CHAPTER ONE
1.0 OVERVIEW OF MACROECONOMICS
The purpose of this chapter is to achieve three goals:
To introduce the concern of macroeconomics
To introduce the goals and instruments of macroeconomics
To introduce the most important past and current schools of thought in macroeconomics
1.1 What Macroeconomics is about?
By time-honored tradition, economics is divided into two fields: microeconomics and
macroeconomics. These words are derived from two Greek words, where micro means
something small and macro means something large. This course introduced you to the branch of
macroeconomics.
How do the Two Branches of the Discipline Differ?
i. Is it a matter of using different tools?
It is not a matter of using different tools. As we shall see in next chapter, supply and demand
provide the basic organizing framework for constructing macroeconomic models, just as they do
for microeconomic models.
ii. Is it a matter of size?
The micro-macro distinction in economics is not based solely on size. For example, someone
who studies General Electronics’, whose annual sales exceed the total production of many
nations, pricing policies is a micro economist, whereas someone who studies inflation in a small
country like Djibouti is a kind macroeconomist. This implies that the micro-macro distinction is
not a matter of size.
iii. What, then, is the basis for this long-standing distinction?
The answer is that, the distinction is rather based on the issues addressed. Microeconomics
focuses on the decisions of individual units, no matter how large, and macroeconomics
concentrates on the behavior of entire economies, no matter how small.
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In microeconomics, the spotlight is on how individual decision-making units behave. For
example, the dairy farmers are individual decision makers; so are the consumers who purchase
the milk. How do they decide which actions are in their own best interests? How are these
millions of decisions coordinated by the market mechanism, and with what consequences?
Questions such as these lie at the heart of microeconomics.
In contrast, macroeconomists study the overall price level, unemployment rate, and other things
that we call economic aggregates. Economic aggregate is simply an idea that people use to
describe some salient feature of economic life. For example, although we observe the prices of
gasoline, telephone calls, and movie tickets every day, we never actually see “the general price
level.” Yet many people—not just economists—find it meaningful to speak of “the cost of
living.” In fact, the government’s attempts to measure it are widely publicized by the news media
periodically.
Among the most important of these abstract notions is the concept of domestic product, which
represents the total production of a nation’s economy. The process by which real objects such as
software, car, and theater tickets are combined into an idea called total domestic product is
aggregation, and it is one of the foundations of macroeconomics.
Thus, as discussed above, macroeconomics attempts to answer the following principal issues,
i) Why do output and employments sometimes fall, and how can unemployment be
reduced?
ii) What are the sources of price inflation, and how can it be kept under control?
iii) How can a nation increase its rate of economic growth?
Above all, macroeconomics is concerned with economic growth, which refers to the
growth in the productive potential of an economy.
1.2. Basic Concepts and Methods of Macroeconomics Analysis
Macroeconomics encompasses a variety of concepts and variables, but there are three central
topics for macroeconomic research. Macroeconomic theories usually relate the phenomena of
output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also
extremely important to all economic agents including workers, consumers, and producers.
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a. Output and Income
National output is the total value of everything a country produces in a given time period.
Everything that is produced and sold generates income. Therefore, output and income are usually
considered equivalent and the two terms are often used interchangeably. Output can be measured
as total income, or, it can be viewed from the production side and measured as the total value of
final goods and services or the sum of all value added in the economy.
Macroeconomic output is usually measured by Gross Domestic Product (GDP) or one of the
other national accounts. Economists interested in long-run increases in output study economic
growth. Advances in technology, accumulation of machinery and other capital, and better
education and human capital all lead to increased economic output over time. However, output
does not always increase consistently. Business cycles can cause short-term drops in output
called recessions. Economists look for macroeconomic policies that prevent economies from
slipping into recessions and that lead to faster long-term growth.
b. Unemployment
The amount of unemployment in an economy is measured by the unemployment rate, the
percentage of workers without jobs in the labor force. The labor force only includes workers
actively looking for jobs. People who are retired, pursuing education, or discouraged from
seeking work by a lack of job prospects are excluded from the labor force.
Unemployment can be generally broken down into several types that are related to different
causes. Classical unemployment occurs when wages are too high for employers to be willing to
hire more workers. Wages may be too high because of minimum wage laws or union activity.
Consistent with classical unemployment, frictional unemployment occurs when appropriate job
vacancies exist for a worker, but the length of time needed to search for and find the job leads to
a period of unemployment.
Structural unemployment covers a variety of possible causes of unemployment including a
mismatch between workers' skills and the skills required for open jobs. While some types of
unemployment may occur regardless of the condition of the economy, cyclical unemployment
occurs when growth stagnates.
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c. Inflation and Deflation
A general price increase across the entire economy is called inflation. When prices decrease,
there is deflation. Economists measure these changes in prices with price indexes. Inflation can
occur when an economy becomes overheated and grows too quickly. Similarly, a declining
economy can lead to deflation.
Central bankers, who control a country's money supply, try to avoid changes in price level by
using monetary policy. Raising interest rates or reducing the supply of money in an economy
will reduce inflation. Inflation can lead to increased uncertainty and other negative
consequences. Deflation can lower economic output. Central bankers try to stabilize prices to
protect economies from the negative consequences of price changes.
1.3. Goals and Instruments of Macroeconomic Policy
Having discussed the central questions (concerns) of macroeconomics, we now turn to a
discussion of the major goals and instruments of macroeconomic policy. Economists evaluate the
success of an economy’s overall performance by how well it attains the following listed
macroeconomic policy goals.
i. A High and Growing Level of National Output,
The ultimate objective of economic activity is to provide the goods and services that the
population desires. The most comprehensive measure of the total output in an economy is the
gross domestic product (GDP). GDP is a measure of the market value of all final goods and
services produced in a country during a year. There are two ways to measure GDP. Nominal
GDP is measured in actual market prices. Real GDP is calculated in constant or invariant prices.
Thus, the most plausible measure is, therefore, Real GDP.
ii. Low Unemployment and High Employment
Of all the macroeconomic indicators, employment and unemployment are most directly felt by
individuals. People want to be able to get high-paying jobs without searching or waiting too
long, and they want to have job security and good benefits. The trend in unemployment over a
period of time is measured using unemployment rate. The unemployment rate tends to reflect
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the state of the business cycle: when output is falling, the demand for labor falls and the
unemployment rate rises.
iii. Price-level stability (or lower inflation).
The third macroeconomic goal is to maintain price stability. This term means that the overall
price level is either unchanged or rising very slowly. To follow the price change the government
constructs the price indexes, or the measures of the overall price level. An important example is
the consumer price index (CPI), which measures the average price of goods and services bought
by consumers. Using these indexes economists compute the percentage change in the overall
level of prices from one year to the next. Thus, economists measure price stability by looking at
the inflation rate, or rate of inflation.
Instruments of Macroeconomic Policy
Today, there are numerous instruments with which the government can steer the economy.
Policy instruments are the economic variables under the control of government that can affect
one or more of the macroeconomic goals.
A nation has two major kinds of policies that can be used to pursue its macroeconomic goals:
fiscal policy and monetary policy.
Fiscal policy consists of government expenditure and taxation. Monetary policy, conducted by
the central bank, determines the money supply and financial conditions. It is conducted through
managing the nation’s money, credit, and banking system.
1.4. The State of Macroeconomics: Evolution and Recent Developments
Macroeconomics as a branch of economics was emerged 249 years back with the writing of
Adam Smith “The wealth of Nation” in 1776. Some of the historical evolutions (schools of
thought) of macroeconomics since 1776 are the classical school of thought, the neo-classical
school of thought, and the Keynesian macroeconomics.
A. The Classical Macroeconomics
The Classical theory of employment (macroeconomics) traces its origins to the nineteenth
century and to such economists as John Stuart Mill and David Ricardo. The Classical theory
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dominated modern economic thought until the middle of the Great Depression when its
predictions simply were at odds with reality. However, the work of the classical school laid the
foundations for current economic theory and a great intellectual debt is owed to these
economists.
Classical macroeconomic theory economists believe the economy is, in general, a self-correcting
entity. In the economy, it assumes potential output at full employment levels. This concept is
pretty straightforward. In good times, prices and wages rise, while in bad times, prices and wages
fall instead.
B. Keynesian Macroeconomics
Keynesian economics is a macroeconomic theory of total spending in the economy and its effects
on output, employment, and inflation. It was developed by British economist John Maynard
Keynes during the 1930s in an attempt to deal with the effects of the Great Depression.
The central belief of Keynesian economics is that government intervention can stabilize the
economy. Keynes’ theory was the first to sharply separate the study of economic behavior and
individual incentives from the study of broad aggregate variables and constructs.
Based on his theory, Keynes advocated for increased government expenditures and lower taxes
to stimulate demand and pull the global economy out of the Depression.
Subsequently, Keynesian economics was used to refer to the concept that optimal economic
performance could be achieved and economic slumps could be prevented by influencing
aggregate demand through economic intervention by the government.
Keynesian economists believe that such intervention can result in full employment and price
stability.
C. Neoclassical Macroeconomics
The idea of the neoclassical school of thought was not different from the classical school. The
only difference between the two schools of thought is the contribution that is made by Marshall
on ‘absolute and comparative advantage’ of nations in international trade.
