lecture1

Lecture 1: The Science of MacroeconomicsTextbook Chapter 1These notes are supplementary to the textbook, and I expect you to read both. I won’t simply repeat material in the text, because you can simply open it and read it for yourself!The word macroeconomics comes from the Greek ‘macro oikos nomia’ – literally,‘large-scale household management’. In its modern context, the ‘houses’ are nations, butthe meaning remains largely unchanged. Macroeconomists are concerned with the management of a nation’s resources and capabilities, much like professional stewards of classical Greece balanced their household’s needs and desires against its income and production capabilities.What does this mean, exactly? Anewcomer to the field might have avague impression thatmacroeconomics has something to dowith interest rates, investment,foreign exchange, recessions,unemployment, economic growth andother such buzz-words, liberallysprinkled with charts reminiscent of aheartbeat and charts full of numbersin fine print. Without training, it is difficult to see just how all these things are related – apart from the fact that they all involve money at some point or another.Broadly speaking, macroeconomics concerns itself with understanding the relationship between a nation’s resources, institutions and production and the satisfaction of its needsand desires. A country does not have needs or desires any more than a swarm of bees ora colony of ants does, of course – but as in those cases, considering the collective as a single unit and abstracting away from the fact that it is made up of many individuals can provide insights that we would not otherwise obtain. Thus, a biologist may often treat an animal as a whole in her studies, ignoring the fact that it is made of cells, a physicist may pretend the metal balls in her experiments are unitary, and not collections of atoms, and a macroeconomist thinks of a country as a single entity instead of a complicated web of relationships between the government, the private sector and consumers.The microeconomic foundations (Greek: ‘micros’ = ‘small’) of the economy are never too far from a macroeconomist’s mind. These are the decisions of individual or small groups of firms and consumers, and quite worthy of study in their own right – but in macroeconomics, the focus is on the national level, and smaller background details, being out of focus, become blurry.Now we have some idea of what is being studied (don’t worry about the lack of detail at this point – you’ll get plenty of it in the weeks to come!), but why do we bother doing so?Different economists will give you different answers. Many might tell you that policy is the end of macroeconomic study. We need to understand how national economies work so that the institutions that are charged with influencing nations – governments and international organizations such as the United Nations and the World Bank – will know what the effects of their actions will be, and what to do to work towards a particular desired result. The United States Fed needs to know when it should raise or lower interest rates, and what the consequences are of doing so. The IMF needs to know how large its loans should be, and what conditions (if any) should be attached to help a country out of a difficult period.Other economists might say that knowledge of the macroeconomy is its own reward. Not a single one among us, from the homeless persons on the street to the rich in their yachts, is free of the influence of macroeconomic concerns. Understanding how the national economy works helps individuals, firms and families within that country with their own‘household management’. It is a simpler task to plan for future economic conditions when an understanding of current conditions and their consequences allows you a glimpse into what may come.Moreover, some macroeconomic knowledge is necessary for anyone to understand how a country is doing at a given moment. There is an unimaginable amount of economic data collected every day, simply during the course of ordinary business. This data is all but useless if it is not organized, and in order to organize the data, we must know something about its meaning and relevance.Imagine, as the Argentinean writer Borges once did, a library containing a copy of every single possible collection of letters and spaces that can be printed on a standard page. All facts and written knowledge past, present and future would be there – but so would all random ‘noise’, falsehoods, mistaken accounts and fairy tales. Even being in the same room as all the answers, one might emerge none the wiser unless one knew the right questions to ask – and how to identify and assemble the answers, once they were found. (Just because you found page twenty-one of the Ultimate Guide to Studying doesn’t guarantee you’ll find the rest!)The collected data, information and accounts generated by the macroeconomy is very similar to the library above. The discipline of econometrics (Greek: ‘oikos nomos metron’ – ‘household management measure’) concerns itself with sifting through this vast assembly of facts and teasing relevance and meaning out of them. Econometricians are the ones responsible for the charts and graphs seen so often in the newspaper and on the evening news. Without them, we wouldn’t know how large an economy is, if it is growing, whether it is experiencing a boom or a bust, except perhaps in the most general of ways. Macroeconometricians – take a breath after that word! – allow policymakers, business managers and others to see the world around them in terms of general movements of general rates and figures instead of relying on anecdotes relating to a small subset of the economy.While properly organized data is invaluable, theory is also of great importance. The two enhance and affect each other, just as in any other science. New data leads to new theories, which often suggest new places to look for facts that may confirm the original prediction or force its revision or abandonment.A science is any discipline that conforms to the scientific method, which has four steps.1. Observation and description of an interesting fact.2. Coming up with an hypothesis (Greek ‘hypo thesis’ = ‘under placing’), oreducated guess as to what explains that fact.3. Using the hypothesis to predict other facts not observed in step 1.4. Performing experiments to test the predictions of step 3.Economists call the facts in stage 1, that the hypothesis is trying to explain, endogenous variables (Greek ‘endon genos’ = ‘[from] within birth’ Latin ‘variabilis’ = ‘changeable’). These are called that because they are (hopefully!) being explained, or created, out of the reasoning behind the educated guess in stage 2. This hypothesis often takes the form of a model – just like a child might have a model plane to help explain air combat to herself, economists create economic models, or simplified toy versions of the economy, to help them understand it. These models take some things for granted, or assume a certain state of the world. Those facts that are simply taken as given by the model, without trying to explain them, are called exogenous variables (Greek ‘exo’ = ‘outside’). For example, an economic model of wine sales might have wine prices as an endogenous variable, and rainfall, which is important for the growth of grapes and hence the quality of the resulting wine, as an exogenous variable.Step 3 is the key to the scientific method. It’s easy enough to come up with a story to fit any facts, but in order for something to be able to be proven to be true, it must be falsifiable, or capable of being proven false under certain conditions. Since the hypothesis in stage 2 was created to explain the facts in step 1, it’s obviously no good to say that it explains them. It must make other predictions that can be tested to see whether they are true or not.Take the following example:1. Fact: A slice of chocolate cake left on the picnic table has disappeared.2. Guess: The cake melted in the sun and dripped below the table.3. Prediction: The grass underneath the table will be covered in chocolate.4. Experiment: The experimenter looks underneath the table, and finds that there isno chocolate present.Here, the endogenous variable is a rapid fall in theamount of cake on the table. Some exogenousvariables are the sun shining and the melting point ofchocolate. The model is a mental image of the hot sunmelting a slice of chocolate cake, and the resulting goodripping through the cracks in the table to the grassbelow.In this simple example, not finding chocolate goo forces us back to the drawing board and step 2. The next iteration of the process might go:1’. Facts: A slice of chocolate cake on the picnic table disappeared. There is no sign of chocolate beneath the picnic table.2’. Guess: Your neighbour ate the cake while you weren’t looking.3’. Other fact predicted by the theory: Your neighbour will have chocolate breath.4’. Experiments to test 3’ find that your neighbour not only has chocolate breath, but is also covered in chocolate crumbs.Note that the positive result in 4’ doesn’t mean that your theory is true – the neighbour could have eaten her own cake. Further experiments would be needed to make sure.In general, an hypothesis is called a theory once it’s backed up with enough data that conforms to its predictions.The iteration of the steps of the scientific method is how macroeconomists do their research. Not all steps are necessarily performed by the same researcher. An econometrician might document a startling fact, which a theorist explains with a model that is then tested by more econometricians.As you might expect, macroeconomists can’t usually perform experiments – much the same is true of evolutionary biologists, astronomers and cosmologists. Instead, they rely on natural experiments. The idea behind natural experiments is simple: if you can’t make a change on something in order to observe the results, check to see if someone else has done it in the past, and use their data. For instance, if a macroeconomist wanted to see what happens when the interest rate is raised in a large economy during a recession, she might check historical government statistics for Western Europe and North America for cases where that has taken place. The data will probably be ‘noisy’, and full of things that would be excluded from a perfect experiment – strange government practices particular to a country, year-specific droughts or wars, for instance. This makes the task of the econometrician all the more important, since it is up to her to clean up the information.In the next lecture, we’ll look at some of the more common types of economic data and what they mean.。