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I N F O R M AT I O N S H E E T S What is the economy/economics ? 1 Every trade has its own jargon, every specialism has its basic concepts. That also applies to the sometimes very rarefied world of central banks. Yet even the everyday press refers to GDP, interest rates, growth, inflation, etc. The assumption is that all these terms are understood, but are we always sure what they mean ? We shall clarify some of them here. The management of scarce resources, or all the human behaviour connected with the production, distribution and consumption of goods and services ? “Economy” frequently refers to just one particular aspect of human behaviour, namely the attempt to make optimum use of scarce resources to satisfy needs which, by contrast, are numerous and unlimited. Economics is the study of how society manages its scarce resources (1). However, there is no consensus on the definition of economic science. For example, it could be defined in the broader sense as the study of all behaviour connected with the production, distribution and consumption of goods and services. But such a definition is all-embracing, covering all human activities requiring not only economic choices, but also political or ethical ones. However, it has the merit of demonstrating the interdependence of human behaviour and the difficulty of defining precisely the respective areas covered by the various social sciences (economics, sociology, political science, psychology, etc.). The difficulty of specifying the limits of the analysis while recognising the interdependences is inherent in all human sciences. The term “economics” comes from the Greek word which means “relating to household management”. There are many similarities between the economy and a household. Managing a household means allocating domestic duties, taking decisions on expenditure, making choices : if I buy a car, I shall not be able to go on holiday. The same issues arise in managing the economy : what types of goods or services to produce, how to allocate the available resources, such as labour, land or certain facilities among the various types of production desired ? Who will decide on that production and for what consumption purposes ? How will incomes be distributed ? Will the money be spent – and on what – or saved – and why ? The answer to these questions implies choices, which are all the more necessary where the resources (land, commodities, working time, machines, etc.) are limited. By studying scarcity and the choices which it imposes, economics also takes part in the debate on the distribution of wealth and sustainable development. The economy thus represents a social and political issue. These choices may be studied at the level of consumers, firms or the economy as a whole. (1) Principles of Economics, N. Gregory Mankiw, Economica, September 2004. In French, the word “économie” is used to denote both the science of economics and the economy itself. © National Bank of Belgium, 1 September 2014 All rights reserved. Reproduction of all or part of this publication for educational and non-commercial purposes is permitted provided that the source is acknowledged. Microeconomics and macroeconomics Microeconomics is the study of individual behaviour, particularly that of consumers, producers or the owners of resources, and the analysis of their interaction. Macroeconomics examines the economy as a whole, by trying to understand the links between the various aggregates such as income, employment, investment and savings. It is impossible to grasp and comprehend the reality in all its complexity. In Belgium, there are several million consumers and almost 600 000 enterprises active in hundreds of different markets, some of them concerning exports. It is impossible to understand the behaviour of each of these economic agents. So how can we measure the impact of an economic decision or compare two actions in terms of the costs and benefits for the economy as a whole ? In an attempt to do that, microeconomics has to put forward a number of hypotheses and reduce the reality to a few types of reference behaviour. Neo-classical microeconomics proposes an approach – and this is a first important hypothesis – in which human behaviour is considered to be rational. People are therefore guided primarily by reason and not by feelings, passions or other external influences. Another important hypothesis is that each individual is assumed to have complete and immediate information. It is because they are perfectly informed that consumers and producers can take the most rational decisions, which conform most closely to their objective economic interests. Finally, individuals are independent and no-one can impose his decisions on anyone else : there is “perfect competition”. These hypotheses lead to the construction of fairly simple models which aim to simulate certain economic behaviour : how does consumer demand for a product vary ? How does a firm’s supply respond ? How are prices fixed ? In this theoretical environment, all the economic agents will want to maximise their objectives while being subject to certain constraints. The firm will want to maximise its profit, while being limited by technical constraints and costs. The consumer will try to maximise his preferences within the constraints of his income. It is the market, the place where consumers and producers meet, that will determine the quantities traded and the prices. Macroeconomics considers the possible interactions between larger units. A country’s gross domestic product, unemployment, exports or imports are known as macroeconomic data. They tell us nothing about a particular firm or household, but they do tell us about the state of the economy as a whole and the interactions between its main components. Some of these concepts are presented on subsequent pages. Macroeconomics as founded by the economist J. M. Keynes (°1883 – †1946), tries to answer questions such as : why do we have unemployment ? Why do prices rise ? Why do output and employment increase in some years and not in others ? How do incomes vary and how are they distributed ? Since what happens to the national economy depends on the behaviour of millions of individuals, it is not possible to understand macroeconomic developments without looking at the underlying microeconomic decisions. Economists today devise syntheses and macroeconomic models based on microeconomic foundations, by modifying some of the classical microeconomic hypotheses (e.g. by taking account of market “imperfections” : market power exercised by large firms and unions, asymmetric information, etc.) and by going beyond the mechanical links of Keynesian macroeconomics (e.g. by taking account of the expectations of economic agents). Economic policies In economic life, the government is not the same as other stakeholders : it can exert a decisive influence on the economy via its legislation and transactions. First, it is the government that decides the rules, e.g. via contract law, company law, competition rules, etc. The government also plays an economic role via its transactions : it supplements the market by supplying public services, for example in the form of infrastructure, education, health care, money, etc. The government also arranges the redistribution of income (taxes, social security, etc.). Finally, it influences overall demand either by adjusting the quantity of money in circulation, interest rates and exchange rates (monetary policy), or by decisions on the amount of public revenue and expenditure, and hence the movement in the public debt ratio : this is fiscal policy. The science of economics also analyses the action of the government and is used to make recommendations on economic policy. It provides possible answers to numerous questions facing the government : what are the consequences of protecting national producers (“protectionism”) by high rates of customs duty ? How do various forms of taxation modify behaviour ? What price should be charged for public services ? What incentives can reduce pollution at the lowest cost ? What are the consequences of various labour regulations ? What is the most appropriate fiscal policy in a particular environment ? Is economics a science ? Economists try to apply a scientific method. As in the case of physics, they aim to : – observe reality while not judging by appearances ; – construct coherent theories, increasingly resorting to mathematics ; – measure the validity of these theories by comparing them with the facts. However, there are some important differences between physics and economics : – the economy, as the outcome of millions of decisions, is extremely complex so that economics is more like meteorology, and it is difficult if not pointless to create laboratory conditions or reproducible experiments ; – economic science analyses the behaviour of subjects, innovative players, so that the patterns observed in the past are always conditioned by their historical context, and are liable to change ; – economic science itself modifies its research subject, because the economic views of the stakeholders affect their behaviour. These characteristics, a feature of all human sciences, explain the persistence of competing theories. Hypotheses and models To define a complex reality, scientific reasoning establishes hypotheses which simplify reality and make it easier to understand. For example, the analysis of consumer behaviour cannot take account of everything that may influence the consumer’s decisions, or all the choices confronting him. The analysis is therefore simplified by studying consumer demand for a particular product in the light of variations in its price. To identify this link, it is necessary to establish hypotheses : the consumer’s income remains constant or his tastes do not change. These hypotheses make it possible to isolate the link between the two variables (the quantity of demand for a product and the variation in its price) and limit the analysis, in this case the study of demand for a product, to make it possible to measure how demand for the product changes as its price varies. The models are often expressed in the form of diagrams or equations. On the basis of a number of hypotheses, they make it possible to show up the links between two or more variables. Of course, these hypotheses will attract criticism, and the models that they help to build will be compared with reality. If their ability to explain a situation is not satisfactory, the hypotheses will be modified and other links will be established in order to improve the theory, to introduce new concepts or to construct a new model. It is unusual for a theory or analysis to be entirely good or entirely bad. Each one succeeds in explaining certain situations and can always be improved. That work is the essence of scientific thought.