Chapter One
Introduction to
Macroeconomics
Course instructor
:Yohannes A.
1.1 What Macroeconomics is about?
Why
have some countries experienced rapid
growth in incomes over the past century while
others stay mired in poverty?
Why do some countries have high rates of
inflation while others maintain stable prices?
Why do all countries experience recessions and
depressionsrecurrent periods of falling incomes
and rising unemployment, and
how can government policy reduce the frequency
and severity of these episodes?
Macroeconomics, the study of the economy as a
whole, attempts to answer these and many
related questions.
Contd
Macroeconomics
is concerned with
the behavior of the economy as a
whole- with
booms and recessions,
the economys total output of
goods and services
the growth of output,
the
rate
of
inflation
and
unemployment,
the balance of payments, and
exchange rates.
Contd
Macroeconomics
focuses
on
the
economic behavior and policies that
affect
consumption and investment,
trade balance,
the determinants
of
changes
wages and prices,
monetary and fiscal policies,
the money stock,
government budget,
interest rate, and
in
Contd
In macroeconomics, we do two things
First, we seek to understand the economic
functioning of the world we live in; and
Second, 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.
Explanation
involves an attempt to
understand the behavior of economic
variables, both at a moment in time and as
time passes.
Evolution and Recent
Developments(Schools of thoughts in
Macroeconomics)
Classical 1776 1870.
The ruling principle was the invisible hand.
They contend that labor demand and labor supply are
brought into equilibrium by the real wage.
As a result there is no involuntary unemployment.
saving and investment are brought into equilibrium by the
interest rate and investment respond to the interest rate.
Money demand is simply a transaction demand and
money has no any effect on the real economy.
6
Contd
Hence raising the money supply simply pushes
up prices (i.e. inflationary).
The implication is that, government has no any
role in the economy through its monetary policy.
To this end, the classical are the proponents of
laissez-faire (no government role).
In general, for this school markets (be it,
commodity, factor, and money) works best if left
to themselves.
Neo-classical 18701936.
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 them is that the economy is subjected to
failure so that it may not achieve full employment
level.
Thus, government intervention is inevitable.
This school views the labor market in that workers and
firms bargain for a money wage, not for real wage.
Money wages adjust slowly and workers resist any
drop in the money wage.
8
Contd
Unlike the classicals, for Keynesians saving and investment are
brought into equilibrium by changes in income.
Investment is affected by expectations of the future, which is
uncertain.
Money demand is affected by transactions, but also by other
things, in particular fear, which may lead to a speculative
demand for high money balances.
Keynes argued that the government role was needed to preserve
capitalism.
Because with out management, a modern capitalist economy is
so unstable that it may threaten the social compact that it rests
on.
1970s present.
There is no dominant school of thought of 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,
10
Contd
Who by and large replaced the monetarists.
they keep 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
11
Keynesians View of the Economy
Imagine an economy that is chugging along
happily at full employment.
Alongside the smoothly functioning real
economy there will be a smooth financial
flows.
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.
This
12
happens
when
businessmen
lose
Contd
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.
The amount of cash in the economy is fixed.
So what happens when everyone tries to accumulate cash
simultaneously?
The answer is that income falls along with spending.
Implying that neither of us succeeds in increasing our
13
cash holdings
Contd
What if we remain determined to hold more
cash?
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
14
so shrunken that the demand for cash falls to equal
the available supply.
Keynes and Economic Policy
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
i.e. preventing the downward spiral of shrinking
spending and shrinking income.
The way to do this is simple to print more money, and
somehow get it into circulation.
i.e. monetary expansion.
But, even this might sometimes not be enough,
particularly if a recession had been allowed to get out
of hand and become a true depression.
15
Contd
A
situation, in which monetary policy has
become ineffective, has come to be known as a
liquidity trap
In such a case, the government has to do what
the private sector will not: spend.
When monetary expansion is ineffective, fiscal
expansion must take its place.
Such a fiscal expansion can break the vicious
16
circle of low spending and low incomes and
getting the economy moving again.
Monetarism
Monetarism, as advocates of free market,
started challenging Keyness theory in the
1970s.
Milton Friedman, the founder of monetarism,
attacked Keynes idea of smoothing business
cycle.
Such active policy is not only unnecessary
but actually harmful, worsening the very
economic instability that it is supposed to
17 correct, and
According to Friedman most recessions did not arise
because the private sector was trying to increase its
holdings of a fixed amount of money.
Rather, they occurred because of a fall in the quantity of
money in circulation.
Policy Rule under Monetarism
If economic slumps begin when people spontaneously
decide to increase their money holdings,
then
the monetary authority must monitor the
economy and pump money in when it finds a slump is
imminent.
18
Contd
If such slumps are always created by a fall in
the quantity of money, then the monetary
authority need not monitor the economy;
it need only make sure that the quantity of
money doesnt slump.
In other words, a straightforward rule- Keep
the money supply steady- is good enough.
Thus, for Monetarists, depressions were
19
the consequence of a temporary shortage
of money.
The New Classical School
The new classical macroeconomics remained influential
in the 1980s.
It sees the world as one in which individuals act
rationally in their self-interest in markets that adjust
rapidly to changing conditions.
The government, it is claimed, is likely only to make
things worse by intervening.
The central working assumptions of the new classical
school are three:
Economic agents maximize
Expectations are rational, and
Markets clear
The essence of the new classical approach is the
assumption that markets are continuously in
20 equilibrium.
The New Keynesians
Evolved from the ideas of John Maynard Keynes in
1980s as responded to this new classical critique.
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.
Both information problems and costs of changing
21
prices lead to some price rigidities, which help
cause macroeconomic fluctuations in output and
Contd
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" marketsbalance supply and demandby
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
22
prices to explain why involuntary unemployment exists and why
monetary policy has such a strong influence on economic
activity.
Contd
In the presence of this aggregate-demand externality, small menu
costs can make prices sticky, and this stickiness can have a large cost to
society.
Suppose that General Motors announces its prices and then, after a fall in
the money supply, must decide whether to cut prices.
If it did so, car buyers would have a higher real income and would,
therefore, buy more products from other companies as well.
But the benefits to other companies are not what General Motors cares
about.
Therefore, General Motors would sometimes fail to pay the menu cost and
cut its price, even though the price cut is socially desirable.
This is an example in which sticky prices are undesirable for the economy
as a whole, even though they may be optimal for those setting prices.
23
The Staggering of Prices
New Keynesian explanations of sticky prices often emphasize
that not everyone in the economy sets prices at the same time.
Instead, the adjustment of prices throughout the economy is
staggered.
Staggering complicates the setting of prices because firms care
about their prices relative to those charged by other firms.
Staggering can make the overall level of prices adjust slowly,
even when individual prices change frequently.
Suppose, first, that price setting is synchronized: every firm
adjusts its price on the first of every month.
24
Contd
If the money supply and aggregate demand rise on May 10,
output will be higher from May 10 to June 1 because prices are
fixed during this interval.
But on June 1 all firms will raise their prices in response to the
higher demand, ending the three-week boom.
Now suppose that price setting is staggered: Half the firms set
prices on the first of each month and half on the fifteenth.
If the money supply rises on May 10, then half the firms can
raise their prices on May 15.
Yet because half of the firms will not be changing their prices on
25
the fifteenth, a price increase by any firm will raise that firm's
relative price, which will cause it to lose customers.
Contd
Therefore, these firms will probably not raise their prices very
much. (In contrast, if all firms are synchronized, all firms can
raise prices together, leaving relative prices unaffected.)
If the May 15 price setters make little adjustment in their
prices, then the other firms will make little adjustment when
their turn comes on June 1, because they also want to avoid
relative price changes. And so on.
The price level rises slowly as the result of small price
increases on the first and the fifteenth of each month.
Hence, staggering makes the price level sluggish, because no
firm wishes to be the first to post a substantial price increase.
26
Coordination Failure
Some new Keynesian economists suggest that
recessions result from a failure of
coordination.
Coordination problems can arise in the setting of
wages and prices because those who set them
must anticipate the actions of other wage and
price setters.
Union leaders negotiating wages are
concerned about the concessions other unions
will win.
27
Contd
To see how a recession could arise as a failure of
coordination, consider the following parable.
The economy is made up of two firms.
After a fall in the money supply, each firm must
decide whether to cut its price.
Each firm wants to maximize its profit, but its
profit depends not only on its pricing decision but
also on the decision made by the other firm.
If neither firm cuts its price, the amount of real
28
money (the amount of money divided by the price
level) is low, a recession ensues, and each firm
Contd
If both firms cut their price, real money balances
are high, a recession is avoided, and each firm
makes a profit of thirty dollars.
Although both firms prefer to avoid a recession,
neither can do so by its own actions.
If one firm cuts its price while the other does not,
a recession follows.
The firm making the price cut makes only five
dollars, while the other firm makes fifteen dollars.
29
Contd
The inferior outcome, in which each firm makes
fifteen dollars, is an example of a coordination
failure.
If the two firms could coordinate, they would
both cut their price and reach the preferred
outcome.
In
the real world, unlike in this parable,
coordination is often difficult because the
number of firms setting prices is large.
30
The moral of the story is that even though
Efficiency Wages
Another important part of new Keynesian economics has
been the development of new theories of unemployment.
Persistent unemployment is a puzzle for economic theory.
Normally, economists presume that an excess supply of
labor would exert a downward pressure on wages.
A reduction in wages would, in turn, reduce
unemployment by raising the quantity of labor demanded.
Hence,
according
to
standard
economic
unemployment is a self-correcting problem.
31
theory
Contd
New Keynesian economists often turn to theories of what
they call efficiency wages to explain why this marketclearing mechanism may fail.
These theories hold that high wages make workers
more productive.
The influence of wages on worker efficiency may explain
the failure of firms to cut wages despite an excess
supply of labor.
Even though a wage reduction would lower a firm's wage
bill, it would alsoif the theories are correctcause
worker productivity and the firm's profits to decline.
32
Theories about how wages affect worker productivity.
One efficiency-wage theory holds that
high wages reduce labor turnover.
By paying a high wage, a firm reduces the
frequency of quits, thereby decreasing the time
spent hiring and training new workers.
A second efficiency-wage theory holds
that the average quality of a firm's work
force depends on the wage it pays its
employees.
By paying a wage above the equilibrium level,
33
the firm may avoid this adverse selection,
Contd
A third efficiency-wage theory holds that a high
wage improves worker effort.
Workers can choose to work hard, or they can choose to
shirk and risk getting caught and fired.
The firm can raise worker effort by paying a high
wage.
The higher the wage, the greater is the cost to the
worker of getting fired.
By paying a higher wage, a firm induces more of its
34
employees not to shirk and, thus, increases their
productivity.
Policy Implications
In
new Keynesian theories recessions are
caused by some economy-wide market failure.
Thus, new Keynesian economics provides a
rationale for government intervention in the
economy, such as countercyclical monetary or
fiscal policy.
Whether
policymakers should intervene in
practice, however, is a more difficult question
that entails various political as well as
economic judgments.
35
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.
There is a core of macroeconomic principle on which all
economists agree
One principle is that there is no tradeoff between the rate
of unemployment and inflation in the long run but there is
trade off in the short run
Another principle is the idea of forward looking: thus
36
expectation matters for assessing the impact of monetary
and fiscal policies
