Capstone: Macroeconomics in Practice

This is Unit Eighteen of Principles of Macroeconomics, part one of three: the capstone. Unit seventeen closed the subject matter. This unit teaches nothing new. Its whole job is to make the course usable under exam conditions. Carry one idea through. The exam states four things it tests, and three of them are things you do rather than things you recall — so the work here is procedure, not revision. This part reduces the whole course to seven models and gives you the rule for deciding which one an unfamiliar question belongs to, because most wrong answers come from working the right method in the wrong market. By the end you will work any single-market question in four steps, trace any shock through aggregate demand and supply, follow a policy action to output and the price level, say which market a question about an interest rate lives in, and choose the right model for a question you have never seen.

Five entries on what this exam asks, how it is distributed, and how its questions are built.

What the exam is about.

MAC 1701 What This Exam Tests

The exam asks about the economy as a whole: output, employment, the price level, and the policies aimed at them. It runs about an hour and a half, with about eighty questions. It rewards recognising which model a question belongs to. And almost nothing on it requires calculation beyond arithmetic.

How they are distributed.

MAC 1702 The Seven Categories

The content divides into seven categories: basic concepts, measurement, national income and price determination, the financial sector, stabilisation policy, growth, and the open economy. Stabilisation policy is the largest, at a fifth to a quarter of the questions. The three middle categories together are about half the exam.

What they ask you to do.

MAC 1703 The Four Abilities

The exam states four things it tests: knowing the terms, reading and manipulating graphs, interpreting data, and applying simple models. Three of the four are things you do rather than things you recall, so practising the procedures matters more than rereading definitions. This is why the course's worked entries carry more weight than its short ones.

How a question is built.

MAC 1704 How the Questions Are Built

Most questions give a situation and ask what follows. A few give a table or a described graph. The wrong options are usually right answers to a slightly different question, and an option may name a real tool pointed in the wrong direction. Read what the question asks before reaching for what you recognise.

Where the outlines differ.

MAC 1705 Two Published Outlines

The exam's web page and its older printed fact sheet give slightly different weights for two categories, and they place tariffs differently. The course followed the current web page, and teaches tariffs once, under both price controls and trade. Either version leaves the same material examinable; only the emphasis differs.

Four entries on the first two models, and on the fixed order that works each of them.

One market.

MAC 1706 Model One: Demand and Supply

One market, one good. Demand slopes down, supply slopes up, and the crossing gives price and quantity. Everything else in the model is a shift of one curve or the other. Unit two built it, and units thirteen and seventeen reuse it for currencies and for traded goods. A price control stops the market clearing and creates a shortage or a surplus.

The four steps.

MAC 1707 Any Market: The Four-Step Method

Work any single-market question in four steps and never skip one. First, name the market and draw the starting equilibrium. Second, decide which curve the event touches — demand, supply, or both. Third, decide the direction of each shift. Fourth, read off what happens to price and to quantity. A frost destroys part of a coffee harvest. The market is coffee. The event touches supply rather than demand, because it changes what producers can bring to market at any price. Supply shifts left, so price rises and quantity falls. Now a second case: incomes rise and, at the same time, a new growing technique lowers costs. Demand shifts right and supply shifts right. Quantity certainly rises. Price is indeterminate, because the two shifts push it in opposite directions, and the answer is that it depends on which shift is larger. That second case is the one worth drilling. When both curves move, one result is determinate and the other is not, and the correct answer to the indeterminate one is that it cannot be determined. Units two, eight and thirteen each met this, and in every case claiming certainty about the indeterminate variable is the error.

The whole economy.

MAC 1708 Model Two: Aggregate Demand and Aggregate Supply

The whole economy on one diagram. Real GDP on the horizontal axis, the price level on the vertical. Aggregate demand slopes down, short-run supply slopes up, and long-run supply stands vertical at potential output. This is the course's central model, and units eight to sixteen all use it. The vertical axis is a price level, not an inflation rate.

Tracing a shock.

MAC 1709 Any Shock: Cause, Curve, Direction, Result

Trace any macroeconomic event through the model in one fixed order: name the cause, say which curve it touches, say which way that curve moves, and read off what happens to real GDP and to the price level. Saying it in that order is what stops the guessing. Energy prices triple worldwide. The cause is an input price, and input prices touch short-run aggregate supply rather than aggregate demand. Higher input prices shift short-run supply left, so output falls and the price level rises, which is stagflation. Now a second case: households become far more optimistic and spend more. That touches aggregate demand, which shifts right, so output rises and the price level rises — and how much of each depends on where the economy sits against potential. That last clause is the part most often dropped. Below potential, a demand increase mostly buys output. At or beyond potential, it mostly buys a higher price level. The zone decides what the shift accomplishes, and a question that tells you where output sits relative to potential is telling you which answer it wants.

Three entries on two models underneath the big one, and on following a policy action to the end.

Spending against output.

MAC 1710 Model Three: The Expenditure Model

Total planned spending against real GDP, with a forty-five degree line marking where the two are equal. Equilibrium is the crossing, and the price level does not appear anywhere in it. This is where the multiplier and both gaps are worked. Omitting the price level is what makes its inflationary gap a measure of excess spending rather than a forecast of output.

Money against the rate.

MAC 1711 Model Four: The Money Market

The quantity of money against the interest rate. Demand slopes down, because holding money costs the interest given up; supply is vertical, because the central bank sets it. The crossing gives the interest rate. Unit twelve built it, and the bond market moves alongside it. The interest rate is the outcome here, not the thing chosen.

Following it to the end.

MAC 1712 Any Policy: Tool to Output and Prices

Take any policy action and follow it to real GDP and the price level, naming every link, because most mistakes happen in the middle and an unstated middle cannot be checked. The central bank sells bonds. Reserves in the banking system fall. The federal funds rate rises, and other rates follow it up. Higher rates reduce investment and purchases of durable goods, and they raise the currency's value, which reduces net exports. Aggregate demand shifts left by the multiplier times those initial changes, so output falls and the price level falls. Now a fiscal case: the government raises purchases. Aggregate demand shifts right by the multiplier times the increase, partly offset by higher interest rates reducing private investment, so output rises and the price level rises. Both traces end at the same two variables, which is the point of having one order. Note also what the second trace contains that the first does not: a fiscal expansion has to be financed, so it works partly against itself through the interest rate. Unit fifteen called that crowding out, and it is why the two instruments are not interchangeable.

Four entries on the market that prices saving, how to tell it from the money market, and two more models.

The market for saving.

MAC 1713 Model Five: Loanable Funds

The supply of saving against the demand for borrowing, with the real interest rate as the price. More saving lowers the rate; more borrowing raises it, and government borrowing enters on the demand side. Unit two built it and unit fifteen used it for crowding out. This market and the money market both produce an interest rate, and they answer different questions.

Placing the question.

MAC 1714 Which Market Does a Question Live In

Several models produce an interest rate, so the first move is placing the question. Ask what is bought and sold. Money against bonds is the money market. Saving against borrowing is loanable funds. One currency against another is foreign exchange. Naming the market fixes which curves exist. Most wrong answers come from working the right method in the wrong market.

The currency market.

MAC 1715 Model Six: The Foreign Exchange Market

One currency priced in another, with demand and supply as in any market. Exports, visitors and foreign asset purchases demand a currency; imports, travel abroad and foreign asset purchases supply it. The same market drawn from the other currency's side is its mirror image. Here both curves often shift together, so the rate's direction is certain and the quantity is not.

The oldest model.

MAC 1716 Model Seven: The Production Possibilities Frontier

Two goods, all resources used. The frontier shows the combinations attainable, and its slope is the opportunity cost of one good in terms of the other. Points inside are wasteful; points outside are unattainable. Trade lets a country consume outside its own frontier without moving it. Growth moves the frontier; trade moves the consumption point. Those are different claims.

One entry to close this part: deciding which of the seven answers a question you have never seen.

Choosing among them.

MAC 1717 Choosing the Right Model

Given an unfamiliar question, decide which model answers it before doing anything else. Ask what the question's variables are. Output and the price level together means aggregate demand and supply. One good's price and quantity means a single market. An interest rate means either the money market or loanable funds, and what is traded decides which. A question asks what a rise in consumer confidence does to output and prices: two aggregate variables, so aggregate demand and supply. A question asks what a tax on imported steel does to the price and quantity of steel: one good, so a single market. A question asks what happens to the real interest rate when households save more: saving against borrowing, so loanable funds. A question asks what happens to the interest rate when the central bank buys bonds: money against bonds, so the money market. A question asks what happens to exports when a currency weakens: foreign exchange, then the goods market it feeds. Two of those could be argued into a second model, and the tie-breaker is what the question names as changing. A central bank action names the money supply, so it is the money market. Household saving names saving, so it is loanable funds. Follow the variable the question actually moves rather than the outcome it asks about.

Look at what you can now do. You can work any single-market question in four fixed steps, and say that when both curves move, one answer is determinate and the other cannot be determined. You can trace any shock through aggregate demand and supply in one fixed order, and say why the zone the economy sits in decides what a demand shift accomplishes. You can follow a policy action from the tool all the way to output and the price level, naming every link, so that the middle can be checked. You can say which market a question about an interest rate lives in, because most wrong answers are the right method worked in the wrong market. And you can choose among all seven models for a question you have never seen, by following the variable the question moves rather than the outcome it asks about. Part two takes up the distinctions that recur across every one of them.