CHAPTER-ONE

THE STATE OF MACROECONOMICS

1. Introduction
1.1.Definition, focus area, and instruments of macroeconomics
Economics is the study of the economy and the behavior of people in the economy.
Traditionally, economics is divided into two: microeconomics and macroeconomics.
Microeconomics studies the behavior of individuals and organizations (consumers, firms
and the like) at a disaggregated level and macroeconomics studies the overall or aggregate
behavior of the economy. That means macroeconomics explains phenomena such as
inflation, unemployment, and economic growth while microeconomics concerned with the
demand for or supply of a specific commodity.

Definition
Macroeconomics is a branch of economics that deals with aggregate components of the
economy. In other words, macroeconomics is concerned with the behavior of the economy as a
whole-
 with booms and recessions,
 the economy’s total output of goods and services and the growth of output,
 the rate of inflation and unemployment,
 the balance of payments, and
 Exchange rates.
Macroeconomics focuses on the economic behavior 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 rate, and national debt. Besides,
macroeconomics concerned with both explanation and policy prescriptions. Explanation
involves an attempt to understand the behavior of economic variables, both at a moment in
time and as time passes.
The macroeconomics policy of any country focuses in achieving the following three most
important objectives. These are:
1) Economic growth. This refers to the growth of output (GDP) in an economy.
2) Stability of the economy. This refers to achieving low or stable inflation (Л), nominal
interest rate (r), and exchange rate.
3) Reducing unemployment, particularly the cyclical unemployment which is the outcome of
poverty. Poverty is the outcome of many factors. Some of the factors include socio economic

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 backwardness, natural hazards, war, poor governance (administration) of a nation and poor
policies. 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 an economy is temporary. As a result, economic policy makers give due attention or
emphasize to address the cyclical unemployment which could be permanent unless they are
capable using different macroeconomics instruments.
Macroeconomics instruments
To achieve the above three objectives economic policy makers of countries use mix of
macroeconomics instruments. The most important instruments among others include monetary
policy, fiscal policy, income policy, and labor policy. 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. Evolution of macroeconomics schools of thoughts and recent development

When do studies on economic issues started?
Available documents suggest that formal study on economic issues was started around 2 century
AD in ancient Greek philosophy/wisdom. This implies that economics is an old science like Art,
literature, Astronomy, Mathematics, Physics, Medicine, and the like. Plato and Aristotle were the
two prominent (famous) ancient Greek philosophers who produced enormous economic articles
on economics that served as foundation/basis for further studies and advancement of economics.
However, the studies of scholars conducted on economic issues and theories developed up to the
industrial revolution of the 18th century focus only on microeconomic issues.
When do macroeconomic regard as a branch of economics?
Macroeconomics as a branch of economics was emerged 247 years back with the writing of
Adam Smith “The wealth of Nation” in 1776. The historical evolution of macroeconomics from
1776 to date is discussed briefly by dividing it into two broad categories: the orthodox and
recent/contemporary macroeconomics schools. Orthodox economics is the body of knowledge,
theories, and models of economics, as taught by universities worldwide that are generally
accepted by economists as a basis for discussion. It can be contrasted to heterodox economics,

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which encompasses various schools or approaches that are only accepted by a minority of
economists.
1. The orthodox macroeconomics: includes macroeconomics thinking of schools of thoughts
evolved between 1776 and 1975.The three schools of thought categorized under the orthodox
macroeconomics school are the classical school of thought, the neo-classical school of
thought, and the Keynesian macroeconomics.
A. The classical school of thought (1776 - 1870)
This is the era of the marginalist approach (thought). During this period, the distinction between
micro and macro economics was not clear. The ruling principle (the dominant idea) of this
school of thought was the invisible hand or laissez-faire (which means leave the market free or
free market) coined by Alfred Marshall and advocated by Adam Smith. The reason for their
argument was that supply will create its own demand or price set by the private sector alone will
automatically correct/equilibrate any imbalance or disequilibria created in the economy both in
the short run and the long run without government intervention. This law is called the “Says
law”.
Adam Smith also described the government as the necessary evil and hence advocated that the
government should refrain from intervening in the market. For Adam Smith and his followers
any government policy is ineffective to correct economic disorder or disequilibrium. In other
words, government intervention will distort the market rather than stabilizing.
B. The Neo classical school of thought (1870 - 1936)
The idea of the neoclassical school of thought was not different from the classical school. The
only difference between the two schools of thought is the contribution that is made by Marshall
on ‘absolute and comparative advantage’ of nations in international trade.

C. The Keynesian macroeconomics (1936-1975)

An American economist called Keynes challenged/criticized the classical wisdoms of
macroeconomics based on the events or episodes during the great economic depression of the
early 1930s (1929 to 1935). The great depression was caused by excessive or overproduction of
wheat and coffee. Due to excess production than demanded the price of wheat and coffee goes
down, implying supply fails to create its demand as argued by the classical. So, 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 (unavoidable).

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2. Recent Developments in Macroeconomics (1970s – Present)
There is no dominant school of thought of macroeconomics from 1970s onward. 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 the same
issues brought to the 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 except the belief that government policy can help the
economy to perform better.
A. The New Classical School
The new classical macroeconomics remained influential in the 1980s. This school
of macroeconomics shares many policy views with Friedman. It sees the world as one in which
individuals act rationally in their self-interest in the markets that adjust rapidly to
changing conditions. According to it, the government worsens things if it intervenes in the
market. The central working assumptions of the new classical school are three:

 Economic agents maximize

Households and firms make optimal decisions if all available information is given and those
decisions are the best possible in the circumstances in which they find themselves.

 Expectations are rational

Rational expectations are statistically the best predictions of the future as they can be made using
the available information.

 Markets clear
The essence of the new classical approach is the 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.

B. The New Keynesians

The New Keynesian macroeconomics is the school of thought in modern macroeconomics
that evolved from the ideas of John Maynard Keynes. Keynes wrote The General Theory of
Employment, Interest, and Money in the thirties, and his influence among academics and

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policymakers increased through the sixties. In the seventies, however, new classical economists
such as Robert Lucas, Thomas J. Sargent, and Robert Barro called into question many
of the precepts (principles) of the Keynesian revolution. The label "new Keynesian"
describes those economists who, in the eighties, responded to the new classical critique
with adjustments to the original Keynesian tenets (doctrine).

The new classical group remains highly influential in today’s macroeconomics. But a new
generation of scholars, the new Keynesians, mostly trained in the Keynesian tradition but
moving beyond it, emerged in the 1980s. They do not believe that markets clear all the time but
seek to understand and explain exactly why markets fail.

The new Keynesians argue that markets sometimes do not clear even when individuals
are looking out for their own interests because of information problem and cost of changing
prices. Both information problems and costs of changing prices lead to some price rigidities
which cause macroeconomic fluctuations in output and employment. For example, in
the labor market, firms that cut wage not only reduce the cost of labor but are likely to wind
up with a poorer quality labor. Thus they will be reluctant to cut wages.

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 this stickiness of wages and prices to explain why involuntary unemployment
exists and why monetary policy has such a strong influence on economic activity.

Due to information problem and cost of changing prices =Sticky price and wage=fluctuation in
employment and output thus market sometimes don’t clear.

Concluding Remark

All school of macroeconomics agree on the purpose of macro policy but they disagree on how to
achieve the macro objectives of higher output, lower level of unemployment and inflation
rate.

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