Introduction to Eonomic Policy

2021-2022 Fall
 What is Economics?
• Economics is a study of rationing systems
- Planned Economies
- Free Market Economies

• It is the study of how scarce resources are

allocated to fulfill the infinite wants of
consumers
• Economics can generally be broken down into
macroeconomics, which concentrates on the
behavior of the economy as a whole, and
microeconomics, which focuses on individual
people and businesses.
 What is Economic Policy
• An economic policy is a course of action that is
intended to influence or control the behavior of the
economy. Economic policies are typically
implemented and administered by the government.
Examples of economic policies include decisions
made about government spending and taxation,
about the redistribution of income from rich to poor,
and about the supply of money. The effectiveness of
economic policies can be assessed in one of two
ways, known as positive and normative economics.
 Positive economics
• attempts to describe how the economy and
economic policies work without resorting to value
judgments about which results are best. The
distinguishing feature of positive economic
hypotheses is that they can be tested and either
confirmed or rejected. For example, the hypothesis
that “an increase in the supply of money leads to an
increase in prices” belongs to the realm of positive
economics because it can be tested by examining the
data on the supply of money and the level of prices.
 Normative Economics
• involves the use of value judgments to assess the
performance of the economy and economic policies.
Consequently, normative economic hypotheses
cannot be tested. For example, the hypothesis that
“the inflation rate is too high” belongs to the realm
of normative economics because it is based on a
value judgment and therefore cannot be tested,
confirmed, or refuted. Not surprisingly, most of the
disagreements among economists concern
normative economic hypotheses.
 Goals of Economic policy
• The goals of economic policy consist of value
judgments about what economic policy should
strive to achieve and therefore fall under the
heading of normative economics. While there
is much disagreement about the appropriate
goals of economic policy, several appear to
have wide, although not universal,
acceptance.
 Cont.
• Economic growth: Economic growth means that the
incomes of all consumers and firms (after accounting
for inflation) are increasing over time.
• Full employment: The goal of full employment is that
every member of the labor force who wants to work
is able to find work.
• Price stability: The goal of price stability is to prevent
increases in the general price level known as
inflation, as well as decreases in the general price
level known as deflation.
 What Macroeconomics is About
• Macroeconomics is the study of the structure
and performance of national economies and
of the policies that governments use to try to
affect economic performance.
• Macroeconomics studies economy-wide
phenomena such as inflation, price levels,
rate of economic growth, national income,
gross domestic product (GDP), and changes in
unemployment.
Issues Addressed by Macroeconomists

• What determines a nation’s long-run

economic growth?
• What causes a nation’s economic activity
to fluctuate?
• What causes unemployment?
Issues Addressed by Macroeconomists
(continued)

• What causes prices to rise?

• How does being a part of a global
economic system affect nations’
economies?
• Can government policies be used to
improve economic performance?
 Long-Run Economic Growth
– Rich nations have experienced
extended periods of rapid economic
growth.
– Poor nations either have never
experienced them or economic growth
was offset by economic decline.
 Increased Output
• Total output is increasing because of
increasing population, i.e. the number of
available workers.
• Increasing average labour productivity:
the amount of output produced per unit
of labour input.
 Rates of Growth of Output
• Rates of growth of output (or output per
worker) are determined by:
– rates of saving and investment;
– rates of technological change;
– rates of change in other factors.
 Business Cycles

• Business cycles are short-run contractions

and expansions of economic activity.
• The most volatile period in the history of
Canadian output was between 1914 and
1945.
 Recessions
• Recession is the downward phase of a
business cycle when national output is falling
or growing slowly.
– Hard times for many people
– A major political concern
 Unemployment
• Recessions are usually accompanied by
high unemployment: the number of
people who are available for work and are
actively seeking it but cannot find jobs.

Unemployed
Unemployme nt Rate   100%
Labour Force
 The Unemployment Rate
• The unemployment rate can stay high even
when the economy is doing well.
• After eight years of economic growth, in 2000,
the unemployment rate in Canada was near
7%.
 Inflation

• When prices of most goods and services

are rising over time it is inflation. When
they are falling it is deflation.
• The inflation rate is the percentage
increase in the average level of prices.
 Effects of Inflation
• When the inflation rate reaches an extremely
high level the economy tends to function
poorly. The purchasing power of money
erodes quickly, which forces people to spend
their money as soon as they receive it.
 The International Economy
• An economy which has extensive trading and
financial relationships with other national
economies is an open economy. An economy
with no relationships is a closed economy.
 The International Economy
(continued)
• International trade and borrowing
relationships can transmit business cycles
from country to country.
 Exports and Imports
• Canadian exports are goods and services
produced in Canada and consumed abroad.
• Canadian imports are goods and services
produced abroad and consumed in Canada.
 Trade Imbalances

• Trade imbalances (trade surplus and

deficit) affect output and employment.
– Trade surplus: exports exceed imports.
– Trade deficit: imports exceed exports.
 The Exchange Rate
• The trade balance is affected by the exchange
rate: the amount of Canadian dollars that can
be purchased with a unit of foreign currency.
 Macroeconomic Policy

• A nation’s economic performance depends

on:
– natural and human resources;
– capital stock;
– technology
– economic choices made by citizens;
– macroeconomic policies of the government.
Macroeconomic Policy (continued)
• Macroeconomic policies:
– Fiscal policy: government spending and taxation at
different government levels.
– Monetary policy: the central bank’s control of
short-term interest rates and the money supply.
 Budget Deficits
• The economy is affected when there are large
budget deficits: the excess of government
spending over tax collection.
 Budget Deficits (continued)

• The large budget deficits of the 1980s and

early 1990s are unusual.
– Borrowing from the public might divert funds
from more productive uses.
– Federal budget deficits might be linked to
the decline in productivity growth.
 Aggregation
• Macroeconomists ignore distinctions between
individual product markets and focus on
national totals.
• The process of summing individual economic
variables to obtain economywide totals is
called aggregation.
 What Macroeconomists Do
• Macroeconomic forecasting
• Macroeconomic analysis
• Macroeconomic research
• Data development
 Macroeconomic Forecasting

• Macroeconomic forecasting – prediction

of future economic trends - has some
success in the short run. In the long run
too many factors are highly uncertain.
 Macroeconomic Analysis
• Macroeconomic analysis - analyzing and
interpreting events as they happen – helps
both private sector and public policymaking.
 Macroeconomic Research
• Macroeconomic research - trying to
understand the structure of the economy in
general – forms the basis for macroeconomic
analysis and forecasting.
 Economic Theory

• Economic theory: a set of ideas about the

economy to be organized in a logical
framework.
• Economic model: a simplified description
of some aspects of the economy.
 Developing and Testing a Theory
• State the research question.
• Make provisional assumptions.
• Work out the implications of the theory.
• Conduct an empirical analysis.
• Evaluate the results.
 Data Development

• Macroeconomists use data to assess the

state of the economy, make forecasts,
analyze policy alternatives, and test
theories.
 Data Development (continued)
• Providers of data must:
– Decide what types of data should be collected
based on who is expected to use the data and
how.
– Ensure the measures of economic activity
correspond to economic concepts.
– Guarantee the confidentiality of data.
Why Macroeconomists Disagree

• A positive analysis examines the economic

consequences of an economic policy, but
it does not address its desirability.
• A normative analysis tries to determine
whether a certain economic policy should
be used.
 Why Macroeconomists Disagree
(continued)
• Economists can disagree on normative issues
because of differences in values.
• Economists disagree on positive issues
because of different schools of thought.
 The Classical Approach

• The invisible hand of Economics: General

welfare will be maximized (not the
distribution of wealth) if:
– there are free markets;
– individuals act in their own best interest.
The Classical Approach (continued)
• To maintain markets’ equilibrium – the
quantities demanded and supplied are equal:
– Markets must function without impediments.
– Wages and prices should be flexible.
The Classical Approach (continued)
• Thus, according to the classical approach, the
government should have a limited role in the
economy.
 The Keynesian Approach

• Keynes (1936) assumed that wages and

prices adjust slowly.
• Thus, markets could be out of equilibrium
for long periods of time and
unemployment can persist.
 The Keynesian Approach
(continued)
• Therefore, according to the Keynesian
approach, governments can take actions to
alleviate unemployment.
 The Keynesian Approach
(continued)
• The government can purchase goods and
services, thus increasing the demand for
output and reducing unemployment.
• Newly generated incomes would be spent and
would raise employment even further.
 Evolution of the Classical-
Keynesian Debate
• After stagflation – high unemployment
and high inflation – of the 1970s, a
modernized classical approach
reappeared.
• Substantial communication and cross-
pollination is taking place between the
classical and the Keynesian approaches.
 Unified Approach to
Macroeconomics
• Individuals, firms and the government interact
in goods, asset and labour markets.
• The macroeconomic analysis is based on the
analysis of individual behaviour.
The Unified Approach (continued)

• Keynesian and classical economists agree

that in the long run prices and wages
adjust to equilibrium levels.
• The basic model will be used either with
classical or Keynesian assumptions about
flexibility of wages and prices in the short
run.
 Monetarist
• The Monetarist school is largely credited to the
works of Milton Friedman. Monetarist economists
believe that the role of government is to control
inflation by controlling the money supply.
Monetarists believe that markets are typically clear
and that participants have rational expectations.
Monetarists reject the Keynesian notion that
governments can "manage" demand and that
attempts to do so are destabilizing and likely to
lead to inflation.
 Economic problebms
• 1. Instability
– Inflation
– Recession
• 2. Unemployment
• 3. Government budget deficit
• 4. Low productivity OR inefficiency
 Solutions to economic problems
• 1. Monetary policy
• 2. Fiscal Policy