Economics Notes Economics for Public Policy Notes
These are lecture notes for an introductory microeconomics course at the University of Oxford....
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Economics for Public Policy
Week 1: How Economists Think
The challenge: governments are increasingly employing professional economists to work alongside policy generalists
You are likely to be asked to collaborate with and/or direct these professional economists
To meet this challenge effectively, you will require a critical appreciation of the mainstream economic approach
Rational Choice Theory: Implications and Anomalies
What is Economics?
Backhouse & Medema (2009) point to evolving views in the profession.
Early definitions emphasised subject matter: economics was about nationalwealth and economic growth.
Marshall (1890) instigated a shift towards individualism: economics wasprimarily a study of man.
Robbins (1932) introduced the notion of scarcity: economics was ‘thescience which studies human behaviour as a relationship between ends andscarce means which have alternative uses’.
From 1940’s, greater emphasis on the choice process and rational action.
Becker (1976) emphasised approach: economics combines assumptions ofmaximising behaviour, market equilibrium, & stable preferences
But if economics is an approach (a framework), rather than a subject matter, what should it be applied to?
Robbins: as long as there are opportunity costs imposed by scarcity, there are no limitations on the subject matter of economic science
Becker: the economic approach is applicable to all human behaviour, be it behaviour involving money prices or imputed shadow prices
Which view do you agree with?
Rational Choice Theory
Exogenous – something determined outside of the economic model
Endogenous – something determined inside the relevant economic model
Total cost = opportunity cost + actual cost/explicit cost + implicit cost
Opportunity cost is of NEXT BEST ALTERNATIVE – can only do one alternative
Transitivity allows indifference
General equilibrium effect – where changes in one market affect another market
Partial equilibrium – where a market is analyzed in equilibrium
Macroeconomics and Microfoundations
Simon Wren-Lewis
An example of micro to macro: Ricardian Equivalence
An example of macro from data: The Philips Curve
A synthesis? The Great Moderation
The crisis – where does this leave macro?
History of Macroeconomic Thought
Classic model: idea of representative agent, micro to macro
Full employment and price adjustment
Keynes General Theory and Post-war Macro
Great Depression led to separate discipline of macro
Aggregate relationships validated by econometrics
Microfoundations take a back seat
How prices adjust also takes a back seat – comes unstuck with 1970s inflation (Friedman)
New Classical counter-revolution (Lucas)
Rational expectations, Ricardian Equivalence
Demand denial, ‘schools of thought’ macro
New Keynes consensus?
Microfounded price stickiness, so microfound Keynesian theory
2008 crisis – what consensus?
Microfoundations example: consumption
Would you spend a one-off tax cut (ceteris paribus – all things equal)
How does the government ay for the cut?
Assume government spending (now and future) is unchanged
So you assume the money is borrowed
Borrowing implies higher future taxes at some point
So you really should tell yourself that you’re better off in the short term, but will have higher taxes in the long term
A rational consumer will take this into account
Consumption smoothing by borrowing and saving. People borrow or save to get a balance of consumption over their life, even if income is unbalanced (ex. saving for retirement)
How to avoid consuming less in the future – an example
$100 tax cut
Government borrows the money, and pays back the borrowing after 10 years. In addition it pays 5% on that borrowing after 10 years. So taxes rise by $5 each year for 10 years, and then by $100 in the final year.
You can invest money at a 5% interest rate. To pay the higher taxes without reducing consumption you need to invest all of the tax cut.
So you save all of the tax cut. Saving anything less means you consume more now, but less later.
Ricardian Equivalence
The idea that a tax cut will be completely saved by consumers
Needs consumption smoothing – but this is just the apples and pears choice problem, except that it is consumption today or consumption tomorrow
Key assumptions:
Rationality
You can borrow or save as much as you want, at the same rate of interest that the government pays on its borrowing
You will be paying taxes when the tax increases take place
Final assumption may be empirically less important. Second could be, but it modifies theory rather than destroying it
Key policy implications: austerity that involves temporary tax increases will have less of a demand impact than temporary cuts in government spending.
Business Cycle Analysis: The Phillips Curve
Keynesian theory: business cycles due to movements in aggregate demand
Alternative New Classical Theory – Real Business Cycles – implies cycles involve voluntary unemployment
Keynesian theory needed a model of inflation
Originally an empirical observation by Phillips
As unemployment went down, inflation increased
As unemployment increased, inflation decreased
This is the Phillips curve
1970s stagflation
There was high inflation and high unemployment
Excess demand ratchets up inflation
Friedman 1968 AEA presidential address
Inflation depends on expected inflation as well as unemployment – a new variable
If expectations are backward-looking
A boom, or an oil price increase, will raise inflation, but if expectations about inflation follow, ending the boom (or stabilizing oil prices) will leave you with higher inflation
Booms (or oil price hikes) have to be followed by recessions to keep inflation constant
1970s story: oil prices. Initially governments failed to do this, and even tried to do the opposite (because higher oil prices tended to reduce demand), so inflation accelerated. Inflation only brought down by significant recessions.
Microfoundations and the Phillips...
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These are lecture notes for an introductory microeconomics course at the University of Oxford....
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