ECN2010 Lecture Notes by Bob Schaller Ó2002

Chapter 1 The Nature and Method of Economics

"Economics is the painful elaboration of the obvious." See http://netec.mcc.ac.uk/JokEc.html for more amazing insight.

Economics Basics:

Take an Economic Perspective:

Economic Perspective (way of thinking) embodies:

Why Study Economics?

Economic Methodology:

Policy Economics: policies derived from theories directed as some course of action (e.g., tax policies)

Macro vs. Micro:

Positive (what is) vs Normative (what ought to be) Analysis:

See Last Word on standing in line (everyday economic decision)

Ch 1 Appendix on Graphs and Their Meaning

We will use graphs a lot - need to be familiar with this appendix

Graphs are simply a tool used to illustrate numeric data in economics and many sciences

In economics, graphs typically used to compare relationship between two variables:

Construct two graphs:

Describe:

Review assignments

Chapter 2 The Economizing Problem

From first chapter: core problem is scarcity (i.e., limited economic resources vs society's unlimited wants and desires), thus must choose (or economize)

Factors of Production (economic resources):

Resource Payments or types of Income include Rent (Land), Interest (Capital), Wages (Labor), and Profit (Entrepreneurial Ability)

See Ch1 goals: full employment and economic efficiency (full production)

Production Possibilities Curve (PPC):

Opportunity Cost:

Law of Increasing Opportunity Cost:

Efficiency, Inefficiency, and Economic Growth:

How to Decide (economic systems in theory):

Markets vs Government:

Circular Flow Diagram (very important):

Chapter 3 Individual Markets

Overall economic goal is to maximize (driven by self-interest):

Specialization and exchange occurs through markets

Circular Flow Model (counter-clockwise flow, fig 2.6):

Market is not just a place, but an institution: function is to bring together buyers (demanders) and sellers (suppliers)

Demand:

Determinants of Demand:

Supply:

Determinants of Supply:

Note that demand and supply schedules/curves represent willingness or intentions, not actual purchases or sales

Market Equilibrium (bringing together supply and demand):

Market Outcomes:

Examples:

Review homework problems

Extra (now in Micro chapters): Legal Prices (gov't policies for ceilings and floors):

Chapter 4 The Market System

Capitalist Ideology: Markets Rule!, assumptions:

None of these totally true, therefore a mixed economy in U.S. and elsewhere

The Four Fundamental Questions:

  1. What goods and services will be produced?
  2. How will the goods and services be produced?
  3. Who will get the goods and services?
  4. How will the system accommodate change?

Circular Flow Model illustrates how market system communicates from consumers to producers to resource suppliers and effectively answers these questions

Economic vs Normal Profits:

Expanding (information technology) vs Declining (cigarettes) industries determined by presence or lack of economic profits (entrepreneurial incentive or "chum")

Examples of expanding or declining industries:

Other terms:

Market System Evaluation:

but…

Review homework problems

Chapter 5 The U.S. Economy: Private and Public Sectors

Comparative Size:

GDP Components and Distribution (inside back cover):

Distribution of Income: functional (fig 5.1) vs personal (fig 5.2):

Business Organization (fig 5.5):

Public Sector: Governments intervene in the economy because of market failure:

Economic role of government is to balance market system forces with society's interests through:

Circular Flow Revisited (see fig 5.6, compare with fig 2.6 p35)

Government Finance:

Discuss "Two Views" essay from previous edition

Chapter 6 The U.S. in the Global Economy

International linkages (see fig 6.1) of goods/svs (via product markets), factors of production (via resource markets), and money (via financial markets)

Specialization and Comparative Advantage

Adam Smith's 'butcher, baker, candlestick maker' advice (p99): "If a foreign country can supply us with a commodity cheaper than we can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage."

Comparing opportunity costs (pp 99-101): step through Mexico vs U.S. example, also basis of EOC #4 problem

Exchange rates: remember strong dollar hurts exports, helps imports

Free Trade Restrictions:

European Union and other regional trade blocks:

See Last Word p110, note that the Ford Crown Victoria (flagship sedan) is not made in America (but in Canada): so true of most products today.

Chapter 7 Measuring Domestic Output and National Income

Welcome to Macroeconomics! National income accounting provides the basis for formulation and application of public policies to improve the performance of the economy as a whole

National measurements didn't really exist before the Great Depression (inside cover of textbook starts at 1929) - "classical" economists didn't believe it was necessary

Gross Domestic Product (GDP) is total market value of all final goods and services produced in a nation's domestic economy in one year.

Value Added: avoid double counting, count only final goods, or value added of intermediate goods, not both - see tab 7-2, basis for VAT (vs retail sales) tax

Other GDP exclusions:

Two methods of counting: expenditures (product mkt) and income (resource mkt) - see tab 7.3 and figure 7.3 circular flow

Will use expenditures (output) approach:

Gross Investment (Ig) = Net Investment (In) [this year's added investment] + depreciation or replacement investment:

Net investment (In) rules (see fig 7.2):

In = (+), expanding (adding capital - 1960s)

In = 0, static (replacing capital - 1990s)

In = (-), declining (reducing capital - 1930s)

Net exports (Xn) = exports (X) - imports (M)

GDP accounts (see tables 7.3, 7.4, inside covers of book):

 

C

 

Ig (In + depreciation)

 

G

+

Xn (eXports - IMports)

 

GDP (Gross Domestic Product), "all" output

 

 

-

depreciation (replacement investment)

 

NDP (Net Domestic Product), "new" output

 

 

-

NFFI (net foreign factor income)

-

IBT (indirect business taxes)

 

NI (National Income), "earned" income by U.S. resources

 

 

-

SSC, CIT, UCP (earned by BUS, but not rec'd by HH)

+

TP (received but not earned by households)

 

PI (Personal Income), "received" income by households

 

 

-

PT

 

DI (Disposable Income), household income after taxes

Additional notes:

Nominal GDP vs Real GDP:

See tab 7.7: since 1933, nominal GDP increased 100x while real GDP increased only about 12x - in other words, our general cost of living rose over 12x more than it was in 1933 (e.g., a $.15 loaf of bread in 1933 cost $1.80 today, but it's the same bread)

Shortcomings of GDP:

Assignment EOC #9: use expenditures approach

GDP = C + Ig + G + Xn

Given the following accounts, compute GDP, NDP, NI, PI, and DI:

Compensation of employees

194.2

U.S. exports of goods and services

17.8

Consumption of fixed capital (Depreciation)

11.8

Government purchased

59.4

Indirect business taxes

14.4

Net private domestic investment

52.1

Transfer payments

13.9

U.S. imports of goods and services

16.5

Personal taxes

40.5

Net foreign factor income earned in the U.S.

2.2

Personal consumption expenditures

219.1

Social security contributions

20.5

Corporate income taxes

18.4

Undistributed corporate profits

16.3

Answers:

GDP

343.7

NDP

331.9

NI

315.3

PI

274.0

DI

233.5

Chapter 8 Economic Growth and Instability

The economic Business Cycle is like Newton's law of gravity; what goes up must come down (see fig 8.1):

Stable or Unstable?

Unemployment (first ill):

Types of Unemployment:

  1. Frictional: short-term, in-between, first-time, with marketable skills, inevitable 2-3% and somewhat desirable, includes seasonal unemployment (e.g., agriculture, recreation)
  2. Structural: long-term, no longer have marketable skills (decreased derived demand), requires retraining or moving, also inevitable
  3. Cyclical: caused by downturn in business cycle (recession) via income multiplier (ripple) effect, simply not enough jobs, "full" employment occurs when this is eliminated

Full Employment:

Costs of unemployment:

Inflation (second ill):

Inflation is an increase in the average level of all prices, or price level (the worst "tax"), we live in post-WWII inflation era (see fig 8.4), it has slowed, but it's still there:

Redistribution Effects of Inflation: although inflation economically hurts, many actually benefit:

Other issues:

Chapter 9 Building the Aggregate Expenditures Model

Welcome to Macroeconomic theory of demand!

Background/History: Classical Theory of Employment

  1. First footnote in Keynes' The General Theory reads, "'The classical economists' was a name invented by Marx to cover Ricardo, Mill, and their predecessors, [including Adam Smith]."
  2. Classical economic theory is essentially Adam Smith's "invisible hand" view that dominated economic thought before the Great Depression. A basic premise was that the economy normally operated at full employment, including:
    1. insufficient aggregate spending (AD) was most unlikely to occur
    2. if underspending were to occur, price-wage adjustments would result quickly to ensure no real declines in output, employment, and incomes - thus a vertical AS curve at QF (full-employment real output, see fig's 8.5, 11.5, and below)

  3. Say's Law (J.B. Say was another classical economist) says that production (supply) of any output would automatically provide the income needed to take (demand) that output off the market. John Stuart Mill wrote:
    1. "What constitutes the means of payment for commodities is simply commodities. Each person's means of paying for the productions of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers."
    2. In other words, "Supply creates its own demand." Relates to the simple circular flow model and GDP (income vs expenditures approaches).
  4. Regarding leakage of savings, Alfred Marshall wrote: "The whole of a man's income is expended in the purchase of services and of commodities. . . a man spends some portion of his income and saves another. He is said to spend when he seeks to obtain present enjoyment. . . to save when he expects to derive enjoyment in the future."
  5. Classical economists believed strongly in price-wage flexibility (up and down) from the forces of competition as the self-regulating function to ensure QF real output, thus laissez-faire or minimal government role
  6. Classical economists believed that economic fluctuations were caused by external forces such as wars, droughts, and other abnormalities
  7. Classical employment theory sufficiently explained the workings of the economy until the Great Depression of the 1930s

Keynesian Theory of Employment

  1. John Maynard Keynes' The General Theory of Employment, Interest and Money, published in 1936, begins by explaining the book's title.

    2. "The object of such a title is to contrast the character of my arguments and conclusions with those of the classical theory of the subject, upon which dominates the economic thought, the governing and academic classes of this generation. I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case. Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience."

  2. Keynes argued convincingly that capitalism in practice had no automatic or self-regulating mechanism to propel it to full-employment output (QF)
    1. see Great Depression video and Last Word discussion p177
    2. Keynes brought forward the idea of persistent cyclical unemployment from lack of aggregate spending (demand), not supply
    3. thus demand not "created" by supply, but derived from the amount of total income available
    4. components of AE same as GDP (see p191):
      1. consumption (C)
      2. investment (I)
      3. net exports (Xn or X-IM)
      4. government spending (G)
  3. Consumption (C) dependent upon disposable income (DI = GDP, see fig 9.1 or below) note 45o line (total output curve or DI = C + S, breakeven or equilibrium income where C = DI (or where C line intersects 45o line, see fig 9.2)

The Consumption Function

  1. APC/APS (average) vs MPC/MPS (marginal or slopes of C and S curves - see tab 9-1):
    1. APC decreases as income increases (like avg tax rate of a regressive tax) - APS does just the opposite; APC + APS = 1
    2. Note "dissaving" (APC > 1) at very low levels of income due to borrowing or withdrawing from past savings
    3. MPC and MPS deal with changes (like marginal tax rates)
    4. MPC and MPS are both constants for simplicity (straight line curves)
    5. MPC + MPS = 1
  2. Total consumption (C) = autonomous consumption [independent of income] (a) + income-dependent consumption (bDI):
    1. consumption curve is a linear equation (y = a + bx) where y is C, a is y-intercept, b is MPC, and x is DI
      1. thus C = autonomous C + MPC (DI)
    2. note that b (slope) = MPC
    3. see fig 9.2 GDPE (equilibrium GDP) at $390 (C=DI), dissaving below and saving above
    4. shifts of C occur from changes in "a" (fig 9.4 example consumer confidence)
    5. AD shifts (right/left) coincide with C shifts (up/down), see fig 11.2 - note both GDP and Price level constant
  3. Leakages and Injections:
    1. leakages: saving, imports, taxes
    2. injections: investment, government, exports
    3. GDPF is full-employment GDP (like QF)
    4. (see fig 10.2) - equilibrium also occurs when saving = desired/planned investment: S = I, see tab 9.4
    5. bathtub drain-spigot keeps water or "ring" at same level
    6. Note that S shifts in opposite direction of C (fig 9.4)
    7. S = DI - C, more C means less S, assuming same DI
  4. Investment:
    1. I is autonomous of income (DI), see tab 9.3 and fig 9.7: Ig stays at $20B at all levels of income
      1. Ig plots as a horizontal line by itself
      2. when added to C, Ig "lays on top of" C by amount of Ig (see fig 9.9 and below)
    2. I is more volatile than rest of GDP (see fig 9.8), businesses (like consumers) not really that rational
    3. excess of desired S over desired I is same as recessionary gap
    4. actual I = desired/planned I + undesired/unplanned I
    5. undesired change in I at GDPF (see tab 9.4):
      1. (-) is underproduction or shortage of inventories which increases output, employment, incomes, prices (inflationary gap) or AE > GDP (AD > AS)
      2. (+) is overproduction, unintended investment or surplus of inventories which decreases output, employment, incomes, prices (recessionary gap) or AE < GDP (AD < AS)

  5. Aggregate Expenditure (same as AD and GDP, see tab 9.4)
    1. spending on investment (I), government (G), and net exports (X-IM) is autonomous of income
    2. see fig 9.9 "layer cake" AE curve, GDPE = 470
    3. see also fig 10.4 and below - note multiplier effect: how much GDP changes [bottom axis] from aggregate spending changes [left axis], multiplier = 2.5

Review EOC questions 5, 6, and 10.

Chapter 10 Aggregate Expenditures (continuation of Ch9)

Courtesy of http://netec.mcc.ac.uk/JokEc.html

Keynes' Multiplier effect: note last graphic in Ch9 notes - real GDP changes 2½ times more than changes in aggregate expenditures

Multiplier

=

change in real GDP

 

 

initial change in spending

Multiplier

=

1

=

1

 

 

MPS

 

1 - MPC

Multiplier kicks in because of consumption behavior (MPC) but has same result regardless of type of change in spending (C, Ig, Xn, or G)

Equilibrium GDP (GDPE) vs Full-Employment GDP (GDPF)

Applications:

Read this last word!

EOC question #5

Very interesting and timely article:

MARCH 18, 2002, Business Week, COVER STORY

The Surprise Economy: First-half growth could be three or four times recent expectations

http://www.businessweek.com/magazine/content/02_11/b3774001.htm?c=bwinsidermar08&n=link60&t=email

Chapter 11 Aggregate Demand and Supply

Aggregate Demand (AD):

Aggregate Supply (AS):

Macro Equilibrium (Qe):

Equilibrium Revisited:

Basic Policy Strategies:

See EOC #4

Chapter 12 Fiscal Policy

Keynes' conclusion: the private economy does not self-adjust to full-employment, thus the government must intervene to manage the level of aggregate demand: simplest way to shift AD or change AE is to increase G

Fiscal policy is the proactive "tax and spend" approach intended to stabilize the macroeconomy via public spending (G included in AD):

Expansionary vs Contractionary Fiscal Policy:

Fiscal policy options include changes in:

Long-term issue: Deficit spending through borrowing (see Ch18):

Built-in Stability (automatic stabilizers):

Tax and transfer changes not as effective as G spending changes:

Problems, Criticisms, and Complications:

Supply-side fiscal policy (see fig 12.6)

See EOC #2