Overview of Macroeconomics

A. Key Concepts of Macroeconomics

1. Macroeconomics is the study of the behavior of the entire economy: It analyzes long-run growth as well as the cyclical movements in total output, unemployment and inflation, and international trade and finance. This contrasts with microeconomics, which studies the behavior of individual markets, prices, and outputs.


2. The United States proclaimed its macroeconomic goals in the Employment Act of 1946, which declared that federal policy was "to promote maximum employment, production, and purchasing power." Since then, the nation's priorities among these three goals have shifted. But all market economies still face three central macroeconomic questions: (a) Why do output and employment sometimes fall, and how can unemployment be reduced? (b) What are the sources of price inflation, and how can it be kept under control? (c) How can a nation increase its rate of economic growth?


3. In addition to these perplexing questions is the hard fact that there are inevitable conflicts or tradeoffs among these goals: Rapid growth in future living standards may mean reducing consumption today, and curbing inflation may involve a temporary period of high unemployment.


4. Economists evaluate the success of an economy's overall performance by how well it attains these objectives: (a) high levels and rapid growth of output (measured by real gross domestic product) and consumption; (b) a low unemployment rate and high employment, with an ample supply of good jobs; (c) low and stable inflation.


5. Before the science of macroeconomics was developed, countries tended to drift around in the shifting macroeconomic currents without a rudder. Today, there are numerous instruments with which governments can steer the economy: (a) Fiscal policy (government spending and taxation) helps determine the allocation of resources between private and collective goods, affects people's incomes and consumption, and provides incentives for investment and other economic decisions. (b) Monetary policy—particularly the setting of short-term interest rates by the central bank—affects all interest rates, asset prices, credit conditions, and exchange rates. The most heavily affected sectors are housing, business investment, consumer durables, and net exports.


6. The nation is but a small part of an increasingly integrated global economy in which countries are linked together through trade of goods and services and through financial flows. A smoothly running international economic system contributes to rapid economic growth, but the international economy can throw sand in the engine of growth when trade flows are interrupted or the international financial mechanism breaks down. Dealing with international trade and finance is high on the agenda of all countries.

B. Aggregate Supply and Demand

7. The central concepts for understanding the determination of national output and the price level are aggregate supply (AS) and aggregate demand (AD). Aggregate demand consists of the total spending in an economy by households, businesses, governments, and foreigners. It represents the total output that would be willingly bought at each price level, given the monetary and fiscal policies and other factors affecting demand. Aggregate supply describes how much output businesses would willingly produce and sell given prices, costs, and market conditions.


8. AS and AD curves have the same shapes as the familiar supply and demand curves analyzed in microeconomics. But beware of potential confusions of microeconomic and aggregate supply and demand.


9. The overall macroeconomic equilibrium, determining both aggregate price and output, comes where the AS and AD curves intersect. At the equilibrium price level, purchasers willingly buy what businesses willingly sell. Equilibrium output can depart from full employment or potential output.


10. Recent American history shows an irregular cycle of aggregate demand and supply shocks and policy reactions. In the mid-1960s, war-bloated deficits plus easy money led to a rapid increase in aggregate demand. The result was a sharp upturn in prices and inflation. At the end of the 1970s, economic policymakers reacted to the rising inflation by tightening monetary policy and raising interest rates. The result lowered spending on interest-sensitive demands such as housing, investment, and net exports. Since the mid-1980s, the U.S. economy has experienced a period of low inflation and infrequent and, until recently, mild recessions.


11. Over the long run, the growth of potential output increased aggregate supply enormously and led to steady growth in output and living standards.