1.1. What macroeconomics is about?

Macroeconomics: branch of economics, concerned with the aggregate, or overall, economy, deals
with economic factors such as total national output and income (GDP), unemployment, balance of
payments, Exchange rate and the rate of inflation attempt both to explain economic events and to
devise policies to improve economic performance

Exercise: Differentiate microeconomics from macroeconomics.

1.2. National Income: Where It Comes From and Where It Goes ?

Let’s look at the flow of dollars from the viewpoints of these economic actors.
Households receive income and use it to pay taxes to the government, to consume goods and
services, and to save through the financial markets.
Firms receive revenue from the sale of goods and services and use it to pay for the factors of
production.
Both households and firms borrow in financial markets to buy investment goods, such as houses and
factories.
The government receives revenue from taxes and uses it to pay for government purchases.
Any excess of tax revenue over government spending is called public saving, which can be either
positive (a budget surplus) or negative (a budget deficit).
 Economic agents
As per the concern of macro economics, there are various economic agents and markets exist in
an economy:
 Millions of households [demanding imported and domestically produced goods and services
(consumers),
 supplying factors: labor, capital, land, and entrepreneurial skills (factor suppliers), saving their
income];
 Millions of firms [producing and supplying goods and services (producers);
 Thousands of markets [domestic and foreign];
 Many countries/foreigners [supplying goods and services (Imports), demanding our goods and
services (Exports), supplying/demanding capital goods, transfers and supplying/demanding
factors];
 Government sectors [setting and enforcing “the rule of the game”–policies (fiscal and
monetary), other laws, regulations, demanding goods and services (government expenditure),
demanding/supplying factors, controlling key resources: land, minerals, etc, collecting tax and
paying transfers, owning and managing ‘key’ firms: electricity, telephone, supplying public goods
and services: defense, justice, research and development, road, and many others depending on
the economic policy of the country and controls key economic variables (such as money supply,
foreign reserves)]

Therefore, macroeconomics studies the behavior of the economy given the behavior of economic
agents in the various markets:

 How each agent behaves?

 How they are interrelated and interacting?
 What are the outcomes of these interrelation and interaction on key macroeconomic
variables such as income, consumption, saving, price, etc?
 How the economy as a whole behaves as a result of these relations and interaction?
 How to influence these interaction and behavior toward ‘desired’ outcome?
Macroeconomics views the overall pattern that comes out of interaction of economic agents. It is
like watching the pattern of a certain circus team in making a concert. In other words,
macroeconomics aggregates or combines different things into a single category and treating them
as a whole. For instance;
 Prices in the markets are aggregated into single Price index;
 Outputs of firms aggregated into single output value (GDP);
 Demands for outputs into Aggregate Demand and
 Labor employed in firms aggregated into employment/unemployment rate.
1.3. Macroeconomic Goals and instruments
In general there are five macroeconomic goals of the nation. These are:
 high economic growth,
 low unemployment,
 low inflation,
  balance of payments equilibrium and stable exchange rate.

a) High Economic Growth:

High economic growth will lead to a rapid rise in the standard of living. Economic growth is an increase
in real national income or real national output over a period of time. Although there is no standard
measure of the standard of living, it is commonly believed that the welfare of the people depends to a
large extent on the amount of goods and services available for consumption and this is directly, though
not perfectly, related to national output. High economic growth will also help the economy achieve full
employment and will put the government in a good position to redistribute income from high income
groups to low income groups.

b) Low Unemployment:

Low unemployment helps the economy avoid the adverse effects of high unemployment.
Unemployment is the state of the economy where some people who are able and willing to work are
not employed in the production of goods and services. High unemployment will cause the economy to
lose a large amount of output. It will also cause a large number of people to lose their income. Further, if
the unemployed remain unemployed for a long period of time, they may lose their skills and knowledge.
When unemployment is high, the employed will lose some of their income in the form of pay cut. High
unemployment will cause firms to lose a large amount of profit. When unemployment is high, the
government will lose a large amount of tax revenue. High unemployment will lead to a high crime rate,
high divorce rate, high suicide rate and social unrest.

c) Low Inflation:

Low inflation helps the economy avoid the adverse effects of high inflation. Inflation is a rise in the
general price level over a period of time. Monetary economists, however, define inflation as a sustained
rise in the general price level and refer to a one-off rise as a price shock. When inflation is high, nominal
interest rates will not fully compensate for the rise in the general price level which will reduce the
amount of goods and services that can be purchased with any given amount of savings.

When inflation is high, domestic goods and services may become relatively more expensive than foreign
goods and services. If this happens, net exports will fall. Since high inflation tends to be less stable, firms
will find it harder to estimate the costs and revenues of investments when inflation is high which will
lead to a decrease in investment expenditure. High inflation will lead to a high menu cost and a high
shoe-leather cost of inflation. The most common measure of the overall price level is the consumer price
index (CPI), which measures the cost of a fixed basket of goods bought by the typical urban consumer.

d) Balance of Payments’ Equilibrium

Balance of payments equilibrium helps the economy avoid the adverse effects of persistent balance of
payments disequilibrium. The balance of payments is a record of all the transactions between the
residents of the economy and the rest of the world over a period of time through international trade.
A persistent balance of payments deficit, which occurs when money outflows persistently exceed money
inflows, may lead to adverse consequences such as high imported inflation, high cost-push inflation,
lower national income, higher unemployment and rising foreign debt. A persistent balance of payments
surplus is also undesirable because if the surplus had been used to purchase imports, the standard of
living would have been higher.

e) Exchange Rate Stability:

Foreign exchange rate represents the price of own currency in terms of the currency of other nation.
When a nation’s exchange rate rises, the prices of imported goods fall while exports become more
expensive for foreigners & the nation becomes less competitive in world markets and net exports
decline. Changes in exchange rates can also affect output, employment, and inflation.

Macroeconomic Policy Instruments

How should government policymakers respond to macroeconomic problems? According to the popular
saying, macroeconomic policy should “lean against the wind,’’ stimulating the economy when it is
depressed and slowing the economy when it is overheated. Hence, stabilization policies are the
procedures undertaken by governing authorities to maintain full employment, a reasonably stable price
level and desired economic growth i.e. to say to correct unemployment & inflation.

a) Monetary Policy: Monetary policy is defined as the deliberate action of government to control
the supply of money and the interest rate with the goal to achieve and maintain full
employment of labor and the other productive resources without inflation. There are three
ways to implement monetary policy.
I. Open Market Operations: As the National Bank has the duty to control the supply on
money in the economy; one of the ways that it uses for this purpose is to involve itself in
the market by selling and buying bonds. When the national bank buys bonds from
individuals, banks or other organizations the amount of money supply is increased. This
is so, because the National Bank receives the bonds from the sellers and in exchange the
sellers receive money. Thus, as a result of the purchase quantity of money is increased.

In case of the sale of bonds by the National Bank, a reduction in the quantity of money
occurs. This so, because now the National Bank receives money in exchange for the
bonds. Thus, if it is the bank that has purchased the bond that means it has reduced its
reserve which makes the supply of money. If it is individuals that have bought the
bonds, here also the supply of money is reduced since the assumption is that it is by
withdrawing their saving from banks that they buy the bonds.
As the supply of money is reduced or increased through such sales or purchases of
bonds, the availability of funds for credits by banks will be affected. As the supply of
 money is increased the reserve position of banks will be increased, thus they will be
willing to provide more credits to investors. This will lead to an expansion in economic
activity. And therefore employment, output & income increases, the opposite is also
true as the supply of money is reduced, the reserve position of banks will be reduced,
thus the availability of credits will also be limited which leads to decline in economic
activities, thus unemployment and reduced income.
II. Changes in Bank Reserves:

Suppose the National Bank requires all commercial banks to keep a reserve 20% of their
deposits. These banks therefore, cannot lend out of the reserve sum. This directly affects
the availability credits by the commercial banks to borrowers. The national bank can also
manage to control the supply of money by increasing or decreasing the reserve
requirements of commercial banks. If there is an overall decline in the economy, the
National Bank lower, the reserve requirements of banks, so that now they could be able to
make credits available for investors. The availability of credits will lead to invest in certain
activities thereby creating more employment & income.

III. Changes in Discount Rate:

Discount rate is the interest rate that the national bank charges when it lends reserves
temporarily to commercial banks. If the National bank wants to keep the supply of
money lower, it can discourage banks from borrowing by increasing the discount rate
(interest rate)

Table 1.1. Examples of Easy (Expansionary) Vs Tight (Concretionary) monetary policy

MONETARY POLICY: MAINSTREAM INTERPRETATION

(1) (2)
Easy money policy Tight money policy
Problem: Unemployment and Recession Federal reserve buys bonds, Problem : inflation
lowers reserve ratio, or lowers the discount rate Federal reserve sells bonds, increases
↓ reserves ratio, or increases the discount rate
Money supply rises ↓
↓ Money supply falls
Interest rate falls ↓
↓ Interest rate rises
Investment spending increases ↓
↓ Investment spending decreases
Aggregate demand increases ↓
↓ Aggregate demand decreases
Real GDP rises ↓
Inflation declines
b) Fiscal policy
Fiscal policy consists in managing the national budget and its financing so as to influence
economic activity. This entails the expansion or contraction of government expenditures related
 to specific government programs such as building roads or infrastructure, military expenditures
and social welfare programs. It also includes the raising of taxes to finance government
expenditures and the raising of debt to bridge the gap (budget deficit) between revenues (tax
receipts) and expenditures related to the implementation of government programs.
 Raising taxes and reducing the budget deficit is deemed to be a restrictive fiscal policy as it
would reduce aggregate demand and slow down GDP growth. Lowering taxes and increasing the
budget deficit is considered an expansive fiscal policy that would increase aggregate demand
and stimulate the economy.

Discretionary Vs Non- Discretionary Fiscal Policies

Discretion fiscal policy is the deliberate manipulation of taxes and government spending to alter real
GNP and employment, control inflation, and stimulate economic growth.

Non Discretionary Fiscal policy is the increase (decrease) in net taxes (Taxes – transfer payments) which
occur without deliberate action of the government, when the GDP rises (falls) and which tend to
stabilize the economy also called built-in stabilizers.

1.4.The State of Macroeconomics: Evolution and recent Developments:

1.4.1. Classical macroeconomics (1776-1870)

Two basic questions in classical macroeconomics:

• Is the market economy self-equilibrating, especially can a sustained situation of

unemployment exist?

• If the economy is self-equilibrating, can the government do anything to improve it, in

particular, can the government reduce and/or prevent sustained states of unemployment

Classical macro answers the two basic questions as follows:

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 – where people wish to work at the existing
wage rate but cannot find a job – cannot occur.

Essentially, macroeconomic relationships, and wages and prices are assumed to be flexible at macro as
well as at micro level

Classical macroeconomics was thus hardly a separate branch of the subject.

 It had no theory of the demand for (or supply of) output as a whole.
 It had a theory of price determination, the quantity theory of money, and a theory of the
determination of real wages in the labor market.
  But, it had very little to say about aggregate demand, it perceived no problem of unemployment
and it envisaged no role for any form of macro policy other than control of money supply to
prevent inflation.

• The essential reason for all this was that classical economics concentrated, at least in its more
formal and rigorous analysis, on the long-term development of the economy, and it produced
no clear-cut agreed explanation of short-run fluctuations in economic activity.

Influential classical ECONOMISTS INCLUDE

 David Hume (1711 – 76)

 Adam Smith(1723 – 90)
 Thomas Malthus(1766 – 1834)
 David Ricardo (1772 – 1823)
 John Stuart Mill(1806-1873)
 Karl Marx (1818 – 1883)
 Alfered Marshall (1842 – 1924)
 Arthur Pigou(1877 – 1959)
 Jean – Baptiste Say(1767 – 1832)

Classical economists focused on:

 Real assets - determine the productive capacity of an economy.

 Markets would act to co-ordinate people’s plans – i.e. the “invisible hand” of Adam Smith.

 This vi ew can also captured by Say’s Law: which states that the sum of the values of all
commodities produced always equals the sum of the values of all commodities bought.

 Supply creates its own demand

Basic tenets of the classical school

 The economy is inherently stable

 All economic agents are rational and aim to maximize their profits or utility

 All markets are perfectly competitive

 All agents have perfect knowledge of market conditions

 Trade only takes place when market-clearing prices have been established

 Economic agents have stable expectations

 The dominant idea of this school of thought was the invisible hand or Laissez faire
  Adam Smith also described the government as necessary evil.

1.4.2. Keynesian macroeconomics (1936-1970)

 John Maynard Keynes (1883-1946): He was the Cambridge (UK) economist, whose work has
produced a revolution in macroeconomics (The Keynesian Revolution in Macroeconomics)

 His work can be regarded as the sine quo non of modern macroeconomics

 Keynes’s answers to the two basic questions of macroeconomics were:

1. The economy is not self-equilibrating, and sustained states of involuntary unemployment may
occur,

2. The government can do something to reduce and/or prevent unemployment, by making

appropriate use of monetary and fiscal policy.

He thus provided a justification for a policy of macroeconomic intervention, in contrast to the laissez-
faire principles of the classical economists who proceeded him.

 In 1930s a major world event occurred that gave rise to a new way of thinking about the
operation of the macro-economy.

 Influencial keynesian economists include:

 John Maynard keynes (1883 – 1946)

 Paul Samuelson (1915-)

 James Tobin (1918-)

 Franco Modigliani(1918-)

 Robert Solow (1924-)

 Sir John Hicks(1904-)

The Great depression:

 What challenged the theories of the classical economists and motivated keynes was the effect of
the depression of 1929 – 1933

 Classical economists did not seem able to explain something like the great depression.

Basic tenets of the Keynesian model:

 The economy is inherently unstable and is subject to erratic shocks

 The economy can take a long time to return to being close to full equilibrium after being
subjected to a shock

 Need for government intervention

 AD is the predominant determinant of the output and employment , and AD can be

altered by the authorities

 Fiscal policy is preferred to monetary policy in carrying out stabilization

 Information is the key

 ”Keynesian” thus refers to the work of those economists who saw themselves as
following in Keynes’s footsteps.

 In contrast to the classical economics, Keynes was very concerned to develop a theory
of the demand for output as a whole and hence a model of the (short-run)
determination of national income.