Economic Methodology & the Economising Problem

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- Standards of living: Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services - Depends on ability to produce goods and services

Differences in living standards from one country to another are quite large. Changes in living standards over time are also great. It is deal to the differences in country’s productivity (Productivity: the quantity of goods and services produced from each hour of a worker’s time). High productivity results in a high standard of living. Thus, policymakers must understand the impact of any policy on our ability to produce goods and services.

- Money supply: Principle #9: Prices Rise When the Government Prints Too Much Money - Prices increase when the money supply increases.

Inflation: an increase in the overall level of prices in the economy. When the government creates a large amount of money, the value of money falls.

- Trade-0ff between inflation and unemployment: Principle #10: Society Faces a Short-Run Trade-off between Inflation and Unemployment - Decrease in unemployment results in increased inflation

Most economists believe that the short-run effect of a monetary injection is lower unemployment and higher prices.

An increase in the amount of money in the economy stimulates spending and increases the quantity of goods and services sold in the economy. The increase in the quantity of goods and services sold will cause firms to hire additional workers. An increase in the demand for goods and services leads to higher prices over time.

Economic models

- Economics deals with generalities/statements about regularities, concerning economic behaviour.

- Models are simplified representations of the real world.

- Economists try to address their subject with a scientist’s objectivity. Like all scientists, they make appropriate assumptions and build simplified models in order to understand the world around them.

- Economists follow the scientific method.

- 1. Observations help us to develop theory.

- 2. Data can be collected and analyzed to evaluate theories.

- 3. Using data to evaluate theories is more difficult in economics than in physical science because economists are unable to generate their own data and must make do with whatever data are available.

- Assumptions make the world easier to understand. CETERIS PARIBUS = ‘OTHER THINGS BEING EQUAL’ or ‘IF ALL OTHER THINGS REMAIN UNALTERED’. Economists use the term ceteris paribus to point out that all other relevant variables are assumed fixed. Used as a reminder that all variables other than the ones being studied are assumed to be constant

- In examining economic models, it is useful to concentrate on one factor at a time, and hold all other factors constant.

- In this way it is possible to investigate the effects of the variables being considered.

- EG: to understand international trade, it may be helpful to start out assuming that there are only two countries in the world producing only two goods. Once we understand how trade would work between these two countries, we can extend our analysis to a greater number of countries and goods.

- Economists often use assumptions that are somewhat unrealistic but will have small effects on the actual outcome of the answer.

- Economists use economic models to explain the world around us.

- Most economic models are composed of diagrams and equations. The goal of a model is to simplify reality in order to increase our understanding. This is where the use of assumptions is helpful.

- Road map: Point out how unrealistic it is. For example, it does not show where all of the stop signs, gas stations, or restaurants are located. It assumes that the earth is flat and two-dimensional. But, despite these simplifications, a map usually helps travelers get from one place to another. Thus, it is a good model.

The circular-flow diagram

Circular-flow diagram: a visual model of the economy that shows how dollars flow through markets among households and firms.

There are two decision makers in the model: households and firms and there are two markets: the market for goods and services and the market of factors of production.

Firms are sellers in the market for goods and services and buyers in the market for factors of production. Households are buyers in the market for goods and services and sellers in the market for factors of production.

The inner loop represents the flows of inputs and outputs between households and firms. The outer loop represents the flows of dollars between households and firms.

Positive and normative analysis

- Positive: Claims that attempt to describe the world as it is. Statements of facts. Can be tested empirically.

- Normative: Claims that attempt to prescribe how the world should be. Opinions. Cannot be tested empirically.

Ex: a discussion of minimum-wage laws: Kim says, “Minimum-wage laws cause unemployment.” Kath says, “The government should raise the minimum wage.”

- Positive statements can be evaluated by examining data, while normative statements involve personal viewpoints.

- Positive and normative statement may be related. Positive views about how the world works affect normative views about which policies are desirable.

- Much of economics is positive; it tries to explain how the economy works. But those who use economics often have goals that are normative. They want to understand how to improve the economy.

Microeconomics and macroeconomics

- Macroeconomics is concerned either with the economy as a whole or with aggregates such as the govt, household and business sectors that make up the economy.

- Involves discussion of the determination of the aggregate output of goods and services, total level of employment, total income, aggregate expenditure, general level of prices, and the influence of government policy.

- Macroeconomics: the study of economy-wide phenomena,