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WHAT YOU WILL LEARN IN THIS CHAPTER >> Macroeconomics: The Big Picture Krugman/Wells ©2009 Worth Publishers 1 of 40 WHAT YOU WILL LEARN IN THIS CHAPTER How scarcity and choices are central to the study of economics The importance of opportunity cost in individual decision-making The difference between positive and normative economics When economists agree and why they sometimes disagree What makes microeconomics different from macroeconomics 2 of 40 Individual Choice Individual choice is the decision by an individual of what to do, which necessarily involves a decision of what not to do. Basic principles behind the individual choices: 1. Resources are scarce. 2. The real cost of something is what you must give up to get it. 3. “How much?” is a decision at the margin. 4. People usually take advantage of opportunities to make themselves better off. 3 of 40 Resources Are Scarce A resource is anything that can be used to produce something else. Ex.: Land, labor, capital, entrepreneurship Resources are scarce – the quantity available isn’t large enough to satisfy all productive uses. Ex.: Petroleum, lumber, intelligence 4 of 40 The Real Cost of Something Is What You Must Give Up to Get It The real cost of an item is its opportunity cost: what you must give up in order to get it. Opportunity cost is crucial to understanding individual choice: Ex.: The cost of attending the economics class is what you must give up to be in the classroom during the lecture. Sleep? Watching TV? Rock climbing? Work? All costs are ultimately opportunity costs. 5 of 40 Opportunity Cost I WOULD RATHER BE SURFING THE INTERNET In fact, everybody thinks about opportunity cost. The bumper stickers that say “I would rather be … (fishing, golfing, swimming, etc…)” are referring to the “opportunity cost.” It is all about what you have to forgo to obtain your choice. 6 of 40 Macroeconomics vs. Microeconomics Let’s begin by looking more carefully at the difference between microeconomic and macroeconomic questions. MICROECONOMIC QUESTIONS Go to business school or take a job? What determines the salary offered by Citibank to Cherie Camajo, a new Columbia MBA? MACROECONOMIC QUESTIONS How many people are employed in the economy as a whole? What determines the overall salary levels paid to workers in a given year? 7 of 40 Macroeconomics vs. Microeconomics MICROECONOMIC QUESTIONS MACROECONOMIC QUESTIONS What determines the cost to a university or college of offering a new course? What government policies should be adopted to make it easier for low-income students to attend college? What determines whether Citibank opens a new office in Shanghai? What determines the overall level of prices in the economy as a whole? What government policies should be adopted to promote full employment and growth in the economy as a whole? What determines the overall trade in goods, services and financial assets between the U.S. and the rest of the world? 8 of 40 Macroeconomics vs. Microeconomics Microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions. Example: How much it would cost for a university or college to offer a new course ─ the cost of the instructor’s salary, the classroom facilities, the class materials, and so on. Having determined the cost, the school can then decide whether or not to offer the course by weighing the costs and benefits. 9 of 40 Macroeconomics vs. Microeconomics Macroeconomics examines the aggregate behavior of the economy (i.e. how the actions of all the individuals and firms in the economy interact to produce a particular level of economic performance as a whole). Example: Overall level of prices in the economy (how high or how low they are relative to prices last year) rather than the price of a particular good or service. 10 of 40 Macroeconomics vs. Microeconomics In macroeconomics, the behavior of the whole macroeconomy is, indeed, greater than the sum of individual actions and market outcomes. Example: Paradox of thrift: when families and businesses are worried about the possibility of economic hard times, they prepare by cutting their spending. This reduction in spending depresses the economy as consumers spend less and businesses react by laying off workers. As a result, families and businesses may end up worse off than if they hadn’t tried to act responsibly by cutting their spending. 11 of 40 Economy-Wide Interactions Principles that underlie economy-wide interactions: 1. One person’s spending is another person’s income. 2. Overall spending sometimes gets out of line with the economy’s productive capacity. 3. Government policies can change spending. 12 of 40 Using Models Positive economics is the branch of economic analysis that describes the way the economy actually works. Normative economics makes prescriptions about the way the economy should work. A forecast is a simple prediction of the future. 13 of 40 Macroeconomics: Theory and Policy In a self-regulating economy, problems such as unemployment are resolved without government intervention, through the working of the invisible hand. According to Keynesian economics, economic slumps are caused by inadequate spending and they can be mitigated by government intervention. Monetary policy uses changes in the quantity of money to alter interest rates and affect overall spending. Fiscal policy uses changes in government spending and taxes to affect overall spending. 14 of 40 Using Models Economists can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments. The exceptions are when policies designed to achieve a certain prescription can be clearly ranked in terms of efficiency. It is important to understand that economists don’t use complex models to show “how clever they are,” but rather because they are “not clever enough” to analyze the real world as it is. 15 of 40 When and Why Economists Disagree There are two main reasons economists disagree: Which simplifications to make in a model Values 16 of 40 ►ECONOMICS IN ACTION Why George W. Bush Wasn’t Herbert Hoover Herbert Hoover didn’t do much to fight the Great Depression. At the time, conventional wisdom dictated that the government take a hands-off approach to the economy. Leading economists, including Joseph Schumpeter, offered similar advice. “Remedial measures which work through money and credit. Policies of this class are particularly apt to produce additional trouble for the future.” Under President George W. Bush: The 2004 Economic Report of the President stated “Strong fiscal policy actions by this Administration and the Congress, together with the Federal Reserve’s simulative monetary policy,” the report declared, “have softened the impact of the recession and have also put the economy on an upward trajectory.” 17 of 40 ►ECONOMICS IN ACTION The boost to the economy given by fiscal policy and the Federal Reserve’s interest rate cuts reduced the severity and duration of the 2001 recession. 18 of 40