Chapter I

Introduction
 Basic Concepts and Macroeconomic Analysis
 The State of Macroeconomics: Evolution and recent developments

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 Concepts of Macroeconomics
 Macroeconomics is the study of the economy as a whole and sub-aggregates of the
economy - including growth in incomes, changes in prices and the rate of unemployment.
 It is concerned with the behavior of the economy as a whole, i.e., 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 deals both with the long run economic growth and the short run
fluctuations that constitutes the business cycle.
 It focuses on the economic behavior and policies that governments use to try to 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.
 Issues Addressed by Macroeconomics
 Long run economic growth –
 Unemployment
 Inflation
 Business cycle
 The international economy
 Macroeconomic Policy
Measuring The Macroeconomic Performance
oMacroeconomic performance is judged by the three broad measures we have introduced: the inflation rate,
the growth rate of output (GDP), and the rate of unemployment.
 During periods of inflation;
 The prices of goods people buy are rising
 The living standard of citizens deteriorates
 Thus, it is a major political issue of every nation.
 Cont.
When the growth rate of output is high;
Good performance of the economy
Increase employment of resources
More production of goods and services
Improvements in living standard
Thus, it is a target goal and hope of every nation.
o During high unemployment rate;
Jobs are difficult to find
Unemployment of more resources
Decline in production of goods and services
Suffering of unemployed in their standard of living, personal distress, etc.
Thus, it is the number one social, economic and political issue.
Goals of Macroeconomics
Macroeconomics studies the working of an economy in aggregation or as a whole. It aimed
at how;
To achieve high economic growth
To reduce unemployment
To attain stable prices
To reduce budget deficit and balance of payment (BoP) deficit
To ensure fair distribution of income
Macroeconomic Policy Instruments
Policy measures are geared at achieving moderate inflation rate, keeping
unemployment rate low, balancing foreign trade, stabilizing exchange and interest
rates, etc and in general attaining stable and well-functioning macroeconomic
environment.
 Monetary Policy
 Monetary policy refers to the adoption of suitable policy regarding the control of money
supply and the management of credit which is important measure for adjusting aggregate
demand to control inflation.
 It is concerned with the money supply, lending rates and interest rates and is often
administered by a central bank.
 Open market operation, discount rate, and cash reserve ratio are monetary policy
instruments.
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.
Expenditure, tax and borrowing are fiscal policy instruments.
Income Policy
It refers government control of wages.
 The state of Macroeconmics:Evolution and recent development

School of thouhgts in Macreconomics

 There has 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
Classical economists (1776 – 1870)
 In this period the distinction betweem micro and macro economics was not clear
 The ruling principle was the invisible hand coined by Alfered Marshall.

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 Market force will determine real variable such as output, employment and prices and this will
be made possible by flexibility of price and wage levels.
 Believe that AS (aggregate supply) curve is vertical so that no change in equilibrium level of
output and employment (because price and nominal wage are flexible)
 The question is: how does the supply of aggregate output respond when the price level
increases?
 As P rises, there tends to be excess demand in the labor market if the nominal wage
remains unchanged (a lower real wage)
 For any price level, the nominal wage is fully flexible and adjusts to keep the supply
of labor and the demand for labor equilibrated.
 Wages are perfectly flexible, the nominal wage will rise by the same amount as the
price level in order to reestablish the market clearing real wage.

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 Thus, the real wage remains unchanged, as does the equilibrium level of employment and the
supply of output

 A market economy is self-equilibrating, it adjusts so that the supply of and demand for labor are
equated, and sustained states of involuntary unemployment cannot occur – at full employment
level.

 The economy’s output would always equal the full employment output (or what later economists
were to call the natural level of output.

 Any involuntary unemployment of resources would quickly lower resource prices and establish
full-employment – through an increase in quantity demanded, a decrease in quantity supplied, or a
combination of both.

 Changes in aggregate demand or aggregate supply would in no way alter this conclusion.
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 Under these circumstances, argued the classical economists, deliberate governmental
intervention to raise or lower aggregate demand makes no sense.
 Full employment is assured through flexible input prices.
 The sale of full employment output is assured through flexible output prices.
 A government that raised AD would only raise the price level, thus creating inflation.
 A government that lowered AD would only lower the price level, thus bringing about deflation.
 Its policy, however, would have no effect on output, employment, and unemployment. The
best policy, therefore, was one of “laissez-faire,” of leaving things alone.
 A greater labor supply, for example, would lower wages, so would a lower demand for labor
that might accompany a laborsaving technical advance.
 Given the higher aggregate supply of goods and an unchanged level of aggregate demand, the
extra physical output would quickly be sold at lower prices.
 Thus, “Supply would create its own demand,” as stated in say’s law.
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Neoclassical economists (1870 – 1936)
 This school of thought suggests that economic fluctuations can be explained while maintaining
classical assumptions of free market with little government intervention and endorsement of
classical ‘price and wage flexibility’
 i.e, basically this school is not different from the classical school
 The main distinction is the tool of analysis, such as the marginal analysis

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 The Keynesians (1936-1970)
 In 1936, in the midst of the Great Depression, the British economist John Maynrad Keynes
challenged the views of his classical predecessors in a now famous work, The General
Theory of Employment, Interest and Money.
 As Keynes saw it, despite massive involuntary unemployment of resources, no rapid
downward adjustment of resource prices was occurring to return the economy to full
employment.
 Among the reasons were minimum wage laws and widespread bargaining agreements
between firms and labor unions.
 In addition there was little evidence that say’s law was working well
 In such a situation of downward price inflexibility, argued Keynes, the classical prescription
of laissez-faire had become irrelevant.
 Government demand management now made sense.

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 In such a situation of downward price inflexibility, argued Keynes, the classical
prescription of laissez-faire had become irrelevant.
 Government demand management now made sense. The government, noted Keynes, had
two major tools in its possession to accomplish this desirable goal.
Monetary and fiscal policy
 Keynes concluded that concretionary government policies that reduced aggregate demand could
only make the depression worse.
 Yet in the 1930s, many governments were doing just that. They raised tax rates, reduced
government purchases, and lowered the money supply, which raised interest rates.
  In subsequent decades, Keynes gained many followers throughout the world who, naturally
enough, are called Keynesians.
 A list of well known Keynesians includes Paul Samuelson, Franco Modigliani and James Tobin
(all Nobel Prize Winners), as well as Arthur Okun, Walter Heller, and Gardner Ackley.
 These economists were optimistic that the government, by managing the level of aggregate
demand, could assure full employment without inflation year after year.
 The Keynesians, however, have not been without their critics.
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The Monetarists
 Economists such as Milton Friedman (Nobel Prize Winner), Karl Brunner, and Allen
Meltzer have argued that Keynesian interventionist policies designed to eliminate
unemployment are likely to do more harm than good.
 As they see it, the government, being neither all-knowing nor all-powerful, is unlikely to
succeed in establishing a long-run macro equilibrium.
 For instance the government may raise its own spending (G) and – through lower taxes,
higher transfer payments, and easier credit – stimulate private spending so much as to shift
the aggregate demand to the right and then to increase output.
 The resultant inflation may then induce the government to cut aggregate demand and the
reduce output.
 Such stop-go policies that continually turn the aggregate demand off and on, merely
aggravate the business cycle.

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 As monetarists see, a better policy would be a constitutional amendment that took all choice
away from “inevitably unskilled” fiscal policy makers and mandated an annual balancing of
the government budget.
 Beyond that the monetary authorities might be instructed by the parliament to increase the
money supply by fixed annual percentage, such as 3 percent, in order to accommodate
the gradual growth of the potential output over time.
 Because of their advocacy of the fixed money growth rule, these economists are also
known as monetarists.

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New Classical Macroeconomics
 The monetarist counterattack on Keynesian ideas was pushed even farther during the 1970s
and 1980s by the so-called school of new classical macroeconomics led by Robert Lucas,
Thomas Sargent, Robert Barro, Edward Prescott and Neil Wallace.
• It sees the world as one in which individuals act rationally in their self-interest in
markets that adjust rapidly to changing conditions.

• It argues that the government is only likely to make things worse by intervening.

• The central working assumptions of the new classical school are three: Economic
agents maximize, expectations are rational, and; markets clear

• The essence of this school is the assumption that markets are continuously in
equilibrium

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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, markets clear.

 One dramatic implication of these assumptions, which seem so reasonable individually, is

that there is no possibility for involuntary unemployment.

 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, any one with an excess supply of goods on the shelf will cut prices so as to sell.

 Flexible adjustment of wages and prices leaves all individuals all the time in a situation in
which they work as much as they want and firms produce as much as they want.

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 The essence of the new classical approach is the assumption that markets are
continuously in equilibrium.

 In particular new classical macroeconomists regard as incomplete or unsatisfactory any

theory that leaves open the possibility that private individuals could make themselves
better off by trading among themselves.

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The New Keynesians
 The new Keynesians, mostly trained in the Keynesian tradition but moving beyond it,
emerged in the 1980s.

 The group includes among others George Akerlof and Janet Yellen and David Romer of
the University of California. Berkely, Oliver Blanchard of MIT, Greg Mankiw and Lary
summers of Harvard and Ben Bernanke of Princeton University.

 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.

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 Both information problems and costs of changing prices lead to some price rigidities,
which help cause macroeconomic fluctuations in output and employment.

 For example, in the labor market, firms that cut wages not only reduce the cost of labor
but are also likely to wind up with poorer quality labor force.

 Thus they will be reluctant to cut wages.

 If it is costly for firms to change the prices they charge and the wages they pay, the
economy wide level of wages and prices may not be flexible enough to avoid occasional
periods of even high unemployment.

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• This group does not believe that markets clear all the time but seeks to understand
and explain exactly why markets can fail.
• They argue that markets sometimes do not clear even when individuals are looking
out for their own interests.
• The Keynesian model of unemployment is built on the notion that nominal wages and
prices do not adjust quickly to maintain labor - market equilibrium
• It differs from the classical model in its focus on nominal rigidities rather than real
rigidities
• Sluggishly adjusting, with slowly responding prices, poor information, and costs of
changing price impeds the rapid clearing of markets, which cause macroeconomic
fluctuations in output and employment.

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Thank You