CHAPTER ONE

INTRODUCTION

1.1 AN OVERVIEW: DEFINITION, FOCUS AREAS AND INSTRUMENTS OF

MACROECONOMICS

Macroeconomics is the study of the economy as a whole – 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 economies total output of goods and services and the growth of output,
 The rates of inflation and unemployment,
 The balance of payments and exchange rates.

Macroeconomics deals both with long run economic growth and with the short run fluctuations
that constitutes the business cycle. It precisely defined as the study of the overall performance of
the economy and the way in which the various sectors of the economy are related to one another.
It focuses on the economic behaviors and policies that affect consumption and investment, trade
balance, the determinants of changes in wages and prices, Monetary and fiscal policies, the
money stock, government budget, interest rates, and the national debt.

In dealing with the essentials, which can be grouped under the ultimate and central issues of
economic growth, inflation, unemployment and open economy market policies, we go beyond
details of the behavior of individual economic units and the determinants of prices in particular
markets. For instance, we deal with the markets of goods as a unit rather than considering the
market for a specific good. We do the same thing for the labor market and for the money market.
The essential central issues described above are also areas of controversy.

Macroeconomics attempts not only to explain economic events but also to devise policies to
improve economic performance. The emphasis in macroeconomics is on the manageability of the
theory and on its application, rather than a primary theoretical concern. However, because
macroeconomic events arise for many microeconomic interactions, macroeconomists use many
tools of microeconomics. Although an active government intervention is an area of controversy,
governments play roles in the economy in one way or another.

The major policy instruments in macroeconomics are:

fiscal,
monetary
trade policy instruments
 In analyzing the economics facts and the effects of these policy instruments, macroeconomics
makes use of algebraic and geometric tools of analysis like differentiation, aggregate demand
aggregate supply (AD-AS) model and IS-LM model, and different theories for a particular issue.

1.2. THE STATE OF MACROECONOMICS: EVOLUTION AND RECENT

DEVELOPMENTS

School of thoughts in Macroeconomics

 Classical 1776 – 1870. In this period the distinction between micro and macro was not
clear. The ruling principle was the invisible hand coined by Alfred Marshall.
 Neo classical 1870 – 1936. Basically the neoclassical school is not different from the
classical school. The main distinction is the tool of analysis, such as the marginal
analysis.
 Keynesian 1936 – 1970s. The main thesis of the Keynesian stream is that the economy is
subjected to failure so that it may not achieve full employment level. Thus, government
intervention is inevitable.
 1970s – Present. There is no dominant school of thought of macroeconomics.

There have 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. In the 1960s, the debate on these
questions involved Keynesians, including Franco Modigliani and James Tobin, on one side, and
monetarists, led by Milton Friedman, on the other. In the 1970s, the debate on much the same
issues brought to the fore a new group- the new classical macroeconomists, who by and large
replaced the monetarists in keeping up the argument against using active government policies to
try to improve economic performance. On the other side are the new Keynesians; they may not
share many of the detailed belief of Keynesians three or four decades ago, except the belief that
government policy can help the economy perform better.

1.2.1 The Classical and Neo-classical Macroeconomics

When modern economics was born more than 200 years ago with the publication of Adam
Smith’s “Wealth of Nation”, there was no distinction between micro and macroeconomics. Early
economic thinkers believe that it was necessary to study consumers and producers in the market
to understand the economy as a whole. After all, the macro economy is nothing more than the
sum total of individual decisions. These early pioneers didn’t realize that generalizing from the
part to the whole could lead to mistakes.

These groups advise no government intervention in an economic system for the economy has a
self-correction mechanism. For example, when aggregate demand fluctuates so that equilibrium
real GDP is less than potential real GDP and unemployment exceeds that natural rate of
unemployment, according to these economists, there is a downward pressure on wages and
prices. As nominal wages fall, the aggregate supply curve shifts out until macro-economic
equilibrium is re-attained at full employment.

The basic assumptions of these economists are:

 Flexible wages and prices,

 Supply creates its own demand – Say’s Law,
 Households are forward looking,
 The price level is proportional to the money stock in the long run.

In general, there is no need for government intervention (using fiscal and monetary policies), and
inflation is caused only by excessive growth in the money market.

1.2.2 The Keynesian Macroeconomics

Macroeconomics was not formally born until the Great Depression (1929 – 1933), a decade of

high unemployment and stagnant production. Classical economists believed that markets would
adjust quickly and direct the economy toward full employment. The huge decline in output,
prolonged unemployment, and lengthy duration of the Great Depression undermined the classical
view and provided the foundation for Keynesian economics. Keynes, founder of modern
macroeconomics, discussed causes of Great Depression in his book of ‘General employment,
interest and money’ published in 1936.

In a very simplified form we can present Keynes’s theory of recessions. Imagine an economy
that is chugging along happily at full employment. Alongside the smoothly functioning ‘real’
economy there will be a smooth financial flows, as firms earn money from their sales, pay out
their earnings in wages and dividends, and household spend these receipts on new purchases
from the firms.

But now suppose that for some reason each household and firm in this economy decides that it
would like to hold a little more cash. Keynes argued, in particular, this happens when
businessmen lose confidence and start to think of potential investments as risky, leading them to
hesitate and accumulate cash instead; today we might add the problem of nervous households
who worry about their jobs and cut back on purchases of big-ticket consumer items. Either way,
each individual firm or household tries to increase its holdings of cash by cutting its spending so
that its receipts exceed its outlays.

But as Keynes pointed out, what works for an individual does not work for the economy as a
whole, because the amount of cash in the economy is fixed. An individual can increase her cash
holding by spending less, but she does so only by taking away cash that other people had been
holding. Obviously, not everybody can do this at the same time. So what happens when everyone
tries to accumulate cash simultaneously?
The answer is that income falls along with spending. I try to accumulate cash by reducing my
purchases from you, and you try to accumulate cash by reducing your purchases from me; the
result is that both of our incomes fall along with our spending, and neither of us succeeds in
increasing our cash holdings.

If we remain determined to hold more cash, we will react to this disappointment by cutting our
spending still further, with the same disappointing result; and so on and so on. Looking at the
economy as a whole, you will see factories closing, workers laid off, stores empty, as firms and
households throughout the economy cut back on spending in a collectively vain effort to
accumulate more cash. The process only reaches a limit when incomes are so shrunken that the
demand for cash falls to equal the available supply.

In general, Keynesian View of spending and output:

– Keynes argued that spending induced business firms to supply goods & services.

– Hence, if total spending fell, then firms would respond by cutting back
production. Less spending would lead to less output.

Keynes policy rule

For Keynes to do about recessions, the first and most obvious thing to do is to make it possible
for people to satisfy their demand for more cash without cutting their spending, preventing the
downward spiral of shrinking spending and shrinking income. There are two ways to do this, i.e.
Keynes developed expansionary policies that consist of two elements:

i. Increasing money supply - Increase in money supply decreases the interest rate. This
encourages agents (investors) to invest their money rather than putting it in banks. The increase
in investment results in increased output (as Y= C+I+G+X-M).

However, interest rate (and thus investors) may not respond to the change in money supply or all
the increase in money supply may be absorbed at the existing interest rate.

This is particularly the case when recession is deep. If this is the case, the economy is said to be
in a liquidity trap. If there is liquidity trap, Keynes argued that, the Classical model will be
incapable of producing equilibrium, and that monetary policy is ineffective.

In such a case, the second element is proposed.

ii. Increasing government expenditure - so as to increase aggregate demand, which will in turn
encourage production. Increased output/income again increases consumption, consumption
further boosting aggregate demand … – the multiplier effect.

Keynes focused primarily on the short-term. He wanted to cure an immediate problem almost
regardless of the long-term consequences of the cure.
However, increased government spending:

might trigger inflation (if supply doesn’t rise immediately with the
increased aggregate demand), and
might lower the long-term growth rate of production (by lowering saving
and investment where people/firms decide not to accumulate wealth in
fear of future increase in taxes).

With a lower long-term growth rate, the economy would create fewer jobs and thus
unemployment rate would rise.

For the Keynesians, inflation can be kept under control with either a contractionary fiscal or a
contractionary monetary policy.

Their basic assumptions are:

 Inflexible nominal wages and prices in the downward direction,

 The economy is unstable subject to shifts in AD (Aggregate Demand),
 There is a large multiplier effect for changes in government spending and tax
rates.

1.2.3 The Monetarists

As the Great Depression gave birth to modern macroeconomics, an accelerating inflation in the
late 1960s and early 1970s facilitated the monetarist counter-revolution. The debate on whether
government intervention can significantly improve the operation of the economy or not went on
and groups of intellectuals continued to emerge. In the 1960s, the debate involved Monetarists
(led by Friedman) on one side and Keynesians (Franco Modigliani and James Tobin among
others) on the other.

The monetarists strongly debated against the Keynesians on:

 the ability of government to improve the operation of the economy,

 the relative importance of fiscal and monetary policy, and
 the tradeoff between inflation and unemployment (suggested by the Phillips
Curve)

The problem of stagflation (stagnation + inflation) was what the monetarists considered to be the
weakness of the Keynesians. As aggregate demand increases when government spending
increases, the price level and nominal interest rate will increase. Thus, discretionary
(government) policies are more likely to cause stagnation and inflation. For them,

 expansionary fiscal policy can lead to inflation when accompanied by monetary

authorities with increased money growth,
  fiscal policy primarily affects the mix between private and government use of resources.
The multiplier in fiscal policy is very low (could even be zero) because an increase in
government purchases causes (a nearly) equal reduction in private purchases.

Even if it is the case that an economy can be unstable in the short-run, it has a good self-
correction mechanism in the long run. According to the monetarists inflation is primarily a
monetary phenomenon – that the only way to keep inflation from getting out of hand is to control
the growth of the money stock. They also argue that the money expansion method cannot be
applied, as the position of the economy on the business cycle is not known with certainty. If
money supply is increased when the economy is at slump, the effect might come about after
sometime when the economy has already moved back to trough so that the policy would have
unwanted consequences.

In the 1970s, the debate on much of the same issues brought to the fore a new group – the New
Classical Macroeconomists, who by and large replaced the monetarists in keeping up the
argument against using active government policies to try to improve economic performance. On
the other side are the New Keynesians, who may not share many of the detailed beliefs of
Keynesians, expect the belief that government policy can help the economy perform better.

1.2.4 The New Classicals

The new classical economists, such as Robert Lucas, attached great importance to the role of
expectation in influencing macroeconomic equilibrium. They introduced the analysis of
macroeconomics from micro foundation. They believe that expansionary fiscal policy tends to
increase inflationary expectations which in turn induce shifts in aggregate supply that causes real
GDP to fall and the price level to rise. Many of the new classical economists support supply-side
policies designed to increase the growth rate of potential real GDP.

Their central working assumptions are:

 Rational expectations – economic agents are forward looking.

 Markets clear.
 Aggregate supply is responsive to changes in expectations about inflation.
 Incentives to produce, work and 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 aggregate supply caused by changes in

expectations of inflation.

1.2.5 The New Keynesians

The New Keynesians, such as Mankiw and Summers, gave micro foundation for the Keynesian
thought. According to this school of economists, markets sometimes do not clear even when
individuals are looking out for their own interests. Both information problems and costs of
changing prices lead to some price rigidities, which cause macroeconomic fluctuations in output
and employment. For instance, firms cut wages infrequently because wage cuts not only reduce
the cost of labor but also are likely to wind up with a poorer quality labor force.

If firms adjust prices and wages infrequently (because 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.

There is much to be learned from the insights of all the major schools of macroeconomic
thought, and each of these schools has contributed to our understanding of the way the economy
works.

A large majority of economists now believe that:

both monetary and fiscal policies have powerful effects on the economy (at least in
the short run),
stabilization policies are likely to affect interest rates and foreign exchange rates
and to influence the incentives of both households and businesses to make
purchases, and
policies encouraging the long term growth of potential real GDP are likely to raise
the future living standards of households.

In general, while each school of macroeconomics pointed out above has its own contributions to
our understanding (and, of course, its own critics), there is no single school that best describes an
economy.