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Economic news this morning

The economy added no job in August

Total unemployed: 14 million


Unemployment rate: 9.1%

Gaining sector: healthcare


Losing sector: government

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Jobs added (lost)

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Economic news this morning

Consumer confidence drops to two-year low.

The Conference Boards index slumped to 44.5,


the weakest since April 2009, from a revised 59.2 reading in July.

A leading indicator.

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Two confidence indices

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How do economists study economics?

Primary tool: models simplified versions of a more complex reality irrelevant details are stripped away

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Models

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Models

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Economic models
are used to show relationships between variables explain the economys behavior devise policies to improve economic performance

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Economic Models

Key: identify variables to be determined by the


model (endogenous variables), and variables that are determined outside of the model (exogenous).

Endogenous variables: can be solved by your


model

Exogenous variables: taken as given

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A math analogy

X = 2+aY,

Y = 3 bX.
a = 10, b = 4.

X and Y: endogenous
a and b: exogenous

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Example of a model:

Supply & demand for new cars

shows how various events affect price and


quantity of cars

assumes the market is competitive: each buyer


and seller is too small to affect the market price

Variables:
Q d = quantity of cars that buyers demand Q s = quantity that producers supply P = price of new cars Y = aggregate income Ps = price of steel (an input)
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The demand for cars


demand equation: Q d = D (P,Y )

shows that the quantity of cars consumers


demand is related to the price of cars and aggregate income

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Digression: functional notation

General functional notation


shows only that the variables are related.

Q d = D (P,Y )

A specific functional form shows


the precise quantitative relationship.
A list of the Example: variables that affect D (P,Y ) = 60 Q d 10P + 2Y

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The market for cars: Demand


demand equation:
Price of cars

D (P ,Y )

The demand curve shows the relationship between quantity demanded and price, other things equal.

D
Quantity of cars

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The market for cars: Supply


supply equation:
Price of cars

P
S

Q S (P , Ps )
The supply curve shows the relationship between quantity supplied and price, other things equal.

D
Quantity of cars

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The market for cars: Equilibrium


Price of cars

P
S

equilibrium price

D
Quantity of cars

equilibrium quantity
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The effects of an increase in income


demand equation:

Q d D (P ,Y )
An increase in income increases the quantity of cars consumers demand at each price which increases the equilibrium price and quantity.
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Price of cars

P
S

P2

P1
D1 Q1 Q2

D2

Quantity of cars

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The effects of a steel price increase


supply equation:

Q S (P , Ps )
An increase in Ps reduces the quantity of cars producers supply at each price

Price of cars

S2

S1

P2 P1 D Q2 Q1
Quantity of cars

which increases the market price and reduces the quantity.

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Endogenous vs. exogenous variables

The values of endogenous variables


are determined in the model.

The values of exogenous variables


are determined outside the model: the model takes their values & behavior as given.

In the model of supply & demand for cars,


endogenous:
exogenous:
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P, Q , Q
Y , Ps

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Now you try:


1. Write down demand and supply

equations for wireless phones; include two exogenous variables in each equation.
2. Draw a supply-demand graph

for wireless phones.


3. Use your graph to show how a

change in one of your exogenous variables affects the models endogenous variables.
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Now you try:

Demand for cell phones Exogenous variables Supply for cell phones Exogenous variables Change of equilibrium

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A multitude of models

No one model can address all the issues we


care about.

e.g., our supply-demand model of the car


market

can tell us how a fall in aggregate income


affects price & quantity of cars.

cannot tell us why aggregate income falls.

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A multitude of models

So we will learn different models for studying


different issues (e.g., unemployment, inflation, long-run growth).

For each new model, you should keep track of its assumptions which variables are endogenous,
which are exogenous the questions it can help us understand, and those it cannot
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Prices: flexible vs. sticky

Market clearing: An assumption that prices are


flexible, adjust to equate supply and demand.

In the short run, many prices are sticky


adjust sluggishly in response to changes in supply or demand. For example, many labor contracts fix the nominal wage for a year or longer many magazine publishers change prices only once every 3-4 years
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Prices: flexible vs. sticky

The economys behavior depends partly on


whether prices are sticky or flexible:

If prices are sticky, then demand wont always


equal supply. This helps explain unemployment (excess supply of labor) why firms cannot always sell all the goods they produce

Long run: prices flexible, markets clear,


economy behaves very differently
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Sticky labor price and labor market disequilibrium


With decreasing labor demand, sticky wage leads to a surplus of labor (unemployment) in the labor market.

real wage

W D2
Unemployment

D1

Q Labor
hired
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Why Macroeconomists Disagree

Economists as a group are sometimes criticized


for giving conflicting advice to policymakers.

Differences in scientific judgment Differences in values When economists do agree, policymakers may

not 93% of economists believe tariffs hurt general welfare 90% of economists believe fiscal stimulus works
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Why Macroeconomists Disagree


Classicals vs. Keynesians The classical approach
The economy works well on its own The invisible hand: the idea that if there are free markets and individuals conduct their economic affairs in their own best interests, the overall economy will work well Wages and prices adjust rapidly to get to equilibrium Changes in wages and prices are signals that coordinate peoples actions Result: Government should have only a limited role in the economy
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Why Macroeconomists Disagree

Classicals vs. Keynesians The Keynesian approach


The Great Depression: Classical theory failed because high unemployment was persistent Keynes: Persistent unemployment occurs because wages and prices adjust slowly, so markets remain out of equilibrium for long periods Conclusion: Government should intervene to restore full employment
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Why Macroeconomists Disagree

Classicals vs. Keynesians The evolution of the classical-Keynesian debate


Keynesians dominated from WWII to 1970 Stagflation led to a classical comeback in the 1970s Last 30 years: excellent research with both approaches

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See how economists disagree

Paul Krugman and Holtz-eakin debate on


Newshour:
Video Link

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