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Introduction to Macroeconomics

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1 Introduction to Macroeconomics
Chapter 1. An Overview of Macroeconomics

2 An Overview of Macroeconomics
1. What is Macroeconomics 2. Macroeconomic Goals 3. Key Principles of Economics 4. Economic Theory in Practice Introduction to Macroeconomics

3 1. What Is Macroeconomics?
Microeconomics - study of behavior of individual economic agents. Macroeconomics - study of aggregate measures of the economy Forest vs. trees. Macroeconomics is study of the forest. Microeconomics is study of individual trees. Aggregate - (n) a total, a mass or amount, brought together. (v) to collect or form into an aggregate. Aggregate demand represents the total spending on all final goods and services in an economy by all consumers. Problem with aggregation of preferences. Could add pro-con votes as in an election. But, how do you account for differences in intensity of preferences? Introduction to Macroeconomics

4 Complementary and Conflicting Goals
2. Macroeconomic Goals Low Unemployment Price Stability Economic Growth Complementary and Conflicting Goals List of goals is not exhaustive. Many other economic goals such as: equitable distribution of income balanced government budget balanced international trade low real interest rates Introduction to Macroeconomics

5 2. Macroeconomic Goals Low Unemployment
Great Depression ( ) World War II ( ) recession recession recession U.S. Fairfax Co., VA. Source: Bureau of Labor Statistics Introduction to Macroeconomics

6 2. Macroeconomic Goals Price Stability
Introduction to Macroeconomics

7 2. Macroeconomic Goals Economic Growth
Economic Growth - distinction between short-run and long-run. Short-run changes in economic growth described by business cycle models. The business cycle represents fluctuations in economic growth around a long-run trend. the long-run trend is determined by such factors as investment, productivity, changes in technology, etc. Introduction to Macroeconomics

8 2. Macroeconomic Goals Complementary and Conflicting Goals
Complementary Goals Low unemployment and high economic growth Conflicting Goals Low unemployment and low inflation Are high economic growth and low inflation conflicting goals? Not necessarily if your policy action is to increase productivity then you could increase economic growth while maintaining low inflation. Because of conflicting goals economics has been described as the “Dismal Science” Introduction to Macroeconomics

9 3. Key Principles of Economics
Scarcity, Choice, and Opportunity Cost Rational Self-Interest Relationship Between Opportunity Cost and Rational Self-Interest Decisions Are Made at the Margin Introduction to Macroeconomics

10 3. Key Principles of Economics Scarcity, Choice, and Opportunity Cost
The Production Process Inputs Nonhuman Resources Natural Resources Real Capital Human Resources Outputs Goods Services Real capital - human-made resources used to produce final goods and services. Requires foregoing current consumption. Financial capital - not included as an economic resource Introduction to Macroeconomics

11 3. Key Principles of Economics Scarcity, Choice, and Opportunity Cost
Limited Resources Unlimited Wants Scarcity - resources, goods and services are limited relative to the wants and desires for them Choice Opportunity Cost - the highest valued alternative foregone in making any choice Scarcity: - if the good or service were free, the quantity supplied would exceed the quantity demanded at a zero price. - scarcity requires both limited resources and unlimited wants. Each is necessary but not sufficient by itself to have scarcity. Choice: in a world of scarcity we must make choices regarding the allocation of scarce resources. Opportunity Cost: each choice involves a cost - something must be given up. You plan on attending class but start thinking about how nice it would be to skip and stay at home. How can an instructor influence your estimate of the net benefit of attending class, or increase the opportunity cost of staying home? Reduce costs of attending class: make class shorter Increase benefit of attending class: tell you what will be on exams give good lectures require attendance Why do parents and teachers complain that students do not study enough? Students face relatively certain opportunity costs but uncertain future benefits for attending class. Perception is that students discount the expected benefits too heavily because of the uncertainty, while parents and teachers view the future benefits with more certainty. Introduction to Macroeconomics

12 3. Key Principles of Economics Rational Self-Interest
Individuals are able to estimate benefits and costs (net benefit) of a particular action They are able to compare the net benefits of alternative actions Self-Interest Only engage in that activity if the net benefit is greater than zero Engage in the activity that yields the greatest net benefit Additional characteristics - given identical conditions, people will consistently make the same choices. - (not in text) if A is preferred to B, and B is preferred to C, then A is preferred to C. Does a 5 year-old ever exhibit rational self-interested behavior? Consider a child who is an angel at home but a terror at the supermarket. When at a store the benefit of misbehaving (the potential payoff of pestering Mom or Dad for candy) is greater than at home. Also, because the parent is less likely to punish the child as severely in public, the costs are lower as well. We don’t think the child is actually making this calculation, but behaves as if he is. Why do people contribute to public radio and television? Problem of free-riding. Public TV fundraisers often provide something for the contribution, like a video of the program. Refer to lecture notes for relationship between rational self-interest and opportunity cost. Introduction to Macroeconomics

13 3. Key Principles of Economics Decisions Are Made at the Margin
Marginal Benefit the increase in total benefit from the production or consumption of one additional unit of a good or service Marginal Cost the increase in total cost from the production or consumption of one additional unit of a good or service Introduction to Macroeconomics

14 4. Economic Theory in Practice
Economic Theory and Models Fallacy of Composition Normative vs. Positive Economics A theory is like a map to a friends house. The map is necessarily incomplete and in many ways inaccurate. The map probably only shows the roads that will take you directly where you want to go. It may show a few landmarks like the gas station where you turn right. The map is useful precisely because it is a simplification. Showing every building and intersecting street won’t get you where you want to go any faster or with significantly greater confidence. Similarly, an economic theory tries to take you directly where you want to go without burdening you with the details. But when the details of the map or a theory are left out it becomes less useful for other purposes. If we use one economic model to study economic growth it is likely unsuitable for studying short-term economic fluctuations. Introduction to Macroeconomics

15 4. Economic Theory in Practice Economic Theory and Models
What makes a good model? Accurately explains history Makes reasonable predictions about the future John Maynard Keynes, General Theory of Employment Interest and Money, 1936 (p. 297): “The object of our analysis is not to provide a machine or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organized and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking.” Introduction to Macroeconomics

16 4. Economic Theory in Practice Economic Theory and Models
Keep models simple Occam’s Razor - eliminate complicating details that don’t significantly contribute to the model Ceteris Paribus - other things being equal Introduction to Macroeconomics

17 4. Economic Theory in Practice Fallacy of Composition
You can’t generalize to the aggregate based on the expected behavior of a single person acting alone. The Fallacy is presented as an illustration of why the field of macroeconomics is distinct from microeconomics. Micro theories and their implications may not hold at the macro level. Examples of the Fallacy of Composition When one major league baseball team spends more money acquiring better players it is better off, but if all other teams do the same thing in order to compete none of them is better off When one member of Congress secures government spending projects for his/her home district he/she is rewarded with votes in the next election. When all members of Congress attempt to bring home the bacon, citizens decry the behavior. Introduction to Macroeconomics

18 4. Economic Theory in Practice Normative versus Positive Economics
Positive Economics - explains what will happen under certain conditions Normative Economics - explains what should happen Why do economists disagree even over positive theories? Economics is a social science, like psychology, anthropology, and political science. It is concerned with reaching generalizations about human behavior. Human behavior is more variable and often difficult to predict. But, probably more important, humans too often can’t explain their true motivations. Economics assumes people are rational self-interest maximizers. All that we can really claim is that people act as if they are rational. Social scientists don’t have laboratories to conduct controlled repeatable experiments to test theories like physical scientists. We can’t manipulate the economy simply to test our theories Introduction to Macroeconomics

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