Question

Exercise 2:

1. Which is the most common assumption made in economics because reality is too complex?
2. Why most macro models group together all households into a single representative unit?
3. What are the conditions that the theory must fulfill in order to be acceptable?
4. We know that most macro models simplify the economy reducing it to only four sectors (households, firms, public sector, and the foreign sector). Since this is an unrealistic assumption, the Basic Macroeconomic Model is useless. Is this statement true or false?

Answer 1

1. The most common assumption made in economics is that people are assumed to be rational. Rationality emcompasses that every individual makes decisions by comparing the marginal costs and marginal benefits of every choice. People have rational preferences among outcomes that can be identified and associated with a value. This assumption is important because in reality humans are complex individuals and differ greatly in making.

Other main assumptions include that people are self-interested, they are utility maximisers and they have access to all relevant information. The economy is assumed to be in equilibrium, markets are efficient and perfect competition prevails.

2. Macroeconomics takes economy as a whole and studies problems such as unempmoyment, inflation, poverty etc that prevail in an entire economy. Since macro models involve analysis on the basis of aggregates, households are usually grouped into a single representative unit due to their identical underlying conditions and decision making. All households face the identical conditions of decision making in terms of consumption, offering their labor, etc. that it makee little economic sense to treat them as different units.

3. The basic conditions that a theory must meet are:

(a) substantiated- a theory cannot be independent of prior work and evidence. It should encompass previous work in the field and address the available evidences.

(b) explanatory- it should be able to explain its hypothesis and also cover causality.

(c) predictive- a theory needs to make predictions that can be tested, so that the theory itself can be rejected if need be.

(d) testable- it should be testable in some form in the real world.

4. False

The economy is extremely complex, an attempt to understand it as it is will likely fail. Theories are deliberate simplifications and assumptions are necessary to establish important relationships between variables.

Most macro models might simplify the economy reducing it to only four sectors (households, firms, public sector, and the foreign sector). This assumption may appear unrealistic but the conclusions of the models are very much rooted in reality. Thus it is wrong to say that the Basic Macroeconomic Model is useless.