Chapter 4 Review
4.1 - Assessing the health of the economy: performance and policy
Macroeconomics studies long-run economic growth and short-run economic
Macroeconomics focus their attention on three key economic statistics:
GDP is the dollar amount of all final goods and services
produced in a country during a given period of time.
The unemployment rate measures the percentage of all
workers who are not able to find paid employment despite
being willing and able to work.
The inflation rate measures the extent to which the overall
price level is rising in the economy.
4.2 – The miracle of modern economic growth
Before the Industrial Revolution, living standards did not show any sustained
increases over time.
o Economies grew, but any increase in output tended to be an offset by
an equally large increase in population, so that the amount of output
per person did not rise.
o By contrast, since the Industrial Revolution began in the late 1700s,
many nations have experienced modern economic growth in which
output has grown faster than population—so that standards of living
have risen over time.
4.3 – Saving, investment, and modern economic growth
Macroeconomists believe that one of the keys to modern economic growth is
the promotion of saving and investment (for economists, the purchase of
capital goods) o Investment activities increase the economy’s future potential output
But investment must be funded by saving, which is possible
only if people are willing to reduce current consumption.
o Consequently, individuals and society face a trade-off between current
consumption and future consumption.
o Banks and other financial institutions help to convert saving into
investment by taking the savings generated by households and
lending them to businesses that wish to make investments.
4.4 – Uncertainty, expectations, shocks, and short-run fluctuations
Expectations have an important effect on the economy for two reasons.
o First, if people and businesses are more positive about the future, they
will save and invest more.
o Second, individuals and firms must adjust to shocks—situations in
which expectations are unmet and the future does not turn out the
way people were expecting.
In particular, shocks often imply situations where the quantity supplied of a
given good or service does not equal the quantity demanded of that good or
If prices were always flexible and capable of rapid adjustment, then dealing
with situations in which quantities demanded did not equal quantities
supplied would always be easy since prices could simply adjust to the market
equilibrium price at which quantities demanded do equal quantities
o Unfortunately, real-world prices are often inflexible (or “sticky”) in
the short run so that the only way for the economy to adjust is
through changes in output levels.
“Sticky” prices combine with shocks to drive short-run fluctuations in output
and employment. o Consider a negative demand shock in which demand is unexpectedly
Because prices are fixed, the lower-than-expected demand will
result in unexpectedly slow sales.
This will cause inventory to increase.
If demand remains low for an extended period of time,
inventory levels will become too high and firms will have to cut
output to layoff workers.
Thus, when prices are inflexible, th