Introduction to Economics PDF

Introduction Intro. Economics Social science which deals with the way scarce resources are allocated among alternative uses. Economic Theory - Microeconomics and Macroeconomics Microeconomics Concerned with the behaviour of individual units such as a single consumer, a household (hh), a f...

Introduction Intro. Economics Social science which deals with the way scarce resources are allocated among alternative uses. Economic Theory - Microeconomics and Macroeconomics Microeconomics Concerned with the behaviour of individual units such as a single consumer, a household (hh), a firm or an industry. e.g. how a consumer or hh allocates its income among expenditures for various g/s. Determining a firms profit maximising level. Intro. Conti… Macroeconomics Deals with the economy as a whole- with booms and recessions, the economy‟s total output of goods and services, the rates of inflation and unemployment, the balance of payments and ex. Rates. It deals both with the long run economic growth and with shirt run fluctuations that constitute the business cycle - Thus macroeconomics entails studying the structure & performance of national economies and the policies that govts use to influence economic performance. Goals of Macroeconomic Policy The major objective of macroeconomic policy is to influence the performance of the economy in order to achieve: Full employment Price stability Economic growth External balance Macroeconomic policies include Fiscal policy & monetary policy. Fiscal policy – use of govt spending and taxation to influence economic performance Monetary policy- use of money supply & interest rates by the central bank to achieve macroeconomic stability. Goals cont… Full employment – All available resources are used in the most economically efficient way. – High unemployment means decrease in the amount of g/s produced. – The poor tend to be adversely affected by a high unemployment rate. Price stability – Price level remains constant within a given period of time. – General increase in the price level is inflation, while a decrease is deflation. Goals cont… - People whose incomes increase at a slower rate than the rise in the price level (inflation) are usually adversely affected e.g. pensioners - Lenders will be hurt by inflation coz they are repaid with money that is worth less than the money they lent out. - NB. to maintain a stable and predictable level of inflation. Goals cont… Economic growth - Occurs if society‟s real output increases more rapidly than its population - Means that there will be more g/s at society‟s disposal hence a higher standard of living. - N.B sustainable economic growth is more desirable than a high growth followed by stagnation. External balance - It‟s a summary of all economic transactions btwn hhs, firms & govt agencies of one country & the rest of the world in a given period of time Goals cont… - The transactions include exports, imports, and capital flows. - Exports increase & 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 the pattern of expansion (recovery) and contraction (recession) in economic activity around the path of trend of growth Business cycles – alternating rises & declines in the level of economic activity A peak is when business activity reaches a temporary maximum with full employment and near-capacity output – price level likely to rise. 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 – employment & output at their lowest levels. Recovery is when output and employment are expanding toward full-employment level The blue line shows the trend path of real GDP. This is the path GDP would take if factors of production were fully employed. Over time, real GDP changes for two reasons: Firstly more resources become available allowing the economy to produce more goods and services resulting in a rising trend level of GDP  Secondly, factors are not fully employed all the time. Thus output is not always at its trend level instead output fluctuates around the trend level. During and expansion (recovery) the employment of factors of production increases, and that is a source of increased production. Output can rise above trend because People work overtime and machinery is used for several shifts. Conversely, during a recession unemployment increases and less output is produced. Deviations of output from trend are referred to as OUTPUT GAP. The output Gap measures the gap between Actual output and the Output the Economy could produce at full employment given existing resources Output Gap= Potential Output-actual Output  The Business Cycle Peak Peak Level of Real Output Peak Trough Trough Time  Relationship between GDP and Unemployment: Okuns’s Law Okun‟s Law – for every 1% increase in unemployment rate a negative GDP gap of about 2.25% occurs Okun‟s Law – for every 1% increase in unemployment rate a negative GDP gap of about 2.25% occurs This relationship is stated though the following equation: Change in unemployment rate= -0.5(y-2.25) Schools of Macroeconomic Thought CLASSICAL ECONOMICS - 1st school of economic thought. Based on the ideas of Adam Smith presented on his famous book “An Enquiry into the Nature & Causes of the Wealth of Nations” in 1776. - Its based on the notion that markets can regulate themselves if left alone or free of human intervention. - i.e. there is an automatic mechanism („invisible hand‟) that moves markets towards a natural equilibrium without the requirement of any intervention. Schools of Macroeconomic Thought Assumptions a) Flexible prices - Prices of all things, commodities, land, labour etc are assumed to be mobile i.e. they can freely rise or fall. - This implies that there cant be involuntary unemployment due to the self correcting mechanism in the economy. - i.e. any unemployment would mean a temporary disequilibrium caused by excess ss of labour at the current wage rate, but since wages are perfectly flexible, the wage rate will fall to eliminate the excess labour thus reducing unemployment back to equilibrium levels. Assumptions cont… b) Say‟s Law Say's law proposes that supply creates its own demand. This means that the income derived from producing certain goods by some, allows them to purchase goods produced by others. Since all people have a need to purchase goods, they will seek to produce some goods to derive income and buy whatever they want. Thus the product markets will always necessarily be in equilibrium. - Says that “supply creates its own demand” i.e. aggregate prodn in an economy must generate an income enough to purchase all of the economy‟s output. Aggregate demand must be equal to aggregate supply.AD = AS. - i.e. any disequilibrium in the commodity mkts will be corrected due to the flexible prices.e.g.any excess ss of a commodity leading to a disequilibrium will be eliminated when flexible prices come down until ss = dd and the economy is back in equilibrium. Assumptions cont… c) Savings – Investment Equality - Hh savings are equal to capital investment expenditures and are det. by prevailing i-rates. - i.e. no human/govt intervention is required to lead capital mkts to equilibrium. Any mismatch btwn savings & investment would be temporary and can be corrected as interest rates adjust. - If some income happens not to be consumed immediately it will enter the money market as a saving. This saving will be put back into the economy as investment (i.e increase in capital) when it is borrowed. The interest paid by borrowers to savers assures that no saving will be idle. The money market equilibrates through an adjustment in the interest rate.  Thus the following three assumptions underpin classical economic theory: Rational thinking: People make rational choices between options based on the value that they identify in each choice. Maximizing: Consumers aim to maximize utility, while businesses aim to maximize profits. Information: People act independently based on having all the relevant information related to a choice or action  SUMMARY OF CLASSICAL THEORY 1. The classical theory is essentially the laissez faire belief of pure capitalism. In this view, business cycles are natural processes of adjustment which do not require any action on the part of government.  CLASSICAL MONEY MARKET 2. If some income happens not to be consumed immediately it will enter the money market as a saving. This saving will be put back into the economy as investment (i.e increase in capital) when it is borrowed. The interest paid by borrowers to savers assures that no saving will be idle. The money market equilibrates through an adjustment in the interest rate.  PRICE AND WAGE FLEXIBILITY The classical theory proposes that all markets reequilibrate because of adjustments in prices and wages which are flexible. For instance, if an excess in the labor force or products exist, the wage or price of these will adjust to absorb the excess.  INVOLUNTARY UNEMPLOYMENT 3. The classical theory proposes that no involuntary unemployment will exist because an adjustment in the wage rate will assure that the unemployed will be hired again. In addition, the need of workers to buy goods will encourage them to accept work at even the lower wage rates  Criticism of the Neo Classical Theory Critics of classical economics believe that the classical approach cannot accurately describe actual economies. They maintain that the assumption that consumers behave rationally in making choices ignores the vulnerability of human nature to emotional responses. Other critiques of classical economics include: Distribution of resources: Resource distribution impacts how people make decisions, but resources are not distributed equally. There are important differences, especially between those whose income comes from performing labor and those whose income comes from owning capital.  Appropriation of resources: Resources are often claimed by those with economic or military power, regardless of whether they were previously owned by people or groups with less power. Available choices: People may attempt to make rational decisions, but they can only choose between the available choices. For example, choosing between a job that endangers your health or losing your family home is not the same as choosing between a dangerous job and a safe one.  Irrational decisions: People do not always make e most rational decision, or only consider the benefit to themselves as an individual when making choices. They may be influenced by social pressure, the needs of others, available choices, income restraints, imperfect information, or existing power structures to make choices that don't maximize utility to themselves. Pursuit of profit: Maximizing profit is not the only or best way for markets to function, as this can exacerbate inequality, exploit workers, and damage the environment or community. Markets or businesses structured around solving a problem, such as non-profit organizations or single-payer healthcare systems, can often function with equal levels of efficiency and effectiveness.  Pursuit of profit: Maximizing profit is not the only or best way for markets to function, as this can exacerbate inequality, exploit workers, and damage the environment or community. Markets or businesses structured around solving a problem, such as non-profit organizations or single-payer healthcare systems, can often function with equal levels of efficiency and effectiveness. Standards of living: Producing more goods and services (having a higher GDP) does not always equal a higher standard of living. Neoclassical economics equates standards of living with "amount of goods and services consumed," but consuming more does not always improve measures such as health, life expectancy, social equality, economic stability, or other factors in quality of life.  KEYNESIAN SCHOOL OF THOUGHT - Based on the ideas of John Maynard Keynes first presented on his book “The General Theory of Employment, Investment & Money” in 1936. - Argues that there is no invisible hand that drives the economic system back to equilibrium, hence govt intervention is absolutely necessary to ensure economic growth & stability.  Assumptions a) Rigid/ Inflexible prices - Prices of most things, respond slowly to changes in ss & dd conditions, resulting in shortages & surpluses. b) Effective Demand - Contrary to Say‟s law, only a fraction of hh income is used for consumption. c) Savings & Investment Determinants - There are other determinants of savings & Investment apart from the prevailing i-rates such as disposable income & hhs desire to save for the future.  The primary disagreement between Classicals & Keynesians is over the speed of adjustment of wages and prices. - Classicalists believe that prices “clear" markets i.e. prices balance demand & supply by adjusting quickly. - Keynesians advocate for sticky wages & prices to explain why unemployment & inflation exists & why govt intervention is necessary.  The Keynesian Approach Keynes (1936) assumed that wages and prices adjust slowly. Thus given that markets could be out of equilibrium for long periods of time and unemployment can persist, according to the Keynesian approach, governments can take actions to alleviate unemployment. The government can purchase goods and services, thus increasing the demand for output and reducing unemployment. Newly generated incomes would be spent and would raise employment even further.  CLASSICAL-KEYNESIAN CONTROVERSY Keynesian employment theory is built on a critique of the classical theory. In this critique, Keynes argued that savers and investors have incompatible plans which may not assure that an equilibrium exists in the money market, that prices and wages tend to be rigid and equilibrium may not exist in the product and labor markets, and that periods of severe unemployment have occurred (which the classical theory denied).  KEYNESIAN SAVING-INVESTMENT PLANS Keynes showed that savers and investors are separate groups which do not necessarily interact: financial intermediaries (banks) are in between. When a recession is present, investment may not be equal to saving because, although the interest rate is very low, 1) borrowers have poor sales prospect, 2) banks are afraid of lending because of potential bankruptcy, and 3) savers want to wait for higher returns. This causes a liquidity trap: some saving is idle.  KEYNESIAN PRICE-WAGE RIGIDITY Keynes argued that prices and wages are not flexible as the classical theory asserts. Wages tend to be rigid on the down side because workers will not accept wages which do not permit them to live adequately; this is reinforced by the actions of unions. If wages are too low, unemployment will exist. In the case of prices, firms producing large tag items prefer to cut production and lay off workers than cut price. Their monopoly power often permits them to act that way.  AGGREGATE DEMAND Aggregate demand shown graphically represents the sum total of what household are willing and able to buy at different level of the price level. Aggregate demand can be thought of as a combination of all the different products people may want to buy.  REAL BALANCE EFFECT Aggregate demand curve is downsloping because of the real balance effect. If prices are higher than averages, then the purchasing power of monetary assets decreases and individuals tend to feel poorer and buy less. If prices are lower than historical price averages, the purchasing power of monetary assets increases, individuals tend to feel wealthier and buy more.  There is an inverse mathematical relationship between interest rates and financial assets. Securities markets, such as the New York Stock Exchange, are very sensitive to inflation which is the major cause for increasing interest rates. This sensitivity was observed in October 19, 1987 stock market crash. It was also observed in securities markets reactions to to lowering of interest rates by the US federal reserve bank in 2001.  AGGREGATE SUPPLY Aggregate supply is made of three sections: the classical range is vertical, the Keynesian range is horizontal and the intermediate range is upsloping. Graph1  CLASSICAL RANGE The classical range of aggregate supply is vertical because of the proposition of the classical theory that prices will adjust so that output is always at full employment. In this range, expanding aggregate demand will cause inflation, while contracting aggregate demand will reduce inflation.  KEYNESIAN RANGE The Keynesian range of aggregate supply corresponds to the proposition that when price are very low, firms will prefer to cut production rather than sell at a loss. In this range, any change in aggregate demand will produce a change in output. Thus, in the case of a recession the correct government policy is to expand aggregate demand.  INTERMEDIATE RANGE This intermediate range of aggregate supply represents the case of preliminary inflation (or sectoral inflation): when demand and output expand, some sectors of the economy may experience bottlenecks and require that prices increase because output cannot.  AGGREGATE DEMAND POLICIES When the intersection of aggregate demand and aggregate supply occurs in the Keynesian horizontal range a recession and excessive unemployment are present: the recommended policy would be to stimulate aggregate demand. When the intersection is in the classical vertical range, inflation is present: the recommended policy would be to contract aggregate demand. Graph 2  SUPPLY SIDE POLICIES Supply side policies can be shown by attributing periods of stagflation (high prices and low level of output) to upward shifts of aggregate supply. The recommended policy would then not be an increased aggregate demand which adds to inflation, but instead a shift in aggregate supply downward by cutting costs of production  NEXT: National Income Accounting