Chapter 1
Introduction to
Macroeconomics
Session 1
What Macroeconomics is
About
• Macroeconomics is the study of the
structure and performance of
national economies and of the policies
that governments use to try to
affect economic performance.
What is macroeconomics?
The study of the economy as a whole, and the variables
that control the macro-economy.
The study of government policy meant to control and
stabilize the economy over time, that is, to reduce
fluctuations in the economy.
The study of monetary policy, fiscal policy, and supplyside economics.
Who introduced macroeconomics, and what was its
major objective?
John Maynard Keynes, an English economist, hence
macroeconomics is also referred to as Keynesianism.
Keynes argued that by itself the market is unable to
generate enough savings (capital) to sustain
investment at full employment levels; and that this
could be achieved only with the periodic sharp increase
in government spending.
What is Macroeconomics
• Macroeconomics examines economies
at the aggregate (international,
national, regional) level.
• Some aspects of macroeconomics are
about comparing two aggregate
economies at the same time.
Why study the economy at the
aggregate level?
• Much of macroeconomics is concerned with
policies such as money supply or tax policy
which is national in scope.
• Equilibrium effects means that outcomes
are different when we consider the
economy in aggregate.
• There are certain phenomenon like economic
growth and business cycles which affect the
aggregate economy equally.
.
Macroeconomics
7
Deals with the classic issues in economics:
• Unemployment
• Inflation
• National Output & National Income
• Population Growth
• Economic Growth
• Money & Banking
• Output
• Business Cycle
Macro Economic Goals
•
•
•
•
•
•
•
The goal of economic growth
The Goal of Low Unemployment
The Goal of Low Inflation
Price Stability
Complementary and Conflicting Goals
A rise in average living standards
Sustainable position on the balance of
payments
• Sound government finances
2. Macroeconomic Goals
Complementary and
Conflicting Goals
• Complementary Goals
– Low unemployment and high economic
growth
• Conflicting Goals
– Low unemployment and low inflation
•
The Main Problems of
Managing the
Macroeconomy
Inaccurate economic data: All of the main macroeconomic
indicators are subject to a margin of error. They rely on statistical
data collected from tax returns and surveys and data is often
revised many months after its first release
• Conflicting policy objectives: A policy of stimulating aggregate
demand may reduce unemployment in the short term but initiate a
period of higher inflation and exacerbate the current account of
the balance of payments. Choices have to be made between
objectives i.e. there exist trade-offs between them
• Selecting the right policy instrument: Each macroeconomic
objective requires a separate policy instrument: The usual ‘rule of
thumb’ is that one main policy instrument should be assigned to one
policy objective. So, for example, interest rates might be assigned
as the main instrument for keeping control of inflation, whilst fiscal
policy instruments such as changes to the tax system might be
allocated to achieving some supply-side objectives such as increasing
the labour supply, boosting incentives, raising investment and
increasing productivity. There are quite deep-rooted disagreements
between some economists (who belong to different ‘schools of
thought’) as to which policies are most effective to meet a certain
objective
• Uncertain time lags when running a policy: Changes
in economic policies are subject to uncertain time lags
e.g. a change in interest rates is estimated to take
some 18-24 months to work its way fully through the
whole economy to filter through to a change in prices.
The length of the time lags can change over the years
as the reactions of consumers and businesses to
policy measures alters
• External shocks: Unexpected external shocks to
economy such as the events surrounding Sept 11th
2001 or unexpected volatility in exchange rates and
commodity prices can upset economic forecasts and
take the economy some distance from the expected
path. The Government might under-estimate or
exaggerate the potential impact of an economic shock
to either the demand or supply-side of the economy
and therefore apply too little or too much of a policy
response.
The main instruments of
Macro Economic Policy
• Fiscal Policy
– Fiscal policy involves the use of government
spending, taxation and borrowing to influence
both the pattern of economic activity and also
the level and growth of aggregate demand,
output and employment.
• Monetary Policy
– Monetary policy involves the use of interest
rates to control the level and rate of growth of
aggregate demand in the economy.
Major Macroeconomic Variables
• Economic output
Short-run business fluctuations
Long-run economic growth
• Unemployment and Employment
• Inflation
Key Macroeconomic Variables
• Interest rates
• Government budget balances and
finance
• International trade balances and
finance
• Productivity
•
Macroeconomics &
Microeconomics
Microeconomics
– Decisions of individual units
• No matter how large
• Macroeconomics
– Behavior of entire economies
• No matter how small
– Economic aggregates
14
•
Macroeconomics &
Microeconomics
Aggregation
– Combine many individual markets
– Into one overall market
• Composition of demand & supply
– In various markets
– Important for microeconomics issues
– Not important for macroeconomics issues
• During economic fluctuations
– Markets – move up or down together
15
•
Macroeconomics &
Microeconomics
Macroeconomics
– Assume most details
• Resource allocation & income distribution
• Relatively unimportant
• Microeconomics
– Ignore macroeconomics issues
– Focus – individual markets
• Allocate resources
• Distribute income
16
Supply & Demand in
Macroeconomics
• Aggregate demand curve
– Quantity of domestic product – demanded
– Each possible value of price level
• Aggregate supply curve
– Quantity of domestic product – supplied
– Each possible value of price level
17
Figure 1
D1
S
D
Price
Price
Two interpretations of a shift in the demand curve
S
D0
A
P1
E
E
P0
P0
S
S
D1
D
0
Q0
Quantity
(a)
D0
0
Quantity
(b)
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Supply & Demand in
Macroeconomics
• Inflation
– Sustained increase in price level
– Outward shift of aggregate demand curve
• Recession – period of time
– Total output – declines
• Production falls
• People lose jobs
– Leftward shift of aggregate demand curve
19
Figure 2
An economy slipping into a recession
S
D0
D2
Price Level
E
P0
B
P2
S
D2
0
Q2
D0
Q0
Domestic Product
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Supply & Demand in
Macroeconomics
• Macroeconomists study
– Inflation
– Recession & unemployment
– Economic growth
Figure 3
Economic growth
D1
S0
D0
S1
Price Level
C
E
D1
S0
0
D0
S1
Q0
Q1
Domestic Product
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Gross Domestic Product
• Gross domestic product (GDP)
– Sum: money values
– All final goods & services
• Produced - domestic economy
• Sold – organized markets
– Specified period of time
• Usually a year
23
Gross Domestic Product
• Nominal GDP
– GDP in current dollars
– Value outputs – current prices
• Real GDP
– Value outputs of different years
• Common prices
24
Gross Domestic Product
• GDP - particular year
– Add up money value of things
– Goods & services
• Produced within the year
– Final goods & services
– Production: geographic boundaries of U.S.
– Organized markets
25
Gross Domestic Product
• Final goods and services
– Purchased by their ultimate users
• Intermediate good - purchased
– For resale
– For use in producing another good
26
Gross Domestic Product
• Limitations of GDP
–
–
–
–
Not measure: nation’s economic well-being
Includes only market activity
Places no value on leisure
Ecological costs
• Not deducted from GDP
27
microeconomics Examines the functioning of individual industries
and the behavior of individual decision-making units—firms and
households.
macroeconomics Deals with the economy as a whole. Macroeconomics
focuses on the determinants of total national income, deals with
aggregates such as aggregate consumption and investment, and looks at
the overall level of prices instead of individual prices.
aggregate behavior The behavior of all households and firms together.
sticky prices Prices that do not always adjust rapidly to maintain
equality between quantity supplied and quantity demanded.
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Macroeconomic Concerns
Output Growth
business cycle The cycle of short-term ups and downs in the
economy.
aggregate output The total quantity of goods and
services produced in an economy in a given period.
recession A period during which aggregate output declines.
Conventionally, a period in which aggregate output declines for two
consecutive quarters.
depression A prolonged and deep recession.
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Macroeconomic Concerns
Output Growth
expansion or boom The period in the business cycle from a
trough up to a peak during which output and employment
grow.
contraction, recession, or slump The period in
the business cycle from a peak down to a trough
during which output and employment fall.
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Macroeconomic Concerns
Output Growth
 FIGURE 20.1 A Typical Business
Cycle
In this business cycle, the
economy is expanding as it
moves through point A from
the trough to the peak.
When the economy moves
from a peak down to a trough,
through point B, the economy
is in recession.
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Macroeconomic Concerns
Output Growth
 FIGURE 20.2 U.S. Aggregate Output (Real GDP), 1900–2007
The periods of the Great Depression and World Wars I and II show the largest fluctuations in
aggregate output.
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Macroeconomic Concerns
Unemployment
unemployment rate The percentage of the labor
force that is unemployed.
Inflation and Deflation
inflation An increase in the overall price level.
hyperinflation A period of very rapid increases in
the overall price level.
deflation A decrease in the overall price level.
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The Components of the Macro economy
Macroeconomics focuses on four groups. To see
the big picture, it is helpful to divide the
participants in the economy into four broad groups:
(1) households,
(2) firms,
(3) the government, and
(4) the rest of the world.
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The Components of the Macroeconomy
The Circular Flow Diagram
circular flow A diagram showing the income
received and payments made by each sector of
the economy.
transfer payments Cash payments made by the
government to people who do not supply goods,
services, or labor in exchange for these payments.
They include Social Security benefits, veterans’
benefits, and welfare payments.
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The Components of the Macroeconomy
The Circular Flow Diagram
Households receive income from firms
and the government, purchase goods
and services from firms, and pay taxes
to the government. They also
purchase foreign-made goods and
services (imports). Firms receive
payments from households and the
government for goods and services;
they pay wages, dividends, interest,
and rents to households and taxes to
the government. The government
receives taxes from firms and
households, pays firms and
households for goods and services—
including wages to government
workers—and pays interest and
transfers to households. Finally,
people in other countries purchase
goods and services produced
domestically (exports).
Note: Although not shown in this
diagram, firms and governments also
purchase imports.
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The Components of the Macroeconomy
The Three Market Arenas
Another way of looking at the ways households,
firms, the government, and the rest of the world
relate to each other is to consider the markets in
which they interact.
We divide the markets into three broad arenas:
(1) the goods-and-services market,
(2) the labor market, and
(3) the money (financial) market.
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The Components of the Macroeconomy
The Three Market Arenas
Goods-and-Services Market
Firms supply to the goods-and-services market.
Households, the government, and firms demand
from this market.
Labor Market
In this market, households supply labor and firms
and the government demand labor.
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The Components of the Macroeconomy
The Three Market Arenas
Money Market
Households supply funds to this market in the
expectation of earning income in the form of
dividends on stocks and interest on bonds.
Firms, the government, and the rest of the world
also engage in borrowing and lending which is
coordinated by financial institutions.
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The Components of the Macroeconomy
The Three Market Arenas
Money Market
Treasury bonds, notes, and bills Promissory
notes issued by the federal government when it
borrows money.
corporate bonds Promissory notes issued by
firms when they borrow money.
shares of stock Financial instruments that give to
the holder a share in the firm’s ownership and
therefore the right to share in the firm’s profits.
dividends The portion of a firm’s profits that the
firm pays out each period to its shareholders.
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The Components of the Macroeconomy
The Role of the Government in the Macroeconomy
fiscal policy Government policies concerning
taxes and spending.
monetary policy The tools used by the Federal
Reserve to control the quantity of money, which in
turn affects interest rates.
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John Maynard Keynes
Much of the framework of
modern macroeconomics comes
from the works of John Maynard
Keynes, whose General Theory
of Employment, Interest and
Money was published in 1936.
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Issues Addressed by
Macroeconomists
• What determines a nation’s long-run
economic growth?
• What causes a nation’s economic
activity to fluctuate?
• What causes unemployment?
Issues Addressed by
Macroeconomists
(continued)
• What causes prices to rise?
• How does being a part of a global
economic system affect nations’
economies?
• Can government policies be used to
improve economic performance?
Long-Run Economic Growth
– Rich nations have experienced
extended periods of rapid
economic growth.
– Poor nations either have never
experienced them or economic
growth was offset by economic
decline.
Increased Output
• Total output is increasing because of
increasing population, i.e. the number
of available workers.
• Increasing average labour
productivity: the amount of output
produced per unit of labour input.
Rates of Growth of
Output
• Rates of growth of output (or output
per worker) are determined by:
– rates of saving and investment;
– rates of technological change;
– rates of change in other factors.
Business Cycles
• Business cycles are short-run
contractions and expansions of
economic activity
Recessions
• Recession is the downward phase of a
business cycle when national output is
falling or growing slowly.
– Hard times for many people
– A major political concern
Unemployment
• Recessions are usually accompanied
by high unemployment: the number
of people who are available for work
and are actively seeking it but
cannot find jobs.
Unemployed
Unemployme nt Rate 
 100%
Labour Force
Inflation
• When prices of most goods and
services are rising over time it is
inflation. When they are falling it is
deflation.
• The inflation rate is the percentage
increase in the average level of
prices.
Effects of Inflation
• When the inflation rate reaches an
extremely high level the economy
tends to function poorly. The
purchasing power of money erodes
quickly, which forces people to spend
their money as soon as they receive
it.
The International
Economy
• An economy which has extensive
trading and financial relationships
with other national economies is an
open economy. An economy with no
relationships is a closed economy.
The International
Economy (continued)
• International trade and borrowing
relationships can transmit business
cycles from country to country.
Exports and Imports
Indian exports are goods and services
produced in India and consumed
abroad.
Indian imports are goods and services
produced abroad and consumed in
India
Trade Imbalances
• Trade imbalances (trade surplus and
deficit) affect output and
employment.
– Trade surplus: exports exceed imports.
– Trade deficit: imports exceed exports.
The Exchange Rate
• The trade balance is affected by the
exchange rate: the amount of Indian
Rupee that can be purchased with a
unit of foreign currency.
Macroeconomic Policy
• A nation’s economic performance
depends on:
–
–
–
–
–
natural and human resources;
capital stock;
technology
economic choices made by citizens;
macroeconomic policies of the
government.
Macroeconomic Policy
(continued)
• Macroeconomic policies:
– Fiscal policy: government spending and
taxation at different government levels.
– Monetary policy: the central bank’s
control of short-term interest rates and
the money supply.
Budget Deficits
• The economy is affected when there
are large budget deficits: the excess
of government spending over tax
collection.
Aggregation
• Macroeconomists ignore distinctions
between individual product markets
and focus on national totals.
• The process of summing individual
economic variables to obtain
economywide totals is called
aggregation.
What Macroeconomists
Do
•
•
•
•
Macroeconomic forecasting
Macroeconomic analysis
Macroeconomic research
Data development
Macroeconomic
Forecasting
• Macroeconomic forecasting –
prediction of future economic
trends - has some success in the
short run. In the long run too many
factors are highly uncertain.
Macroeconomic Analysis
• Macroeconomic analysis - analyzing
and interpreting events as they
happen – helps both private sector
and public policymaking.
Macroeconomic Research
• Macroeconomic research - trying to
understand the structure of the
economy in general – forms the basis
for macroeconomic analysis and
forecasting.
Economic Theory
• Economic theory: a set of ideas
about the economy to be organized
in a logical framework.
• Economic model: a simplified
description of some aspects of the
economy.
Developing and Testing a
Theory
• State the research question.
• Make provisional assumptions.
• Work out the implications of the
theory.
• Conduct an empirical analysis.
• Evaluate the results.
Data Development
• Macroeconomists use data to assess
the state of the economy, make
forecasts, analyze policy
alternatives, and test theories.
Data Development
(continued)
• Providers of data must:
– Decide what types of data should be
collected based on who is expected to
use the data and how.
– Ensure the measures of economic
activity correspond to economic
concepts.
– Guarantee the confidentiality of data.
Why Macroeconomists
Disagree
• A positive analysis examines the
economic consequences of an
economic policy, but it does not
address its desirability.
• A normative analysis tries to
determine whether a certain
economic policy should be used.
Why Macroeconomists
Disagree (continued)
• Economists can disagree on normative
issues because of differences in
values.
• Economists disagree on positive
issues because of different schools
of thought.
The Classical Approach
• The invisible hand of Economics:
General welfare will be maximized
(not the distribution of wealth) if:
– there are free markets;
– individuals act in their own best
interest.
The Classical Approach
(continued)
• To maintain markets’ equilibrium –
the quantities demanded and supplied
are equal:
– Markets must function without
impediments.
– Wages and prices should be flexible.
The Classical Approach
(continued)
• Thus, according to the classical
approach, the government should
have a limited role in the economy.
The Keynesian Approach
• Keynes (1936) assumed that wages
and prices adjust slowly.
• Thus, markets could be out of
equilibrium for long periods of time
and unemployment can persist.
The Keynesian Approach
(continued)
• Therefore, according to the
Keynesian approach, governments can
take actions to alleviate
unemployment.
The Keynesian Approach
(continued)
• The government can purchase goods
and services, thus increasing the
demand for output and reducing
unemployment.
• Newly generated incomes would be
spent and would raise employment
even further.
Evolution of the
Classical-Keynesian
Debate
• After stagflation – high
unemployment and high inflation – of
the 1970s, a modernized classical
approach reappeared.
• Substantial communication and
cross-pollination is taking place
between the classical and the
Keynesian approaches.
Unified Approach to
Macroeconomics
• Individuals, firms and the
government interact in goods, asset
and labour markets.
• The macroeconomic analysis is based
on the analysis of individual
behaviour.
The Unified Approach
(continued)
• Keynesian and classical economists
agree that in the long run prices and
wages adjust to equilibrium levels.
• The basic model will be used either
with classical or Keynesian
assumptions about flexibility of
wages and prices in the short run.
Importance of Macro
Economics
• Growing importance of macro
economic issues
• Persistence of Macroeconomic
Problems
• Growing Complexity of economic
system
• Need for Govt. intervention with the
market system
• Use of Macro Economics in Business
Limitations
• It ignores structural Changes
• Aggregate are nor reality but a
picture or approximation of reality
• Some Economist consider
macroeconomics only as an
intellectual attraction without much
of practical use. Such as J.R.Hicks.
Global Economy
GDP
CPI
IIP
Emp
US
UK
Euro
Japan
China
1.6
Q2-2013
1.3
-0.5
1.2
7.5
Q2-2013
Q2-2013
Q2-2013
Q2-2013
1.5
Aug2013
2.7
Aug2013
1.1
0.9
Aug2013
2.6
Aug2013
2.7
Aug2013
-1.5
-0.2
July2013
-2.1
July2013
Aug2013
10.4
Aug2013
7.3
Aug2013
7.7
June2013
12.0
Aug2013
4.1
4.1 Q2-2013
Updated on 07 October, 2013
Emp : Unemployment Rate
Sept2013
Aug2013