Origin The of Modern Macroeconomics Economists began to study long-run economic growth, inflation and international payments as long ago as the 1750s, and this work was the origin of macroeconomics. But modern macroeconomics did not emerge until the Great Depression, a decade (19291939) of high unemployment and stagnant production throughout the world economy. In the Depressions worst year, 1933, the production of U.S. farms, factories, shops, and offices was only 70 percent of its 1929 level and 25 percent of labor force was unemployed. These were years of human misery on a scale that is hard to image today. They were also years of extreme pessimism about the ability of the market economy to work properly. Many people believed that private ownership, free markets, and democratic political institutions would not survive. The science of economics had no solutions to the Great Depression. The major alternative system of central planning and socialism seemed increasingly attractive. It was in this climate of economic depression and political and intellectual turmoil that modern macroeconomics emerged with the publication in 1936 of John Maynard Keyness The General Theory of Employment, Interest and Money. Keynes theory was that depression and high unemployment result from insufficient private spending and that to cure these problems, the government must increase its spending. Keyness focused primarily on the short term. He wanted to cure an immediate problem almost regardless of the long-term consequences of the cure. In the long run, said Keynes, were all dead. But Keynes believed that after his cure for depression had restored the economy to a normal condition, the long-term problems of inflation and slow economic growth would return. And he suspected that his cure for depression, increased government spending, might trigger inflation and might lower the long-term growth rate, the economy would create fewer jobs. If this outcome did occur, a policy aimed at lowering unemployment in the short run might end up increasing it in the long run. By the late 1960s and through the 1970s, Keynes prediction became a reality. Inflation increased, economic growth slowed down, and in some countries, unemployment became persistently high. The causes of these developments are complex. But they point to an inescapable conclusion: The long-term problems of inflation, slow growth, and persistent unemployment and the short-term problems of depression and economic fluctuations intertwine and are most usefully studied together. So although macroeconomics was reborn during the Great Depression, it has now returned to its older tradition. Today, macroeconomics studies long-term economic growth and inflation as well as short-term business fluctuations and unemployment. From Michael Parkin, Economics, 5th edition, 2000, Addison, Wesley & Longman, MA.
Econ. 102. Chapter 1: Economic Model NGM(15-16) To understand the economy, economists use models theories that simplify reality in order to reveal how exogenous variables influence endogenous variables. The art in the science of economics is in judging whether a model captures the important economic relationships for the matter at hand. Because no single model can be answer all questions, macroeconomics use different models to look at different issues. 1. The Economic Approach (Scientific Approach) Recognize the Problem } } Assumptions Make Develop } Model Make } Predictions Test Model
2. Economics proceeds by developing models of social phenomena, which are simplified representations of reality. 3. Economic Model: an abstract representation of reality. 3.1. (Mansfield): Economics is based on the formulation of models. A model is a theory. It is composed of a number of assumptions from which conclusions - predictions are deduced. 3.2. (1) A theoretical system of relationships which tries to capture the essential elements in a real world situation. (2) A real-world problem will, in general, consist of a large number of variables, and a large number of often quite complex relationships between them. (3) If any headway is to be made in the analysis of such situations, it is necessary to try to isolate the most important elements and the disregard rest. the (4) Although this may mean that a model is unrealistic in the sense that it does not completely describe the real world situation, it may still give us far more insight into the problem and far greater predictive ability, than would a less abstract approach which tried to take everything into account. 3.3. Economic model can be described by (i) verbal statements, (ii) graphs, and (iii) equations. 4. The comparative static (equilibrium) analysis: A basic method of analysis in economics. (1) It begins by examining the equilibrium of the subject of analysis - the individual consumer, the market, the economy, etc. (2) One of the underlying determinants of this equilibrium is then changed and the resulting new equilibrium examined. (3) The new equilibrium position is then compared to the previous equilibrium position, and from this the effects of the change are deduced.
5. Comparative Statics: Five-step Process (1) Choose a problem to investigate - pick up endogenous variables. (2) Determine what is and is not relevant to the problem - pick up exogenous variables or parameters. (3) Determine the equilibrium condition. (4) Change an exogenous variable or a parameter. (5) Compare the new equilibrium to the initial equilibrium. 6. (1) Variable is something whose magnitude can change. (2) Endogenous variable which is assumed to be determined by forces in the model, and whose solution value can be obtain from the model. (3) Exogenous variable (parameter) which is assumed to be determined by forces external to the model, and whose magnitude is accepted as a given data. 7. Example: A Market Assumptions: (1) other things being equal, (2) the law of demand and supply hold. Endogenous variables: P (price) Qd (quantity demanded), Qs (quantity supplied). Exogenous variables: Y (aggregate income), Pm (the prices of input). (1) Qd = D(P, Y) Qd/P < 0, Qd/Y > 0. (2) Qs = S(P, Pm) Qs/P > 0, Qs/Pm < 0. (3) Qd = Qs. 8. Example: AD-AS model [NGM chapter 13] The economy of Midland has the following aggregate demand and aggregate supply schedules: P Yd Ys (in the short-run) 90 600 150 100 500 200 110 400 250 120 300 300 130 200 350 140 100 400 . AD; Yd = 1,500 10P SRAS: YS = -300 + 5P (a) In a figure, plot AD curve and SRAS curve (b) What are the value of RGDP (Y) and the price of in Midland in a short-run macroeconomic equilibrium? (c) Midlands potential GDP is 350. Plot LRAS in the same graph in which you answered part (a).
Assumptions; (1) AD: Expectations, fiscal policy and monetary policy are fixed. The world economy does not change. (2) SRAS: the quantity of capital stock (K) and technology (T) are fixed. Money wage and other resources prices are held constant. (3) LRAS: quantity of labor = full-employment quantity of labor. ********. AD curve is the negative relationship between the quantity of RGDP demanded and the price level when other things remain the same. SRAS curve is the positive relationship between the quantity of RGDP supplied and the price level in the short-run when money wage, other resources and potential GDP remain the same. LRAS is the relationship between the quantity of RGDP supplied and the price level in the long-run when RGDP = potential GDP. It is vertical at potential GDP. Potential GDP = RGDP supplied at full employment where unemployment rate = natural rate of unemployment. *******. NGM(p. 11) The art in economics is judging when an assumption is clarifying and when it is misleading. Any model constructed to be completely realistic would be too complicated for anyone to understand. Simplification is a necessary part of building a useful model. Yet models lead to incorrect conditions if they assume away features of the economy that are crucial to the issue at hand. Economic modeling therefore requires care and common sense. This book presents many different models that address different questions and make different assumptions. Remember that a model is only as good as its assumptions and that an assumption that is useful for some purposes may be misleading for others. When using a model to address a question, the economist must keep in mind the underlying assumptions and judge whether these are reasonable for the matter in hand.