Theories in Economics

Question 1

What is a theory?

Answer 1

It is a simplified representation of how two or more variables interact with each other. The purpose is to take a complex, real-world issue and simplify it down to its essentials. This enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.

Theory: a causal law (I have established that A causes B) or a causal hypothesis (I surmise that A causes B). A theory that cannot be arrow diagrammed is not a theory and needs reframing to become a theory (Van Evera 1997).

Question 2

How do you test a theoretical model?

Answer 2

By examining the reasonableness of the assumptions on which they are based.

Question 3

How do you test predictions?

Answer 3

By asking if they can accurately predict real-world events.

Question 4

What is a positive normative distinction?

Answer 4

It argues that models invariably have normative consequences that should be recognized. It’s the development of normative theories about how the world should be.

Question 5

What is international economics?

Answer 5

The study of the production, distribution, and consumption of goods, services, and capital on a worldwide basis.

Question 6

What is the optimization principle?

Answer 6

When people try to choose the best patterns of consumption that they can afford.

Question 7

What is the equilibrium principle?

Answer 7

When prices adjust until the amount that people demand of something is equal to the amount supplied.

Question 8

What is the Economic Theory of the Consumer?

Answer 8

Economists assume that consumers choose the best bundle of goods they can afford, based on preference. A consumption bundle (x1, x2) is a list of two numbers that tells how much a consumer is choosing to consume good 1, x1, and how much the consumer is choosing to consume good 2, x2. We then suppose that the prices for two goods are (p1, p2), and the amount of money the consumer has to spend is m.

Thus, the budget constraint of the consumer is p1x1+p2x2m, we can then view this as p1x1+x2m, where the amount of money spent on good 1, p1x1, plus the amount spent on all other goods (ceteris paribus), x2, must be no more than the total amount of money the consumer has to spend, m.

Question 9

What is the Theory of Choice?

Answer 9

It begins by describing people’s preferences. This means accounting for how a person feels about all things he or she might do. This also means that preference is based on the consumer’s behavior. Thus, in terms of consumer preference, utility is seen only as a way to describe preferences.

Economic models use the concept of utility, defined as the satisfaction that a person receives from his or her activities. The objects of consumer choice are consumption bundles, which are a complete list of the goods and services that are involved in the choice problem that is being investigated.

A utility function is a way of assigning a number to every possible consumption bundle such that more-preferred bundles get assigned a larger number than less-preferred bundles. That is, a bundle, (x₁, x₂), is prefered to bundle (y₁, y₂), if and only if the utility of (x₁, x₂) is larger than the utility of (y₁, y₂): in symbols, (x₁, x₂) (y₁, y₂), if and only if u(x₁, x₂) > u(y₁, y₂).

Question 10

What is the Standard Economic Theory?

Answer 10

It describes a formal process for making rational decisions. People consider all the options available to them. They consider the outcomes of all these options and how advantageous each outcome would be. They consider the probabilities of each of these options, and then make a decision.

Question 11

What is the Labor Theory of Value?

Answer 11

It assumes that labor is the only relevant factor of production.

Question 12

What is the Factor Proportions Theorem?

Answer 12

The premise that a country will have a comparative advantage and export goods whose production intensively uses its relatively abundant factor of production. A country will have a comparative disadvantage in goods whose production intensively uses its relatively scarce factor of production.

Question 13

What is the Least Common Denominator Theory?

Answer 13

It minimizes the intellectual distance between the General Theory and the standard classical economics of the day. In this standard economic theory, there are no animal spirits and people act only for economic motives, only acting rationally (Akerlof and Shiller 2009).

Question 14

What is the Multiplier Theory?

Answer 14

Any initial government stimulus, say a program of increased government expenditure, puts money into people’s hands, which they spend. The initial government stimulus is the first round. Each dollar spent by the government ultimately becomes income to some people, and, once it has been put into their hands, they spend some fraction of it.

This fraction is called the marginal propensity to consume (MPC).

The sum of all the rounds of expenditures $1+$MPC+$MPC₂+$MPC₃+$MPC₄…and is not infinite, this spending equals 1/(1-MPC), called the Keynesian multiplier.

This theory explains that a small dip in expenditure could have greatly magnified effects. There is also a confidence multiplier that represents the change in income that results from one unit change in confidence.

Question 15

What is the Neoclassical Theory of Wage Determination?

Answer 15

It is the determination of the level of employment and the unit price of labor is dealt with as belonging to a perfectly competitive market, comparable to that of a consumer good. The only difference is that the roles of the agents are reversed. On the one hand, companies are suppliers on the market for goods and demanders on the labor market. On the other hand, households are demanders on the market for goods and suppliers (of their productive services) on the labor market. The wage rate (or equivalently, the unit wage; still more concretely, the hourly wage) and the volume of labor (the number of people employed multiplied by the duration of their work done at a given intensity, or work rates) result in the free confrontation of the global supply of, and demand for, labor.

Question 16

What is the Economic Theory of Exchange?

Answer 16

It is who trades what to whom in which markets.

Question 17

What is the Equity Theory - Social Psychological Theory of Exchange?

Answer 17

On either side of an exchange the inputs should equal the outputs. An early version of this theory comes from Peter Blau’s study of government agents involved in complex litigation. (Akerlof and Shiller 2009).

Question 18

What is the Theory of Fair Exchange?

Answer 18

When subjective elements enter an evaluation, such as the values of ingratiation and thanks. It explains why those of low status are subservient. To equalize the subjective and objective inputs and outputs in the exchange, they have to give more than those of higher status.

Question 19

What is Money Illusion?

Answer 19

It occurs when decisions are influenced by nominal dollar amounts. Economists believe that if people were “rational” their decisions would be influenced only by what they could buy or sell in the marketplace with those nominal dollars. In the absence of money illusion, pricing and wage decisions are influenced only by relative costs or relative prices, not by the nominal values of those costs or prices.

Question 20

What is the Unitary Price Theory?

Answer 20

The price of a good should be the same everywhere.

Question 21

What is the Interest Rate Determination Theory?

Answer 21

Irving Fisher, describes the relationship between inflation and both real and nominal interest rates. The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. It relates the nominal interest rate (i) to the rate of inflation (π) and the “real” interest rate (r). The real interest rate (r) is the interest rate after adjustment for inflation. It is the interest rate that lenders have to have to be willing to loan out their funds. The relation Fisher postulated between these three rates is:

(1+i) = (1+r) (1+π) = 1 + r + π + r π and is equivalent to 
i = r + π(1 + r).

Question 22

What is the Standard Theory of the Determination of the Interest Rate?

Answer 22

It is the rate of interest, or the opportunity cost for holding money, or the “price” of holding money. It is the basis of the theory. The demand for money is considered to depend on the level of income and also on the rate of interest. Economists would also say that this demand is price inelastic, because holding some money in one’s checking account is necessary to engage in transactions, but the total cost of holding it is typically not a large part of people’s budgets. There is low elasticity of demand with respect to the interest rate.

Question 23

What is the Trade Off Theory?

Answer 23

When labor markets get tight, workers will ask for higher wage increases. When the economy is close to full employment, prices will also rise, partly because labor would be asking for wage increase and also because the demand for firms’ products would be high as well.

Question 24

What is the Natural Rate Theory?

Answer 24

It explains the rise in inflation as the result of the significant shock that occurred and an increase in inflationary expectations, both of which causes a shift in the Phillips curve outward. It explains the rise in unemployment as the result of a decline in demand. It has become the basis for macroeconomic policy relied on by almost all policy makers at the Fed, the Treasury, and the Council of Economic Advisers. It is commonly accepted theory not just in the US but in Europe and in Canada as well. In the absence of money illusion, the natural rate theory will hold, as its key element is that it assumes people do not believe in money illusion. If the theory is correct, it has major consequences for monetary policy and there is little loss from very low inflation targets. However, if it is not true, then there is a long-term trade-off between inflation and unemployment, a zero inflation target is poor economic policy.

Question 25

What is the Theory of Central Banking?

Answer 25

Supply and Demand: In terms of checking account balances, when the supply changes proportionately with changes in the reserves held at the Federal Reserve Banks. The demand for checking accounts derives from their usefulness in transitions.

Question 26

What is it called when the Fed affects the economy?

Answer 26

It is known as the Loanable Funds Theory

Question 27

What is the Efficiency Wage Theory of Unemployment?

Answer 27

It focuses on wages as a means of motivating labor. The amount of effort workers make on the job is related to how well the job pays relative to alternatives. It does not offer why the average nominal wage is slow to change, but does help explain the existence of unemployment, and nominal wage stickiness. The idea that the efficiency or effectiveness of labor depends on the wage employees are paid. The transaction between the buyer and the seller of labor only begins when the labor is employed and the wage is agreed upon. This theory violates their usual conceptual framework of how to set up a theoretical problem. Statistics show that most employers do willingly pay more for their labor than they have to. This theory views high unemployment as due to a large gap between the wages that firms pay and the wages at which the supply and demand for labor are equal. When unemployment is high the supply of labor considerably exceeds the demand for it. When unemployment is low there is only a small gap between the number of people who want jobs and those who get them. Thus we would expect that when unemployment is high relatively few people will quit their jobs. When the unemployment rate goes up, the quits invariably go down.

Question 28

What is the Theory of Unemployment?

Answer 28

Carl Shapiro and Joseph Stiglitz - that firms want to pay more for their workers than what is merely necessary to attract them and that they cannot fully monitor their workers. This gives workers a choice, they can work or they can shirk.

Question 29

What is Game Theory?

Answer 29

It is concerned with the general analysis of strategic interaction. It can be used to study parlor games, political negotiation, and economic behavior. It is said that Game Theory does not predict human behavior well, either in the real world or in controlled laboratory experiments. Thus, Economists rationalize prediction failures by arguing that game theoretic models were designed to indicate how perfectly rational agents ought to behave in their interaction with other perfectly rational agents. Therefore, Game Theory models in economics should be regarded as strictly normative.

Question 30

What is the Neoclassical Growth Theory?

Answer 30

Neoclassical model - focuses on capital accumulation and its link to savings decisions and the like. Robert Solow is the best known contributor. It begins with a simplified assumption, and starts the analysis by pretending that there is no technological progress. This implies that the economy reaches a long-run level of output and capital called the steady-state equilibrium, which is the combination of per capita GDP and per capita capital where the economy will remain at rest, that is, where per capita economic variables are no longer changing, (Delta)y=0 and (Delta)k=0. Where Delta means the change in.

There are three broad steps: (1) seeing how various economic variables determine the economy’s steady state, (2) the transition from the economy’s current position to this steady state, and (3) add technological progress to the model.

Question 31

What is Endogenous Growth Theory?

Answer 31

Endogenous - focuses on the determinants of technological progress. It emphasizes different growth opportunities in physical capital and knowledge capital. There are diminishing marginal returns to the former, but perhaps not the latter. The idea that increased investment in knowledge increases growth is a key to linking higher saving rates to higher equilibrium growth rates.

Question 32

What is the Life Cycle Permanent Income Theory of Consumption and Saving?

Answer 32

It is the consumption function [C= C1 +cYD] where 0

Question 33

What is the Demand for Money Theory?

Answer 33

It is a demand for a real balance. People hold money for its purchasing power, for the amount of goods they can buy with it. They are not concerned with their nominal money holdings, that is, the number of dollar bills they hold. Two implications: (1) Real money demand is unchanged when the price level increases, and all real valuables, such as interest rates, real income, and real wealth, remain unchanged and (2) Equivalently, nominal money demand increases in proportion to the increase in the price level, given the real variables just specified. In other words, we are interest in a money demand function that tells us the demand for real balances, MP, not nominal balances, M. An individual is free from money illusion if a change in the level of prices, holding all real variables constant, leaves a person’s real behavior, including real money demand, unchanged. The theories of money demand are built around a tradeoff between the benefits of holding more money versus the interest costs of doing so. Baumol-Tobin formula for the demand for money: M/P=sqrt((tc)(Y)/2i) which shows that the demand for money decreases with the interest rate and increases with the cost of transacting. Money demand increases with income, but less than proportionately, thus, there are economies of scale in cash management.

Question 34

What is the Equilibrium Real Business Cycle Theory?

Answer 34

Nelson and Plosser - asserts that fluctuations in output and employment are the result of a variety of real shocks that hit the economy, with markets adjusting rapidly and remaining always in equilibrium. RBC theorists prefer using calibration or quantitative theory techniques, meaning choosing a small number of parameters that are crucial to the behavior of a model and estimating the value of each parameter from microeconomic studies, rather than from macroeconomic data itself.

Question 35

What is the Theory of the Aggregate Demand Schedule?

Answer 35

Aggregate demand is the total amount of goods demanded in the economy. It distinguishes among goods demanded for consumption (C), investment (I), government (G), and net exports (NX), thus AD=C+I+G+NX. Output is at its equilibrium level when the quantity of output produced is equal to the quantity demanded. Thus, an economy is at equilibrium output when Y=AD=C+I+G+NX. When AD, the amount people want to buy, is not equal to output, there is unplanned inventory investment or disinvestment, IU=Y-AD, where IU is the unplanned additions to inventory. If output is greater than AD, there is unplanned inventory investment, IU > 0. If output is below AD, inventories are drawn down until equilibrium is restored. The relationship between consumption and income is described by the consumption function, C=C+cY where C>0 and 0

Question 36

What is the Factor Proportions Theory of International Trade?

Answer 36

A country’s comparative advantage is determined by its initial resource endowments of the factors of production. (1) two countries, two goods, with two factors of production; (2) both countries have the same technology, and each good is produced under constant returns to scale; (3) both countries have perfectly competitive product and factor markets, and prices of the two goods and factors of production are determined by supply and demand; (4) there are no transportation costs, tariffs, or other obstructions to free trade between countries, and after introduction of international trade, neither country completely specializes in producing a particular good; (5) consumers in the two countries have equal tastes and preferences for each of the two goods; (6) labor and capital are assumed to be mobile domestically but not internationally; (7) the production techniques available to produce the two goods are such that one good is everywhere capital intensive, and the production of the other good is everywhere labor intensive; and (8) the resources of both countries are fully employed both before and after trade.

Question 37

What is Production Theory?

Answer 37

There is a positive relationship between investment and the rate of economic growth (Galbis 1979). Cobb-Douglas Production Function: Q=K^a(L^1-a), where
a+(1-a)=1, meaning there is a constant return to scale.

Question 38

What is the Stolper-Samuelson Theory?

Answer 38

That international trade will reduce income of the scarce factor of production and increase the income of the abundant factor of production within a country.

Question 39

What is a utility function?

Answer 39

A utility function is a way of assigning a number to every possible consumption bundle such that more-preferred bundles get assigned a larger number than less-preferred bundles.

That is, a bundle, (x1, x2), is prefered to bundle (y1, y2), if and only if the utility of (x1, x2) is larger than the utility of (y1, y2): in symbols, (x1, x2) (y1, y2), if and only if u(x1, x2) > u(y1, y2).