Lecture notes on Macroeconomics Theory

what is macroeconomic theory and policy. what are macroeconomics and microeconomics. what are macroeconomics principles. pdf free download
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Macroeconomics: Theory, Models & Policy Macroeconomics Theory, Models and Policy Doug Curtis and Ian Irvine 2014 Macroeconomics: Theory, Models & Policy publishing with a major international publisher. This time they Our philosophy decided to break out and publish a high-quality book in electronic Macroeconomic: Theory, Models and Policy is focused on the format only. This format has several advantages over the traditional material that students need to cover in a first introductory course. It format. is slightly more compact than the majority of introductory macroeconomics books in the Canadian marketplace. Decades of  It is fully downloadable, in contrast to texts that are teaching experience and textbook writing has led the authors to avoid typically ‘on-line’. Most publishers give electronic access to the encyclopedic approach that characterizes the recent trends in students who purchase their books, but do not permit textbooks. downloads. Our open access policy is expressed in the use of the Creative Commons icon at the beginning of this Consistent with this approach, there are no appendices or introductory section. ‘afterthought’ chapters. If important material is challenging then it is still included in the main body of the text; it is not relegated  The book is accompanied by a full set of power elsewhere for a limited audience; the text makes choices on what points for instructors and students. These are downloadable issues and topics are important in an introductory course. This in their original Microsoft PowerPoint format, and philosophy has resulted in a Macro book of just 15 chapters, with consequently can be further developed by instructors. three introductory chapters and the International Trade chapter, common to both Micro and Macro.  Multiple choice questions and problems requiring numerical and graphic solutions that match each chapter are Examples are domestic and international in their subject matter available in sets to instructors who adopt the Lyryx Learning and are of the modern era – financial markets, monetary and fiscal Package. policies aimed at inflation and debt control, globalization and the importance of trade flows in economic structure and concerns about  While there is no requirement that users of the book slow growth and the risk of deflation are included. do anything more than download the pdf files and use them for non-profit educational purposes, the texts are aligned The title is intended to be informative. Students are introduced to with the interactive on-line testing software supplied by the concepts of models early, and the working of such models is LYRYX Learning. This software can be used by instructors illustrated in every chapter. Calculus is avoided; but students learn to to formulate weekly assignments and labs or can be used by master and solve linear models. Hence straight line equations and the student for self-testing with instant feedback. diagrams are introduced early and are used throughout.  Instructors may obtain the original Word files from the authors if the instructors decide that they want to amplify Accessibility and linkages certain sections for their own students The form of this book is completely new to the Canadian market. The authors have many years of experience in hard-copy book Curtis Irvine Macroeconomics 2014 ii Macroeconomics: Theory, Models & Policy A traditional Aggregate Demand and Supply model is introduced Structure and Content to provide a consistent analytical framework for development of Macroeconomics: Theory, Models and Policy, provides complete, sector topics that follow. The analysis builds on a study of short-run concise coverage of introductory macroeconomic theory and policy. business cycle fluctuations in output and employment, under It examines the Canadian economy as an economic system, and constant equilibrium price conditions. The balance of payments, embeds current Canadian institutions and approaches to monetary exchange rate policy, and monetary and fiscal policy under different policy and fiscal policy within that system. Particular attention is exchange rate systems complete the short-run open economy model. given to the recent structure, performance, and evolution of the Canadian economy, and to the current targets and instruments of A basic modern Aggregate Demand and Supply model of output Canadian monetary and fiscal policy. and the inflation rate is also developed based on: These are exciting and challenging times in which to study • Current Canadian monetary policy based on inflation macroeconomics. We focus on short-run macroeconomic targets, interest rate policy instruments, and current Bank of performance, analysis, and policy motivated by the recessions of the Canada operating techniques, including the potential for early 1980s and 1990s, the financial crisis and recession of 2008– quantitative or credit easing. 2009, and the prolonged recovery in most industrial countries. To • Current Canadian fiscal policy based on deficit and that end, the text examines macroeconomic institutions, performance, and policies in ways that help students understand and evaluate debt control targets, the government’s budget function, the temporary shift to fiscal stimulus in 2009 and the implications critically the news media coverage and broader public discussion of: for budget balances and the public debt. • Recessions and recoveries, unemployment, inflation, deflation and conditions in financial markets—topics of Numerical examples, diagrams, and basic algebra are used in combination to illustrate and explain economic relationships. ongoing reporting, discussion, and debate. Students learn about the importance of trade flows, consumption; • Monetary and fiscal policy announcements and government budgets; money supply; financial asset prices, yields, discussions focused on inflation targets, interest rate settings, and interest rates; employment and unemployment; and other key budget balances, tax rates, expenditures, and public debt relationships in the economy. Canadian and selected international targets as these affect economic performance. data are used to provide real world examples and comparisons • Exports, imports, international capital flows, foreign exchange rates, and the importance of the international sector of the Canadian economy. • Economic growth, productivity growth, and the importance of productivity growth for standards of living in Canada and other countries. Curtis Irvine Macroeconomics 2014 iii Macroeconomics: Theory, Models & Policy 3.6 Simultaneous supply and demand impacts 3.7 Market interventions Table of Contents 3.8 Individual and market functions Part One: Introduction Chapter 1 Introduction to Key Ideas Part Two: Introduction to Macroeconomics 1.1 The big issues in economics Chapter 4 Economic Activity & Performance 1.2 Understanding through the use of models 4.1 Indicators of macroeconomic activity and performance 1.3 Opportunity cost and the market 4.2 Recent Canadian economic performance 1.4 A model of exchange and specialization 4.3 National accounts and economic structure 1.5 Economy wide production possibilities 4.4 Nominal GDP, real GDP and the GDP deflator 1.6 Aggregate output, growth and business cycles 4.5 Per capita real GDP, Productivity and Standards of living Chapter 2 Theories and Models Meet Data Chapter 5 Output, Business Cycles and Employment 2.1 Observations, theories and models 5.1 An aggregate demand and supply model 2.2 Variables, data and index numbers 5.2 Equilibrium output and potential output 2.3 Testing economic models and analysis 5.3 Growth in potential output 2.4 Diagrams and economic analysis 5.4 Business cycles and output gaps 2.6 Ethics, efficiency and beliefs 5.5 Output gaps and unemployment rates Chapter 3 Demand and Supply in the Classical Marketplace 5.6 Adjustments to output gaps? 3.1 Trading 5.7 The role of macroeconomic policy 3.2 The market’s building blocks Chapter 6 Aggregate Expenditure and Aggregate Demand 3.3 Demand and supply curves 6.1 Short run aggregate demand and output 3.4 Other influences on demand 6.2 Consumption, saving and investment 3.5 Other influences on supply Curtis Irvine Macroeconomics 2014 iv Macroeconomics: Theory, Models & Policy 6.3 Exports and imports Chapter 9 Financial Markets, Interest Rates, Foreign Exchange Rates and Aggregate Demand 6.4 Aggregate expenditure and equilibrium output 9.1 Portfolio choices between money and other assets 6.5 The multiplier 9.2 Bond prices, yields and interest rates 6.6 Equilibrium output and the AD curve 9.3 The demand for money balances Chapter 7 The Government Sector 9.4 Financial market equilibrium and interest rates 7.1 Government in Canada 9.5 Interest rates and foreign exchange rates 7.2 Government expenditure, taxes and equilibrium real GDP 9.6 Interest rates, exchange rates and aggregate demand 7.3 The government budget and budget balance 9.7 The monetary transmission mechanism 7.4 Fiscal policy and government budgets Chapter 10 Central Banking and Monetary Policy 7.5 Automatic and discretionary fiscal policy 10.1 Central banking and the Bank of Canada 7.6 The public debt and the budget balance 10.2 Central banking operating techniques 7.7 Aggregate demand and equilibrium output 10.3 Monetary policy targets and instruments 10.4 Monetary policy rules Part Three: Financial Markets and Economic Activity 10.5 The long-run neutrality of money 10.6 Monetary policy indicators Chapter 8 Money, Banking and the Money Supply 8.1 Money and the functions of money Part Four: Real GDP, Business Cycles, Policy and 8.2 Measures of the Canadian money supply Growth 8.3 Banking in Canada today 8.4 Money created by banks Chapter 11 Traditional AD-AS model 8.5 The monetary base and the money supply 11.1 The construction of an AD curve 11.2 The slope of the AD curve Curtis Irvine Macroeconomics 2014 v Macroeconomics: Theory, Models & Policy 11.3 The short run AS curve Part 5: International Macroeconomics and Trade Theory 11.4 Short run equilibrium GDP and the price level 11.5 The causes of business cycles in real GDP Chapter 14 International Macroeconomics 11.6 Automatic adjustment to output gaps? 14.1 The balance of payments accounts 11.7 Monetary policy and fiscal policy 14.2 The foreign exchange market 14.3 Flexible vs. fixed exchange rates Chapter 12 An AD – AS Model: Inflation & Real GDP 14.4 Monetary and fiscal policy under flexible exchange rates 12.1 Inflation and aggregate demand 14.5 Monetary and fiscal policy under fixed exchange rates 12.2 Aggregate supply 12.3 The equilibrium inflation rate Chapter 15 International Trade 12.4 Adjustment to output gaps 15.1 Trade in our daily lives 12.5 Monetary policy & fiscal policy 15.2 Canada and the world economy 12.6 Recession and deflation 15.3 Comparative advantage: the gains from trade 15.4 Returns to scale Chapter 13 Economic Growth 15.5 Trade barriers: tariffs, subsidies and quotas 13.1 Growth in potential output 15.6 The politics of protection 13.2 Growth in per capita GDP 15.7 Institutions governing trade 13.3 Technology and growth in per capita output 13.4 Neoclassical growth theory and the convergence hypothesis Glossary 13.5 Recent growth studies and policy issues Curtis Irvine Macroeconomics 2014 vi Economics is everywhere. It is about how society deals with the problems of scarcity and the allocation of resources among Part 1 alternatives. It is the study of individual behaviours based on economic motives and the interactions among individual behaviours that result in societal and economy wide outcomes. Sometimes it makes sense to use markets and sometimes we Introduction need other solutions. Sometimes what seems to be common sense for individuals or individual families is nonsense for the economy as a whole. Economic analysis helps us to think about the need for and design of government policies to influence economic behaviour and outcomes. Chapter 1: Introduction to Key Ideas This part of the text uses three chapters to introduce economics Chapter 2: Theories, Models and Data issues, economic questions, economic theory, economic tools of analysis and simple economic models Chapter 3: The Classical Marketplace – Demand and Supply Chapter 1 Introduction to key ideas Economics, at its best, is a set of ideas and methods for the improvement of society. It is not, as so often seems the case today, a set of ideological rules for asserting why we 1 cannot face the challenges of stagnation, job loss and widening inequality. Christopher Sims, Nobel Laureate in Economics 2011 Introduction to key This is an elegant definition of economics and serves as a timely ideas caution about the perils of ideology. Economics evolves continuously as current observations and experience provide new evidence about economic behavior and relationships. Inference and In this chapter we will explore: policy recommendations based on earlier theories, observations and institutional structures require constant analysis and updating if they 1. The big issues in economics are to furnish valuable responses to changing conditions and problems. 2. Understanding through the use of models Much of today’s developed world faces severe challenges as a 3. Opportunity cost and the market result of the financial crisis that began in 2008. Unemployment rates among young people are at historically high levels in several 4. A model of exchange and specialization economies, government balance sheets are in disarray, and inequality 5. Production possibilities for the economy is on the rise. In addition to the challenges posed by this severe economic cycle, the world simultaneously faces structural upheaval: 6. Aggregate output, growth and cycles overpopulation, climate change, political instability and globalization challenge us to understand and modify our behavior. These challenges do not imply that our world is deteriorating. Literacy rates have been rising dramatically in the developing world 1.1 What’s it all about? for decades; child mortality has plummeted; family size is a fraction of what it was 50 years ago; prosperity is on the rise in much of Asia; The big issues life expectancy is increasing universally and deaths through wars are Economics is the study of human behavior. Since it uses scientific in a state of long term decline. methods it is called a social science. We study human behavior to better understand and improve our world. During his acceptance These developments, good and bad, have a universal character speech, a recent Nobel Laureate in Economics suggested: and affect billions of individuals. They involve an understanding of Curtis Irvine Macroeconomics 2014 1 Chapter 1 Introduction to key ideas economies as large organisms with interactive components. The Individual economic decisions need not be world-changing study of economies as large interactive systems is called events, or motivated by a search for profit. For example, economics macroeconomics. Technically, macroeconomics approaches the is also about how we choose to spend our time and money. There are economy as a complete system with feedback effects among sectors quite a few options to choose from: sleep, work, study, food, shelter, that determine national economic performance. Feedbacks within transportation, entertainment, recreation and so forth. Because both the system mean we cannot aggregate from observations on one time and income are limited we cannot do all things all the time. household or business to the economy as a whole. Application Box Many choices are routine or are driven by necessity. You have to eat 1.1 gives an example. and you need a place to live. If you have a job you have committed some of your time to work, or if you are a student some of your time Macroeconomics: the study of the economy as system in which is committed to lectures and study. There is more flexibility in other feedbacks among sectors determine national output, employment and choices. Critically, microeconomics seeks to understand and explain prices how we make choices and how those choices affect our behavior in the workplace and society. Individual behaviors A critical element in making choices is that there exists a Individual behavior underlies much of our social and economic scarcity of time, or income or productive resources. Decisions are interactions. Some individual behaviors are motivated by self-interest, invariably subject to limits or constraints, and it is these constraints others are socially motivated. The Arab Spring of 2011 was sparked that make decisions both challenging and scientific. by individual actions in North Africa that subsequently became mass movements. These movements were aimed at improving society at Microeconomics also concerns business choices. How does a large. Globalization, with its search for ever less costly production business use its funds and management skill to produce goods and sources in Asia and elsewhere, is in part the result of cost-reducing services? The individual business operator or firm has to decide and profit-maximizing behavior on the part of developed-world what to produce, how to produce it, how to sell it and in many cases, entrepreneurs, and in part attributable to governments opening their how to price it. To make and sell pizza, for example, the pizza parlor economies up to the forces of competition, in the hope that living needs, in addition to a source of pizza ingredients, a store location standards will improve across the board. The increasing income (land), a pizza oven (capital), a cook and a sales person (labour). share that accrues to the top one percent of our population in North Payments for the use of these inputs generate income to those America and elsewhere is primarily the result of individual self- supplying them. If revenue from the sale of pizzas is greater than the interest. costs of production, the business earns a profit for the owner. A business fails if it cannot cover its costs. At the level of the person or organization, economic actions form the subject matter of microeconomics. Formally, microeconomics is In these micro-level behaviors the decision makers have a the study of individual behavior in the context of scarcity. common goal: to do as well as he or she can, given the constraints imposed by the operating environment. The individual wants to mix Microeconomics: the study of individual behavior in the context of work and leisure in a way that makes her as happy or contented as scarcity Curtis Irvine Macroeconomics 2014 2 Chapter 1 Introduction to key ideas possible. The entrepreneur aims at making a profit. These actors, or agents as we sometimes call them, are maximizing. Such maximizing behavior is a central theme in this book and in Application Box 1.1 The Paradox of Thrift. economics at large. Finance Minister Jim Flaherty and Bank of Canada Governor Mark Carney in 2011 urged Canadian households to increase Markets and Government their savings in order to reduce their record high debt-to-income Markets play a key role in coordinating the choices of individuals ratio. On an individual level this makes obvious sense. If you with the decisions of business. In modern market economies goods could save more and spend less you could pay down the and services are supplied by both business and government. Hence balances on credit cards, your line of credit, mortgage and we call them mixed economies. Some products or services are other debts. available to those who wish to buy them and have the necessary But one household’s spending is another household’s income. income - as in cases like coffee and wireless services. Other For the economy as a system, an increase in households’ services are provided to all people through government programs saving from say 5 percent of income to 10 percent reduces like law enforcement and health care. spending accordingly. But lower spending by all households will reduce the purchases of goods and services produced in Mixed economy: goods and services are supplied both by private the economy, and therefore has the potential to reduce national suppliers and government. incomes. Furthermore, with lower income the troublesome debt- Markets offer the choice of a wide range of goods and services to-income ratio will not fall, as originally intended. Hence, at various prices. Individuals can use their incomes to decide the while higher saving may work for one household in isolation, higher saving by all households may not. The interactions and pattern of expenditures and the bundle of goods and services they feed backs in the economic system create a ‘paradox of prefer. Businesses sell goods and services in the expectation that the thrift.’ market price will cover costs and yield a profit. The paradox can also create problems for government finances The market also allows for specialization and separation and debt. Following the recession that began in 2008/09, between production and use. Rather than each individual growing many European economies with high debt loads cut spending her own food, for example, she can sell her time or labor to and increased taxes to in order to balance their fiscal accounts. employers in return for income. That income can then support her But this fiscal austerity reduced the national incomes on which desired purchases. If businesses can produce food more cheaply government tax revenues are based, making deficit and debt than individuals the individual obviously gains from using the problems even more problematic. Feedback effects, within and market – by both having the food to consume, and additional across economies, meant that European Union members could income with which to buy other goods and services. Economics not all cut deficits and debt simultaneously. seeks to explain how markets and specialization might yield such gains for individuals and society. Curtis Irvine Macroeconomics 2014 3 Chapter 1 Introduction to key ideas We will represent individuals and firms by envisaging that they 1.2 Understanding through the Use of Models have explicit objectives – to maximize their happiness or profit. Most students have seen an image of Ptolemy’s concept of our However, this does not imply that individuals and firms are Universe. Planet Earth forms the centre, with the other planets and concerned only with such objectives. On the contrary, much of our sun revolving around it. The ancients’ anthropocentric view of microeconomics and macroeconomics focuses upon the role of the universe necessarily placed their planet at the centre. Despite government: how it manages the economy through fiscal and being false, this view of our world worked reasonably well - in the monetary policy, how it redistributes through the tax-transfer system, sense that the ancients could predict celestial motions, lunar patterns how it supplies information to buyers and sets safety standards for and the seasons quite accurately. products. More than one Greek astronomer believed that it was more Since governments perform all of these socially-enhancing natural for smaller objects such as the earth to revolve around larger functions, in large measure governments reflect the social ethos of objects such as the sun, and they knew that the sun had to be larger voters. So, while these voters may be maximizing at the individual as a result of having studied eclipses of the moon and sun. level in their everyday lives, and our models of human behavior in Nonetheless, the Ptolemaic description of the universe persisted until microeconomics certainly emphasize this optimization, economics Copernicus wrote his treatise “On the Revolutions of the Celestial does not see individuals and corporations as being devoid of civic Spheres” in the early sixteenth century. And it was another hundred virtue or compassion, nor does it assume that only market-based years before the Church accepted that our corner of the universe is activity is important. Governments play a central role in modern heliocentric. During this time evidence accumulated as a result of the economies, to the point where they account for more than one third work of Brahe, Kepler and Galileo. The time had come for the of all economic activity in the modern mixed economy. Ptolemaic model of the universe to be supplanted with a better model. While governments supply goods and services in many spheres, All disciplines progress and develop and explain themselves governments are fundamental to the just and efficient functioning of using models of reality. A model is a formalization of theory that society and the economy at large. The provision of law and order, facilitates scientific enquiry. Any history or philosophy of science through our legal system broadly defined, must be seen as more than book will describe the essential features of a model. First, it is a simply accounting for some percentage our national economic stripped down, or reduced, version of the phenomenon that is under activity. Such provision supports the whole private sector of the study. It incorporates the key elements while disregarding what are economy. Without a legal system that enforces contracts and respects considered to be secondary elements. Second, it should accord with property rights the private sector of the economy would diminish reality. Third, it should be able to make meaningful predictions. dramatically as a result of corruption, uncertainty and insecurity. It is Ptolemy’s model of the known universe met these criteria: it was not the lack of such a secure environment in many of the world’s excessively complicated (for example distant stars were considered economies that inhibits their growth and prosperity. as secondary elements in the universe and were excluded); it corresponded to the known reality of the day, and made pretty good Let us consider now the methods of economics, methods that are common to science-based disciplines. Curtis Irvine Macroeconomics 2014 4 Chapter 1 Introduction to key ideas predictions. Evidently not all models are correct and this was the 1.3 Opportunity Cost and the Market case here. Individuals face choices at every turn: In deciding to go to the hockey game tonight, you may have to forgo a concert; or you will Model: a formalization of theory that facilitates scientific enquiry. have to forgo some leisure time this week order to earn additional In short, models are frameworks we use to organize how we income for the hockey game ticket. Indeed, there is no such thing as think about a problem. Economists sometimes interchange the terms a free lunch, a free hockey game or a free concert. In economics we theories and models, though they are conceptually distinct. A theory say that these limits or constraints reflect opportunity cost. The is a logical view of how things work, and is frequently formulated on opportunity cost of a choice is what must be sacrificed when a the basis of observation. A model is a formalization of the essential choice is made. That cost may be financial; it may be measured in elements of a theory, and has the characteristics we described above. time, or simply the alternative foregone. As an example of an economic model, suppose we theorize that a Opportunity cost: what must be sacrificed when a choice is made household’s expenditure depends on its key characteristics: such a model might specify that wealth, income, and household size Opportunity costs play a determining role in markets. It is determine its expenditures, while it might ignore other, less precisely because individuals and organizations have different important, traits such as the household’s neighborhood or its opportunity costs that they enter into exchange agreements. If you religious beliefs. The model reduces and simplifies the theory to are a skilled plumber and an unskilled gardener, while your neighbor manageable dimensions. From such a reduced picture of reality we is a skilled gardener and an unskilled plumber, then you and your develop an analysis of how an economy and its components work. neighbor not only have different capabilities, you also have different opportunity costs, and you could gain by trading your skills. Here’s Theory: a logical view of how things work, and is frequently why. Fixing a leaking pipe has a low opportunity cost for you in formulated on the basis of observation. terms of time: you can do it quickly. But pruning your apple trees An economist uses a model as a tourist uses a map. Any city map will be costly because you must first learn how to avoid killing them misses out some detail—traffic lights and speed bumps, for example. and this may require many hours. Your neighbour has exactly the But with careful study you can get a good idea of the best route to same problem, with the tasks in reverse positions. In a sensible world take. Economists are not alone in this approach; astronomers, you would fix your own pipes and your neighbor’s pipes, and she meteorologists, physicists, and genetic scientists operate similarly. would ensure the health of the apple trees in both backyards. Meteorologists disregard weather conditions in South Africa when If you reflect upon this ‘sensible’ solution—one that involves predicting tomorrow’s conditions in Winnipeg. Genetic scientists each of you achieving your objectives while minimizing the time concentrate on the interactions of limited subsets of genes that they input—you will quickly realize that it resembles the solution believe are the most important for their purpose. Even with huge provided by the marketplace. You may not have a gardener as a computers, all of these scientists build models that concentrate on the neighbor, so you buy the services of a gardener in the marketplace. essentials. Likewise, your immediate neighbor may not need a leaking pipe repaired, but many others in your neighborhood do, so you sell your Curtis Irvine Macroeconomics 2014 5 Chapter 1 Introduction to key ideas service to them. You each specialize in the performance of specific In figure 1.1 Amanda's capacity is represented by the line that tasks as a result of having different opportunity costs or different meets the vertical axis at 18 and the horizontal axis at 12. The efficiencies. Let us now develop a model of exchange to illustrate the vertical point indicates that she can produce 18 units of V if she advantages of specialization and trade, and hence the markets that produces zero units of F – keep in mind that where V has a value of facilitate these activities. This model is developed with the help of 18, Amanda has no time left for fish production. Likewise, if she some two-dimensional graphics. devotes all of her time to fish she can produce 12 units, since each unit requires 3 of her 36 hours. The point F = 12 is thus another possibility for her. In addition to these two possibilities, which we can term 'specialization', she could allocate her time to producing 1.4 A model of exchange and specialization some of each good. For example, by dividing her 36 hours equally We have two producers and two goods: Amanda and Zoe produce she could produce 6 units of F and 9 units of V. A little computation vegetables (V) and or fish (F). Their production capabilities are will quickly convince us that different allocations of her time will defined in table 1.1 and in figure 1.1, where the quantity of V lead to combinations of the two goods that lie along a straight line appears on the vertical axis and the quantity of F on the horizontal joining the specialization points. We will call this straight line axis. Zoe and Amanda each have 36-hour weeks and they devote that Amanda’s production possibility frontier (PPF): it is the time to producing the two goods. But their efficiencies differ: combination of goods she can produce while using all of her Amanda requires two hours to produce a unit of V and three hours resources - time. She could not produce combinations of goods for a unit of F. As a consequence, if she devotes all of her time to V represented by points beyond this line (to the top right). She could she can produce 18 units, or if she devotes all of her time to F she indeed produce combinations below it (lower left) - for example a can produce 12 units. Or, she could share her time between the two. combination of 4 units of V and 4 units of F; but such points would not require all of her time. The (4, 4) combination would require just 20 hours. In sum, points beyond this line are not feasible, and points Table 1.1 Production Possibilities in a Two-Person Economy within it do not require all of her time resources. Hours/ Hours/ Fish Vegetable Production possibility frontier (PPF): the combination of goods production production that can be produced using all of the resources available fish vegetable Having developed Amanda’s PPF, it is straightforward to Amanda 3 2 12 18 develop a corresponding set of possibilities for Zoe. If she requires 4 Zoe 2 4 18 9 hours to produce a unit of V and 2 hours to produce a unit of F, then her 36 hours will enable her to specialize in 9 units of V or 18 units Each producer has a time allocation of 36 hours. By allocating total time to of F; or she could produce a combination represented by the straight one activity, Amanda can produce 12F or 18V, Zoe can produce 18F or 9V. line that joins these two specialty extremes. By splitting their time each person can also produce a combination of the two. Curtis Irvine Macroeconomics 2014 6 Chapter 1 Introduction to key ideas So we have established two things about Amanda and Zoe’s production possibilities. First, if Amanda specializes in V she can produce more than Zoe, just as Zoe can produce more than Amanda if Zoe specializes in F. Second, their opportunity costs are different: Amanda must sacrifice more V than Zoe in producing one more unit of F. To illustrate the gains from specialization and trade, let us initially suppose that Amanda and Zoe are completely self-sufficient (they consume exactly what they produce), and they each divide their production time equally between the two goods. Hence, Amanda produces and consumes 6F and 9V, whereas Zoe’s combination is 9F and 4.5V. These combinations must lie on their respective PPFs and are illustrated in figure 1.1. Upon realizing that they are not equally efficient in producing the two goods, they decide to specialize completely in producing just the single good where they are most efficient. Amanda specializes in V and Zoe in F. Right away we notice that this allocation of time will realize 18V and 18F, which is more than the combined amounts they Consider now what we term the opportunity costs for each produce and consume when not specializing - 15F and 13.5V. Logic person. If Amanda, from a starting point of 18 V and zero F, wishes dictates that each should be able to consume more following to produce some F, and less V she must sacrifice 1.5 units of V for specialization. What they must do however, is negotiate a rate at each unit of F she decides to produce. This is because F requires 50% which to exchange V for F. Since Amanda's opportunity cost is 3:2 more hours than V. Her trade-off is 1.5:1.0, or equivalently 3:2. In and Zoe's is 1:2, perhaps they agree to exchange V for F at an the graphic, for every 3 units of V she does not produce she can intermediate rate of 2:2 (or 1:1, which is the same). With Amanda produce 2 units of F, reflecting the hours she must devote to each. specializing in V and Zoe in F they now trade one unit of V for one Yet another way to see this is to recognize that if she stopped unit of F. Consider figure 1.2. producing the 18 units of V entirely, she could produce 12 units of F; If Amanda can trade at a rate of 1:1 her consumption and the ratio 18:12 is again 3:2. This then is her opportunity cost: the opportunities have improved dramatically: if she were to trade away cost of an additional two units of F is that 3 units of V must be all of her 18V, she would get 18 fish in return, whereas when 'sacrificed'. consuming what she produced, she was limited to 12 fish. Suppose Zoe’s opportunity cost, by the same reasoning, is 1:2 - 1 unit of she wants to consume both V and F and she offers Zoe 8V. Clearly V for 2 units of F. Curtis Irvine Macroeconomics 2014 7 Chapter 1 Introduction to key ideas she will get 8F in return, and she will consume (8F + 10V) – more 1.5 Economy-wide Production Possibilities than she consumed prior to specializing. The PPFs in figure 1.1 define the amounts of the goods that each individual can produce while using all of their productive capacity - time in this instance. The national, or economy-wide, PPF for this two-person economy reflects these individual possibilities combined. Such a frontier can be constructed using the individual frontiers as the component blocks. First let us define this economy-wide frontier precisely. The economy-wide PPF is the set of goods combinations that can be produced in the economy when all available productive resources are in use. Figure 1.3 contains both of the individual frontiers plus the aggregate of these, represented by the kinked line a, c, e. The point on the V axis, a = 27, represents the total amount of V that could be produced if both individuals devoted all of their time to it. The point e = 30 on the horizontal axis is the corresponding total for fish. Economy-wide PPF: the set of goods combinations that can be produced in the economy when all available productive resources are in use. To understand the point c, imagine initially that all resources are devoted to V. From such a point, a, we consider a reduction in V and By the same reasoning, after specializing in producing 18 fish, an increase in F. The most efficient way of increasing F production Zoe trades away 8F and receives 8V from Amanda in return. at the point a is to use the individual whose opportunity cost of F is Therefore Zoe consumes (10F + 8V). The result is that they are now least - Zoe. She can produce one unit of F by sacrificing just 1/2 unit each consuming more than in the initial allocation. Specialization 1 of V. Amanda on the other hand must sacrifice 1.5 units of V to and trade have increased their consumption. produce 1 unit of F. Hence, at this stage Amanda should stick to V 1 consumption gains of the type that arise here can also result if one of the In the situation we describe above one individual is absolutely more individuals is absolutely more efficient in produce both goods, but that the efficient in producing one of the goods and absolutely less efficient in the degree of such advantage differs across goods. other. We will return to this model in chapter 15 and illustrate that Curtis Irvine Macroeconomics 2014 8 Chapter 1 Introduction to key ideas and Zoe should devote some time to fish. In fact as long as we want As a final step consider what this PPF would resemble if the to produce more fish Zoe should be the one to do it, until she has economy were composed of many persons with differing degrees of exhausted her time, which occurs after she has produced 18F and has comparative advantage. A little imagination suggests (correctly) that ceased producing V. At this point the economy will be producing it will have a segment for each individual and continue to have its 18V and 18F - the point c. outward concave form. Hence, a four-person economy in which each person had a different opportunity cost could be represented by the segmented line a,b,c,d,e, in figure 1.4. Furthermore, we could represent the PPF of an economy with a very large number of such individuals by a somewhat smooth PPF that accompanies the 4- person PPF. The logic for its shape continues to be the same: as we produce less V and more F we progressively bring into play resources, or individuals, whose opportunity cost, in terms of reduced V is higher. The outputs V and F in our economic model require just one input – time. But the argument for a concave PPF where the economy uses machines, labor, land etc. to produce different products is the same. Furthermore, we generally interpret the PPF to define the output possibilities when it is running at its normal capacity. In this example, we consider a work week of 36 hours to be the ‘norm’. Yet it is still possible that the economy’s producers might work some additional time in exceptional circumstances, and this would increase total production possibilities. This event would be represented by an outward movement of the PPF. From this combination, if the economy wishes to produce more fish Amanda must become involved. Since her opportunity cost is 1.5 units of V for each unit of F, the next segment of the economy- wide PPF must see a reduction of 1.5 units of V for each additional unit of F. This is reflected in the segment c, e. When both producers allocate all of their time to F the economy can produce 30 units. Hence the economy's PPF is the two-segment line ace. Since this has an outward kink, we call it concave (rather than convex). Curtis Irvine Macroeconomics 2014 9 Chapter 1 Introduction to key ideas • the skill, knowledge and experience of the labour force; • the capital stock: buildings, machinery, and equipment, and software the labour force has to work with; and • the current technology embodied in the labour force and the capital stock. Productivity of labour: the output of goods and services per worker. Capital stock: the buildings, machinery, equipment and software used in producing goods and services. The economy’ output, which we define by Y, can be defined as the output per worker times the number of workers; hence, we can write: Y = (number of workers employed) x (output per worker). When the employment of labour corresponds to ‘full employment’ in the sense that everyone willing to work at current wage rates and normal hours of work is working, the economy’s actual output is also its capacity output Y . We also term this c capacity output as full employment output: 1.6 Aggregate Output, Growth & Business Cycles Full employment output: Y = (number of workers at full c The PPF can also be used to illustrate three aspects of employment) x (output per worker) macroeconomics: the level of a nation’s output, the growth of Suppose the economy is operating with full employment of national and per capita output over time, and short run business-cycle resources producing outputs of two types: goods and services. In fluctuations in national output and employment. figure 1.5, PPF shows the different combinations goods and services 0 that the economy could produce in a particular year using all its Aggregate output labour, capital and the best technology available at the time. An economy’s capacity to produce goods and services depends on its endowment of resources and the productivity of those An aggregate economy produces a large variety of outputs in two resources. The two person – two product examples in the previous broad categories. Goods are the products of the agriculture, forestry, section reflect this. mining, manufacturing and construction industries. Services are provided by the wholesale and retail trade, transportation, hospitality, The productivity of labour, defined as output per worker or per finance, health care, legal and other service sectors. As in the two- hour, depends on: Curtis Irvine Macroeconomics 2014 10 Chapter 1 Introduction to key ideas product examples used earlier, the shape of the PPF illustrates the opportunity cost of increasing the output of either product type. Point X on PPF shows one possible structure of capacity output. 0 0 This combination may reflect the pattern of demand and hence expenditures in this economy. Output structures differ among economies with different income levels. High-income economies spend more on services than goods and produce higher ratios of services to goods. Middle income countries produce lower ratios of services to goods, and low income countries much lower ratios of services to goods. Different countries also have different PPF’s and different output structures, depending on their labour forces, labour productivity and expenditure patterns. Economic Growth Three things contribute to growth in the economy. The labour supply grows as the population expands; the stock of capital grows as spending by business on new offices, factories, machinery and equipment expands; and labour-force productivity grows as a result of experience, the development of scientific knowledge combined Recessions and Booms with product and process innovations, and advances in the The objective of economic policy is to ensure that the economy technology of production. Combined, these developments expand operates on or near the PPF – it would use its resources to capacity capacity output. In Figure 1.5 economic growth shifts the PPF out to and have minimal unemployment. However, economic conditions PPF . 1 are seldom tranquil for long periods of time. Unpredictable changes This basic description of economic growth covers the key in business expectations of future profits, in consumer confidence, in sources of growth in total output. Economies differ in their rates of financial markets, in commodity and energy prices, in output and overall economic growth as a result of different rates of growth in incomes in major trading partners, in government policy and many labour force, in capital stock, and improvements in the technology. other events disrupt patterns of expenditure and output. Some of But improvements in standards of living require more than growth in these changes disturb the level of total expenditure and thus the total output. Increases in output per worker and per person are demand for total output. Others disturb the conditions of production necessary. Sustained increases in living standards require sustained and thus the economy’s production capacity. Whatever the exact growth in labour productivity based on advances in the technologies cause, the economy may be pushed off its current PPF. If used in production. expenditures on goods and services decline the economy may Curtis Irvine Macroeconomics 2014 11 Chapter 1 Introduction to key ideas experience a recession. Output would fall short of capacity output demand, increase output and employment and move the economy and unemployment would rise. Alternatively, times of rapidly back to capacity output and full employment. The development and growing expenditure and output may result in an economic boom: implementation of such policies forms the core of macroeconomics. output and employment expand beyond capacity levels. Recession: a fall in output to less than the economy’s capacity output. Boom: a period of high growth that raises output above normal capacity output. Recent history provides examples. Following the U.S financial crisis in 2008-09 many industrial countries were pushed into recessions. Expenditure on new residential construction collapsed for lack of income and secure financing, as did business investment, spending and exports. Lower expenditures reduced producers’ revenues, forcing cuts in output and employment and reducing household incomes. Lower incomes led to further cutbacks in spending. In Canada in 2009 aggregate output declined by 2.9 percent, employment declined by 1.6 percent and the unemployment rate rose from 6.1 percent in 2008 to 8.3 percent. Although economic growth recovered, that growth had not been strong enough to restore the economy to capacity output at the end of 2011. The unemployment rate fell to 7.4 but did not return to its pre-recession Alternatively, an unexpected increase in demand for exports value. would increase output and employment. Higher employment and output would increase incomes and expenditure, and in the process An economy in a recession is operating inside its PPF. The fall in output from X to Z in figure 1.6 illustrates the effect of a recession. spread the effects of higher output sales to other sectors of the Expenditures on goods and services have declined. Output is less economy. The economy would move outside its PPF as at W in figure 1.6 by using its resources more intensively than normal. than capacity output, unemployment is up and some plant capacity is idle. Labour income and business profits are lower. More people Unemployment would fall and overtime work would increase. Extra would like to work and business would like to produce and sell more production shifts would run plant and equipment for longer hours and work days than were planned when it was designed and installed. output but it takes time for interdependent product, labour and financial markets in the economy to adjust and increase employment Output at this level may not be sustainable, because shortages of and output. Monetary and fiscal policy may be needed to stimulate labour and materials along with excessive rates of equipment wear Curtis Irvine Macroeconomics 2014 12 Chapter 1 Introduction to key ideas and tear would push costs and prices up. Again we will examine how the capital stock, and the advances in technology that are the keys to the economy reacts to such a state in our macroeconomic analysis. growth in aggregate output and output per person. Output and employment in Canadian economy over the past Conclusion twenty years fluctuated about growth trend in the way figure 1.6 We have covered a lot of ground in this introductory chapter. It is illustrates. For several years prior to 2008 the Canadian economy intended to open up the vista of economics to the new student in the operated slightly above the economy’s capacity; but once the discipline. Economics is powerful and challenging, and the ideas we recession arrived monetary and fiscal policy were used to fight it – to have developed here will serve as conceptual foundations for our bring the economy back from a point such as Z to a point such as X exploration of the subject. Our next chapter deals with methods and on the PPF. models in greater detail. Macroeconomic models and Policy The PPF diagrams illustrate the main dimensions of macroeconomics: capacity output, growth in capacity output and business cycle fluctuations in actual output relative to capacity. But these diagrams do not offer explanations and analysis of macroeconomic activity. We need a macroeconomic model to understand and evaluate the causes and consequences of business cycle fluctuations. As we shall see, these models are based on explanations of expenditure decisions by households and business, financial market conditions, production costs and producer pricing decisions at different levels of output. Models also capture the objectives fiscal and monetary policies and provide a framework for policy evaluation. A full macroeconomic model integrates different sector behaviours and the feedbacks across sectors that can moderate or amplify the effects of changes in one sector on national output and employment. Similarly, an economic growth model provides explanations of the sources and patterns of economic growth. Demographics, labour market structures and institutions, household expenditure and saving decisions, business decisions to spend on new plant and equipment and on research and development, government policies in support of education, research, patent protection, competition and international trade conditions interact in the growth process. They drive the growth in the size and productivity of the labour force, the growth in Curtis Irvine Macroeconomics 2014 13

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