Lecture 1 · Slides L1 · Mankiw ch. 1 · about 25 min

The Science of Macroeconomics

What macroeconomics studies, the big questions it tries to answer, how economists use models and data, and the map of the economy we will use all term.

By the end you can

Say what separates macroeconomics from microeconomics
Name the six big questions and the three headline variables
Tell positive from normative statements and correlation from causation
Describe the four sectors and three markets of the circular flow

Macro versus micro

Microeconomics studies how individual households and firms make decisions and how they meet in particular markets. Macroeconomics studies the economy as a whole: total national income, aggregates such as total consumption and total investment, and the overall price level.

The key word is aggregate. Macroeconomics asks what happens when all households and all firms act together. When the macroeconomy does well, jobs are easy to find, incomes rise and profits are high. When it slows down, new jobs are hard to find, incomes stall and profits fall. That is why it matters to everyone, not only to economists.

The six big questions

The lecture frames the whole course around six questions:

What determines a nation’s long-run economic growth?
What causes economic activity to fluctuate?
What causes unemployment?
What causes prices to rise?
How does being part of a global economy affect a nation?
Can government policy improve economic performance?

Growth

Growth of output, and especially of output per worker, decides in the end whether a nation is rich or poor. Why did resource-poor Japan and South Korea turn from war-torn countries into industrial powers within a generation or two, while resource-rich Venezuela had erratic or even negative growth? Economists have no complete answer, but they have strong ideas, and Lecture 5 develops them.

Business cycles

Unemployment and inflation

The unemployment rate is the percentage of the labour force that is unemployed. Unemployment means the aggregate labour market is not in equilibrium. Inflation, the rise in the overall price level, is the third headline variable. You will measure all three in Lecture 2.

Two ways to write GDP

The lecture previews the two frameworks that organise the whole term. Keep them apart: they answer different questions.

Short run: demand sideShort runFormula sheet →

Y = AE = C + I + G + NX

$AE$: aggregate (planned) expenditure
$C$: consumption
$I$: investment
$G$: government purchases
$NX$: net exports

Use it when you explain fluctuations. In the short run, spending decides output (Lectures 6, 8 to 13).

Long run: supply sideLong runFormula sheet →

Y = A K^{a} L^{b} \quad\Longleftrightarrow\quad \ln Y = \ln A + a\ln K + b\ln L

$A$: technology (productivity)
$K$: capital
$L$: labour
$a, b$: output elasticities of K and L

Use it when you explain growth. In the long run, inputs and technology decide output (Lectures 3 to 5). Taking logs turns the product into a sum.

How economists think

Economics is a social science: it tries to apply scientific methods to human behaviour. It builds models, gathers real-world data, tests theories against the data and forecasts events from limited evidence. For that to count as science, economists’ statements must be verifiable or falsifiable.

Positive and normative

Models and the scientific method

“How do policymakers know what to do?” The lecture’s answer is one word: theory. Macroeconomists observe the world, then build a theoretical framework, expressed in equations or diagrams, that explains what they saw. It must be simple enough to work with but realistic enough to be useful. There is a bit of art in that balance.

The scientific method (empiricism) has two steps:

Develop models that explain part of the world. A model is a simplified description of reality.
Test them with data (empirical evidence). Hypotheses are the model’s predictions that can be tested.

Correlation is not causation

Two variables are correlated when they move together: in the same direction (positive) or opposite directions (negative). Causation means one directly affects the other. Correlation suggests causation may be present and deserves investigation; it does not prove it.

The map of the economy

To see the big picture, divide the participants into four groups:

Sector	Who	Part of
Households	consumers and workers	private sector
Firms	producers	private sector
Government	public sector	public sector
Rest of the world	foreign buyers, sellers, lenders	foreign sector

They meet in three markets:

Goods and services market: households and government buy from firms; firms buy from each other; the rest of the world buys (exports) and sells (imports).
Labour market: households supply labour; firms and government demand it; labour also crosses borders.
Money (asset, financial) market: households supply funds hoping to earn a return and also borrow; firms borrow to build new capacity; government borrows by issuing bonds. Financial institutions coordinate most of this lending.

The circular flow ties these together: spending on goods becomes firms’ revenue, which is paid out as wages, rent and profit, which becomes household income, which is spent again.

Summary and review

Macroeconomics studies aggregates: total income, total spending, the price level.
Six questions: growth, fluctuations, unemployment, inflation, the global economy, policy.
Short run: $Y = C + I + G + NX$ . Long run: $Y = AK^aL^b$ .
Positive = what is; normative = what ought to be. Models are tested with positive statements.
Scientific method: build models, test them with data. Correlation does not prove causation.
Four sectors (households, firms, government, rest of the world), three markets (goods, labour, money).