I want to spend a little bit of time discussing the role of models in economics.

As you will quickly see, Macroeconomics, indeed all of economics, relies very heavily on what can often appear to be abstract, highly-idealized models. Alfred Marshall, one of the great economists in the discipline's history, famously described economics as dealing with the ordinary business of life. It is this promise that economics offers a systematic way of thinking about everyday life, which attracts many to the discipline. Indeed maybe something like this that attracted many of you to this course. However students of economics often find it confronting to see how much analysis is conducted using abstract models. Representations of the economy and decision making, that appear to relate perhaps only marginally to the ordinary business of life. Without question, this is a potential stumbling block for everyone who encounters economics for the first time. How can a discipline that claims to offer so much by way of understanding the world around us. Rely on analytical methods that appear so far removed from that very world. The use of models in economics is an important part of the second Macroeconomic theme we are going to explore in this course. Hypothesizing. Models provide a very powerful way of focusing on the key fundamental forces that are at work in shaping macroeconomic outcomes. And of specifying testable hypotheses about those forces. Without models, a lot of economic discourse would be vacuous, fake statements about what might be going on or what might be important. With models, we have a way of formulating testable hypothesis which can then be compared to the real world data. To decide the extent to which those models provide us with any real insight. This, I think, is an important advantage of the way economists use models. It is one I would like you to not lose sight of as we proceed through the course. To let you know what you are in for, the next slide shows how we will model the

process. Of long run economic growth. Don't panic, I will take you through this model slowly and carefully and you will soon understand all of it's intricacies and subtlety. But I want to give you a test, for what you are in for. And the next slide will show one of the ways in which we think about the business cycle. Again this will look completely foreign to you now. However, we all go through the construction of this model very carefully. And you'll find that it is a highly logical and very powerful way of analyzing important aspects of the business cycle. What then, is the rationale for economists reliance on abstract models such as these? Given that the subject matter of economics is so grounded in the real world. With all of it's complexity, and innate messiness. The following analogy maybe useful. A paper plane is a highly simplified, abstract representation of a real airplane. One would never trust one's life to a paper plane. Yet the laws of physics that keep a real plane in the air are exactly the same, as the laws of physics that keep a paper plane flying. And one can learn a great deal about those laws by observation and experimentation with a paper plane. Indeed, its simplicity means it is an ideal instrument with which to learn about something which is incredibly complex in reality. It is exactly the same with economic models. No one, I hope, thinks that the abstract, highly simplified, and stylized models that economists work with correspond exactly to a real world economy. That is not what the model's designed to do. Instead, models exist as abstract and very simplified representations of reality. And in doing so, enable careful analysis and hypothesizing. About the fundamental forces at work in a real world economy.

Without models, economists would have little to say about the economy in any formal sense. It will take you time to get used to economists use of models. For those new to the discipline, it can all seem a bit strange at first. But rest assured, you will soon get the hang of it. And in doing so will come to appreciate the enormous analytical benefits that economists' models provide. Benefits that would not be available any other way. The third thing we will explore in this course is the role of Public Policy in managing the economy. So I mentioned earlier in this lecture a central tenant of economics is that markets, under ideal conditions, will allocate resources efficiently. Where those conditions don't exist, and markets fail to provide optimal outcomes. There may be a role for governments to become actively involved in the economy. To secure better outcomes. This is the rational for government Macroeconomic policy. I know of no modern economy that allows it's Macroeconomic outcomes to be determined purely by market forces. The management of the economy is one of the central responsibilities of government the world over. The picture that you are looking at here is of the United States Federal Reserve, the Agency responsible for the design and implementation of US Monetary Policy. And it is Monetary Policy that is one of the chief policy instruments available to manage the Macroeconomy. Particularly in the short to medium term. We will be spending a lot of time in this course discussing Monetary Policy. So, let's look briefly at the main types of acoreconomic policy. And here I'm going to confine myself to policies that aim to manage the economy in the short to medium run. An entirely different set of policies exist to promote long run economic growth. First, as just mentioned, is Monetary Policy. This is the responsibility of Central Banks like the United States Federal Reserve, or the Bank of England, or the European Central Bank. Monetary policies can take various forms depending on the economy.

Most nations operate their Monetary policy by targeting a key interest rate in the economy. In the belief that other interest rates will adjust in line with the rate that is being targeted by the Monetary policy. And that this then influences the amount of aggregate spending in the economy. In turn, this exerts a powerful influence on Macroeconomic outcomes, primarily GDP and inflation. Monetary policy was an important policy response for most countries to the global financial crisis. Central banks the world over aggressively cut interest rates in the hope that this would encourage spending by firms and consumers. The extent to which this was successful remains a matter of debate. The Monetary policy response to the global financial crisis. Resulted in very low interest rates in a number of countries, such as the United States. This in itself has created new challenges for economies because once interest rates have been driven close to zero. And even more encouragement is needed to entice spending, what can be done? In the US the answer has been a different form of monetary policy. Quantitative easing, in which liquidity, money, is directly pumped into the economy through the federal reserve buying assets from the private sector in return for cash. Whilst the former policy in the US is unorthodox, the intent of this policy is the same as when Central banks target a low interest rate. Namely, to encourage aggregate spending in the economy, to try to stimulate economic activity. We will spend a lot of time looking at Monetary policy. It's one of the primary ways in which the Macroeconomy is managed. Fiscal policy is the other main arm of Macroeconomic management. Fiscal policy involves the government's budgetary variables. Government expenditure and taxation and the difference between them, the budget deficit or surplus. And the subsequent implications for the governments level of debt. Extent to which Fiscal policy is used as an instrument of short and medium term Macroeconomic management.

Has ebbed and flowed over a number of years. Since around the 1980s the extent to which governments used Fiscal policy to manage their economies was greatly reduced as Monetary policy became seen as a more responsive. And powerful means of securing favorable Macro-, Macroeconomic outcomes. The global financial crisis changed this however. As a combination of interest rates being already low, this limiting the Monetary policy response, and the severity of the problem. Led many governments to aggressively pursue Fiscal policy responses to the crisis. Amongst Macroeconomists, there is a huge debate now raging about the extent to which Fiscal policy was an effective response to the crisis. A lot of the debate, is about the size of what is known as the Fiscal policy multiplier. The extent to which a change in budgetary variables flows through and effects GDP and employment. There's also debate about how best to manage the massive increase in governments debt that the Fiscal policy response has created. We will look at these debates, as well as explaining what governments are hoping to acheive from their Fiscal policy responses to the crisis. I'm going to conclude this section of the lecture by outlining six conventional aims of Macroeconomic policy. Or more broadly, the circumstances that would have to occur, before one would conclude that a nation was experiencing an overall favorable balance of Macroeconomic outcomes. The first, is rising living standards. In one sense this is self evident, but at the same time. defining exactly what we mean by this statement is a matter of some controversy. We often use a Nation's Gross Domestic Product as an admittedly crude measure of the standard of living. As we will see in the next lecture, GDP certainly does give an indication of the availability of goods and services to enjoy. But as many people have quite correctly pointed out. Access to goods and services is by no

means equivalent to happiness or a high standard of living. And when we take into account the many sacrifices that have to be made to secure a growing level of GDP. To take but one example, the possibility of damage to the environment. Then the link between the standard of living and GDP may be more tenuous than what at first seems to be the case. We will look at this issue in the next lecture. What we can say at this stage is that along many dimensions, for example human life span. There have been clear improvements in the standard of living over the long run. And this has been associated with growth in GDP. The next slide shows something quite signifigant about GDP. The extraordinary growth that has been achieved in Western economies since the conclusion of the second world war. Whether there are limits to this growth, as some argue, or that the costs associated with this growth out way the benefits, as others argue, is a matter of furious debate. We won't shy away from this debate in our next lecture, but it really is a topic fully deserving of it's own course. The second indicator of good Macroeconomic performance is to avoid extreme outcomes. Essentially this means managing the business cycle. Ensuring that GDP grows smoothly without either excessive growth which may put upward pressure on prices or significant slowdowns which are associated with increased unemployment. For a period over the 1990s and 2000s many economies appeared to have achieved exactly this. Federal Reserve Chairman Ben[UNKNOWN] christened this period the Great Moderation. By which he meant Macroeconomic outcomes in many countries were relatively benign. Featuring solid growth. And the avoidance of recessions. The global financial crisis put paid to this, with Macroeconomic outcomes that were nothing short of disastrous. By this criterion, recent Macroeconomic performance in many parts of the world has been, to put it mildly, poor. The maintenance of the real value of the currency refers to avoiding high rates of

inflation. The period of the 1960s, 70s and 80s for many countries was characterized by prolonged bouts of high inflation. A period we now know as the Great Inflation. We will discuss why this was the case in a later lecture. This is a topic of more than historical interest. Because the changes to the way Central banks operated, in the wake of the great inflation, are still very much with us today. Indeed, it is very difficult to understand contemporary Monetary policy, without understanding the link between Monetary policy, Central banks, and Inflation. And once the global financial crisis has muddied the waters somewhat. There's still a great deal of truth in the idea that Monetary policy today is erected at avoiding a re-occurrence of the great inflation of the 1970s and 1980s. The next indicator of Macroeconomic performance relates to the sustainability of the debt carried by, respectively, the private and public sectors. Sustainability refers to the ability to generate a flow of income in the future that allows repayment of any past borrowing, plus the interest. What matters here is not the absolute size of the debt. But clearly, this is important. At first the uses to which the borrowed funds have been put. And secondly the likelihood that sufficient income will be generated in the future that the debt can be repaid without undue hardship. The massive increase in government expenditure. That many countries put into place as an attempt to support economic activity during the global financial crisis has left many economies with unprecedented levels of debt. Certainly unprecedented during peace time. We will look at debt in this course. Explain where it comes from and clarify the issues that surround the concept of debt sustainability. One of the key themes that will emerge from this course, is the important role that saving plays in determining a variety of Macroeconomic outcomes.

Saving represents a particular economic decision, namely, to postpone current spending, and transfer that purchasing power into the future. This decision, in aggregate, has far reaching consequences, for Macroeconomic outcomes, including, in the short run, the business cycle. And in the long run, economic growth. For this reason, Macro economists pay a lot of attention to what is happening to saving in an economy. The graph shown in this slide, which presents data for Australia, shows one type of saving, that undertaken by households. Specifically, the graph show the proportion after after tax, or disposable income that is saved. As you can see, household decisions about saving can change through time. And in this course, you will learn how this has important implications for a whole variety of Macroeconomic outcomes. Finally, the performance of the economy is often judged by the extent to which those seeking work are able to find employment. The unemployment rate. This is probably the most visible effect of the business cycle. In a variable that shows considerable variation across countries. The chart in this slide shows Spain's unemployment record since 1980. Spain is a country that has had a persistently high rate of unemployment. The rates reached in the wake of the global financial crisis are worrying indeed.