Macroeconomics

Session 1

Atul Mehta

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 What Is Macroeconomics?

• Macroeconomics is the study of behavior of the economy

as a whole and the policy measures that the government
uses to influence it

• Macroeconomic variables - total output, rates of unemployment

and inflation, and exchange rates

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 The Origin of Macroeconomics
• The Classical Economics
• Assumption of full employment of labour and other resources –
no involuntary unemployment
• Say’s Law – Supply creates its own demand
• Wage-price flexibility - adjust to restore full employment
• Free market economy without government intervention
• Savings turn into investments determined by interest rates
• However, the great depression never self-corrected itself
• They even asserted on cutting down the wages during GD.

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 The Origin of Macroeconomics
• The Keynesian Economics – J.M. Keynes
• Wage cuts may expand employment in a particular industry but
not at aggregate level
• Attacked full employment assumption – aggregate demand
determines output – demand creates its own supply
• Prices and Wages are sticky downwards – money illusion, wage
contracts, trade unions, minimum wage laws, reduced worker
efficiency
• Government intervention is necessary
• Savings and investments determined differently and by different
groups with different motives
• Short-run view of the economy – in the long-run, we all are dead
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 Macroeconomic Aggregates and firm’s
decision-making
• Stable Aggregate Demand
• crucial for deciding on capacity and arriving at revenue stream.
• Stable Interest rates.
• to get a hold on the cost of money.
• Stable prices, i.e. rate of inflation.
• for getting an accurate estimate of costs and returns.
• Stable Tax rates.
• determines costs and prices
• Minimum fluctuations in Exchange rate.
• another cost variable.

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 Key Terminologies
• Output: total goods and services produced in an economy

• Potential Output/Full employment: what an economy can

produce when all its resources such as workforce,
equipment, technology, natural resources and others are
fully utilized

• Gross Domestic Product (GDP): GDP is the value of all

final goods and services produced in the country within a
given period.

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• Growth rate: the rate at which the gross domestic product
(GDP) is increasing

• Inflation: is the rate of change in the overall price level of

goods and services in an economy

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• Aggregate supply: the total supply of goods and services
produced in an economy

• Aggregate demand: the total demand for goods and

services to consume, for new investment, for goods
purchased by the government, and for net goods to be
exported abroad (after adjusting for imports).

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 Importance of Macroeconomics for
Managers
• To understand how an economy functions.
• What causes fluctuations in demand? What leads to instability in
interest rates, tax rates, exchange rates, and prices?

• To come to a judgment about the direction of government

policies.

• To arrive at a decision on timing of fresh investments,

takeovers, penetration to new markets etc.

• To get the best return on investment.

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Macroeconomic Policy Environment

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 Output of the U.S. Economy,
1929–2014.

The output of the U.S. economy has increased by more than 15 times
since 1929 and by more than 4 times since 1964.
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 Unemployment and Recessions in US

Unemployment increased significantly following the onset of each

recession

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 Typical Questions in Macroeconomics
• What determines the long-run economic growth?
• Why have many developing nations of Asia, Africa, and Latin
America not enjoyed the same rates of economic growth as the
industrialized countries?
• What causes business cycles (episodes of stronger and
weaker economic growth)?
• Why unemployment rates sometimes differ markedly from
country to country and what explains these differences?
• Can government policymakers do anything about them?

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Macroeconomics In Three Models

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 Macroeconomics In Three Models
• Study of macroeconomics is grounded in three models,
each appropriate for a particular time period
• Very Long Run Model: domain of growth theory  focuses on
growth of the production capacity of the economy
• All that matters is how quickly the economy grows on an average
• What explains:
• the 8 percent annual growth miracle of Japan in early post-war?
• China’s even more impressive growth over last few decades?
• Will China surpass the United States? Or will something else happen?
• Zimbabwe’s zero and even negative growth over many decades?

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 Very Long Run Growth
• Figure illustrates growth of income per person in the U.S. over last
century  growth of 2-3% per year
• Growth theory examines how the accumulation of inputs and
improvements in technology lead to increased standards of living
• Rate of saving is a significant determinant of future well being and
economic growth.

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 Growth and GDP
• The growth rate of the economy is the rate at which
GDP is increasing
• Growth in GDP is caused by:
• Increase in available resources
• Human Capital - education, training, experience, intelligence,
energy, and initiative that affects the a worker’s marginal product
• Physical capital – equipment and tools (such as machines and
factories) needed to complete one’s work
• Land and other natural resources
• Increase in the productivity of those resources (Technology)

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 Successful recovery of Germany and
Japan post-World War II?
Germany and Japan sustained extensive destruction of their
cities and industries during World War II and entered the
postwar period impoverished. Yet within 30 years both
countries not only had been rebuilt but had become
worldwide industrial and economic leaders. What accounts
for these “economic miracles”?
High levels of human capital played a crucial role in
both countries
Education
On-the-job training

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 Why is the average American so much
richer than the average Indian?

Differences in total efficiency units of labor and physical capital are important. If India had access to the
same technology as the United States, its GDP per worker would be $24,057 instead of $13,261, almost
twice as high. Increasing India’s total efficiency units of labor and physical capital to U.S. levels would
increase its income per worker by another 4.7 times.

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 The Long Run Model
• Long Run Model: a snapshot of the very long run model,
in which capital and technology are largely fixed
• The given level of capital and technology determine the level
of potential output
• Output is fixed, but prices determined by changes in AD

• What determines the inflation rate—the change in the

overall price level?
• Why do prices in some countries remain stable for many
years, while prices in other countries double every
month?
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 The Long Run Model
• In the long run, the AS curve is [Insert Figure 1-2 here]
vertical and pegged at the
potential level of output
• Output is determined by the
supply side of the economy and
its productive capacity
• The price level is determined by
the level of demand relative to the
productive capacity of the
economy
• Conclusion: very high rates of
inflation are always due to
changes in AD in the long run

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 Short Run Model
• Short Run Model: business cycle theories
• Changes in AD determine how much of the productive capacity
is used and the level of output and unemployment
• Prices are fixed in this period, but output is variable

• What is the reason behind the year-to year fluctuation in

output?
• Why did GFC occur, and what should governments have done to
reduce their severity?
• What caused worldwide stock markets to lose over half their
value in a year’s time?
• Why did so many major banks suddenly become insolvent?
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 The Short Run Model
• Short run fluctuations in output [Insert Figure 1-4 here]
are largely due to changes in
AD
• The AS curve is flat in the short
run due to fixed/rigid prices, so
changes in output are due to
changes in AD

• In the short run, AD determines

output, and thus unemployment

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 The Medium Run
• How do we get from the [Insert Figure 1-5 here]
horizontal short run AS curve
to the vertical long run AS
curve?
• The medium run AS curve is
tilting upwards towards the
long run AS curve position
• When AD pushes output above
the sustainable level, firms
increase prices
• As prices increase, the AS curve
is no longer pegged at a particular
price level

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The Business Cycle and the Output Gap
• Business cycle is the pattern of [Insert Figure 1-7 here]
expansion and contraction in
economic activity about the
path of trend growth
• Trend path of GDP is the path
GDP would take if factors of
production were fully utilized
• Deviation of output from the
trend is referred to as the
output gap
• Output gap = actual output –
potential output
• Output gap measures the
magnitude of cyclical deviations
of output from the potential level

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[Insert Figure 1-8 here]

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