MACROECONOMICS I

CHAPTER ONE

THE STATE OF MACROECONOMICS -

INTRODUCION
 1.1 An Overview: Definition, Focus Areas &
Instruments of Macroeconomics

 Macroeconomics is study of behavior of economy as a whole

& policy measures that government uses to influence it.
 It is concerned with:
a) Economy‟s total output and growth of output,
b) Booms & recessions,
c) Rates of inflation and unemployment,
d) Balance of payments and exchange rates.
 Most important objectives

 The macroeconomic policy of any country focuses in achieving the

following three most important objectives:-
1. Economic growth: growth of output (GDP).
2. Stability of economy: achieving low or stable inflation (Л),
nominal interest rate (r), and exchange rate.
3. Reducing unemployment, particularly cyclical unemployment
which is outcome of poverty.
 Frictional and structural unemployment, which are caused due to
poor or imperfect information and change in technology
respectively, can be addressed easily, Therefore, their effect on
economy is temporary.
 Economic policy makers give due attention or emphasize to
address cyclical unemployment which could be permanent unless
they are capable using different macroeconomic instruments.
 Major policy instruments in macro-economics

 To achieve the above three objectives economic policy makers of

countries use mix of macroeconomic policy instruments.
 The most important policy instruments among others include:-
1. Fiscal policy,
2. Monetary policy
3. Trade policy
4. Income policy
5. Labor policy
 Cont’d

 In macroeconomics, we do two things:

1. we seek to understand economic functioning of the world we
live in; and
2. we ask if we can do anything to improve performance of
economy
 That is, we are concerned with both explanation and policy
prescriptions.
 Macroeconomics makes use of:
 algebraic & geometric tools of analysis like differentiation &
graphs;
 models like AD-AS model & IS-LM model.
 Cont’d
 In general there have been two main intellectual traditions in
macroeconomics:- Conservatives and Liberal
 Two Basic Questions & Two Broad Answers in
Macroeconomics are:
1) Can Governments influence the Economy?
No Yes
- Classicals - Keynesians
- Neoclassicals - Monetarists (?)
- New Classicals (?) - New Keynesians
2) Should Governments Intervene?
No Yes
- Classicals -Keynesians
- New Classicals (?) - New Keynesians
- Neoclassicals
- Monetarists
 Stages of evolutions of macroeconomics

 Macroeconomics thinking has stages of evolutions.

 Throughout its stages of development there has been
consensus that the above three are the main objectives of
macroeconomics.
 However, schools of thoughts disagree on the policy
instruments they prescribe to achieve them.
 This disagreement is discussed in detail in the section that
follows.
1.2 The State of Macroeconomics: Evolution & Recent
Developments

1776-1936 1936 - 1975 1970s 1980…

 Evolution of Macroeconomics
 Macroeconomics as a branch of economics was emerged with the
writing of Adam Smith “The wealth of Nation” in 1776.
 Historical evolution of macroeconomics from 1776 to date is
discussed briefly by dividing it into categories-schools of thoughts
1.2.1. THE CLASSICAL SCHOOL OF THOUGHT (1776-1870)
 During this period macroeconomics ideas were not distinct from

that of microeconomics.
 The dominant idea was the invisible hand which implies market

price will always correct any market imbalances.

 It also implies that the government should stay away from
intervening in the economy
 The government is regarded as “the necessary evil”

 According to them wages and prices are flexible.

 If unemp’t is high workers should cut the nominal wage and if

products are not sold suppliers should cut price.

1.2.2. THE NEO CLASSICAL SCHOOL OF THOUGHT
(1870-1936)
 Their ideas are much more similar to the classical.

 According to this school product’s price is determined by

consumer’s perception of its value, but according to classical

product’s price is determined by cost of production.
 The action of private agents is to maximize their welfare; that

of firms is to maximize profits and consumers is to maximize

utility- will bring equilibrium in an economy.
 Thus, government intervention in an economy will disturb the

smooth operation of the economy.

 Cont’d

 For neo- classical (classical) economists full employment was

normal state of affairs
 But how did these economists reach such optimistic conclusion?
 In their model it is assumed that:
1. All economic agents (firms and households) are rational and aim
to maximize their profits or utility; furthermore, they do not
suffer from money illusion;
2. All markets are perfectly competitive, so that agents decide how
much to buy and sell based on a given set of prices, which are
perfectly flexible;
 Cont’d
3. All agents have perfect knowledge of market conditions and
prices before engaging in trade
4. Trade only takes place when market-clearing prices have been
established in all markets
5. Agents have stable expectations.
These assumptions ensure that in classical model, markets,
including labor market, always clear.
 1.2.3. The Keynesian macroeconomics (1936-1975)

 The birth of modern macroeconomics is linked to the Great

Depression (period of high unemp’t & stagnant production) &
Keynes.
 The market adjustment concept of classicals & neoclassicals
didn‟t work during 1929-1935.
 Basic Assumptions:
 Economy is unstable due to shifts in AD.
 Nominal wages & prices are inflexible, especially downwards.
 Large multiplier effect for changes in government spending &
tax rates.
 Keynes emphasized “effective demand” or AD, and proposed
expansionary policies.
 Cont’d
These Policies are fiscal & monetary:
1. Increasing government expenditure (G):
G  AD  Y (production)  Y (output/income)  C
(Consumption)  AD  Y ... – the multiplier effect.
2. Increasing money supply (M):
M  r (interest rate)  I (investment)  AD  Y ... –
the multiplier effect.
 But, all the M may be absorbed at the existing r (especially
when recession is deep) – the economy is in liquidity trap!
 A liquidity trap is a situation where people hoard cash instead of
spending or investing it, even when interest rates are low.
 This can happen when people expect a negative event, such as
deflation, low demand, or war.
 A liquidity trap makes it difficult for economic policymakers to
stimulate growth, as changes in the money supply do not affect
the price level.
 Cont’d
 With liquidity trap, the Classical model is incapable of producing
equilibrium – Keynes.
 Keynes preferred fiscal to monetary policy.
 Keynes focused primarily on short-term: cure for immediate
problem almost regardless of long-term results of the cure.
 But, AD:
 (given supply) may  inflation, and
 may  long-term growth rate (by ring saving/investment
if firms/people decide not to accumulate wealth in fear of
future increase in taxes).
 With lower long-term growth rate, the economy would create
fewer jobs & thus unemp‟t rate would rise.
 For Keynesians, inflation can be controlled with contractionary
fiscal or monetary policy.
 Cont’d
 Keynes sets out to „discover what determines at any time the
national income of a given system and the amount of its
employment.
 According to Keynes, national income depends on the volume
of employment macroeconomic equilibrium is consistent with
involuntary unemployment.
 The theoretical novelty and central proposition of his book is the
principle of effective demand, together with the equilibrating
role of changes in output rather than prices.
 The emphasis given to quantity rather than price adjustment
in the General Theory is in sharp contrast to the classical
model, where discrepancies between saving and investment
decisions cause the price level to oscillate.
 1.2.4. Monetarists (1965s)
 argument against using active government policies to try to
improve economic performance.
 Strongly debated against the Keynesians on:
• the ability of government to improve the operation of the
economy;
• the relative importance of fiscal & monetary policy;
• the tradeoff between inflation & unemp‟t (the Phillips Curve) –
problem of stagflation (= stagnation + inflation).
 Expansionary fiscal policy, with monetary authority raising M
growth, leads to inflation.
 Fiscal policy affects the mix b/n private & government use of
resources – insignificant or no multiplier effect in fiscal policy.
 Cont’d
 Monetary policy is very powerful & changes in M explain
most fluctuations in output.
 The Great Depression resulted from major mistake in
monetary policy (i.e., fall of quantity of money in circulation).
 The tradeoff b/n unemp‟t & inflation quickly vanishes if policy
makers try to exploit it: no long-run tradeoff b/n inflation &
unemp‟t.
 Because of uncertainty in the position of the economy & lags
in policy effects, policy measures may do more harm than
good.
 Though an economy can be unstable in the short-run, it has a
good self-correcting mechanism in the long run.
 Inflation is chiefly a monetary phenomenon.
 Cont’d

• Policy Rule of Monitarists

“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 forthcoming.”
 CONTEMPORARY MACROECONOMIC SCHOOL
OF THOUGHTS
This include New classical school (NCS), Real Business cycle (RBC),
and New Keynesian schools (NKS).
1.2.5. New Classical (1980s)
 New classical macroeconomics remained influential in 1980s.
 This school of macroeconomics shares many policy views with
Friedman.
 It sees world as one in which individuals act rationally in their
self-interest in markets that adjust rapidly to changing conditions
 According to it, government worsens things if it intervenes in market
 The central working assumptions of new classical school are three:
1. Economic agents maximize
 Households and firms make optimal decisions if all available information
is given and those decisions are the best possible in circumstances in which
they find themselves
 Cont’d
2. Expectations are rational
 Rational expectations are statistically the best predictions of the
future as they can be made using the available information.
3. Markets clear
 The essence of the new classical approach is assumption that
markets are continuously in equilibrium.
 That means prices and wages adjust in order to equate supply
and demand.
 In other words they are market clearing.
 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 employer.
 Similarly, anyone with an excess supply of goods on the shelf
will cut prices so as to sell.
 1.2.6. New Keynesians

 They do not believe that markets clear all the time but seek to
understand and explain exactly why markets fail.
 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 (or 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 stickiness of wages and prices to
explain why involuntary unemployment exists and why
monetary policy has such strong influence on economic activity
 Why real wages rigidity exists?

 it exist because of wage indexation, labour unions, Menu

costs and efficiency wages.
 Wage indexation means wages are specified in advance in
accordance to changes in the prices of goods and services.
 Thus, workers negotiate for real wages consistent on the
basis of wage indexation, which makes w/p constant.
 Efficiency wage: Firms have an incentive to pay high
wages to increase productivity by reducing shaking
moral hazard.
 Thus, the disequilibrium will not be adjusted overtime.
 1.2.7. The real Business cycle (RBC):

 Modeling the economy as an efficient system in w/c

upturns & down turns in the economy are beyond the
control of the governments- animal sprits of
economic agents create volatile & unpredictable
economy that oscillates between boom &
recession.
 It emphasized inter-temporal substitution of
consumption and leisure caused by exogenous
technological disturbance (Barro & King, 1984; Prescott,
1986)
 Cont’d
 The RBC models have been rigorously founded on
microeconomics principles.
 The RBC theory contrasts sharply with the consensus
view of the 1960’s.
The four main propositions of RBC are
 The economy experiences large and sudden
changes in the available production technology
 Leisure is highly substitutable overtime

 Fluctuations in employment are fully voluntary &

socially optimal.
 Monetary policy has no ability to affect real
variables, such as output and employment.
 Cont’d
Concluding Remark
 All schools of macroeconomics agree on purpose of macro
policy but they disagree on how to achieve macro objectives
of higher output, lower level of unemployment and
inflation rate.