MACROECONOMICS I

(ECON 2031:3/5)
OUTLINE
1. The state of macroeconomics

2. National income accounting

3. Aggregate demand in closed economy

4. Aggregate demand in open economy

5. Aggregate supply
 1. Chapter One: Introduction
1.1. What macroeconomics is about?
1.2. Basic Concepts and Methods of
Macroeconomics Analysis
1.3. Macroeconomic Goals and Instruments
1.4. The State of Macroeconomics: Evolution and
Recent Developments
1.4.1. Classical macroeconomics
1.4.2. Keynesian macroeconomics
1.4.3. Neo-classical macroeconomics
 1.1 What macroeconomics is about?
about?
 Macroeconomics: is the study of the behavior of the economy as a
whole & the policy measures that the government uses to
influence it.
 Macroeconomics- it deals with the effects and consequences of
the aggregate behavior of all decision making units in a certain
economy.
 It is an aggregative economics that examines the interrelations
among various aggregates, their determination and the causes
of fluctuations in them.
 It looks at the economy as a whole and discusses about the
economy-wide phenomena.
 It is concerned with:
 The economy’s total output of goods & services and the growth
of output, aggregate consumption, Investment, and saving
 Booms & recessions,
 The rates of inflation and unemployment,
 Balance of payments (trade account, capital account, financial account)
& exchange rates,
 Cont…
 Macroeconomics is concerned with the structure, performance and
behavior of the economy as a whole.
 It explains the overall level of the total output in the economy, the
aggregate price level, employment and unemployment, interest rates,
wage rates and foreign exchange rates.
 The subject matter of macroeconomics includes factors that
determine both the levels of these variables and how the variables
change over time: such as
 The rate of growth of output
 The inflation rate
 Changing unemployment in periods of expansion and recession,
 Appreciation or depreciation in foreign exchange rates.
 Specifically, its analysis seeks to explain the cause and impact of
short run fluctuation in GDP (the business Cycle), and the major
determinants of the long run path of GDP (economic growth).
 Macroeconomists attempt both to explain economic events and to
devise policies to improve economic performance.
 Focus of macroeconomics
 Macroeconomic generally focus on the levels and
causes and consequences of major macro variables
such as:
1. Aggregate output and its growth (GDP and its growth)

2. Aggregate consumption, saving and investment, and their

changes over time

3. Inflation and its changes over time

4. Unemployment and its growth rate

5. External economy –Balance of payment (trade account,

capital account, financial account and foreign exchanges,
etc)
1.2. Basic Concepts and Methods of Macroeconomics Analysis
 Basic concepts in macroeconomics:
 Macroeconomics is defined as a study of aggregates of the
economy and concerns itself with wider economic issues like
aggregate demand and supply, aggregate savings and
investments, national output, general price level and money
supply, international trade etc.
 There are various basic concepts in macroeconomics, such
as
1. Income and Output (GDP or GNP)
2. Unemployment (structural, cyclical, frictional etc)
3. Inflation and Deflation
4. Business cycle (Boom, Recession, Contraction,
Expansion)
5. Balance of payment (trade account, capital account,
financial account etc)
6. Macroeconomic policy (monetary policy, Fiscal policy,
trade policy, income policy etc)
Macroeconomics study the state(variables) and it's dynamism
 Method of macroeconomic analysis
 There are various method of macroeconomic
analysis which are classified as follows:
1. Traditional (backward-looking) models,

2. Linear rational expectations (future-looking) models,

3. Intertemporal optimization models,

4. Endogenous growth models, and

5. Continuous time stochastic models

 1.3. Macroeconomic Goals and Instruments
Goals of macroeconomics:
 The macroeconomics aims to meet the following goals as a
subject matter:
1. Generating a higher level of production of economic
goods and services for the population… Rapid and
sustainable Economic growth
2. High employment- providing jobs- lower unemployment
3. A stable or gently rising level of price level with prices
and wages are determined by free markets… Stable price
, lower inflation
4. Foreign economic relations marked by a stable foreign
exchange rate and export more or less balancing
imports…. External Balance
5. Reducing budget deficit and balance of payment (BoP)
deficit
6. Ensuring fair distribution of income at national level
The required reserve ratio is the ratio of money that a commercial bank must hold in
reserve to the amount of money it has on deposit. This money, which is the required
bank reserves, is held on reserve and is not allowed to be used in lending or investing
activities.
 Cont… money supply

Instruments of macroeconomics
 Macroeconomics uses the following policy
instruments so as to meet its major Goals:
 Monetary Policy (MS, OMO, RRR, r)
a) Open market operation-buying & selling of bonds, treasury bills etc.
b) Required reserve ration-raising or reducing required reserve ration
c) Discount /interest rate- mobilizing saving via interest rate
 Fiscal Policy (T, G, TR)
Revaluation vs devaluation are occur because of
a) Government expenditure POLICY DESIGHN
Appreciation vs depreciation both are occur
b) Government like
transfer
bonuses because of MARKET FORCE
c) Tax policy
Example if 1$ be equal with 5 Ethiopian birr then after a certain years it will reach 6.67
 Trade policy Ethiopian birr this is called depreciation. but when the our gov.t make it suddenly to 10
birr we call this one devaluation
a) Currency devaluation
b) Setting imported quota and related policies (regulations and
restrictions)
c) Setting imported tariffs , etc
 Income policy (wage, salary, pensions)
1.4. The State of Macroeconomics: Evolution and Recent
Developments
1.4. The State of Macroeconomics: Evolution and
Recent Developments
 In macroeconomics, we do two things:
1. we seek to understand the economic
functioning of the world we live in; and
2. we ask if we can do anything to improve
the performance of the economy.
 That is, we are concerned with both
explanation and policy prescriptions.
 Macroeconomics makes use of:
 algebraic & geometric tools of analysis like
"investment-savings" (IS) and "
differentiation & graphs; liquidity preference-money
supply" (LM)
 models like AD-AS model & IS-LM model.
aggregate supply and
aggregate demand
 Cont…
"investment-savings" (IS) and "
liquidity preference-money
supply" (LM)

Two Basic Questions & Two Broad Answers in

Macroeconomics
1) Can Governments influence the Economy?
No Yes
Classicals & Neoclassicals Keynesians
New Classicals (?) Monetarists (?)
New Keynesians
2) Should Governments Intervene?
No Yes
Classicals & Neoclassicals Keynesians
Monetarists
New Classicals (?) New Keynesians
 Cont…..

1930 1960 1970 1980

 Cont….
1.4.1 Classical & Neo-classical Macroeconomics
Basic Assumptions:
Flexible wages and prices.
Supply creates its own demand, Say’s Law.
Forward-looking agents with perfect
foresight.
The price level is proportional to the money
stock in the long run.
Main argument:
No need for government intervention as the
economy has a self-correction mechanism.
Inflation is caused by excessive growth in
money stock.
 No distinction b/n macro- & micro-economics.
 Cont….
1.4.2 Keynesian Macroeconomics
 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 1929-1933.
 Basic Assumptions:
 Economy is unstable due to shifts in AD.
 Nominal wages & prices are inflexible, esp.
downwards.
 Large multiplier effect for changes in
government spending & tax rates.
 Keynes emphasized “effective demand” or
AD, and proposed expansionary policies.
 Cont…
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 (esp. when recession is deep) – the
economy is in liquidity trap!
With liquidity trap, the Classical model is
incapable of producing equilibrium – Keynes.
 Keynes preferred fiscal to monetary policy.
 1.2 The State of Macroeconomics: Evolution & Recent
Developments
 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…..
1.4.3 Monetarists
 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….
 Monetary policy is very powerful & changes in
M explain most fluctuations in output.
The Great Depression resulted from major
mistake in monetary policy
policy.
 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….
1.4.4 New Classicals
 In the 1970s, the debate on active policy
brought to the fore new groups – new
classicals & new Keynesians.
 New classicals attached great importance to
the role of expectation in influencing macro
macro--
economic equilibrium
equilibrium.
 They introduced macroeconomic analysis
from micro foundations.
 Expansionary fiscal policy tends to increase
inflationary expectations, shifting AS, causing
real GDP to fall & the price level to rise.
 Many of them supported supply-side policies
meant to raise growth rate of potential GDP.
 Cont…
 Their central working assumptions are:
 forward looking economic agents with
rational expectations.
 Markets clear.
 AS is responsive to changes in
expectations about inflation.
 Incentives to produce, work & save are
affected by government policies which
influence marginal tax rates and subsidize
households and businesses.
 The self-correction mechanism is based on
shifts in AS caused by changes in
expectations of inflation.
 Cont…
1.4.5 New Keynesians
 They gave micro foundation for Keynesian
thoughts.
 Markets sometimes do not clear even when
individuals are rationally looking out for their
own interests.
 Emphasize imperfections in various markets
(labor, credit, product).
 Information problems & costs of changing
prices may lead to price rigidities, causing
macroeconomic fluctuations in output &
emp’t.
 Cont….
Conclusion:
 Much is to be learned from the insights of all
these schools of macroeconomics, and each
has contributed to our understanding of the
way the economy works.
 However, there is no single school that best
describes how an economy operates.
 The majority of economists now agree that:
 Stabilization policies are likely to influence
incentives of households & firms,
 Long-term growth (in real GDP), resulting
from capital accumulation & technological
progress, is the key to raise living standards.
 Changes in AD affect output (at least) in the
short run.
 Cont….
 Some of the disagreements involve:
 The length of the “short run,” the period of
time over which AD affects output.
 The role of policy. Those who believe that
output returns quickly to the natural level
advocate the use of tight rules on both
fiscal & monetary policy. Those who
believe that the adjustment is slow prefer
more flexible stabilization policies.
THE END OF CHAPTER ONE!!!

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