Chapter 6: An Introduction to Macroeconomics

ECO 112 Principles of Macroeconomics

Today’s Roadmap

Key Concepts

• Why macroeconomists boil the whole economy down to a handful of summary statistics
• Economic growth: total output growth versus growth per person
• Saving, investment, and the financial system that connects them
• What “investment” means to an economist versus what it means in everyday speech
• Sticky prices versus flexible prices in the short run
• Why price stickiness is the reason we study the short run and the long run separately

Zooming Out: From Markets to the Whole Economy

From One Market to the Whole Economy

So far in this course, most of our tools have zoomed in on one market at a time: one budget line, one PPF, one supply and demand diagram.

Macroeconomics studies the economy as a whole rather than one market at a time, output, employment, and prices across every industry simultaneously.

There is no way to track every one of the millions of individual markets in the economy at once. Macroeconomists instead rely on a small number of summary statistics that condense an enormous amount of information into a few numbers.

The Big Three Summary Statistics

• Real GDP: the total value of everything the economy produces, adjusted for price changes. Tells us how big the economy is and whether it is growing or shrinking.
  • Real means adjusted for price changes, so that we can compare output across time without confusing growth with inflation.
• Unemployment rate: the share of people who want a job but do not have one. Tells us how fully the economy is using its labor resources.
• Inflation rate: how fast the average price level is rising. Tells us whether money is holding its value.

These three numbers cannot tell you everything, but together they capture the health and trajectory of the entire economy well enough to guide most everyday decisions and policy debates. The next three chapters take each one in turn.

Why Not Just Track Every Market?

• Every individual market (used cars, haircuts, lumber) has its own supply and demand story.
• No one, not even a government agency, can track all of them individually in real time.
• Macroeconomists trade precision about any one market for a clear read on the whole economy.

Economic Growth

Total Output Growth vs. Growth Per Person

Economic growth is an increase in a nation’s total output over time, usually measured as the percentage change in real GDP.

But total output growing is not the same as people getting better off. Two ways to measure growth:

• Total output growth: how fast the whole economic pie grows.
• Growth per capita: how fast the pie grows once you divide it among however many people are sharing it.

If total output grows 3 percent but the population also grows 3 percent, the average person is no better off at all. Per-capita growth, not total growth, is what tracks rising living standards.

Visualizing Total vs. Per-Capita Growth

Simple Illustration

The pie doubles in size in both futures, total output growth is identical. But in Future A the population stays the same, so everyone’s slice gets bigger. In Future B, population also doubles, so each slice ends up exactly the size it started at. Same total growth, very different outcome for the average person.

Quick Refresher: Calculating a Growth Rate

A growth rate (or percentage change) always follows the same formula:

\[ \text{Growth rate} = \frac{\text{New value} - \text{Old value}}{\text{Old value}} \]

Example: Your hourly wage rises from $10 to $12.

\[ \frac{12 - 10}{10} = \frac{2}{10} = 0.20 = 20\% \]

Same formula works for GDP, population, prices, anything you want to compare across two points in time. New minus old, divided by old.

Example: Total Growth vs. Per-Capita Growth

A country’s real GDP is $200 billion this year and its population is 10 million people.

Next year, real GDP rises to $212 billion, and population rises to 10.4 million.

1. What is the growth rate of total real GDP?
2. What is real GDP per capita in each year?
3. What is the growth rate of real GDP per capita?

Solution: Total vs. Per-Capita Growth

	This year	Next year
Real GDP	$200 billion	$212 billion
Population	10 million	10.4 million
GDP per capita	$20,000	$20,384.6

• Total GDP growth: \((212 - 200) / 200 = 6.0\) percent
• GDP per capita growth: \((20{,}384.6 - 20{,}000) / 20{,}000 \approx 1.9\) percent

Population grew 4 percent, which ate up most of the 6 percent total growth. The typical person is only about 1.9 percent better off, not 6 percent.

Example: Two Countries Compared

• Country A:
  • Real GDP grows from $500 billion to $525 billion
  • Population grows from 50 million to 51.5 million.
• Country B:
  • Real GDP grows from $90 billion to $93.6 billion
  • Population grows from 6 million to 6.06 million.

1. Find the total real GDP growth rate for each country.
2. Find the real GDP per capita in both years for each country, and the per-capita growth rate.
3. Which country’s typical resident is better off after one year, even if it is not the country with the higher total growth rate?

Two Countries Compared: Review

	Country A	Country B
Total GDP growth	\((525-500)/500 = 5.0\%\)	\((93.6-90)/90 = 4.0\%\)
GDP per capita, year 1	\(500{,}000{,}000{,}000/50{,}000{,}000 = \$10{,}000\)	\(90{,}000{,}000{,}000/6{,}000{,}000 = \$15{,}000\)
GDP per capita, year 2	\(525{,}000{,}000{,}000/51{,}500{,}000 \approx \$10{,}194\)	\(93{,}600{,}000{,}000/6{,}060{,}000 \approx \$15{,}446\)
Per-capita growth	\(\approx 1.9\%\)	\(\approx 3.0\%\)

• Country A had the higher total growth rate
  • 5.0 percent versus 4.0 percent
• Country B’s population grew much more slowly
  • Per-capita growth rate, 3.0 percent, was actually higher.
• The typical resident of Country B got better off faster, even though Country B’s economy as a whole grew more slowly.

Why Growth Rates Matter

Small differences in growth rates compound into enormous differences over time, and a nation’s sustained growth rate also shapes its living standards and its influence on the world stage.

• A country growing at 1 percent per year takes about 70 years to double its output per person.
• A country growing at 3.5 percent per year doubles in about 20 years.

Sustained modern economic growth, where output per person rises generation after generation, is a relatively recent phenomenon. For most of human history before the Industrial Revolution, output per person barely changed across centuries. The sustained growth we now consider normal only began roughly two centuries ago.

Discussion: Why Doesn’t Growth Always Feel Good?

GDP per capita is an average, total output divided evenly across the whole population. It says nothing about how that output is actually distributed.

• If most of the gains from growth go to a relatively small share of the population, GDP per capita can rise while the typical household’s income grows much more slowly, or barely at all.
• Economists distinguish the mean (GDP per capita, an average) from the median (the middle household, right in the middle of the income distribution). In the United States, real median household income has historically grown more slowly than real GDP per capita.

Real Data: Real GDP

Series GDPC1

1. Real GDP has grown almost every year on this chart. What would it mean for growth to be negative for two consecutive quarters?

Answer: two consecutive quarters of shrinking real GDP is one common informal definition of a recession, output is actually falling rather than merely growing more slowly.

2. This chart shows total real GDP, not GDP per capita. Why might that distinction matter when comparing growth across decades?

Answer: the population has grown steadily over this period, so some of the rise in total real GDP simply reflects more people producing, not necessarily a rising standard of living per person.

3. Look at any sharp, brief dip on the chart. What do you think was happening in the economy at that point?

Answer: a sharp brief dip typically lines up with a recession, such as the 2008 to 2009 financial crisis or the 2020 pandemic shock, when output fell quickly before recovering.

Saving, Investment, and the Financial System

The Tradeoff: Consumption Today vs. Tomorrow

Every dollar of income faces the same basic choice: spend it now, or set it aside.

• Saving: income not spent on current consumption.
• Saving is what makes future consumption possible. Resources not used to produce consumer goods today can instead be used to produce capital goods, machines, factories, tools, that make the economy more productive in the future.

A society that saves more today gives up some consumption now in exchange for a larger economy, and more consumption, later. That is the growth tradeoff in a single sentence.

How Saving Becomes Investment

Saving on its own does nothing for growth, it has to actually get used to build new capital. Banks and other financial institutions are the bridge between the two.

• Households and firms with extra income deposit savings in banks, buy bonds, or buy stock.
• Banks and financial markets channel those funds to firms that want to borrow money to build a new factory, buy new equipment, or expand a business.
• The financial system’s job is matching savers, who have funds but no project, with borrowers, who have a project but need funds.

Example: Saving Funds Investment

A small town has 500 households. Each household saves an average of $4,000 per year, depositing it at the local bank.

A local firm wants to borrow money to build a new $1.5 million factory.

1. How much total saving flows into the bank each year from these households?
2. Can this year’s household saving alone fund the new factory? If not, how many years of saving would it take?

Solution: Saving Funds Investment

• Total saving per year: \(500 \times \$4{,}000 = \$2{,}000{,}000\)

• One year of saving, $2 million, already covers the $1.5 million factory.
• Answer: yes, this year’s saving alone is enough. Banks can lend out the pooled deposits well before a full year passes, once enough has accumulated.

What “Investment” Really Means

Two Very Different Meanings of “Investment”

Everyday Meaning

Buying a financial asset, stocks, bonds, cryptocurrency, in hopes it rises in value.

• Buying shares of a company on the stock market
• Buying a government bond
• Buying an existing house as a rental property

Economic Meaning

Investment, in economics, means spending on new capital goods, things that expand the economy’s ability to produce.

• A firm building a new factory
• A firm buying new machinery or software
• Construction of new commercial buildings

Buying an existing share of stock does not, by itself, create any new capital. It just transfers ownership of an existing asset from one person to another. Economic investment only happens when new capital is actually built.

Human Capital

Investing in Yourself

Paying for college, a trade certification, or job training is often called an “investment in yourself,” and that framing makes sense: you give up money and time now, expecting a future payoff:

• Higher wages
• New skills
• Better judgment and a deeper understanding of how the world works (especially for a humanities or social science degree)

Economists have a name for this too, human capital, the skills, knowledge, and abilities a person builds up over time. Building human capital genuinely raises a person’s future productivity and earning potential, much like a firm’s investment in a machine raises the firm’s future output.

Here is the catch: tuition and training spending is not counted in GDP’s Investment (I) component. GDP accounting only counts spending on new physical capital, and residential construction, as Investment. Money you spend on your own education counts as Consumption (C) instead, even though economically you are doing something very similar to what a firm does when it invests in a new factory.

What Drives Investment Decisions?

Firms invest in new capital when they expect it to pay off. That word, expect, is doing a lot of work, investment is a bet on the future, not a reaction to the present.

• Expected future demand for the firm’s product
• Expected future profitability of the project
• The cost of borrowing, since most capital projects are financed with borrowed funds
• Business confidence: how certain firms feel about the economic outlook

Because investment depends on expectations rather than current conditions, it is one of the most volatile parts of the economy. A shift in how firms feel about the future can change investment spending sharply even if nothing else in the economy has changed yet.

Where Does “Business Confidence” Actually Come From?

“Business confidence” is not a mood a manager wakes up with, it is built from real information a firm gathers before committing to a project. A few concrete inputs:

• Their own recent sales and order trends, is demand for the firm’s own product rising or falling?
• Industry surveys, such as the ISM Manufacturing Purchasing Managers’ Index (PMI), a monthly survey asking purchasing managers whether business conditions are improving or worsening.
• The interest-rate outlook, since borrowing is more attractive when rates are low or expected to fall.
• What competitors and suppliers are doing, expanding, cutting back, raising prices.

None of these guarantee a correct forecast, firms get it wrong in both directions all the time. That uncertainty is exactly why investment spending swings so much more than consumption spending over the business cycle, a topic we will return to later in the course.

Real Data: Personal Saving Rate

Series PSAVERT

1. Notice any sharp spike on this chart. What might cause households to suddenly save a much larger share of their income?

Answer: a sudden spike often reflects a shock, such as the 2020 pandemic, where stimulus payments arrived while normal spending options like travel and dining out were unavailable, pushing more income into saving.

2. If this rate falls for a sustained period, what does that suggest is happening to the funds available for banks to lend to firms for investment?

Answer: a falling saving rate means less of current income is being set aside, which, all else equal, shrinks the pool of loanable funds available for firms to borrow and invest.

3. Is a very high saving rate always good for the economy in the short run? Think about what would happen to businesses if consumer spending dropped sharply.

Answer: not necessarily. If households suddenly save much more, current spending falls, and businesses selling consumer goods can see sales and revenue drop sharply in the short run, even though more saving can support more investment later.

Sticky Prices and the Short Run

Not All Prices Adjust at the Same Speed

• Flexible prices: prices that adjust quickly to changing supply and demand conditions.
  • Stock prices
  • Gasoline prices at the pump
  • Prices at a farmer’s market
• Sticky prices: prices that adjust slowly, even when supply and demand conditions have already changed.
  • Wages, often set by a contract lasting a year or longer
  • Prices printed in a catalog or menu that is expensive to reprint
  • Drug prices set under a long-term supply contract between businesses and insurance companies

Why don’t all prices just adjust instantly?

Long-term contracts, printing and menu costs, and a general reluctance to cut wages or prices (workers and customers dislike sudden cuts) all slow price adjustment down.

Why Stickiness Matters: Falling Demand

• Demand for a good falls (both panels shift the same way).
• Left, flexible price: the price falls to a new equilibrium, quantity sold barely changes.
• Right, sticky price: the price cannot fall quickly. Instead, firms cut back production and jobs to match the lower demand at the old price.

Why Economists Split Short Run from Long Run

Because sticky prices behave so differently from flexible prices, economists deliberately use two different frameworks rather than one model for every situation.

• Short run: some prices, especially wages, are sticky. Changes in demand show up mainly as changes in output and employment, not prices.
• Long run: given enough time, contracts expire, wages and prices adjust fully. Changes in demand show up mainly as changes in prices, not output.

This distinction is the bridge to the rest of the course. It is why a recession can mean rising unemployment (Chapter 9) rather than just falling prices, and why the growth story (Chapter 8) is fundamentally a long-run, flexible-price story even though the day-to-day economy we experience is a short-run, sticky-price one.

Example: Sticky or Flexible?

For each situation below, decide whether the price described is more likely sticky or flexible, and be ready to explain why:

1. The price of a share of Apple stock, five minutes after a surprise earnings announcement.
2. A factory worker’s hourly wage, one month after the company’s sales unexpectedly fall.
3. The price of gasoline at a local station, the day after a hurricane disrupts oil refining.
4. The price a magazine charges for a yearly subscription, printed on the cover and locked in for the year.

1. Flexible. Stock prices trade continuously and react to new information almost instantly.

2. Sticky. Wages are typically set for a year or more by an employment agreement, they do not adjust the same month sales fall.

3. Flexible. Gasoline prices at the pump adjust quickly, often within days, when a supply shock hits.

4. Sticky. A printed annual subscription price is locked in by design, changing it means a whole new print run and a broken promise to current subscribers.

Looking Ahead

Where This Chapter Leads

This chapter is a bridge, it does not give you the full picture yet, it provides a guide to understanding why the toolkit is built the way it is.

• Chapter 7 builds the first summary statistic properly: how real GDP is actually measured.
• Chapter 8 returns to economic growth in depth: what drives it, and why some nations grow rich while others do not.
• Chapter 9 builds the other two summary statistics, unemployment and inflation, and connects sticky prices directly to why recessions cost people their jobs.

Keep the sticky-price idea in mind going forward, it explains why the short run and the long run need separate models.