ECON 102 Midterm One

Economics

Economics is the study of the allocation of scarce resources.

What Is Produced, How, and For Whom in An Economy?

i. Which goods and services do people demand? Preferences

ii. How do firms produce? Production process

iii. Who gets the goods and services? (Re)-distribution

What and how involve efficiency, and how involves equity.

What is Microeconomics?

Microeconomics is the study of how individual decision-makers (economic agents) such as consumers (income), workers (time), or firms (revenue) allocate scarce resources as well as their interaction in markets.

What Is Macroeconomics?

Macroeconomics is the study of economic aggregates such as economic growth, inflation, and unemployment as well as entire economic systems.

Microeconomics Components

i. Individual income

ii. Quantity of products a business produces

ii. Spending of a household or company

Macroeconomics Components

i. Total income in the country

ii. Total output produced by all businesses

iii. Total spending across all households, businesses and the government

Positive Analysis

Positive analysis describes the world objectively and fact-based. Positive statements do not have to be true, but they do need to be statements that can be validated as correct or incorrect.

Normative Analysis

Normative analysis describes the world the way it should be. Normative statements are opinion based, so they cannot be proved or disproved.

Economic Models

Economic models are simplified versions of reality that are used to analyze real-world situations.

Model Components

i. Leave out irrelevant details

ii. Are goal-oriented

iii. Explicitly name their assumptions

iv. Often expressed in mathematical terms to be precise and transparent

Thus, economic models can be thought of as maps of reality. Social science is “messier” than natural science. Using a model for prediction can change the predicted outcome.

The Scientific Model

A theory leads to a testable prediction. If the testable prediction is falsified, then the theory is revised. If the testable prediction is consistent, it is repeated.

A theory becomes part of scientific consensus. The scientific consensus of point in time becomes a paradigm.

Classical Economics

i. Inflation and interest (Wicksel)

ii. Quantity Theory (Fisher)

iii. Founding of National Bureau of Economics (Mitchel)

iv. Business cycles (Kuznets)

The Keynesian Revolution

i. The General Theory of Employment, Interest, and Money

ii. Response to Great Depression

iii. Effective (aggregate) demand

iv Consumption, income, and multiplier effects

v. Liquidity preferences for momey

vi. Countercyclical fiscal policy

Neoclassical Synthesis

i. Refinement and mathematical formulation of Keynes’ theories

ii. IS-LM model (Hicks)

iii. Foundations of Economic Analysis (Samuelson)

iv. Investment

v. Solow model

vi. Discovery of the Philips Curve (Philips)

Monetarism

i. Restatement of Quantity Theory (Friedman)

ii. Money supply (F. and Schwarz)

iii. Expectations-adjusted Philips Curve (Phelps)

New Keynesian Economics

i. Sticky wages (Fisher)

ii. Sticky prices (Calvo)

iii. Coordination failure (Diamond)

iv. Monopolistic competition (Blanchard, Kiyotaki)

New Classical Economics

i. Rational expectations (Lucas)

ii. Policy ineffectiveness (Sargent)

iii. Lucas critique (Lucas)

iv. Real Business Cycle Theory (Kydland, Prescott)

New Neoclassical Synthesis

i. The New Keynesian Model (Clarida, Gali, Gertler); the Real Business Cycle, sticky prices, and monopolistic competition

ii. Great Moderation (until 2008)

iii. Financial frictions (Bernake)

Challenge to current paradigm

Behavioural macroeconomics

Classical Economics Elaborated

Prevalent paradigm

i. Flexible prices

ii. Quantity theory; money and prices are proportional

iii. Say’s Law; supply creates its own demand

The Keynesian Revolution Elaborated

General equilibrium in three markets; goods, financial, and labour.

In the short run, output is determined by aggregate demand.

The Neoclassical Synthesis Elaborated

Prevalent paradigm

i. Prices are rigid in the short run

ii. Recessions are due to shortfalls in demand

iii. Countercyclical fiscal policy can manage the business cycle

The Monetarist Counter Revolution Elaborated

Focused on the money supply. Friedman predicted the collapse of the Philips Curve as people adjusted their inflation expectations, and that is exactly what happened.

Stagflation is a recession caused by supply side factors.

New Classical Economics Elaborated

Lucas critiqued that economic (policy) predictions are invalid if they do not account for the endogenous change in behaviour.

Policy ineffectiveness is when monetary and fiscal policy are ineffective, people will reflect policy changes in their expectations and adjust their behaviour accordingly.

Prevalent paradigm

i. People are rational

ii. Recessions are optimal responses to exogenous changes

iii. Monetary and fiscal policy are neutral

iv. Recommendation of rule-based monetary and fiscal policy

New Keynesian Economics Elaborated

Focused on disequilibrium and market imperfections.

Nominal rigidity is when prices adjust slowly while real rigidity is when markets are not perfectly competitive.

The New Neoclassical Synthesis Elaborated

Prevalent paradigm

i. Monetary and fiscal non-neutrality

ii. Independent and inflation-targeting monetary policy

iii. Fiscal policy should focus on redistribution

iv. Countercyclical fiscal policy can manage the business cycle

The Circular Flow Diagram

Government Saving Equation

Government saving = Net taxes - Government expenditures

This is the government budget. If the budget is a surplus, government saving is greater than zero. If budget deficit, government saving is less than zero (negative).

Foreign Markets Equation

Net exports NX = Exports EX - Imports IM = Current Account CA

To buy Canadian goods, foreign businesses need to buy Canadian dollars first. Capital flows into the country and vise versa.

Firms Equation

Production Y = Production function F(K, L) = Aggregate expenditures C + I + G + NX

Households Equation

Income Y = Factor income WL + rK +Non-factor income sK

Value Added Approach (Production)

Sum of all final goods and services

Y = F(K, L)

Expenditure Approach (Spending)

Sum of all spending on final goods and services

Y = C + I + G + NX

Income Approach (Factor Payments)

Sum of all factor (and non-factor) payments

Y = WL + RK

Nominal Gross Domestic Product

Nominal GDP per person is the average income of residents in terms of the domestic currency.

In Canada (2021) nom. GDP/population = C$2.5 trillion/38.2 million = C$65 300

Median income (2021) = C$41 650

Real Gross Domestic Product Equation

Real GDP = nom. GDP/price index

Y = $Y/P

Real Domestic Product

Real GDP compares average income in a country over time. To compare average income between countries, exchange rates need to be adjusted.

The Limitations of Gross Domestic Product

GDP is a very bad measure of standard of living

i. Prices are not values

ii. Non-market activities are excluded

iii. The shadow economy is missing

iv. Environmental degradation is not counted

v. Leisure does not count

vi. GDP ignores distribution

However, compared to other measures of the standard of living, GDP is the best measure.

Facts of Economic Growth

i. There are vast differences in GDP per capita

ii. There are also vast differences in growth rates; if poorer countries grow faster, they should catch up with richer countries however it may take a long time

iii. Some countries do catch up (e.g., The Asian Tigers), while others do not

iv. Economic growth is a recent phenomenon; the Industrial Revolution kicked off economic growth in Western Europe and the United States

The Source of Economic Growth, Production Function

Methods for transforming inputs into output

Y = AF(K, L, H)

L is the number of total hours of labour provided

K is the amount of physical capital (machines, production facility, land, resources)

H is the amount of human capital (education)

A is the level of technology (research and development)

How To Increase Output

i. Increase labour supply (does not necessarily increase the standard of living)

ii. Increase capita per worker (capital accumulation)

iii. Increase human capital per worker (education)

iv. Increase level of technology (reaearch and development)

Constant returns to scale is assumed.

Malthusian Economic Growth

Production increases output, income increases output, infant mortality goes down, population increases labour, standard of living is constant (y/l = const.)

Malthusian growth describes the pre-industrial revolution period well. During the Industrial Revolution, productivity grew so rapidly that population growth could not keep up. Then, population growth started falling since 1950.

Neoclassical Growth (Solow)

Diminishing returns to capital is when for a given amount of labour, physical capital becomes less and less productive.

Capital Accumulation

The capital stock per person increases with the amount of investment and decreases with the amount of depreciation.

Change in capital = investment - depreciation

When investment is greater than depreciation, capital stock increases. When investment is lesser than depreciation, captivate stock decreases.

Assumptions for Capital Stock

A constant share 𝛿 of the capital stock per person

k depreciates each period (year)

Investment/saving is a constant share of

output/income sy.

Technological Process

Technological progress leads to more production with the same amount of inputs.

Technological progress is the only way to achieve sustained economic growth (expansion of the technological frontier).

Technology is usually labour-saving.

Innovation, New Growth Theory

Where does technological progress come from?

Investment in research with positive externalities i. Ideas can be freely shared (non-rivalry and non-excludability in consumption)

ii. Ideas do not depreciate

iii. Ideas promote other ideas (positive externality)

Creative Destruction

i. Least productive firms go bankrupt

ii. New firms enter the market

iii. Over time average productivity increases

Technology Diffusion/Spillovers

i. International trade and direct investment let developing countries access newer technologies quicker (imitation)

Education

i. Education behaves similarly to capital stock and has decreasing returns

Government and Institutions

i. Property rights ensure economic exchange

ii. Government stability encourages capital accumulation

iii. Subsidizing education and research corrects positive externality

Sustainability

Limited economic resources

Y = AF(K, L, oil O)

As the limited resource becomes more scarce, its price will increase.

As the limited resource becomes more expensive as an input factor, production processes shift away from it.

Limited resources can slow down economic growth.

Environmental Degradation

Production processes that use fossil fuels have a negative production externality

The negative impact on the environment is not priced in when making a production decision.

Governments can correct the price through taxation (carbon pricing).

Distributional conflict is that it is much easier for advanced countries to reduce emissions as they have already gone through the energy-intensive process of industrialization.

Kuznets Curve

Working Age Population Equation

Working age population N = Labour force L + Not in the labour force NL

Labour Force Equation

L = Employed E + Unemployed U

Employed Equation

E = Employed full time Eft + Employed part time Ept

Employed Part Time Equation

Ept = Employed part time voluntary + Employed part time involuntary

To Be Considered Unemployed

One must be

i. Currently not be employed

ii. Available for work

iii. Actively looking for work

Unemployment Rate Over Time

u = U/L = U/U + E

unemployed/labour force = unemployed/unemployed + employed

i. Highly pro-cyclical

ii. Downward trend since early 1980s

The Employment Rate

e = E/N

employed/working age population

Share of working-age population currently employed.

The Participation Rate

p = L/N

labour force/working age population

i. Increase in participation rate since 1980s due to women entering the labour force

ii. Decrease in participation rate since 2010 due to baby-boomers retiring

iii. Dips during recession due to discouraged workers

Defining Unemployment

Unemployment u = Natural unemployment un + cyclical unemployment (u - un)

Cyclical Unemployment (Short Run)

During a boom, demand is high, firms increase production, and firms demand more labour.

During a recession, demand is low, firms decrease production, and firms demand less labour.

The Natural Rate of Unemployment (Long Run)

The natural rate of unemployment is the unemployment that arises from structural and frictional factors, void of cyclical components. It is the long-run trend of the unemployment rate.

The natural rate of unemployment is neither natural nor desirable.

Natural unemployment = frictional unemployment + structural unemployment

Frictional Unemployment

In between jobs unemployment. Firms go bankrupt, new firms enter the market. Workers retire, new workers enter the market.

It takes time to find employer-employee matches. Time and cost of acquiring information, skill matching, and geographical matching.

Structural Unemployment

A wage higher than the market clearing level creates a labour surplus.

Extensive margin leads to unemployment, and intensive margin leads to underemployment.

Efficiency wage, union wage setting, employment protection, minimum wage.

Hysteresis

Interaction between cyclical and natural unemployment. Long periods of high cyclical unemployment can increase natural unemployment.

Skill loss, loss of social capital, negative signal for potential employers.