Branches of &

Approaches to
Economics
Macroeconomics vs. Microeconomics

Macroeconomics
- branch of economics that studies how the
aggregate economy behaves

Microeconomics
- branch of economics that analyzes the market
behavior of individual consumers and firms in
an attempt to understand the decision-making
process of firms and households
 Branches of Economics
Macroeconomics
• studies national income
• analyzes total employment
in the economy
• deals with aggregate
decisions
• studies overall price level
• analyzes aggregate
demand and aggregate
supply
Microeconomics
• studies individual income
• analyzes demand and
supply of labor
• deals with households and
firms decisions
• studies individual prices
• analyzes individual
demand and individual
supply
Approaches to Economics

Positive Economics Normative Economics

- Studies the way the world - Studies the way the world
is: “what is” of economics should be: “what ought to be”
- Factual, objective and is - Subjective and judgmental
used to describe the
occurrence of a
phenomenon
- Usually quantified - Far more difficult to quantify
- More descriptive than - More predictive than
predictive in its usage descriptive in it usage
 2.
Economic
Systems
Economic Systems

The economy is a system for coordinating a

society’s productive and consumptive activities.

Due to scarcity, every economic system in the

world, past and present, has to answer these
questions:
• What should be produced?
• How will society produce it?
• For whom should society produce?
Traditional Economic System

• People produce goods and services for their own

consumption
• Decisions are based on customs and traditions
• Allocation of scarce resources stems from ritual,
habit, or customs
Traditional Economic System

• What should be produced?

- Whatever tradition, values, and rituals dictate

• How will society produce it?

- However tradition, values, and rituals dictate

• For whom should society produce?

- Whomever tradition, values, and rituals dictate
Command Economic System
• Central government makes all decisions on the
production and consumption of goods and
services.
• Central government controls all major sectors of
the economy and formulates all decisions about
their use
• Government decides what should be produced
and direct enterprises to produce those goods
• Works based on the interest of the country and not
of the individual
 Command Economic System
Communism
• government owns most of
the factors of production and
decides on the allocation of
resources and what products
and services will be provided
Command Economic System

Socialism
• an economic system
based on government
ownership of property
and control of economic
decisions but where
most small or
nonessential enterprises
remain privately owned
Command Economic System

• What should be produced?

- Whatever the government decides

• How will society produce it?

- Government directs enterprises to produce it

• For whom should society produce?

- Whomever the government decides needs it
Market Economic System

• Production, distribution, pricing, and investment

decisions are made by the private owners of the
factors of production based upon their own
interests.
• Business enterprises are owned and controlled by
private individuals.
• Inherent in a market is freedom from government
control.
Market Economic System

• What should be produced?

- Whatever the consumer wants

• How will society produce it?

- Entrepreneurs will respond to demand

• For whom should society produce?

- Whomever is willing to work for it (or afford it)
Mixed Economic System

• Incorporates a mixture of private and government

ownership or control, or a mixture of market and
command economy.
• The private capitalist and the government play a
major role in solving the basic problems of the
economy for the benefits of the consumers.
• The government sets laws and rules that regulate
economic life, produces educational and police
services and regulates pollution and business.
 3.
Business
Cycle
Business Cycle
A business cycle is the periodic but irregular up
and down movements in economic activity,
measured by fluctuations in real GDP and
economic growth.
Business Cycle
• Contraction / Recession - slowdown in the
pace of economic activity
Business Cycle
What determines whether a downturn in the economy
is sufficiently severe be deemed a recession?
• There is no simple answer.
• According to an old rule of thumb, a recession is a
period of at least two consecutive quarters of
declining real GDP. This rule, however, does not
always hold.
The Great Recession
• December 2007 to
June 2009
• began with the
bursting of an 8
trillion dollar
housing bubble

• caused by unsustainable debt

• banks got greedy and lent money to people who
have a hard time paying these loans back
The Greek Recession
• Greece announced
in October 2009
that it had been
understating its
deficit figures for
years

• Greece was shut out from borrowing in the

financial markets. By the spring of 2010, it was
veering toward bankruptcy, which threatened to
set off a new financial crisis.
Business Cycle
• Contraction / Recession - slowdown in the
pace of economic activity
• Trough / Depression - lower turning point of
the business cycle, where a contraction turns
into expansion
The Great Depression
The Great Depression
• deepest and longest-lasting economic downturn
in the history of the Western industrialized world
• in the United States, the Great Depression began
soon after the stock market crash of October
1929, which sent Wall Street into a panic and
wiped out millions of investors
The Great Depression
• over the next several years, consumer spending
and investment dropped, causing steep declines
in industrial output and rising levels of
unemployment as failing companies laid off
workers
• by 1933, when the Great Depression reached its
lowest point, some 13 to 15 million Americans
were unemployed and nearly half of the country’s
banks had failed
The Great Depression
The Great Depression
Business Cycle
• Contraction / Recession - slowdown in the
pace of economic activity
• Trough / Depression - lower turning point of
the business cycle, where a contraction turns
into expansion
• Expansion / Recovery - a speedup in the pace
of economic activity
• Peak - the upper turning of the business cycle
Business Cycle
Some factors:
• Changes in interest rates
• Consumer confidence
• Business confidence
• Fiscal policy
 4.
Inflation and
Hyperinflation
Inflation
Inflation
• It is a rise in the general level of prices of goods
and services in an economy over a period of
time. When the general price level rises, each
unit of currency buys fewer goods and services.

• Inflation also reflects an erosion in the

purchasing power of money – a loss of real
value in the internal medium of exchange and
unit of account in the economy.
Types of Inflation
1. Creeping inflation: when the rise in prices is very
low like that of a snail or creeper.

The general level of prices rise at a

moderate rate over a long period of time.

2. Walking / Trotting inflation:

when the rate of rising prices is
more than creeping inflation
Types of Inflation
3. Running inflation: a rapid acceleration in the
rate of rising prices

4. Galloping / Jumping inflation: when prices rise

by dual or triple digit inflation rates (e.g., 20% or
999%) yearly

5. Hyperinflation: prices rise at an alarming high

rate; often defined as inflation that exceeds 50%
per month)
Types of Inflation

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Types of Inflation

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Causes of Inflation
Cost-push inflation: results from shocks to aggregate
supply, usually brought about by an increase in the price
of a key resource used in production (e.g., increase in the
price of oil or steel)
Causes of Inflation
Cost-push inflation: continuous increase in the cost of
production.
Causes of Inflation
Demand-pull inflation: results from shocks to aggregate
demand (“Too much money chasing too few goods.”)
Hyperinflation
• If inflation gets totally out of control (in the upward
direction), it can grossly interfere with the normal
workings of the economy, hurting its ability to
supply goods.

• Hyperinflation can lead to the abandonment of the

use of the country's currency, leading to the
inefficiencies of exchange.
Hyperinflation
Why do hyperinflation start, and how do they end?
• The most obvious answer is that hyperinflations
are due to excessive growth in the supply of money.
• When the central bank prints money, the price level
rises.
• When it prints money rapidly enough, the result is
hyperinflation. To stop the hyperinflation, the
central bank must reduce the rate of money
growth.
Hyperinflation
Why central banks in hyperinflating economies choose
to print so much money?
• Most hyperinflations begin when the government
has inadequate tax revenue to pay for its spending.
• Although the government might prefer to finance
this budget deficit by issuing debt, it may find itself
unable to borrow, perhaps because lenders view
the government as a bad credit risk.
• To cover the deficit, the government runs to the
only mechanism at its disposal…
Hyperinflation

…the printing press.

Cases of Hyperinflation

• After WWI, Germany experienced one of history’s

most spectacular examples of hyperinflation. At
the war’s end, the Allies demanded that Germany
pay substantial reparations. These payments led to
fiscal deficits in Germany, which the German
government eventually financed by printing large
quantities of money.
Cases of Hyperinflation

Weimar Germany: At its height,

hyperinflation reached rates of
more than 30,000% per month,
causing prices to double every
few days.

Loaf of bread:
January 1923 = 250 marks
November 1923 =
200,000,000,000 marks
 Cases of Hyperinflation

Hungary: Economists estimate that

the daily inflation rate exceeded
200%, which equates to an annual
inflation rate of more than 13
quadrillion %. During this period,
prices in Hungary doubled every 15
hours.
Cases of Hyperinflation

• In 1980, after years of colonial rule, the old British

colony of Rhodesia became the new African nation
of Zimbabwe. A new currency, the Zimbabwe
dollar, was introduced to replace the Rhodesian
dollar.
Cases of Hyperinflation
Hyperinflation
• The ends of hyperinflations almost always coincide
with fiscal reforms.
• Hyperinflation in Germany ended when the
government replaced the worthless mark with a
new currency – the Reichsmark.
• Zimbabwe ended its hyperinflation by abandoning
its currency altogether. Now its citizens use US
dollars or currencies from neighboring countries
such as South Africa (rand) and Botswana (pula).
Effects of Inflation
High or unpredictable inflation rates are regarded as
harmful to an overall economy.
• They add inefficiencies in the market, and make it
difficult for companies to budget or plan long-term.
• Inflation can act as a drag on productivity as
companies are forced to shift resources away from
products and services in order to focus on profit and
losses from currency inflation.
• Uncertainty about the future purchasing power of
money discourages investment and saving.
Effects of Inflation
High or unpredictable inflation rates are regarded as
harmful to an overall economy.
• Extreme inflation forces people to spend as quickly as
possible rather than save or lend, so there is no money
available to fund new businesses. And all that
uncertainty limits foreign investment and trade.
Measures of Inflation
• Inflation is usually estimated by calculating the
inflation rate of a price index, usually the Consumer
Price Index.

• The Consumer Price Index measures prices of a

selection of goods and services purchased by a "typical
consumer". The inflation rate is the percentage rate of
change of a price index over time.
Consumer Price Index
The computation of the CPI involves consideration of the
following important points:

• Base Period. Since the CPI measures the average

changes in the retail prices of a fixed basket of goods, it
is necessary to compare the movement in prices in the
current year to movements in previous years back to a
reference date at which the index is taken as equal to
100.

• Market Basket. A fixed list of commonly purchased

items used to track inflation.
Consumer Price Index
Steps involved in measuring the CPI:

• Survey consumers to determine the relevant “basket

of goods”.
• Record the price of each good in each year.
• Compute the cost of the basket in each year.
• Choose a base year and compute the CPI for the
current year.
• Compute the inflation rate as the percentage change
in the CPI from one year to the next.
Consumer Price Index
The value of the CPI for any other period is calculated by
taking the ratio of the current cost of a market basket of
goods to the cost of the same market basket of goods in
the reference base period and multiplying by 100.

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑

𝐶𝑃𝐼 = 𝑥100
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
Consumer Price Index
Market Base Year Base Year Base Year
Basket 2010 2011 2012
2010 P 200
2011 P 400
2012 P 500
Activity: Consumer Price Index
Market Base Year Base Year Base Year
Basket 2010 2011 2012
2010 P 400 100
2011 125 100
2012 200 100
Consumer Price Index
How should economists aggregate the many prices in the
economy into a single index that reliably measures the
price level?

Could they simply compute an average of all prices?

- This approach would treat all goods and services
equally, but because people buy more chicken than
salmon (for example), the price of chicken should
have a greater weight in the CPI than the price of
salmon.
 Consumer Price Index
For example, suppose that the typical consumer buys 5
apples and 2 oranges. Then the basket of goods consists
of 5 apples and 2 oranges, and the CPI is

5 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑃 𝑜𝑓 𝑎𝑝𝑝𝑙𝑒𝑠 + (2 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑃 𝑜𝑓 𝑜𝑟𝑎𝑛𝑔𝑒𝑠)

𝐶𝑃𝐼 =
5 𝑥 2011 𝑃 𝑜𝑓 𝑎𝑝𝑝𝑙𝑒𝑠 + (2 𝑥 2011 𝑃 𝑜𝑓 𝑜𝑟𝑎𝑛𝑔𝑒𝑠)
Consumer Price Index
In Mythica, there are only 3 goods: chips, books, and soda.
The following table shows the prices and quantities produced
of these goods in 1990, 2000, and 2010.
1990 2000 2010
Goods:
P Q P Q P Q
Chips 100 50 100 60 105 59
Books 500 30 1,000 20 1,050 21
Soda 70 30 80 40 75 42

A ‘market basket’ for a typical family is deemed to be 5 chips,

3 books, and 3 sodas. Compute for the consumer price index
for each of the three years, using 1990 as the base year.
Consumer Price Index
1990 2000 2010
Goods:
P Q P Q P Q
Chips 100 5 100 5 105 5
Books 500 3 1,000 3 1,050 3
Soda 70 3 80 3 75 3
Market
2,210 3,740 3,900
basket

Market Base Year

Basket 1990
1990 P 2,210 100
2000 P 3,740
2010 P 3,900
Consumer Price Index
1990 2000 2010
Goods:
P Q P Q P Q
Chips 100 5 100 5 105 5
Books 500 3 1,000 3 1,050 3
Soda 70 3 80 3 75 3
Market
2,210 3,740 3,900
basket

Market Base Year

Basket 1990
1990 P 2,210 100
2000 P 3,740 169.2
2010 P 3,900 176.5
Consumer Price Index
The main purpose of the CPI is to measure inflation.

The inflation rate is the percentage change in the price

level from one year to the next.

𝐶𝑃𝐼𝑇ℎ𝑖𝑠 𝑌𝑒𝑎𝑟 − 𝐶𝑃𝐼𝐿𝑎𝑠𝑡 𝑌𝑒𝑎𝑟

𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑥 100
𝐶𝑃𝐼𝐿𝑎𝑠𝑡 𝑌𝑒𝑎𝑟
Consumer Price Index
Market Base Year
Basket 1990
1990 P 2,210 100
2000 P 3,740 169.2
2010 P 3,900 176.5

What was the rate of inflation from 2000 to 2010, using the
calculated CPI?

𝐶𝑃𝐼2010 − 𝐶𝑃𝐼2000
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑥 100
𝐶𝑃𝐼2000

176.5 − 169.2
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑥 100 = 𝟒. 𝟑%
169.2
Activity: Consumer Price Index
Market Base Year Base Year Base Year
Basket 2010 2011 2012
2010 P 450
2011 P 500
2012 P 700
Activity: Consumer Price Index
Suppose the residents of country M consume only peaches and
mangoes. The table below shows the prices and quantity of peaches
and mangoes consumed for two consecutive years. Note that all
prices are per kilo. Suppose that the typical consumer basket
consists of 10 kilos of peaches and 15 kilos of mangoes. Assume 2000
is the base year.
Peaches Mangoes
Year
P Q P Q
2000 110 10 60 10
2001 90 20 100 10

1. What is the consumer price index for 2001? Interpret this value.
2. What was the inflation rate in 2001? Interpret this value.