Introduction to Macroeconomics

Macroeconomics studies the performance of the economy as a whole derived by aggregating the performance by households, business firms, and governments. A logical treatment of macroeconomics is consistent with the assumptions of microeconomic behavior.

I. The Art and Science of Economic Analysis

A. The economic problem: scarce resources but unlimited wants.

1. Economic choice arises from scarcity.

2. Resources include land, labor, capital, and entrepreneurial ability.

3. Income is the return from resources in the form of rent, wages, interest, and profit.

4. The combination of resources to produce an output is called a production function.

B. Goods and services are the output used to satisfy wants.

1. A good is scarce if the amount people desire exceeds the amount that is available at a zero price.

2. A market-based economy allocates resources in the direction of those goods and services that people value the most.

3. The opportunity cost of providing each good or service is the amount of other goods and services that are not provided.

II. The Art of Economic Analysis

A. Rational Self-Interest

1. A key assumption in economics is that individuals make rational choices that they perceive to be in their best interests.

2. The best choices frequently occur under conditions of uncertainty.

3. Rational self-interest is not blind materialism or greed, but includes the welfare of the family, friends, and perhaps the poor of the world.

4. Even charity required economic choices.

B. Economic Analysis is Marginal Analysis

1. Economic choices are made on the margin.

2. You will rationally change from the status quo when a decision has an expected marginal benefit that exceeds your expected marginal cost.

3. The change is typically small but may require a major economic adjustment (closing a plant, changing an occupation, etc.)

C. Choice requires time and information

1. Both time and information are scarce and valuable.

2. Saving time through better information can increase productivity.

3. Because information is costly to acquire, we often pay others to gather and digest it for us.

III. The Science of Economic Analysis

A. Use of an economic theory, or economic model

1. A theory or model simplifies reality in order to make predictions about the real world.

2. A model captures the important elements of the problem under study without spelling out every detail.

3. A theory can be presented verbally, graphically, or mathematically.

B. The Scientific Method

1. The first step is to define the key variables that are relevant to the economic problem under consideration.

2. The second step is to specify the assumptions under which the theory is to apply. One assumption is the other-things-constant assumption that allows us to isolate the influence of key variables. Other assumptions are behavioral assumptions regarding individual behavior.

3. The third step is to a formulate hypothesis that implies causality, i.e. if…, then… statements. This is called a positive economic statement (rather than a normative economic statement.)

4. The fourth step is to test the theory by confronting its predictions with the evidence. Competing theories are evaluated on the basis of their ability to predict.

5. Economists rely on the scientific method, but they tell stories about how they think the world works. These stories help breathe life into economic theory and allow economists to personalize abstract ideas.

C. Predicting average behavior and some pitfalls of faulty economic analysis

1. Macroeconomic behavior can be predicted more accurately because an group average may offset the unusual behavior of individuals who are “outliers.”

2. The fallacy of composition, however, may be a problem in generalizing from the individual to a group. For example, if one household saves they will be able to consume more in the future, but if all households save then national income falls and less consumption may occur in the future.

3. Other pitfalls in economic analysis include the assumption that association (correlation) implies causality and ignoring secondary effects of policies that may be perverse.