The Four Most Important Lessons of Macroeconomics

We begin with four lessons that have recurred throughout this book and that most economists today would endorse. Each lesson tells us how policy can influence a key economic variable—output, inflation, or unemployment—either in the long run or in the short run.

Lesson No. 1: In the long run, a country’s capacity to produce goods and services determines the standard of living of its citizens.


Of all the measures of economic performance introduced in Chapter 2 and used throughout this book, the one that best measures economic well-being is GDP. Real GDP measures the economy’s total output of goods and services and, therefore, a country’s ability to satisfy the needs and desires of its citizens. Nations with higher GDP per person have more of almost everything—bigger homes, more cars, higher literacy, better health care, longer life expectancy, and more Internet connections. Perhaps the most important question in macroeconomics is what determines the level and the growth of GDP.

The models in Chapters 3, 7, and 8 identify the long-run determinants of GDP. In the long run, GDP depends on the factors of production—capital and labour—and on the technology for turning capital and labour into output. GDP grows when the factors of production increase or when individuals become better at turning the inputs into an output of goods and services.

This lesson has an obvious but important corollary: public policy can raise GDP in the long run only by improving the productive capability of the economy. There are many ways in which policymakers can attempt to do this. Policies that raise national saving—either through higher public saving or higher private saving—eventually lead to a larger capital stock. Policies that raise the efficiency of labour—such as those that improve education or increase technological progress—lead to a more productive use of capital and labour. All these policies increase the economy’s output of goods and services and, thereby, improve the standard of living. It is less clear, however, which of these policies is the best way to raise an economy’s productive capability.

Lesson No. 2: In the short run, aggregate demand influences the amount of goods and services that a country produces.

Although the economy’s ability to supply goods and services is the sole determinant of GDP in the long run, in the short run GDP depends also on the aggregate demand for goods and services. Aggregate demand is of key importance because prices are sticky in the short run. The IS–LM model developed in Chapters 10, 11, and 12 (along with the no-LM-curve version given in the appendix of Chapter 11) shows what causes changes in aggregate demand and, therefore, short-run fluctuations in GDP.

Because aggregate demand influences output in the short run, all the variables that affect aggregate demand can influence economic fluctuations. Monetary policy, fiscal policy, and shocks to the money and goods markets are often responsible for year-to-year changes in output and employment. Because changes in aggregate demand are central to short-run fluctuations, policymakers monitor the economy closely. Before making any change in monetary or fiscal policy, they want to know whether the economy is booming or heading into a recession.

Lesson No. 3: In the long run, the rate of money growth determines the rate of inflation, but it does not affect the rate of unemployment.


In addition to GDP, inflation and unemployment are among the most closely watched measures of economic performance. Chapter 2 discussed how these two variables are measured, and subsequent chapters developed models to explain how they are determined.

The long-run analysis of Chapter 4 stresses that growth in the money supply is the ultimate determinant of inflation. That is, in the long run, a currency loses real value over time if and only if the central bank prints more and more of it. This lesson can explain the decade-to-decade variation in the inflation rate that we have observed in Canada, as well as the far more dramatic hyperinflations that various countries have experienced from time to time.

We have also seen many of the long-run effects of high money growth and high inflation. In Chapter 4 we saw that, according to the Fisher effect, high inflation raises the nominal interest rate (so that the real interest rate would remain unaffected if it were not for the fact that the Canadian income-tax system taxes nominal interest income and capital gains). In Chapter 5 we saw that high inflation leads to a depreciation of the currency in the market for foreign exchange.

The long-run determinants of unemployment are very different. According to the classical dichotomy—the irrelevance of nominal variables in the determination of real variables—growth in the money supply does not affect unemployment in the long run. As we saw in Chapter 6, the natural rate of unemployment is determined by the rates of job separation and job finding, which in turn are determined by the process of job search and by the rigidity of the real wage. In our study of efficiency wages, we saw that real wages can be rigid, even without minimum wage laws or unions, if firms find it profitable to use high wages as a mechanism to induce higher productivity from their workforce. Thus, we concluded that persistent inflation and persistent unemployment are unrelated problems. To combat inflation in the long run, policymakers must reduce the growth in the money supply. To combat unemployment, they must alter the structure of labour markets. In the long run, there is no tradeoff between inflation and unemployment.

Lesson No. 4: In the short run, policymakers who control monetary and fiscal policy face a tradeoff between inflation and unemployment.

Although inflation and unemployment are not related in the long run, in the short run there is a tradeoff between these two variables, which is illustrated by the short-run Phillips curve. As we discussed in Chapter 13, policymakers can use monetary and fiscal policies to expand aggregate demand, which lowers unemployment and raises inflation. Or they can use these policies to contract aggregate demand, which raises unemployment and lowers inflation.

Policymakers face a fixed tradeoff between inflation and unemployment only in the short run. Over time, the short-run Phillips curve shifts for two reasons. First, supply shocks, such as changes in the price of oil, change the short-run tradeoff; an adverse supply shock offers policymakers the difficult choice between higher inflation or higher unemployment. Second, when people change their expectations of inflation, the short-run tradeoff between inflation and unemployment changes. The adjustment of expectations ensures that the tradeoff exists only in the short run. That is, only in the short run does unemployment deviate from its natural rate, and only in the short run does monetary policy have real effects. In the long run, the classical model of Chapters 3 through 8 describes the world.