03 Intro to Macro Theory - The Supply Side and the Demand Side

03 Intro to Macro Theory - The Supply Side and the Demand Side

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Economics 104B - Lecture Notes - Professor Fazzari Topic III: Introduction to Macroeconomic Theory: The Supply Side and the Demand Side (Updated March 25, 2007) A. Objectives of macro theory 1. Provide explanations for the key macro variables (positive theory) Positive analysis focuses on understanding economic variables (unemployment, inflation, growth rates, interest rates, etc) and how they relate to one another. This goal of theory is to explain how the macro economy works. Positive theory attempts to answer questions like: What causes business cycles? What are the determinant of long-run economic growth? Why was inflation high in the mid-1970s? Positive theory is the “science” of economics. 2. Policy advice (normative theory): how should government activity in the economy be designed to promote national welfare? Normative analysis using positive economic theories to give advice on policies. Positive economics would address the question “what effect will lowering interest rates have on GDP growth rates?” while normative economic would address the question “Should the Fed cut interest rates?” The theories we are about to study will address both positive and normative issues. 3. Causation vs. correlation Some analysts have observed that the outcome of the Super Bowl (The American football championship game) predicts the economic outlook for the year. If the AFC (American Football Conference) wins, the economy will do poorly. If the NFC (National Football Conference) wins, the economy will do well. (And sure enough, the AFC won this year). Statistically speaking, the outcome of the Super Bowl may have been a better predictor of economic performance than the policies of the Fed. (AFC teams won in the rough years of the 1970s while NFC teams won in the (usually) better years of the mid 1980s and 1990s.) However, based on economic theory, there is no causal relationship between the winner of the Super Bowl and the economic performance of the year. There may be correlation between these variables, but it is important not to confuse correlation with causation. We use economic theory to distinguish between the two. We may observe a correlation, but we need a theory to identify
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causation. In the football example, there is no existing theory that implies causation. The correlation is almost certainly a pure coincidence. Separating correlation from causation is a key objective of any scientific theory. From a positive perspective, we want to know what is really going on. From a normative perspective, we want to know if a policy change will truly cause a change in economic performance. Another example from a past class: Professor Fazzari's weight and long-term economic output since 1982 are highly correlated (both are trending upward slowly). But no one will suggest that Fazzari's weight "causes" economic growth. This, again, is correlation without a theory to establish causation.
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03 Intro to Macro Theory - The Supply Side and the Demand Side

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