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ECO209Y5 Midterm: Test 1 Notes

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Miquel Faig

Chapter 1 Introduction (Pgs. 2-27) What is Macroeconomics? • Macroeconomics is the study of the behaviour of large collections of economic agents • It focuses on the aggregate behaviour of consumers and firms, the behaviour of governments, the overall level of economic activity in individual countries, the economic interactions among nations, and the effects of fiscal and monetary policy • Deals with the overall effects on economics of the choices that all economic agents make, rather than the choices of individual consumers or firms (Micro) • Economic models: a description of consumers and firms, their objectives and constraints, and how they interact • Long-run growth: the increase in a nation’s productive capacity and average standard of living that occurs over a long period of time • Business cycles: short-run ups and downs, or booms and recessions, in aggregate economic activity Gross Domestic Product, Economic Growth, and Business Cycles • Gross domestic product (GDP): the quantity of goods and services produced within a country’s borders during some specified period of time • Also represents the aggregate quantity of income earned by those who contribute to production in a country • Fundamental macroeconomic questions: 1. What causes sustained economic growth? 2. Could economic growth continue indefinitely, or is there some limit to growth? 3. Is there anything that governments can or should do to alter the rate of economic growth? 4. What causes business cycles? 5. Could the dramatic decreases and increases in economic growth that occurred during the Great Depression and World War II be repeated? 6. Should governments act to smooth business cycles? • Example: o 𝑦 i𝑡 an observation on an economic time series in period 𝑡 o the growth rate from period 𝑡 − 1 to period 𝑡 in 𝑦 can be denoted by 𝑔 𝑡 𝑡 where 𝑔 = 𝑦𝑡 − 1 𝑡 𝑦𝑡−1 o if 𝑥 is a small number, then log(1 + 𝑥) ≈ 𝑥, the natural logarithm of 1 + 𝑥 is approximately equal to x o if 𝑔 𝑡s small, log(𝑔𝑡+ 1) ≈ 𝑔 𝑡 𝑦 𝑡 log(𝑦 ) ≈ 𝑔𝑡 𝑡−1 log𝑦𝑡− log𝑦 𝑡−1 ≈ 𝑔 𝑡 o since log𝑦 − log𝑦 is the slope of the graph of the natural logarithm 𝑦 𝑡 𝑡−1 𝑡 between periods 𝑡 − 1 and 𝑡, it follows that the slope of the graph of the natural logarithm of a time series 𝑦 is a𝑡good approximation to the growth rate of 𝑦 wh𝑡n the growth rate is small • trend: the smooth growth path around which an economic variable cycles Macroeconomic Models • economics is a scientific pursuit involving the formulation and refinement of theories that can help us better understand how economies work and how they can be improved • in economics, experimentation is a new and growing activity, but for most economic theories experimental verification is simply impossible • in macroeconomics, most experiments that might be informative are simply too costly to carry out • models: artificial devices that can replicate the behaviour of real systems • use models which are organized structures that explain long-run economic growth, business cycles, and the role economic policy should play in the macroeconomy • all economic models are abstractions; they are not completely accurate descriptions of the world, nor are they intended to be • the purpose of an economic model is to capture the essential features of the world needed for analyzing a particular economic problem • a model must be simple and simplicity requires that we leave out some “realistic” features of actual economies • the basic structure of a macroeconomic model is a description of the following features: 1. The consumers and firms that interact in the economy 2. The set of goods that consumers want to consume 3. Consumers’ preferences over goods 4. The technology available to firms for producing goods 5. The resources available • Use the model to make predictions • Need to know what the goals of the consumers and firms in the model are • Assume that consumers and firms optimize • optimize: the process by which economic agents (firms and consumers) do the best they can given the constraints they face • must specify how consistency is achieved in terms of the actions of consumers and firms, in economic models this means the economy must be in equilibrium • equilibrium: the situation in an economy when the actions of all the consumers and firms are consistent • competitive equilibrium: equilibrium in which firms and households are assumed to be price-takers, and market prices are such that the quantity supplied equals the quantity demanded in each market in the economy • when beginning to ask the model questions think of this process as the economic model is by an experimental apparatus and want to attempt to run experiments using this apparatus • begin by running experiments for which we know the answers • once we are satisfied that a model reasonably and accurately captures the economic phenomenon we are interested in, we can start running experiments on the model for which we do not know the answers • macroeconomic research is a process whereby we continually attempt to develop better models, along with better methods for analyzing those models • economic models continue to evolve in a way that helps us better understand the economic forces that shape the world we live in, so that we can promote economic policies that will make society better off Microeconomic Principles • macroeconomic behaviour is the sum of many microeconomic decisions • the best way to construct a macroeconomic model is to work our way up from decision making at the microeconomic model • rational expectations: macroeconomics movement that occurred in the 1970s, introducing more microeconomics into macroeconomics • Lucas critique: the idea that macroeconomic policy analysis can be done in a sensible way only if microeconomic behaviour is taken seriously Disagreement in Macroeconomics • There is a little disagreement in macroeconomics concerning the general approach to be taken to constructing models of economic growth • The Solow growth model is a widely accepted framework for understanding the economic process, and newer endogenous growth models • Endogenous growth models: models that describe the economic mechanism determining the rate of economic growth • There is much controversy among macroeconomists concerning business cycle theory and the role of the government in smoothing business cycles over time • Business cycle theories can be differentiated according to whether they are Keynesian and non-Keynesian • Traditional Old Keynesian models are based on the notion that wages and prices are sticky in the short run, and do not change sufficiently quickly to yield efficient outcomes • In the Old Keynesian world, government intervention through monetary and fiscal policy can correct the inefficiencies that exist in private markets • The rational expectations revolution produced some non-Keynesian theories of the business cycle, including real business cycle theory • Real business cycle theory: a theory, initiated by Finn Kydland and Edward Prescott, implying that the business cycles are caused primarily by shocks to technology and that the government should play a passive role over the business cycle • Keynesian used the developments in macroeconomics that came out of the rational expectations revolution to integrate Keynesian economics with modern macroeconomic thought • The result was two strands of Keynesian thoughtcoordination failures and New Keynesian economics • Coordination failures: a modern incarnation of Keynesian business cycle theory positing the business cycles are caused by self-fulfilling waves of optimism and pessimism, whic
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