. 27
( 126 .)


Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 5 85
An Introduction to Macroeconomics

green peppers? The answer is: They do not care. In the aggregate measures of macro-
economics, output is output, no matter what form it takes.

The Foundations of Aggregation
Amalgamating many markets into one means ignoring distinctions among different
products. Can we really believe that no one cares whether the national output of Agraria
consists of $800,000 worth of pickles and $200,000 worth of ravioli rather than $500,000
each of lettuce and tomatoes? Surely this is too much to swallow.
Macroeconomists certainly do not believe that no one cares; instead, they rest the case
for aggregation on two foundations:
1. Although the composition of demand and supply in the various markets may be
terribly important for some purposes (such as how income is distributed and
the diets people enjoy), it may be of little consequence for the economy-wide is-
sues of growth, inflation, and unemployment”the issues that concern macro-
2. During economic fluctuations, markets tend to move up or down together. When
demand in the economy rises, there is more demand for potatoes and tomatoes,
more demand for artichokes and pickles, more demand for ravioli and hot dogs.
Although there are exceptions to these two principles, both are serviceable enough as
approximations. In fact, if they were not, there would be no discipline called macroeco-
nomics, and a full-year course in economics could be reduced to a half-year. Lest this
cause you a twinge of regret, bear in mind that many people believe that unemployment
and inflation would be far more difficult to control without macroeconomics”which
would be a lot worse.

The Line of Demarcation Revisited
These two principles”that the composition of demand and supply may not matter for
some purposes, and that markets normally move together”enable us to draw a different
kind of dividing line between microeconomics and macroeconomics.
In macroeconomics, we typically assume that most details of resource allocation and
income distribution are relatively unimportant to the study of the overall rates of infla-
tion and unemployment. In microeconomics, we generally ignore inflation, unemploy-
ment, and growth, focusing instead on how individual markets allocate resources and
distribute income.
To use a well-worn metaphor, a macroeconomist analyzes the size of the proverbial
economic “pie,” paying scant attention to what is inside it or to how it gets divided among
the dinner guests. A microeconomist, by contrast, assumes that the pie is of the right size
and shape, and frets over its ingredients and who gets to eat it. If you have ever baked or
eaten a pie, you will realize that either approach alone is a trifle myopic.
Economics is divided into macroeconomics and microeconomics largely for the sake of
pedagogical clarity: We can™t teach you everything at once. But in reality, the crucial inter-
connection between macroeconomics and microeconomics is with us all the time. There
is, after all, only one economy.

Whether you are taking a course that concentrates on macroeconomics or one that focuses
on microeconomics, the discussion of supply and demand in Chapter 4 served as an in-
valuable introduction. Supply and demand analysis is just as fundamental to macroeco-
nomics as it is to microeconomics.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 2
86 The Macroeconomy: Aggregate Supply and Demand

A Quick Review
Figure 1 shows two diagrams that should look familiar from Chapter 4. In Figure 1(a), we
find a downward-sloping demand curve, labeled DD, and an upward-sloping supply
curve, labeled SS. Because the figure is a multipurpose diagram, the “Price” and “Quan-
tity” axes do not specify any particular commodity. To start on familiar terrain, first imag-
ine that this graph depicts the market for milk, so the vertical axis measures the price of
milk and the horizontal axis measures the quantity of milk demanded and supplied. As
we know, if nothing interferes with the operation of a free market, equilibrium will be at
point E with a price P0 and a quantity of output Q0.
Next, suppose something happens to shift the demand curve outward. For example,
we learned in Chapter 4 that an increase in consumer incomes might do that. Figure 1(b)
shows this shift as a rightward movement of the demand curve from D0D0 to D1D1. Equi-
librium shifts from point E to point A, so both price and output rise.

Moving to Macroeconomic Aggregates
Now let™s switch from microeconomics to macroeconomics. To do so, we reinterpret
Figure 1 as representing the market for an abstract object called “domestic product””one
The aggregate demand
of those economic aggregates that we described earlier. No one has ever seen, touched, or
curve shows the quantity
eaten a unit of domestic product, but these are the kinds of abstractions we use in macro-
of domestic product that is
economic analysis.
demanded at each possible
Consistent with this reinterpretation, think of the price measured on the vertical axis as
value of the price level.
being another abstraction”the overall price index, or “cost of living.”1 Then the curve DD
The aggregate supply
in Figure 1(a) is called an aggregate demand curve, and the curve SS is called an
curve shows the quantity
aggregate supply curve. We will develop an economic theory to derive these curves
of domestic product that is
explicitly in Chapters 7 through 10. As we will see there, the curves have rather different
supplied at each possible
origins from the microeconomic counterparts we encountered in Chapter 4.
value of the price level.

F I GU R E 1
Two Interpretations of
a Shift in the Demand








S D D0

Quantity Quantity
(a) (b)

The appendix to Chapter 6 explains how such price indexes are calculated.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 5 87
An Introduction to Macroeconomics

With this macroeconomic reinterpretation, Figure 1(b) depicts the problem of inflation. Inflation refers to a
sustained increase in the
We see from the figure that the outward shift of the aggregate demand curve, whatever its
general price level.
cause, pushes the price level up. If aggregate demand keeps shifting out month after
month, the economy will suffer from inflation”meaning a sustained increase in the
general price level.

Recession and Unemployment
The second principal issue of macroeconomics, recession and unemployment, also can be
illustrated on a supply-demand diagram, this time by shifting the demand curve in the
opposite direction. Figure 2 repeats the supply and demand curves of Figure 1(a) and in
addition depicts a leftward shift of the aggregate demand curve from D0D0 to D2D2. Equi-
librium now moves from point E to point B so that domestic product (total output)
declines. This is what we normally mean by a recession”a period of time during which A recession is a period of
time during which the total
production falls and people lose jobs.
output of the economy
Economic Growth
Figure 3 illustrates macroeconomists™ third area of concern: the process of economic growth.
Here the original aggregate demand and supply curves are, once again, D0D0 and S0S0,
which intersect at point E. But now we consider the possibility that both curves shift to the
right over time, moving to D1D1 and S1S1, respectively. The new intersection point is C, and
the brick-colored arrow running from point E to point C shows the economy™s growth path.
Over this period of time, domestic product grows from Q0 to Q1.

F I GU R E 2 F I GU R E 3
An Economy Slipping into a Recession Economic Growth

S D1

Price Level

Price Level



D0 D1
Q2 Q0
Q0 Q1
Domestic Product
Domestic Product

Up to now, we have been somewhat cavalier in using the phrase “domestic product.”
Let™s now get more specific. Of the various ways to measure an economy™s total output,

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 2
88 The Macroeconomy: Aggregate Supply and Demand

the most popular choice by far is the gross domestic product, or GDP for short”a term
Gross domestic product
(GDP) is the sum of the you have probably encountered in the news media. GDP is the most comprehensive meas-
money values of all final ure of the output of all the factories, offices, and shops in the United States. Specifically, it
goods and services pro-
is the sum of the money values of all final goods and services produced in the domestic econ-
duced in the domestic
omy within the year.
economy and sold on or-
Several features of this definition need to be underscored.2 First, you will notice that
ganized markets during a
specified period of time, We add up the money values of things.
usually a year.


. 27
( 126 .)