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Chapter One

THE STATE OF MACROECONOMICS – INTRODUCTION

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Objective:

at the end of this unit you will be able to

 Differentiate between macro and micro economics

Explain macroeconomic variables

Know macroeconomics goals and instruments

Discuss different school of thought in macro economics

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Cont..
Definition of Economics
• Economics has given different definitions by different scholars?

Some of them are

• Adam Smith defines Economics as “an inquiry in to the nature and

cause of the wealth of nation.”

• Alfred Marshall defines “Economics is the study of mankind in the

ordinary business of life; it examines that part of individual and social

action
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cont….
1.1.What Macroeconomics Is About?
• Paul A. Samuelson “Economics is the study of how the people make
choice, with or without the use of money.
• But all of them have similar message about economics i.e., Economics
is a sciences that study how human beings use the scarce) resources
so as to satisfy their unlimited wants.
• Branches of Economics
Definition :- Microeconomics: studies about a single /group of economic
agents…..a single economic variables.
Macroeconomics: studies the behavior of the economy as a whole.
What macroeconomists study ?
 Why have some countries experienced rapid growth in incomes over the past
century while others stay in poverty?
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cont...
Why do all countries experience recessions and
depressions—recurrent 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.
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.
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cont….
To appreciate the importance of macroeconomics,
you need only read the newspaper or listen to the
news.
Every day you heard a number of things about
macroeconomics such as income growth,
edevelopment Economics , investment, saving,
funds, inflation, or exchange rate ,import, export---
etc.
Therefore economics is found every where that is
there is economics when we are producing,
consuming, walking, even when we sleeping.
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cont…
 These macroeconomic events may seem
abstract, but they touch all of our lives.
Business executives forecasting the demand for
their products must guess how fast consumers’
incomes will grow.
Senior citizens living on fixed incomes wonder
how fast prices will rise.
Recent college graduates looking for jobs hope
that the economy will boom and that firms will be
hiring.
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1.2 Basic Concepts and Methods of Macroeconomics Analysis

From the methods of macroeconomics are

deductive methods; the movement from general to
particular.
inductive methods; the movement from particular to
general.
Normative economics is need to the value judgment.
Positive economics is based on facts.
Key Macroeconomic Variables are:
Output and Income
Nominal and Real GDP
 Potential output
Business cycle
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1.3.Macroeconomics Goals and

Instruments
Macroeconomics Goals:
Economic growth: sustainable long run growth of
output (GDP) in an economy.
Reducing unemployment : reducing
unemployment rate to the natural level ( mostly
5% to 6%)
Price stability: achieving low or stable inflation
(Л).mostly up to 7% is advisable.
• The major macro economic problems are: price
instability, unemployment, business cycle and
Inflation.
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1.3.2.Macroeconomics
Instruments
To achieve the above three objectives economic policy
makers of countries use macroeconomics instruments.
The most important instruments among others include
monetary policy, fiscal policy and income policy.
Fiscal Policy is a change in government purchases or in
net taxes to stabilize the economy (to achieve particular
economic goals, such as low unemployment, price
stability, and economic growth.)
Expansionary Fiscal Policy: Increases in government
expenditures and/or decreases in taxes to achieve
particular economic goals.
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Cont…
the major instruments of expansionary FP are:
 increasing the government expenditure & decease
tax.
Decreasing the public borrowing.
Fiscal policy variables : Tax (T) and government
purchase (G)
Example: a low in tax and/or a higher government
Purchase(expenditure) has expansionary effect in
output and employment.
 It cause spending to rise, and business firms able
to sell more would surely hire more workers and
produce more goods and services.
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Contractionary Fiscal Policy:

• It is Decreases in government expenditures and/or
increases in taxes to achieve macroeconomic goals.
• • A change in consumption, investment,
government purchases, or net exports can
change aggregate demand and therefore shift the
aggregate Demand (AD) curve.
• • A change in taxes can affect consumption or
investment or both.
the major instruments of contractionary FP are:
 decreasing the government expenditure &
increase tax.
increasing the public borrowing
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Monetary policy (MP)
MP is the policy of central bank to control money
supply and the interest rate or cost. MP refers to
actions taken by national banks to manipulate either
the supply of money or interest rate. It can be also
Expansionary MP: Increases in the money supply
and/or decreases in interest rate to achieve particular
economic goals.
• Contractionary MP: Decreases in the money supply
and/or increases in interest rate to achieve
macroeconomic goals. Incomes policies are policies
that control the allocation of inputs and the volume and
composition of output by directly or indirectly
controlling income shares.
Both
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of stabilization police, actions to move the economy closer

to full employment or potential output.
• Stabilization policy is difficult because there are time lags
between recognition and response to changes in the
economy, and because we simply do not know enough about
all aspects of the economy.
There are two types of lags
Inside lags
the time between the shock and recognize shock.
takes time to recognize shock
Outside lags
The time it takes for policy to affect economy.
Or it is the time between a policy action and its influence on
the economy. takes time to implement policy, especially fiscal
policy
This lag arises because policies do not immediately influence
spending, income, and employment.
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1.4 The school of thought ;

Evolution
 Macroeconomic thought has evolved over
time.
 We cannot to understand fully our modern
theories and debates if we do not understand
the past.
To understand our present we have to know
and 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.
Cont…
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• However, the studies on economic issues and

theories developed up to the industrial revolution
of the 18th century focus only on microeconomic
issues. If so, When do macroeconomics regard
as a branch of economics?
with the writing of Adam Smith(father of
economics) “The wealth of Nation” in 1776.How
many years back?245
The historical evolution of macroeconomics from
1776 to date is discussed into two broad
categories:
1- Classical macroeconomics thought
2-Keynesian macroeconomic thought
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Cont…
Macroeconomic school of thoughts
1. The classical school of though(1776-1870)
2.The neo classical school of thought (1870 - 1936)
3.The Keynesian macroeconomics (1936-1970)
4.Recent Developments in Macroeconomics (1970s –
Present)
The classical school of though(1776-1870)- Laissez
- Faire
the distinction between micro and macro was not
clear.
ruling principle was the invisible hand or laissez-faire
(free market) invented by Adam Smith
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cont.….

 Government's job should be limited to

defense its country from enemies and work
on obeying the law.
REASON; supply will create its own demand or
price set by the private sector alone will
automatically correct/equilibrate any
imbalance or disequilibria(SR and LR) without
government intervention.
 This law is called the “Says law”.
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Cont…
Adam Smith also described the government
as the necessary evil.
Hence ,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.
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Cont…
 In other words, government intervention will
distort the market rather than stabilizing.
 The classical view prevailed before the
Great Depression(1929-1933-G.C).
 Main Classical economists
• David Hume
• Adam Smith
• Thomas Malthus
• David Ricardo
• Jean ,B. Say
. However, they believed that such disturbances would
be temporary and very short-lived
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:
Classical economists assume that
1.All economic agents (firms and households) are
rational and aim to maximize their profits or utility;
furthermore, they do not suffer from money illusion;
2. All markets are perfectly competitive, so that agents
decide how much to buy and sell based on a given
set of prices, which are perfectly flexible;
3. All agents have perfect knowledge of market
conditions and prices before engaging in trade
4. Trade only takes place when market-clearing prices
have been established in all markets
5. Agents have stable expectations. 
These assumptions ensure that in the classical model,
markets, including the labor market, always clear.
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2.The Neo classical school of

thought (1870 - 1936)
The idea of the neoclassical school of
thought was not different from the
classical school.
The main distinction is the tool of
analysis, such as the marginal
analysis. 
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3.The Keynesian Macroeconomics

(1936-1970)
Macroeconomics as separate course of study
was born out of the Great Depression in the
1930s due to the work of John Maynard Keynes,
a British economist.
Keynes criticized the classical; based on the
events during the great economic depression of
the early 1930s (1929 to 1933).
For the early post-war years, the central
distinguishing beliefs within the orthodox
Keynesian school can be listed as follows.
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cont.….
The aggregate level of output and employment is
essentially determined by aggregate demand and the
authorities can intervene to influence the level of
aggregate ‘effective’ demand to ensure a more rapid
return to full employment.
In the conduct of stabilization policy, fiscal as opposed
to monetary policy is generally preferred as the effects
of fiscal policy measures are considered to be more
direct, predictable and faster acting on aggregate
demand than those of monetary policy.
 These beliefs found expression in the orthodox
Keynesian model, known as the IS–LM model.
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Keynes and Economic Policy

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.
 The way to do this is simple to print more
money, and somehow get it into circulation.
 
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cont.…
For Keynes to do about recessions, the first and most
thing to do is to make it possible for people to satisfy
their demand for more cash.  

• So the usual and basic Keynesian answer to recessions is

a monetary expansion.
But Keynes worried that even this might sometimes not be
enough, particularly if a recession had been allowed to get
out of hand and become a true depression.
Once the economy is deeply depressed, households and
especially firms may be unwilling to increase spending no
matter how much cash they have; they may simply add any
monetary expansion to their hoarding.
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cont..
Such a situation, in which monetary policy has
become ineffective, has come to be known as a
“liquidity trap”. i.e. aggregate demand, production,
and employment may be “trapped” at low levels.
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 circle
of low spending and low incomes and getting the
economy moving again.
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4.Recent Developments in
Macroeconomics (1970s – Present)
Monetarists
New classical
New Keynesian
Monetarists
Friedman was the main challenger of Keynesian .
As Friedman and his follower government never
take any kind of actions to direct and influence
employment, spending and wage. As Friedman
expansion of monetary policy leads to core
problems of inflation. Friedman argues laissez faire
government policy is more desirable than
government intervention in the economy.