Summary Principles of Macroeconomics - N. Gregory Mankiw PDF

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Summary Principles of Macroeconomics N. Gregory Mankiw 6th Edition Contents 1. Ten Principles of Economics ........................................................................................................... 2 2. Thinking Like an Economist ........................................................

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Summary Principles of Macroeconomics N. Gregory Mankiw 6th Edition

Contents 1. Ten Principles of Economics ........................................................................................................... 2 2. Thinking Like an Economist ............................................................................................................. 6 3. Interdependence and the Gains from Trade ............................................................................... 14 4. The Market Forces of Supply and Demand................................................................................. 24 5. Elasticity and Its Application ......................................................................................................... 43 6. Supply, Demand, and Government Policies ................................................................................ 57 7. Consumers, Producers and Efficiency of Markets ..................................................................... 68 8. Application: The Cost of Taxation ................................................................................................ 77 9. Application: International Trade ................................................................................................... 87 10. Measuring A Nation's Income ..................................................................................................... 96 11. Measuring the Cost of Living .................................................................................................... 102 12. Production and Growth ............................................................................................................. 106 13. Saving, Investment and the Financial System ......................................................................... 111 14. The Basic Tools of Finance ....................................................................................................... 118 15. Unemployment ........................................................................................................................... 122 16. Monetary System ....................................................................................................................... 128 17. Money Growth and Inflation .................................................................................................... 134 18. Open-Economy Macroeconomics: Basic Concepts ............................................................... 140 19. A Macroeconomics Theory of the Open Economy................................................................ 145 20. Aggregate Demand and Aggregate Supply ............................................................................. 155 21. The Influence of Monetary Policy and Fiscal Policy on Aggregate Demand ...................... 169 22. The Short-Run Trade-Off between Inflation and Unemployment....................................... 178 23. Six Debates Over Macroeconomics Policy ............................................................................. 187

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1. Ten Principles of Economics Abstract: The word economy comes from a Greek word for “one who manages a household”. A household and a society as whole face many decisions:    

Who will work? What goods and how many of them should be produced? What resources should be used in production? At what price should the goods be sold?

The management of society’s resources is important because resources are scarce. Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Therefore, Economics is the study of how society manages its scarce resources. In this chapter, we look at Ten Principles of Economics. The ten principles are introduced here to give you an overview of what economics is all about. TEN PRINCIPLES OF ECONOMICS

How People Make Decisions

1. People face trade-offs It is expressed as “there is no such things as free lunch”. To get one thing, we usually have to give up another thing. Classic example of guns (national defence) vs butter (consumer goods), or other examples such as food vs clothing, and leisure time vs work. Making decisions require trading of one goal against another. Society face trade-off between efficiency and equality. Efficiency means society gets the most that it can from its scarce resources. Equality means the property of distributing economic prosperity uniformly among the members of society

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2. The cost of something is what you give up to get it Decisions require comparing costs and benefits of alternatives. For example, decision to go to college. The benefits are intellectual enrichment and a lifetime of better job opportunities. However it comes with the costs of the money you spend on tuition, books, room, and board. The cost of any action is measured in terms of foregone opportunities. The opportunity cost of an item is what you give up to get that item. When making any decision, decision makers should be aware of the opportunity costs that accompany each possible action.

3. Rational people think at the margin Rational people are people who systematically and purposefully do the best they can to achieve their objectives. Marginal changes are small, incremental adjustments to an existing plan of action. Rational people make decision by comparing marginal costs and marginal benefits.

4. People respond to incentives An incentive is something that induces a person to act, such as the prospect of a punishment or a reward. Because rational people make decisions by comparing marginal costs and marginal benefits, therefore, marginal changes in costs or benefits motivate people to respond. The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs.

How People Interact

5. Trade can make everyone better off People gain from their ability to trade with one another. Trade allows each person to specialize in what he or she does do best. Competition results in gains from trading, as people can buy greater variety of goods and services at lower cost. © StuDocu.com 3

6. Markets are usually a good way to organize economic activity A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Firms decide who to hire and what to make, and households decide what to buy and who to work for. Adam Smith made the observation that households and firms interacting in markets act as if guided by an “invisible hand.” Prices are the instrument with which invisible hand direct economic activity. Households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions. As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole.

7. Governments can sometimes improve economic outcomes Property rights is the ability of an individual to own and exercise control over scarce resources. The invisible hand can work only if the government enforces the rules and maintains the institutions to enforce property rights so individuals can own and control scarce resources. Another reason for government intervention to promote efficiency and equality. Market failure occurs when the market fails to allocate resources efficiently. Market failure may be caused by an externality, which is the impact of one person or firm’s actions on the well-being of a bystander, and market power, which is the ability of a single person or firm to unduly influence market prices. In term of equality, government intervention, for example through tax and a welfare system, aims to achieve more equal distribution of wealth.

How the Economy as a Whole Works

8. The standard of living depends on a country’s production Standard of living may be measured in different ways: a. By comparing personal incomes © StuDocu.com 4

b. By comparing the total market value of a nation’s production Almost all variations in living standards are explained by differences in countries’ productivity. Productivity is the amount of goods and services produced from each hour of a worker’s time.

9. Prices rise when the government prints too much money Inflation is an increase in the overall level of prices in the economy. In almost all cases of large or persistent inflation, the cause is growth in the quantity of money. When the government creates and circulates large quantities of money, the value of the money falls.

10. Society faces a short-run trade-off between inflation and unemployment. Higher level of prices, in the long run, is the primary effect of increasing amount of money. However, increasing amount of money creates more complicated effects, a short run trade-off between inflation and unemployment. Increasing amount of money means creating higher demand, which in turn encouraging firms to produce more and hire more workers that can result in lower unemployment. However, low inflation and low unemployment seem to be not possible to be achieved at the same time, choosing the inflation means forgo the unemployment, and vice versa. This short-run trade-off plays a key role in the analysis of the business cycle—the irregular and largely unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed.

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2. Thinking like an Economist Every field of study has its own language. Mathematics talks about Integrals, axioms, and vector spaces. Psychology discusses ego, id, and cognitive dissonance. Law promotes terms such as promissory estoppel, torts, and venues. Economics uses its own terminologies, for instance supply, opportunity cost, elasticity, consumer surplus, demand, comparative advantage, and deadweight loss. This chapter is aimed to get acquainted with the economics terminologies and how economics approaches the real world Chapter 2 Thinking like an Economist

THE ECONOMIST AS A SCIENTIST Economics is seen as a science. Therefore, the economic way of thinking involves thinking analytically and objectively, and making the use of the scientific method. Scientific Method: Observation, Theory, and More Observation Scientific method is the dispassionate or objective development and testing of theories about how the real world works. The steps required for scientific method:  

Uses abstract models to help explain how a complex, real world operates. Develops theories, collects, and analyses data to evaluate the theories,

The Role of Assumption   

Economists make assumptions in order to simplify the complex world and make it easier to understand. The art in scientific thinking is deciding which assumptions to make. Economists use different assumptions to answer different questions.

Economics Models

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Economists use models to learn about the world and simplify reality in order to improve the understanding of the real world Two of the most basic economic models are:  

The Circular-Flow Diagram. The Production Possibilities Frontier.

Our First Model: The Circular-Flow Diagram The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.

Summary of the circular-flow diagram: 1. Firms  

Produce and sell goods and services Hire and use factors of production

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 

Buy and consume goods and services Own and sell factors of production

3. Markets for Goods and Services  

Firms sell Households buy

4. Markets for Factors of Production  

Households sell Firms buy

5. Factors of Production  

Inputs used to produce goods and services Land, labor, and capital

Our Second Model: The Production Possibilities Frontier The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Concepts illustrated by the Production Possibilities Frontier are: 

Efficiency

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An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available. Points on (rather than inside) the production possibilities frontier represent efficient levels of production. When the economy is producing at such a point, say point A, there is no way to produce more of one good without producing less of the other. Point D represents an inefficient outcome. 

Tradeoffs

The production possibilities frontier shows one trade-off that society faces. Once we have reached the efficient points on the frontier, the only way of producing more of one good is to produce less of the other. When the economy moves from point A to point B, for instance, society produces 100 more cars but at the expense of producing 200 fewer computers. 

Opportunity Cost

The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good. When society moves from point A to point B, it gives up 200 computers to get 100 additional cars. That is, at point A, the opportunity cost of 100 cars is 200 computers. Put another way, the opportunity cost of each car is two computers. Notice that the opportunity cost of a car equals the slope of the production possibilities frontier. 

Economic Growth

Society can move production from a point on the old frontier to a point on the new frontier. Which point it chooses depends on its preferences for the two goods. In this example, society moves from point A to point G, enjoying more computers (2,300 instead of 2,200) and more cars (650 instead of 600).

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Microeconomics and Macroeconomics The main differences between microeconomics and microeconomics can be summarized as following: 



Microeconomics focuses on the individual parts of the economy, for example how households and firms make decisions and how they interact in specific markets Macroeconomics looks at the economy as a whole, dealing with economy-wide phenomena, including inflation, unemployment, and economic growth

THE ECONOMIST AS A POLICY ADVISOR  

When economists are trying to explain the world, they are scientists When economists are trying to change the world, they are policy advisor

Positive versus Normative Analysis Statements about the world come in two types:  

Positive statements are statements that attempt to describe the world as it is, the analysis upon positive statement is descriptive Normative statements are statements about how the world should be or ought to be, the analysis upon normative statement is prescriptive

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Why Economists Disagree Two basic reasons: 

They may disagree about the validity of alternative positive theories about how the world works. Economics is a young science, and there is still much to be learned. Economists sometimes disagree because they have different hunches about the validity of alternative theories or about the size of important parameters that measure how economic variables are related.



They may have different values and, therefore, different normative views about what policy should try to accomplish. Policies cannot be judged on scientific grounds alone. Economists give conflicting advice sometimes because they have different values.

Perception versus Reality The differences in scientific judgments and differences in values create some disagreement among economists. Table 1 below contains 20 propositions about economic policy. Following surveys conducted among professional economists, the table summarizes the consensus among public.

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Additional Questions: Q: Draw and explain a production possibilities frontier for an economy that produces milk and cookies. What happens to this frontier if disease kills half of the economy’s cows? A: Figure below shows a production possibilities frontier between milk and cookies (PPFJ). If a disease kills half of the economy's cow population, less milk production is possible, so the PPF shifts inward (PPF)). Note that if the economy produces all cookies, so it doesn't need any cows, then production is unaffected. But if the economy produces any milk at all, then there will be less production possible after the disease hits.

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Q: The first principle of economics discussed in Chapter 1 is that people face tradeoffs. Use a production possibilities frontier to illustrate society’s trade-off between two “goods”—a clean environment and the quantity of industrial output. What do you suppose determines the shape and position of the frontier? Show what happens to the frontier if engineers develop a new way of producing electricity that emits fewer pollutants. A: See figure below. The shape and position of the frontier depend on how costly it is to maintain a clean environment-the productivity of the environmental industry. Gains in environmental productivity, such as the development of a noemission auto engine, lead to shifts of the production-possibilities frontier, like the shift from PPFJ to PPF) shown in the figure.

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3. Interdependence and the Gains from Trade Economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members. Every day, people rely on others to provide them with the goods and services. Such interdependence is possible because people trade with one another. However, the others providing you goods and services are not acting out of generosity. They provide consumers with the goods and services they produce because they get something in return. One of the Ten Principles of Economics highlighted in Chapter 1 is that trade can make everyone better off. In this chapter, this principle is examined more closely, what people exactly gain when they trade with one another and why people choose to become interdependent. A PARABLE FOR MODERN ECONOMY Imagine that in this world exist:  

only two goods: potatoes and meat only two people: a potato farmer and a cattle rancher

Production Possibilities Suppose that the farmer and the rancher each work 8 hours per day and can devote this time to growing potatoes, raising cattle, or a combination of the two. The table in Figure 1 shows the amount of time each person requires to produce 1 ounce of each good. The last two columns in the table show the amounts of meat or potatoes the farmer and rancher can produce if they work an 8-hour day producing only that good. By choosing for self-sufficiency and ignoring each other:   

Each consumes what they each produce The production possibilities frontier is also the consumption possibilities frontier Without trade, economic gains are diminished

The two graphs in Figure 1, panel (b) and panel (c), show the production possibilities frontier for both the farmer and the rancher. These production possibilities frontiers are useful in showing the trade-offs that the farmer and rancher face, but they do not © StuDocu.com 14

tell us what the farmer and rancher will actually choose to do.

Specialization and Trade Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other. Figure 2 shows and summarizes what the farmer and the rancher can gain from specialization and trade. The farme...