Macroeconomics – The Basics

DoaneX

MODULE 1
Economics = a social science that examines how humans make decisions and the impacts of those
decisions. All decisions are necessitated by scarcity. Something is scarce if the amount available is less than
desired.

Macroeconomics = examines how we as a group make such decisions and the impact of these decisions on
society

Microeconomic = looks at the decisions of individuals.

1.1 Basic 5 step decision model

criteria are the characteristics of the alternatives that are most important to you.

Opportunity cost is the highest valued foregone alternative or what you give up for what you get. It is the
real cost of any decision. increasing opportunity cost is typical.

1.2 production possibilities curve

Notice it is “bowed out” meaning that it is

concave in nature. This is due to the
increasing opportunity cost. All points on this
curve or inside it are possible.

Points inside the curve would represent

unemployment or inefficiency.

Points outside the curve are not

possible given our resources and
technology.
 Suzy Land can produce more of each good than Carter
Court. This is called an absolute advantage.

We can still have a mutually advantageous trade. The key

is the opportunity costs. If the opportunity costs are
different, then mutually advantageous trade is possible.

Mutually Advantageous trade is possible because of

comparative advantage.

A country or an individual has a comparative advantage when he or she can produce something at the
lowest opportunity cost. Notice this advantage is comparative – that means that if one has a comparative
advantage in the first good the other must have the advantage in the second. This is the beauty of
comparative advantage, everybody has an advantage!

The trade will be mutually advantageous if the terms of the trade are between the opportunity costs of
each country.

We can choose any point on the production possibilities curve, inside the curve and through trade we can
consume at a point even beyond the curve. To know where we are on the curve, we must measure the
economic activity of the country. The Bureau of Labor Statistics do this by surveying.

The broadest measure of the economy is GDP – Gross Domestic Product.

GDP = the total market value of all final goods and services produced in the economy in one year.

has its flaws:

1. it only includes items that go through a market. So illegal goods, or goods traded between individuals
would not be counted.

2. the GDP counts final goods and services. This helps us avoid double counting. A Final good is a good
ready for the ultimate consumer. The alternative is intermediate goods. Intermediate goods are goods used
in the production of other things.

3. Considers what is produced in one year. Goods are counted in the year they are made not sold.

Gross Domestic Product versus Gross National Product.

These two attempt to measure the economic activity for the economy but they look at the matter slightly
differently.
The two are used for different purposes.

The GDP is used to gauge domestic economic activity and domestic employment. While GNP is used to
gauge the wealth of a country’s citizens. You see some third world countries may have very high GDP but
low GNP because the output and the wealth it produces belongs to people in other countries.

real versus nominal GDP

Nominal GDP is measured in current dollars. And it shows that between the years we had inflation. This is
why it is called inflation, because it inflates the output.

To get rid of this inflation factor so we can see what really happened to output, we use real GDP.

Real GDP holds prices constant and holds the consecutive years' GDP at these constant prices.

To compare GDP across countries we look at GDP per capita. That is GDP divided by population. Even if we
look at a country with a high GDP per capita, that assumes the output is distributed evenly across the
population. And we know that is not the case. So GDP per capita is a poor measure of the welfare of the
citizens in a country.

What matters most is not how high GDP is but is it growing. Growing GDP is key to a better tomorrow. GDP
can be large but stagnant.
MODULE 2
2.1 The Business Cycle
The business cycle is a non-symmetric wave like pattern of Real GDP. The amplitude (height) and wave
length varies in an inconsistent way. The cycle is not smooth, does not have a consistent amplitude or
height, or wavelength. Hopefully, the long run trend is upward as the economy grows.

There are many reasons offered for the business cycle:

Life cycle hypothesis – the life cycle of new technology. As the new technology comes into use we see an
expansion. The new technology gets applied in many new ways, but then the applications decline and that
technology leads to no further expansion. At this point, we await the next technological boom. Now, this
explains booms but not busts.

Monetary policy and interest rates - this is a policy-driven explanation. Low interest rates lead to
expansions, then as inflation heats up the Federal Government (we will talk about them in module 6)
increases interest rates which slows down the economy.

Consumer confidence - everything has to do with expectations. As consumer confidence increases, people
behave in an expansion manner. If their expectations fail, then their decreased actions follow and create
recessions.

How do we know where we are in the cycle?

Economists use economic indicators = economic variables that economists use to determine where we are
in the business cycle.

Leading economic indicators are economic variables that change before the economy changes average
work week
Coincidence economic indicators are economic variables that change with changes in the economy
manufacturing sales, these are sales of goods that have been produced.

Lagging economic indicators are economic variables that change after the economy changes

 consumer price index (measures what has already happened to prices)

 growth of GDP
 unemployment rate
 inflation

If the Leading Index turns up we can interpret this to mean we are headed for expansion.

If the Coincidence Index moves up, we can interpret this to mean we are actually in an expansion period.

If the Lagging Index moves up, we can interpret this to mean that we have been in an expansion for a while.
Sometimes these indexes agree sometimes and they disagree.

MODULE 3
3.1 Comparative Economic Systems
An economic system is the institutions, regulations, organizations, beliefs and culture that influence how
productive activity takes place. No matter how an economic system is organized it must address three basic
questions:

 What will be produced?

 How will it be produced?
 For whom will it be produced?

To differentiate systems we look primarily at property rights. That is, who owns the property. The rights
you must possess to own something are:

 the right to determine the use of something

 the right to the income generated by the use
  the right to sell the item.

There are three basic types of property rights structures: private, public and collective.

Here are the major types of economic systems, capitalism, market socialism and planned economies.

The circular flow model shows the flow of products from businesses to households and the flow of
resources from households to businesses. In exchange for these resources, money payments flow between
businesses and households.
There are a few assumptions in this model.

- Represents a simple economy where households spend all their income in the upper loop and
demand all consumer goods and services from businesses.
- Businesses seek profits by supplying all goods and services to households through the product markets
(no inventories).

INNER CIRCLE

The price and quantities in all markets are determined

by the market supply and demand model.

The consumer demands from business the products and

services they are willing to purchase.

Those payments are revenue for the businesses and

businesses then use the revenue to pay for their factors
of production.

There is an equilibrium point for wage and quantity of

worker.

The employees get paid and take it to their household and the households spend the money to purchase goods
and services in the markets, which shows demand and supply at the top of the chart.

OUTER CIRCLE

Price and quantities in all markets are

determined by the market supply and demand
model.

The actual goods and services are supplied to

the households upon purchase.
The households supply the factors of production in the markets resources such as land, labor, and capital, which
are owned by households and supplied to businesses.

The forces of supply and demand determine the returns to the factors (wages and the quantity of labor
supplied).

These factors are supplied to the businesses and, continuing on the circle, the businesses supply the goods and
services to the markets in exchange for money payments.

The simple circular flow model fails to mirror the real world. But it does aid your understanding of the
relationships among product markets, factor markets, the flow of money, and the theory behind GDP
measurement.

3.2 Market
The market is the key to capitalism and the allocation of resources. It is THE mechanism for that allocation. The
market is where our two actors meet, producers and consumers. We are interested in how these actors make
their decisions.

CONSUMERS

Consumers want to buy things, we call that demand.

Demand = a schedule or a curve that shows the quantities of a good consumers are willing and able to purchase
at alternative prices, ceteris paribus.

It’s a list of various prices and the corresponding quantities demanded. Ceteris paribus means everything else
equal. There are lots of factors that affect a person's willingness and ability to buy something, these are held
constant at one point in time so we can examine the demand.

Notice that demand is the entire table or the entire line, while quantity demanded is a single entry in the table
or a single point on the curve. Quantity demanded is associated with a single price, while demand is a list of
prices and quantities.

Notice the relationship of quantity demanded and price. As price falls the quantity demanded increases. This
inverse relationship is called the Law of demand. In the real world sometimes when price falls people actually
buy less, it is called the snob effect. People may perceive the lower price as inferior and stop buying the good.
If something other than price changes the demand curve can shift. An increase in demand means that at every
price the quantity demanded rises. This will make the curve move to the right. If there is a decrease in demand,
at every price the quantity demanded falls and the curve moves left.
MODULE 4
4.1 Economic Philosophies
Demand = the quantity demanded of a good at various prices of that good.

Aggregate Demand = the total market value of all final goods and services consumers are willing and able to
purchase at alternative prices indexes ceteris paribus. So, Aggregate demand shows the total spending (the real
GDP) at each level of a price index.

There are philosophies of how the economy works.

1. Neoclassical

Neoclassicists believe Supply creates its own demand. Every sales create income for workers and producers.
Supply is the key economic variable to watch. Neoclassical economists have great faith in the market
mechanism: they believe Macroeconomic problems correct themselves, we return to equilibrium with no
shortages and no surpluses and stable price levels. This philosophy has proven accurate in the Long-run view of
the economy. There policy view is non-interventionist, a limited role for government. They are often called
Supply siders.

2. Keynesians

Keynesians believe that demand is the most important - Demand creates its own supply. Designed to explain
great depression that did not correct itself.

They are considered Interventionists, that is they believe in an activist role of government in the economy. They
believe that there are times when the outcome of the market, the equilibrium, can set itself at a place of
massive unemployment – like the great depression. So the government must correct the market equilibrium.
This is a short-term view. The founder of this philosophy, John Maynard Keynes even said, “In the long-run we
are all dead!”

Aggregate Supply = shows the total real GDP produced in the economy at various price levels. As a curve, it
slopes upward. As the price level rises (if input prices fixed), firms have an incentive to produce more because
selling output at a higher price, if costs have not gone up, means more profit! In the long-run, this Aggregate
Supply curve goes vertical.
Aggregate demand = shows total spending on real GDP at various price levels. How much of real GDP will people
buy at various prices.

This curve is downward sloping for three reasons:

1. The Wealth effect = as the price level rises that decreases the real value (the purchasing power) of wealth so
spending decreases.

2. The Interest rate effect = as the price level rises, the nominal interest rate (the rate lenders ask) will increase
in order to maintain their rate of return and so spending will fall, people won’t be able to afford to borrow
money to buy homes or businesses won’t be able to afford to borrow money to build new factories.
3. The Foreign price effect = as the US price level rises relative to other countries, US people switch to cheaper
imports and foreign citizens see our goods as more expensive so they decrease exports, so the amount spent on
US goods falls.
What causes these curves to shift? Determinants.
Starting with Aggregate Supply, the determinants are:

 Productivity of Inputs - the more productive the resources the lower the costs and the AS curve will
shift to the right – more real GDP can be produced at each price level.
 Input prices – wages, energy – as these prices fall they lower the costs and the AS curve will shift to the
right – more real GDP can be produced at each price level.
 Regulations - again as they are removed costs are lowered and the AS curve will shift to the right.
 Business taxes - again as these fall costs are lower and the AS curve will shift to the right.

In case of an increase in aggregate supply, AS curve moves to the right. Price level falls and real GDP
increases. This means inflation falls and employment increases, or unemployment decreases.
For a decrease in AS – the curve moves to the left. Price level rises and real GDP falls. This will cause
inflation to rise and can cause unemployment.
An increase in AD moves the curve to the right, causes an increase in the price level increasing inflation and
increasing real GDP and perhaps decreasing unemployment.
A decrease in AD moves the curve left, this causes a decrease in real price level and inflation and a decrease
in real GDP and employment.
MODULE 6
6.1 Money
Money is anything generally accepted in exchange for goods and services.
It is the acceptability of something that makes it money.
Why do we need money? Money performs functions in an economy.
MEDIUM OF EXCHANGE
- without money you would have to trade goods and services for goods and services, that is called
bartering.
- Money solves the issue of double coincidence of wants, which says for trade to occur, you have to
want what I have and I have to want what you have.
- Money makes complex transactions possible in an economy.

STORE OF VALUE
- you can hold your purchasing power in money.
UNIT OF ACCOUNT
- this is the idea that you can use the monetary price of two items to compare them.
STANDARD OF DEFERRED PAYMENT
- means that you can denominate future payments in money. You can borrow from your future
today (A loan).

When something that can be used to produce something else is used as money, like gold or silver or even
flour or meat, that is called commodity money.

Why do people demand money?

demand for money = demand for non-interest bearing money balances in a bank account or as cash.
the interest rate is the price of money. It is the actual price if you borrow money and the opportunity cost
you forego it you use your own money, because you could earn that interest rate why would people hold
cash or money in a non-interest bearing checking account?

Money Demand
There are three main reasons why people hold money balances.
1. transactions demand people hold cash and money in their checking accounts to pay the bills, to shop, to
go to the movies and do other spending.
2. people hold money balances for speculative reasons, that is, just in case a good deal comes along.
3. people hold money balances just in case something bad happens, that is called the precautionary
demand.
The demand for money balances (non-interest earning) follows
the law of demand.
The nominal interest rate is the price and the MD is the demand
for money. At high interest rates the quantity demanded of
money balances in checking accounts or in our pockets will be
small. People will hold very little cash, instead they will invest
their money to get this high rate.
As the nominal interest rate falls the quantity demanded of
money balances increases. At low interest rates, the return will
not be enough to make up for the inconvenience of transferring
money from some interest earning investment to your checking
account in order to buy things. So people will leave the money in
their checking accounts or as cash and the quantity demanded of
money balances will be high.
Money Supply

The money supply can be defined in many ways.

1. consists of coin and currency in the hands of the public, checkable deposits (which I will call demand
deposits) and traveler's checks. This definition of money includes the most liquid of assets, that is things
that can be used immediately to buy goods.
2. we can adds less liquid assets like savings accounts and CDs.

Notice the money supply is vertical.

That is because the supply of money in the market does not
change as the interest rate changes, the money supply changes in
order to change the interest rate.
The quantity of money supplied does not depend on the interest
rate, the interest rate depends on the quantity of money supplied.
And the quantity of money supplied is used to set the interest
rate.

The demand for money balances could increase, because of

changes in the transactional, speculative and precautionary
demands. This increase in demand for money causes a
shortage at the original nominal interest rate and that drives
up the interest rate.
If the interest rate increases, business and household
spending decreases – people don’t buy houses, businesses
don’t expand and real GDP falls.
If the demand for money decreases (income drops) it causes a
surplus at the original nominal interest rate and drives down
the interest rate.
If the interest rate decreases, the interest rate can cause
business and household spending to increase – people buy
houses, businesses expand and real GDP rises.

If the Money supply increases, the interest rate falls causing increases in business and household spending
and real GDP.
If the Money supply decreases, the interest rate rises, decreasing business and household spending and
real GDP. So who ever controls the Money supply can impact employment, inflation and trade.
MODULE 7
7.1 The 3 Major Economic Philosophies
The three major economic philosophies of our time: Neoclassical, Keynesian and Marxism agree that
“Capitalism is unstable.” Capitalism is plagued by periods of expansion and contraction, expansion and
recession. The disagreement between the philosophies comes when we talk about what to do about it.

For Neoclassical thinkers the solution to these fluctuations is to do nothing. Neoclassical economists see
such cycles as necessary to spur innovation and drive the economy forward to create greater wealth for all.

Keynesians say we must smooth out these cycles by government intervention, guaranteeing consistent
demand for goods and services and thus consistent incomes for all.

But Marxists reject the source of these fluctuations – capitalism itself. Marxist conclude we must replace it
with something else, something other than the market and capitalism.

7.2 Neoclassical

Adam Smith is the father of classical economics. In his book called The Causes and Nature of the Wealth of
Nations published in 1776, he explained his idea: within human interactions, seeking their own self-interest
was a regulating mechanism, which he called the invisible hand.
Individuals seeking their own self interest in unregulated exchange will lead to the greatest wealth of all
and efficient use of resources. Smith concluded that the wealth of a nation lies in the ability of individuals
to pursue their own self interest in the free exchange of goods and services.
According to Adam Smith, the productive ability of the people of a nation is its true wealth, not gold, not
the King.
How did this theory affect policy?
- The key is faith in the market and its invisible hand.
- If the market is efficient and if it does lead to the highest level of wealth for all, then the policy
implication is – leave the market alone.
- economy is a very complex machine and the government is a very bad mechanic.
- Government is often a foe rather than a friend of the market.
Policies supported by neoclassical economists include:
- to endow and protect each individual with the full freedom to act in his or her own self-interest
(including public education, the small business administration that provides loans and other aid to
entrepreneurs).
- Protections would include provision of a legal system that limits monopoly and protects private
property.
- the government should establish the institutional framework (competitive markets and private
property) that guarantees that freedom, limiting regulations and negotiating free trade.

To a neoclassical economists, business cycles are necessary. They provide impetus for innovation, they
move resources from falling industries and nudge the economy into new markets.
The first rule of economics for the neoclassical economists is that people respond to incentives. If you
impose regulations to prop up failing industries you decrease the incentives for businesses and workers to
look elsewhere, to new markets, new products, to innovate.
Unemployment will occur as industries change – so government should provide safety nets for individuals
to help them until they find new jobs. And should help them retrain for new industries. But too much help
can discourage initiative.
Money was left out of neoclassical theory until the mid seventies, when Nobel prize economist Milton
Friedman wrote a book called Free to Choose. Friedman said some inflation, small steady increases in
prices, was good for an economy to keep business investing and wages rising. But too much inflation was
due to having too much money in circulation! Think of an auction, bidders will bid for a good based on how
much they value it and the amount of money they have to spend. If we double the amount of money they
have to spend, then the final prices of the auction will be twice as high. Friedman also brought up the
notion of reality is less important to individuals when making decisions than what is expected.

According to modern neoclassical economists, expectations are the most important predictor of human
behavior. Since the economic activity results from the decisions and actions of individuals, then
understanding and predicting those decisions and actions is central to predicting the economy. The key to
this prediction is expectations. According to this theory people act on what they expect. If you expect gas
prices to increase on labor day because you have seen that in the past, then you fill up before labor day!
That is adaptive expectation in action – using what you know from the past to predict the future, you adapt.
Rational expectations are formed using all information. So maybe in the past gas prices have risen on labor
day weekend BUT this year you read that there is a surplus of gasoline and prices are not expected to rise
by experts.

The bottom line is if you are a neoclassical economist then you favor - Less government regulation, Lower
taxes, Privatization, and Steady growth of money supply. Let markets work.

7.2 Keynesian
JM Keynes wrote the General Theory of Employment , Interest , and Money (1936), this book was his
explanation of the lingering unemployment the world experienced during the great depression.
According to Keynes the free market, the invisible hand, failed, so he created a new model where the
behaviour of individuals did not determine the economy, but the economy determined human behaviour.

The key to economic health is spending or aggregate demand.

The government has the charge and the tools to cure unemployment and inflation with fiscal policy,
changes in spending and taxes.
Keynesian economics ruled from the 1940s to the 1980 when stagflation – high unemployment and high
inflation together, something Keynes said could not happen, proved the theory to be at the least,
incomplete.
Then in 2008, we had worldwide recession that caused policy makers seeking action to return to Keynesian
ideas.
7.3 Marxism

Marx’s dialectic materialism is an extension of Hegel’s philosophy the Dialectic.

The Dialectic stated that all human history is a series of conflict and resolution, the great dialogue. Marx
added the notion that all conflict arises from material concerns.

He said human society develops or evolves through 5 stages :

1. Human history starts with the primitive communal stage – hunter and gatherers.
2. As the group expands this mode of production cannot sustain the population so the relations of
production evolve to slavery. One group conquers and enslaves another.
3. Eventually, this mode of production will evolve to a feudal system where slaves become peasants
working for landlords. Though no longer actual slaves, an enslavement persist in the tribute – rent - due the
landlord.
4. Next, the relations of production changes to capitalism, where peasants become wage earners and the
landlords are replaced by capitalists. Again, though free, enslavement continues as capitalists exploit the
workers for their own profit.
5. Finally, all exploitation is removed when society evolves to communism.

Marx is most well known for his critique of capitalism. Destined to fail due to internal struggle, capitalism
was only one stop on the evolutionary trek of human society to the ultimate communism. Let’s examine
these forces that lead to the downfall of capitalism.

 First, is the notion of surplus value. This is the concept that workers create goods and services of value
beyond their wages. As a matter of fact, Marx believed wages would always be at a subsistence level,
capitalist paying only enough to keep the workforce alive. Any extra value above what was returned to
the worker was called surplus value. This was the capitalist profit, unearned because he did not
participate in the production. This surplus value taken by the capitalist from the worker was
exploitation. The system of capitalism, built on the exploitation of the worker would experience
increasing income inequality that would eventually cause revolution within the system.
 Marx said the foundation of the exploitation was private property – the base of the society. The
superstructure were the laws and institutions it took to maintain this unjust and unnatural base. The
base of private property created relations of production where workers were alienated from the fruits
of their labour and from each other. Work, which Marx felt was a communal, collaborative effort was
segregated by the employer- employee relationship. How could the output of a worker be owned by
another? Did it not belong to the worker as much, if not more than to the capitalist who employed
him?
 Another source of instability in capitalism was competition. To expand their business, capitalist would
compete by lowering prices, but restrained by, at least subsistence wages, profit rates would decline.
Such forces would encourage monopoly and the means of production would become concentrated in
the hands of a few. This consolidation would further increase the income inequality and lead to a
transition. But a transition to what?
Marx never got around to writing about the ultimate society called communism. Modern communism and
socialism for that matter is an interpretation of Marx.
What Marx did propose was the abolition of all exploitation by removing the cause of all inequality –
private property. This would change the base of the economy and the mode and relations of production.
Society would be released from the evils of capitalism to explore first, socialism then communism. Here
production is organized so that workers who produce the surplus would get it and distribute it as they
chose. All who labour would have equal say in how production takes place and how the fruits of that
production is distributed.

Today, many nations follow a form of the communist ideas of Marx. Each communist society is organized
differently but they share one theme, public ownership of the means of production. But in most of these
societies that public ownership is concentrated in the hands of a few powerful rulers and not the worker.