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Lecture 1 Introduction
Principles of Macroeconomics
KOF, ETH Zurich, Prof. Dr. Jan-Egbert Sturm
Fall Term 2008
General Information
• Prof. Dr. Jan-Egbert Sturm
• office hours: Tue, 14-15h.
• [email protected]
• Dr. Christoph Moser
• [email protected]
• Frank Somogyi
• [email protected]
General Information
• Internet: http://www.vwl.ethz.ch
• Literature:
• Mankiw (2007): Principles of Macroeconomics,
4th ed., Thomson Learning.
• Book sale (Hörsaalverkauf): October 2nd, 16h.
Discount with Legi, cash payment only.
General Information
23.9.
Introduction
Ch. 1,2
30.9.
National Accounting
Ch. 10, 11
7.10.
Production and Growth
Ch. 12
14.10.
Saving and Investment
Ch. 13
21.10.
Unemployment
Ch. 15
28.10.
The Monetary System
Ch. 16, 17
4.11.
International Trade
(incl. Basic Concepts of Supply, Demand, Welfare)
Ch. 3, 7, 9
11.11.
Open Economy Macro
Ch. 18
18.11.
Open Economy Macro
Ch. 19
25.11.
Aggregate Demand and Aggregate Supply
Ch. 20
2.12.
Monetary and Fiscal Policy
Ch. 21
9.12.
Phillips Curve
Ch. 22
16.12.
Overview / Q&A
General Information
• Exam dates:
• exam period: 07/01/2009 – 18/01/2009
• exact date: will be announced a.s.a.p.
• Type of exam:
• 90 minutes written exam
PRINCIPLES OF ECONOMICS
A household and an economy face many
decisions:
ƒ Who will work?
ƒ What goods and how many of them should be
produced?
ƒ What resources should be used in production?
ƒ At what price should the goods be sold?
PRINCIPLES OF ECONOMICS
• Society and Scarce Resources:
• The management of society’s resources is
important because resources are scarce.
• Scarcity. . . means that society has limited
resources and therefore cannot produce all the
goods and services people wish to have.
PRINCIPLES OF ECONOMICS
Economics is the study of how society
manages its scarce resources.
HOW PEOPLE MAKE DECISIONS
• People face trade-offs.
• The cost of something is what you give up
to get it.
• Rational people think at the margin.
• People respond to incentives.
Principle #1: People Face Trade-offs.
• “There is no such thing as a free lunch!”
Principle #1: People Face Trade-offs.
• To get one thing, we usually have to give up
another thing.
•
•
•
•
Guns v. butter
Food v. clothing
Leisure time v. work
Efficiency v. equity
Making decisions requires trading
off one goal against another.
Principle #1: People Face Trade-offs
• Efficiency v. Equity
• Efficiency means society gets the most that it
can from its scarce resources.
• Equity means the benefits of those resources
are distributed fairly among the members of
society.
Principle #2: The Cost of Something Is What
You Give Up to Get It.
• Decisions require comparing costs and
benefits of alternatives.
• Whether to go to college or to work?
• Whether to study or go out on a date?
• Whether to go to class or sleep in?
• The opportunity cost of an item is what you
give up to obtain that item.
Principle #3: Rational People Think at the
Margin.
• Marginal changes are small, incremental
adjustments to an existing plan of action.
People make decisions by comparing
costs and benefits at the margin.
Principle #4: People Respond to Incentives.
• Marginal changes in costs or benefits
motivate people to respond.
• The decision to choose one alternative over
another occurs when that alternative’s
marginal benefits exceed its marginal costs!
HOW PEOPLE INTERACT
• Trade can make everyone better off.
• Markets are usually a good way to organize
economic activity.
• Governments can sometimes improve
economic outcomes.
Principle #5: Trade Can Make Everyone Better
Off.
• People gain from their ability to trade with
one another.
• Competition results in gains from trading.
• Trade allows people to specialize in what
they do best.
Principle #6: Markets Are Usually a Good Way
to Organize Economic Activity.
• A market economy is an economy that
allocates resources through the
decentralized decisions of many firms and
households as they interact in markets for
goods and services.
• Households decide what to buy and who to
work for.
• Firms decide who to hire and what to produce.
Principle #6: Markets Are Usually a Good Way
to Organize Economic Activity.
• Adam Smith made the observation that
households and firms interacting in markets
act as if guided by an “invisible hand.”
• Because households and firms look at prices
when deciding what to buy and sell, they
unknowingly take into account the social costs
of their actions.
• As a result, prices guide decision makers to
reach outcomes that tend to maximize the
welfare of society as a whole.
Principle #7: Governments Can Sometimes
Improve Market Outcomes.
• Markets work only if property rights are
enforced.
• Property rights are the ability of an individual to
own and exercise control over a scarce resource
• Market failure occurs when the market fails
to allocate resources efficiently.
• When the market fails (breaks down)
government can intervene to promote
efficiency and equity.
Principle #7: Governments Can Sometimes
Improve Market Outcomes.
• Market failure may be caused by:
• an externality, which is the impact of one person
or firm’s actions on the well-being of a
bystander.
• market power, which is the ability of a single
person or firm to unduly influence market
prices.
HOW THE ECONOMY AS A WHOLE
WORKS
• A country’s standard of living depends on
its ability to produce goods and services.
• Prices rise when the government prints too
much money.
• Society faces a short-run trade-off between
inflation and unemployment.
Principle #8: A Country’s Standard of Living Depends
on Its Ability to Produce Goods and Services.
• Standard of living may be measured in
different ways:
• By comparing personal incomes.
• By comparing the total market value of a
nation’s production.
Principle #8: A Country’s Standard of Living Depends
on Its Ability to Produce Goods and Services.
• Almost all variations in living standards are
explained by differences in countries’
productivities.
• Productivity is the amount of goods and
services produced from each hour of a
worker’s time.
Principle #9: Prices Rise When the
Government Prints Too Much Money.
• Inflation is an increase in the overall level of
prices in the economy.
• One cause of inflation is the growth in the
quantity of money.
• When the government creates large
quantities of money, the value of the money
falls.
Principle #10: Society Faces a Short-run Trade-off
between Inflation and Unemployment.
• The Phillips Curve illustrates the trade-off
between inflation and unemployment:
• Inflation or Unemployment
• It’s a short-run trade-off!
• The trade-off plays a key role in the analysis of
the business cycle—fluctuations in economic
activity, such as employment and production
Thinking Like an Economist
Every field of study has its own terminology
ƒ Mathematics
• integrals ™ axioms ™ vector spaces
ƒ Psychology
• ego ™ id ™ cognitive dissonance
ƒ Law
• promissory ™ estoppel ™ torts ™ venues
ƒ Economics
• supply ™ opportunity cost ™ elasticity ™ consumer
surplus ™ demand ™ comparative advantage ™
deadweight loss
Thinking Like an Economist
Economics trains you to. . . .
ƒ Think in terms of alternatives.
ƒ Evaluate the cost of individual and social
choices.
ƒ Examine and understand how certain events
and issues are related.
THE ECONOMIST AS A SCIENTIST
The economic way of thinking . . .
ƒ Involves thinking analytically and objectively.
ƒ Makes use of the scientific method.
ƒ Uses abstract models to help explain how a
complex, real world operates.
ƒ Develops theories, collects and analyzes data to
evaluate the theories.
The Scientific Method: Observation, Theory, and
More Observation
• Uses abstract models to help explain how a
complex, real world operates.
• Develops theories, collects and analyzes
data to evaluate the theories.
The Role of Assumptions
• Economists make assumptions in order to
make the world easier to understand.
• The art in scientific thinking is deciding
which assumptions to make.
• Economists use different assumptions to
answer different questions.
Economic Models
• Economists use models to simplify reality in
order to improve our understanding of the
world.
• Two of the most basic economic models
are:
• The Circular Flow Diagram
• The Production Possibilities Frontier
Our First Model: The Circular-Flow Diagram
• The circular-flow diagram is a visual model
of the economy that shows how dollars flow
through markets among households and
firms.
The Circular Flow
MARKETS
Revenue
FOR
GOODS AND SERVICES
•Firms sell
Goods
•Households buy
and services
sold
Wages, rent,
and profit
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Spending
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
Our First Model: The Circular-Flow Diagram
• Factors of Production
• Inputs used to produce goods and services
• Land, labor, and capital
• Firms
• Produce and sell goods and services
• Hire and use factors of production
• Households
• Buy and consume goods and services
• Own and sell factors of production
Our First Model: The Circular-Flow Diagram
• Markets for Goods and Services
• Firms sell
• Households buy
• Markets for Factors of Production
• Households sell
• Firms buy
Our Second Model: The Production
Possibilities Frontier
• The production possibilities frontier is a
graph that shows the combinations of
output that the economy can possibly
produce given the available factors of
production and the available production
technology.
The Production Possibilities Frontier
Quantity of
Computers
Produced
3,000
C
A
2,200
2,000
B
Production
possibilities
frontier
D
1,000
0
300
600 700
1,000
Quantity of
Cars Produced
Our Second Model: The Production
Possibilities Frontier
• Concepts illustrated by the production
possibilities frontier
•
•
•
•
Efficiency
Trade-offs
Opportunity cost
Economic growth
A Shift in the Production Possibilities Frontier
Quantity of
Computers
Produced
4,000
3,000
2,300
2,200
0
G
A
600 650
of
1,000 CarsQuantity
Produced
Microeconomics and Macroeconomics
• Microeconomics focuses on the individual
parts of the economy.
• How households and firms make decisions and
how they interact in specific markets
• Macroeconomics looks at the economy as a
whole.
• Economy-wide phenomena, including inflation,
unemployment, and economic growth
THE ECONOMIST AS POLICY ADVISOR
• When economists are trying to explain the
world, they are scientists.
• When economists are trying to change the
world, they are policy advisors.
Positive versus Normative Analysis
• Positive statements are statements that
attempt to describe the world as it is.
• Called descriptive analysis
• Normative statements are statements about
how the world should be.
• Called prescriptive analysis
Positive Versus Normative Analysis
• Are the following positive or normative
statements?
?
?
• An increase in the minimum wage will cause a
decrease in employment among the leastskilled.
• POSITIVE
?
?
• Higher federal budget deficits will cause
interest rates to increase.
• POSITIVE
Positive Versus Normative Analysis
?
• Are the following positive or normative
statements?
• The income gains from a higher minimum wage are
worth more than any slight reductions in employment.
• NORMATIVE
?
• State governments should be allowed to collect from
tobacco companies the costs of treating smokingrelated illnesses among the poor.
• NORMATIVE
?
WHY ECONOMISTS DISAGREE
• They may disagree about the validity of
alternative positive theories about how the
world works.
• They may have different values and,
therefore, different normative views about
what policy should try to accomplish.
DO ECONOMISTS AGREE?
• A ceiling on rents reduces the quantity and quality of housing
available
• 93%
• Tariffs and import quotas usually reduce general economic welfare
• 93%
• Fiscal policy has a significant stimulative impact on a less than fully
employed economy
• 90%
• If the government budget is to be balanced, it should be done over the
business cycle rather than yearly
• 85%
• A minimum wage increases unemployment among young and
unskilled workers
• 79%
Summary
Summary
• The principles of personal decision making
are:
– People face trade-offs.
– The cost of something is what you give up to
get it.
– Rational people think at the margin.
– People respond to incentives.
Summary
• The principles of economic interaction are:
– Trade can make everyone better off.
– Markets are usually a good way to organize
economic activity.
– Governments can sometimes improve market
outcomes.
Summary
• The principles of the economy as a whole
are:
– A country’s standard of living depends on its
ability to produce goods and services.
– Prices rise when the government prints too
much money.
– Society faces a short-run trade-off between
inflation and unemployment.
Summary
• Economists try to address their subjects
with a scientist’s objectivity.
– They make appropriate assumptions and build
simplified models in order to understand the
world around them.
– Two simple economic models are the circularflow diagram and the production possibilities
frontier.
Summary
• Economics is divided into two subfields:
– Microeconomics is the study of decisionmaking by households and firms in the
marketplace.
– Macroeconomics is the study of the forces and
trends that affect the economy as a whole.
Summary
• A positive statement is an assertion about
how the world is.
• A normative statement is an assertion
about how the world ought to be.
• When economists make normative
statements, they are acting more as policy
advisors than scientists.
Summary
• Economists who advise policymakers offer
conflicting advice either because of
differences in scientific judgments or
because of differences in values.
• At other times, economists are united in
the advice they offer, but policymakers may
choose to ignore it.