist
were interested in figuring out what factors influence the price of pizza and the
quantity of pizza sold. He or she would develop a model that described the be-
havior of pizza buyers, the behavior of pizza sellers, and their interaction in the
market for pizza. For example, the economist supposes that the quantity of pizza
demanded by consumers Qd depends on the price of pizza P and on aggregate
income Y.This relationship is expressed in the equation
Qd = D(P, Y),
where D( ) represents the demand function. Similarly, the economist supposes
that the quantity of pizza supplied by pizzerias Qs depends on the price of pizza
P and on the price of materials Pm, such as cheese, tomatoes, flour, and anchovies.
This relationship is expressed as
Qs = S(P, Pm),
figure 1-4
Exogenous Variables Model Endogenous Variables
How Models Work
Models are simplified theories that show the key relationships
among economic variables. The exogenous variables are those that
come from outside the model. The endogenous variables are those
that the model explains. The model shows how changes in the
exogenous variables affect the endogenous variables.
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, 8| P A R T I Introduction
where S( ) represents the supply function. Finally, the economist assumes that the
price of pizza adjusts to bring the quantity supplied and quantity demanded into
balance:
Qs = Qd.
These three equations compose a model of the market for pizza.
The economist illustrates the model with a supply-and-demand diagram, as in
Figure 1-5. The demand curve shows the relationship between the quantity of
pizza demanded and the price of pizza, while holding aggregate income con-
stant. The demand curve slopes downward because a higher price of pizza en-
courages consumers to switch to other foods and buy less pizza.The supply curve
shows the relationship between the quantity of pizza supplied and the price of
pizza, while holding the price of materials constant.The supply curve slopes up-
ward because a higher price of pizza makes selling pizza more profitable, which
encourages pizzerias to produce more of it.The equilibrium for the market is the
price and quantity at which the supply and demand curves intersect.At the equi-
librium price, consumers choose to buy the amount of pizza that pizzerias
choose to produce.
This model of the pizza market has two exogenous variables and two endoge-
nous variables. The exogenous variables are aggregate income and the price of
materials.The model does not attempt to explain them but takes them as given
(perhaps to be explained by another model). The endogenous variables are the
figure 1-5
Price of pizza, P The Model of Supply and
Supply Demand
The most famous economic
model is that of supply and
demand for a good or
service—in this case, pizza.
The demand curve is a
downward-sloping curve
Market relating the price of pizza to
equilibrium the quantity of pizza that
consumers demand. The
Equilibrium supply curve is an upward-
price sloping curve relating the
Demand
price of pizza to the quantity
of pizza that pizzerias
Equilibrium supply. The price of pizza
quantity
adjusts until the quantity
supplied equals the quantity
Quantity of pizza, Q demanded. The point where
the two curves cross is the
market equilibrium, which
shows the equilibrium price
of pizza and the equilibrium
quantity of pizza.
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