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Chapter 1
An Introduction to Macroeconomics
Copyright 2006 McGraw-Hill Australia Pty

Ltd
PPTs t/a Macroeconomics 2e by Dornbusch,
11
Objectives
Introduce three linked macroeconomic models that

explain the behavior of the economy
Explain the long-run growth in productive capacity
Use the concepts of aggregate supply and aggregate

demand to explain what determines the rate of inflation
Introduce the concept of the business cycle to explain

variations from the long-run growth path
Outline the two main schools of thought that have

influenced the economic policy debate in the past
50 years 2006 McGraw-Hill Australia Pty
Copyright
Ltd
12
Chapter Organisation
1.1
Macroeconomics Encapsulated in
Three Models
1.2
To Reiterate . . .
1.3
Schools of Thought
1.4
Outline and Preview of the Text
1.5
Prerequisites and Recipes
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1.1 Three Models
Macroeconomics is organised around

three models.
Each model is concerned with different

time frames:
The long run

The medium run
The short run.
Lets consider each in more detail.

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Very Long Run Economic Growth
The long run is a period of decades or more over

which potential output is expected to grow.
The time period is usually measured in multiples

of decades (e.g. 20 years or more).
Growth theory describes the long-run behaviour

of the economy.
Short-run fluctuations in important variables like

employment, investment and output are ignored,
on the assumption that changes in these variables
average out
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over
2006time.
McGraw-Hill Australia Pty
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The long-run level of output is determined solely

by supply-side considerations.
Output is determined by the productive capacity

of the economy.
All factors of production (land, labour, capital and

technology) are assumed to be fully employed.
The economy is operating at its potential output.

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Economic growth is a function of increases in

productive capacity.
Major causes of economic growth are:
Development of new technology

Accumulation of physical and human capital
Appropriate provision of infrastructure
Higher rates of domestic saving.

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Economic growth determines the changes in

the standard of living.
A country growing at an average of 4% per year

instead of 2% will have a 50% higher standard
of living over a generation of 20 years.
This higher 4% average annual growth rate will

lead to a seven-fold increase in the standard of
living over 100 years!

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Fixed Productive Capacity
In the long run the productive capacity of the

economy is assumed to be constant or fixed.
The productive capacity of the economy

determines output.

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This is represented by a vertical aggregate supply

schedule at real output level Y0 (potential output).
AS
Price
Level
Copyright 2006 McGraw-Hill

AustraliaYPty
Y0
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110
This level of output is associated with a certain

rate of growth in prices.
What determines the change in the overall price

level (the inflation rate)?
The aggregate supply (AS)aggregate demand

(AD) model explains short- to medium-run
determination of inflation and real output.

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The AD schedule represents, for each price level,

the level of output where both the goods and
money markets are in equilibrium.
The intersection of the AS and AD schedules

determines the price (P0) and real output (Y0).

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AD and AS in the long run.
Price
Level
P0
AD
AS
What happens
when AD shifts
rightwards?
Price
increases
What happens
when AS shifts
rightwards?
Price
decreases

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Y0
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The Short Run
The short run is a period of time short enough

that markets are unable to clear.
In the short run actual output can deviate from

potential output.
Short-run fluctuations in real output are important.
AD is the major determinant of these variations.
In the short run the price level is pegged, making

the short-run
ASMcGraw-Hill
schedule horizontal.
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2006
Australia Pty
Ltd
114
The Short Run
AD and AS in the short run.
Price
Level
P0
What happens
when AD shifts
rightwards?
Price
unchanged
AS
AD

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Y0
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The Medium Run
How do we describe the transition between

the short run and the long run?
High AD pushes real output above Y0

(according to the long-run model).
Over time, firms will increase prices and the

AS curve will move upwards.
The medium run will give an upward-sloping

AS curve.
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The Medium Run
The relative steepness of the AS curve is a

major controversy in macroeconomics.
Price
Level
P0
AS
AD

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Y0
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1.1
Three Models
1.2
To Reiterate . . .
1.3
Schools of Thought
1.4
1.5

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1.2 To Reiterate
Growth theory and the ASAD framework can be

used to analyse many macroeconomic issues.
These two models provide a basis for the further

analysis of:
Growth and GDP

The business cycle.
Lets consider each in turn.

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Growth and GDP

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Growth and GDP
Table 1.1 compares the per capita real income

growth rates in various countries.
Note the very large differences ranging from

0.3% for Ghana to 3.1% for Japan.
Brazil (2.2%), China (3.1%) and France (2.0%)

are the next band.
Note the lower but similar growth rates for

Australia (1.6%) and New Zealand (1.5%).
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The Business Cycle and GDP
The business cycle describes the variation of

economic activity around the path of trend growth.
Inflation, growth and unemployment all

demonstrate cyclical patterns that contribute
to this variation.
The output gap measures cyclical variations

in output from the trend growth path.
It measures the difference between actual

and potential
output.
Copyright
2006
McGraw-Hill Australia Pty
Ltd
122
The Business Cycle and GDP
Output gap = potential output actual output.
During a recession, actual output falls below

potential output. A negative gap is associated
with unemployment.
During a boom, actual output rises above

potential output. A positive gap is associated
with over employment.

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The Business Cycle and Inflation
The cost of the cycle above trend is inflation

and the cost below trend is unemployment.
The costs of inflation are less obvious than

those of unemployment.
Unemployment is associated with a loss in

potential output.
Inflation upsets price relationships and

reduces the efficiency of the price system.

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Business Cycle Features
Business cycles have common characteristics.
Business cycles are associated with a pattern of

expansion (recovery) and contraction (recession).

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Economic variables can indicate something

of the nature of the business cycle.
Procyclical variables rise with expansionary

business activity (e.g. output, employment,
interest rates and money supply).
Countercyclical variables (like inventories and

bankruptcies) move in the opposite direction
to business activity.

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Some variables exhibit more variability

(volatility) than others.
For example, inventories are volatile while

consumption is smooth, especially relative
to output.
Business cycles do not occur as regular

fluctuations in the level of economic activity.

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The impulse-propagation model can be used

to explain what causes actual output to deviate
from the trend.
The impulse-propagation model explains:
How shocks (impulses) disturb the economy from

its long-run trend
How this leads to effects that last (propagate) over time.
Economists disagree over possible propagation

mechanisms.
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1PPTs t/a Macroeconomics 2e by Dornbusch,
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There are three broad types of shocks:
Policy shocks, which affect fiscal expenditure and interest

rates (e.g. fiscal and monetary policies)
Supply shocks, which affect production and price-setting
(e.g. technology advances)
Private sector shocks, which affect aggregate demand
(e.g. changes in private investment).

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There is debate about the several aspects

of Australian business cycles.
What is a business cycle?
How are variations in economic activity separated

from the trend?
Which indicators should be used to measure

the business cycle?
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Various economic indicators can be used to

measure the course of the business cycle:
Leading indicators, like firms profitability and building

approvals precede changes in GDP.
Lagging indicators, like unemployment lag changes
in real GDP.
Variables can be aggregated into a composite index
that will give a coincident index to measure turning
points in the business cycle.

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Two types of business cycle can be identified:
The classical business cycle considers actual levels

so that a fall in GDP describes negative growth.
Two consecutive quarters of negative growth in real
GDP is called a (classical) recession.
The growth cycle considers fluctuations in growth rates
of the economy around the trend growth rate.

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1.1
Three Models
1.2
To Reiterate . . .
1.3
Schools of Thought
1.4
1.5

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1.3 Schools of Thought
During the 1960s there were two main views:
The monetarists believed the economy is best left

to itself.
The Keynesians argued that government intervention
could improve economic performance.
Two schools have developed since then:
The New Classical school in the 1970s

The New Keynesian school in the 198090s.

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New Classical School
Three central assumptions of the New Classical

school are:
Economic agents optimise

Decisions are made rationally use all available
information (rational expectations)
Markets are assumed to clear.
These assumptions ensure there is no involuntary

unemployment.
They also lead to a further assumption that

markets
are
continuously
in equilibrium.
Copyright
2006
McGraw-Hill
Australia Pty
Ltd
135
New Keynesian School
Extends the earlier Keynesian view that

markets will not always clear even if agents
are maximising.
Reasons are varied and include:
There is incomplete information.

Institutions affect the workings of markets.
Costs of changing wages and prices lead to price
rigidities.
These reasons explain fluctuations in output

and employment.
Copyright
2006 McGraw-Hill Australia Pty
Ltd
136
Economic Controversies
The two main competing views of modern

macroeconomics are highlighted in real-world
political and media discussions.
These differences are frequently exaggerated

in debate.
There are significant areas of agreement.
Debate and research continually evolve new

areas of consensus e.g. there is increasing
agreement on information problems with
wage-price
Copyright
setting.
2006 McGraw-Hill Australia Pty
Ltd
137
1.1
Three Models
1.2
To Reiterate . . .
1.3
Schools of Thought
1.4
1.5

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1.4 Text Outline and Preview
The key overall concepts of this book are growth,

aggregate supply and demand.
Chapters 3 and 4 consider long-run economic growth.

Chapters 56 explore the AS curve and wage/price
impacts.
Chapters 79 explore models of income and expenditure.
Chapters 1011 analyse international adjustment in
an integrating global economy.
Chapters 1216 examine individual sectors that make
up an economy.

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1.4 Text Outline and Preview
The key overall concepts of this book are growth,

aggregate supply and demand.
Chapters 1719 consider big issues in economics

and related policy applications in an uncertain world.
Chapter 20 introduces briefly some frontiers of
macroeconomic research.

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1.1
Three Models
1.2
To Reiterate . . .
1.3
Schools of Thought
1.4
1.5

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1.5 Prerequisites and Recipes
The text requires no mathematical prerequisite beyond

high school algebra.
There are a number of helpful websites, including:
www.mcgraw-hill.com.au/mhhe/econ/ dornbusch
(for chapter summaries and problems)
www.rba.gov.au
www.treasury.gov.au
www.abs.gov.au
www.asx.com.au
www.ecosoc.org.au/
www.economist.com
www.economist.about.com
rfe.wustl.edu

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Chapter 1

Copyright 2006 McGraw-Hill Australia Pty

Introduce three linked macroeconomic models that

Explain the long-run growth in productive capacity

Use the concepts of aggregate supply and aggregate

Introduce the concept of the business cycle to explain

Outline the two main schools of thought that have

Outline and Preview of the Text

1.1 Three Models

Macroeconomics is organised around

Each model is concerned with different

The long run

Lets consider each in more detail.

Copyright 2006 McGraw-Hill Australia Pty

Very Long Run Economic Growth

The long run is a period of decades or more over

The time period is usually measured in multiples

Growth theory describes the long-run behaviour

Short-run fluctuations in important variables like

Very Long Run Economic Growth

The long-run level of output is determined solely

Output is determined by the productive capacity

All factors of production (land, labour, capital and

The economy is operating at its potential output.

Very Long Run Economic Growth

Economic growth is a function of increases in

Major causes of economic growth are:

Development of new technology

Copyright 2006 McGraw-Hill Australia Pty

Very Long Run Economic Growth

Economic growth determines the changes in

A country growing at an average of 4% per year

This higher 4% average annual growth rate will

Copyright 2006 McGraw-Hill Australia Pty

Fixed Productive Capacity

In the long run the productive capacity of the

The productive capacity of the economy

Copyright 2006 McGraw-Hill Australia Pty

Fixed Productive Capacity

This is represented by a vertical aggregate supply

Copyright 2006 McGraw-Hill

Fixed Productive Capacity

This level of output is associated with a certain

What determines the change in the overall price

The aggregate supply (AS)aggregate demand

Copyright 2006 McGraw-Hill Australia Pty

Fixed Productive Capacity

The AD schedule represents, for each price level,

The intersection of the AS and AD schedules

Copyright 2006 McGraw-Hill Australia Pty

Fixed Productive Capacity

AD and AS in the long run.

Copyright 2006 McGraw-Hill

The Short Run

The short run is a period of time short enough

In the short run actual output can deviate from

Short-run fluctuations in real output are important.

AD is the major determinant of these variations.

In the short run the price level is pegged, making

The Short Run

AD and AS in the short run.

Copyright 2006 McGraw-Hill

The Medium Run