CHAPTER ONE

THE STATE OF MACROECONOMICS

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 Outlines

 Introduction
 Basic Concepts and Method of
Macroeconomic Analysis
 Macroeconomic goals and instruments
 Schools of thoughts

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 The State of Macroeconomics:
Introduction
 After studying this chapter, students will be able to:
Define the term macroeconomics
 Discuss the difference between macroeconomics and
microeconomics
Explain the focus areas of macroeconomics
Identify the reasons for the development of macroeconomics as a
separate subject. Differentiate between different school of thoughts
of macroeconomics
 Discuss the goals and instruments of macroeconomics
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 1.1 What macroeconomics is about?

 Economics is divided in to two major branches: Microeconomics

and Macroeconomics.
 Microeconomics
studies the behaviour of individuals and organizations (consumers,
firms) at disaggregated level
 Macroeconomics: studies the overall or aggregate behaviour of
the economy

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 Introduction Cont…

Macroeconomics is concerned with the behaviour 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 rates of inflation and
unemployment, the balance of payments and the exchange rates.

 It concerned with the structure, performance and behaviour of the

economy as a whole. It explains the overall level of a nation's output,
employment, prices, and foreign trade.

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 Introduction Cont…

The prime concern of macroeconomists is to analyse and attempt

to understand the underlying determinants of the main aggregate
trends in the economy with respect to the total output of goods
and services (GDP), unemployment, inflation and international
transactions.

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 1.1 What macroeconomics Cont…
 we do two things in Macroeconomics
 understand the economic functioning of the world we live in
 we ask if we can do anything to improve the performance of the
economy

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 1.1 What Macroeconomics Continues…
Macroeconomics is a young and imperfect science
 Macroeconomists were not generally successful in predicting the global
economic crisis of 2008
 Even after the crisis, they were unable to agree on what should be done

to deal with the crisis

Nevertheless, the importance of the subject is clearer than ever

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 1.2 Macroeconomic Goals and
Instruments
 Macroeconomics deals with such major issues like:
 Economic growth
 Inflation
Unemployment
 Foreign trade
The goals of macroeconomics emanate from the above issues and
these are;

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 1.2 Goals and Instruments: Cont…

I. Generating a high level of production of economic goods and services

for the population.
II. High employment - providing jobs
III. A stable or gently rising level of price level with prices and wages are
determined by free markets.
IV. Foreign economic relations marked by a stable foreign exchange rate
and exports more or less balancing imports.
Generally the goals can be known as follows; full employment, price
stability, economic growth, balance of payment and exchange rate
stability, equitable distribution of income.

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 Goals & Instruments: Cont..

 Macroeconomic policy instruments include monetary policy, fiscal

policy, income policy in a narrow sense.
 Consider two types of policy instruments the two “giants of the
industry” monetary (credit) policy and fiscal (budgetary) policy.
 Monetary policy: attempts to stabilise aggregate demand in the
economy by influencing the availability or price of money, i.e., the
rate of interest, in an economy

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 Goals & Instruments: Cont..

 It may be defined as a policy employing the central bank's control

of the supply of money as an instrument for achieving the
macroeconomic goals.
 Fiscal policy, on the other hand, aims at influencing aggregate
demand by altering tax expenditure-debt programme of the
government. The credit for using this kind of fiscal policy in the
1930s goes to J.M. Keynes who discredited the monetary policy
as a means of attaining some of the macroeconomic goals.

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 The State of Macroeconomics

 The Great Depression gave birth to modern macroeconomics.

The accelerating inflation in the late 1960s and early 1970s
facilitated the monetarist counter-revolution.
Economists before Keynes discussed what we now call
macroeconomic issues like business cycles, inflation,
unemployment and growth.

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 The State of Macroeconomics: Cont…

 The birth of modern macroeconomics as a coherent and

systematic approach to aggregate economic phenomena can be
traced back to the publication in February 1936 of Keynes's book
titled us The General Theory of Employment, Interest and
Money.

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 1.5 Evolution of macroeconomics
 Economic thinking has begun since the cradle of mankind
 Macroeconomics as branch was emerged with the writing of
Adam Smith “The wealth of Nation
 During this period macroeconomics was not distinct from that of
micro.
 Keynes pioneered a new approach to macroeconomics and
macroeconomic policy.
 Any discussion on macroeconomics starts with J M Keynes

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 Classical school of thought
 It is a macroeconomics idea of 1776-1936 periods. During this
time, there was no unified or formalized theory of aggregate
employment and origin of business cycle.
 The ruling principle was the invisible hand coined by Alfred
Marshall.
 The classical have made an ample contribution to the
development of economic science.

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 Classical School: Cont…
 With regard to the labour market, they contend that labour
demand and supply are brought into equilibrium by the real wage.
 As a result there is no involuntary unemployment.
 With regard to the financial market, for Classical saving and
investment are brought into equilibrium by the interest rate and
investment respond to the interest rate.

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 Classical School: Cont…

 In the money market, money demand is simply a transaction

demand and has no any effect on the real economy and 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.

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 Classical School: Cont…
 Classical economists were well aware that a capitalist market
economy could deviate from its equilibrium level of output and
employment.
 However, they believed that such disturbances would be
temporary and very short-lived.
 Classical writers gave little attention to either the factors
determining aggregate demand, or the policies to stabilize the
economy
 For the classical economists full employment was the normal
state of affairs.

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 Classical School: Cont…

But how did the classical economists reach such an optimistic

conclusion?
 In what follows we will present a „stylized‟ version of the classical
model which seeks to explain the determinants of an economy's
level of real output ( Y), real wage (W/P) and nominal wages (W),
the price level (P) and the real interest rate (r).
 In this stylized model it is assumed that:

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 Classical School: Cont…
I. All economic agents (firms and households) are rational and aim to
maximize their profits or utility; furthermore, they do not suffer from
money illusion;
II. 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;
III. All agents have perfect knowledge of market conditions and prices
before engaging in trade
IV. Trade only takes place when market-clearing prices have been
established in all markets
V. Agents have stable expectations.
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 Say’s Law
 classical however, there is no possibility of deficiency of
aggregate demand by appealing to say’s law. This law would be
stated as: supply creates its own demand.
 In other words, the act of production simultaneously creates
income and purchasing power, so there would be no impediment
to full employment caused by deficiency of aggregate demand.

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 The Keynesian Macroeconomics School(1936 –
1970)
 The main concern
 The economy is subjected to failure so that it may not achieve full
employment level. Thus, government intervention is inevitable.
 The labour market in that workers and firms bargain for a money
wage, not for real wage.

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 The Keynesian School: Cont…
The central distinguishing beliefs within the orthodox Keynesian
school can be listed as follows:
I. The economy is inherently unstable and is subject to erratic
shocks, what Keynes referred to as a change in investors‟
„animal spirits‟.
II. The economy can take a long time to return to full employment
after some disturbance; (i.e. the economy is not rapidly self-
equilibrating because of rigidities of prices.
III. The aggregate level of output and employment is determined by
effective aggregate demand .
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 Keynesian School: Cont…

IV. In the conduct of stabilization policy, fiscal as opposed to

monetary policy is generally preferred since the measures are
more direct, predictable and faster acting on aggregate demand
than those of monetary policy.

Keynes argued, economic recession happens when

businessmen lose confidence and start to think of potential
investments as risky,

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 Major assumption
 In general theory of Keynes interest rate is purely a monetary
phenomenon determined by the liquidity preference (demand
for money) of the public in conjunction with the supply of money
which is determined by monetary authorities.
 Keynesian rejects the classical notion of neutrality of money
 Rise in the general price (Inflation) is the result of increase in
nominal wage. An increase in wage causes an increase in
aggregate demand. These will cause excess demand over the
amount of output supplied resulting inflationary condition.
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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.
 basic Keynesian answer to recessions is a monetary expansion.

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 Monetarism

 Monetarism advocates of free market.

 Milton Friedman, the founder of monetarism, attacked Keynes
idea of smoothing business cycle on the ground that such active
policy is not only unnecessary but actually harmful, worsening the
very economic instability that it is supposed to correct, and should
be replaced by simple, mechanical monetary rules. This is the
doctrine that came to be known as “monetarism”.

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 Most recessions, including the huge slump that initiated the Great
Depression, did not follow Keynes’s script. That is, they 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.
 Friedman argues that people do tend to think in real terms and
not in nominal amounts.
 Monetary policy is best tool to make the economy stable

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 The New classical School
 They remained influential in the 1980s & shares many policy
views with Friedman.
 It sees the world as one, individuals act rationally in their self-
interest. The government make things worse by intervening.
 The central working assumptions of the new classical school are
three:
 Economic agents maximize. Households and firms make
optimal decisions given all available information in reaching
decisions and that those decisions are the best possible in the
circumstances in which they find themselves.
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 The New Classical: Cont…

 Markets clear. There is no reason why firms or workers would

not adjust wages or prices if that would make them better off.
Accordingly prices.
 Expectations are rational, which means they are statistically the
best predictions of the future that can be made using the available
information. Rational expectations imply that people will
eventually come to understand whatever government policy used,
and thus that it is not possible to fool most of the people all the
time or even most of the time.
 There is no possibility for involuntary unemployment.
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 The New Keynesians

 They evolved from the ideas of Keynes

 They do not believe that markets clear all the time but seek to
understand and explain exactly why markets fail.
 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 help cause macroeconomic fluctuations in
output and employment.

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 For example, in the labor market, firms that cut waged 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.
 Market-clearing models cannot explain short-run economic
fluctuations, and so they advocate models with "sticky" wages
and prices.
 Involuntary unemployment exists and monetary policy has a
strong influence on economic activity

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 The New Keynesian: Cont…
 Factors for price rigidity according to Keynes are:
Menu Costs
 To change its prices, a firm may need to send out a new
catalogue to customers, distribute new price lists to its sales staff,
or in the case of a restaurant, print new menus. These, costs of
price adjustment, called "menu costs," cause firms to adjust
prices intermittently rather than continuously.

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 The New Keynesian: Cont…
The Staggering of Prices
 The adjustment of prices throughout the economy is staggered.
Staggering can make the overall level of prices adjust slowly, even
when individual prices change frequently .
Coordination Failure
 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. Firms setting prices are mindful of
the prices other firms will charge.
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 The New Keynesian: Cont…
Efficiency Wages
 Persistent unemployment is a puzzle for economic theory.
Normally, economists presume that an excess supply of labour
would exert a downward pressure on wages. A reduction in wages
would, in turn, reduce unemployment by raising the quantity of
labour demanded. Hence, according to standard economic theory
unemployment is a self correcting problem.

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 The New Keynesian: Cont…

 There are various theories about how wages affect worker productivity.
 One efficiency-wage theory: holds that high wages reduce labour turnover.
Workers quit jobs for many reasons—to accept better positions at other firms,
to change careers, or to move to other parts of the country. •
 A second efficiency-wage theory: holds that the average quality of a firm's
work force depends on the wage it pays its employees. If a firm reduces
wages, the best employees may take jobs elsewhere, leaving the firm with less
productive employees who have fewer alternative opportunities.
 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.

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 The End

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