TEACHING MICRO AND MACRO AS SEPARATE COURSES

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1 TEACHING MICRO AND MACRO AS SEPARATE COURSES TEACHING GUIDE Introduction This note shows how The Economy is being used in universities that teach microeconomics and macroeconomics in separate courses. Of course, you can structure your course any way you choose, and we are always interested to hear about your successes and challenges. Reintegrating a divided subject We can argue that the idea that macroeconomics and microeconomics are distinct bodies of theory, which created this practice, is an anachronism. It is comparatively recent. In 1936, after the Great Depression, John Maynard Keynes published the General Theory. Immediately, a lot of new theory was added to economic knowledge. But, at the time, existing theory was connected to the neoclassical model, and the two bodies of knoweldge did not fit easily together. Alvin Birdi UNIVERSITY OF BRISTOL Developments in economics since then mean we can teach the questions and themes that today are classified as 'macro' alongside 'micro' in an integrated way. Why CORE doesn't use the terms 'microeconomics' and 'macroeconomics' in the text The sequence in the text reintegrates topics previously considered either as micro or macro. The CORE Team chose to do this because: It reflects how students see the world. Reintegration allows us to motivate the course by the students natural interest in the economy and the problems that reveals. Moving seamlessly between the decision-making actors in the economy and the aggregate economy comes easily to students. It helps build coherent foundations for learning the tools before we distinguish analytically between the different levels of abstraction. For example, the same toolkit using indifference curves and feasible sets helps understand both the central bank and the household as actors. It better reflects how the world is. The principal-agent problems in the labour and credit markets, which our syllabus teaches early in the course, provide the basis for involuntary unemployment in equilibrium, for the credit-constrained household, and hence also for the multiplier used to study the aggregate economy. So, we can teach these without needing to introduce ad hoc assumptions. 1

2 Teaching separately is possible (and successful) Reintegration in the text has allowed some universities to follow suit in their course structure. For three years, for example, University College London taught the beta version of The Economy as separate Microeconomics and Macroeconomics introductory courses, as it had done with other textbooks for many years. With the publication of the 1.0 version, the UCL course has reintegrated, and from follows the sequence in the text. Like UCL, introductory economics in your university may have been structured as two courses for a long time, and there are many important reasons why this would be the case. If you do not have the freedom or the desire to reintegrate the two subjects, it doesn't rule out using CORE's syllabus. We have learned from UCL and other early adopters shows that it is straightforward to teach The Economy with a micro-macro split. Broadly, the microeconomic aspects of CORE are largely contained in Units 2 to 12 (possibly excluding Unit 9, and some of Unit 10). The macroeconomic aspects are in Units 1 and 2, parts of Units 6 and 7, Unit 9, part of Unit 10, and Units 13 to 17. The capstone units from Unit 17 onwards can be integrated into either microeconomics or macroeconomics (or both). In the rest of this note, we'll go into more detail on how teachers who are familiar with the material have structured separate Introductory Microeconomics and Introductory Macroeconomics syllabuses using The Economy. A course in microeconomics Unit 1: Introduction This unit can be an introduction to any micro or macro course, because it introduces students to a broad range of the key topics and themes that will be treated in the course. For example, it demonstrates the importance of approaching economics through an empirical lens, and it introduces themes such as long-term economic growth and its environmental impacts, inequality and causality. Unit 2: Incentives and rent This is a hybrid unit with elements that traditionally feature in both microeconomics and macroeconomics. We introduce the basic idea of a model, including the ceteris paribus assumption, in this unit, as well as the important concepts of incentives related to relative prices and economic rents. In the unit, the central example illustrating these concepts in the unit is the incentive to innovate, which is used to introduce production functions, isocosts and diminishing average productivity. Although the motivating example in the unit is the growth associated with the industrial revolution, which is an aggregate phenomenon related to changes in GDP, the bulk of the unit contains basic economic ideas that would be central to a microeconomics course. The big question of why the industrial revolution started in England in the eighteenth century keeps the students motivated. Unit 3: Preferences and individual choice This unit contains theory which you will recognize from any microeconomics course. It teaches the fundamental ideas of preference and constrained optimization, including income and substitution effects. The theory is used to 2

3 explain differences in consumption and working hours, and responses to wage increases, in different countries. Unit 4: Games and strategic interactions This unit introduces game theory, motivated in part by new results from behavioural economics. Game theory appears much earlier than in traditional micro texts because The Economy uses Nash equilibrium and interaction between economic actors throughout, and so the material must be covered at this stage. The unit uses behavioural evidence and discusses altruistic preferences. This is also non-standard, but it balances the traditional emphasis on self-regarding behaviour in economics, which we employed in the model in Unit 3. Unit 5: Power, exchange and institutions This unit on power, property and bargaining examines exchange, production and allocation where there is more than one individual. It also teaches how we can evaluate exchanges using to the Pareto criterion, fairness, and inequality. In traditional microeconomics texts, we traditionally have used Edgeworth Boxes in pure exchange equilibrium. This concept abstracts from power and focuses on efficiency. The Economy does not use models like this, but the central component of a Pareto efficiency curve, and the way that the distribution of surplus is related to power relationships and institutions, is their analogue. Once again, these concepts are introduced earlier than in many traditional texts in microeconomics, because of their relevance to subsequent material. Unit 6: The labour market and incomplete contracts This begins the analysis of the labour market. Since the syllabus began by concentrating on human interactions (for example games in Unit 4, and exchange and production in Unit 5), it makes sense to develop the employment relationship before considering goods production, and firm and industry analysis. The first principal-agent problem is introduced in this unit. CORE s treatment of the labour market involves incomplete information in a labour discipline model, with a wage-setting firm. This model is consistent with the firm hiring up to the point where the marginal product of labour (or marginal revenue product) is equal to the wage, but this is not mentioned explicitly in CORE (though it could easily be without causing problems). This is a substantial revision of the traditional microeconomic approach, and it ensures that students understand unemployment is a structural feature of real economies, and that the labour market they learn about in microeconomics is analytically the same as the one that will be used in their macroeconomics course to model involuntary unemployment in equilibrium, and from which Phillips curves are derived. Unit 9 puts together the microeconomics of the wage-setting firm with the price-setting firm from Unit 7 to develop the model of the labour market. This extension of Units 6 and 7 can be omitted from a microeconomics course. The problem of incomplete contracts, introduced here in the labour market context, reappears in different settings in Unit 12, and the later sections of Unit 10. Units 7 and 8: Firms and markets These units most closely resemble the microeconomics of firms and markets in traditional texts. They introduce demand functions, cost functions and the 3

4 determination of market prices, and standard tools such as consumer surplus and elasticity. But, though the material is familiar, we begin with price-making firms selling differentiated goods, and arrive at perfect competition in Unit 8 as a limiting case rather than a benchmark. Unit 10: Intertemporal substitution The main theme here is a familiar model of intertemporal consumption, using a two-period framework. Usually, micro treats this model as an intertemporal extension of the choice problem discussed in Unit 3 (and in this case, it would be possible to teach this unit after Unit 3 to keep the choice models together). The danger with this approach is that it tends to elevate the model of choice above the economic phenomena which the models are introduced to address. Thus, in Unit 3, the choice model will have been useful in explaining the labour supply response to wage increases during and after the industrial revolution. In Unit 10, the intertemporal choice problem provides a way of explaining how markets function in various contexts. In this case, incomplete information is an important feature. This motivation for the model comes from contrasting the opportunities available to two individuals facing a problem of intertemporal substitution, when they have contrasting endowments. One has income this period, and none next period, and the other has no income now, but income next period. The unit highlights the parallel structure of the principal-agent problems in the labour and credit markets. Alternatively, one could leave out this unit entirely and deal with it in a macroeconomics course as a foundation for the behavioural responses in credit markets that will influence the effectiveness of fiscal and monetary policy. A further possibility is to cover sections 10.1 to 10.7 in a microeconomics course, and then come back to 10.8 to (on banks and policy) in a macroeconomics course. Units 11 and 12: Market dynamics and market performance These two units provide a conclusion to a microeconomics course by considering the performance of actual markets. Unit 11 considers how out-of-equilibrium rents drive economic activity, providing an intuitive explanation of how the supply and demand framework functions to generate equilibrium prices. This replacing the sometimes-puzzling explanation usually offered of how price-taking agents could equilibrate a market in excess supply or excess demand. Unit 12 investigates market failure and policy responses to it, bringing the many different cases of external effects together under a unified umbrella of incomplete contracts. Summary: A suggested course structure for microeconomics Introduction Units 1 and 2 Interactions between economic actors Units 3 to 6 Firms and markets Units 7 and 8 Intertemporal choice Unit 10, sections 1 to 7 Market performance and failure Units 11 and 12 4

5 A course in macroeconomics Units 1 and 2: Introduction As noted above, a standalone course in either microeconomics or macroeconomics would probably start with Units 1 and 2 because they introduce concepts such as causality and models, which are fundamental aspects of economic explanation. Unit 2 s macroeconomic aspects include changes and growth in GDP, and the explanation of this aggregate growth by innovation in response to price incentives. Unit 7: The product market It is unlikely that a macroeconomics course would spend a long time on product markets, but it is important to ensure that students understand price-making optimal behaviour on the part of firms. The relationship between firms profit maximization and the competitive conditions inherent in the elasticity of demand is critical for understanding the price-setting curve that later will be integral to the macroeconomic modelling. Relevant material can be found primarily in sections 5 and 8. Units 6 and 9: The labour market A macroeconomics course will need to cover the foundational material on the labour market, because it is key to understanding the inflation-stabilizing rate of unemployment in the economy, and what determines the fluctuations around this (primarily variations in aggregate demand). If Unit 6 has already been covered in a microeconomics course, then a macroeconomics course could move to Unit 9 quickly after revising the efficiency wage (labour discipline) model. Unit 10: Credit markets, money and banking As suggested above, sections 10.1 to 10.7 (specifically those which are concerned with the intertemporal choice model) may already have been treated in a microeconomics course. If so, sections 10.8 onwards need to be covered. In any case, it may be necessary to revise the model of preferences and feasible sets from Unit 3 or the intertemporal choice model, because this framework is used throughout the macroeconomic units (for example, the MRS = MRT equality recurs when we model monetary policy). The material on asset bubbles from Unit 11 (especially 11.5 to 11.8) may also be useful to cover in a macroeconomics course because it relates very well to the discussion on the financial crash in Unit 17. Unit 13: Economic fluctuations This provides standard material on macroeconomic variables, which follows on directly from the discussion of GDP in Units 1 and 2. The treatment of consumption focuses on consumption smoothing and the role of credit constraints. Units 14 and 15: Fiscal and monetary policy These two units bring together the labour market model, the multiplier model and the model of the policymaker to discuss fiscal and monetary policy. The use of the labour market diagram from Unit 9 unifies these units, and provides a 5

6 wide range of experience for students in using this framework to analyze the aggregate economy. Unit 16: Long-run economic performance A macroeconomics course could be rounded off by considering the problem of longer term growth. This brings the macroeconomics course back to a topic from Unit 2: how economies can grow through innovation, capital investment, and technological progress. Schumpeterian creative destruction is used to unify the treatment of the flow approach to the labour market with endogenous growth. Capstone unit 17: Great Depression, the golden age and the global financial crisis This is a particularly useful capstone unit to use in a macroeconomics course. It provides case-study material for the existence and effects of dramatic fluctuations in the economy. Students find the exercise of applying the set of models they have learnt to 100 years of economic history very rewarding. They also see that economics develops as a discipline because real-world events challenge dominant theories. This also provides an opportunity to cover asset price bubbles in the macroeconomics course (in Unit 11). Summary: A suggested course structure for macroeconomics Introduction Units 1 and 2 Labour markets and unemployment Unit 6, sections on wage-setting if not covered previously Unit 7, sections on price-setting if not covered previously Unit 9 Credit markets Unit 10, sections 10.8 onwards (or whole unit if not covered previously) Unit 3 (and Unit 10), revision of the basic feasible sets and preference model Economic accounting and Unit 13 fluctuations Fiscal and monetary policy Units 14 and 15 Long-run economic performance Unit 16 Applications of the models Unit 17 Unit 11, can use material on asset price bubbles 6