Chapter 1 Introduction to Macroeconomics

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Chapter 1Introduction to Macroeconomics

• Session 1

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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.

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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 supply-side economics.
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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.
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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.

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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.
• .

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Macroeconomics

• Deals with the classic issues in economics
• Unemployment
• Inflation
• National Output National Income
• Population Growth
• Economic Growth
• Money Banking
• Output
• Business Cycle

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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

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2. Macroeconomic Goals Complementary and
Conflicting Goals

• Complementary Goals
• Low unemployment and high economic growth
• Conflicting Goals
• Low unemployment and low inflation

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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

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• 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.

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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.

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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
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Macroeconomics Microeconomics

• Microeconomics
• Decisions of individual units
• No matter how large
• Macroeconomics
• Behavior of entire economies
• No matter how small
• Economic aggregates

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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

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Macroeconomics Microeconomics

• Macroeconomics
• Assume most details
• Resource allocation income distribution
• Relatively unimportant
• Microeconomics
• Ignore macroeconomics issues
• Focus individual markets
• Allocate resources
• Distribute income

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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

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Figure 1
Two interpretations of a shift in the demand curve
(a)
(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

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Figure 2
An economy slipping into a recession
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Supply Demand in Macroeconomics

• Macroeconomists study
• Inflation
• Recession unemployment
• Economic growth

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Figure 3
Economic growth
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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

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Gross Domestic Product

• Nominal GDP
• GDP in current dollars
• Value outputs current prices
• Real GDP
• Value outputs of different years
• Common prices

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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

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Gross Domestic Product

• Final goods and services
• Purchased by their ultimate users
• Intermediate good - purchased
• For resale
• For use in producing another good

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Gross Domestic Product

• Limitations of GDP
• Not measure nations economic well-being
• Includes only market activity
• Places no value on leisure
• Ecological costs
• Not deducted from GDP

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microeconomics Examines the functioning of
individual industries and the behavior of
individual decision-making unitsfirms 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),
19002007
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
• households,
• firms,
• the government, and
• 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 servicesincluding wages to
government workersand 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
• the goods-and-services market,
• the labor market, and
• 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 firms ownership and
therefore the right to share in the firms
profits.
dividends The portion of a firms 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 nations long-run economic
  growth?
• What causes a nations economic activity to
  fluctuate?
• What causes unemployment?

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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?

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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.

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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.

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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.

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Business Cycles

• Business cycles are short-run contractions and
  expansions of economic activity

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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

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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.

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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.

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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.

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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.

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The International Economy (continued)

• International trade and borrowing relationships
  can transmit business cycles from country to
  country.

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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

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Trade Imbalances

• Trade imbalances (trade surplus and deficit)
  affect output and employment.
• Trade surplus exports exceed imports.
• Trade deficit imports exceed exports.

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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.

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Macroeconomic Policy

• A nations economic performance depends on
• natural and human resources
• capital stock
• technology
• economic choices made by citizens
• macroeconomic policies of the government.

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Macroeconomic Policy (continued)

• Macroeconomic policies
• Fiscal policy government spending and taxation
  at different government levels.
• Monetary policy the central banks control of
  short-term interest rates and the money supply.

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Budget Deficits

• The economy is affected when there are large
  budget deficits the excess of government
  spending over tax collection.

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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.

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What Macroeconomists Do

• Macroeconomic forecasting
• Macroeconomic analysis
• Macroeconomic research
• Data development

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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.

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Macroeconomic Analysis

• Macroeconomic analysis - analyzing and
  interpreting events as they happen helps both
  private sector and public policymaking.

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Macroeconomic Research

• Macroeconomic research - trying to understand the
  structure of the economy in general forms the
  basis for macroeconomic analysis and forecasting.

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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.

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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.

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Data Development

• Macroeconomists use data to assess the state of
  the economy, make forecasts, analyze policy
  alternatives, and test theories.

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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.

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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.

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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.

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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.

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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.

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The Classical Approach (continued)

• Thus, according to the classical approach, the
  government should have a limited role in the
  economy.

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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.

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The Keynesian Approach (continued)

• Therefore, according to the Keynesian approach,
  governments can take actions to alleviate
  unemployment.

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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.

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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.

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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.

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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.

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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 Management

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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.

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Global Economy Global Economy Global Economy Global Economy Global Economy Global Economy
US UK Euro Japan China
GDP 1.6Q2-2013 1.3Q2-2013 -0.5Q2-2013 1.2Q2-2013 7.5Q2-2013
CPI 1.5Aug2013 2.7Aug2013 1.1Sept2013 0.9Aug2013 2.6Aug2013
IIP 2.7Aug2013 -1.5July2013 -2.1July2013 -0.2Aug2013 10.4Aug2013
Emp 7.3Aug2013 7.7June2013 12.0Aug2013 4.1Aug2013 4.1  Q2-2013
Updated on 07 October, 2013 Updated on 07 October, 2013 Updated on 07 October, 2013 Updated on 07 October, 2013 Updated on 07 October, 2013 Updated on 07 October, 2013
Emp Unemployment Rate