• <b>United States Federal Reserve</b>

Principles of Macroeconomics

1. Production Possibilities Frontier

The production possibilities frontier is an graphical illustration of quantities of production of various goods that an economy can produce. Because society's resources are not limitless, there exist trade-offs. When an economy is fully utilizing its resources, in order to produce more of one type of good, there must be a reduction in the production of other good(s). When this happens, resources such as labor, land, and/or capital that were used in the production of one type of good are re-assigned to the production of another good.

2. Supply and Demand

The supply and demand model predicts what quantities of goods will be sold in the market, and what prices these goods will be sold for. Prices and quantities are determined in an equilibrium where the choices for purchases by consumers at given prices (demand) are consistent with the choices of production by businesses at given prices (supply). In these Pencasts, we discuss what other factors besides price that can affect the demand and/or supply of goods and services. The model can be used to predict how prices and quantities of production change in response to changes in the economy.

3. Measuring the Macroeconomy

In this section we learn about how we measure macroeconomic performance and conditions. We explore three issues: (1) the aggregate level of production in an economy (measured by gross domestic product), (2) the aggregate price level (measured by GDP deflator or the consumer price index), and (3) the conditions in the labor market (measured by the unemployment rate). These are just some of the issues important for measuring macroeconomic conditions, and just some of the measures we have. Still, these measures tell a great deal about the state of the macroeconomy and lay a foundation for more detailed economic measures.

4. Loanable Funds Market and Production Possibilities

Here we learn about what determines savings decisions (the supply of loanable funds) and investment decisions (the demand for loanable funds). Investment decisions are the decisions of firms to build or purchase capital equipment, i.e. manufactured goods that are used in the production of other goods. The implications for the loanable funds market concern short-run and long-run economic activity. In the short-run, less investment in equilibrium leads to lower demand for final goods and services. In the long-run, less investment in the present leads to an otherwise lower capital stock in the future, which limits production possibilities.

5. Expenditure Multiplier

In this section we learn how changes in spending plans are magnified to even larger changes in aggregate income and spending. Spending plans includes consumption (consumer's decisions for purchases of final goods and services), investment (producer's decisions for purchasing and building capital), government spending on final goods and services, and net exports. Changes in spending are magnified, because when one economic agent decides to spend one dollar more, that becomes an additional dollar of income for another economic agent. In turn, that economic agent saves part of that dollar, and spends part of that dollar. The amount he or she spends, becomes income for someone else, and the cycle continues. This expenditure multiplier model can be used to explain why macroeconomic fluctuates. Small shocks to people's spending plans result in larger changes in macroeconomic activity.

6. Aggregate Supply / Aggregate Demand

In this section, we combine the idea of aggregate demand for goods and services (which is what we explore in the Expenditure Multiplier section) with aggregate supply. We discuss how both the aggregate demand and the aggregate supply for all final goods and services depend on the aggregate price level. We develop a graphical model of aggregate demand and aggregate supply that shows how real GDP and aggregate price level are determined in equilibrium. We also discuss what other factors (besides aggregate price level) can influence demand and supply decisions, and demonstrate the effect that it has on the economy in the short-run and the long-run.

7. Monetary Theory

Here we discuss the influence that monetary policy can have on the business cycle. Monetary policy refers to actions taken by the central bank of a country to increase or decrease the supply of money. We develop a model of money supply and money demand, and show how changes in the supply of money influence the interest rate in equilibrium. We combine this model with the aggregate supply / aggregate demand model to show how changes in the market for money influence real GDP and price level. The last pencasts in this series demonstrate how macroeconomic problems may be remedied with monetary policy actions.

8. Market for Currency

In this section, we discuss how currency exchange rates are determined by supply and demand for currency. We focus on a two-country graphical model. The demand for the domestic currency comes from the demand people from the foreign country have to make financial investments in the domestic country, or to buy products that are produced in the domestic country. Similarly, the demand for the foreign currency comes from the demand people in the domestic country have to make financial investments in the foreign country, or to buy products that are produced in the foreign country. Since people in one country must sell their own currency in order to buy a different currency, it will be the case that the supply of the domestic currency is the same thing as the demand for the foreign currency. Similarly, the supply of the foreign currency is the demand for the domestic currency. We will use the equilibrium model to show how exchange rates are determined, and what causes them to change.