There are FOUR major goals or objectives of macroeconomics:

1. Large and rising total output and consumption

2. High employment with low involuntary unemployment

3. Stable price level

4. Foreign trade balance

There are FOUR groups of POLICY TOOLS, used to reach these goals:

1. Fiscal Policy: Taxing and spending policies of governments

2. Monetary Policy: Control of the supply of money and interest rates

3. Incomes Policies: Manipulation of market mechanism to control incomes,

i.e., wage and price controls, price supports, etc.

4. Foreign Economic Policies: Import quotas, currency exchange-rate controls, etc.

We have Policy Variables (parameters), External (Exogenous) variables, and Induced (Endogenous) variables.

All of the variables influence the level of economic activity. The level of economic activity is usually measured by total output. We can analyze total output and the price level with a special supply and demand diagram,


Aggregate Demand: Amount of total output economy is willing and able to buy at each price level, cet. par.

Aggregate Supply: Amount of total output economy is willing and able to produce and sell at each price level, cet. par.

AD slopes down because, as the price level falls, members of the economy can purchase more goods with the same amount of money.

AS slopes up because as the price level rises, with fixed raw material contracts, firms can make higher revenue with stable costs, i.e., higher profits.

The AD curve will shift when the aggregate expenditure  increases or decreases.

1. Fiscal Policy is used. [Changes in Tx or G cause changes in autonomous spending.]

2. Consumer or business confidence changes.

3. Monetary policy changes.

4. The demand for holding money balances changes.

5. Inflationary expectations change. [Individuals will spend differently if they believe inflation will change.]

Why does the AS curve slope upward?

1. If more output is created as the price level rises, firms must have an incentive to hire more workers and resources. This will happen if the real wage falls, that is, if the money wage rises slower than the price level. In this case, workers are cheaper, in real terms, and more will be hired.

2. But, if workers can immediately renegotiate their labor contracts when the price level rises, the real wage will not fall as inflation goes on, but will remain constant. If the real wage is constant, no new employment will occur, and the AS curve would be vertical.

3. Economists usually assume that workers are not able to renegotiate their contracts quickly. So, when the price level starts to rise, the real wage will fall for a time, and in the short run, employment and output will rise.

The Short Run Adjustment Story

1. AD shifts to the right, caused by an increase in any form of autonomous spending.

This increase in AD causes a disequilibrium (see diagram below), and prices will begin to rise to eliminate the excess demand.


2. As P rises, w/P starts to fall; this drop in the real wage makes expansion profitable, and so employment rises, and so does GNP.

Workers do not force up w, the money wage by the same percentage as the increase in P because:

a. They may not realize what is happening right away. They may not recognize how prices are rising; seeing higher prices in the supermarket may represent a microeconomic relative price adjustment, not an inflation. So, workers don't know that an inflation has until prices rise across the board for a while. They don't ask for higher wages to compensate them for inflation until inflation has become bad enough for them to feel it in their everyday purchases.

b. Once workers realize the price level is rising, that is, that an inflation is under way, they may not be able to renegotiate their contracts for a significant period of time.

c. Since job search is often difficult, time consuming and costly, workers do not just quit and look for a new job as soon as they realize their real purchasing power has fallen.

The short run adjustment in the above diagram is the movement from point E to point F. At F, both GNP and the Price Level have risen. The extent of the increase in these variables is determined by the elasticity of AS, once AD has increased.

Long Run Adjustment:

1. Eventually, workers realize what has happened to their real purchasing power, and take steps to get it back up to its former level.` At this point, after point F is reached, workers have the time to act to negotiate for higher wages.

2. When wages have been raised enough to balance the increase in the price level, that is, when the money wage has risen by the same percentage as the price level, then the real wage is restored to its original level. At this point, point G in the diagram, employment and output have returned to their original levels.

Thus, the long run adjustment involves an upward shift in the short run AS curve, as the real wage returns to its original level.

In the long run, the aggregate supply curve is vertical at the full employment level of GNP {the natural rate of unemployment}.

The short run and long run adjustments, taken together, synthesize the Keynesian (short run) and the Classical (long run) points of view.

Shifts in short run AS come from:

1. Changes in the size and composition of the labor force.
2. Changes in attitudes toward work and leisure.
3. Changes in the inflationary expectations of workers.
4. Changes in the market power of unions.
5. Changes is social security, unemployment compensation, welfare, etc.
6. Changes in government regulation of business.
7. Changes in resource costs and availability. {e.g.,oil prices}
8. Changes in tax policy toward investment
9. Changes in the technology of production and distribution.
10.Changes in industrial structure; mergers and acquisitions.

Supply Shocks   [See Graph 1 below.]

A shift backward in the short run AS curve is called a supply shock. The most famous supply shock of the past 30 years was the OPEC oil embargo of the early 1970's.

The aggregate supply curve AS shifts up to AS' due to a sharp cutback in the availability of oil.
The new short run solution will be point F.

With no further action, the system will adjust until the real wage is restored to its original level. This would move the economy to point G in the diagram, the new long run equilibrium.

The government has three basic short run policy option, represented by the points K, F and M.

At K, AD is increased to accommodate the shock, and keep employment constant. But, this brings higher prices than we would get at F.

At F, AD is not manipulated. This is a neutral policy, in that employment and the price level are permitted to adjust along the original AD curve.

At M, AD is reduced to fight inflation at the expense of a reduction in employment and output. If this policy is done very quickly, M can become the new long run equilibrium.

Graph 1

With a drop in oil prices, AS shifts downward; this is a beneficial supply shock. Analysis of this type of shock is analogous to the one above.


You are considered unemployed if you:

a. tried to find a job in the past 4 weeks
b. were laid off and are awaiting recall
c. are waiting to report to a job next month

The labor force is the sum of the employed and the unemployed.

Individuals who do not have jobs and are not defined as unemployed are not considered to be in the labor force; if you are not employed and are not looking for work, you are not in the labor force.

Voluntary Unemployment: If someone is not willing and able to work for the going wage, he or she is voluntarily unemployed.

Involuntary unemployment: If someone is willing and able to work at the going wage, but can find no job opening, he or she is involuntarily unemployed.

[Data from Samuelson and Nordhaus, chapter 11, p. 213]
Unemployment Recovery Recession
rate of: in           1973          1982

16-19 years old    14.5          23.2

over 20 years old   3.8          8.6

White                    4.3           8.6

Black                    8.9          17.6

Male                     3.3            8.8

Female                  4.8            8.3

Labor Force          4.9            9.7

In a recession, more people are out of work longer than in a recovery. A larger percentage of the unemployed are out of work for 15-26 weeks, or for over 26 weeks, than in a recovery.

In a recovery, most unemployment is short term, less than 14 weeks. Nearly 1/2 of the unemployed in a recovery are out of work less that 4 weeks.

Percentage of labor force unemployed, by reason for unemployment:

                                       Recovery              Recession

                                        1973                        1982

Lost job                            1.9                           5.7

labor force                        1.5                           2.2

New entrant                      0.7                           1.1

Leave job                         0.7                            0.8

Three types of unemployment:

Frictional: Normal turnover as individuals move from seek better jobs.

Structural: Mismatch of skills and opportunities. Some jobs are open, and some individuals are unemployed, because the unemployed do not have the skills to match those required by job opportunities.

Cyclical: Lay offs caused by the business cycle.

Natural Rate of Unemployment: rate at which expectations about inflation and the price level are correct; the rate at which the price level is what people expect it to be. [Currently, the natural rate of unemployment is considered to be 5.5%.]

Policies that shift AE and AD will not change the natural rate of unemployment. Changes in the natural rate require a change in the structure of the economy.

To lower the natural rate, we can:

1. Improve job search services and improve the availability of information about job requirements and availability.

2. Provided better job training to improve the mobility of the labor force. This can be done by government or the private section.

3. Restructure transfer payments to raise the incentives to find employment quickly.

4. Provide employment at the public expense if it cannot be found in the private sector.

Changes in the natural rate of unemployment are changes in the position of the long run aggregate supply curve, which is considered to be vertical, i.e., the level of GNP at the natural rate of unemployment is not responsive to changes in the price level. It is determined by the structure and institutions of the economy.


Inflation is defined as a continuous increase in the price index. It is not higher prices, but a rising price level.

Anticipated inflation: When inflation is anticipated, individuals know what is coming, and how to deal with it. For example, banks may raise interest rates to compensate for the anticipated inflation, workers may ask for raises to maintain their real incomes, wealth holders will put their wealth into assets that will rise in value at least at the same rate as the increase in the price index, etc.

Unanticipated inflation: When inflation is unanticipated, individuals do not realize that they should protect their real purchasing power against a rising price level until the price level has already risen and their real purchasing power has already fallen. In this instance, there will be gainers and losers, in terms of purchasing power, from the inflation.

Losers: Individuals on fixed incomes, retirees, all creditors (who will have their loans paid back in dollars of reduced purchasing power.)

Gainers: Individuals whose incomes rise faster than inflation, debtors (who will pay their debts in dollars of reduced purchasing power).

Costs of Unanticipated Inflation: an overview.

In general, unanticipated inflation causes a misallocation of resources.

Firms, unions, banks, will push prices and wages up. Those who can do it best will cause a misallocation of resources.

1. Suppose manufacturing workers get fast wage increases, and public employees don't. Then, resources (labor) will be reallocated due to the relative market power of the different workers.

2. Lenders will lose with respect to borrowers, giving individuals an incentive to borrow. In relative terms, borrowing becomes cheaper than paying in cash.

3. Individuals have an incentive to spend now before the price level rises further. This will push prices up even faster, and may cause the inflation rate to accelerate.

4. Uncertainty increases. Consumers and investors are less certain about the future, as prices rise in an unanticipated fashion. They may change their pattern of spending, and be less willing to undertake projects that take a long time to payoff.

If inflation accelerates wildly, it may become a hyperinflation.

In this case, the rate of inflation is so high, money becomes virtually worthless, and can no longer serve as a medium of exchange.

GERMANY: After WWI, the German economy suffered a serious hyperinflation. Using a wholesale price index, base year 1913, we can see how prices rose in the early 1920's. [P = 100 in 1913]

DATE                     VALUE OF PRICE INDEX

Jan 1921                           1400 or 14 x 102

Jan 1922                           3700 or 37 x 102

July 1922                        10100 or 10.1 x 103

Jan 1923                        278500 or 2.785 x 105

July 1923                      7480000 or 7.48 x 106

Aug 1923                     94400000 or 9.44 x 107

Sept 1923                  2390000000 or 2.39 x 109

Oct 1923                709600000000 or 7.096 x 1011

15 Nov 1923       75000000000000 or 7.5 x 1014

On 15 November 1923 the currency was converted to new denominations.

After WWII, Greece and Hungary had serious hyperinflations.

In 1948, the Federal Republic of Germany also had a serious hyperinflation. Again, monetary conversion was used to stop the process.

Old Currency         New Currency

10 Reichsmarks = 1 Deutschmark

1/2 of old currency was converted.

1/2 was held in "blocked" bank accounts, and could not be withdrawn, so it could not be spent.

The money supply fell from 150 Billion RM to 12 Billion DM

Types of Inflation:

1. Demand Pull: Aggregate Demand continuously rises faster than Aggregate Supply, and an inflation results.

2. Cost Push: Costs of production rise without an increase in aggregate demand. This is the supply shock case we saw earlier.

No inflation can continue for long if the aggregate demand curve does not increase to give it room. To stop an inflation, we have two choices:

1. Lower Aggregate Demand (or stop it from growing).
2. Increase Aggregate Supply (or stop it from falling).

All fiscal and monetary policies are demand side policies. Supply side policies involve economic restructuring.