Introduction To Macroeconomics PDF

1. Introduction 1. What is Macroeconomics? a) What is Economics? Economics is the study of the allocation of scarce resources An allocation is an answer to the question: What is produced how and for whom in an economy? (1) What? Which goods and services do peopl...

1. Introduction 1. What is Macroeconomics? a) What is Economics? Economics is the study of the allocation of scarce resources An allocation is an answer to the question: What is produced how and for whom in an economy? (1) What? Which goods and services do people demand ⇒ Preferences (2) How? How do firms produce ⇒ Production Process (3) For Whom? Who gets the goods and services? ⇒ (Re-)Distribution ECON 102 Page 1  b) What are Micro- and Macroeconomics? Microeconomics is the study of how individual decision-makers (economic agents) such as consumers, workers, or firms allocate scarce resources as well as their interaction in markets. Macroeconomics is the study of economic aggregates such as economic growth, inflation and unemployment as well as entire economic systems. Note: Macroeconomics builds upon microeconomics Microeconomics Macroeconomics  Individual income  Total income in the country  Quantity of products a  Total output produced by all business produces business  Spending of a household of  Total Spending across all company households, businesses and the government ECON 102 Page 2  2. The Science of Macroeconomics a) Positive vs. Normative Analysis Positive Analysis Normative Analysis ⇒ positive analysis describes the ⇒ normative analysis describes world objectively and fact-based. the world the way it should be. Positive statements do not have Normative statements are to be true, but they do need opinion based, so they cannot to be statements that can be be proved or disproved validated as correct or incorrect Examples: We should increase spending on education Economic theory clearly tells us that we should increase spending on education There is a significant relationship between a country's spending on human capital and its economic growth If a country spends more on human capital, it causes faster economic growth Because human capital increases economic growth, developing countries should spend more on human capital ECON 102 Page 3  b) Economic Models Economic Models are simplified versions of reality that are used to analyze real-world situations. Models… □ leave out irrelevant details □ are goal-oriented □ explicitly name their assumptions □ often expressed in mathematical terms to be precise and transparent  Economic models can be thought of as maps of reality "All models are wrong, but some are useful" (George Box, 1976) Note: Social science is "messier" than natural science. Using a model for prediction can change the predicted outcome. ECON 102 Page 4 c) The Scientific Method (Karl Popper, 1934) Revision Falsification Testable Theory Prediction repeat Consistent Testable Prediction Consistent Testable Prediction Consistent Theory becomes part of scientific consensus ECON 102 Page 5  3. The History of Macroeconomics Market Sceptics Government Sceptics 1870 Classical Economics  Inflation & Interest (Wicksel, 1898)  Quantity Theory (Fisher, 1911)  Founding of NBER (Mitchel, 1920) Irving Fisher  Business Cycles (Kuznets, 1930) 1936 The Keynesian Revolution  "The General Theory of Employment, Interest, and Money" John Maynard Keynes  Response to Great Depression (1929-1939)  Effective (Aggregate) Demand  Consumption, Income, and Multiplier Effects  Liquidity Preference for Money  Countercyclical Fiscal Policy 1950 Neoclassical Synthesis Milton Friedman  Refinement and mathematical formulation of Keynes' theories Monetarism 1960  IS-LM model (Hicks, 1937)  Restatement of  "Foundations of Economic Analysis" Quantity Theory (Samuelson, 1947) (Friedman, 1958)  Investment (Tobin, 1966)  Money Supply  Solow Model (1956) (F./Schwarz, 1963) ECON 102 Page 6   Discovery of the Phillips Curve  Expectations- (Phillips, 1958) adjusted Phillips Curve (Phelps, 1968) 1970 New Keynesian Economics New Classical Economics  Sticky Wages (Fisher 1977)  Rational Expectations  Sticky Prices (Calvo 1983) (Lucas, 1972) Robert E. Lucas  Coordination Failure  Policy Ineffectiveness 1980 Olivier (Diamond, 1982) (Sargent, 1975) Blanchard  Monopolistic Competition  Lucas Critique (Lucas, 1976) (Blanchard, Kiyotaki, 1987)  Real Business Cycle Theory (Kydland, Prescott, 1982) 1990 New Neoclassical Synthesis  The New Keynesian Model (Clarida, Gali, Gertler, 1999) Jordi Gali ⇒ RBC + sticky prices + monopolistic competition 2007/  Great Moderation (until 2008) 2008  Financial Frictions (Bernanke, 1998) Challenge to current paradigm: now  Behavioural Macroeconomics ECON 102 Page 7  a) Classical Economics (Pre-1940) "Intellectual Witch's Brew: many ingredients, some of them exotic, many insights, but also a great deal of confusion" (Olivier Blanchard, 2000) Prevalent Paradigm: ► Flexible prices ► Quantity theory: Money and Prices are proportional ► Say's Law: Supply creates its own demand b) The Keynesian Revolution (1936) The General Theory of Employment, Interest and Money (John Maynard Keynes, 1936) "It is a badly written book, poorly organized; […] Flashes of insight and intuition intersperse tedious algebra. […] its analysis is found to be obvious and at the same time new. In short, it is a work of genius." (Paul Samuelson, 1946)  General Equilibrium in three markets: goods, financial and labour  In the short run, output is determined by aggregate demand  In the long run we are all dead ECON 102 Page 8  c) The Neoclassical Synthesis (1940-1960) A refinement, mathematical formulation, and expansion of Keynes' ideas ► The golden age of macroeconomics "We are all Keynesians now" (Richard Nixon, 1971) The US Phillips Curve 1960-1969 Prevalent Paradigm: ► Prices are rigid in the short run ► Recessions are due to shortfalls in demand ► Countercyclical fiscal policy can manage the business cycle ECON 102 Page 9  d) The Monetarist Counter Revolution ► Focus on the money supply "Inflation is always and everywhere a monetary phenomenon" (Milton Friedman, 1963) Friedman predicted the collapse of the Phillips Curve as people adjust their inflation expectations… … and that's exactly what happened Stagflation is a recession caused by supply side factors ECON 102 Page 10  e) New Classical Economics (1970-2000) Lucas Critique: Economic (policy) predictions are invalid if they don't account for the endogenous change in behaviour Policy Ineffectiveness: Monetary and fiscal policy are ineffective people will reflect policy changes in their expectations and adjust their behaviour accordingly. Time to Build and Aggregate Fluctuations, Kydland and Precsott, 1982 Prevalent Paradigm: ► People are rational ► Recessions are optimal responses to exogenous changes ► Monetary and fiscal policy are neutral ► Recommendation of rule-based monetary and fiscal Policy ECON 102 Page 11 f) New Keynesian Economics (1970-2000) ► Focus on disequilibrium and Market imperfections Nominal Rigidity ⇒ Prices adjust slowly Why are Prices Sticky?, Alan Blinder, 1992 Real Rigidity ⇒ Markets are not perfectly competitive g) The New Neoclassical Synthesis (2000-now) Prevalent Paradigm: ► Monetary and fiscal non-neutrality ► Independent and inflation-targeting monetary policy ► Fiscal policy should focus on redistribution ► Countercyclical fiscal policy can manage the business cycle ECON 102 Page 12