CHAPTER ONE

I. INTRODUCTION

1. What Is Macroeconomics?
Macroeconomics: is the study of relationships between aggregate economic variables,
such as between output, unemployment, and the rate of inflation. Macroeconomics was
born out of the Great Depression in the 1930s due to the work of John Maynard Keynes, a
British economist. It was the result of people desperately wanting to know what caused
the Depression and how it could be ended. People study macroeconomics for the
following reasons:

A. Curiosity — people want to figure out how what we observe happens and there are
two major questions people seek answers for:
i) What causes the economy to grow over time? (as we want to know what factors will
make people permanently better off).
ii) What causes the economy to experience fluctuations? (as we want to understand why
there are fluctuations in output produced, the number of people unemployed, and the rate
of inflation).
In addressing these two fundamental questions we need to answer questions such as:
What causes inflation?
What causes unemployment?
What affect does inflation have on economic activity?
What affect does a government budget deficit have on economic activity?
How do a country’s international links affect economic activity? And there are so many of
such questions that need to be answered in order to answer the two major questions raised
above.

B. To Become Educated — the Oxford Concise English Dictionary defines this as “the
development of character or mental powers” which is very different from being trained
which is “to teach a person a specified skill by practice”. Universities teach academic
subjects (“abstract, theoretical, not of practical relevance”) and concentrate on educating
students whereas polytechnics teach vocational subjects (“directed at a particular
occupation and its skills”) and concentrate on training students. Economics is first and
foremost an academic subject although studying it also happens to teach good quantitative
(working with numerical information) and analytical (examining and understanding
structures or systems) skills which are valuable in many areas of employment.

C. Employment. — Employment can be gained directly through the education and

knowledge received at university eg. if we understand how economies work we can do
better in life than if we don’t understand how they work. If employers think this subject,
and the skills taught, are useful for the jobs they want to be filled they in their
organizations or enterprises it will increase our chances of gaining employment. The
completion of university study and relatively good performance are also used by
employers as signals of a student’s capabilities regardless of what the students studied.

2. How Do We Study Macroeconomics?

Economics is a social science which means it involves studying society to understand
why people do what they do, but it tries to approach it ”scientifically”. Note that this
approach is not the myth of the neutral uninvolved scientist in a white lab coat seeking the
greater absolute truth. Instead, it is prejudiced, emotive, involved people seeking to make
some sense of what we observe and experience.

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2.1 Economic Models
A fundamental tool used by economists to understand the economy, and one which we
will use repeatedly through this course, is an economic “model” where:
Economic Model: is a theory that summarises, often in mathematical terms, relationships
among economic variables.
And from Concise Oxford Dictionary,
Theory: is a system of ideas explaining something, especially one based on general
principles independent of the particular things to be explained. Or, an economic theory is
a generalisation based on a few principles that enables us to understand and predict the
economic choices made by people. You should note, however, that any model is a
simplified description of a system to assist calculations and predictions. A model takes the
general theoretical view of the world and applies it to a specific setting. In formulating a
model we attempt to approximate the normally very complex and messy reality using a
few factors which believe are the most important ones. Why simplify and approximate?
Because if we didn’t we would have no hope of understanding anything as the complexity
of the literal real world would overwhelm us. Some models use plain old English. Some
models use mathematics. The language of mathematics can be useful because it makes
clear what is going on, and helps us to dispense with less important or irrelevant things. In
developing a model we use two types of variables: exogenous variables and endogenous
variables:

Exogenous Variables: are determined outside of the model. So that they do not capture the
decisions made by people in which we are primarily interested in learning about.
Assuming that some variables are exogenous helps to simplify matters by not having
everything being decided at once.

Endogenous Variables: are determined within the model. And do capture the decisions
made by people in which we are primarily interested in learning about.

So a model is a set of very general “assumptions” plus some more specific assumptions.
Using deductive logic we can then deduce what we expect to happen given certain
circumstances. Then we can compare our deductions with what actually happens using
inductive logic when interpreting data. That is, we can “test” the model using real world
data. If we got it right, great, then maybe we know something about what is going on. If
we got it wrong, then try and think of anew economic model learning from our failure.
This is the scientific part (based on falsification of models and theories — if this interests
you then you should study the philosophy of science), although in economics it is really
only “pseudo-scientific” as the data tends to be non-replicable in many cases (unlike the
natural sciences where experiments can be held under tightly controlled conditions and
repeated) and many theories are not rejected and abandoned even when the data does not
support them.

In building economic models economists tend to assume two general principles about
how people and the societies in which they exist behave in trying to understand the
decisions made by people:
1. Optimisation Principle — people are motivated by self-interest, or equivalently, that
people try and do the best they can. Note that this can be doing the best you can to act
charitably; it doesn’t mean that people are selfish or greedy as is a common
misperception! It also does not rule out making mistakes or having regrets afterwards as

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people may not be all informed or all wise; it simply means people do the best they can
with what they have available to them, including their own decision making capabilities.
2. Equilibrium Principle — that people’s actions tend to become consistent with each
other. In the limit the economic forces are so balanced that there is no tendency for
people’s behaviour to change. Note that this doesn’t mean that the world is static or
unchanging, or that it ever reaches such a state, and it doesn’t tell us how long it takes to
reach an equilibrium even if one was ever reached, it simply says that if people’s actions
are inconsistent with each other that there are economic forces that try and make them
consistent. In many cases, we look at what happens when these forces have worked
through and people’s actions are actually consistent and misses out how this state of
affairs came to be (and some economists are critical of this approach saying the path we
go down influences where we end up.)

Example of the Process of Building an Economic Model:

Say we want to understand what will happen to a firm’s output if the price of the good it
produces increases. To get anywhere we have to set some structure; that is we have to
make some assumptions. So assume that:
- The markets for inputs and outputs are perfectly competitive (=> the prices of
the inputs and outputs are exogenous variables in this problem).
- The technology available is given, that is it is exogenous, and we will also have
to assume what particular type of technology the firm is using i.e. what
characteristics it embodies.
- The level of output is endogenous; it is the variable that is being determined by
the firm, given the other variables.
- We will also have to assume what sort of behaviour we think firms follow i.e.
profit max., output max., wage bill maximiser! (This is where the optimisation
principle is used)
- We will have to assume something about how demand plans and supply plans
are co-ordinated. (This is where the equilibrium principle is used).
All of these things together form a theory of how the firm works, i.e. it is an economic
model. Then we see what behaviour we would expect to be followed by a firm that
experiences a price rise given the model. Going through this exercise can help us
understand what factors influence the behaviour of firms in what ways i.e. we are better
able to understand how firms work. We can also test these models using real world data.
For example, say output of the firm falls if the price of its good increases, then we may
reject our model and have to think some more about how firms work. This may mean
making big changes to the model or small changes, depending on the circumstances.

Once we have developed a model how do we tell if we have a good one? A good model is
one that:
1. Helps us to understand better what we observe.
2. Can be used to predict the macro variables of interest in the future.
Some models are designed to aid our understanding, for other models their predictive
power is the key thing. The key is to test our theories and models against the real world
(and to be honest some economists are not good at this). If the model is shown to be poor
then we learn from it and change it, and if enough different models are shown to be poor
then we take a hard look at the general principles on which they are built and possibly
change them as well.
The method goes something like:
1. Why do people do what they do?

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2. Hypothesise general principles (make a testable proposition/tentative theory) to
understand and make sense of people’s behaviour.
3. Focus on specific behaviour of people that looks interesting and requires
understanding.
– 4. Develop a model to try and understand and make sense of it; i.e. using general
principles + specific assumptions + logical reasoning => deductions.
– 5. Observe and measure relevant people’s behaviour. (That is, collect data on the
relevant variables).
– 6. If observations are inconsistent with deductions then reject model and back to 4.,
learning from the failure.
– 7. If observations are consistent with deductions then do not reject model and go back
to 3., learning from the non-failure.
– 8. If there are lots of rejections of models using the same general principles then go
back to 2., learning from failures. And of course life, being messy and complex, does not
tend to work as smoothly as this makes it out to be. Some people start at 5. and go to 3.
and then to 1. Some people get failures and hide them because there are no rewards for
failures! There are fads and the like which skew what is looked at and what isn’t. Some
people forget entirely about 5! Such is the messy and difficult path to understanding!

3. Why Macroeconomics Is Different From Microeconomics: The Issue of

Aggregation
Since the previously described approach to developing an economic understanding of
society is generic in nature, an obvious question to ask is what makes macroeconomics
any different from microeconomics since they both just involve studying economic
behaviour of people? Recall that microeconomics is the study of the decisions made by
firms and households, and how these decision makers interact in the marketplace.
Macroeconomics is the study of the decision made by all firms and households, and the
interactions of these decision makers in all markets. Furthermore, when studying a single
market we invoke the ceteris paribus assumption but in macroeconomics this is no longer
true since we are studying all markets at the same time. So macroeconomics is different
because of the sheer scale, all markets are aggregated together, and because the general
effects of any changes in behaviour have to be taken into account, rather than just
analysing economic decisions in isolation from each other.

3.1 Techniques for Developing Aggregate Models in Macroeconomics

Studying the aggregation of all markets at the same time creates a major problem — how
do we model aggregate economic behaviour? In microeconomics this was easy, just
model a household or a firm, but how do we model a whole economy? We could try and
model each firm, household, each type of good, at each point in time in a year, but this is
far too complex a task, even if we did have the computing power to do it (there are other
problems with this approach which I will leave alone). So how do we cope with the issue
of aggregation in developing macroeconomic models? There are four basic methods used
to develop macroeconomic models allowing for the fact that we are dealing with whole
economics instead of individual markets:

1) The “Macro Relationship” Paradigm

This just looks at the relationships between macro variables and examines if there is are
systematic relationships and patterns between them, and use our micro economic theory
to guide us in exploring and modelling such relationships and patterns. Our hope is that
distributional stuff averages out, is of secondary importance, or has a systematic bias
which does not change too often over time.

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2) The “Representative Agent” Paradigm
Everyone is the same so we can model the economy as though it behaves like one person,
or firm. This is really just a special case of 1), where the guidance of micro theory is
made explicit.

3) The “Small Number of Differences” Paradigm

Allow people and firms to be different, but only have a very small number of different
agents i.e. two types such as young and old, or rich and poor. This is an extension of 1),
and the hope is that it allows for the major distributional influences.
4) The “Large Number of Differences” Paradigm
Allow lots of differences, but only in very special ways. Typically this means that no
agent can have any measurable effect on economic activity by themselves. That is, there
are few individuals that are so rich (like Bill Gates) that can significantly influence the
economy. This is an extension of 3) with some restrictive assumptions imposed to make it
workable.

Which way is best should be determined by how well the resultant theories and models
help us understand economic behaviour and predict into the future i.e. it is an empirical
matter. In each case we have to compare or test the results of our predictions based on
such modelling with what actually happens. If in using an approach we don’t do a good
job of predicting the future then it could be because this is a bad assumption and we
should reject it. Similar things can be done to handle differences in goods and services,
financial assets, time, geographic space. There is no ultimate solution to the issue of
aggregating over all markets, and whichever way we deal with it involves some problems
we just have to learn to live with. Finally, notice that with each technique we use our
microeconomic ideas and theories to help guide our creation of macroeconomic models.
This is why for the first half of the course we be learning about specific microeconomic
theories and models, so we can use them later on in the second half of the course to guide
us in developing our macroeconomic models.

3.2 The Aggregation Problem

While these basic techniques for aggregating over all markets makes it appear as though
we have figured out how to deal with the issue of aggregation in developing
macroeconomic models, the act of aggregating over all markets creates a problem when
we come to empirical studies of an economy. This is called the aggregation problem: we
can’t distinguish empirically between changes in people’s underlying behaviour and
changes in the distribution of economic activity.