Prelim Lecture in Macroeconomics PDF

Prelim Lecture in Macroeconomics Prepared by: Engr. Emmanuel A. Camba  Chapter 1 Introduction to Macroeconomics Macroeconomics  3 Origin of the word “Economics” The two Greek roots of the word economics are oikos...

Prelim Lecture in Macroeconomics Prepared by: Engr. Emmanuel A. Camba  Chapter 1 Introduction to Macroeconomics Macroeconomics  3 Origin of the word “Economics” The two Greek roots of the word economics are oikos – meaning household – and nomus – meaning system or management. Oikonomia or oikonomus therefore means the “management of household”  4 Introduction to Economics Economics is one of those words that seems to be constantly in the newspapers and on television news shows. Most people have some vague idea of what the word economics means, but precise definitions generally require some academic exposure to the subject. Economics is the study of the allocation of SCARCE resources to meet UNLIMITED human wants. In other words, economics is the study of human behavior as it pertains to the material well-being of people (as either individuals or societies).  5 Introduction to Economics Robert Heilbroner describes economics as a "Worldly Philosophy“. It is the organized examination of how, why and for what purposes people conduct their day-to-day activities, particularly as relates to the production of goods and services, the accumulation of wealth, earning incomes, spending their resources, and saving for future consumption.  6 “ Two categories of Economics 1. Microeconomics 2. Macroeconomics  7 Microeconomics Microeconomics is concerned with decision- making by individual economic agents such as firms and consumers. In other words, microeconomics is concerned with the behavior of individuals or groups organized into firms, industries, unions, and other identifiable agents.  8 Macroeconomics Macroeconomics is concerned with the aggregate performance of the entire economic system. Unemployment, inflation, growth, balance of trade, and business cycles are the topics that occupy most of the attention of students of macroeconomics.  9 Methods in Economics Economists seek to understand the behavior of people and economic systems using scientific methods. These scientific endeavors can be classified into two categories, (1) economic theory and (2) empirical economics. Economic theory relies upon principles to analyze behavior of economic agents. These theories are typically rigorous mathematical models (abstract representations) of behavior. A good theory is one that accurately predicts future behavior and is consistent with the available evidence.  10 Methods in Economics Empirical economics relies upon facts to present a description of economic activity. Empirical economics is used to test and refine theoretical economics, based on tests of economic theory. The tests that are typically applied to economic theories are statistically based, and is generally called econometric methods.  11 Two forms of Logic Sociology, psychology and anthropology typically rely on inductive logic to create theory. Inductive logic creates principles from observation. In other words, the scientist will observe evidence and attempt to create a principle or a theory based on any consistencies that may be observed in the evidence. Economics relies primarily on deductive logic to create theory. Deductive logic involves formulating and testing hypotheses. Often the theory that will be tested comes form inductive logic or sometime informed guesswork.  12 Ceteris Paribus One assumption frequently used in economics is ceteris paribus which means all other things equal (notice that economists, like lawyers and doctors will use Latin to express rather simple ideas). This assumption is used to eliminate all sources of variation in the model except for those sources under examination (not very realistic!).  13 Economic Goals, Policy, and Reality Economics can be again classified into positive and normative economics. Positive economics is concerned with what is; and normative economics is concerned with what should be. Economic goals are examples of normative economics. Evidence concerning economic performance or achievement of goals falls within the domain of positive economics.  14 Economic Goals, Policy, and Reality Most nations have established broad social goals that involve economic issues. The types of goals a society adopts depends very much on the stage of economic development, system of government, and societal norms. Most societies will adopt one or more of the following goals: 1. economic efficiency 2. economic growth 3. economic freedom 4. economic security 5. an equitable distribution of income 6. full employment 7. price level stability 8. a reasonable balance of trade.  15 Policy Policy can be generally classified into two categories, public and private policy. The formulation of public and private policy is the creation of guidelines, regulations, or law designed to effect the accomplishment of specific economic (or other) goals. Public policy is how national economic goals are pursued. In the private sector, policy formulation means the creation of rules, regulations and procedures to guide the operation of the company. Therefore, to understand goals one needs to understand something of the process of formulating policy.  16 Steps in formulating policy: 1. Stating goals - must be measurable with specific stated objective to be accomplished. 2. Options - identify the various actions that will accomplish the stated goals & select one, and 3. Evaluation - gather and analyze evidence to determine whether policy was effective in accomplishing goal, if not reexamine options and select option most likely to be effective.  17 Both the public and private policy formulation process are dynamic processes. Economic goals change with public opinion and with the achievement or failure of certain elements of policy. Step 1 involves the setting of goals. Often this is based on little more than stating value judgments, but the statement of goals should be based on informed opinion (which requires the gathering and analyzing of evidence concerning the effects of the goal on other economic activities, and the expected results of the goal). Step 2 involves selecting the appropriate model and the options associated with that model to accomplish the specified goal. The final step involves the implementation of the policies designed to accomplish the goal and the monitoring of progress toward accomplishing that goal.  18 The 3 Es of Economics In the production of goods and services there are three Es that need to be considered. These are efficiency, effectiveness, and equity. 1. Efficiency - refers to productivity and proper allocation of economic resources. It also refers to the relationship between scarce factor input and output of goods and services. This relationship can be measured in physical terms (technological efficiency) or cost terms (economic efficiency) (Pass & Lowes 1993). Being efficient in the production and allocation of goods and services saves time, money, and increases the firm’s or economy’s level of output. For instance, in the production of a commodity, a firm or economy utilizing modern technology can improve the quantity and quality of its products, which ultimately translates into an increase in the revenue and profits or economic growth.  19 The 3 Es of Economics 2. Effectiveness means attainment of goals and objectives. Economics therefore is an important and functional tool that can be utilized by other fields. For instance, with the use of both means of production such as manual labor and technological advancement, whatever the output is, being effective will enable firms to address the consumption needs of society and the rest of the world.  20 The 3 Es of Economics 3. Equity means justice and fairness. Thus, while technological advancement may increase production, it can also bear disadvantages to the employment of workers. Due to the presence of new equipment and machineries, manual labor may no longer be necessary, and this can result in the retrenchment or displacement of workers.  21 “ Positive and Normative Economics  22 Positive Economics Positive economics is an economic analysis that considers economic conditions “as they are”, or considers economics “as it is”. It uses objective or scientific explanation in analyzing the different transactions in the economy. It simply answers the question ‘what is’ Examples of Positive statements:  The economy is now experiencing a slowdown because of too much politicking and corruption in the government.  The economy is now on a slowdown because the world is experiencing financial and economic crisis. Other reasons are also due to the financial problems of the US, higher crude oil prices in the international market and the lack of investment capital.  23 Positive Economics Normative economics is an economic analysis which judges economic conditions “as it should be”. It is that aspect of economics that is concerned with human welfare. It deals with ethics, personal value judgments and obligations analyzing economic phenomena (Kapur 1997). It answers the question ‘what should be’. It is also referred to as policy economics because it deals with the formulation of policies to regulate economic activities (Omas-as 2008). Examples of Normative statements:  The Philippine government should initiate political reforms in order to regain investor confidence, and consequently uplift the economy.  In order to minimize the effect of global recession, the Philippine government should release a stimulus package geared towards  24 Positive vs Normative Economics  25 “ Types of Economics Systems  26 Traditional Economy Traditional economy is basically a Subsistence economy. An individual or a family produces goods and services only for his or his own family’s consumption. The decisions on what, how, how much, and for whom to produce are made by him or the family head, in accordance with traditional: means of production. In a traditional economy, therefore, each individual member produces whatever good or service he or his family needs or wants with no or little concern of the needs and wants of the other members of the economy.  27 Command Economy Command economy is a type of economy wherein the manner of production is dictated by the government. The government decides on what, how, how much, and for whom to produce. It is an economic system characterized by collective ownership of all resources, and the existence of a central planning agency of the state — the government. In this system, productive enterprises are owned. by the government and administered by the state while distribution of the goods and services are also done by the government.  28 Market Economy Market economy or capitalism’s basic characteristic is that the resources are privately owned, and that the people themselves make the decisions. It is an economic system wherein most economic decisions and means of production are made by the private owners. Under this economic system, factors of production are owned and controlled by individuals, and people are free to produce goods and services to meet the demand of consumers, who, in turn, are also free: to choose goods according to their own likes.  29 Socialism Socialism is an economic system wherein key enterprises are owned by the state. In this system, private ownership is recognized. However, the state has control over a large portion of capital assets, and is generally responsible for the production and distribution of important goods. In a socialist economy, the main emphasis is on equitable distribution of income and wealth. As such, it is considered as an economy bordering between capitalism and communism.  30 Mixed Economy This economy is a mixture of market system and the command system. The Philippine economy is described as a mixed economy since it applies a mixture of forms of decision-making. However, it is more market-oriented rather than command or traditional.  31 “ Important Economic Terms  32 Wealth Wealth is anything that has a functional value (usually in money), which can be traded for goods and services. Accordingly, wealth is the stock of net assets owned by individuals or households. In aggregate terms, one widely used measure of the nation total stock of wealth is that-of the ‘marketable wealth’, that is, physical and financial assets which are mainly relatively liquid. (Pass & Lowes 1993)  33 Consumption Consumption is the direct utilization or usage of the available goods and services by the buyer (individual) or the consumer (household) sector. It is also the satisfaction obtained by consumers for the use of goods and services (Pass & Lowes 1993)  34 Production Production is defined as the formation or creation by firms of an output (products or services) & is basically the process by which land, labor and capital are combined in order to produce goods and services. Exchange This is the process of trading or buying and selling of goods and/or services for money and/or its equivalent. It also includes the buying. of goods and services either in the form. of barter or through an exchange or market  35 Distribution This is the process of allocating or apportioning scarce resources to be utilized by the household, the business sector, and the rest of the world. In specific term, however, it refers to the process. of storing and moving products to customers often through intermediaries such as wholesalers and retailers (Pass & Lowes 1993).  36 “ Brief History: The Classical, Keynesian and Modern Economics  37 Birth of Economic Theory: Classical Economics Economic theory saw its birth during the. mid-1700s and 1800s. During this era, two important economists emerged. First is Adam Smith of Scotland, who is considered the most important personality in the history of economics—being regarded as the “Father of Economics’. Among others, he was responsible for the recognition of economics as a separate body of knowledge. His book, “Wealth of the Nations’, published in 1776, became known as “the bible in economics” for hundred of years (Fajardo 1977). One of his major contributions was his analysis of the relationship between consumers and producers through demand and supply, which ultimately explained how the market works through the invisible hand  38 Birth of Economic Theory: Classical Economics Other important classical economists include John Stuart Mill who was the heir to David Ricardo, who developed the basic analysis of the political economy or the importance of a state’s role in its national economy. The term political economy is an older English term that applies management to an entire polis (state). Karl Marx, a German, also emerged during this period. He is much influenced by the conditions brought about by the industrial revolution upon the working classes. His major work, Das Kapital, is the centerpiece from which major socialist thought emerged. (Sicat 1983).  39 Neoclassical Economics (1870’s) Neoclassical Economics was believed to have transpired around the year 1870. Its main concern was market system efficiencies. It brought recognition to such economists as Leon Walras, who introduced the general economic system, and Alfred Marshall, who became the most influential economist during that time because of his book Principles in Economics. Leon Walras developed the analysis of equilibrium in several markets. On the other hand, Alfred Marshall developed the analysis of equilibrium of a particular market and the concept of “marginalism”. (Sicat 1983)  40 Keynes’ General Theory of Employment, Interest & Money John Maynard Keynes is an English economist who offered an explanation of mass unemployment and suggestions for government policy to cure unemployment in his influential book: The General Theory of Employment, Interest and Money (1936). Keynes’ concern about the extent and duration of the worldwide interwar depression led him to look for other explanations of recession. (Pass & Lowes 1993) In particular, Keynes argued that classical political economists were concerned with the relative shares in national output of the different factors of production, rather than the forces which determine the level of general economic activity, so that their theories of value and distribution related only to the special case of full employment.  41 Non-Walrasian Economics (1939) During the Non-Walrasian Era, John Hicks was recognized for his analysis of the IS—LM model, which is considered as an important macroeconomic model. IS refers to the goods market for a given interest rate, while LM means money market for a given value of aggregate output or income. The IS-LM model is a theoretical construct that integrates the real, IS (investment-saving), and the monetary, LM (demand for, and - supply for money), sides of the economy simultaneously to present a determinate general equilibrium position for the economy as a whole (Pass & Lowes 1993).  42 Post-Keynesian Economics (1940 and 1950s) After World War II, the Post-Keynesian Period saw the development of rules and regulations of different private and public institutions. This period introduced major post-Keynesian, neoclassical economists, whose views are known as the post-Keynesian “mainstream economics’. This period welcomed various economists like Paul A. Samuelson, Kenneth J. Arrow, James Tobin and Lawrence Klein, Joan Robinson, and Michael Kolechi. Another stream of thought was introduced by liberal market post-Keynesians, mainly the monetarists, led by Milton Friedman. (Sicat 1983)  Chapter 2 Basic Analysis of Demand & Supply Macroeconomics  44 Demand and Supply Demand is generally affected by the behavior of consumers, while supply is usually affected by the conduct of producers. The interplay between these two sectors is the foundation of economic activity. Thus, the consumer identifies his needs, wants, and demands, while producers address these by accordingly producing goods and services. In the end, the consumer gains satisfaction while the producer gains profit. As the economy cannot operate without this interaction between the consumer and the producer, it is essential, therefore, that students understand the different movements of the demand and supply curves, as well as the concept of market equilibrium.  45 Demand Demand pertains to the quantity of a good or service that people are ready to buy at given prices within a given time period, when other factors besides price are held constant. Simply put, the demand for a product is the quantity of a good or service that buyers are willing to buy given its price at a particular time. Demand therefore implies three things:  desire to possess a thing (good or service)  the ability to pay for it or means of purchasing it  willingness in utilizing it.  46 Market Take note that when there is demand for a good or service, there is a market. A market is where buyers and sellers meet. It is the place where they both trade or exchange goods or services—in other words, it is where their transaction takes place. There are different kinds of markets, such as wet and dry. Wet market is where people usually buy vegetables, meat, fish, etc. On the other hand, dry market is where people buy shoes, clothes, or other dry goods. However, in economic parlance, the term market does not necessarily refer to a tangible area or location where buyers and sellers could be seen transacting.  47 Methods of Demand Analysis Demand can be analyzed in several ways. However, the most common way of analyzing demand is through demand schedule, demand curve, and demand function.  48 Demand Schedule A demand schedule is a table that shows the relationship of prices and the specific quantities demanded. at each of these prices. Generally, the information provided by a demand schedule can be used to construct a demand curve showing the price-quantity demanded relationship in graphical form.  49 Demand Schedule Take note that as the price goes up (down) the quantity of rice being purchased by the consumer goes down (up). This implies that quantity demanded is inversely related with price. In other words, consumers are not willing to purchase more rice at higher prices but will consume more if prices are low.  50 Demand Curve As we have said earlier, the demand curve is a graphical representation showing the relationship between price and quantities demanded per time period. A demand curve has negative slope thus it slopes downward from left to right. The downward slope indicates the inverse relationship between price and quantity demanded.  51 Demand Curve Observe that most demand curves -slope downwards because (a) as the price of the product falls, consumers will tend to substitute this (now relatively cheaper) product for others in their purchases; (b) as the price of the product falls, this serves to increase their real income allowing them to buy more products (Pass & Lowes 1993). End