CHAPTER ONE: INTRODUCTION TO MACROECONOMICS

CHAPTER ONE

INTRODUCTION TO MACROECONOMICS

1.1. What Macroeconomics is about?

Economics is the study of the economy and the behavior of people in the economy. Traditionally,
economics is divided into microeconomics, which studies the behavior of individuals and
organizations (consumers, firms and the like) at a disaggregated level, and macroeconomics,
which studies the overall or aggregate behavior of the economy. Since our interest here is with
macroeconomics, we seek to explain phenomena such as inflation, unemployment, and economic
growth and we are not concerned with, say, the demand for or supply of a specific commodity.
Macroeconomics is concerned with the behavior of the economy as a whole- with booms and
recessions, the economy’s total output of goods and services and the growth of output, the rate of
inflation and unemployment, the balance of payments, and exchange rates. Macroeconomics
focuses on the economic behavior and policies that affect consumption and investment, trade
balance, the determinants of changes in wages and prices, monetary and fiscal policies, the
money stock, government budget, interest rate, and national debt.

In macroeconomics, we do two things.

✓ First, we seek to understand the economic functioning of the world we live in; and,
✓ Second, we ask if we can do anything to improve the performance of the economy.
That is, we are concerned with both explanation and policy prescriptions. Explanation involves
an attempt to understand the behavior of economic variables, both at a moment in time and as
time passes. Modern macroeconomics recognizes that it is important to focus on more than just
short period of time, and so has an explicitly dynamic focus. We thus try to explain the behavior
of economic variables over time. This means that we wish to explain the behavior of the
economy both in the long run and in the short run.

1.2.Macroeconomic Goals and Instruments

What are the basic macroeconomic goals that any nation wants to fulfill through different
economic policy instruments?
a) Economic Growth: - produce more and better services, or, more simply, develop a higher
standard of living.

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b) Full Employment: - Provide suitable jobs for all citizens who are willing and able to
work. c) Economic efficiency: - Achieve the maximum fulfillment of wants using the
available productive resources
d) Price level stability: - stability: - Avoid large upswings and downswings in the general
price level that is to avoid inflation and deflation.
e) Equity: - Ensure that no group of citizens faces stark absolute poverty while others enjoy
luxury.
f) Balance of trade: - seek a reasonable overall balance with the rest of the word in
international trade and financial transactions.
Nations use different policy instruments in order to achieve these and other goals.

1.3The State of Macroeconomics: Evolution and Recent Developments

The Development of Macroeconomics

Partly as a reaction to the Great Depression of the 1930’s and with the publication of Keyne’s
General Theory of Employment, interest and Money in 1936, modern macroeconomics
developed as analytical framework for understanding what causes fluctuations in the levels of
employment and output.

What economic theory needed during the 1930’s was an explanation of the disastrous experience
of those years. How could an economy plunge to a predicament in which a quarter of a nation’s
resources were idle? Keynes provided a theory to explain this phenomenon. It was so successful
that it began a Keynesian era in macroeconomic theory that stood in sharp contrast to the
classical theory that had prevailed over the preceding century or more.

During the decade, following the appearance of the General Theory of Keynes, economists
addressed themselves to refining and building on the pioneer work of Keynes, to analyzing the
complex economic processes that determine the actual level of employment. This was a major
shift from early held belief that the economy, through forces of competitive market, will remain
uninterruptedly at full utilization (full employment).

The accepted economic theory of the pre-Keynesian era argued that full employment was the
normal state of affairs and that departure from this were strictly temporary.

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Schools of Thoughts in Macroeconomics

Following the appearance of the General Theory of Keynes, macroeconomic theory could be
neatly divided into two parts: Classical and Keynesian. Keynes chooses to contrast the ideas he
presented in the General Theory with the prevailing ideas by labeling them as classical.

In economic theory, the term “Classical” had been coined by Karl Marks, who used it to cover
the theories of David Ricardo, James Mill and their predecessors. Keynes extended the term to
include the followers of Ricardo, who perfected the theory of the Ricardian economics, like
J.S.Mill, Marshal, Edge Worth, and Pigou.

Despite the tremendous success of Keynes work, it did not by any means put an end to the
further development of classical macroeconomics. New and different formulations of Classical
theory appeared under the heading neoclassical in 1870s. Beginning in 1950s another extension
of classical macro-economic theory has emerged. This theory is known as monetarism, so called
because of the critical role it assigns to money as a determinant of what happens in the economy.
Finally, in 1970s came the latest theoretical development with roots in classical theory-the New
Classical Economics.

As these developments were occurring on the classical side, there were also changes on the
Keynesian side. Over the years following the publication of the General theory, economists
refined and extended the many insights contained in it and gradually built what is known as
Keynesian economics. Keynesian economics has also two groups: Neo-Keynesian (members of
this school are predominantly British) and Post-Keynesians (members are predominantly
Americans).

So much is about the development of Macroeconomic thought. Based on the current debates, it is
possible to classify the schools of thought into two:

✓ The New Classical School

✓ The New Keynesian School

So far, it has been tried to highlight the evolution of macroeconomic thinking over time. Now,
let’s consider somewhat deeper analysis of macroeconomic thinking of each school emphasizing
major tenets and policy implications of the same.

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1. Classical (1776 – 1870)

In this period the distinction between micro and macro was not clear. The ruling principle was
the invisible hand coined by Alfred Marshall. The Classical have made an ample contribution to
the development of economic science. They felt the market was self-adjusting.

o With regard to the labor market, they contend that labor demand and labor supply are
brought into equilibrium by the real wage. As a result, there is no involuntary
unemployment.
o With regard to the financial market, for Classical saving and investment are brought into
equilibrium by the interest rate and investment responds to the interest rate. In the money
market, money demand is simply a transaction demand and money has no any effect on the
real economy and hence raising the money supply simply pushes up prices (i.e.
inflationary). In general, for this school markets (be it, commodity, factor, and money)
works best if left to themselves.
Implication
Government has no any role in the economy through its fiscal and monetary policy. To this end,
the classical are the proponents of laissez-faire (no government role).
Influential Classical Economists Include:

✓ David Hume (1711-1776), Adam Smith (1723-90), Thomas Malthus (1766-1834), David
Ricardo (1772-1823), John Stuart Mill (1806-1873), Karl Marx (1818-1883), Alfred
Marshall (1842-1924), and Arthur Pigou (1877-1959).

2. Neo-classical 1870–1936: Basically, the neoclassical school is not different from the
classical school. The main distinction is the tool of analysis, such as the marginal analysis. In
the area of growth theory; they gave us neoclassical growth models. Eg: Solow growth model
3. Keynesian Macroeconomics (1936 – 1970s)
Influential Keynesian Economists Include:

✓ John Maynard Keynes (1883-1946), Paul Samuelson (1915-),

✓ James Tobin (1918-), and Franco Modigliani (1918- ),

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The main theme of the Keynesian stream is that the economy is subjected to failure so that it may
not achieve full employment level. Thus, government intervention is inevitable. This school
views the labor market in that workers and firms bargain for a money wage, not for real wage.
Money wages adjust slowly and workers resist any drop in the money wage. Unlike the
Classical, for Keynesians saving and investment are brought into equilibrium by changes in
income. Investment is not influenced by a mere change in interest rate; rather it is affected by
expectations of the future, which is uncertain. Money demand is affected by transactions, but
also by other things, in particular fear, which may lead to a “speculative demand” for high
money balances. With regard to the role of the government, Keynes argued that the government
role was needed to preserve capitalism because without management, a modern capitalist
economy is so unstable that it may threaten the social compact that it rests on.

❑ In short, the following are the Principal Tenets of the Keynesian school:

❖ Keynesians believe that AD is influenced by a host of economic decisions – both public

and private.

❖ Changes in AD, whether anticipated or unanticipated, have their greatest short-run impact
on real output and employment, not on prices.

❖ Keynesians believe that prices and especially wages respond slowly to changes in supply
and demand, resulting in shortages and surpluses,

❖ Keynesians are more concerned about combating unemployment than about conquering
inflation.

Policy Implication

✓ During recessions, government should satisfy peoples demand for more cash preventing the
downward spiral of shrinking income and shrinking spending via monetary expansion. But
Keynes worried that even this might sometimes not be enough, particularly if a recession had
been allowed to get out of hand and become a true depression. Once the economy is deeply
depressed, households and especially firms may be unwilling to increase spending no matter
how much cash they have; they may simply add any monetary expansion to their hoarding.
Such a situation, in which monetary policy has become ineffective, has come to be known as
a “liquidity trap”. In such a case, the government has to do what the private sector will not:
spend. When monetary expansion is ineffective, fiscal expansion must take its place. Such

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a fiscal expansion can break the vicious circle of low spending and low incomes and getting
the economy moving again.
4. 1970s – Present.

There is no dominant school of thought of macroeconomics. There have been two main
intellectual traditions in macroeconomics. One school of thought believes that government
intervention can significantly improve the operation of the economy; the other believes that
markets work best if left to themselves. In the 1960s, the debate on these questions involved
Keynesians, including Franco Modigliani and James Tobin, on one side, and monetarists, led by
Milton Friedman, on the other. In the 1970s, the debate on much the same issues brought to the
fore a new group- the new classical macroeconomists, who by and large replaced the monetarists
in keeping up the argument against using active government policies to try to improve economic
performance. On the other side are the new Keynesians; they may not share some of the detailed
belief of Keynesians, except the belief that government policy can help the economy perform
better.

5. Monetarism

Influential Monetarists Include:

✓ Milton Friedman (1912-), &Karl Brunner (1916- )

✓ Allan Meltzer (1928-), &David Laidler (1938-)

Monetarism, as advocates of free market, started challenging Keynes’s theory in the 1970s.
Milton Friedman, the founder of monetarism, attacked Keynes idea of smoothing business cycle
on the ground that such active policy is not only unnecessary but actually harmful, worsening the
very economic instability that it is supposed to correct, and should be replaced by simple,
mechanical monetary rules. This is the doctrine that came to be known as “monetarism.”
Friedman began with a factual claim: most recessions, including the huge slump that initiated
the Great Depression, did not follow Keynes’s script. That is, they did not arise because the
private sector was trying to increase its holdings of a fixed amount of money. Rather, they
occurred because of a fall in the quantity of money in circulation. With regard to the labor
market, while not putting forward his own theory of the labor market, Friedman argues that

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people do tend to think in real terms and not in nominal amounts. Friedman had a strong faith in
the ability of the private sector to produce growth and stability if it is not constrained by
government. Friedman is a libertarian, opposed to government interference on principle.

Policy Rule under Monetarism

If economic slumps begin when people spontaneously decide to increase their money holdings,
then the monetary authority must monitor the economy and pump money in when it finds a
slump is imminent. If such slumps are always created by a fall in the quantity of money, then the
monetary authority need not monitor the economy; it need only make sure that the quantity of
money doesn’t slump. In other words, a straightforward rule- “Keep the money supply steady”-
is good enough, so that there is no need for a “discretionary” policy of the form, “Pump money
in when your economic advisers think a recession is imminent.” Thus, for Monetarists,
depressions were the consequence of a temporary shortage of money and this implied that
monetary policy was of prime importance in determining the aggregate level of output and
employment.

6. The New Classical School(1980s)

Influential New Classical Economists include:

✓ Robert Lucas (1937- ), Neil Wallace (1939- ),

✓ Thomas Sargent (1943- ), Robert Barro (1944- )

The new classical macroeconomics remained influential in the 1980s. This school of
macroeconomics shares many policy views with Friedman. It sees the world as one in which
individuals act rationally in their self-interest in markets that adjust rapidly to changing
conditions. The government is claimed, likely only to make things worse by intervening. The
central working assumptions of the new classical school are:

1. Economic agents maximize. Households and firms make optimal decisions given all
available information in reaching decisions and that those decisions are the best possible in
the circumstances in which they find themselves.
2. Expectations are rational, which means they are statistically the best predictions of the
future that can be made using the available information. Rational expectations imply that

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people will eventually come to understand whatever government policy used, and thus that
it is not possible to fool most of the people all the time or even most of the time.
3. Markets clear. There is no reason why firms or workers would not adjust wages or prices if
that would make them better off. Accordingly, prices and wages adjust in order to equate
supply and demand; in other words, market clear. For instance, any unemployed person who
really wants a job will offer to cut his or her wage until the wage is low enough to attract an
offer from some employer. Similarly, anyone with an excess supply of goods on the shelf
will cut prices so as to sell. The essence of the new classical approach is the assumption that
markets are continuously in equilibrium.
7. The New Keynesian Macroeconomics (1980s)
Influential New Keynesians include:

✓ Edmund Phelps (1933-), David Romer

✓ Greg Mankiw(1958-), Stanley Fischer (1943-),
✓ John B. Taylor (1946-), Olivier-Jean Blanchard (1948-),

New Keynesian economics is the school of thought in modern macroeconomics that evolved
from the ideas of John Maynard Keynes. Keynes wrote The General Theory of Employment,
Interest, and Money in the thirties, and his influence among academics and policymakers
increased through the sixties. In the seventies, however, new classical economists such as Robert
Lucas, Thomas J. Sargent, and Robert Barro called into question many of the principles of the
Keynesian revolution. The label "new Keynesian" describes those economists who, in the
eighties, responded to this new classical critique with adjustments to the original Keynesian
tenets.

The new classical group remains highly influential in today’s macroeconomics. But a new
generation of scholars, the new Keynesians, mostly trained in the Keynesian tradition but moving
beyond it, emerged in the 1980s. They do not believe that markets clear all the time but seek to
understand and explain exactly why markets fail.

The new Keynesians argue that markets sometimes do not clear even when individuals are
looking out for their own interests. Both information problems and costs of changing prices lead

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to some price rigidities, which help cause macroeconomic fluctuations in output and
employment.

The primary disagreement between new classical and new Keynesian economists is over how
quickly wages and prices adjust. New classical economists build their macroeconomic theories
on the assumption that wages and prices are flexible. They believe that prices "clear" markets—
balance supply and demand—by adjusting quickly. New Keynesian economists, however,
believe that market-clearing models cannot explain short-run economic fluctuations, and so they
advocate models with "sticky" wages and prices. New Keynesian theories rely on this stickiness
of wages and prices to explain why involuntary unemployment exists and why monetary policy
has a strong influence on economic activity.

A long tradition in macroeconomics (including both Keynesian and monetarist perspectives)

emphasizes that monetary policy affects employment and production in the short run because
prices respond sluggishly to changes in the money supply. According to this view, if the money
supply falls, people spend less money, and the demand for goods falls. Because prices and wages
are inflexible and don't fall immediately, the decreased spending causes a drop-in production and
layoffs of workers. New classical economists criticized this tradition because it lacked a
coherent theoretical explanation for the sluggish behavior of prices. Much new Keynesian
research attempts to remedy this omission.

A. Menu Costs and Aggregate-Demand Externalities

One reason that prices do not adjust immediately to clear markets is that adjusting prices is
costly. To change its prices, a firm may need to send out a new catalog to customers, distribute
new price lists to its sales staff, or in the case of a restaurant, print new menus. These cost of
price adjustment, called "menu costs," cause firms to adjust prices intermittently rather than
continuously.

Economists disagree about whether menu costs can help explain short-run economic fluctuations.
Skeptics point out that menu costs usually are very small. They argue that these small costs are
unlikely to help explain recessions, which are very costly for society. Proponents reply that small

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does not mean inconsequential. Even though menu costs are small for the individual firm, they
could have large effects on the economy as a whole.

Proponents of the menu-cost hypothesis describe the situation as follows. To understand why
prices, adjust slowly, one must acknowledge that changes in prices have externalities—that is,
effects that go beyond the firm and its customers. For instance, a price reduction by one firm
benefits other firms in the economy. When a firm lowers the price it charges, it lowers the
average price level slightly and thereby raises real income. (Nominal income is determined by
the money supply.) The stimulus from higher income, in turn, raises the demand for the products
of all firms. This macroeconomic impact of one firm's price adjustment on the demand for all
other firms' products is called an "aggregate-demand externality." Firms which do not lower
their prices causes real aggregate demand to be lower in recessions than it would be
otherwise; if all firms were to lower their prices together, real balances would rise and real
demand for all firms’ output would increase. Thus, aggregate demand externality due to
firms’ inability to reduce prices explains fluctuations in aggregate output and employment.

In the presence of this aggregate-demand externality, small menu costs can make prices sticky,
and this stickiness can have a large cost to society. Suppose that General Motors announces its
prices and then, after a fall in the money supply, must decide whether to cut prices. If it did so,
car buyers would have a higher real income and would, therefore, buy more products from other
companies as well. But the benefits to other companies are not what General Motors cares about.
Therefore, General Motors would sometimes fail to pay the menu cost and cut its price, even
though the price cut is socially desirable. This is an example in which sticky prices are
undesirable for the economy as a whole, even though they may be optimal for those setting
prices.

B. The Staggering of Prices

New Keynesian explanations of sticky prices often emphasize that not everyone in the economy
sets prices at the same time. Instead, the adjustment of prices throughout the economy is
staggered. Staggering complicates the setting of prices because firms care about their prices

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relative to those charged by other firms. Staggering can make the overall level of prices adjust
slowly, even when individual prices change frequently.

Consider the following example. Suppose, first, that price setting is synchronized: every firm
adjusts its price on the first of every month. If the money supply and aggregate demand rise on
May 10, output will be higher from May 10 to June 1 because prices are fixed during this
interval. But on June 1 all firms will raise their prices in response to the higher demand, ending
the three-week boom.

Now suppose that price setting is staggered: Half the firms set prices on the first of each month
and half on the fifteenth. If the money supply rises on May 10, then half the firms can raise their
prices on May 15. Yet because half of the firms will not be changing their prices on the fifteenth,
a price increase by any firm will raise that firm's relative price, which will cause it to lose
customers. Therefore, these firms will probably not raise their prices very much. (In contrast, if
all firms are synchronized, all firms can raise prices together, leaving relative prices unaffected.)
If the May 15 price setters make little adjustment in their prices, then the other firms will make
little adjustment when their turn comes on June 1, because they also want to avoid relative price
changes. And so on. The price level rises slowly as the result of small price increases on the first
and the fifteenth of each month. Hence, staggering makes the price setting sluggish, because no
firm wishes to be the first to post a substantial price increase.

C. Coordination Failure

Some new Keynesian economists suggest that recessions result from a failure of coordination.
Coordination problems can arise in the setting of wages and prices because those who set
them must anticipate the actions of other wage and price setters. Union leaders negotiating
wages are concerned about the concessions other unions will win. Firms setting prices are
mindful of the prices other firms will charge.

To see how a recession could arise as a failure of coordination, consider the following parable.
The economy is made up of two firms. After a fall in the money supply, each firm must decide
whether to cut its price. Each firm wants to maximize its profit, but its profit depends not only on
its pricing decision but also on the decision made by the other firm.

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If neither firm cuts its price, the amount of real money (the amount of money divided by the
price level) is low, a recession ensues, and each firm makes a profit of only fifteen dollars.

If both firms cut their price, real money balances are high, a recession is avoided, and each firm
makes a profit of thirty dollars. Although both firms prefer to avoid a recession, neither can do so
by its’ own actions. If one firm cuts its price while the other does not, a recession follows. The
firm making the price cut makes only five dollars, while the other firm makes fifteen dollars.

The essence of this parable is that each firm's decision influences the set of outcomes available to
the other firm. When one firm cuts its price, it improves the opportunities available to the other
firm, because the other firm can then avoid the recession by cutting its price. This positive
impact of one firm's price cut on the other firm's profit opportunities might arise because of an
aggregate-demand externality.

What outcome should one expect in this economy? On the one hand, if each firm expects the
other to cut its price, both will cut prices, resulting in the preferred outcome in which each
makes thirty dollars. On the other hand, if each firm expects the other to maintain its price, both
will maintain their prices, resulting in the inferior solution, in which each makes fifteen dollars.
Hence, either of these outcomes is possible: there are multiple equilibrium.

The inferior outcome, in which each firm makes fifteen dollars, is an example of a
coordination failure. If the two firms could coordinate, they would both cut their price and reach
the preferred outcome. In the real world, unlike in this parable, coordination is often difficult
because the number of firms setting prices is large. The moral of the story is that even though
sticky prices are in no one's interest, prices can be sticky simply because people expect them to
be.

D. Efficiency Wages

Another important part of new Keynesian economics has been the development of new theories
of unemployment. Persistent unemployment is a puzzle for economic theory. Normally,
economists presume that an excess supply of labor would exert a downward pressure on wages.
A reduction in wages would, in turn, reduce unemployment by raising the quantity of labor

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demanded. Hence, according to standard economic theory unemployment is a self-correcting

problem.

However, New Keynesian economists often turn to theories of what they call efficiency wages to
explain why this market-clearing mechanism may fail. These theories hold that high wages make
workers more productive. The influence of wages on worker efficiency may explain the failure
of firms to cut wages despite an excess supply of labor. Even though a wage reduction would
lower a firm's wage bill, it would also—if the theories are correct—cause worker productivity
and the firm's profits to decline.

Let’s mention three of the various theories about how wages affect on workers’ productivity.

1. One efficiency-wage theory holds that high wages reduce labor turnover. Workers quit jobs
for many reasons—to accept better positions at other firms, to change careers, or to move to
other parts of the country. The more a firm pays its workers, the greater their incentive to
stay with the firm. By paying a high wage, a firm reduces the frequency of quits, thereby
decreasing the time spent hiring and training new workers.
2. The average quality of a firm's work force depends on the wage it pays its employees. If a
firm reduces wages, the best employees may take jobs elsewhere, leaving the firm with less
productive employees who have fewer alternative opportunities. By paying a wage above the
equilibrium level, the firm may avoid this adverse selection, improve the average quality of
its work force, and thereby increase productivity.
3. A high wage improves workers’ effort. This theory posits that firms cannot perfectly monitor
the work effort of their employees and that employees must themselves decide how hard to
work. Workers can choose to work hard, or they can choose to shirk and risk getting caught
and fired. The firm can raise worker effort by paying a high wage. The higher the wage, the
greater is the cost to the worker of getting fired. By paying a higher wage, a firm induces
more of its employees not to shirk and, thus, increases their productivity.

Policy Implications

Because new Keynesian economics is a school of thought regarding macroeconomic theory, its
adherents do not necessarily share a single view about economic policy. At the broadest level

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new Keynesian economics suggests—in contrast to some new classical theories—that recessions
do not represent the efficient functioning of markets. The elements of new Keynesian economics,
such as menu costs, staggered prices, coordination failures, and efficiency wages, represent
substantial departures from the assumptions of classical economics. In new Keynesian theories
recessions are caused by some economy-wide market failure. Thus, new Keynesian economics
provides a rationale for government intervention in the economy, such as countercyclical
monetary or fiscal policy.

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