1. Why Study Macroeconomics?
a. Economics is the study of the economy and the behavior of people in the economy. Economics is divided into :
i. Microeconomics studies the behavior of individuals and organizations (consumers, firms and the like) at a disaggregate level.
ii. Macroeconomics studies the overall or aggregate behavior of the economy.
b. We seek to explain phenomena such as inflation, unemployment and economic growth. see Figure 1-1. We are not concerned with, say, the supply and demand for computers.
c. We try to do two things in macroeconomics.
i. Understand the economic functioning of the world we live in, i.e. both analysis and explanation.
ii. Can we do anything to improve the performance of the economy, i.e. policy prescription.
d. Try to understand the behavior of macroeconomic variables both at a moment in time and as time passes.
i. Macroeconomist recognize that it is important to focus on more than just short period of time, and so has an explicitly dynamic focus.
ii. This means we wish to explain the behavior of the economy both in the long run and the short run.
2. How economist think.
a. The use of economic models.
i. A key element of economic analysis is the study of markets and prices.
(1) In an economy goods are traded.
(2) We think about this taking place in markets. The market is an abstract representation of a real market, where, for example, farmers might bring their produce for sale.
(3) Economist analyze markets by thinking about suppliers and demanders for goods.
(4) As an example consider the market for bread.
(a) Thinking first about the supply of bread,
(i) an economist might posit that the amount of bread that the baker would put up for sale depends on the price of bread - the higher the price, the more bread bakers will supply.
(ii) Also an economist might think that the supply of bread depends upon the cost of the materials the bakers use - most importantly, flour. The higher the cost of flour, the less bread bakers will supply.
(b) Turning to the demand for bread,
(i) an economist might think that the amount of bread that consumers want to buy will depend upon the price of the bread and on consumer's aggregate income.
(5) Economists use mathematics - particularly graphs and algebra - to help understand the economy.
(6) In the example we have thus far said two things:
(a) The supply of bread depends on the price of bread and the price of flour.
(b) The demand for bread depends upon the price of bread and aggregate income.
(7) A mathematical expression for these concepts is more compactly given by
(a) Qs = S (Pb,Pf );
(b) Qd = D(Pb, Y);
(c) Here S(.) is a function: it indicates a relationship between Qs , Pb and Pf which are variables represented quantity supply, price of bread and price of flour, respectively. Similar definitions occur in the demand relation (b).
(d) An example of (a) is: (i) Qs = 15Pb - 2Pf.
(8) Very often in economics we do not know very much about the exact nature of the relationship among variables, so we prefer the general functional notation used in (7a) and (7b).
(9) We can illustrate the functional relations on a diagram - Figure 1-3. This diagram shows
(a) The supply of bread increases with the price of bread.
(b) The demand for bread decreases with the price of bread.
(c) To remind you that the supply of bread also depends on the price of flour, Pf is sometimes put in the parenthesis when we label the supply curve. Similarly Y is placed on the demand curve to remind you that the demand for bread is dependent on the income of consumers.
(10) If we imagine that the price of bread adjusts so that demand equals supply, we add an equilibrium condition to our representation of the bread market. Qs = Qd . In terms of the graph this is equivalent to looking for the point where the supply and demand curves cross.
ii. The economy is a complicated system.
(1) Every day millions of people make economic decisions. They buy their morning coffee, buy lunch, withdraw money from checking accounts, go to a movie, buy clothes, and sell old textbooks. All of these actions are economic decisions with implications for the economy.
(2) If someone buys a molson beer from Canada instead of a Budwieser, that makes a difference for the trade deficit.
(3) In macroeconomics we are trying to understand the way the whole economy works. But obviously we cannot consider every individual transaction in every market in the economy.
(4) Instead we have to simplify; we have to abstract from reality, i.e., focus on what is important and discard what is unimportant.
iii. In order to try and understand the economy and focus on what is important, we do a couple of things:
(1) We aggregate-- Instead of worrying about individual goods--- we think about some aggregate of all the goods. We call this good real GDP, and denote it by the symbol Y. GDP stands for gross domesticl product. GDP is a measure of the total production in the economy; indeed explaining the behavior of the economy is largely a matter of explaining the behavior of real GDP over time. The definition of GDP is considered more carefully in chapter 2.
(2) We build models. Models are abstractions from reality that serve as frameworks of analysis. Just as aerospace engineers build model planes to put in a wind tunnel and judge that these models need not be equipped with "fasten seat belt" signs, but should be equipped with wings, so economists construct representations of the economy that include important variables and exclude unimportant variables.
(3) Many different sciences use models. In economics as in many other sciences, the models with which we work are usually mathematical. We develop mathematical explanations of the economy and use algebra and graphs to help us understand how the economy works.
(4) The aim of macroeconomics and your textbook is not so much to provide facts about macroeconomics as to give a framework of analysis for coherent thinking about macroeconomic issues.
iv. The analysis of the bread market in (i) is an example of a model. This model represents the determination of the equilibrium price and quantity traded in a simple setting.
(1) In constructing the model, we judge that the price of bread, the price of flour, and aggregate income are important in understanding the demand for and supply of bread.
(2) We implicitly decided that all other variables were less important and could be left out.
(3) Knowing what to include in a model is the art of the economist; it requires judgement and skill.
(4) We can use the model of the bread market to answer certain questions.
(a) What is the effect of an increase in consumer's income on the price of bread. see figure 1-4.
(b) What is the effect of an increase in the price of flour on the price of bread. see figure 1-5.
(5) This experiment is typical of the way economists use a model. They change one variable taken as given, and look at the effect on other variables that the model explains.
(a) Variables taken as given from outside the model are known as exogenous variables.
(b) Variables explained within the model are known as endogenous variables.
(6) A typical experiment with an economic model thus involves changing an exogenous variable and looking at the effect on endogenous variables. This is known as a comparative static experiment. See figure 1-2.
b. The role of Microeconomics in Macroeconomics. Although micro and macro are separate aspects of economic inquiry they make use of many of the same tools. Modern macro recognizes that good macro analysis is usually based on sound micro and thus emphasizes the microfoundations of macroeconomic behavior.
i. At times in the textbook the use of microeconomic tools is explicit; at other times it is implicit.
ii. Example, we often suppose that individuals' consumption depends upon their income without going into the details about the macroeconomics behind the choices the individuals make.
c. Eclectic Macroeconomics. Macroeconomists use many different models because different models are appropriate for different questions.
i. If we want to understand the effects of government deficits on interest rates, for example, we would not want to use the price of flour.
ii. An important aim of the book is to demonstrate economist's methods of analysis and use of models, and so the textbook works as economists do, by using different models to answer different questions.
d. Prices: Flexible versus Sticky. We noted earlier that macro is concerned with both explanation and policy recommendations.
i. Not surprisingly much of the debate among Macroeconomists has to do with their different views on policy. Eventually, these debates often come down to whether or not :
(1) the economy , left on its own, does a good job of allocating resources, or
(2) If government intervention can improve upon the performance of the economy.
ii. In trying to understand the role of policy in macro, our conclusions depend crucially on what we believe about the behavior of prices.
(1) In our example of the bread market, we suppose that the price of bread adjust to equate supply and demand -- we supposed that the market cleared.
(2) In this example the market does a good job of matching up suppliers and demanders, and no mutually beneficial trades fail to occur.
(3) In some markets, prices are indeed very flexible., but other markets we have much less confidence that market clearing occurs at all times.
(4) We think of some prices as sticky -- slow to adjust. For example labor contracts often set wages for a number of years in advance, and mail order catalogs post prices that are set for a number of months.
iii. Economists thus usually think that, for macro, it is reasonable to suppose:
(1) that prices are completely flexible in the long run only.
(2) In the short run, we often make an assumption of price stickiness to help explain the behavior of the economy.
iv. Other differences between micro and macro.
(1) Micro usually focus on a single market.
(2) In Macro we pay attention to how outcomes in one market affect what goes on in another market.
(a) For example we often think about the market for goods, real GNP, and the market for labor.
(b) Macro develops a way of putting markets together. In economist's terminology
(i) Much of macroeconomics has a general equilibrium focus.
(ii) In contrast to micro which tends to have partial equilibrium focus.
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This page last revised December 16, 1996