Ch.

1: Macroeconomics-Introduction
1-1: What Macroeconomics Study

1-2: Macroeconomic Goals

1.3: Macroeconomic Policy Instruments

1.4: The state of Macroeconomics: Evolution & Recent

Developments

1.4.1: Mercantilists (1500s – 1600s),

1.4.2. Classical & Neo-Classical Economics(1770s -1930s),

1.4.3. Keynesian Macroeconomics(1930s – 1970s).

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1-1 What Macroeconomists Study?
While microeconomics studies the behavior of
individuals & institutions in an economy, Ｍａｃｒｏｅｃｏｎ
ｏｍｉｃｓ is the study of the economy as a whole.

It addresses many macro topics/issues like:

 Why does the cost of living keep rising? Can gov’t combat
inflation?

 Why are millions of people unemployed even when the economy

is booming?

 What causes recessions?

 Can the gov’t do any thing to combat recessions? Should it?

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…What Macroeconomists Study contd.
 What is trade deficit, and why some country run huge trade deficit,
while others have trade surplus, or have trade balance?

 What is gov’t budget deficit? What causes gov’t budgtet

deficit, how can it affect the economy?

 Why are so many countries poor?

 What policies might help them grow out of poverty?

 And, other related macro issues.

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 …What Macroeconomists Study contd.
All of these macroeconomic issues might seem abstract, but each of
them touch our daily lives in various significant ways.
For instance:
 A business man forecasting the demand of its product need to know
how fast the income of its customers will grow,

 Citizens living on fixed income wonder why and how fast prices are
rising?

 A college graduate looking for jobs how the economy will grow and
create more job opportunities?

 Voters are set to cast their vote look at the performance of an

economy to decide for whom to vote, etc.

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 1.2: Macroeconomic Goals
 Broadly, there are three major objectives of macroeconomic policies
are:

i) Realize Full Employment

 achieved when all available resources like labor, capital, land,
and entrepreneurship are used efficiently & effectively to produce
goods and services,

 This goal is commonly indicated by the employment of labor

resources in the economy( as measured by unemployment rate),
though all resources are important in the economy,

 With full employment of resources, a nation can produce more

goods and services and thereby satisfy the needs of
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society/reduce scarcity of G & S).
 …Macroeconomic Goals (cond.)
ii) Maintain Macroeconomic Stability: w/c could be achieved
when:
 Fluctuations/changes in macroeconomic variables like prices of G & S, production level,
employment level are avoided,

 Stability basically seek to avoid recessionary decline & inflationary expansion of business cycles,

 This goal is indicated by month-to-month or year-to-year changes in various economic measures

such as the inflation rate, unemployment rate, & the growth rate of production.

 In dealing with macroeconomic stability, usually, policy makers tends to focus more on price
stability(i.e. Maintaining inflation rate( GDP Deflator/CPI) at certain reseasonable level.

Maintaining macroeconomic stability is quite necessary b/s:

 It avoid uncertaininities and disruptions in the economy,

 Consumers & businesses can confidently pursue(plan and execute) their (long run) objectives,

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…Macroeconomic Goals (cond.)
iii) Ensure economic growth or output/national income/ It
is achieved by:

 increasing the economy‟s ability to produce goods &

services,

 increasing the quantity and/or quality of resources –

like labor, capital, land, entrepreneurship used to
produce goods & services.

With economic growth, society can get more goods &

services from w/c it can get more utility/satisfaction and
can enjoy better living standards. 7
Tradeoffs between Macroeconomic Goals
Each of three major macroeconomic goals (full employment, stability & economic growth)
are beneficial and worth perusing in it self ,

However, the pursuit of one goal often restricts attainment of others. For example:

 Policies that promote economic growth may risk economic stability,

 Policies meant to ensure economic stability may undermine economic growth and
could trigger rise in unemployment rate,

 Policies meant to promote economic growth may also lead to increased

unemployment rate at times (e.g. promotion of R&D that can enhance economic
growth),

 Macroeconomic goals may also conflict with microeconomic goals of efficiency and
equity.

Hence, attaining balance between these economic policies is the most challenging task
for policy makers.

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 Other Macroeconomic Objectives
There are other (secondary) macroeconomic objectives
meant to achieve long-run economic growth.

These includes:

 Sustainability- economic growth be structurally and

environmentally sustainable,

 External balance- equilibrium in the balance of payment

without the use of artificial constraints i.e.
export = imports
 Equitable distribution of income/wealth-ensuring fare share of
economic prosperity for every one,
 Increasing Productivity- more output per unit of labor per hour. 9
 1.3: Macroeconomic Policy Instruments
Macroeconomic Policy Instruments-refers to macroeconomic tools that can be directly
controlled by economic policy maker,

Macroeconomic policy instruments are divided into two major categories:

i. Monetary Policy Instruments- w/c are conducted by national/central bank

of a country, and constitutes policy tools like:

 Bank Discount Rate(Federal Fund Rate),

 Bank Reserve Requirement,

 Open Market Operation(Buying and selling of gov‟t short term securities).

 Monetary Policies could be expansionary or contractionery:

 Contractionery monetary policy instruments-include rise in discount rate, rise in

bank reserve requirement, and open market sell of securities- to slow inflation

 Expansionary monetary policy tools-include reduction of interest rate, reduction of

bank reserve requirement, and conducting open market purchase of securities- to
promote/stimulate economic growth and job creation. 10
 …Macroeconomic Policy Instruments (cond.)
ii) Fiscal Policy Instruments-consists of polices used to manage the national
budget and its financing so as to influence economic activities. It constitutes:

 Government expenditure-increase/decrease in government

expenditure,

 Increase/decrease in Tax rate.

 Fiscal Policy could be:

 Expansionary - i.e. increase in gov‟t expenditure and/or decrease in tax

rate)- w/c is meant to boost economic growth & create jobs,

 Contractionery - decrease in gov‟t expenditure and/or increase in tax rate

-w/c is used to reduce aggregate demand, and slow down economic
growth so as to reduce inflation.

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1.4: The state of Macroeconomics: Evolution & Recent Developments

• Macroeconomic thought has evolved considerably

over time,

o Hence, to fully understand our modern theories &

debates, we need to understand the history of our
thoughts & how they have evolved,

o To understand our present, we have to know &

understand our past;
 because there is a high thread of unity in human thinking:
current ideas are old ideas but with some changes in form or
shape.
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…The state of Macroeconomics: Evolution & Recent Developments..(cond)
As mentioned earlier, the prime concern of macroeconomists is to
analyze & attempt to understand the underlying determinants of the
main aggregate trends in the economy with respect to:

 total output of goods & services (GDP),

 unemployment,

 economic stability/like inflation/, and

 other international transactions

Macroeconomic analysis seeks to explain:

 the cause and impact of short-run fluctuations in GDP (the business cycle),
and

 the major determinants of the long-run path of GDP (economic growth).13

…The state of Macroeconomics: Evolution & Recent Developments..(cond)
Almost all macroeconomists agree that steady & sustainable growth, stable price
level (avoid unpredictability in price level), ensuring low unemployment/ promoting high
employment / represent the major objectives of macroeconomics,
However, macroeconomists disagree on:

 whether these objectives are compatible or not(achieved simultaneously),

 how the economy can achieve these goals(the role of various policy instruments ).

In this part, we will try to discuss the main schools of macroeconomic thought
emphasizing on:

 their historical backgrounds & their basic tenets,

 the policy implications of each school of thought.

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…The state of Macroeconomics: Evolution & Recent Developments..(cond).
1.4.1: Mercantilists (1500s – 1600s),
Mercantilists believed that:

 The wealth & power of a nation is determined by its stock of precious metals (in
the old parlance) or what we call stock of foreign currency assets today ,

 So, to accumulate nation‟s stock of precious metals/foreign currency asset/

gov‟t has to intervene :

o through export subsidies(to encourage export), and

o import duties(to discourage imports).

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…The state of Macroeconomics: Evolution & Recent Developments..(cond).
Policy Implications:
o even today(at the time of so called free trade and
globalization), there are individuals/groups who believe
that encouraging export and discouraging import
(Protectionism) is the appropriate policy measure ,

o This is in contrast to the free trade ideals and the ideals

of comparative advantages of countries,

o After all, who buy your export if every body restrict

import?

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…The state of Macroeconomics: Evolution & Recent Developments..(cond).
1. 4.2. Classical & Neo-Classical Economics(1770s -1930s)

The classical(also known as liberal economics) was developed in

the late 18th and early 19th century by prominent economists like
Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Robert
Malthus, and John Stuart Mill,

Many writers found Adam Smith's idea of free markets more

convincing than the idea widely accepted at the time
of protectionism,

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…The state of Macroeconomics: Evolution & Recent Developments..(cond).
… Classical & Neo-Classical Economics(1770s -1930s)

This centered economic debate around the individual, instead of society as a

“collective individual”,

Basically the neoclassical school is not different from the classical school.
The main distinction is the tool of analysis, such as the marginal analysis.

Given the industrializing(less agrarian) economy of Europe at

the time, it was not surprising that economics developed ideas
about specialization, gains from trade, and the importance of
individual welfare maximization.,
Classical economists argue that markets would act to co-ordinate
people’s plans (i.e. the “invisible hand” of Adam Smith). This
view is captured by Say‟s law “supply creates its own demand”.
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 …The state of Macroeconomics: Evolution & Recent Developments..(cond).
Basic tenets of the classical school & Policy Implication
 the economy is always at its full employment equilibrium:-thought
there might be short term deviations from full employment, market could quickly and
efficiently correct it,

o Policy implication: gov‟t should not intervene in the economy/market .

 all economic agents (firms & households) are rational and aim to
maximize their profits or utility, and they do not suffer from money
illusion (i.e. the know that money has no fixed value in terms of its
purchasing power, and changes in prices may not represent real gains
and losses)

o money is neutral or change in nominal variables(like money supply) do not affect real
variables(real GDP), 19
 …The state of Macroeconomics: Evolution & Recent Developments..(cond).
 All markets are perfectly competitive-agents decide how much to buy &
sell on the basis of a given set of prices which are perfectly flexible

o Policy Implication: agents have perfect knowledge of market conditions and prices
before engaging in trade.

 Trade only takes place when market-clearing prices/equilibrium price/

have been established in all markets.

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1.4.3: Keynesian Macroeconomics(1930s-1970s)
 The Classical school of thought was dominant until the 1930s,

 In the 1930s a major world event occurred(Great Depression- w/c is the longest,
deepest, and most widespread depression of the 20th century), that gave rise to
a new way of thinking about the operation of the macroeconomics,

 Keynesian economics(named after famous British Economist John Maynard

Keynes (1883-1946), challenged the dominance of classical economics, b/s
classical view of macroeconomics fail to explain great depression,

 An economy could be inherently Unstable and is Subject to Erratic Shocks,

o Uncertainty about future economic performance causes loss of investors
confidence,

o Loss of confidence by investors results in inherently volatile investment

performance,

o Inherently volatile investment performance produce sudden & large changes

in AD and output,
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Great Depression(1929-1939)

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 Basic tenets of the orthodox Keynesian model & their policy implications
 This may causes economies “stuck in ” producing less than full employment level of
output(the economy may attain equilibrium at employment level below natural rate of employment(as
in the case of great depression).

 The Economy Can Take a Long Time to Return to Being Close To Full Equilibrium after
Being Subjected to a shock unless gov’t intervene using appropriate policy measures.

Hence:

o gov’t intervention in the economy is necessary,

o Create AD w/c is predominantly determinant of output and employment,

o To this end, fiscal policy measures (like increasing gov’t spending and reducing gov’t
tax are important measure during the time of economic down turn,

o Monetary policy takes too long if it is going to have any effect and is likely to have a
weak effect if it has an effect at all,

 According to Keynesian view, information, w/c is a key for efficient market functioning is not perfect as
claimed by classical economists view., w/c also complement their argument about role of gov‟t in the
economy.
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 Basic tenets of the orthodox Keynesian model & their policy implications

Monetarism (1960s and 1970s)

Monetarism is a school of thought in monetary economics that
emphasizes the role of governments in controlling the amount
of money in circulation,

Monetarist theory asserts that variations in the money supply have

major influences on national output in the short run and on price levels
over longer periods,

Monetarists assert that the objectives of monetary policy are best met
by targeting the growth rate of the money supply rather than by
engaging in discretionary monetary policy,

Monetarism is a theoretical challenge to Keynesian economics that

increased in importance and popularity in the late 1960s and 1970s,
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 Basic tenets of the orthodox Keynesian model & their policy implications

… Monetarism (1960s and 1970s)…cond.

Monetarism today is mainly associated with the work of Milton Friedman, who
was among the generation of economists to accept Keynesian economics and
then criticize Keynes' theory of gluts using fiscal policy (government spending),

Friedman and Anna Schwartz wrote an influential book, „A Monetary History in

the United States, 1867-1960‟, and argued "inflation is always and
everywhere a monetary phenomenon."
They argue that excessive expansion of the money supply is inherently
inflationary, and that monetary authorities should focus solely on
maintaining price stability,
Friedman advocated that central bank policy regarding money supply
should aim at keeping the supply & demand for money at equilibrium,
as measured by growth in productivity and demand.

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 NEW- KEYNESIAN MACROECONOMICS (1940s-)
 New Keynesian economics is a school of contemporary macroeconomics that
strives to provide microeconomic foundations for Keynesian economics

 Two main assumptions define the New Keynesian approach to macroeconomics:

o assumes that households & firms have rational expectations,(i.e. assuming that
agents expectations may be wrong, but are correct on average over time)

o New Keynesian analysis usually assumes prevalence of a variety of market failures,

o imperfect competition and other market failures results in sticky price & wage(w/c
don‟t adjust instantaneously to changes in economic conditions,

o Such wage and price stickiness, and the other market failures present in New
Keynesian models, imply that the economy may fail to attain full employment.

o They try to develop macroeconomic models using microeconomic variables.

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 New-classical Macroeconomics
 New-classical macroeconomics-is a school of thought in macroeconomics
originated in early 1970s, that builds its analysis entirely on
a neoclassical framework,

 it emphasizes the importance of rigorous foundations based

on microeconomics, especially rational expectations,

 The two fundamental tenets of the new classical

macroeconomics are:

o First, individuals are viewed as optimizers: given the prices, including wage rates, they
face and the assets they hold, they choose the best options available

 Firms maximize profits;

 people maximize utility.

o Second, to a first approximation, prices adjust, changing the incentives to individuals,

and thereby their choices, to align quantities supplied and demanded.

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