Principles of Macroeconomics Lecture notes PDF

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Principles of Macroeconomics  

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Scarcity: the limited nature of society’s resources Economics: the study of how society manages its scares resources, e.g. - How people decide what to buy, how much to work, save, and spend. - How firms decide how much to produce, how many workers to hire - How society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs Principle 1: People Face Tradeoffs & Complementarities - All decisions involve tradeoffs - Ex: Going to a party the night before your midterm leaves less time for studying. - Having more money to buy stuff requires working longer hours, which leaves less time for leisure. - Protecting the environment requires resources that could otherwise be used to produce consumer goods. - Efficiency: when society gets the most from its scarce resources - Equality: when prosperity is distributed uniformly among society’s members - Tradeoff: redistribution of income from wealthy to poor may reduce incentive to work and produce, shrinking the size of the economic “pie”. - Complementarity: high levels of inequality may increase the need for higher security spending, leading to an inefficient use of resources, e.g. South Africa vs Scandinavian countries. Principle 2: The Cost of Something Is What You Give Up to Get It/ Making decisions requires comparing the costs and benefits of alternative choices. - The opportunity cost of any item is whatever must be given up to obtain it. - Ex: The opportunity cost of…going to college for a year is not just the tuition, books, and fees, but also the foregone wages. - Ex: The opportunity cost of…seeing a movie is not just the price of the ticket, but the value of the time spent at the theatre. - It is the relevant cost for decision-making. Principle 3: Rational People Think At The Margin - Rational people: systematically and purposefully do the best they can to achieve their objectives. - Make decisions by evaluating costs and benefits of marginal changes, incremental adjustments to an existing plan. - Ex: When a student considers whether to go to college for an additional year, he compares the fees and foregone wages to the extra income he could earn with the extra year of education. Principle 4: People Respond to Incentives - Incentive: something that induces a person to act, i.e. the prospect of reward or punishment. - Rational people respond to incentives. - Ex: When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs.

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Ex: When cigarette taxes increase, teen smoking falls.

Applying the principles: A. Fix the transmission. You would make $200. B. Do not fix the transmission. You would lose $100.

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Principle 5: Trade Can Make Everyone Better Off When Countries Have Mature Industries - Rather than being self sufficient, people can specialize in producing one good or service and exchange it for other goods - Countries also benefit from trade and specialization when they have mature industries:  Get a better price abroad for goods they produce  Buy other goods more cheaply from abroad than could be produced at home - At earlier stages of development, it is more beneficial to protect new, or “infant”, industries until they gain competitiveness in international markets.

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Episodes of Globalization - Early 1900s - Collapsed during WWI - 1971: Bretton Woods collapses - Brexit: putting a block on globalization - US elections outcome could also affect globalization

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Principle 6: Markets Are A Good Way To Organize Economic Activity When Proper Regulations Are In Place - Market: a group of buyers and sellers (need not be in a single location) - “Organize economic activity” means determining  WHAT goods to produce  HOW to produce them  HOW MUCH to produce  WHO gets the products - A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets. - Famous insight by Adam Smith in The Wealth of Nations (1776):  Each of these households and firms act as if “let by an invisible hand” to promote general economic well being. - Adam Smith also has many chapters in this book where he discusses the role of government in providing anti monopoly regulations and supplying public goods such as heath and education. Principle 7: Government Improve Market Outcomes- Markets Need Proper Regulations to Function

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Market failures: when the market fails to allocate society’s resources efficiently Causes of market failure:  Externalities: when the production or consumption of a good affects bystanders (e.g. pollution, contagion from financial markets- Chinese example)  Market power: a single buyer or seller has substantial influence on market price (e.g. monopoly) Public policy promotes efficiency

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Principle 8: A Country’s Standard of Living Depends On Its Ability to Produce Goods & Services - Huge variation in living standards across countries and over time  Average income in rich countries is more than ten times average income in poor countries.  The U.S. standard of living today is about eight times larger than 100 years ago. - The most important determinant of living standards:  Productivity: the amount of goods and services produces per unit of labor  Productivity depends on the equipment, skills, and technology available to workers

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Principle 9: Prices Rise When the Government Prints Too Much Money / Conducts Expansionary Monetary Policy - Inflation: increases in the general level of prices - In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall - The faster the government creates money, the greater the inflation rate

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Principle 10: Society Faces a Short Run Tradeoff Between Inflation and Unemployment - In the short run (1-2 years), many economic policies push inflation and unemployment in opposite directions - Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.

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Microeconomics: the study of how households and firms make decisions and how they interact in specific markets. Macroeconomics: the study of economy wide phenomena, including inflation, unemployment, and economic growth. As scientists, economist make positive statements. As policy advisors, economists make normative statements. Positive Statements: make a claim about how the world is; descriptive. - Can be confirmed or refuted.

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Normative Statements: make a claim about how the world ought to be; prescriptive. - Cannot be confirmed or refuted.

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Circular Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms

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Two types of “actors” - Households - Firms

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Two markets - The market for goods and services - The market for factors of production

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Factors of Production

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Households: - Own the factors of production, sell/rent them to firms for income - Buy and consume goods & services

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Firms: - Buy/hire factors of production, use them to produce goods and services - Sell goods & services

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The Production Possibilities Frontier (PPF): A graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology. - Example:  Two goods: computers and wheat  One resource labor (measured in hours)  Economy has 50,000 labor hours per month available for production - Points on the PPF line are possible and efficient - Points under the PPF are possible but not efficient (some resources underutilized, ex: workers unemployed, factories idle) - Points above the PPF line are not possible - Moving along a PPF involves shifting resources (ex: labor) from the production of one good to the other - Society faces a tradeoff: Getting more of one good requires sacrificing some of the other - The slope of the PPF tells you the opportunity cost of one good in terms of the other - Slope is rise/run - The PPF line could be straight or bow shaped - Depends on what happens to opportunity cost as economy shifts resources from one industry to another.

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 If opportunity cost remains constant, straight line  If opportunity cost of good rises as more of the good is produced, line is bow shaped  PPF is bow shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other.  The PPF would also be bow shaped when there is some resource, or mix of resources with varying opportunity costs (ex: different types of land suited for different uses). The PPF shows all combinations of two goods than an economy can possibly produced, given its resources and technology. Illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth. A bow shaped PPF illustrates the concept of increasing opportunity cost.

Market: a group of buyers and sellers of a particular product. Competitive Market: one with many buyers and sellers, each has a negligible effect on price. Perfectly Competitive Market: - All goods are exactly the same - Buyers and sellers are so numerous that no one can affect market price; each is a “price taker” Quantity Demand: the amount of the good that buyers are willing and able to purchase. Law of Demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal. Demand Schedule: a table that shows the relationship between the price of a good and the quantity demanded The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. The demand curve shows how price affects quantity demanded, other things being equal. These “other things” are non-price determinants of demand (i.e. things that determine buyers demand for a good, other than the good’s price). - Increase in number of buyers increases quantity demanded at each price, shifts D curve to the right. - Income:  Demand for a normal good is positively related to income. - Prices of Related Goods  Two goods are substitutes if an increase in the price of one causes an increase in demand from the other.  Ex: pizzas and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right.  Ex: Coke and Pepsi, laptops and tablets

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Complements:  Two goods are complements if an increase in the price of one causes a fall in demand for the other.  Ex: College tuition and textbooks, bagels and cream cheese, eggs and bacon, computers and software Expectations  Expectations affect consumers buying decisions  Ex: If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now.  Ex: if the economy sours and people worry about their future job security, demand for auto………

Price  causes a movement along the D curve Number of buyers  shifts the D curve Income  shifts the D curve Price of related goods  shifts the D curve Tastes  shifts the D curve Expectations  shifts the D curve   

Supply: the quantity supplied of any good is the amount that sellers are willing and able to sell. Law of Supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal Supply Schedule: A table that shows the relationship between the price of a good and the quantity supplied - Ex: Starbucks’ supply of lattes

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Supply Curve Shifters - The supply curve shows how price affects quantity supplied, other things being equal  Ex of input prices: wages, prices of raw materials.  A fall input prices makes production more profitable at each - Expectations:  Events in the Middle East lead to expectations of higher oil prices.  In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price.  S curve shifts left  In general, sellers may adjust supply when their expectations of future prices change  Not valid for perishable goods

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Gross Domestic Product (GDP): Measures total income of everyone in the economy. - Also measures total expenditure on the economy’s output of g&s.

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The market value of all final goods and services produced within a country in a given period of time. Goods are valued at their market prices (all goods measured in the same units, ex: dollars) Things that don’t have a market value are excluded (housework you do for yourself) Final goods: intended for the end user Intermediate goods: used as components or ingredients in the production of other goods Includes currently produced goods, not goods produced in the past. Measures the value of production that occurs within a country’s borders, whether done by its own citizens or by foreigners located there. Four components:  Consumption (C)  Investment (I)  Government Purchases (G)  Net Exports (NX)  GDP (Y)  Y = C + I + G + NX Consumption: is total spending by households g&s  For renters, consumption includes rent payments  For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments. Investment is total spending on goods that will be used in the future to produce more goods  Includes spending on…  Capital equipment (machines, tools)  Structures (factories, office buildings, houses)  Inventories (goods produced but not yet sold)  Does not mean the purchase of financial assets like stocks and bonds Government Purchases: all the spending on the g&s purchase by government at the federal, state, and local levels  Excludes transfer payments, such as Social Security or unemployment insurance benefits  They are not purchases of g&s Net Exports: exports – imports  Exports represent foreign spending on the economy’s g&s  Imports are the portions of C,I, and G that are spent on g&s produced abroad

Real vs Nominal GDP - Inflation can distort economic variables like GDP, so we have two versions of GDP Nominal GDP - PxQ + PxQ

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The change in nominal GDP reflects both prices and quantities. The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation). GDP deflator: a measure of overall level of prices - GDP deflation = 100 x nominal GDP/real GDP - One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next. Real GDP per capita is the main indicator of the average person’s standard of living Real GDP per capita = Real GDP/Total Population - GDP is not a perfect measure of well being - GDP does not value  The quality of the environment Having a large GDP enables a country to afford Consumer Price Index (CPI) - Measures the typical consumer’s cost of living - The basis of cost of living adjustments (COLA’s) in many contracts and in Social Security - Calculate 1. Fix the “basket”: The Bureau of Labor Statistics (BLS) surveys consumers to determine what is in the typical consumer’s “shopping basket” 2. Find the prices: The BLS collects data on the prices of all the goods in the basket. 3. Computer the basket’s cost: use the prices to compute the total cost of the basket. 4. Choose a base year and compute the index: The CPI in any year equals 100 x cost of basket in current year/cost of basket in base year 5. Compute the inflation rate: the percentage change in the CPI from the preceding period. Inflation rate = CPI this year – CPI last year/CPI last year x 100%

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Problems with CPI: - Overtime, some prices rise faster than others. - Consumers subsitite toward goods that become relatively cheaper, mitigating the effects of price increase. - The CPI misses this substitution because it causes

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The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. In effect, dollars become more valuable. The CPI misses this effect because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

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Unmeasured Quality Change: - Improvements in the quality of goods in the basket increase the value of each dollar. - The BLS tries to account for quality changes but probably misses some, as quality

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Imported consumer goods: - Included in CPI - Excluded from GDP deflator

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Capital goods: - Excluded from CPI - Included in GDP deflator (if produced domestically)

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The basket: - CPI uses fixed basket - GDP deflator uses basket of currently produced goods & services - This matters if different prices are changing by different amounts

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Amount in today’s dollars = Amount in year T dollars x Price level today/ price level in year T

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A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract - The COLA is in many multi year labor contracts - Adjustments in Social Security payments

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Nominal interest rate: - The interest rate not corrected for inflation - The rate of growth in the dollar value of a deposit or debt The real interest rate: - Corrected for inflation - = Nominal interest rate – inflation

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Unemployment Labor Force Statistics - Produced by Bureau of Labor Statistics (BLS), in the US Dept of Labor - Calculates people ages 16+ - Employed: paid employees, self-employed, and unpaid workers in a family business - Unemployed: people not working who have looked for work during previous 4 weeks - Not in the labor force: everyone else (students, retired) - Unemployment Rate = 100 x # of unemployed/labor force - Labor force participation rate = 100 x labor force/adult population

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Natural rate of unemployment: the normal rate of unemployment around which the actual unemployment rate fluctuates Frictional Unemployment: occurs when workers spend time searching for the jobs that best suit their skills and tastes - Short term for most workers (-6 months) Structural Unemployment: occurs when a mismatch between skills or locations of workers and the skill requirements or locations of jobs - Results from sectoral shifts - Usually longer term Unemployment Insurance: a government program that partially protects workers’ incomes when they become unemployed - May increase frictional unemployment - Benefits end when a worker takes a job, so workers may have less incentive to search or take jobs while eligible to receive benefits. Sticky wages: wages that are high but socially accepted so they will not fall Union: a worker association that bargains with employers over wages, benefits, and working conditions - Unions exert their market power to negotiate higher wages for workers, which is important to counter the high bargaining power of employers. Efficiency wages: firms voluntarily pay above equilibrium wage - Worker health: in less developed countries, poor nutrition is a common problem. Paying higher wages allows workers to eat better, makes them healthier, more productive - Worker turnover: hiring & training new workers is costly. Paying high wages gives workers more incentive to stay, reduces turnover - Worker quality: offering higher wages attract better job applications, increases quality of the firm’s workforce - Worker effort: workers can work hard or shirk. Shirkers are fired if caught. Is b...