Introduction to Economics: Micro & Macro Concepts

Introduction to Economics

• Economics is a social science that studies how scarce resources are allocated among different uses.

Economic Theory

• Microeconomics and Macroeconomics are two major branches of economic theory.

Microeconomics

• Focuses on the behavior of individual economic units, such as consumers, households, firms, and industries.
• Examples include how a consumer allocates income for goods and services, or determining a firm's profit-maximizing level.

Macroeconomics

• Examines the economy as a whole.
• Includes topics such as economic growth, booms and recessions, inflation, unemployment, balance of payments, and the business cycle.
• Macroeconomics studies the structure and performance of national economies, and the government policies that influence economic performance.

Goals of Macroeconomic Policy

• The primary objective is to influence economic performance to achieve:
  • Full employment: Using all available resources efficiently. High unemployment reduces output and negatively impacts those with low incomes.
  • Price stability: Maintaining a constant price level. A rise in price level (inflation) negatively impacts pensioners and lenders.
  • Economic growth: A rise in real output more rapidly than population growth. This increases the availability of goods and services and hence standard of living.
  • External balance: A summary of all economic transactions between households, firms and government of one country and the rest of the world in a given period of time. Exports increase and imports decrease a nation's external balance. Capital outflows decrease and capital inflows increase a nation's external balance.

Phases of the Business Cycle

• Inflation, growth and unemployment are related through the business cycle.
• The business cycle is a recurring pattern of expansion (recovery) and contraction (recession) of economic activity.
• A peak is when business activity reaches a temporary maximum with full employment and near capacity output. Prices are likely to rise during a peak.
• A recession is a decline in total output, income, employment, and trade lasting six months or more.
• The trough is the bottom of the recession period, where employment and output are at their lowest levels.

Relationship between GDP and Unemployment: Okun's Law

• Okun's Law describes a negative relationship between GDP gap and unemployment rate.

Schools of Macroeconomic Thought: Classical Economics

• First school of economic thought, based on Adam Smith's ideas.
• Believes markets can regulate themselves without intervention. There is an automatic mechanism ('invisible hand') that moves toward natural equilibrium.
• Assumptions:
  • Flexible prices: Prices of all goods and services are mobile; rising or falling to accommodate supply and demand.
  • Say's Law: Supply creates its own demand. This means that output will generate sufficient income for that to be spent, hence aggregate supply equals aggregate demand. Any imbalance is temporary.
  • Savings and Investment Equality: Household savings equal capital investment expenditures.

Schools of Macroeconomic Thought: Classical Economics – Assumptions continued

• Rational thinking: People make rational choices between options.
• Maximizing: Consumers aim to maximize utility, while businesses aim to maximize profits.
• Information: People act independently with all relevant information when making choices.
• Summary: Classical theory advocates laissez-faire capitalism, where business cycles are natural adjustment processes and government intervention isn't needed.

Classical Money Market

• If some income isn't consumed immediately, it enters the money market saving.
• This subsequently leads to investment to compensate, ensuring saving isn't idle and the market adjusts according to interest rates.

Price and Wage Flexibility

• Classical theory proposes all markets reequilibrate due to flexible prices and wages.
• If there is excess labor or products, wages or prices will change to absorb the excess.

Involuntary Unemployment

• Classical theory: No involuntary unemployment because adjustments in wages hire the unemployed, and workers accept even lower wages to buy goods.

Criticism of Neo Classical Theory

• Critique of classical economics: Classical approach cannot fairly describe actual economies. The assumption that consumers always act rationally ignores individual vulnerabilities, emotional responses, and realities of resource distribution, which is not equal for all.
• Distributing resources is uneven, especially between those who earn income from labor and those who earn income from capital.

Additional Criticisms of Neo Classical Theory

• Appropriation of resources: Resources are often taken over by businesses, or those with economic or military power.
• Available choices: People have limited choices, and choices often come with difficulties. Ex: Choosing between dangerous jobs or losing a house.
• Irrational decisions: People may not always make the best decision or only consider their own benefit.
• Pursuit of profit: Maximizing profit is not always the best for markets and can exacerbate inequality, exploit workers, damage the environment.

Keynesian School of Thought

• Argues that there is no invisible hand, and hence government intervention is needed to ensure stable economies.

Keynesian Assumptions

• Rigid/Inflexible prices: Prices adjust differently to changes in supply and demand and this leads to surpluses or shortages.
• Effective Demand: A fraction of household income is used for consumption.
• Savings and Investment Determinants: Other factors besides interest rates determine savings and investment, such as disposable income and future desires to save.

Classical versus Keynesian Dispute

• Disagreement over the speed at which wages and prices adjust. Classicalists argue that prices quickly adjust to rebalance markets. Keynesians argue that wages and prices are sticky and require government intervention.

Keynesian approach

Government actions (such as purchasing goods and services) can increase aggregate demand and stimulate the economy. This can correct periods of unemployment.

Keynesian Savings/Investments Plans

• Savers and investors operate separately. Banks mediate between them. A liquidity trap exists when investors lack a clear outlook on market behavior and hence are reluctant to take on investments. Saving tends to be idle.

Keynesian Price/Wage Rigidity

• Keynes argues that wages are sticky (and inflexible) on the down side. Wage cuts won't reduce unemployment. Hence, unions need to protect worker wages, even in times of recession. Firms also tend to cut production before cutting prices (when demand is low).

Aggregate Demand

• Aggregate demand is the summation of the total amount of goods and services households are willing and able to buy at different price levels.

Real Balance Effect & Aggregate Demand

• Aggregate Demand curves generally are downsloping. This is because of the relation between prices and purchasing power of monetary assets. When prices are high compared to average prices, purchasing power of assets is reduced. People will then tend to buy less.

Aggregate supply

• Aggregate supply is composed of three sections: (i) classical range which is vertical, (ii) Keynesian range which is horizontal, and (iii) the intermediate range which is upsloping.

Classical Aggregate supply range

• Vertical, as prices will adjust to ensure full employment. Any increased demand will just create inflation without affecting production levels.

Keynesian Aggregate supply range

• Horizontal as prices are low. Hence, increasing demand will increase production and employment without increasing prices.

Intermediate range of Aggregate supply

• Upsloping, as higher demands will increase prices which lead to higher outputs and hence bottlenecks.

Aggregate demand policies

• If the economy is in recession (low output and high unemployment), government policies aim to boost demand.
• If the economy is overheating (high inflation), government policies aim to slow it down. These policies may involve spending and tax changes.

Supply-side policies

• Supply-side policies aim to increase aggregate supply.
• Policies such as cutting production costs would mitigate the effects of stagflation (high inflation and low output).

Next topic

• National Income Accounting