Week 1 chapter notes

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Chapter 1 The Science of Macroeconomics Notes
1.1 What Macroeconomists Study
x macroeconomics Æ the study of the economy as a whole
x because the state of the economy affects everyone, macroeconomic issues play a central role in national political debates
x voters are keenly aware of how economy is doing, and they know that government policy can affect economy in powerful ways
x as a result, the popularity of the government often rises when the economy is doing well and falls when it is doing poorly
x macroeconomic issues are also at the center of world politics
x although the job of making economic policy belongs to world leaders, the job of explaining how the economy as a whole works
falls to macroeconomists due to which macroeconomists collect data on incomes, prices, unemployment, and many other
variables from different time periods and different countries
x then they attempt to formulate general theories that help to explain these data
x macroeconomists observe that economies differ from one another and that they change over time
x these observations provide both the motivation for developing macroeconomic theories and the data for testing them
x since the Canadian economy is a mixture of markets and government policy involvement, this knowledge is useful both for
explaining economic events and for formulating economic policy
x macroeconomic history is not a simple story, but it provides a rich motivation for macroeconomic theory
x although the basic principles of macroeconomics do not change from decade to decade, the macroeconomist must apply these
principles with flexibility and creativity to meet changing circumstances
Case Study: The Historical Performance of the Canadian Economy
x economists use many types of data to measure the performance of an economy
x 3 macroeconomic variables are particularly important: real GDP, the inflation rate, and the unemployment rate
x real GDP Æ measures the total income of everyone in the economy (adjusted for the level of prices)
x inflation rate Æ measures how quickly prices are rising
x unemployment rate Æ measures the fraction of the labour force that is out of work
x macroeconomists study how these variables are determined, why they change over time, and how they interact with one another
x recession Æ a sustained period of falling prices
x depression Æ a very severe recession
x deflation Æ a decrease in the overall level of prices
1.2 How Economists Think
Theory as Model Building
x model Æ a simplified representation of relation, often using diagrams or equations, that shows how these variables interact
x economists build their “toy economies” to help explain economic variables, such as GDP, inflation, and unemployment
x economic models illustrate, often in mathematical terms, the relationships among the variables
x models have two kinds of variables: endogenous variables and exogenous variables
x endogenous variable Æ variable that is explained by particular model; variable whose value is determined by model’s solution
x exogenous variable Æ variable that particular model takes as given; variable whose value is independent of model’s solution
x in other words, exogenous variables come from outside the model and serve as the model’s input, whereas endogenous variables
are determined inside the model and are the model’s output
x the art in economics is in judging where a simplifying assumption clarifies thinking and when it misleads
x simplification is necessary part of useful model: any model constructed to be completely realistic would be too complicated
x yet models lead to incorrect conclusions if they assume away features of the economy that are crucial to the issue at hand
The Use of Multiple Models
x macroeconomists study many facets of the economy: influence of fiscal policy on economic growth, impact of employment
insurance on unemployment rate, effect of inflation on interest rates, and influence of trade policy on exchange rate
x although economists use models to address all these issues, no single model can answer all questions
x economist use different models to explain different economic phenomena
x a model is only as good as its assumptions and an assumption that is useful for some purposes may be misleading for others
x when using a model to address a question, the economist must keep in mind the underlying assumptions and judge whether these
are reasonable for studying the matter at hand
Prices: Flexible versus Sticky
x economists normally presume that price moves quickly to bring quantity supplied and quantity demanded into balance
x market-clearing model (MCM) Æ a model that assumes the prices freely adjust to equilibrate supply and demand
x for answering most questions, economists use market-clearing models
x yet this assumption of continuous market is not entirely realistic
x for markets to clear continuously, prices must adjust instantly to change in supply and demand
x although market-clearing models assume that all wages and prices are flexible, in real world some wages and prices are sticky
x flexible prices Æ prices that adjust quickly to equilibrate supply and demand
x sticky prices Æ prices that adjust sluggishly and, therefore, do not always equilibrate supply and demand
x the apparent stickiness of prices does not necessarily make market-clearing models useless
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x after all, prices are not stuck forever; eventually, they do adjust to changes in supply and demand
x MCMs might not describe economy at every instant, but they do describe equilibrium toward which economy slowly gravitates
x therefore, most macroeconomists believe that price flexibility is a good assumption for studying long-run issues, such as the
growth in real GDP that is observed from decade to decade
x for studying short-run issues, such as year-to-year fluctuations in real GDP and unemployment, assumption of price flexibility is
less plausible as over short periods, many prices are fixed at predetermined levels
x therefore, most macroeconomists believe that price stickiness is better assumption for studying short-run behaviour of economy
Microeconomic Thinking and Macroeconomic Models
x microeconomics Æ the study o individual markets and decision-makers
x a central principle of microeconomics is that households and firms optimize—they do the best they can for themselves given
their objectives and the constraints they face
x in microeconomic models, households choose their purchase to maximize their level of satisfaction, which economists call
utility, and firms make production decisions to maximize their profits
x because economy-wide events arise from interaction of many households and firms, macro and micro are inextricably linked
x although microeconomic decisions underlie all economic models, in many models the optimizing behaviour of households and
firms is implicit rather than explicit
x although microeconomic decisions lie behind all macroeconomic phenomena, macroeconomic models do not necessarily focus
on optimizing behaviour of households and firms but, instead, sometimes leave that behaviour in background
1. Macroeconomics is the study of the economy as a whole—including growth in incomes, changes in prices, and the rate of
unemployment. Macroeconomists attempt both to explain economic events and to devise policies to improve economic
2. To understand the economy, economists use models—theories that simplify reality in order to reveal how exogenous variables
influence endogenous variables. The art in the science of economics is in judging whether a model usefully captures the
important economic relationships for the matter at hand. Because no single model can answer all questions, macroeconomists use
different models to look at different issues.
3. A key feature of a macroeconomic model is whether it assumes that prices are flexible or sticky. According to most
macroeconomists, models with flexible prices describe the economy in the long run, whereas models with sticky prices offer a
better description of the economy in the short run.
4. Microeconomics is the study of how firms and individuals make decisions and how these decision makers interact. Because
macroeconomic events arise from many microeconomic interactions, all macroeconomic models must be consistent with
microeconomic foundations, even if those foundations are only implicit.
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