Week 1- Introduction to Macroeconomics

Question 1

What is Macroeconomics the study of?

Answer 1

The economy as a whole

Question 2

What is the chief aim of macroeconomics?

Answer 2

To formulate policies that will make nations better off (measured by some objective/unbiased standard)

Question 3

What should be a macroeconomists goal in terms of people and preferences?

Answer 3

A good economist shouldn’t impose preferences on people but instead take them for what they are (as given) and aim to maximise them in the face of constraints such as the population of workers in economy, pace of technological processes and rate of economic growth in other nations

Question 4

What is a model and what is its role in macroeconomics?

Answer 4

A model is a simplified representation of reality

Macroeconomists rely on models to explain how economies work which can help them to explain economic events and formulate the necessary policies

Question 5

Why are models useful and necessary?

Answer 5

• models exclude certain features of reality which are not relevant for solving the problem at hand
• models are necessary because we cannot conduct controlled experiments in a laboratory (too many factors e.g. politics, war, media, policies of other nations etc)
• it would also not make sense to trial these policies in the national economy before granting them approval as this can be very costly (if trialled policy poor then it may lead to lower incomes and increased unemployment) … mathematical models are the easiest way to test new policies (new policy will need to perform well in many different models of the economy and in a wide range of alternative scenarios- these models act as the economists laboratory)

Question 6

Describe the features of modern macroeconomic models

Answer 6

• system of mathematical equations
• make precise numerical predictions about the impact of particular policies including where the economy is headed

Question 7

What is the job of economic research?

Answer 7

1) to design models of the economy

2) to establish which models are useful

Question 8

What is an example of a macroeconomic model?

Answer 8

Paul Samuelson’s multiplier accelerator model

Question 9

What is Paul Samuelson’s multiplier accelerator model?

Answer 9

Main equations of the Samuelson model:
1) Y = C + I + G upper bar
2) C = a + b(Y with -1 in bottom right - T upper bar)
3) I = d + e(C - C with -1 in bottom right)

NOTE that -1 basically just refers to the past so, Y in equation 1 refers to present GDP/aggregate output/aggregate expenditure BUT in equation 2 Y with -1 in bottom right refers to past aggregate income (total income) and C with -1 in bottom right refers to past consumption expenditure

Equation 1 is aggregate expenditure or GDP

Equation 2 is the economy’s consumption function and states that consumption is positively related to past disposable income (income minus taxes)- the greater the disposable income consumers have, the greater they’ll consume- example of Keynesian consumption function

Equation 3 states that investment expenditure is positively related to the change in consumption expenditure- so if consumption expenditure increase then firms should increase investment in additional productive capacity to take advantage of the increase in spending

Where Y (aggregate output/aggregate expenditure/GDP), C (consumption expenditures by households), I (investment expenditures by firms), G upper bar (fixed government expenditure, T upper bar (fixed taxes) and where a, b, d, e are positive parameters whose values are fixed

Question 10

Are precision and accuracy the same and state why?

Answer 10

They are not the same- prediction is precise if it can be stated as an exact number e.g. 1.2% but precise predictions don’t need to be accurate as the actual outcome could be 10.1%

… accuracy is about how close a prediction is to the true value whereas precision is about how specific you can be

Question 11

What does upper bar mean?

Answer 11

It means that the variable is fixed/given and does not change over time and …does not need to solved for in the model

Question 12

How is the multiplier effect in play in Samuelson’s model equations?

Answer 12

Parameter b is known as the Marginal Propensity to Consume (MPC) and is responsible for the multiplier effect in this model because:
If past income (Y with -1 in the bottom right) increases then the MPC will increase causing consumption to increase (due to equation 2) which will further raise GDP/aggregate output/aggregate expenditure (Y)- due to equation 1

Question 13

If you combine the 3 Samuelson equations what do you get algebraically and graphically?

Answer 13

Y = sigma + b(1+e)Y with -1 in bottom right corner - beY with -2 in bottom right corner

Where sigma is a constant parameter

MOST IMPORTANTLY you get the business cycle when you draw a numerical solution to the combined equation above

You DON’T need to be able to show how to derive the combined equation above- it is included just to show where the business cycle comes from

Question 14

What is a business cycle?

Answer 14

The business cycle obtained by combing the 3 Samuelson equations shows that periods of expansion in output are followed by periods of contraction (up and down curve)- the periods of contraction in output are known as recessions which is defined by a period when real GDP falls for at least 2 successive quarters- the periods of expansion in output are known as booms

Question 15

How could you determine whether the model generated by the Samuelson equations is a good one?

Answer 15

1) You could compare the business cycles it generates with actual GDP to see if there is a statistical difference between the 2
2) You could use the model to make GDP forecasts and assess its accuracy (how close the GDP predictions are to actual GDP)
3) You could check its predictions for consumption and investment expenditure

Question 16

How do economists establish which models are useful?

Answer 16

They test the ability of competing models to explain data
Models which cannot explain data are rejected
Process of rejecting incorrect models known as falsification

Question 17

What is falsification and where did the idea come from?

Answer 17

Falsification- process of rejecting incorrect models

Karl Popper (philosopher) argued in favour of falsification that science progresses by rejecting models/theories that make false predictions- by continuing to do this the pool of non-rejected models gets smaller over time and … the science progresses- left with models that can explain data

Question 18

How can a model or theory be scientific?

Answer 18

It needs to be testable which means that it must make predictions that can be disproven/refuted using data

Question 19

Are macro models scientific?

Answer 19

They are scientific because they make concrete predictions which can be tested on data

Question 20

In reality, how is the idea of falsification (process of rejecting incorrect models) applied?

Answer 20

In reality, existing models are refined to improve their performance rather than rejecting them completely- this is because only a few models have an excellent record though most contain something useful

Question 21

What is one way economists test their models and how do they do this?

Answer 21

They may use econometric methods such as regressions:

1) Find a regression model that provides a good statistical fit for the data and then estimate its parameters (this model is compared to the regression model that was run on the official data)
2) The economic model is then simulated under many different scenarios by hitting it with shocks
3) The simulated data from the model is then used to estimate the same regression model that was run on the official data
4) If the estimated parameters from the model regressions are close to those estimated on the data, then the model is doing a good job of replicating the dynamic behaviour of the economy

This way the question of whether a model does a ‘good job’ is not left up to subjective judgement but instead decided by a formal statistical test that will reject poor models … bad macro models are rejected based on strong statistical evidence rather than just chance