Principles of

Macroeconomics
D. Curtis and I. Irvine

2020 - A
(CC BY-NC-SA)
 Principles of Macroeconomics
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Chapter 1
Introduction to key ideas

In this chapter we will explore:

1.1 What it’s all about

1.2 Understanding through the use of models
1.3 Opportunity cost and the market
1.4 A model of exchange and specialization
1.5 Production possibilities for the economy
1.6 Aggregate output, growth and cycles

1.1 What’s it all about?

The big issues
Economics is the study of human behaviour. Since it uses scientific methods it is called a social
science. We study human behaviour to better understand and improve our world. During his
acceptance speech, a recent Nobel Laureate in Economics suggested:

Economics, at its best, is a set of ideas and methods for the improvement of society. It
is not, as so often seems the case today, a set of ideological rules for asserting why we
cannot face the challenges of stagnation, job loss and widening inequality.
Christopher Sims, Nobel Laureate in Economics 2011

This is an elegant definition of economics and serves as a timely caution about the perils of ide-
ology. Economics evolves continuously as current observations and experience provide new evi-
dence about economic behaviour and relationships. Inference and policy recommendations based
on earlier theories, observations and institutional structures require constant analysis and updating
if they are to furnish valuable responses to changing conditions and problems.

Much of today’s developed world still faces severe challenges as a result of the financial crisis
that began in 2008. Unemployment rates among young people are at historically high levels in
several economies, many government balance sheets are in disarray, and inequality is on the rise.
In addition to the challenges posed by this severe economic cycle, the world simultaneously faces
structural upheaval: Overpopulation, climate change, political instability and globalization chal-
lenge us to understand and modify our behaviour.

7
8 Introduction to key ideas

These challenges do not imply that our world is deteriorating. Literacy rates have been rising
dramatically in the developing world for decades; child mortality has plummeted; family size is a
fraction of what it was 50 years ago; prosperity is on the rise in much of Asia; life expectancy is
increasing universally and deaths through wars are in a state of long-term decline.

These developments, good and bad, have a universal character and affect billions of individuals.
They involve an understanding of economies as large organisms with interactive components.

Aggregate Output in a National Economy

A national economy is a complete multi-sector system, made up of household, business, financial,
government, and international sectors. Each of these sectors is an aggregate or sum of many smaller
economic units with very similar characteristics. The government sector, for example, aggregates
the taxing and spending activities of local, provincial and national governments. Similarly, the
household sector is an aggregate of the income, spending and saving of all households but not
the specifics of each individual household. Economic activity within any one of these sectors
reflects, in part, the conditions and choices made in that sector. But it also affects and is affected
by conditions and actions in the other sectors. These interactions and feedbacks within the system
mean that the workings of the macro-economy are more complex than the operation of the sum of
its parts.

Macroeconomics: the study of the economy as a system in which interactions and

feedbacks among sectors determine national output, employment and prices.

For example, consider a simple economy with just household, business and financial sectors. The
household sector earns income by providing labour to the other sectors. Households make choices
about spending or saving this income. Businesses make decisions about the sizes of their establish-
ments, their labour forces, and their outputs of goods and services. The financial sector provides
banking services: bank deposits, loans, and the payments system used by all three sectors.

Suppose households decide to spend more money on goods and services and save less. That deci-
sion by itself does not change household sector income, but it does increase business sector sales
and revenues. It also reduces the flow of household savings into bank deposits in the financial
sector. As a result the business sector has an incentive to increase employment and output and
perhaps to borrow from the financial sector to finance that expansion. Increased employment in
the business sector increases incomes in the household sector and further increases household ex-
penditure and savings. These inter-sector linkages and feedbacks produce a response in aggregate
economy greater than the initial change.

Expanding this simple example to include more sectors increases its complexity but does not
change the basics. A change in behaviour within a sector, or disturbance from outside that sec-
tor, changes aggregate levels of output, employment and prices. A complete multisector macroe-
conomic theory and model is required to understand the effects, on the aggregate economy, of
 1.1. What’s it all about? 9

changes in either internal or external economic conditions. It is also essential for the design of
policies to manage the macroeconomic conditions.

Mitigating the effects of a large random shock from outside the economy, like the COVID-19
pandemic, disrupts all sectors of the economy. Flows of income, expenditure, revenue,and output
among sectors are reduced sharply both by the pandemic and by government and financial sectors
policy responses.

Application Box 1.1: COVID-19 and the Economy

The COVID-19 pandemic attacked Canada in early 2020. It revealed the complexities and
interdependencies that drive the macro economy. Control and elimination of the disease
depends on stopping person to person transmission. This is why the government mandated
personal and social distancing for individuals plus self-isolation and quarantine in some cases.
In addition businesses, mainly in the service sector, that relied on face to face interactions with
customers or live audiences were forced to close.

As a result, businesses lost sales revenues and cut output. They reduced employment to cut
labour costs, but overhead costs remained. Households lost employment and employment
incomes. They reduced their discretionary spending, but their overhead costs continued. As
a result the economy faced a unique, simultaneous collapse in overall private supply and de-
mand and the risk of a deep recession. The government and financial sectors intervened with
fiscal and monetary policy support. Government introduced a wide range of new income sup-
ports for the household sector, and loan and subsidy programs to support businesses, funded
by large increases in the government’s budget deficit. The central bank lowered interest rates
and increased the monetary base to support the government’s borrowing requirements, and
the credit demands on private banks and other financial institutions. The banking system
lost the normal growth in customer deposits, but worked to accommodate the needs of their
business and household clients.

This unprecedented support from government fiscal policy and central bank monetary policy
will offset part of the loss in national output and income. But it will not reverse it. Recovery
will begin with the reopening of business and the growth of employment at some time in the
uncertain future. The size of the estimated effect of COVID-19 on the Canadian economy
is stark. In its Monetary Policy Report, April 2020, The Bank of Canada estimates that real
GDP in Canada will be 1% to 7.5% lower in 2020Q1 and lower by 15-30% in 2020Q2 than in
2019Q4. The Monetary Policy Report is available on the Bank of Canada’s website at www.
bankofcanada.ca.

Individual behaviours
Economic actions, at the level of the person or organization, form the subject matter of microeco-
nomics. Formally, microeconomics is the study of individual behaviour in the context of scarcity.
10 Introduction to key ideas

Not all individual behaviours are motivated by self-interest; many are motivated by a concern for
the well-being of society-at-large. Philanthropic societies are goal-oriented and seek to attain their
objectives in an efficient manner.

Microeconomics: the study of individual behaviour in the context of scarcity.

Individual economic decisions need not be world-changing events, or motivated by a search for
profit. Microeconomics is also about how we choose to spend our time and money. There are quite
a few options to choose from: Sleep, work, study, food, shelter, transportation, entertainment,
recreation and so forth. Because both time and income are limited we cannot do all things all the
time. Many choices are routine or are driven by necessity. You have to eat and you need a place
to live. If you have a job you have committed some of your time to work, or if you are a student
some of your time is committed to lectures and study. There is more flexibility in other choices.
Critically, microeconomics seeks to understand and explain how we make choices and how those
choices affect our behaviour in the workplace, the marketplace, and society more generally.

A critical element in making choices is that there exists a scarcity of time, or income or productive
resources. Decisions are invariably subject to limits or constraints, and it is these constraints that
make decisions both challenging and scientific.

Microeconomics also concerns business choices. How does a business use its funds and manage-
ment skill to produce goods and services? The individual business operator or firm has to decide
what to produce, how to produce it, how to sell it and in many cases, how to price it. To make and
sell pizza, for example, the pizza parlour needs, in addition to a source of pizza ingredients, a store
location (land), a pizza oven (capital), a cook and a sales person (labour). Payments for the use of
these inputs generate income to those supplying them. If revenue from the sale of pizzas is greater
than the costs of production, the business earns a profit for the owner. A business fails if it cannot
cover its costs.

In these micro-level behaviours the decision makers have a common goal: To do as well as they
can, given the constraints imposed by the operating environment. The individual wants to mix
work and leisure in a way that makes her as happy or contented as possible. The entrepreneur
aims at making a profit. These actors, or agents as we sometimes call them, are maximizing. Such
maximizing behaviour is a central theme in this book and in economics at large.

Markets and government

Markets play a key role in coordinating the choices of individuals with the decisions of business.
In modern market economies goods and services are supplied by both business and government.
Hence we call them mixed economies. Some products or services are available through the mar-
ketplace to those who wish to buy them and have the necessary income—as in cases like coffee
and wireless services. Other services are provided to all people through government programs like
law enforcement and health care.
 1.1. What’s it all about? 11

Mixed economy: goods and services are supplied both by private suppliers and gov-
ernment.

Markets offer the choice of a wide range of goods and services at various prices. Individuals can
use their incomes to decide the pattern of expenditures and the bundle of goods and services they
prefer. Businesses sell goods and services in the expectation that the market price will cover costs
and yield a profit.

The market also allows for specialization and separation between production and use. Rather than
each individual growing her own food, for example, she can sell her time or labour to employers in
return for income. That income can then support her desired purchases. If businesses can produce
food more cheaply than individuals the individual obviously gains from using the market – by both
having the food to consume, and additional income with which to buy other goods and services.
Economics seeks to explain how markets and specialization might yield such gains for individuals
and society.

We will represent individuals and firms by envisaging that they have explicit objectives – to max-
imize their happiness or profit. However, this does not imply that individuals and firms are con-
cerned only with such objectives. On the contrary, much of microeconomics and macroeconomics
focuses upon the role of government: How it manages the economy through fiscal and monetary
policy, how it redistributes through the tax-transfer system, how it supplies information to buyers
and sets safety standards for products.

Since governments perform all of these society-enhancing functions, in large measure governments
reflect the social ethos of voters. So, while these voters may be maximizing at the individual
level in their everyday lives, and our models of human behaviour in microeconomics certainly
emphasize this optimization, economics does not see individuals and corporations as being devoid
of civic virtue or compassion, nor does it assume that only market-based activity is important.
Governments play a central role in modern economies, to the point where they account for more
than one third of all economic activity in the modern mixed economy.

Governments supply goods and services in many spheres, for example, health and education. The
provision of public education is motivated both by a concern for equality and a realization that an
educated labour force increases the productivity of an economy. Likewise, the provision of law
and order, through our legal system broadly defined, represents more than a commitment to a just
society at the individual level; without a legal system that enforces contracts and respects property
rights, the private sector of the economy would diminish dramatically as a result of corruption,
uncertainty and insecurity. It is the lack of such a secure environment in many of the world’s
economies that inhibits their growth and prosperity.

Let us consider now the methods of economics, methods that are common to science-based disci-
plines.
12 Introduction to key ideas

1.2 Understanding through the use of models

Most students have seen an image of Ptolemy’s concept of our Universe. Planet Earth forms the
centre, with the other planets and our sun revolving around it. The ancients’ anthropocentric view
of the universe necessarily placed their planet at the centre. Despite being false, this view of our
world worked reasonably well – in the sense that the ancients could predict celestial motions, lunar
patterns and the seasons quite accurately.

More than one Greek astronomer believed that it was more natural for smaller objects such as the
earth to revolve around larger objects such as the sun, and they knew that the sun had to be larger
as a result of having studied eclipses of the moon and sun. Nonetheless, the Ptolemaic description
of the universe persisted until Copernicus wrote his treatise “On the Revolutions of the Celestial
Spheres” in the early sixteenth century. And it was another hundred years before the Church
accepted that our corner of the universe is heliocentric. During this time evidence accumulated as
a result of the work of Brahe, Kepler and Galileo. The time had come for the Ptolemaic model of
the universe to be supplanted with a better model.

All disciplines progress and develop and explain themselves using models of reality. A model is
a formalization of theory that facilitates scientific inquiry. Any history or philosophy of science
book will describe the essential features of a model. First, it is a stripped down, or reduced, version
of the phenomenon that is under study. It incorporates the key elements while disregarding what
are considered to be secondary elements. Second, it should accord with reality. Third, it should be
able to make meaningful predictions. Ptolemy’s model of the known universe met these criteria: It
was not excessively complicated (for example distant stars were considered as secondary elements
in the universe and were excluded); it corresponded to the known reality of the day, and made
pretty good predictions. Evidently not all models are correct and this was the case here.

Model: a formalization of theory that facilitates scientific inquiry.

In short, models are frameworks we use to organize how we think about a problem. Economists
sometimes interchange the terms theories and models, though they are conceptually distinct. A
theory is a logical view of how things work, and is frequently formulated on the basis of observa-
tion. A model is a formalization of the essential elements of a theory, and has the characteristics
we described above. As an example of an economic model, suppose we theorize that a household’s
expenditure depends on its key characteristics: A corresponding model might specify that wealth,
income, and household size determine its expenditures, while it might ignore other, less important,
traits such as the household’s neighbourhood or its religious beliefs. The model reduces and sim-
plifies the theory to manageable dimensions. From such a reduced picture of reality we develop an
analysis of how an economy and its components work.

Theory: a logical view of how things work, and is frequently formulated on the basis
of observation.
 1.3. Opportunity cost and the market 13

An economist uses a model as a tourist uses a map. Any city map misses out some detail—traffic
lights and speed bumps, for example. But with careful study you can get a good idea of the best
route to take. Economists are not alone in this approach; astronomers, meteorologists, physicists,
and genetic scientists operate similarly. Meteorologists disregard weather conditions in South
Africa when predicting tomorrow’s conditions in Winnipeg. Genetic scientists concentrate on the
interactions of limited subsets of genes that they believe are the most important for their purpose.
Even with huge computers, all of these scientists build models that concentrate on the essentials.

1.3 Opportunity cost and the market

Individuals face choices at every turn: In deciding to go to the hockey game tonight, you may have
to forgo a concert; or you will have to forgo some leisure time this week in order to earn additional
income for the hockey game ticket. Indeed, there is no such thing as a free lunch, a free hockey
game or a free concert. In economics we say that these limits or constraints reflect opportunity
cost. The opportunity cost of a choice is what must be sacrificed when a choice is made. That
cost may be financial; it may be measured in time, or simply the alternative foregone.

Opportunity cost: what must be sacrificed when a choice is made.

Opportunity costs play a determining role in markets. It is precisely because individuals and or-
ganizations have different opportunity costs that they enter into exchange agreements. If you are
a skilled plumber and an unskilled gardener, while your neighbour is a skilled gardener and an
unskilled plumber, then you and your neighbour not only have different capabilities, you also have
different opportunity costs, and you could gain by trading your skills. Here’s why. Fixing a leak-
ing pipe has a low opportunity cost for you in terms of time: You can do it quickly. But pruning
your apple trees will be costly because you must first learn how to avoid killing them and this
may require many hours. Your neighbour has exactly the same problem, with the tasks in reverse
positions. In a sensible world you would fix your own pipes and your neighbour’s pipes, and she
would ensure the health of the apple trees in both backyards.

If you reflect upon this ‘sensible’ solution—one that involves each of you achieving your objectives
while minimizing the time input—you will quickly realize that it resembles the solution provided
by the marketplace. You may not have a gardener as a neighbour, so you buy the services of a
gardener in the marketplace. Likewise, your immediate neighbour may not need a leaking pipe
repaired, but many others in your neighbourhood do, so you sell your service to them. You each
specialize in the performance of specific tasks as a result of having different opportunity costs
or different efficiencies. Let us now develop a model of exchange to illustrate the advantages
of specialization and trade, and hence the markets that facilitate these activities. This model is
developed with the help of some two-dimensional graphics.