Prof. Bryan Caplan

Econ 311

Fall, 1999

Weeks 1-2: Aggregate Demand and Aggregate Supply

  1. The Happiness Explosion
    1. Human beings have existed as a species for at least 1,000,000 years (the approximate time the first tool-using primate, homo erectus, appears to have existed).
    2. For the first 990,000 of those years, the human population seems to have been no more than 4,000,000 in the world.
    3. During those first 990,000 years, humans' their living standard was extremely low.
      1. Lifespan: 20-30 years.
      2. Child mortality: 40-60% died before the age of 5.
      3. Long hours of hard physical labor necessary to stay alive; almost all resources devoted to survival.
    4. To sum up: during this period of pre-history, human population seems to have been roughly constant, and living standards around the "subsistence level." That is, if they got much poorer, they wouldn't have remained alive.
    5. During the last 1% or so of human history, this stable pattern has radically changed:
    6. The total number of people has increased over a thousand times to over 5,000,000,000.
    7. The average living standard of each of these people is incredibly high compared to the subsistence level.
      1. Lifespans: 60-70 years for poorer countries; 70-80 for richer countries.
      2. Child mortality: Around 15% die before age 5 in poorer countries, about 1% in richer countries.
      3. Average hours of work are much lower, labor on average is much less physically demanding, and a much smaller fraction of labor is devoted to survival.
      4. Quantifying the change in living standards is somewhat complicated:
        1. Quality and availability of goods.
        2. Non-market goods.
        3. Leisure.
      5. A very low estimate: 20x increase in per-capita real income in richer countries. 3x increase in poorer countries.
      6. More speculative estimate: 1000x in richer countries, 5x in poorer countries.
    8. Multiplying the total number of people by the average living standard, it is clear that the total wealth of the world has truly exploded. Conservatively: 10,000x; perhaps 500,000x. Not only do modern individuals typically live incomparable more pleasant lives than in the past, but far more individuals are doing so.
    9. I call this "the happiness explosion": the simultaneous increases in total population and average living standards beyond the wildest dreams of primitive human beings (or even "naively" optimistic philosophers 300 years ago!).
    10. People in the U.S. have a very high living standard even by the standards of rich countries. The living standard of the average U.S. citizen living below the poverty line looks roughly comparable to the average living standard in Japan, Britain, France, or even Germany in terms of square feet of living space per capita, ownership of color TVs, meat consumption, and car ownership.
    11. The story of Edward Gibbon; the time machine.
    12. Puzzle: How did this happiness explosion happen? How is it even possible?
  1. A Short History of Economic Growth, 10,000 BC to 1800 AD
    1. The state of humanity was roughly constant for 990,000 years; almost everything economically interesting has happened in the last 10,000 years. (Imagine a day sitting in a room watching a seed. You spend 23 hours, 45 minutes looking at a seed. Then suddenly, in the last 15 minutes, the seed becomes a 1000 foot high tree).
    2. Now let's focus on the last 10,000 years. What happened?
    3. General pattern: "virtuous spiral" of ideas and population. (Fogel diagram)
    4. New ideas increase the average amount of wealth one person can produce. More wealth means more people survive, so population increases; it also means fewer people have to concentrate their labor on immediate survival. But a larger number of people devoting less time to bare survival means a larger number of people thinking of new ideas!
    5. Example: 10,000 years ago marks the approximate discovery of agriculture. People switch from hunting/gathering to settling in one place and planting and harvesting crops. By figuring out this new productive technique, human beings increase their average productivity, which means extra food, less effort needed for survival, and greater probability of survival. This means a larger population with a larger fraction of effort devoted to innovation, leading to more discoveries, such as pottery, the plow, irrigation, cities, metal-working, writing, and mathematics.
    6. Great feature of ideas: Their "marginal cost" is close to zero; once you have an idea, everyone can adopt it for the cost of communication.
    7. What held economic growth back? Partly, just normal scarcity; if you're poor, ignorant, and few:
      1. There is little time to think.
      2. You don't figure out much when you do.
      3. Total ideas=# people*average hours of thinking*average # of good ideas per hour
    8. In addition, new productive techniques could be adapted for non-productive purposes like making war and enslaving people; surplus wealth creates the incentive. (There's no point in enslaving someone who only produces his subsistence!)
    9. Counter-productive policies often institutionalized by governments, stifling progress or even reversing it.
    10. Major reverses: Most famously, the Fall of Rome.
      1. Also, Mongol invasions; 30 Years' War; Ming collapse.
  2. A Short History of Economic Growth, 1800 AD to the Present
    1. Important point: While living standards did on average start getting better after the development of agriculture, average lifespans and childhood mortality only improve a small amount until about 1800 AD
    2. All this changes with what has been called "the 2nd Agricultural Revolution" and especially the Industrial Revolution. From 10,000 BC to 1600 AD, new important inventions were often spaced centuries apart. With the Industrial Revolution, progress seems to become continuous:
      1. The stream engine
      2. The railroad
      3. Germ theory
      4. Electrification
      5. Telephone
      6. Automobile
      7. Penicillin
    3. These inventions increase life span, reduce child mortality, and increase lifespan in the countries they originate in; the benefits gradually spread.
    4. From 1800-1900, child mortality before age 5 falls from about 20% to about 10% in the richer countries. Lifespans extend from about 40 to about 55 over the century.
    5. From 1900-present, child mortality in rich countries falls from about 10% to 1%. Lifespans extend further from about 55 to about 75.
    6. The Industrial Revolution dramatically cuts the percentage of the labor force engaged in agriculture. In the U.S., 80% in 1800 falls to 40% in 1900, and then falls further to about 2% by 2000!
    7. This means that an increasing percentage of people's efforts focus not on bare survival, but on comfort, entertainment, etc. Variety of goods and life styles explodes.
    8. Poorer countries still get richer during this period. Lifespans in India today, for example, exceed U.S. lifespan in 1900. Other countries about as poor as India in 1900 become rich by 2000: Korea, Japan, Taiwan, Hong Kong most obviously.
  3. Macroeconomics
    1. What does "the happiness explosion" have to do with macroeconomics? Everything; understanding the happiness explosion is really the central task of the field.
    2. By definition, macroeconomics is the study of the "overall economy" rather than particular markets. This means that good macroeconomics needs to explain not only the current state of the world economy, but the development of the world economy over time.
    3. Most macroeconomic questions are just the "macro" analog of "micro" questions:
      1. What determines the quantity of output produced?
      2. What determines the level of prices?
      3. What determines workers' real wages?
      4. What determines interest rates?
      5. What causes unemployment?
    4. But as we answer these questions, we are also looking to solve the main puzzles of the "happiness explosion":
      1. How did the happiness explosion happen?
      2. Why did it happen in some places sooner than others?
      3. Why have some countries been able to "catch-up" to the rich countries, but not others?
  4. Aggregate Demand and Aggregate Supply
    1. How can elementary supply-and-demand analysis be extended to the whole economy? We begin with two simple abstractions:
      1. "The level of real output" - a weighted sum of all of the goods and services produced during a given time period.
      2. "The price level" - a weighted average of the prices of all the goods and services produced during a given time period.
    2. On a simple S&D diagram, the quantity of a good goes on the x-axis, e.g. "the number of cars"; the price of a good goes on the y-axis, e.g. "the price of a car."
    3. Natural extension: put "the level of output" on the x-axis. This is the analog of quantity.
    4. Then put "the price level" on the y-axis. This is the analog of price, the price paid for one unit of output.
    5. Once it is clear what goes on the axes, we just have to think about what the "demand for total output" (or Aggregate Demand) curve, and the "supply of total output" (or Aggregate Supply) curve look like.
    6. Writing down the AD curve seems fairly simple. Just imagine how much stuff people would choose to buy at each possible price level. The higher the price level, the less people would be willing to buy. So the AD curve has the familiar negative slope.
    7. The AS curve is trickier. For individual goods, we always draw the AS curve as upward-sloping or even horizontal. The reason: if the price of a good rises, it becomes more profitable to produce. If a good becomes more profitable to produce, existing firms will hire more workers, build more factories, etc., plus new firms will enter. For individual markets, a rise in the price attracts productive inputs from other markets.
    8. But once we consider the economy as a whole, this argument doesn't work. If prices rise in one market, productive inputs flow into that market. But if prices rise in all markets, can more productive inputs flow into all markets?
    9. Implication: It seems like AS would have to be VERTICAL rather than upward-sloping. An AS curve with this shape is often called a "Classical" AS curve; models that assume a Classical AS curve are often called "Classical" models. We will be analyzing Classical models for the first half of the course.
  5. The Determination of the Level of Output and the Price Level
    1. Once we have set up the AD and AS curves, we can analyze the whole economy as we have previously analyzed individual unregulated markets. People adjust prices to eliminate excess demand and excess supply.
    2. What happens if AD exceeds AS? Shortage of output, the price level must rise.
    3. What happens if AS exceeds AD? Surplus of output, the price level must fall.
    4. In equilibrium, AD=AS.
    5. What happens if AD increases? Price level rises, output stays the same.
    6. What happens if AS falls? Price level falls, output stays the same.
    7. What happens if AS increases? Price level falls, output increases.
    8. What happens if AS falls? Price level rises, output falls.
    9. Hume's thought experiment.
  6. Classical AS and the Production Possibilities Curves
    1. Upon seeing this analyses, many people say "this assumes full employment." Incorrect.
    2. What the analysis does assume is that the price level is flexible, that it adjusts to keep AD equal to AS.
    3. Full employment is a conclusion that follows from the flexible price assumption. It is not itself an assumption.
    4. In terms of a Production Possibilities Curve, the flexible price assumption implies that the economy is always on the frontier.
    5. Recall that when on the frontier, you have to give up some of one good to get more of another.
    6. Even when the level of output stays unchanged, changes in the demand for individual goods may change the economy's position on the frontier of the PPC.
  7. Macroeconomic Statistics: What They Capture and What They Don't
    1. How do you actually measure "the level of real output" or "the price level"? Most macro classes spend 1-2 weeks on macroeconomic statistics, but in my view they teach far more detail than undergraduates need - and often leave them fuzzy on the few important points.
    2. Main statistics we'll be using:
      1. Measures of the level of real output (real GDP)
      2. Measures of the price level (CPI; GDP deflator)
      3. Other indices
      4. Unemployment rate
    3. Key idea of indices: summarize a lot of related numbers using a single number.
    4. Technique for constructing indices:
      1. Make a list of all of the items you need to have an informative measure.
      2. Choose reasonable weights for each item.
      3. Measure each item accurately.
      4. Multiply each item by its weight, and add them up.
    5. Example: You want to summarize the behavior of all prices. So you make up a representative list of items, weight them by the average percentage of income people spend on them, send people out to check the prices, and compute the index.
    6. Important Point #1: Levels vs. Rates of Change
      1. Some statistics measure LEVELS; others measure RATES OF CHANGE.
      2. A level is where you are; a rate of change is how fast and what direction you're moving in. Rate of Change=(Levelt-Levelt-1)/Levelt-1.
      3. Standard distinction: CPI vs. inflation rate; GDP level vs. GDP growth. Inflation rate1999=(CPI1999-CPI1998)/CPI1998
      4. Ex: Bob has been earning $100,000/year for 3 years. In 1999, his level of income is $100,000/year; his rate of change is 0%. Fred earned $20,000 in 1997, $30,000 in 1998, and $50,000 in 1999. In 1999, his level of income is $50,000; his rate of change is 67%.
    7. Important Point #2: The Real/Nominal Distinction
      1. What are you trying to measure? Macroeconomists routinely distinguish between REAL and NOMINAL variables, and non-economists routinely fail to.
      2. REAL measures adjust for changes in the purchasing power of money.
      3. NOMINAL measures don't.
      4. Ex: Hyperinflation.
    8. How do you get from nominal to real and back again?
      1. In levels, nominal measure/price index=real measure.
      2. In rates of change, nominal measure-inflation rate=real measure.
      3. Ex: Mortgage rates during the 70's.
    9. Important Point #3: Getting the Components Right
      1. No index is perfect, but some are worse than others. Even if you can't come up with a good way to "fix" a statistic, at least be aware of its flaws.
    10. Nominal GDP and Its Flaws
      1. Reminder: Nominal GDP is calculated by adding up total dollars spent on "final goods and services."
      2. Main Flaws:
        1. Government services counted at cost, even though they use up about twice the inputs to get the same output.
        2. Leisure and non-market goods ignored.
        3. Pollution, crime, etc. not fully counted.
        4. Black market usually not measured.
    11. CPI and Its Flaws
      1. Reminder: CPI is calculated by taking weighted averages of a lot of prices of different goods.
      2. Main Flaws:
        1. Quality changes (usually improvements!) ignored.
        2. Benefits of variety ignored.
    12. Real GDP and Its Flaws
      1. Reminder: Real GDP=Nominal GDP/CPI.
      2. Man Flaws: Combines all of the flaws of Nominal GDP and CPI!
  8. Basic Determinants of AS
    1. Though the Classical AS curve is vertical, it can be vertical at any quantity. What determines its position at a given point in time?
    2. Labor:
      1. Quantity
      2. Quality
      3. Labor/leisure preferences.
    3. Natural resources
    4. Prior Investments
      1. In knowledge of productive techniques.
      2. In productive intermediate ("capital") goods like machines, buildings, etc.
      3. In people - training, useful education, past experience.
    5. The Quality of the Economic System
      1. Capitalism, socialism, and in between
      2. Incentives for production and investment
      3. Dis-incentives for counter-productive activities
    6. The shifting AS curve:
      1. The long-run price of oil
      2. Agricultural productivity before the Green Revolution
  9. Basic Determinants of AD
    1. How is AD different from demand for a particular good? Main difference: you are considering all markets at once, so you often need to understand where a possible "increase in demand" is coming from.
    2. Ex: If the government taxes people's incomes and buys oranges, the demand for oranges surely goes up. But if government taxes people's incomes and buys a representative bundle of goods, demand may not rise: The government demands more, but poorer taxpayers may demand correspondingly less.
      1. Similarly, if the government borrows money to buy real output, AD may not rise. The government may just "crowd out" private borrowers.
    3. What tends to increase everyone's demand without causing corresponding reductions in someone else's demand? Slight simplification (more details later!):
    4. Increases in the supply of money shift AD out. If a helicopter drops newly printed money all over the economy, everyone can spend more.
      1. Ex: U.S. during WWII.
    5. Decreases in the demand for money shift AD out. If everyone decides they can be happy with a lower quantity of cash, everyone can spend more. This might just be a change in tastes, but more frequently it is the result of advances in financial technology.
      1. Ex: Invention of the ATM machine.
  10. Fallacies
    1. Fallacy #1: Real/nominal confusion. Many variants: "Print more money to make people richer," "People don't have money to buy products," "Stock market crash caused the Great Depression," "Real interest rates are down - the real rates you pay at the bank."
    2. The essence of the fallacy: Forgetting the "Wealth consists in an abundance of commodities." Whenever you're confused by some economic claim, try to see if it make sense in real terms. If the proponent can't explain it in real terms, they probably don't understand it themselves.
    3. Fallacy #2: The Broken Window. Many variants: "Machinery creates poverty," "War creates prosperity," "Overproduction," "Hurricane a stimulus to the economy," "Environmental regulations help the economy by creating jobs."
      1. Note two contrasting theories that one person often holds: "World War II got the U.S. out of the Great Depression"; "The U.S. beat the U.S.S.R. by forcing them to spend too much on armaments."
    4. The essence of the fallacy: Measuring wealth by inputs rather than output. Giving a person a job may make that person richer, but if his job is to dig ditches and re-fill them, the economy over all is not better off.
    5. Moreover, wasted resources could have been used to make something useful. The money used to pay a leaf raker could have been refunded to taxpayers, who would have used it to buy something they actually wanted.
    6. Another example: Demilitarization after the Cold War.
    7. Fallacy #3: Buy Back the Product. "If employers don't pay the workers enough, they won't have enough to 'buy back the product.'"
    8. The essence of the fallacy: Forgetting that employers and investors are human. If wages rise and profits fall by the same amount, AD need not change.
    9. However, the composition of output demanded may shift from non-luxuries to luxuries.
  11. Applications: Comparative Advantage, Free Trade, and Free Immigration
    1. Basic economic principle: Comparative advantage. Total production tends to be greater if individuals and nations specialize in what they are RELATIVELY efficient at and then trade, rather than trying to produce everything in isolation.
    2. RELATIVE efficiency is the key. You don't have to be good at anything to be a valuable member of the world economy; you just have to find the best way to use whatever talents you happen to have.
    3. Famous example: What if the world's best brain surgeon is also the world's best typist? Should he hire a secretary? Do his own webpage?
    4. The free trade implications are valid whether or not other countries have free trade: If all of your friends jumped off the Brooklyn Bridge, would you?
    5. Landsburg on the Iowa car crop: Free trade is conceptually identical to a purely technological shift out of the AS curve.
    6. Many accept comparative advantage reasoning for free trade, but not for free immigration. The logic is identical, however, and quite compelling.
    7. Ex: Educated American women stay home with their kids because they can't afford a nanny. Mexican women work on a farm for $1/hour. Allowing the American woman to hire a Mexican nanny makes U.S. and world production go up.
    8. While particular segments of the U.S. labor force might earn lower wages, relaxation of immigration restrictions is a positive AS shock for the U.S. and world economies.