January 29, 2015 Introduction to Macroeconomic Theory Chapter 1: The Science of Macroeconomics Important Issues in Macroeconomics Major topical issues: - Why does the cost of living keep rising? - Why are millions of people unemployed, even when the economy is booming? - What cases recession? Can the government do anything to combat recessions? Should it? - What is the government budget deficit? How does it affect the economy? - Why does the U.S. have such a huge trade deficit? - Why are so many countries poor? What policies might help them grow out of poverty? Macroeconomic issues are generally categorized into three main topics: - Standard of living- Cost of living - Economic fluctuations – booms and recessions Standard of Living and Employment - For most people achieving a high standard of living means finding a good job. - The average unemployment rate in the United States in the past 20 years has been 6 percent and it takes about 15 weeks to find a suitable job. Why Learn Macroeconomics? 1. The macroeconomy affects society’s well-being. 2. The macroeconomy affects your well-being. 3. The macroeconomy affects electiona. Main point of this data: the state of the economy has a huge impact on election outcomes. When the economy is doing poorly, there tends to be a change in the party that controls the White House. How Do Economists Study Economics? - Primary tool: models o Simplified versions of a more complex reality o Irrelevant details are stripped away - Used to…o Show relationships between variables o Explain the economy’s behavior o Devise policies to improve economic performanceEconomic Models - Key: identify variables to be determined by the model (endogenous variables), and variablesthat are determined outside of the model (exogenous) Example of a model: Supply & Demand for New Cars - Shows how various events affect price and quantity of cars - Assumes the market is competitive - Variables: o Qd= quantity of cars that buyers demand o Qs= quantity that producers supply o P= prices of new cars o Y= aggregate income o Ps= price of steel (an input) - Demand Equation: Qd= D(P,Y)o Shows that the quantity of cars consumers demand is related to the price of cars andaggregate income. Effects of an Increase in Income - An increase in income increases the quantity of cars consumers demand at each price- This increases the equilibrium price and quantity Effects of a Steel Price Increase - An increase in Ps reduces the quantity of cars producers supply at each price - Which increases the market price and reduces the quantity A Multitude of Models - No one model can address all the issues we care about - Ex. Our supply-demand model of the car market o Can tell us how a fall in aggregate income affects price and quantity of cars o Cannot tell us why aggregate income falls - So we will learn different models for studying different issues (ex. Unemployment, inflation, long-run growth)- For each new model, you should keep track of o Its assumptions o Which variables are endogenous, which are exogenous o The questions it can help us understand, and those it cannot Why Macreconomists Disagree - Economists as a group are sometimes criticized for giving conflicting advice to policymakers - They disagree with each other a lot- Example: in 2012, 500 economists, including Nobel laureates, back Mitt Romney’s economic plan. Many economists, including the famous Nobel laureate Paul Krugman, support Barack Obama - Differences in scientific judgmento One main difference in judgment: how much government intervention is necessary to achieve a socially optimal outcome o Fundamental economic issue: efficient allocation of resources o What’s the best way to allocate resources? o Free market vs. government intervention- Differences in values Central Planning - Suppose resources were allocated not by the market, but by a central planner who cares about society’s well-being - To allocate resources efficiently and maximize total surplus, the planner would need to knowevery seller’s cost and every buyer’s willingness to pay for every good in the entire economy - This is impossible, and why centrally-planned economies are never very efficient Free Market vs. Government Intervention - Markets are usually a good way to organize economy activity- The market equilibrium is efficient. o No other outcome achieves higher total surplus - Gov’t cannot raise total surplus by changing the market’s allocation of resourcesExample - When the market for wheat reaches an equilibrium, social welfare is also maximized - Society: buyers and sellers - Welfare: consumer surplus and producer surplus - Free market transactions lead to the best outcome for society Adam Smith and the Invisible Hand - The Wealth of Nations, 1776 o “Every individual…neither intends to promote the public interest, nor knows how much he is promoting it…He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” o “By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” Where is the Invisible Hand? - A clean environment is beneficial to both consumers and producers - In a “socially optimal” situation, there definitely should not be heavy pollution- But the “invisible hand” does not seem to be able to produce this socially optimal situation - In the market equilibrium, the welfare of buyers and sellers are still maximized - The only problem is that in this case, society is not equal to buyers & sellers any more - “Bystanders” are also part of society. They are hurt because of pollution - Buyers and sellers maximize their welfare by reducing the bystanders’ welfare (via pollution)- The invisible hand cannot produce socially optimal outcomes when a part of “society” is not in the market Examples of Negative Externalities - Air pollution from a factory - The neighbor’s barking dog - Late-night stereo blasting from the dorm room next to yours - Noise pollution from construction projects - Health risk to others from second-hand smoke - Talking on cell phone while driving makes the roads less safe for others Solutions - Government interventions can reduce market failures o Pollution taxeso Law that prohibits talking on the phone while driving - Therefore, the government has an important role to play in the economy Public Goods - Consider