ECON A232
Introduction to Macroeconomics
Unit 1
What is macroeconomics?
229
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Contents
Introduction
1
How the economy as a whole works
2
Principle 8: A country’s standard of living depends on its ability
to produce goods and services
Principle 9: Prices rise when the government prints too much
money
Principle 10: Society faces a short-run trade-off between inflation
and unemployment
2
3
3
The circular-flow model
5
Summary
6
Feedback on self-tests
7
Unit 1
Introduction
Welcome to ECON A232 Introduction to Macroeconomics. There are six
units in this course. This first unit is introductory in nature: it provides
you with the basic background you will need to understand how the
economy as a whole works.
In the first of two sections, you will learn about some well-known
observations economists have made in the past about the macroeconomy.
The second section introduces a simple model that describes the
macroeconomy.
In sum, this unit:
•
relates a country’s standard of living to its productivity;
•
discusses why prices will rise when too much money is printed;
•
explains why there is a short-run trade-off between inflation and
unemployment; and
•
explains the flows of funds in a macroeconomy with the circular-flow
model.
As you study this unit, you will need to follow the instructions and read
the following chapters of your textbook:
Mankiw, Chapter 1 and Chapter 2.
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ECON A232 Introduction to Macroeconomics
How the economy as a whole
works
The first reading for this unit comprises the second half of Chapter 1 from
your textbook. The first few pages you will read list and describe some
‘microeconomic’ principles, which deal mainly with the decisions taken
by individuals. In this course we care more about how the interaction of
such individual decisions affect the economic welfare of the whole
society.
You will be introduced to three principles in your first textbook reading.
These principles are basic observations that economists have made over
the past decades that relate to arguably the three most important
macroeconomic questions that concern an average worker — the level of
income earned from work, the purchasing power of that income, and
whether an individual can find employment. By bearing these principles
in mind, you will have a much better idea of why we need to study the
subject matter of the later units.
Reading
Mankiw, ‘Principle 8 to Principle 10’, 11–14.
You have seen that the three observations you’ve just read about are
Principles 8 to 10 from Chapter 1 of your textbook. Principles 1 to 7
relate to microeconomics, which are about economic choices made in
individual markets, which are only a part of the whole economy. Even
though these principles are not our focus in the study of macroeconomics,
if you have not yet taken a microeconomics course, reading over these
seven principles will help you better understand economics as a subject.
Let’s now consider Principles 8 to 10 in a bit more detail.
Principle 8: A country’s standard of living
depends on its ability to produce goods and
services
This principle goes to the heart of the study of macroeconomics: it
defines the standard of living as the aim of economic activity, and tells us
about the long-term positive relationship between an average worker’s
productivity and the average standard of living in a country. Essentially,
the message to take home is that living standards depend on how much is
produced within a certain period of time. The higher productivity is, the
higher the living standard.
Unit 1
Principle 9: Prices rise when the government
prints too much money
The issue of inflation is well-known to almost everyone because news
about it appears very often in the press. The mechanisms that drive trends
in inflation require more detailed study, which you’ll do in later units.
Inflation, however, can be understood in a very simple way — when too
much money is printed by the governing authorities, then the value of
money declines relative to the goods that people buy. It takes more
money to buy the same goods, hence inflation.
A word of caution is in order when reading about this principle. Even
though the textbook mentions that money is printed by the government,
in modern day societies the money supply is usually presided over by the
central bank, a specific, frequently independent, government body. In
later units we will in fact distinguish clearly between ‘the government’
and ‘the central bank’.
Principle 10: Society faces a short-run tradeoff between inflation and unemployment
The last of the major concerns for workers in an economy is the prospect
of finding work or protecting one’s job. Again, the actual mechanism
behind this principle is the subject of detailed study in a later unit. What
you should remember right now at this beginning stage of your study is
that, in the short run of a few quarters or a couple of years, inflation and
unemployment tend to go in different directions. Given that the central
bank can more or less control the money supply, that means the
unemployment rate can be manipulated too.
We can explain this principle in a concise form — if the central bank
prints lots of money, then it will find its way into people’s pockets, and it
will be used to buy more goods and services. That spurs production
because sellers will try to satisfy this extra demand. Higher production
requires more workers, so the unemployment rate goes down.
Activity 1.1
After reading about these three principles, you may feel that you have
thought about these problems before. Everyone who has participated in
the job market must have thought about securing (or wished to secure!) a
job with stability, perhaps with less overtime work, but also with an
acceptably high income. That means you were at once thinking about the
possibility of unemployment and the standard of living — Principles 10
and 8, respectively, from the reading.
However, even though news about the price level is common enough in
the press, it seems difficult to relate anything we see in daily life with
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ECON A232 Introduction to Macroeconomics
Principle 9, because the author links it with the amount of money printed
by the government. Can we find out anything meaningful about Principle
9? How would you do this?
Principle 9 is actually all around us. To find out more about it, you could
go to the websites of major news outlets, whether in Chinese or English,
and browse through the financial pages for about one week consecutively.
The HKMU Library has paid for subscriptions to a number of major
newspapers from around the world. Try to see if you can identify any
news about foreign currencies or interest rates. In fact, like changes in the
price level, these two quantities are just different manifestations of the
same actions carried out by the central bank in relation to the quantity of
money.
Your textbook tells us how the quantity of money can affect the price
level in the local economy. At an international level, there are many
different currencies in the world, and the quantity of different currencies
can affect the exchange rates between them. The interest rate can actually
be understood as the price to borrow money from other people (usually
banks or on financial markets). Again, how much money there is in the
economy can affect the price charged by lenders. You will learn about all
of this in later units.
You should now complete the following self-test before moving on the
next topic in this unit. Do your best to answer all of the questions before
checking the feedback provided at the end of this unit.
Self-test 1.1
1
Suppose you are offered two similar job opportunities in two different
countries. The Country A job pays $500,000 per year in salary, and
the Country B job pays only $350,000. The general price level of
goods and services is quite high in Country A, and considerably
lower in Country B. From talking to your friends in these two places,
you find that the lifestyle in Country A is hectic but exciting, and in
Country B it is quiet and relaxed.
Assuming that visa rules do not prevent you from taking either job,
when you are deciding which job to take, what are some of the factors
you will consider, and how do they relate to the three macroeconomic
principles in this section?
2
One day, all of a sudden, the central bank announces that all monies
in the country you are living in are now automatically multiplied by
1,000 times. In other words, if you had a five-dollar coin last night,
you now have a $5,000 coin this morning. If you had $1,000 in the
bank account yesterday, you are now a millionaire. What do you
expect the prices of goods and services to be today?
Unit 1
The circular-flow model
The first economic model you will learn about in your study of
macroeconomics attempts to link together different groups of people
within the economy by studying the flow of funds and goods and services
between them. An economic model is a simplification of real life; this
means that only the important subject matter included, which makes it
easier for us to understand. Please read the following section to learn
more about this model.
Reading
Mankiw, ‘Our first model: The circular-flow diagram’, 22–24.
As the last paragraph of the reading indicates, this is a very simple
version of the circular-flow model. Sometimes this version is referred to
as the ‘two-sector circular-flow model’ because it only contains two
sectors, i.e. households and firms.
Take note that even though we describe the people in the model as being
divided into two groups, individual people of course belong to different
groups at the same time, so these sectors are not exclusive. For example,
you may be working for a company and engage in production during the
day, so you form part of the firms sector — in fact, you are part of the
factors of production that are hired by the firm. Once you go home after
work, however, you are part of the households sector, and may engage in
consumption decisions through spending money. This shows the
interconnectedness of different sectors in the macroeconomy and
illustrates a very important concept, i.e. that an economic decision usually
has macroeconomic consequences on more than one group of people.
Self-test 1.2
Suppose we are looking at an economy with a firms sector, a households
sector, and a government. The government suddenly decides to spend
$100 million in the economy by buying goods from local firms.
According to the circular-flow model, how will you, as a worker in one
such firm, be impacted?
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ECON A232 Introduction to Macroeconomics
Summary
You’ve now completed the first unit of ECON A232 Introduction to
Macroeconomics. You have seen the three fundamental macroeconomic
issues that all workers are concerned about, and three economic
principles that give some clue to how to assess them. In the next unit, you
will learn how to measure them in real life, before moving on to explore
some theories that seek to explain these observations.
The idea that economic agents are all interconnected in an economy was
also introduced to you in the form of the circular-flow model. This model
shows clearly that when something happens to one section of the
economy, all other parts are affected in different ways. In the later units,
such connections are explored in much more detail.
Unit 1
Feedback on self-tests
Self-test 1.1
1
There are many things to consider, and not all of them are related to
macroeconomics. Among those which are, we need to consider, for
example, whether the higher income in Country A can compensate
for the higher price level there. This requires us to apply Principle 9
because higher inflation in one country is likely to reduce the
purchasing power of the income earned there.
An associated question is what standard of living the income from
these jobs will allow you to afford in these countries. The goods and
services that are affordable form part of your assessment of the
standard of living in these two countries. It is possible that if you
prefer a more relaxed lifestyle, then you will find the quality of life in
Country B better, in particular because goods are also cheaper there.
This relates to Principle 8, and at the same time highlights some of
the difficulty in applying it, since standard of living is subjective up
to a point, and can only be measured and compared approximately.
Job prospects may also be part of the consideration, as the
macroeconomic environment or unemployment rate may be different
in the two countries. If one country has considerably higher
unemployment, then it is unlikely that a pay rise will be given in the
near future in that job, and it may even affect your quality of life
there. This related to Principle 10.
Of course, there are many other non-macroeconomic considerations,
but hopefully the above points allow you to see how macroeconomic
principles have an important impact on job market decisions.
2
The prices of goods and services will immediately rise by 1,000
times. The reason is because everybody has 1,000 times the wealth
overnight, without production of goods and services, or technology,
changing at all.
In later units, you will learn more details about different sectors of the
economy, and consider some problems with adjustments of such
prices in the short run, which may make the price level actually not
move by 1,000 times. But as a first pass on using Principle 9, this
simple insight will do for now.
Self-test 1.2
As a worker in a local firm, part of the produce of your company will be
bought by the government. That means the profit of the company you
work for will increase, thereby increasing the chance that you may get
your share through a large year-end bonus or a pay rise. At the same time,
you are also part of a family within the households sector, so the higher
income you may bring home can also lead to an increase in consumption,
further increasing the profits of the local firms sector, and indirectly your
future wages also.
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