Econ Unit 1 - Summary Principles of Macroeconomics PDF

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Unit 1 of macro textbook...

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Unit 1 Class Notes •

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Economics: study of the allocation of scarce resources—who gets what, and why (what gets produced, how is it produced, who gets it) • Macroeconomics: the study of business cycles, long-run growth, inflation, unemployment, money, financial intermediation, fiscal and monetary policy. Economic Questions: who gets what, how do they get it, why do they get it? • Scarcity is the only reason economics exists Scarcity: feature of reality? • Keynes 1930—famous economist of the 1900s • Addressed whether scarcity is a feature of reality • Yacht envy—trying to satisfy a need for luxuries • Always wanting more—will we always want more? never satisfied • Four Categories of Wants: (Delong) • Things perceived as needed for survival • Perceived necessities—things that you think you need to be a part of society • Conveniences • Luxuries • Over time, these things seem to become more necessary even if they are conveniences or luxuries —i.e. cellphones: not needed for survival but needed for societal interaction There are other ways to study economic questions—anthropology and religion • Global wealth and poverty • Theology’s way of viewing the poor—who gets what and why? • International political economy, sociology, and history How Economists Study Questions • Involves chains of deductive reasoning in conjunction with simplified models • Manipulating models and solving them to figure out certain things • Measures the cost of one choice in terms of the forgone benefits of another—opportunity cost (key concept) • An interest i questions of efficiency—getting the most out of limited resources • Takes a marginalize or incremental approach—how much extra benefit can be achieved by incurring some extra cost • Recognizes that resources have many diverse uses and that substitutions can be made among different resources to achieve desired results “Economic Way of Thinking” • Use models • Marginal thinking—thinking about incremental changes and how they affect other variables • Incentives matter—the most pervasive feature of economic thinking (seen on everyone’s list of answering questions) Key Principles of Economics • Opportunity Cost—every time you do one thing, you're foregoing something else • An idea that escapes non-economists • Marginal principle • Principles of voluntary change—two people exchanging things voluntarily = both must be getting something from a deal/benefitting • Diminishing returns—ceterus paribus = holding certain variables at a held rate means there will be lower and lower change in output • Real-Nominal principle—“real” value vs. “nominal” value • Inflation, behavior of prices. changing of true values

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Electric Car—is it saving the environment (how is electricity generated)? What is the opportunity cost? How much does an electric car cost compared to a gas car? • Is it a smart use of tax-payers money to subsidize electric cars or change from coal to natural gas? Recycling—the resources to recycle paper might be more costly than cutting down trees to make more paper • Trees may not be a limited resource • Recycling might be worse for the environment—the energy and resources necessary to recycle • If people keep buying paper, then more companies will cut down trees to make that paper Positive vs. normative questions: What is? vs. What ought to be?

The Way of the Economist •

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Assumption/Distinctions • Crude and parsimonious model of human behavior: incentives matter • Focus on the individual • Macro v. Micro What distinguishes scientific knowledge from other forms of knowledge = obtaining this knowledge via the scientific method. • The scientific method as commonly understood is a reliance on dispassionate, objective observation and on the rules of logic to provide explanations of the nature of reality Physics—precise observation and controlled experiments Economics—weak empirical science, like geology and medicine • Qualitative NOT quantitate prediction • Can’t run controlled experiments • Has implications for how we do business Debate—science is a culture-bound view of the world—scientific explanations are just a way to maintain the existing power structure—“Science is the social construction of reality” • Believe economics to be the “handmaidens of capitalism and the market system”—not interested in fundamental truths Being a scientist means being a member of a scientific community—these communities value specific types of explanations of phenomena • Economists try to understand economic phenomena on the basis of particular types of explanations—not driven by philosophy, politics, etc. A scientific community is a group that share “epistemic values” about what it means to understand something. • Predictive accuracy • Internal coherence and external consistency • Unifying power—expect explanations to cover unexpected observations that come along • Fertility—explanations should generate new ides about where to look • Simplicity or elegance—everything should be as simple as possible Goal of having explanations that satisfy there virtues limits the types of arguments that economists find persuasive. Biases—Economists are still people • Availability bias: what you’ve seen most recently or most often. • Confirmation bias: interpret, favor, and recall information in a way that confirms preexisting beliefs or hypotheses. • Cognitive dissonance: the mental stress or discomfort experiences by an individual who is confronted by new information that conflicts with existing beliefs, ideas, or values. • Festinger: experience of inconsistency becomes psychologically uncomfortable, motivates an active avoid of information likely to increase it. • Personalities and loyalties still play a role in economics—membership in a scientific community dampens these effects. • Pathological science: a scientist unconsciously veers from the scientific method, begins a pathological process of wishful data interpretation. • Example: polywater, cold fusion

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Example 2: Martin Feldstein—published a paper that concluded that Social Security reduces private savings (positive statement) • Dean Leiber and Selig Lesnoy discovered this was a programming error • Example 3: Reinhart and Rogoff—concluded that there is a threshold value of the ratio of debt to GDP (90%)—excel spreadsheet error/there is no such thing as a threshold Models—abstractions and simplified versions of reality • Useful for the economic problem at hand—assumptions are made • A logical representation of whatever theoretical knowledge economic analysis suggests is most relevant for treating a particular problem—map analogy • “logical representation”—for every economic model, a representation can be boiled down to a collection of equations that express interrelationships among variables. • Variable: quantity free to take on any number of permissible values • Exogenous: (independent) having a value determined outside the model—not to be determined by the economist • Endogenous: (dependent) having its value determined jointly by the particular values taken by exogenous variables and by the logical relationships among variables within the model. • Interrelationship = relationship between two or more variables • Solution: the relationship between each DV and only IV components of a model. • Solving a model means to find what happens to the values of the endogenous variables when the value of an exogenous variable changes. • Steers us clear of mistaking causality for correlation • Assumptions • Behavioral Assumption—a household’s per unit of time expenditure on consumption depends positively on (is an increasing function of) its per unity of time disposable income (money received from wages) • Judgement made by the modeler—wouldn’t pick height or gender instead of household expenditure • Other variables may be important for a different problem • Assuming what variables are exogenous or endogenous is a modeler’s decision—disposable income can be exogenous or endogenous • Behavioral equations: Let C measure consumption per unit of time; Let Yd measure disposable income per unit of time • General functional notation: C = f(Yd) • Parameter: the things that tie together the variables of an equation—an exogenous variable in that its value is given from outside the model. • C = 100 + .9 x Yd —> .9 is the parameter • Cartesian plan: (Yd, C) • Parametric Example: C = Ca + b(Yd) • Ca = autonomous parameter; b = parameter • Crude and Parsimonious Model of Human Behavior • Two Key Assumptions • 1) Individuals pursue their own self-interest—incentives matter • 2) In pursuit of self-interest, people exchange one thing for another—Principle of Voluntary Exchange • What does this imply?—price controls lead to shortages (interferes with peoples willingness and desire to exchange and “price gouging” (exploiting high desire for an object by raising the price) • In pursuit of self-interest, people both engage in exchange with others to exploit opportunities for mutual advantage, and they apply their talents to avail themselves of opportunities presented in nature. •

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Where these exchanges are permitted and protected, extraordinary games for any individual firm are likely to be a short-term phenomenon—whatever the source of these gains. • This is not to say that there are not ways to make a good profit—“Barriers to entry” can limit competition in some sectors for a long time. • Opportunity cost: if you exchange one thing for another, there is a cost—what you give up. • Individual as the Focus of Analysis • Understanding of group behavior is built up from an understanding of individual behavior—it’s individuals whose decision-making that economists want to model and make decisions about • Straw man—assume that the group is the basic unit of analysis • Individual motives don’t exist—individuals may themselves think they are making choices, but in fact they are simply responding in a predetermined way to group social norms and influences. • In this view, people’s choices reflect attitudes and beliefs instilled in them from the group • Macro v. Micro: microeconomics = divides the economy into smaller units of analysis—macroeconomics takes a bunch of different commodities and treats them as a homogenous good bough and sold in the goods market. • Marco = takes all different types of labor and all workers as members of the labor market. • Also takes from a bunch of distinct types of financial assets and treats them all as if they are homogenous parts of the bond market. • Assumes it makes sense to be concerned about the determination of the aggregate level of output and unemployment, the interest rate, and the price level. • There are behaviors that cut across all different sectors and apply to all components of each type of market. • Words used to describe micro: “real”, “relative prices,” • Macro: “monetary”; nominal prices • Real-Nominal principle embodies “Neoclassical paradigm”—inefficiency of the barter system—what matters is the real value of of income and not its face value—face value does matter and has implications • Some questions about actual economies require both macro and micro analysis—trade balance surpluses Allocation of Scarce Resources • War—rise and fall of civilizations (civilization paradox): an economic society that can support abovesubsistence existence faces a choice: • 1) Invest resources in producing more consumption • 2) Invest resources in safety Requirements for “Success” • Thick market—lots of participants on both sides of a transaction (buyers and sellers) • Safety—a transaction must be safe • Example: Monarchs used to guarantee safe roads for travelers to come to market towns—uber/ cab drivers • Not congested—not a problem for commodity markets but a problem for matching markets (i.e. Uber) • Simple to participate—a market will not survive if it is difficult to participate in • Ability to easily participate is a function of the development of cellphone technology (apps, etc.) • Tension and interaction between these requirements Role of Institutions in Making Markets Work • Institutions: the laws, customs, moral principles, ideas and cultural influences that shape people’s behavior. • Economic analysis assumes that institutions are not scarce—question of how they are developed • Scarcity is the touchstone of economies but economists ignore the fact that markets don’t run on air—they depend on an institutional framework to make them work

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• Institutions require time and real resources to maintain. • Trust—huge role in making markets works • Society in which people take things from each other—learn there is a better way than just stealing —learn to not take stuff from each other = better off • Development of trust took a long time but is more beneficial for society = allows more interaction • People won’t go to markets to exchange things if they are afraid their goods will be stolen Market as an Emergent Phenomenon—POW • An emergent behavior or emergent property can appear when a number of simple entities (agents) operate in an environment, forming more complex behaviors as a collective. • “Universality and spontaneity of this economic life”—POW camps • Despite diverse backgrounds, what sprung up in the camps was a market economy—emergent behavior • The impulse to “truck, barter, and exchange” • Simply bilateral negotiations—the market was not “thick” in POW’s—prices varied from place to place • Middle man—making money by carrying out trades • Everyone, including the middle man, profits from using a middle person for exchanges/trades • Facilitates trade that people do not know exist without his help—helping buyers and sellers benefit more • Used when a market is not yet thick • Bilateral negotiations: the actual rates of exchange could occur over a range of values—depends on the negotiating prowess of each individual • Good negotiators can get better deals—exact terms of trade depend on these strategies but trade either way will make both parties better off (voluntary) • People pursue their self-interest—other people notice that the “itinerate priest” (middleman) is earning a lot = people decide to do the same thing and become middlemen—enter the activity = more competition • Developing thickness—developing a standard value (cigarettes) and a lively trade in all commodities and their relative values (real-nominal principle) • Most important prices = relative prices • Knowing dollar prices makes it easy to compute relative prices—how much of a certain currency buys a certain product • Example: • Our daily experience: $/unit, e.g., $/can of bully: how many dollars exchange for one can of bully. • But for any two commodities, we can compute a relative price: If, say, the currency price of a can of bully is $10, and the currency price of sugar is, say, $5/kilo, a person could exchange one (1) can of bully for $10, then exchange the $10 for two (2) kilos of sugar. Thus, the person is exchanging one (1) can of bully for two (2) kilos of sugar. • We can say the relative price of sugar is one-half can of bully/unit sugar. • The opportunity cost of sugar is one-half a can of bully. • Let PB denote the currency price of bully, and PS the currency price of sugar. Let p denote the relative price of sugar, i.e., how much bully it takes to purchase a unit of sugar. Then in a "perfect" market, • p = PS /PB • Relative price of sugar = dollar price of sugar divided by the dollar price of bully From Customs to Commodity: Hidden Characteristics • Example: Wheat—not a long shelf life = buyers (middlemen, bakers) and sellers (farmers) have relationships • “By sample”—took samples for purchase • Chicago Board of Trade was founded—in order to buy and sell wheat in large magnitudes • Technological innovation—wheat became storable (steel roller mill)

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• Wheat became categorized—quality, type, etc. • Wheat is now a commodity market = anonymous buyers and sellers • Example: Coffee—until recently, wholesale buyers paid based on average quality associated with the region—verification of quality was too costly. • Called a Market for Lemons problem—buyers cannot tell if the product is good quality so it turns out that good and bad quality products are put together = buyers are only getting low quality • Called the Market for Lemons because cars had a lot of defects—seemed shiny and new (called lemons) when they were first bought but then little problems showed up after the car was driven for a while. • Used car market = people who got stuck with the “lemon” want to sell their cars— hard to tell these cars are defective • Can be sold for the average quality but the average quality was hard to determine • Cars have become much more reliable—not many “lemons” • If testing quality is very expensive: • Sellers won’t produce high quality if they are only going to get less for their high-quality. • Only a low-quality market occurs—assumption that incentives matter and people pursue their own self-interest • Prisoner’s Dilemma: gain from producers coordinating and refraining from producing low quality is higher than if they did not coordinate, but there are still gains from not coordinating. • Incentive to not coordinate because there is an advantage to producing low quality— everyone follows the same logic • Question: how can social interactions be structured so that people are free to choose their own actions while avoiding outcomes that none would have chosen. • Possible Solution: Ethiopian Coffee Exchange—blind tastings • Example: Milk in India—Solution = National Dairy Development Board provided inexpensive machines to measure butterfat content. • What Do These Examples Tell Us? • Market frictions: the time, effort, and resources spent finding out what choices are available, including quality. • There are many “lemons” problems (hidden characteristics problems) that hamper development of successful markets. • A thick market makes it easier for you to discover what is available and what the prices are —only develop when information problems about quality are fixed • Fixes involve the development of institutions: the laws, customs, moral principles, ideas, and cultural influences that shape people’s behavior (i.e. blind tastings in Ethiopia). Market Thickness: The Contrast with Bargaining • Sales price indeterminate: somewhere between the relative prices for the buyer and seller, each is better off with the transaction going through (bargaining range). • Two sides engage in threats, feints, bluffs: buyer may pretend to not be interested, seller may pretend to have another buyer, etc. • Each side is taking a calculated risk—may end up with bargaining failure • Invest in learning strategies—problem from an economists point of view is that these strategies sometimes fail. • Sellers’ prices reflect their opportunity cost—some prices are higher because the opportunity cost for engaging in a trade is higher. • Sometimes the seller with the higher opportunity cost must drop out because mutual undercutting drives the price down. • Undercutting drives the price to the second-lowest price—always stop bidding at the secondlowest price. • Competition changes bargaining power but also lowers transactions costs by eliminating resources devoted to bargaining.

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Buyers like competition from sellers and vice versa—thick market means each buyer can choose from many sellers and each seller has many buyers to choose from. • Unlike matching market, no one has to wait for an offer to be made personally—an offer that includes features other than just the price. • Problem: getting enough buyers and sellers together—solution: by limiting the time frame and locations in which a market is open = creates thickness. • Farmers market, street markets, etc. • “High Frequency Trading”—computer algorithms that are set up to execute trades for financial assets and trading takes place at the millisecond level—the gains from people who get the best bargain at this level of exchange make a lot...