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PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs

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Macroeconomics ECO 403
VU
LESSON 02
PRINCIPLE OF MACROECONOMICS
Principle #1: People Face Tradeoffs
"There is no such thing as a free lunch!"
To get one thing, we usually have to give up another thing.
­  Guns v. butter
­  Food v. clothing
­  Leisure time v. work
­  Efficiency v. equity
Making decisions requires trading off one goal against another.
Efficiency v. Equity
·
­  Efficiency means society gets the most that it can from its scarce resources.
­  Equity means the benefits of those resources are distributed fairly among the
members of society.
Principle #2: Cost of Something Is What You Give Up to Get It
Decisions require comparing costs and benefits of alternatives.
·
­  Whether to go to college or to work?
­  Whether to study or go out on a date?
­  Whether to go to class or sleep in?
The opportunity cost of an item is what you give up to obtain that item.
·
Principle #3: Rational People Think at the Margin
Marginal changes are small, incremental adjustments to an existing plan of action.
·
People make decisions by comparing costs and benefits at the margin.
Principle #4: People Respond to Incentives
Marginal changes in costs or benefits motivate people to respond.
·
The decision to choose one alternative over another occurs when that alternative's
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marginal benefits exceed its marginal costs!
Principle #5: Trade Can Make Everyone Better Off
People gain from their ability to trade with one another.
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Competition results in gains from trading.
·
Trade allows people to specialize in what they do best.
·
Principle #6: Markets are a good way to organize economic activity
A market economy is an economy that allocates resources through the decentralized
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decisions of many firms and households as they interact in markets for goods and
services.
­  Households decide what to buy and who to work for.
­  Firms decide who to hire and what to produce.
Adam Smith made the observation that households and firms interacting in markets act
·
as if guided by an "invisible hand."
­  Because households and firms look at prices when deciding what to buy and
sell, they unknowingly take into account the social costs of their actions.
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Macroeconomics ECO 403
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As a result, prices guide decision makers to reach outcomes that tend to
­
maximize the welfare of society as a whole.
Principle #7: Governments can sometimes improve market outcomes
Market failure occurs when the market fails to allocate resources efficiently.
·
When the market fails (breaks down) government can intervene to promote efficiency
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and equity.
Market failure may be caused by
·
·  an externality, which is the impact of one person or firm's actions on the well-
being of a bystander.
·  market power, which is the ability of a single person or firm to unduly influence
market prices.
Principle #8: The standard of living depends on a country's production
Almost all variations in living standards are explained by differences in countries'
·
productivities.
Productivity is the amount of goods and services produced from each hour of a
·
worker's time.
Standard of living may be measured in different ways:
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·  By comparing personal incomes.
·  By comparing the total market value of a nation's production.
Principle #9: Prices rise when the government prints too much money
Inflation is an increase in the overall level of prices in the economy.
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One cause of inflation is the growth in the quantity of money.
·
When the government creates large quantities of money, the value of the money falls.
·
Principle #10: Society Faces a Short-run Tradeoff Between Inflation and Unemployment.
The Phillips Curve illustrates the tradeoff between inflation and unemployment:
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↓Inflation
↑Unemployment
It's a short-run tradeoff!
Important issues in macroeconomics
Why does the cost of living keep rising?
·
Why are millions of people unemployed, even when the economy is booming?
·
Why are there recessions?
·
Can the government do anything to combat recessions? Should it??
What is the government budget deficit? How does it affect the economy?
·
Why do the economies have such a huge trade deficit?
·
Why are so many countries poor?
·
What policies might help them grow out of poverty?
Gross Domestic Product of Pakistan
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Macroeconomics ECO 403
VU
GDP at M arket Price (1980-81 Prices)
Rs Millions
900,000
800,000
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
Years
5
Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand