Genuine%20 %2001%20-%20 introduction%20to%20macroeconomics

DEPARTMENT OF FINANCEDEPARTMENT OF FINANCEUniversity Of Dar Es Salaam University Of Dar Es Salaam

Business SchoolBusiness SchoolFN 101: Principles of Macroeconomics

Lecture 1:Introduction to

Macroeconomics

Genuine MartinB.Com, M.A. (Economics)

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Meaning of EconomicsMeaning of Economics

Scarcity (No-Free-Lunch) Principle: we have limited resources relative to boundless needs and wants.

Opportunity Cost: having one thing means having less of another.

Therefore choices have to be made wisely. Cost-Benefit Principle: make choices when

extra benefits exceed extra costs, and rank them in preference scale (prioritizing).

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Meaning of EconomicsMeaning of Economics

Economics: a study of choice in the world of scarcity, and of the results of those choices for society.

Its a study of the best ways of doing things (optimizing).

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Core Economic QuestionsCore Economic Questions

Economics is faced with three core issues to resolve.

What to Produce: specific mix of output (millions points on the PPF).

As directed by prices, central plans or both? How to Produce: production techniques or

methods to use (capital intensive, labour intensive, or technology intensive?)

For Whom to Produce: who gets output?

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Core Economic QuestionsCore Economic Questions

Willing and able to pay price (market), or allocated by government (central plans) or both?

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Ten Economic PrinciplesTen Economic Principles

Principle 1: People Face Tradeoffs To get one involves giving up the other. There is no free lunch. Economic growth and high employment

comes at expense of inflation. Trade off: military vs. food (North Korea)

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Principle 2: The Cost of Something is What You Give Up to Get It.

Decisions require comparing costs and benefits.

What you give up to obtain something is called opportunity cost.

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Principle 3: Rational people think at the margin.

Marginal changes are small, incremental adjustments to existing plan of action.

People make decisions by comparing costs and benefits at the margin.

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Principle 4: People Respond to Incentives. Marginal changes in costs and benefits

motivate people to respond. Decision to choose alternatives occurs when

marginal benefits > marginal costs.

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Principle 5: Trade Can Make Everyone Better Off.

Trade allows specialization. Competition drives innovation, risk taking,

initiative, and creativity. Results are decline in costs and prices, new

and better products and services in the market.

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Principle 6: Markets are Usually a Good Way to Organize Economic Activity.

Markets organized economic activity through decentralized system of demand and supply forces, and prices.

Markets create competition and freedom of choice, and people own their efforts/sweat.

Prices signal profits (producers) and quality (consumers).

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Welfare of a society (total surplus) as a whole is maximized.

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Principle 7: Governments Can Sometimes Improve Market Outcomes.

Market failures occur when markets fail to allocate resources efficiently, as a result of:

1. Externality – environment pollution. 2. Market Power – exploitation. Governments can intervene to promote efficiency

and equity using taxes, legislation and macroeconomic policies.

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Principle 8: Standard of Living Depends on the Level of Production.

Standard of living depends on level of income, GDP, GDP per capita, income distribution, and productivity.

Productivity – level of production per hour of worker’s effort.

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Principle 9: Prices Rise When Too Much Money is Printed.

When money supply increases, value of money falls, products are sold at higher price (inflation).

Proposed by Milton Friedman – inflation is anywhere and everywhere a monetary phenomenon.

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Principle 10: Society Faces a Short Run Trade-off between Inflation & Unemployment.

Phillips Curve: efforts to increase economic growth, to reduce unemployment creates with it inflationary pressures.

Unemployment Unemployment InflationInflation

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Common Fallacies in Common Fallacies in EconomicsEconomics

Fallacy – illogical way of reasoning. Flaw in the line of reasoning. Arises because economic relationships are

complex and many variables are studied. Fallacy of Association: Variables moving together

does not mean causing each other. Don’t confuse correlation with causation. E.g. Inflation and unemployment in Phillips relation.

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Post Hoc Ergo Propter Hoc Fallacy (After this, therefore, because of this): If one event occurred before another, it does not mean it caused it occurrence.

Problem of inferring causation. E.g. Sales may increase after hiring a new

secretary. Is it the cause then?

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Failure to Hold Other Things Constant: Failure to hold other things when analyzing an issue.

E.g. Will tax cuts increase government revenue?

What if incomes are rising?

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Challenges of Using Cost-Challenges of Using Cost-Benefit PrincipleBenefit Principle

Rational people apply cost-benefit principle, Rational people apply cost-benefit principle, though in intuitive and approximate way.though in intuitive and approximate way.

However, certain pitfalls arise.However, certain pitfalls arise. Pitfall of measuring costs/benefits Pitfall of measuring costs/benefits

proportionally:proportionally: Absolute shilling amounts not Absolute shilling amounts not proportions should be used.proportions should be used.

Pitfall of Ignoring Opportunity Cost:Pitfall of Ignoring Opportunity Cost: All All relevant opportunity costs should be considered.relevant opportunity costs should be considered.

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Challenges of Using Cost-Challenges of Using Cost-Benefit PrincipleBenefit Principle

Pitfall of Not Ignoring Sunk Costs:Pitfall of Not Ignoring Sunk Costs: Should Should be ignored.be ignored.

Cannot be avoided even if action won’t be Cannot be avoided even if action won’t be taken. E.g. bought a ticket for concert.taken. E.g. bought a ticket for concert.

Pitfall of Using Average Instead of Pitfall of Using Average Instead of Marginal Costs and Benefits:Marginal Costs and Benefits: Increase Increase activity if marginal benefits > marginal costs.activity if marginal benefits > marginal costs.

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Micro and MacroeconomicsMicro and Macroeconomics Adam SmithAdam Smith is founder and father of is founder and father of

microeconomics (1776).microeconomics (1776). Microeconomics:Microeconomics: Branch of economics Branch of economics

concerned with behaviour of individual entities concerned with behaviour of individual entities (markets, firms, households, government).(markets, firms, households, government).

Smith analyzed prices, inherent strength of market Smith analyzed prices, inherent strength of market mechanism, and power of self-interested actions. mechanism, and power of self-interested actions.

John KeynesJohn Keynes is founder and father of is founder and father of macroeconomics (1936).macroeconomics (1936).

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Micro and MacroeconomicsMicro and Macroeconomics Macroeconomics:Macroeconomics: Branch of economics Branch of economics

concerned with overall performance of economy.concerned with overall performance of economy. It studies total investment, consumption, It studies total investment, consumption,

management of money and interest rates, management of money and interest rates, business cycles and financial crises, economic business cycles and financial crises, economic growth and development, problems of inflation growth and development, problems of inflation and unemployment, etc.and unemployment, etc.

Micro and macro are very interdependent and Micro and macro are very interdependent and no one is superior to the other.no one is superior to the other.

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Micro and MacroeconomicsMicro and Macroeconomics Microeconomics forms foundation for Microeconomics forms foundation for

macroeconomics, e.g. national output (macro) macroeconomics, e.g. national output (macro) is derived from aggregation of individual is derived from aggregation of individual production functions of firms (micro).production functions of firms (micro).

Macroeconomic variables (interest rate, Macroeconomic variables (interest rate, inflation, unemployment, money supply, inflation, unemployment, money supply, exchange rate) trickle down their effects to exchange rate) trickle down their effects to micro agents.micro agents.

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How to Study EconomicsHow to Study Economics Economists use tools of economic analysis to Economists use tools of economic analysis to

develop theories/models that explain economic develop theories/models that explain economic choices and working of economy.choices and working of economy.

Theory/Model:Theory/Model: A simplification of economic A simplification of economic reality used to make predictions about real world.reality used to make predictions about real world.

Presented orally, graphically, or mathematically.Presented orally, graphically, or mathematically. Roles:Roles: focus on main elements, develop focus on main elements, develop

analytical framework, make prediction, and analytical framework, make prediction, and foundation for policy formulation.foundation for policy formulation.

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How to Study EconomicsHow to Study Economics To study economic problems, a To study economic problems, a scientific methodscientific method is is

employment.employment. A process of theoretical investigation involving four A process of theoretical investigation involving four

steps.steps. 1. Specify assumptions1. Specify assumptions – lay framework for theory, – lay framework for theory,

e.g. ceteris paribus and rationality.e.g. ceteris paribus and rationality. Flexible if they change.Flexible if they change. 2. Identify and define key variables relevant to 2. Identify and define key variables relevant to

economic problem.economic problem. VariableVariable – a measure that takes different possible – a measure that takes different possible

values.values.

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How to Study EconomicsHow to Study Economics Independent variablesIndependent variables – act as cause. – act as cause. Dependent variablesDependent variables – receive the effect. – receive the effect. 3. Formulate Hypothesis3. Formulate Hypothesis – theory about how key – theory about how key

variables relate to each other.variables relate to each other. A prediction of what happens to dependent A prediction of what happens to dependent

variable when independent variables change.variable when independent variables change. 4. Test validity of theory4. Test validity of theory – predictions confronts – predictions confronts

evidence. evidence. Focus attention on key variables and control Focus attention on key variables and control

others.others.

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How to Study EconomicsHow to Study Economics Conclusion: reject theory as inconsistent or Conclusion: reject theory as inconsistent or

continue using it.continue using it.

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Birth of MacroeconomicsBirth of Macroeconomics Lessons from Great Depression (1929-33).Lessons from Great Depression (1929-33). Most terrible economic event the 20Most terrible economic event the 20thth century. century. Economies shrank drastically, factories and mines Economies shrank drastically, factories and mines

closed, sales decline sharply, production rates cut closed, sales decline sharply, production rates cut by 31%, layoffs tripled, financial markets crushed.by 31%, layoffs tripled, financial markets crushed.

Public and policy makers expected economy to Public and policy makers expected economy to recover automatically (self-adjustment and market recover automatically (self-adjustment and market clearance).clearance).

As it did in 1921-22 recession.As it did in 1921-22 recession.

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Birth of MacroeconomicsBirth of Macroeconomics It tried in 1931, It tried in 1931, Pres. Herbert HooverPres. Herbert Hoover – prosperity – prosperity

is just around the corner.is just around the corner. However, it stopped and drug into deeper recession However, it stopped and drug into deeper recession

and Great Depression.and Great Depression. Causes: Wild speculation in Wall Street (stock Causes: Wild speculation in Wall Street (stock

market crush).market crush). Unstable free market economies – long periods of Unstable free market economies – long periods of

low production and high unemployment.low production and high unemployment. Poor economic policies.Poor economic policies. Lack of understanding how the economy worked.Lack of understanding how the economy worked.

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Birth of MacroeconomicsBirth of Macroeconomics Benefit:Benefit: Forced economists and policymakers to Forced economists and policymakers to

recognize major gaps in understanding on how recognize major gaps in understanding on how economy works.economy works.

That markets fail to adjust and a need of government That markets fail to adjust and a need of government intervention to stimulate economic activity.intervention to stimulate economic activity.

A brilliant economist provided a solution. A brilliant economist provided a solution. John Maynard Keynes (Cambridge economist)John Maynard Keynes (Cambridge economist) – –

insufficient aggregate spending leads to recession insufficient aggregate spending leads to recession and government policies help restore full and government policies help restore full employment.employment.

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Key Macroeconomic Issues Key Macroeconomic Issues and Policiesand Policies

Economic growth and living standardsEconomic growth and living standards – increase in – increase in overall real output, real income, and economic welfare.overall real output, real income, and economic welfare.

What causes economic growth, measures to promote What causes economic growth, measures to promote it.it.

ProductivityProductivity – output per employed worker. – output per employed worker. It determines level of production, real income, and It determines level of production, real income, and

living standards.living standards. What causes productivity growth or declines?What causes productivity growth or declines? Business cyclesBusiness cycles – periods of slower growth – periods of slower growth

(recession) and rapid growth (expansion).(recession) and rapid growth (expansion).

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Sources and government policies to stabilize Sources and government policies to stabilize economy.economy.

UnemploymentUnemployment – wanting to work and can’t – wanting to work and can’t find jobs.find jobs.

It is waste of resources; causes misery and It is waste of resources; causes misery and wider social problems.wider social problems.

What causes and how to address What causes and how to address unemployment?unemployment?

InflationInflation – a rise in general price level. – a rise in general price level.

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Extent to which it becomes harmful, its cumulative Extent to which it becomes harmful, its cumulative nature, its offsetting effect on employment.nature, its offsetting effect on employment.

Why it arises, its trade off with employment and Why it arises, its trade off with employment and how to address it.how to address it.

Economic interdependence among nationsEconomic interdependence among nations – – desirability of free trade agreements, trade desirability of free trade agreements, trade imbalances, international financial flows.imbalances, international financial flows.

To achieve macroeconomic goals, government To achieve macroeconomic goals, government uses uses macroeconomic policymacroeconomic policy..

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Macroeconomic PolicyMacroeconomic Policy – instruments – instruments (economic variables) under control of (economic variables) under control of government used to affect macroeconomic government used to affect macroeconomic goals, avoid worst excesses of business cycle goals, avoid worst excesses of business cycle or increase growth rate of output.or increase growth rate of output.

Fiscal policyFiscal policy – use of taxes and government – use of taxes and government expenditure to affect economic activities.expenditure to affect economic activities.

G affects overall level of spending (relative size G affects overall level of spending (relative size of public and private sectors) and GDP.of public and private sectors) and GDP.

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Taxes affect disposable income and level of Taxes affect disposable income and level of consumption and saving, which affects GDP and level consumption and saving, which affects GDP and level of investment.of investment.

Taxes affect prices of goods and factors of production Taxes affect prices of goods and factors of production affecting demand and supply.affecting demand and supply.

Monetary PolicyMonetary Policy – management of nation’s money, – management of nation’s money, credit and banking system.credit and banking system.

Money supply has critical relationship with financial Money supply has critical relationship with financial (interest rates, stock prices, housing prices, exchange (interest rates, stock prices, housing prices, exchange rates) and real variables (consumption, investment, rates) and real variables (consumption, investment, GDP, price levels).GDP, price levels).

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Expansion of money supply drives down Expansion of money supply drives down interest rates, increase investment, causing a interest rates, increase investment, causing a rise in GDP and inflation.rise in GDP and inflation.

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Key Macroeconomic Key Macroeconomic VariablesVariables

Macroeconomic variables: Macroeconomic variables: characteristics that characteristics that describe a macroeconomy. describe a macroeconomy.

Most important four variables: Most important four variables: aggregate output aggregate output or income; unemployment rate; inflation rate; and or income; unemployment rate; inflation rate; and interest rate. interest rate.

Others:Others: balance of payments, exchange rates, balance of payments, exchange rates, money supply, GDP per capita, etc.money supply, GDP per capita, etc.

Output/Income: Output/Income: measures economy’s overall measures economy’s overall level activity.level activity.

GDP commonly used.GDP commonly used.

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GDPGDP is market value of all final goods and services is market value of all final goods and services produced within geographical boundaries of an produced within geographical boundaries of an economy in a given period of time. economy in a given period of time.

Quoted in nominal or real terms.Quoted in nominal or real terms. Unemployment:Unemployment: quoted using quoted using unemployment rateunemployment rate

(the fraction of labour force not working, but actively (the fraction of labour force not working, but actively seeking employment).seeking employment).

• Inflation Rate: Inflation Rate: the rate of change of general price the rate of change of general price level. It is an important measure of the cost of living.level. It is an important measure of the cost of living.

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Inflation rate is measured as a percentage change in consumer price index (CPI).

Interest Rate:Interest Rate: the price of money, and indicates the price of money, and indicates the health of the financial system, and the economy the health of the financial system, and the economy in general, and forms the basis of pricing financial in general, and forms the basis of pricing financial assets. assets.

Stock vs. Flow Concept:Stock vs. Flow Concept: Economic variables are either stocks or flows.Economic variables are either stocks or flows. Stock Variable: Stock Variable: measured at one specific time, measured at one specific time,

representing a quantity existing at that point in time.representing a quantity existing at that point in time.

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Flow Variable:Flow Variable: measured over an interval of measured over an interval of time. time.

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A A stockstock is accumulated over time by inflows is accumulated over time by inflows and depleted by outflows of and depleted by outflows of flowsflows..

A flow changes a stock over time. For example:A flow changes a stock over time. For example: Capital is a stock that is built by new Capital is a stock that is built by new

investments or depleted by depreciation (flows).investments or depleted by depreciation (flows). Government debt is increased by budget Government debt is increased by budget

deficits, and depleted by budget surplus.deficits, and depleted by budget surplus. Cash is increased by income and depleted by Cash is increased by income and depleted by

spending. spending.

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Theory and RealityTheory and Reality Who is to blame when things don’t work.Who is to blame when things don’t work. Goal ConflictsGoal Conflicts – policies to create jobs – policies to create jobs

(increased public spending and middle-class tax (increased public spending and middle-class tax cut) contradicted a promise to reduce budget cut) contradicted a promise to reduce budget deficit (Bill Clinton)deficit (Bill Clinton)

Low unemployment comes at expense of high Low unemployment comes at expense of high inflation.inflation.

Measurement problemsMeasurement problems – problems of inflation – problems of inflation and unemployment are not clearly visible in time.and unemployment are not clearly visible in time.

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Theory and RealityTheory and Reality Data collection, assembly and dissemination Data collection, assembly and dissemination

take time.take time. Problems of making forecasts, and designing Problems of making forecasts, and designing

macro models that work precisely.macro models that work precisely. Design ProblemsDesign Problems – crafting policies that also – crafting policies that also

foretell how economic agents are going to foretell how economic agents are going to respond is a critical challenge.respond is a critical challenge.

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Theory and RealityTheory and Reality Implementation ProblemsImplementation Problems – making budget – making budget

changes requires approval of parliament.changes requires approval of parliament. When implemented, no assurance it will take When implemented, no assurance it will take

effect at the right time.effect at the right time. Time lags are experienced when problem Time lags are experienced when problem

emerges, recognition, formulating response, emerges, recognition, formulating response, taking action, and action effect on the economy.taking action, and action effect on the economy.

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Time LagsTime Lags Data lag: Data lag: the time needed to gather data on economic the time needed to gather data on economic

variables.variables. Recognition lag: Recognition lag: the substantial amount of time that the substantial amount of time that

may be needed to analyze the trends suggested by the may be needed to analyze the trends suggested by the economic variables.economic variables.

Legislative lag:Legislative lag: fiscal policies require legislative action.fiscal policies require legislative action. Implementation lag:Implementation lag: time to put tax and expenditure time to put tax and expenditure

policy into effect.policy into effect. Impact lag: Impact lag: time for the policy to take effect on the time for the policy to take effect on the

economy after it is finally implemented.economy after it is finally implemented.

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Time LagsTime Lags

Problem emerges

Problem

recognized

Response

formulated

Action

taken

Policy impact

noticeable

Education

Genuine%20 %2001%20-%20 introduction%20to%20macroeconomics