Introduction to Economics

Introduction to Economics Macroeconomics The US Economy

Questions About Your Reading • What is an economy? • Are there different types of economies? • What is a market? • What did Adam Smith mean by the invisible hand?

Markets and the Invisible Hand • A market is an arrangement that allows buyers and sellers to exchange things: A buyer exchanges money for a product; a seller exchanges a product for money. • Adam Smith used the metaphor of the invisible hand to explain how people acting in their own self-interest may actually promote the interest of society as a whole. Chapter 1

Question • What is the principle of diminishing returns?

PRINCIPLE of Diminishing Returns PRINCIPLEof Diminishing ReturnsSuppose output is produced with two or more inputs and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate. Can you think of an everyday example? Chapter 2

Question • What is macroeconomics?

Macroeconomics Macroeconomics is the study of the nation’s economy as a whole. Macroeconomic analysis can be used to: • Understand how a national economy works. • Understand the grand debates over economic policy. • Make informed business decisions. Chapter 1

Outline: Lecture Six, 2002 • Vernon Smith wins Nobel • National Income Accounting • Great Depression of 1930’s • How bad can a downturn get? • Birth of macroeconomics • concepts • tools: national income accounting • Is it Happening Again?

News in 2002 • Why did the Dow go down ? • Why is the Dow going up now? • Are we going to have a double dip recession coming? • How could you figure that out?

Part II Macroeconomics & US Economy • Ch. 20 “Measuring a Nation’s Production and Income” • Ch. 21 “ Unemployment and Inflation

Question • What do we mean by circular flow?

: Chapter Twenty Firms Firms • Conceptual Framework: Circular Flow Supply Goods Demand Goods Income Labor Households Households Income Perspective Expenditure Perspective

Income Perspective: Individual’s Supply of Labor Earnings Lectures 2&3 low value high $480 Optimum $180 for 9 hrs of work high value Leisure (learning) $ 0 15 hours of leisure 0 hours 24 hours

Expenditure Perspective Firms Supply Goods Demand For Goods Consumption Households Households: Consumption of Goods and Services Firms: Investment in Plant and Equipment

Expenditure Perspective: Closed Firms Supply Goods Demand Goods Households Government Households: Consumption of Goods and Services Firms: Investment in Plant and Equipment Government: Expenditures on Goods and Services

Expenditure Perspective: Open Firms Imports (puchases) Supply Goods Demand Goods Exports (Sales) Households Government Households: Consumption of Goods and Services Firms: Investment in Plant and Equipment Government: Purchase of Goods and Services All Three: Exports - Imports = Net Exports

What has been happening to expenditure in the last year? • Sources of information • US Department of Commerce: Survey of Current Business • The Conference Board: Business Cycle Indicators

What is counted in GDP & National Income? • The easy answer: what is easy to count. • Strawberries, cars, steel etc • consumer and business income • What is left out? What is hard to measure. • Underground economy: barter • crime • household production: cleaning, child care etc. produced at home for no pay

Lab Three: National Income and Product Accounts (NIPA)-Ch. 20 Billions of Current $, Seasonally Adjusted at Annual Rates GDP is Gross Domestic Product

Pie Chart of $ 10.2 Trillion of GDP by Component, 01 II consumption investment government net exports Buy more foreign goods than we sell abroad

National Income and Product Accounts (NIPA)-Ch. 20 Percent Change in Real (Constant $) GDP with Component

Percent Change in Real(Constant $) GDP Source: http://www.yardeni.com

Dr. Ed Yardeni, Deutsch Bank Securities http://www.yardeni.com September 24, 1998

How Bad Could It Get? • Great Depression

The Great Depression • Impact on the US Economy • Impact on Economic Thinking as a Consequence • What happens when the economy goes belly up? • Why does the economy go belly up?

Why does consumption fall by 20% between 1929 and 1933? • income has fallen and a large fraction of people are unemployed • times are bad, sentiment and expectations are low, and people save for a rainy day if they can • wealth has decreased • for example, the stock market crash of 1929 decreased the wealth of investors in stocks, and decreased consumption out of wealth

Why does investment fall from $92.4 B in’29 to $9.9 B in ‘32? • Not only are many people idle, so is much of plant and equipment • with existing capital redundant, there is less urgency to invest in new equipment • times are bad, consumers are not buying, and businesses are failing, so business sentiment and expectations are low • if there is any cash flow, businesses may decide to keep it as cash reserve against the unexpected event rather than invest it

federal government was 1.6%, while state & local government was 7.3%

What were the policy options in 1933?

Were consumers & firms afraid to spend? ? $ Consumers Fear ? $ Firms

Impact of the Great Depression on Economic Thought • The conventional wisdom at that time was to wait, and the economy would recover • The Englishman John Maynard Keynes was not only a great economist but was aware of the political danger the depression posed to capitalism • he realized that it would be difficult to convince consumers and businesses to spend more in the depths of a recession • he emphasized the importance of uncertainty and expectations on behavior • he stressed an aggregate expenditures perspective and a role for government spending

A Simple Keynesian model • The aggregate demand emphasis • for simplicity, ignore net exports and government expenditure, small in ‘29 • Aggregate expenditures, GDP, equals consumption, C, plus investment, I • GDP = C + I • National Income, Y, equals consumption, C, plus savings, S • In Equilibrium, Aggregate Expenditures, GDP equals National Income, Y • GDP = Y • so C + I = C + S • and, in equilibrium, savings equals investment

The Consumption Function consumption, C C = C0 + mpc* Y autonomous consumption, C0 the slope of the consumption function, the marginal compensity to consume, mpc, is the increase in consumption per $ increase in income Income, Y

Autonomous Investment Investment, I I Income, Y

Gross Domestic Product Equals Consumption Plus Investment GDP = C + I Consumption, C Investment, I GDP C = C0 + mpc* Y autonomous consumption, C0 I Income, Y

Squares with Equal Sides and 45 degree Lines Y = Y Income, Y Y1 450 Y1 Income, Y

Equilibrium Level of Gross Domestic Product GDP=Y GDP=Y Consumption, C Investment, I GDP autonomous consumption, C0 450 Income GDP=Y

Equilibrium Level of Gross Domestic Product GDP=Y GDP=Y Consumption, C Investment, I GDP autonomous consumption, C0 I 450 Income

Equilibrium Level of Gross Domestic Product GDP=Y GDP=Y Consumption, C Investment, I GDP C = C0 + mpc* Y autonomous consumption, C0 I 450 Income

Equilibrium Level of Gross Domestic Product GDP=Y GDP=Y Consumption, C Investment, I GDP GDP = C + I C = C0 + mpc* Y autonomous consumption, C0 I 450 Income GDP=Y

What Happens if there is a Shock?Using the Model of the Economy • Stock market crash of 1929 • or Attack on America, 9-11-2001? • if consumer confidence is shaken…. • If business confidence is shaken ….

Equilibrium Level of Gross Domestic Product GDP=Y GDP=Y Consumption, C Investment, I GDP GDP = C + I C = C0 + mpc* Y autonomous consumption, C0 I 450 Income GDP=Y

Equilibrium Level of Gross Domestic Product GDP=Y GDP=Y GDP = C + I Consumption, C Investment, I GDP C = C0 + mpc* Y autonomous consumption, C0 I 450 Income GDP=Y

Introduction to Economics