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Principles of Macroeconomics
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Notes for the Spring 2012 Instantiation of Economics 1
at U.C. Berkeley
Lecturer: J. Bradford DeLong

MW 11-2, + 2 hours section/week
Version 2.03: 70,283 words; 168 pages.
http://dl.dropbox.com/u/6731377/Principles%20of%20Macroeconomics%20DRAFT%20for%20Econ%201%20%2820120402--2.03.pdf


1. Overview of Macroeconomics..............................................10
What You Will Learn
..........................................................................................10
What Is Macroeconomics?
..................................................................................11
The Parts of Macroeconomics Shifting the Focus to the Economy as a Whole The Importance of Expectations in Macroeconomics The Four Parts of Macroeconomics ..............................14
Depression Economics
Inflation Economics
Government Budget Economics
Growth Economics
The Relative Importance of These Four Parts......18
Summary .............................................................................................................19
Test Your Knowledge ..........................................................................................20
2. Measuring the Macroeconomy..............................................21
What You Will Learn..........................................................................................21
The Flow of Production and Sales.....................................................................21
Production
Sales
How to Keep Track
Imports and Exports
NIPA Summary
Real and Nominal Magnitudes...........................................................................24
The Circular Flow of Economic Activity...........................................................25
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Say’s Law and the Circular Flow
The Components of GDP
Summary.............................................................................................................27
Test Your Knowledge..........................................................................................28
3. The Circular Flow and Depression Economics.....................29
What You Will Learn..........................................................................................29
The Circular Flow Principle...............................................................................29
Say’s Law and the Circular Flowisrupting the Circular Flow...........................31
The Coming of the Great Recession
Economists and the Possibility of a “General Glut”
Does Excess Supply Here Mean Excess Demand There?
Disrupting the Circular Flow
A Caveat: Not a Consensus Framework..............................................................36
Summary.............................................................................................................38
Test Your Knowledge..........................................................................................39
4. The Income-Expenditure Framework....................................40
What You Will Learn..........................................................................................40
Understanding Downturns.................................................................................40
Downward-Sticky Wages
Consequences of Downward-Sticky Wages
Suppose Wages Were Not Sticky?
Analyzing The Components of National Income and Product
.........................42
Components of Spending
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Consumption Spending
Calculating the Size of Downturns....................................................................44
Expenditure, Output, and Income
Where the Economy Settles: Equilibrium
How Well Does This Work?
Summary.............................................................................................................48
Test Your Knowledge
..........................................................................................48
5. Economic Downturns
............................................................49
What You Will Learn
..........................................................................................49
Recapitulation
.....................................................................................................50
Our Framework for Depression Economics
Macroeconomics and Financial Markets
............................................................51
Keynesians
Monetarists
Minskyites
Who Is Right?
Calculating Output Gaps
....................................................................................57
Savings-Investment Gaps
Money Demand-Money Supply Gaps
Panic and Flight to High-Quality Assets
Summary
.............................................................................................................62
Test Your Knowledge
..........................................................................................63
6. Dealing with the Great Recession
..........................................64
What You Will Learn
..........................................................................................64
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Recapitulation
.....................................................................................................64
Keynesians
Monetarists
But This Time Is Different
The Third Type of Downturn: Minskyite
..........................................................67
An Excess Demand for Safe Financial Assets
Panic and Flight to High-Quality Assets
The Minskyite Cure
............................................................................................68
A Shortage of Safe High-Quality Assets
The Process of Recognition
The Cure to the Downturn: “Lend Freely...”
Risks of Aggressive Policy Activism
The Minskyite Cure: “At a Penalty Rate...”
How Has This Advice Been Implemented?
........................................................73
How are we doing? How has the U.S. government, and other governments, done at carrying out the proper
policies for dealing with a Minskyite downturn?
What If the Government Had Let the Economy Alone?
The Failure to Lend at a Penalty Rate
Summary
.............................................................................................................74
Test Your Knowledge
..........................................................................................74
7. Origins of the Great Recession
..............................................75
What You Will Learn
..........................................................................................75
Origins of the Downturn
....................................................................................75
The Global Savings Glut
Mortgage Finance and Financial Engineering
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Securitization and the Concealment of Risk
The Housing Boom
The Housing Bubble
Government Overlending? No...
The Housing Crash
............................................................................................80
Some Bubbles Burst Harmlessly—or Nearly So
Credit, Finance, and Confidence
The Panic
............................................................................................................82
Behind a Minskyite Panic
A Relatively Small Fundamental Problem
Where Were the Regulators?
Who Is To Blame?
Test Your Knowledge
..........................................................................................86
8. Depression Economics in a Nutshell
......................................88
The Puzzle
..........................................................................................................88
The Diagnosis
.....................................................................................................90
The Cure
.............................................................................................................91
Strategic Interventions
Monetarist Downturns
Keynesian Downturns
Minskyite Downturns.
.........................................................................................93
The Problem
The Cure
The Problems with Bailout
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Where Did the Problem Come From?
Who Is Right?
.....................................................................................................96
Lecture 9
9. Inflation Economics.
...............................................................98
What You Will Learn
..........................................................................................98
The Consumer Price Level and the Inflation Rate
.............................................98
The Consumer Price Index
The Inflation Rate
Why the Salience of Inflation?
Inflation Is a Monetary Phenomenon
...............................................................100
The Money Stock
..............................................................................................101
How the Money Stock Affects Spending
How the Money Stock Is Determined: High-Powered Money
How the Money Stock Is Determined: Checking Account Deposits
Summary
...........................................................................................................103
Test Your Knowledge
........................................................................................103
Lecture 10
10. Aggregate Supply and Aggregate Demand
........................104
What You Will Learn
........................................................................................104
Overview
...........................................................................................................104
Aggregate Demand
...........................................................................................105
The Aggregate Demand Curve
Shifting the Aggregate Demand Curve
Short-Run Aggregate Supply
............................................................................107
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Long-Run Aggregate Supply
............................................................................114
Short-Run Equilibrium
.....................................................................................117
The Phillips Curve
............................................................................................119
The Federal Reserve and the Control of Inflation
............................................123
11. Budget Economics
..............................................................129
The American Business Cycle and the Budget
.................................................129
The Three Runs of Budget Policy
....................................................................134
The Budget in the Short Run: Fiscal and Monetary Policy
..............................136
The Budget in the Medium Run
......................................................................143
The Budget in the Long Run
............................................................................147
Appendix: The Role of China in the Government Budget, and Other Issues
.150
12. Growth Economics
.............................................................152
What You Will Learn
........................................................................................152
From the Invention of Fire to the Neolithic Revolution
...................................152
Behaviorally-Modern Human Beings
Population Growth Rates in the Middle Stone Age
Living Standards in the Middle Stone Age
The Agrarian Age
.............................................................................................153
Population Growth in the Agrarian Age
Living Standards in the Agrarian Age
Was the Invention of Agriculture All a Big Mistake?
If the Loom Could Weave the Cloth without a Hand to Guide It...
The Transition to Modern Economic Growth
.................................................157
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Guessing at Some Numbers
The Great Transformation
Summary
...........................................................................................................158
Test Your Knowledge
........................................................................................159
13. The Shape of Modern Economic Growth
........................160
What You Will Learn
........................................................................................160
Recapitulation
...................................................................................................160
Divergence and Convergence
...........................................................................161
The World in 1800
From 1800 to 1968
From 1968 to 2010
An Economic Growth Equation
.......................................................................166
Categories of Income
Factor Accumulation and Economic Growth
Summary
...........................................................................................................167
Test Your Knowledge
........................................................................................168
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Lecture 1
1. Overview of Macroeconomics
A Roadmap for This Half of the Course
WHAT YOU WILL LEARN
On the first Friday of May 2007, the U.S. Department of Labor’s Bureau of Labor Statistics announced
that it estimated that 6,845,000 American adults were (a) actively looking for work and
yet (b) without jobs. Three years later, on the first Friday of May 2010, the BLS announced
that15,260,000 American adults were looking for work and without jobs. Why did the number of
Americans looking for jobs and yet not finding them more than double over that three year period?
On June 30, 2010, the U.S. Congress’s Congressional Budget Office announced that if laws remain
as they are (except for a few specific changes that Congress is widely regarded as highly
likely to pass), then over the next twenty-five years the most likely outcome would be that federal
taxes averaged 20.7% of Gross Domestic Product while federal spending averaged 25.5% of
GDP, leaving a 4.8% of GDP “fiscal gap” that must be covered somehow, someday. How did qw
in the United States—Presidents, Congresses, and voters—get themselves into a situation in
which the spending promises for the long run that the government has made so far outstrip the
taxes that the government currently raises?
Almost every single Principles of Economics course and textbook has a sharp division about
halfway through it: on one side are discussions of choice, supply and demand, and market equilibrium;
on the other side are discussions of inflation, unemployment, and total production. Remarkably
little is carried over from one side to another. Why is modern American economics—in
both courses and textbooks—divided into a “microeconomic” and a “macroeconomic” half ?
These are all things that we hope you will learn, questions that you hope, when you finish this
lecture and more so when you finish these notes, you should be able to answer. We on the Econ 1
teaching staff all hope that you will be able to:
1. Explain how large fluctuations in the unemployment rate are the result of large changes in
the flow of total economy-wide spending—what economists call aggregate demand—relative
to the productive capacity of the economy—what economists call potential output.
2. Evaluate whether an economic issue is a “microeconomic” or a “macroeconomic” one.
3. Classify macroeconomic issues by which of the four branches of macroeconomics—depression
economics, inflation economics, government budget economics, or growth economics—
they fall into.
4. Assess which of the four branches of macroeconomics is most important for understanding
and dealing with the country’s current economic problems.
as well as answer many other questions.
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WHAT IS MACROECONOMICS?
Half of the first-year economics college curriculum is microeconomics: the study of individual
workers, investors, firms, markets, and industries in our economy. Half of the first-year economics
curriculum is macroeconomics: the study of issues that cannot be analyzed properly without
considering the economy as a whole. This chapter starts the macro half. This half should, given
the big recession outside and the high level of unemployment in this country and the world starting
in 2009, grab and keep your attention.
While studying macroeconomics, watch out for one thing. Some principles, lessons, and techniques
from studying microeconomics carry over to macro. But some do not. And the underpinnings
of macro are sketchier. There is, with macroeconomics, a certain amount of the construction
of an intellectual edifice in midair on shaky foundations. (Economists work diligently to
shore up these “microfoundations.” But so far there work has not been terribly successful.)
How is macro most different from micro? Microeconomics, most of the time, presumes that the
market system as a whole is functioning reasonably well. In its background it presumes that almost
all sellers find willing buyers and almost all buyers find willing sellers at prices more-or-less
like those they expect. It presumes that, as a rule, contracts made will be fulfilled. It presumes
that, as a rule, promises—whether made by governments, financiers, employers, workers, buyers,
or sellers—will be kept.
But what if this overriding assumption is wrong? What if the web of connected markets does not
work smoothly? And when does the web of connected markets not work smoothly? And why
might the web of connected markets not work smoothly?
That is what macroeconomics is for.
The Parts of Macroeconomics
The domain of macroeconomics itself has four topics. Each of them deals with one of four major
ways in which the web of markets can fail.
Depression Economics: The first is depression economics. It examines what happens when
sellers cannot, generally and on average, find willing buyers at more-or-less the normal prices.
The answer is not pretty. It is called recession or depression. This topic should grab you. We entered
the deepest economic recession since the Great Depression back in 2007.
In December 2006 63.4% of American adults of working age had jobs. By December 2009 only
58.2% had jobs. Over those three years the unemployment rate jumped from 4.4% to 10.0%.
Total production in the economy had stood at a level of $13.06 trillion per year at the end of
2006 (measured in the prices as they stood in 2005). It had then been growing at an average rate
of a hair above 3% per year. Thus total production should have stood at $14.3 trillion per year at
the end of 2009. It did not: it was $13.1 trillion per year instead—fully 8.5% lower than what
three years before we had all expected the level of production to be.
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More than 8% of the useful goods and services that we ought to have been making at the end of
2009 were simply not there. They had vanished completely.
This is what happens when the expectation
of sellers that they can, generally and
on average, find willing buyers at more-orless
the prices that they had expected,
goes wrong. It is what happens when, in
general and economy-wide, there is excess
supply. And it is what happens when—as
invariably happens in conditions of macroeconomic
excess supply— the assumption
that private financiers and entrepreneurs
will generally fulfill their contracts
and keep their promises goes wrong as
well.
Inflation economics: The second part
is inflation economics: what happens
when buyers cannot find willing sellers at
the prices they expected. The answer is
that you get situations of moderate inflation.
The economy sees full or near-full employment as firms find that they can sell as much as
they can produce at prices higher than they expect. But it also sees unsettling and disturbing upward
wage-price spirals as workers and managers and consumers change their expectations in
order to expect faster general price rises—more inflation—than they had expected before. And
then they find that prices are rising even faster than their new expectations had led them to believe.
If the only consequence of a situation of inflation economics were that, year after year, purchasers
going to market found that prices were two, three, four, or five percent or so higher than they
had been last year, few would complain. An economy in which it is easy for workers to find or
change jobs and it is easy for managers to sell what their factories have produced is a comfortable
place to be.
The problem arises when managers, workers, and consumers begin to reflect on the process of
moderate inflation. If prices have been rising at five percent per year for several years, shouldn’t
you expect that to continue, and build that into your expectations? And so buyers pay even more,
and prices rise by more than they had been expecting them to. And the entire mechanism breaks
down, as prices rise more than people had been expecting even though people had been expecting
them to rise. The situation can end in a reversal of course as the situation is brought to a
close via a dose of depression economics. Or the situation can end in a breakdown of trust in the
government and the monetary system.
Government budget economics: The consequences of such breakdowns are the third part of
the domain of macroeconomics, which deals with the case in which the macroeconomic market
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failure is one of promise-keeping on the part of the government. As the late Milton Friedman put
it, for the government to spend is for the government to tax. Whenever the government spends, it
is also promising explicitly or implicitly to tax somebody, either in the present or the future, either
directly or indirectly, to pay for that purchase. The government can tax now to pay for spending
later—and so run a budget surplus. The government can spend now and promise to tax later—
and so run a budget deficit and increase the national debt.
But what happens when the government runs up too great a debt and the political system tries to
get the government to break its promise to tax? How to guard against such attempted promisebreaking
by the government, and what happens when the government attempts such promisebreaking
occurs is deficit economics. And once again it is not pretty: capital flight, disinvestment,
stagflation, currency collapse, and hyperinflation.
Growth economics: The fourth part does not fit quite as easily as the other three. It is growth
economics, the study of how economies grow—or don't grow—in the longer run: how material
living standards and labor productivity levels advance, or fail to do so.
Growth economics fits uneasily with the other components of macroeconomics for three reasons.
1. Growth economics is concerned with long-run trends across decades or generations while
they are short run, concerned with whether the government is paying its debts or (implicitly
or explicitly) defaulting on them, whether workers expecting to find jobs can do so or are disappointed,
whether purchasers expecting to buy goods at yesterday's prices can do so or are
disappointed, and whether any or all of these are happening right now.
2. Growth economics is concerned with situations in which expectations are generally satisfied
while the others are concerned with situations in which expectations are disappointed.
3. Growth economics is concerned with situations in which the economy has recently (where
“recently” means something like “the past 200 years”) done relatively well, while the other
three are concerned with situations in which things are or are near the point of going badly.
Nevertheless, growth economics is similar to the other three. It, too, looks not at an individual
market or firm or household or industry but rather at the economy as a whole. It, too, looks at a
situation in which market failures are everywhere and of great importance. For this reason Greg
Mankiw added it to the “macroeconomics” half of the syllabus in the late 1980s, and it has stuck
here ever since.
Thus we have the solution to the puzzle: Why is modern American economics—in both courses
and textbooks—divided into a “microeconomic” and a “macroeconomic” half ? The solution is
that there is a huge divide between those issues in which it is a useful background assumption that
the market system as a whole is functioning acceptably, and those issues in which such a background
assumption confuses and misleads. Microeconomics deals with issues of the first type.
Macroeconomics deals with issues of the second type. To try to mix them up—to fail to set
macro apart from micro—could lead to nothing but utter confusion.
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