Chapter One: Introduction to Macroeconomics

❖ Macroeconomics
❖ Nature and Scope of Macroeconomics
❖ Microeconomics vs Macroeconomics
❖ Macroeconomic Performance: Key indicators of macroeconomics
❖ Business Cycle: Stylized Representation
❖ Macroeconomic Policy: Different concepts of macroeconomic policies
❖ Development of Macroeconomic Thought: Classical Theory, Keynesian Revolution,
Monetarism, Supply side economics, Rational Expectation Theory.
 Macroeconomics

▪ Greek word ‘makros’ means ‘large’.

▪ Macroeconomics is the study of the behavior of entire economy (economy as a whole), concerning
the determination of aggregate and average figures in the economy.

▪ Rather than looking at the price and output of a single company, macroeconomics studies the
overall price level, GDP, unemployment level and other things that we call economic aggregates.
 Nature and Scope of Macroeconomics

Macroeconomics is the study of the economy as a whole.

• Rather than discussing the efficiency in resource used at individual level like Microeconomics,
Macroeconomics deals with the efficiency in resource used at level of entire economy.
• Macroeconomics focuses on aggregation through combining many individual markets into one overall
market.
• It examines total level of expenditure and total level of production, that is, it looks at aggregate
demand and aggregate supply.
• Macroeconomics deals with general price level. In particular, in Macroeconomics, we want to know
what causes general price level to rise, that is, what causes inflation.
As a study of the economy as a whole, Macroeconomics is concerned with-
• booms and recessions
• the economy’s total output of goods and services
• the growth of output
• the rate of inflation and unemployment
• the balance of payment and exchange rates.
• monetary and fiscal policies
 3. Distinguish between Microeconomics and Macroeconomics.

1. Greek word ‘mikros’ means small and ‘makros’ means ‘large’.

Thus microeconomics deals with the analysis of small individual units of the economy (such as
individual consumers, individual firms) and small group of individual units of the economy
(such as various industries and market).
On the other hand, Macroeconomics is concerned with the economic activity in the large.

2. It’s a microscopic study of the economy (looking at the economy through a microscope). It
does not study the economy in its totality.
Macroeconomics analyses the behavior of the whole economic system- through a wide
lens/holistic approach/ in totality / economy as a whole.
 3. Distinguish between Microeconomics and Macroeconomics.

3. Individual or particular quantities vs. Aggregate quantities.

4. Example :
✓ Microeconomics deals with efficiency in resource use at individual level.
Macroeconomics deals with efficiency in resource use at aggregate level, that is, at the level of the
economy as a whole.

✓ How prices of the commodities are determined is discussed in Microeconomics.

In Macroeconomics, we still examine the determination of price, but now it is the general price level.

✓ In Microeconomics, we study what determines the relative quantities produced.

In Macroeconomics, we still examine output, but now it is national output.

✓ In Microeconomics, demand and supply of different commodities are studied separately.

In Macroeconomics, we still study the demand and supply, but now it is total level of expenditure and
total level of production. In other words, we examine aggregate demand and aggregate supply.
5. A key distinction between microeconomics and macroeconomics is that macroeconomic aggregates can
sometimes behave in very different ways or even the opposite of similar microeconomic variables.
❖ Here comes the importance of dealing the macroeconomic issues as a separate approach.

Need for separate approaches:

Need for different approaches in study of economics arises from the common misconception that “what is
true for the individual or part is also necessarily true for the group or whole.”
Example:
1. If price of one commodity rises, its producer will gain. But if the prices of all commodities rise in the same
proportion, nobody may gain.
2. If due to hard work and good weather a single farmer grows a good crop of rice, his income will rise. But if
all farmers get bumper crop, the market supply of rice will rise and price will fall. So, the income of all
farmers may decrease instead of increasing.
3. New Pay-scale in 2015 for govt. employee: rise in income in a larger part of the population drives the
economy to inflation that bears not as much fruit for the employees as expected.
4. Keynes referenced the Paradox of Thrift, which argues that individuals save money to build wealth on a
microeconomic level. However, when everyone tries to increase their savings at once, it can contribute to
a slowdown in the economy and less wealth in the aggregate, macroeconomic level.
 Major Macroeconomics Issues

Major Macroeconomics issues are-

1. Economic Growth
2. Unemployment
3. Inflation
4. Stagflation
5. Business Cycle
6. Balance of Payment and Exchange Rate.

1. Economic Growth
Economic growth occurs when an economy is able to produce more goods and services for each
consumer.

Growth Rate: The growth rate of an economy refers to the percentage increase in output or national
income over a certain time period usually a year.
When the growth rate is positive, the economy is growing meaning that people have more goods and
services than they had. When the growth rate is negative, it means a fall in output and in this case the
economy slides into recession.
We can measure the growth rate of an economy using the following formula- G= [(Y1- Y0)/Y0]×100
Where, Y1=output level at period-1, Y0=output level at previous period (period-0)
 2. Unemployment

The term unemployment refers to a situation where a person searches for employment/job but is
unable to find any work/job. Unemployment is a central issue in Macroeconomics. Because it signals
the ability (or inability) of workers to obtain work and contribute to the productive output of the
economy. More unemployed workers mean less total economic production.

The costs of unemployment are many. It may cause psychological and even physical disorders,
divorces, suicides and crime. Social harmony may be disturbed. Moreover, the economy is deprived
from the possible production that could be produced by the unemployed persons if they are
employed. Definitely, unemployment is a problem and Macroeconomics pays a great deal of attention
to both the causes of and cures for unemployment.
 3. Inflation
Inflation refers to a sustained increase in the general price level. When there is inflation, purchasing
power of the people of an economy falls due to which it becomes difficult to maintain the standard of
living as they maintained.

Moreover, fixed income earners lose their income in terms of real sense and borrowers gain from inflation.
In this way inflation redistributes income. Inflation is another problem of an economy and an important
issue of Macroeconomics. Macroeconomics pay its attention to a greater extend both to the causes of and
cures for inflation.

4. Stagflation

stagflation is the coexistence of unemployment and inflation. When

output falls, unemployment rises along with the rise in price level, it
is called stagflation. It is completely a supply side phenomenon.

While there is a fall in aggregate supply, aggregate supply curve

shifts inward as shown in figure, pushes up the price level and output
level falls, unemployment rises, stagflation generates.
 5. Business Cycle or Trade Cycle

A tendency for alternating periods of upward and downward movements in the aggregate level of
output and employment (GDP), relative to their long-term trends (natural growth rate) is often
referred to as trade cycle.

Business cycles refer to fluctuations in output and employment with alternating periods of boom and
recession. In the periods of boom, both output and employment are at high levels, whereas in recession
periods both output and employment fall and as a consequence there exists a large unemployment in
the economy.
In figure, a stylized (symbolic/non-naturalistic) representation of the relationship between actual and
potential output during a typical trade cycle is shown.

The economy slips into recession at point A. A recession is a

downturn in economic activity during which demand falls off and as
a result production and employment fall.

Economy bottoms out around B which refers to trough which is

characterized by high unemployment and a level of demand that is
low in relation to the economy’s capacity to produce.

Economy is in a recovery period until point D, during which

employment, income, consumption expenditure all begin to rise,
expectations become more favorable as a result of increase in
production, sales and profit.

After point D, it enters an inflationary boom and lasts until point E.

These are the four phases of trade cycle.

 6. Balance of Payment and Exchange Rate

The balance of payments summarizes the economic transactions of an economy with the rest of the world.
It is the difference between all money flowing into the country (exports) in a particular period of time and
the outflow of money (imports) to the rest of the world. It includes exports and imports of goods, services
and financial assets, along with transfer payment (like foreign aid).

If we import more than we export, there will occur a BOP deficit and if no step is taken by the central
authority, there must occur a fall in the (direct) exchange rate*.

BOP deficit and fall in exchange rate- both are problems. The fall in exchange rate pushes up the price of
imports and may fuel inflation. Moreover, fluctuations in exchange rate can cause uncertainty for trades and
can damage international trade and economic growth.

This is why BOP and exchange rate is a matter of great concern to the policy makers.

*An Exchange rate is a relative price of one currency expressed in terms of another currency.
 Macroeconomic Policy: Different concepts of macroeconomic policies.

Objectives

Output: High level and rapid growth of output

Employment: High level of employment/ low involuntary unemployment

Price-level stability: stable price level

Instruments

Monetary Policy: controlling the money supply to determine the interest rate

Fiscal Policy: Government expenditure & Taxation

 Macroeconomic Policy: Different concepts of macroeconomic policies.

When it comes to influencing macroeconomic outcomes, governments have typically relied on one of
two primary courses of action: monetary policy or fiscal policy.

Monetary policy involves the management of the money supply and interest rates by central bank. To
stimulate a faltering (weak) economy, the central bank will cut interest rates, making it less expensive
to borrow while increasing the money supply. If the economy is growing too rapidly, the central bank
can implement a tight/contractionary monetary policy by raising interest rates and removing money
from circulation.

Fiscal policy involves two main tools: taxes and government expenditure. To spur the economy and
prevent a recession, a government will reduce taxes in order to increase consumer spending. The
fewer taxes paid, the more disposable income citizens have, and that income can be used to spend on
the economy. A government will also increase its own spending, such as on public infrastructure,
transfer payment or subsidy to prevent a recession.
 Work out session

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 Schools of Thought

1. Classical School

▪ Classical Macroeconomic theory stems from Adam Smith’s pioneering work ‘An Inquiry into the
Nature and Causes of the Wealth of Nations’ published in 1776.
▪ Prices, wages, and interest rates are kept flexible and markets tend to clear unless prevented
from doing so by government policy. Free Policy,No interfereing.
▪ This theory says that given laissez-faire unemployment and inflation are temporary
phenomena. In the long-run (if the economy is given enough time) the economy will remain
close to full employment of its resources and enjoy a stable level of prices.
This theory dominates during the late eighteenth through the early twentieth centuries.
 2. Keynesian School/Keynesian Revolution

✓ Given laissez-faire, the economy will operate at or near to its full employment and produces maximum
output. It is the theme of Classical theory. But during the great depression of 1930s, the industrial
production, real income and employment continued to decline and Classical self-correcting
Macroeconomic system did not appear to work.
Govt expenditure and TAxation

✓ But it was British economist J. M Keynes, who advocated the use of government fiscal policies to
supplement private spending as a cure of ailing economy.

✓ Keynes (1883-1946) was firmly convinced that, contrary to Classical theory, market forces would not be
sufficient enough to remain full employment in the depressed economy. He dismissed the long run self
adjustment theory of Classical economists, as he said ‘in the long run we are all dead’.

✓ Since the Classical theory, did not offer rescue from the depression, Keynes sought a better model. In
1936, Keynes published his revolutionary work, ‘A general Theory of Employment, Interest and Money’,
which established a new theory of how the economy functions. Keynesian theory made a genuine break
from the Classical and Neo-Classical economics and produced such a fundamental change in economic
thinking that his Macroeconomic analysis earned the names ‘Keynesian Revolution’ and ‘New
Macroeconomics’.
 3. Post Keynesian Developments in Macroeconomics

a) Monetarism _Pratice of contolling the supply of money as the chief method of stabilizing the economy.

✓ Criticizing Keynesian macroeconomic theory, American economist Milton Friedman put forward
the view Monetarism. Monetarists argue that monetary policy is generally a more effective and
desirable policy tool to manage aggregate demand than fiscal policy.

✓ Monetarist viewed inflation as a monetary phenomenon. It causes due to rapid expansion of

money supply. In order to control inflation, Monetarists suggest a growth rate of money supply in
the economy which is equal to the growth rate of Gross Domestic product (GDP).

Thus, while Keynes supports fiscal policy, Monetarists oppose it and welcome monetary policy to
ensure economic stability.
b) Supply-Side Economics

✓ Keynesian theory focused on the fluctuation in aggregate demand and could explain either high
unemployment or high inflation. But it could not explain both high unemployment and high
inflation when they occurred together. When both the problem high unemployment and high
inflation occur together, it is called stagflation. It takes place due to the fall in aggregate supply
pushes the price level up reducing output level and thus generates unemployment. Therefore, it
requires a supply side fluctuation to fight the unemployment and inflation problems.

✓ Advocates of supply-side economies argued that for the expansion of aggregate supply, incentives
to work, save and invest more is required to be promoted. The increase in aggregate supply, given
the aggregate demand curve will lead to the increase in employment and reduce the inflation as
well. Obviously, higher income tax serve as disincentives to work, save and invest more, and thus it
should be reduced advocated by supply-side economists.
c) Neo-Classical Macroeconomics: Rational Expectation Theory

✓ The New Classical school is mainly built on integrating microeconomic foundations into
macroeconomics to resolve the theoretical contradictions between the two subjects. It assumes
that all agents try to maximize their utility and have rational expectations, which they incorporate
into macroeconomic models. Consumers, workers and producers behave rationally to promote their
interests and welfare. Based on their rational expectations, they make rapid adjustment in their
behavior with the new incidence.

✓ If money supply is increased by the central bank, consumers, workers and producers will expect
rationally that price will rise. On the basis of rational expectations, workers would get their wages
raised, landlords will raise their rent, lenders and bankers will increase their rate of interest, and
producers will raise their profit margins. Through the adjustment of different agents of an economy,
the expansionary effects of money supply will be dampened.

As the adverse effects of any economic situation are gone out through the adjustment of the
participants, there is no need of taking any fiscal measure by the Government and the activist role of
the Government is opposed by the supporters of rational expectation theory as like Friedman and other
Monetarists.