Download 1 Preliminaries

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Preliminaries
1.1
What is Macroeconomics?
Let us start from a definition of economics. Economics is the science concerned with
interpreting and predicting social behavior in terms of the incentives and the constraints
affecting agents’ decisions on how to allocate scarce resources among alternative uses.
The aim of interpreting social behavior is common to other disciplines, like sociology
or history. It is the emphasis on “incentives affecting individual decisions” that is
typical of economics.
• Example, consider cross-country differences between female labor force participation: In Ireland, 44% of women work, in Czech republic 93% of women work
(in the U.S., it’s 77%). A sociologist would, for example, emphasize differences in
preferences regarding family structure and women’s role in the home, i.e. cultural
(or social norms) differences. Some economists think culture is important, but
the typical economist would think differently. She would emphasize the economic
incentives that drive the decision to work compared to produce at home or simply enjoy leisure, for example the gender wage gap, the availability of cheap child
care, etc...
• Another example: suppose you want to explain why many kids from the projects
in Chicago join criminal gangs. A sociologist would emphasize they belong to
broken families, their parents do not monitor them and often they do not exactly
set an example for them. Moreover, being part of a gang in that social context
carries no stigma, perhaps gives one even a certain “social status”. These considerations are certainly valid. However, an economist would focus on different
reasons. She would stress the economic incentives that induce a kid to join a
gang. The kid has probably access to very low-quality education and the skills
he can supply to the labor market are very low. Most likely, he could get a job
at McDonald’s or at Walmart for a salary close to the minimum wage. The gang
instead offers much higher earnings, at a high risk. So, in his own individual
economic calculus, the kid may be willing to entertain the risk.
Economics has been traditionally divided between microeconomics and macroeconomics. What is the difference between microeconomics and macroeconomics? Microeconomics focuses on the behavior of a single agent (firm, household, government), or a
single market (e.g., the market for breakfast cereals). Macroeconomics studies the behavior of the main aggregate economic variables, like output, investment, consumption,
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public expenditures, unemployment, trade deficit, exchange rate, price level, income
inequality, etc... Macroeconomic research investigates questions such as: Why isn’t the
whole world developed? Why do we observe expansions and recessions? What are the
causes of unemployment? What makes people unequal in income and wealth? What
determines the level of savings in an economy? How does monetary policy affect the
economy? Are tax cuts a stimulus for the economy? What determines the Euro-Dollar
exchange rate? And so on.
Old macroeconomics had nothing to do with microeconomics because it primarily
relied on assumed relationships between aggregate economic variables. For example,
old macro would just posit that “aggregate saving is a linear function of aggregate
income” without laying the foundations of individual behavior that makes individual
save more when they earn more. In this sense old macro was ad-hoc.
Modern macroeconomics—the one you will learn—is micro-founded. This means that
there is a tight relationship between micro and macro. In modern macroeconomics, we
borrow from microeconomics two key principles:
1. the behavior of household, firms, and government can be described through optimization, i.e. maximization of a well-defined objective function subject to constraints (imposed by nature, markets, governments)
2. markets clear, i.e. supply equals demand (market equilibrium) and prices are
determined
Point 1) means that behavioral rules are derived instead of assumed ad-hoc. Point 2)
means that economic equilibrium determines how the independent individual decisions
are aggregated into the evolution of the macroeconomy.
This new approach to macroeconomics requires a high degree of mathematical
knowledge, which means that it is not accessible to many users of macroeconomics,
like some journalists and policy-makers who (mostly for age reasons or lack of training) still think in terms of a language that belongs to old macro.
To understand the difference between a microeconomic and a macroeconomic analysis, consider the problem of adoption of new technologies. Let’s start from the micro
level. A firm that adopts a new technology must also hire skilled workers (e.g., engineers) that can integrate the new technology with the existing ones in the firm. So,
the microeconomist would emphasize this link in production between new technologies
and skilled labor. Now, let’s take a macro perspective. Consider thousands of firms
that make the same decision. Then, the aggregate demand for engineers in the US
economy would go up, and their salary would increase. I.e., aggregating this rise in the
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demand for skilled labor generates an increase in the equilibrium price of skilled labor.
The macroeconomist would emphasize the effect on equilibrium skilled wages.
1.2
How Does Macroeconomics Work?
Macroeconomics uses formal and rigorous models to provide explanations and answers
to questions such as those listed above. Modern macroeconomics is formalized through
mathematical models. It uses a scientific method of measurement, conjecture of a
theory, validation and falsification of the theory.
Define with Y the set of variables of interest to a macroeconomist, i.e. what needs
to be explained and predicted. The first step is the measurement, i.e. an accurate
description of Y.
The second step is constructing a theory, which is a combination of two things: 1)
a set of assumptions (premises), i.e. objects that are taken as given, or beyond theory,
call them X; and 2) a set of logical deductions from the assumptions, denote them as
⇒. Therefore,
X ⇒Y
is an explanation of Y through a valid theory based on a set of assumptions X. Explanations can be “simple” if they involve relatively few logically connected steps or
“complex” if they involve many. But to be valid, they have to be logically correct.
• Example, suppose I want to understand how monetary policy affects inflation.
Y is inflation, X are a set of behavioral assumption on the Fed’s conduct of
monetary policy, and ⇒ are a sequence of logical statements that take me from
the assumptions on the Fed’s behavior to inflation.
Note that measurement, defined as the description of the facts, is a necessary step
of economic inquiry, but it should not be confused with theory. Description alone is
not an explanation. An explanation requires theory, one can “let the facts speak for
themselves” to describe them properly, but not to explain them: facts do not explain
themselves, they only speak through the mouth of theory.
The third step is the most delicate. How do we validate or falsify a theory? If we
reject too many theories, we risk throwing the baby with the hot water, but if we do
not reject any, we end up working with the wrong models.
Some economists criticize theories based on the “lack of realism of their premises”.
Such criticisms are void. It is almost by definition that a theoretical model is based on
abstract assumptions. In this sense, all models are false. Realism is more often than
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not the wrong way to think about theory. Models are like a road map to get from X to
Y. Clearly, a road map is a simplification of reality: it does not mention all the curves,
all the trees, all the bumps on the road between X and Y, but it is often useful anyway.
Theory should be judged, validate and eventually rejected on the basis of its usefulness, on the basis of how much we can learn from it. Often, there are other theories
available. New theories can be compared and judged as superior or inferior to existing
explanations.
This judgement can be made in various ways. First, one can use a measure of
“closeness” in a statistics sense: how much of fact Y the theory can explain? Following
the road map example, the new map gets me closer to Y than the old map. Second,
the new theory can shed light also on another set of facts Z ignored by the old theory.
For example, not only the new map explains how to get from X to Y , but also from
X to Z which the old map did not do.
1.3
The Macroeconomic Model as “Artificial Economy”
Economics is therefore similar in many ways to hard-sciences, like physics or biology. The main difference between economics and the hard-sciences is that it is a
social science, and as such economists cannot make use of controlled experiments,
like physicists. In physics, a scientist can recreate reality in the lab and run controlled
experiments. E.g., it can create the void to study the gravity laws.
In economics, we can’t do that. E.g. suppose we want to understand how much
the trade with the U.S. affects growth in Mexico. Ideally, we would like to shut down
trade for a year. Impossible!!!
However, we can use our models like laboratories, like “artificial economies” in other
words. In the model we can shut down trade: households and firms populating the
model don’t complain! As we go along, we describe all the ingredients of an artificial
economy in detail.
1.4
What do Macroeconomists Do?
Suppose you like this course so much that you decide that you want to become a
macroeconomist! Would would you end up doing after you graduate? There are three
types of macroeconomists who do different things.
1. Forecasters. These are macroeconomists whose job is to predict how inflation,
GDP or stockmarkets will perform in the short run, i.e. next month or next
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quarter. Unfortunately, economists are pretty bad at predicting in the short run,
even worse than meteorologists.
2. Analysts. As an analyst in the private sector, you would use economic models
to interpret current economic events and inform the decision of a big investment
bank to, say, shift its trading strategies from US to Asia, from stocks to bond,
from oil to gold, etc. As an analyst in the public sector, you would inform the
government on what are the right policies, given a certain political objective that
wants to be reached (e.g., redistributing more to the poor, or creating more jobs
for the manufacturing workers displaced by trade with China, etc.).
3. Researchers. Many economists, especially in academia, spend most of their
time doing research. This means developing new models or validating/falsifying
existing ones. These economists are at the frontier of economics as a science and
are responsible for its advancement. And, by the way, these are the economists
who teach macroeconomics to the new generations of students.
1.5
Why do we care about Macroeconomics?
There are at least 4 reasons why learning macroeconomics is important:
• Culture: as students, you are driven by the desire to understand the world
where you live. Example: Argentina’s financial crisis: why are markets worried
that there could be a contagion to Brazil? Or Bush’s recent tax cut: why did
the stock-market increase following the announcement of the tax cut? Economic
knowledge is today a key component of “culture”. In the old days, a cultivated
person would be judged from his knowledge of art, literature and poetry. Today,
economic literacy is part of the baggage of any educated individual: economics is
present in the news, in the public debate and in dinner-party conversations much
more than literature!
• Self-Interest: the working of the macroeconomy affects our daily life. If the
aggregate price level goes up, our purchasing power decreases. When the interest
rate goes up, student’s loan becomes more expensive. If the stock-market goes
down, our wealth falls. It is useful to understand the impact on shocks and
policies on inflation, interest rates, the stock-market etc. because they affect our
lives directly. We cannot affect the macroeconomy, but we can understand it and
we can know what to expect.
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• Social Concerns: policy makers can affect the welfare of millions of people (beyond ourselves) with their actions and their choices of policies. Every policy has
redistributive consequences. Example: A reduction in taxation for the working
households may lead to cuts of social expenditures for the poor. An increase in
the minimum wage can reduce the profits of a small business owner who employs
unskilled workers. Everyone is free to have her own social preferences on redistribution, but to understand what is the right policy given your preference, you
need to learn macroeconomics.
• Civic Responsibility: we need to understand how the economy works to be able
to judge our government and our politicians. Politicians often claim that when
the economy grows, it’s due to their clever choice of policy, when it stagnates it is
due to negative external shocks. Sometimes this is true, sometimes it’s false. We
need to be able to distinguish good from bad policies. Politicians choose policies,
but we choose them!
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