Introduction To Macroeconomics - Winter 2025 PDF

Concepts, Definitions and Preliminaries Introduction to Macroeconomics - Winter 2025 Jean-Paul Lam1 January 3, 2025 1 These lecture notes are the property of the author. They are intended for the Econ...

Concepts, Definitions and Preliminaries Introduction to Macroeconomics - Winter 2025 Jean-Paul Lam1 January 3, 2025 1 These lecture notes are the property of the author. They are intended for the Econ 102 class and can only be used and shared with students registered in the class. You cannot reproduce these notes with the intent of distributing them to anyone not registered in this course or online for and not for profit without my written consent. 1 / 77  Learning objectives By the end of the lecture, you should understand: 1 What the terms scarcity, trade-off, Pareto efficiency, equity, and marginal cost and benefit mean 2 The difference between comparative and absolute advantage and why they are important concepts 3 The importance of macro models and why economists use models 4 The difference between procyclical, countercyclical, leading and lagging variables 2 / 77  What is economics? Economics is the study of how people make choices when faced with scarce resources and the results of these choices for society. Because resources are scarce (land, labour, time, etc.) and individuals have unlimited wants; we ultimately have to make choices. This scarcity problem implies societal choices involve trade-offs with each decision carrying an opportunity cost 3 / 77  Opportunity costs For example, different entities such as individuals, firms, and government have to choose between how much of a good to consume versus another good - we face trade-offs. We have unlimited needs and wants but only a limited budget/resource For this reason we use our limited budget/resource optimally There is no such thing as a free lunch’ - costs are involved in obtaining goods or services.” 4 / 77  Understanding trade-offs Trade-offs occur when resources are scarce, forcing individuals, firms, governments, and societies to make choices Individuals and firms face trade-offs I How to allocate time: balancing leisure, work, and study I Example: Studying full-time (no job) vs. part-time (time for a job) I Ho to allocate limited resources between capital and labour Societies and governments face trade-offs I Economic growth (more pollution) vs environmental protection (less growth) I Low inflation (higher uemployment) vs high unemployment (lower inflation) in the short run 5 / 77  Equity versus efficiency Societies face trade-offs due to natural resources scarcity and sometimes societies create additional trade-offs. An example is the trade-off.between equity and efficiency Resources are allocated efficiently if society is getting the most from the scarce resources or using the scarce resources optimally Equity means that the benefits are distributed fairly among the members of society - scarce resources of society are distributed in a just manner among members of society 6 / 77  Pareto efficiency When talking about efficiency, economists often use the term Pareto efficiency or Pareto optimality. Pareto efficiency is achieved when one person cannot be made better off without making someone else worse off. Making everyone better off without hurting anyone by redistributing goods and services means that society was not at its Pareto optimal level in the first place. If an allocation is Pareto optimal, is it also equitable? 7 / 77  Single payer or private health care? U.S. Healthcare System Canadian Healthcare System Driven by market forces; Publicly funded and regulated; encourages competition and virtually no competition innovation Slower adoption of medical High-quality medical research innovations due to budget and cutting-edge technologies constraints Inequity in access: millions Universal coverage ensures uninsured or underinsured (26 equitable access to essential m) care Higher healthcare spending per Long wait times for elective capita but mixed health procedures outcomes. Would you rather have a heallthcare system based on efficiency or equity? 8 / 77  Progressive (and high) income taxes Scandinavian tax system U.S tax System Highly progressive taxes: fund Higher levels of income extensive welfare programs inequality and reduced social (parental leave, up to 480 days, safety nets (parental leave not free education for residents) guaranteed federally, high costs Promotes equity by reducing for post-secondary education) income inequality Less progressive than Potential downside: Scandinavian counterparts disincentives to work harder or Encourages entrepreneurship innovate and investment Scandinavian equity vs. U.S. efficiency: Which is more sustainable in the long term? Could the U.S. adopt Scandinavian-style progressive taxation without stifling growth? 9 / 77  Economic growth and pollution Economic growth typically driven by increased industrial activity, transportation, and urban expansion enhances a country’s standard of living, at the cost of green spaces. Increased economic activities lead to negative externalities in the form of more pollution, which is harmful to our well-being and health As a society, we face a trade-off between more economic growth (and hence living better) versus more pollution (potentially sicker). 10 / 77  Rationality Trade-offs force individuals to make choices, and often when individuals make their choices, they consider the cost and benefits of their actions. In economics, we often assume that individuals (or agents) are rational. Faced with trade-offs, rational individuals are assumed to take the best possible decision to maximize their personal gain. 11 / 77  Cost-benefit Cost-benefit analysis helps rational individuals make choices, For example, a person may drink coffee for its energizing effects, as the caffeine from coffee allows the person to work faster and produce more goods However, because caffeine has a limit on how much energy one gets, each additional cup the person drinks has diminishing returns How much coffee should the person consume, given the cost and benefits of each additional cup of coffee? Use marginal cost and marginal benefit to determine the answer 12 / 77  Cost-benefit - example Assume the following: 1 Each cup of coffee costs $1 2 The individual can produce 5 cakes daily without drinking coffee; beyond that, the individual is too tired to continue working 3 Each cake earns generate $2, therefore the total income from 5 cakes is $10 4 Drinking one cup of coffee allows the individual to make an additional cake Would the individual buy the cup of coffee? 13 / 77  Cost-benefit - example In our example, the cost of buying the cup of coffee is $1 while the benefit of doing so, that is producing an extra cake, is 1 × $2 = $2 The marginal benefit of buying the cup of coffee > the marginal cost of doing so A rational individual should buy the cup of coffee. The difference between the benefit of consuming the extra cup of coffee and its cost is known as the economic surplus. 14 / 77  Cost-benefit - example Now, let us assume that having a second cup of coffee also boosts energy and makes the individual work more. However, the boost in energy that the individual receives from drinking a second cup allows them to make only an additional 1/2 a cake Would the individual buy the second cup? 15 / 77  Cost-benefit - example In this case, the cost of buying the cup of coffee ($1 each) is precisely equal to the benefit of doing so ($1 each). Therefore, the individual will be indifferent between buying and not buying the second cup of coffee. 16 / 77  Cost-benefit - example Finally, assume that buying a third cup of coffee does not allow to individual to make any additional cake The cost of buying the extra coffee outweighs the benefits, and the rational individual will not choose to drink a third cup of coffee. We have learned that rational consumers consider the marginal cost and marginal benefit of their actions when making their decisions. 17 / 77  Marginal cost and benefit Marginal cost refers to the cost the individual encounters when buying/producing an additional unit of a good On the other hand, marginal benefit refers to the revenue/benefit the individual receives from consuming/producing an additional unit of a good In our example, the marginal cost is always $1 since this is the cost of buying an extra cup of coffee. On the other hand, the marginal benefit of the first cup of coffee is $2; it is $1 for the second cup and $0 for the third cup. 18 / 77  Marginal cost and benefit The rational individual achieves maximum satisfaction when the marginal cost equals the marginal benefit. Consumption of a good continues as long as its added benefit exceeds the additional cost, ensuring a positive economic surplus. In the example, the optimal economic surplus is attained with the purchase of 2 cups of coffee, where marginal benefit equals marginal cost. Rational agents will always equate their marginal cost to their marginal benefit; choosing a different point implies that the agent is not maximizing 19 / 77  Optimizing To see let us compute the economic surplus the individual receives. Cups of coffee Economic surplus 0 5 × $2 = $10 1 ((5 × 2) + 2) − 1 = $11 2 ((5 × 2) + 2 + 1) − 2 = $11 3 ((5 × 2) + 2 + 1 + 0) − 3 = $10. The economic surplus for one cup and two cups is the same, but since the marginal benefit equals the marginal cost at 2 cups, the worker will consume 2 cups 20 / 77  Sunk costs One thing to bear in mind when doing the cost and benefit analysis is that the only costs we should consider are those we can avoid. Costs that we cannot avoid, known as fixed or sunk costs, should not be considered when performing a cost and benefit analysis. These fixed costs are incurred regardless of how much goods are produced or how many resources are used. What matters for optimal choice/production is the marginal cost and marginal benefit. 21 / 77  Law of Diminishing Return If we consider the coffee example, we find that although each additional cup of coffee allows the worker to produce more cakes, each extra cup contributes less and less to the increase in production. This is an example of diminishing returns or, more precisely, the Law of diminishing returns (LDR). The law of diminishing return implies that as an additional unit of a factor of production is employed (in our case cup of coffee), total production first increases, reaches a maximum and eventually falls. 22 / 77 Paradox of Value - applying marginal cost and benefit Why are diamonds so expensive while water is cheap? Water is essential to sustain life on our planet, but diamonds are not. Diamonds are mostly used in the jewelry industry and have little or no use elsewhere. 23 / 77  Paradox of Value The answer lies again in the concepts of marginal cost and marginal benefit. Water is abundant compared to diamonds and agents do not value the extra amount of water they can consume very highly. In other words, the marginal benefit of an extra glass of water is extremely low Since we maximize welfare by equating marginal cost to marginal revenue or benefit, we are only prepared to pay a low price for water. 24 / 77  Paradox of Value Diamonds are very precious due to their limited supply, making each additional unit particularly valuable. In other words, the marginal benefit associated with consuming an extra amount of diamond is very high, and we are willing to pay a very high price to acquire diamonds. This contradiction is known as the Paradox of Value. 25 / 77  Opportunity cost Opportunity cost refers to the cost of the forgone alternative. In our above example, suppose that by drinking a cup of coffee, the individual can either spend his extra energy by working faster and harder (and earn more money) or go for a run The opportunity cost of going for a run is the extra revenue they would forgo by working harder. 26 / 77  Opportunity cost The concept of opportunity cost is not just limited to monetary or financial costs. It takes into account all the other costs associated with the forgone alternative. For example, the cost of attending university is not only limited to the cost of tuition and living expenses; there are also other opportunity costs There is also an opportunity cost in terms of forgone wages since the alternative to attending university on a full-time basis is a full-time job. Sometimes, opportunity cost can be hard to compute since we may not observe the cost directly or cannot compute the dollar value of the different choices. When the value is not observed or cannot be directly computed, economists use imputed value 27 / 77  Example - sunk and opportunity costs Johh bought a ticket for $40 for an exclusive art gallery opening at 7 pm. He takes a day off from his 9-4 pm job, where he earns $500 per day, to prepare for the event. Upon reaching the gallery, he receives an offer of $100 for his ticket from several art enthusiasts. What is John’s sunk cost? What is John’s opportunity cost of attending the gallery opening? 28 / 77  Comparative and absolute advantage Economic agents have different talents, abilities, skills, and experiences. As a result of our different abilities and experience, we often specialize in specific tasks and jobs. Specialization is at the core of the concepts of absolute and comparative advantage 29 / 77  Comparative and absolute advantage A person is assumed to have an absolute advantage over another person if they take fewer hours to perform the same task as the other person does. For example, If I take one hour to mow the lawn and my neighbour takes two hours to do the same job, then I have an absolute advantage over him for mowing the lawn. Does that mean that it would be better for me to mow the lawn and not my neighbour? No! The answer depends on my comparative advantage. 30 / 77  Comparative and absolute advantage Assume that my neighbour does not have many skills (apart from cutting the grass) and earns $10 an hour at his job. On the other hand, assume that I am good at my job and make $100 an hour. If this is the case, my opportunity cost of cutting the lawn is $100, whereas my neighbour’s opportunity cost of cutting the grass is only $20 ($10 × 2 hours). 31 / 77  Comparative and absolute advantage Hence by cutting the grass, I have to forgo more earnings than my neighbour Although I have an absolute advantage in mowing the lawn (I am better at it), my neighbour, however, has a comparative advantage for mowing the lawn (lower opportunity cost) The concept of comparative advantage then dictates that I should not mow my lawn even if I am better at my neighbour since my opportunity cost is higher 32 / 77  Comparative and absolute advantage Hence, an economic agent has a comparative advantage over another economic agent if their opportunity cost of performing a task is lower than the other agent’s opportunity cost. Absolute advantage involves comparing production levels, whereas comparative advantage is about opportunity costs 33 / 77 An example of comparative and absolute advantage The following table below summarizes how many cars, and trucks workers can produce in Canada and Mexico in a month given resources in each country Cars Trucks Canada 8000 4000 Mexico 4000 1000 Canada has an absolute advantage over Mexico in the production of both trucks and cars Should Canada produce both cars and trucks? 34 / 77 An example of comparative and absolute advantage To answer this question, we compute the opportunity cost of producing cars and trucks for each country 1 If Mexico produces one additional truck, then it forgoes the production of 4 cars 2 If Canada produces one additional truck, then it forgoes the production of 2 cars 3 If Mexico produces one additional car, then it forgoes the production of 1/4 truck 4 If Canada produces one additional car, then it forgoes the production of 1/2 truck 35 / 77  An example Canada, with its lower opportunity cost for trucks (2 cars vs. Mexico’s 4), holds a comparative advantage in truck production. On the other hand, Mexico’s lower opportunity cost for cars (1/4 truck vs. Canada’s 1/2) gives it a comparative advantage in car production. According to this example, Canada should specialize in the production of trucks, whereas Mexico should specialize in the production of cars. It is comparative advantage that dictates where an agent/country should specialize and not absolute advantage 36 / 77  Reasons for comparative advantage Comparative advantage may arise because of many factors: 1 Some individuals may have a comparative over other individuals because of innate talent or because of some acquired skills through education and training. 2 Countries usually possess a comparative advantage over other countries for similar reasons and because of differences in technology, resource endowments, physical and human capital, institutions, geography, climate, etc 37 / 77  Comparative Advantage: China vs. Canada China’s specialization in Canada’s specialization in natural electronics: resources: Lower labour costs and Abundant natural resources (oil, economies of scale gas, timber) Advanced manufacturing Low opportunity cost of capabilities extraction and export Investments in technology and Focuses on primary industries infrastructure that meet global energy and Produces high-demand goods material demands like smartphones, laptops, and Key trading partner for microchips countries requiring raw materials 38 / 77  PPF Comparative advantage is very important in determining which good a country should specialize in How countries or individuals specialize depends on their opportunity cost; therefore, knowing this opportunity cost is essential. The opportunity cost between two goods can be illustrated using the production possibility frontier or curve (PPF). Assume that a country can produce trucks and cars by employing land, labour, and capital and using the technology in place. 39 / 77  Shape of PPF Cars C C1 X C2 Y T1 T2 T Trucks Source: author’s example 40 / 77  Properties of the PPF The PPF shows the various combinations of cars and trucks that the economy can produce, given the resources and technology in place. At point C, only cars are made, and no trucks are built when all the resources are employed At point T, only trucks are made, and no cars are produced when all the resources are employed If resources are allocated to the production of both cars and trucks, then the economy can be at a point such as X or at point Y 41 / 77  Properties of the PPF The PPF is concave to the origin and its shape comes from the assumption of diminishing returns. As more and more factors of production are transferred from cars to trucks; the first transfer is very productive, then the next one is less productive and so on. To increase the production of cars by the same amount every time, more and more trucks have to be sacrificed everytime. In this case, the opportunity cost of producing more trucks (in terms of cars) is increasing 42 / 77  Diminishing returns Cars C C0 W R C1 X C2 Y V C3 Z T O T0 T1 T2T3 Trucks Source: author’s example 43 / 77  Properties of the PPF W , X , Y and Z or any point along the PPF are efficient or productively efficient allocations since they use all available resources These points are Pareto efficient since no one can be made better off without making else worse off. Points within the PPF such as point V are not efficient given the available resources and existing technology; everyone can be made better off by moving to a production point on the PPF Points outside the PPF such as point R would make everyone better off but are unattainable given the existing resources and existing technology 44 / 77  Properties of the PPF Using the points along the PPF, we can easily calculate the opportunity cost of building more cars. The amount of trucks we have to give up to produce one additional car is the opportunity cost of producing more cars. In our case, moving from point Z to point Y implies that the production of cars increases from OC3 to OC2. On the other hand, the production of trucks falls from OT3 to OT2. Therefore the opportunity cost of cars in terms of trucks at point Z 3 −OT2 = OT OC2 −OC3. The opportunity cost increases every time we increase the production of cars 45 / 77  Properties of the PPF Diminishing returns implies that to increase the production of cars by 1 unit, we have to give up more and more trucks Constant returns to scale (CRS), on the other hand, implies that every time the same amount of trucks has to be sacrificed to increase the production of cars by the same amount Increasing returns implies that to increase the production of cars by 1 unit, we have to give up less and less trucks 46 / 77  Properties of the PPF Cars Trucks Decreasing Returns Constant Returns Increasing Returns 47 / 77  Movement in the PPF A movement along the PPF implies an efficient reallocation of resources, assuming that the state of technology and population does not change 48 / 77  Shift in the PPF The PPF will shift (outward) if any of the following occurs: 1 There is an improvement in the state of technology that makes all factors of production more productive 2 Workers acquire skills through education and training; this labour technological progress implies that each worker becomes more productive 3 Population changes; more workers increase the amount and capacity of goods and services an economy can produce 4 An increase in the capital-labour ratio (for example, more machines for the same amount of workers) 49 / 77  Shift in PPF Cars C1 C0 Technological progress O T0 T1 Trucks Source: author’s example 50 / 77  What is macroeconomics? Macroeconomics, unlike microeconomics, focuses on the entire economy rather than on individuals and firms. The entire economy is often referred to as the aggregate economy. Macroeconomics is thus concerned with aggregate outcomes and not outcomes faced by individuals or firms. That said, how individuals, firms, the government and other economic agents behave in their everyday life is extremely important since it ultimately affects the aggregate economy. 51 / 77  Macroeconomics Macroeconomists are interested in various issues; in particular in explaining economic fluctuations and economic growth Economic fluctuations or business cycles are the ups and downs that an economy experiences in the short and medium run. The study of economic growth refers to how the economy is behaving in the long-run Economists also study many other issues related to the behaviour of the economy in the short and long run; unemployment, productivity, trade, financial markets, the role of governments and central banks, etc.. 52 / 77  Macro models Macroeconomists rely on economic models (theoretical and empirical) to explain the behaviour of economic agents and understand the macroeconomy. Models vary in size and complexity and are used as tools to conduct policy simulations. Models can range from simple containing few equations to more complex and elaborate ones with hundreds of equations. Macroeconomists often rely on models to explain economic events, do counterfactual, and perform policy experiment 53 / 77  Macro models Models are like maps; they come in various forms and sizes, focus on a large area or a particular area and are helpful for certain areas only. For example, you would not look at the map of Toronto to travel around Waterloo. Similarly, economists do not use a model of inflation to explain budget deficits. 54 / 77  Macro models Usually, macroeconomists rely on different models to answer the same or different questions. This is because we are uncertain about which model may be the correct representation of the economy. Hence in the face of model uncertainty, economists rely on models that use different approaches and with different assumptions built-in Most macro models typically assume that economic agents are rational. 55 / 77  Macro models Models are used for various reasons: 1 For policy analysis and counterfactuals - Economists can’t perform real-world experiments, and models are often their only way to test different policies or do counterfactuals, that is, what if scenarios 2 To make predictions or forecasts about the future, especially about the three crucial aggregate variables (output, unemployment and inflation). 3 To understand and test economic theory and how economic agents behave 56 / 77  Microfoundations Although models vary in complexity and size, many of them have the same building blocks at their core. The dominant framework or model that macroeconomists use nowadays is deeply rooted in what we call microfoundations. Although macroeconomics studies the aggregate economy, macroeconomists have to understand how individual agents optimize and react to certain events because macroeconomic events arise from the interactions of agents 57 / 77  Microfoundations In other words, macroeconomists have to understand the behaviour of the economy’s agents (mostly households and firms) at the micro-level. We need to comprehend how consumers, firms, financial agents, and the government optimize given their constraints to understand the macroeconomy Hence models are often built from the bottom-up. We start by modelling agents’ behaviour at the micro-level (household, firms, banks and the government, etc..), and we then aggregate or add everything up. 58 / 77  Microfoundations Most models assume that agents are rational (that is, taking the best possible decision given their constraints) and are thus optimizing. In building macro models, we often use the assumption of a representative agent. That is, we assume that all agents are identical, and one agent can represent all the other agents in the economy. This assumption, although questionable, reduces the complexity of models and makes aggregation much easier. Because of the limitations of representative agent models, macroeconomists also use models where agents are assumed to be heterogeneous (different). 59 / 77  Endogenous and exogenous variables Models contain variables that can be classified as endogenous and exogenous. An endogenous variable is determined within the model; the solution or path of an endogenous variable depends on other variables of the model A variable is exogenous if its value is determined outside the model, and its path does not depend on the other variables of the model 60 / 77  Endogenous and exogenous variables For example, in the demand and supply model, price and quantity are both endogenous, whereas changes in the weather, a war, an external shock, and changes in tastes and preferences are all examples of exogenous variables Changes in the exogenous variables affect the value of the endogenous variables and not vice-versa 61 / 77  Macro indicators Although macroeconomists focus on many different kinds of data, they pay particular attention to three main measures of the economy. 1 GDP or aggregate output, and the rate at which it is growing. 2 The unemployment rate, that is the proportion of workers in the economy who do not have a job but are seeking one. 3 The inflation rate, that is the rate at which overall prices are growing over time. 62 / 77  Macro indicators Recent data shows that real gross domestic product (GDP) in Canada grew at 1.7% (annualized rate) in the first quarter of 2024, following a 0.1% increase in 2023Q4. The July 2024 unemployment rate was at 6.4% unchanged compared to the previous month The inflation rate (year over year) was at 2.7 % June 2024 compared to 2.9% in May 2024 63 / 77  Positive correlation When macroeconomists use macro-data, they often analyze how the data behaves over time and how the different variables are correlated with each other Variable X is positively correlated with variable Y if as X increases (decreases), Y also increases (decreases) For example, meat consumption per capita and GDP per capita are positively correlated Meat consumption and GDP per capita 64 / 77 Meat consumption and GDP per capita 65 / 77  Negative correlation Variable X is negatively correlated with variable Y if they move in opposite directions For example, maternal mortality and GDP per capita are negatively correlated Maternal mortality Variable X correlation with variable Y is zero if changes in one of them do not affect the other 66 / 77 Maternal mortality and GDP per capita 67 / 77  Deviations from trend Many macro variables have long-run trends; that is, they tend to increase or decrease over time Economists are very interested in the long-run trend of a macro variable because it tells them where the variable is heading over time in the absence of shocks Economists are also very interested in the deviations of the variable from its long-run trend since this information allows them to evaluate whether the variable is above or below its long-run growth path Because the trend of a variable is not directly observed, economists have to make some assumptions about whether the trend of the variable is linear or not, constant or time-varying 68 / 77  Deviations from trend Once we assume the trend of a variable, economists often calculate the deviations of the variable from its trend For example, economists often compare the path of GDP with its long-run trend since they want to know how well the economy is doing compared to its potential long-run growth path If actual GDP is persistently below (above) its long-run trend growth rate, economists would often denote this as a recession (expansion) 69 / 77 Deviations from trend GDP Trend GDP Expansion Recession Time Source: author’s example 70 / 77  Procyclical and countercyclical A variable is procyclical if its deviations from trend are positively correlated with GDP or their growth rates of GDP are positively correlated A countercyclical variable is negatively correlated with the deviations of GDP from trend, or their growth rates of GDP are negatively correlated A variable is acyclical if it is not procyclical nor countercyclical. 71 / 77  Procyclical Deviation from trend Y X Time Source: author’s example 72 / 77  Countercyclical Y Deviation from trend Time X Source: author’s example 73 / 77  Leading and lagging variables An economic variable is a leading indicator if it changes before GDP; that is, it increases or decreases before GDP does Some examples of leading indicators include the volume of new orders for goods, stock market indices, consumer confidence, the yield curve, new building permits An economic variable is a lagging indicator if it changes after GDP; that is, it increases or decreases after GDP does Some examples of lagging indicator includes the unemployment rate, balance of trade, corporate profits, unit labour cost 74 / 77  Stock market as a leading variable Deviation from trend Time Stockmarket GDP Source: author’s example 75 / 77  Unemployment as a lagging variable Deviation from trend Time GDP Unemployment Source: author’s example 76 / 77  Conclusion and what we learned This lecture is a recap of many concepts you learned in microeconomics and introduce some new ones We will use many of the concepts we have learned in future lectures As rational economic agents, we face trade-offs, and we use scarce resources efficiently Economic agents specialize in areas where they have a comparative advantage, that is, where their opportunity cost is minimized In the following lectures, we focus on some of the most important macro aggregates 77 / 77